Finisar’s Earnings Warning: Bad News for China?

Inflation in Asia has been driven primarily by rising food prices. We expect inflation in Asia to peak mid-year as weather patterns return to normal and food prices stabilize.

– Yiannis Mostrous, Global Investment Strategist

Yesterday (Mar. 9^th), fiber-optic telecom equipment manufacturer Finisar (NasdaqGS: FNSR) collapsed 38.5% on unexpectedly low revenue and earnings guidance for its fiscal fourth quarter ending April 30, 2011. You may not own Finisar, but its importance far exceeds its puny $1.9 billion market cap. If you own Chinese stocks, then you should care about Finisar because the company derives 25% of its revenues from China. The company’s financial performance could be viewed as a leading indicator for the Chinese economy. Executive Chairman Jerry Rawls explained the China slowdown this way in the conference call:

I don’t know how to explain it other than we’ve now seen it for, oh I don’t know, a couple of months in terms of reduced order rates. Expected orders and capacity demands that we had forecast at the end of last year that would occur going into 2011 all of a sudden have been reduced dramatically.

Could Finisar’s financial woes signify an economic slowdown for China? Since 2010, the Chinese central bank has increased bank reserve ratio requirements eight times to its current level of 19.5%, one of the highest reserve ratios in the world. It has also hiked its one-year lending rate three times to its current 6.06% level. The reason for the hikes is to control inflation; in January, non-food inflation rose at its fastest pace in more than a decade. But the risk is that the central bank overshoots and slows the Chinese economy down too much.

China Places Strategic Importance on Telecommunications

Finisar’s earnings warning may be an indication that an overshoot has occurred because the Chinese have identified next-generation telecommunications as one of the country’s four “pillar” industries. This past November, The U.S.-China Economic and Security Review Commission issued its annual report to Congress and discussed the importance China places on developing its telecommunications infrastructure (pp. 221, 225):

In 2010, China continued its sustained, high-level rate of investment in information and communications technology. China has the most Internet users in the world, reaching 420 million by mid-2010 — including 364 million with broadband connections. Cellular telephone adoption rates have increased in kind, with over 800 million subscribers by midyear, including 25.2 million users with web browsing capable third generation service.

China has also made substantial progress with respect to computer-related hardware used in advanced computing systems. For example, a Chinese supercomputer recently ranked as the fastest in the world, marking the first time a Chinese machine surpassed the most powerful U.S. supercomputer.

The rapid, nationwide expansion of Internet and mobile penetration is a strategic priority for China. This is in part due to the recognition that the development of a vibrant indigenous Internet and telecommunications sector is critical for China’s long-term global economic competitiveness.

At the same time, those involved with the Internet in China are fully expected to support and reinforce domestic political stability and to ensure that the Internet and communications technologies will not be used in a manner that threatens Communist Party rule.

Surely China’s government would not “dramatically” (to use Finisar’s description) slow down telecommunications infrastructure spending voluntarily given its strategic importance? Consequently, any telecommunications slowdown must be involuntary and signify problems for the Chinese economy, right?

Chinese Suppression of Political Dissent

Wrong. Don’t forget that the Chinese government is a communist dictatorship that murdered hundreds, if not thousands, of its own citizens during the 1989 Tiananmen Square democracy protests and would not hesitate to do so again. The recent political unrest in the Middle East has the Communist regime worried and, consequently, it is cracking down on dissent even more than usual.

Besides the usual persecution of dissidents, another way to hurt the pro-democracy movement is to slow down communications capabilities. Is it just a coincidence that Finisar experienced a dramatic reduction in Chinese orders for its communications equipment right around the time that Egypt and Libya’s political systems were blowing up? I don’t think so.

Finisar’s largest customer in China is Huawei Technologies, the second-largest telecommunications equipment provider in the world. Huawei’s CEO is a former member of the Chinese military and several members of Congress accuse Huawei of “having ties with the People’s Liberation Army, the Taliban, and the Iranian Revolutionary Guard.” Huawei claims to be a private company, but it does what the Chinese Communists tell it to do. If the government told it to slow down communications equipment orders to quell political dissent, Huawei would comply.

Chinese Industrial Espionage

Chinese companies are also famous for partnering with U.S. companies only for as long as it takes to steal their technology. Perhaps Huawei is cutting off Finisar because it has been able to “reverse engineer” Finisar’s products and doesn’t need Finisar’s technological know-how any more. As one expert on Chinese industrial espionage puts it:

China‘s regular practice is to allow firms into China for the express purpose of ripping off their propriety technology and feeding it to their Chinese competitors.

They don’t have any respect for international property rights. Once they gain a technology, they use it to reverse engineer it or copy it and then take it and use it to promote a Chinese-owned company.

Bottom line: there are many reasons Finisar’s business in China could be hurting that have nothing to do with an economic slowdown.

Look Beyond Chinese Telecommunications

Even if the Communists are clamping down on telecommunications, they are going full-steam ahead spending tens of billions of dollars in other industry sectors, namely low-income housing construction and high-speed rail service. Investing in suppliers to China’s housing and railroad industries may be among the best ways to take advantage of continued growth in China’s centrally-planned economy.

Find the Best Chinese Stocks with the Help of Global Investment Strategist

Yiannis Mostrous, editor of the market-beating Global Investment Strategist investment service, has told his subscribers that investor worries about a Chinese economic slowdown are overblown:

Valuations are decreasing while the region’s strong fundamentals remain intact, this will result in attractive entry points to Asian markets this year. The Chinese market, an all-important bellwether for the region, is beginning to offer favorable entry points in several sectors, particularly for banking stocks. Farsighted investors will seize upon these opportunities in 2011.

In fact, China is one of Yiannis’ favorite emerging markets and he has provided subscribers with his favorite industry sectors within China’s economy (hint: telecommunications is not one of them). To find out which Chinese stocks and industry sectors Yiannis likes best right now, give Global Investment Strategist a try today!