2019-05-31


Author: Eric (Tianli) Wen, Head of Research

For past Pilgrimage publications, please contact BLRI sales (sales@blue-lotus.cn)

Stocks mentioned in this email BABA, YRD, TIGR, BZUN, HMI, 1870 HK, BILI, WB, 700 HK, 3980 HK, NTES, 1569 HK, 1317 HK, TME, MOMO, CTRP, BITA, ATHM, BIDU, SECO
Happy Memorial Day (The Festival of the Dead of America)!
For two countries destined for a fight of supremacy, Chinese ADR’s seems to be an ultimate oddity. We know that in WWII, German assets in US were confiscated. In 2014, when Chinese ADR’s were rushing to delist from the US and relist in China for higher valuations, I thought I would be out of a job. Thank god that didn’t happen because to delist these ADR’s, after multiplying many times since IPO, required a very big pile of cash, so big that it would have materially impacted China’s foreign reserve. I don’t know if the reason that stopped the crazy Chinese last time will stop the crazy Americans this time. I do know that if I were the Chinese government, I would order these ADR’s to repatriate their cash balance home so that they would have zero probability to use these cash to delist themselves from the US stock exchanges.  Already some people are asking to shut down Chinese companies access to US capital markets (https://www.publicwire.com/mark-cuban-schools-trump-ban-chinese-companies-from-trading-in-the-us-instead-of-imposing-tariffs-on-chinese-goods/). I hope I will not be worrying about my job again.

I have not conceded defeat, as yet
Our original predictions were: (1) A deal will be stricken in C3Q19, the reason being the US side will be itching to see how far a Round Two of trade war can go, and the Chinese will be offering terms that the US will not get even after a successful Round Two to close an early deal, (2) The fight between China and US will go on forever (but a temporary truce is needed for both sides).

It seems we have to postpone our prediction by one quarter. We now predict Trump will reach a trade deal with China in C4Q19, so that the trade war will not be lingering into the election year and becoming a liability. Now I don’t claim to know US politics. But if it becomes that extending the trade war into an election year is welcomed by American public, I will be indeed very worried. Because that is simply too stupid to be true.

 Of course a deal neither party has the intention to oblige is not that much a deal. But China has strong, perhaps stronger, reasons to close a deal too. China needs a stable trade environment to carry out its structural reforms in tax, social security and medical care, as we wrote before. China is in a weaker position than the US, but in the matter of war, a weak position doesn’t mean a weak hand, as numerous precedents have shown.

Chinas Sputnik Moment helps structural reform
Apparently a trade war serves domestic agenda for both countries. For US, escalation of the trade war provides the backdrop for ushering in a technology war. China, on the other hand, welcomes with both hands since it accelerates the technology development. The technology war strengthens the argument of the conservative elements of Chinese government regarding the importance of technology self-reliance, errs the policies of Deng Xiaoping era to be selling the country short. Under the policies of Deng and his successors, China ceded the control of technology standards in operating system, Internet, GPS, to name a few, to the US. Now the US is using these standards to strangle China’s national champion. If the technology war goes much deeper, a wholesale backlash on Deng Xiaoping’s legacy in Chinese history will be in order. I believe Deng Xiaoping now yearns to crawl out of his coffin.

Of course, we have outlined many times that a Sputnik Moment for Chinese technology is good for us, because it spawns more companies.

A nasty divorce but a few years later, both end up well
We make this analogy that US and China are a couple undergoing a nasty divorce. China, being the wife, thinks she can strike on her own. US, being the husband, is throwing the roadblocks because he controls the cheque book. When all is settled the US and China each will end up owning a separate set of everything, which translates to more demands for everything.

This analogy doesn’t answer well in regards to Chinese ADR’s trading in the US, which a analogous to a divorced couple still keeping a child at one’s custody. One can hurt the other by hurting the child, but one also hurts himself. One way to prevent US from being hurt is to ban technology oriented Chinese ADR’s from access the US capital markets. This, for now, doesn’t seem to be an issue as technology oriented Chinese companies don’t come to the US anyway because Chinese government bans them to come. Perhaps the most “technology” company among Chinese ADR’s is Alibaba (BABA US, BUY, US$200). It is not clear how BABA will be harassed by US government in the upcoming quarters but at least Jack Ma made no mention of his semiconductor startup, Pingtouge, this time. Maybe he wants to keep a low profile but he also raised the possibility to have BABA dual-listed in HK. For ADR’s other than BABA, as long as they stay within the boundary of media, entertainment and consumer, the US government will likely leave them alone, in our opinion.

Cloud Computing is where China can break USs technology hegemony
In the short term, AliCloud will benefit from US’s flex of muscles. Business continuity has just been given a new definition with US cutting off the air supply of Huawei. Numerous Chinese SOE’s, especially banks, use IBM solutions, Oracle databases, EMC storage and Intel servers. All of a sudden they all feel at risk. There is only one solution: migrating to the cloud. AliCloud is now leading the Asian market in cloud and is not hindered in purchasing US technologies (mostly Intel server chips), making it a leg up against Huawei. Amazon AWS and Microsoft Azure will likely be further restricted in China, imagining someday US export control requiring Amazon AWS to deny service to PetroChina.

In the long run, cloud computing atomizes the building block of IT down to foundry and open source software. This is good to break US technology hegemony, in our view. China’s foundry is already zero in onto TSMC (TSM US, NR). Huawei even used ARM technology (Huawei has the permanent license of ARM V8 while V9, due 2011, will not be revolutionary) to design its own server chip to replace Intel. But a recent news from GitHub and Apache stating that open source codes on these two platforms were also subject to US export control rocked the tech world (https://help.github.com/en/articles/github-and-export-controls). Even though the interpretation of this notice varies, it probably means China’s path of future software advancement will be blocked. This week IEEE removed Huawei scientists from its review board, suggesting that some elements of US is determined to fight a total warfare against China. China hasn’t fight back yet but it doesn’t mean it cannot, effortlessly, imaging:

  1. To counter Google’s sanction of Huawei, even though Google doesn’t operate in China, China can encourage exporters to switch advertising on Google to advertise on Facebook. In 2018, Google derived US$3bn worth of revenues from China, mostly from Chinese exporters advertising on Google US properties;
  2. To counter Intel’s sanction of Huawei, despite Intel has extensive investment in China, China can encourage more use of AMD chips than Intel chips, within Chinese companies;
We just had an expert call with some local experts regarding the Huawei situation, most of whom expressed optimism of Huawei incident as a catalyst to engineer a migration of technology ecosystem away from the US and into China. We have said before that the outcome of the US-China trade war will depend on the speed of (1) Global supply chain moving out of China and (2) China climbing the technology ladder. There are respective pros and cons for both processes to happen. But the Huawei incident successfully galvanized the Chinese about the necessity of (2) and put them into action. This is a great disfavour to the Americans, in our view. Cloud computing provides the vehicle for technology ecosystem to migrate from US to China and along the way, migrate in a more advanced form.

We stay optimistic because to exercise export control, the US must be able to police. Currently the US has multiple points to police, including (1) Android OS, (2) certain semiconductors (analog semiconductors, passive components, FPGA, RF, GPU, CPU, semiconductor equipment, etc.), (3) US-based standard bodies (WiFi, SD Associations), (4) US-based open source platforms, and (5) US-based education institutions. Some of these policing points will be chipped away in the next 6-18 months but in the long run the ultimate US strength lies in its colleges. (1) Huawei already announced it would launch its own mobile OS in C3Q19.

(https://www.dailymail.co.uk/news/article-7058261/Huawei-executive-says-company-launch-operating-months.html); (2) Grand Canyon’s acquisition of GPU technology from Imagination Technologies might help lessen Huawei’s reliance on ARM; (3) China-based fabless firms like Vanchip, recently acquired by MTK (2454 TW, NR), might step up to offer RF components to replace products from Qorvo (QRVO US, NR), Murata (6981 JP, NR) and Skyworks (SKWS US, NR); (4) technology advances render old technology, like PC and soon mobile, obsolete and therefore unenforceable. It looks like outside of semiconductor equipment, FPGA and analog semiconductors the US will run out of enforceable points quite soon. While it doesn’t mean the embargo will NOT be effective, it does mean the incentive to break the entire blockade will be concentrated on a handful of firms, making the policing more difficult, in our opinion.

Here is a short list we complied that might rise to meet the call to supply Huawei. We also need to remind investors that because Huawei develops its own semiconductor used in its own devices, it can use workarounds in designing its products. Huawei smartphone can test with Huawei base stations six month before the rollout. So technically Huawei’s in-house components do not need to be as good as outside suppliers to meet the selling requirements.



We notice that several ethnic Chinese have risen to the posts of CEO in their firms, indicating the bench depth of ethnic Chinese in this industry can form a solid foundation for semiconductor technology to migrate to China.  CEO’s or founders of AMD, Broadcom, nVidia and Xilinx are ethnic Chinese. Historically ethnic Chinese also founded Atmel, ATI, Cadence, Lam and Trident. This bench depth is even more pronounced if we consider the industry statues of companies in Taiwan. If Huawei uses its plight as a lightning rod for the global Chinese to build a semiconductor supply chain in China, the chance for success is substantial. Similar situations existed in the nuclear and ballistic technologies in the 1950’s.

From Incheon to Chosin Reservoir to Triangle Hill
US and China fought a war in Korea between 1950-53. The governments that fought this war are still in place today. So we believe it pays to study the history of conflict between these two countries and two governments.

When North Korea crossed the 38th parallel in June 25, 1950, about 1/3 to 1/2 of its troop were actually Chinese, or more precisely, were ex-soldiers of the People’s Liberation Army (PLA). Mao Zedong gave Kim Il-sung three ethnic Korean PLA Divisions to form the backbone of Korea People’s Army (KPA), with the remaining supplied by the Soviets. During the Japanese occupation of Korea (1910-1945) numerous Koreans exiled to China, forming a provisional government sponsored by China’s Nationalist government (Taiwan), as well as joining guerrillas force under the Chinese Communist Party (CCP). Unfortunately the Nationalist government lost China to the Communist. Exiled Korea provisional government, perhaps the most legitimate contender for power after WWII, lost its support. Its leader Kim Koo was assassinated by a lieutenant of the South Korean Army in June 1945. The Russians chosen Kim Il-sung because he was easier to control.

So president Trump’s launching the surprise trade war on China in July, 2018 = General McArthur’s landing in Incheon in September 1950. The Americans surprised the Chinese. Many months after the attack the Chinese society was still in disbelief.

After Incheon, McArthur, being himself, did not pursue the KPA then attacking the US 8th Army in the south port of Busan. He was preoccupied with occupying Seoul and therefore let the KPA regroup and retreat in Seoul. The Battle of Seoul was mainly fought by the Chinese Korean troops. McArthur successfully captured Seoul and Pyongyang but then met the Chinese People’s Volunteer Army (PVA) at the Chosin Reservoir. At the Chosin Reservoir, three divisions of the US X Corps encountered twelve PVA divisions which eventually led to a casualty of 17,843 on the US side and 48,156 on the China side  (https://en.wikipedia.org/wiki/Battle_of_Chosin_Reservoir). The US ordered a full scale retreat and abandoned Seoul after the Battle of Chosin Reservoir.

So President Xi’s refusal to sign the trade deal in May 10, 2019=Chinese PVA surrounded the US X Corps in the Chosin Reservoir in November 1950. The Chinese surprised the Americans. It was rumoured that President Xi was a big fan of the Battle of the Chosin Reservoir.

After the Americans and the Chinese took turns to surprise each other , they entered into a year of manoeuvring warfare and started a peace negotiation in July 1951, less than one year after entering into the war. Yet it took two more years to conclude the peace treaty in Panmonjom in July 1953, during which time the two sides fought continuously to gain advantage in battle field and negotiation table.

But the upside is that once the deal is concluded, it was followed by 66 years of peace, until today.


Figure 1 General McArthur prepared to land in Incheon   Figure 1 Three PLA Companies reportedly frozen to death at their ambush positions
 
Source: Google   Source: Google

A particularly savage battle near the conclusion of the peace treaty was fought at the Triangle Hill in October, 1952. Coded named Operation Showdown to show the US resolve, this operation picked a petty village in front of the PVA’s main defence line in Osongsan to be its theatre. General James Van Fleet picked Triangle Hill because it can maximize the US advantage in fire power. According to Wiki, “the goal of the submitted plans was to improve the defensive line of the US 7th Infantry Division north of Gimhwa near Triangle Hill, pushing the PVA defensive line back 1,250 yd (1,140 m)”. Further, “UN planners expected the operation to last no more than five days with 200 casualties on the UN side, based on the assumption that maximum artillery and air support would be available”. So, 5 days, 200 casualties, advance 1km. This is a battle fought for the bargaining table.

Yet this battle did not finish easily. Perhaps being the reason for its chosen, on the opposite side were three PVA Companies of the 45th Division of the 15th Corps, a relative weak unit of the PVA. The PVA has deployed a weak column at Triangle Hill because it believed the main UN offensive would be from another direction. Yet it was the soldiers of this so-so rated 15th Corps withstood the initial assault of the UN forces, eventually led to a casualty of 5,000 by UN count and 25,000 by Chinese count. After the war, General Qin Jiwei of the 15th Corps was promoted, eventually to the rank of Defence Minister (1988-1993). The so-so rated 15th Corps was selected to become China’s first airborne corps to glorify 15th Corps’ unexpected heroic endeavours at the Battle of Triangle Hill.

Today, Huawei=15th Corps and will bring the Americans to their senses. Will it succeed?