Sanctions Threaten to Shoot Down China’s Spyware Star

(Bloomberg Opinion) -- Hangzhou Hikvision Digital Technology Co. is a rare example of a Chinese national champion that's also become a global leader. But the very ties to China's surveillance state that powered the company's rise now threaten to check its progress.

Hikvision's footprint has grown in tandem with China's political agenda. Its cameras dot the western region of Xinjiang, where the government has greatly expanded its security apparatus and faces accusations of human rights abuses. The U.S. is now considering sanctions against companies and Chinese officials over Beijing's detention of thousands of ethnic Uighurs and other Muslim minorities in internment camps, the New York Times reported Sept. 10, citing American officials. It's already banned government agencies from buying Hikvision products. The company's shares tanked 8 percent in Shenzhen last week, bringing their decline this year to 29 percent.

That's interrupted a spectacular rise for Hikvision, which is based in Hangzhou, the eastern city that's also home to U.S.-listed internet giant Alibaba Group Holding Ltd. The company's spy-tech wares have spread across the globe, from London and Memphis to Canberra, sending its shares up fourfold in two years by the time they peaked in March.

For the foreign investors that helped drive that rally, Hikvision's numbers offer plenty to like. Return on equity has hovered around 34 percent for the past couple of years, while margins are north of 20 percent. The company commands almost 40 percent of the surveillance market in China and 11 percent globally, ranking it among the world's biggest.

Hikvision's products are found in homes; its Hikrobots are used in factories; the company's industrial drones hover above us; and its cameras look down on street corners across the world. Revenue for the company's smart-home segment, which includes fingerprint locks, climbed 60 percent in the first half. With access to a wealth of data, the company is also developing artificial intelligence for use in cars, homes and warehouses.

Surveillance gear is one area of technology where China is leading the world: Local companies making such equipment have applied for five times the number of patents of their U.S. peers.

Deemed a key national software enterprise, Hikvision enjoys a preferential corporate tax rate of 10 percent to 15 percent, versus the standard 25 percent. It's also a recipient of China's Innovation Company, or InnoCom, program, which hands out fiscal incentives to companies that meet requirements on parameters such as the percentage of R&D employees with college degrees.

The government has given the company thousands of square kilometers of land for its headquarters and facilities in Hangzhou. These forms of subsidies far outweigh the tax savings on R&D that are commonly available elsewhere in the world.

Hikvision does have other options for expansion in the event that it's shut out of developed markets, with management citing Latin America, Russia and India to analysts at a briefing in July.

The company also has room to grow further at home. Several mega-cities with populations greater than 30 million “might arise in China in the near future, which calls for more advanced video surveillance solutions,” as analysts at Nomura Holdings Inc. note.

While the company can count on government backing, the nature of its ties is vague. About 40 percent of Hikvision is held by firms connected to the state. In monetary terms, government-related gains account for a fifth of net income. That doesn't include other privileges such as the winning of government contracts. 

Support could wane if shrinking fiscal coffers force Beijing to pull back spending. The cost of its pursuit of technological dominance is high: A recent study of the InnoCom program found that doubling research and development investment would cost the government 36.9 percent of corporate tax revenue.

Investors who decide that surveillance can only grow should also remember the stream of adverse news for the spy-gear maker is unlikely to disappear. Betting on the ever-expanding hold of China's Big Brother may not be a sure thing.

To contact the editor responsible for this story: Matthew Brooker at mbrooker1@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Anjani Trivedi is a Bloomberg Opinion columnist covering industrial companies in Asia. She previously worked for the Wall Street Journal.

©2018 Bloomberg L.P.