Investors betting on the growth of China’s semiconductor industry should not overlook this company

Image Credits: CGTN

• SMIC is the largest and most advanced foundry in Mainland China. Despite the pandemic and sanctions from the US, the company’s revenue rose by 28% in 2020. 

• As China’s leading foundry, SMIC is in the best position to capitalise on the rising domestic demand as local fabless companies start shifting orders back to domestic foundries. 

• A massive amount of state funding and preferential tax treatments should spur the company’s next leg of growth. 

• Our target price for SMIC is HKD 32, which represents an upside potential of close to 28%.

When it comes to semiconductor manufacturing, most people will think of places like Taiwan and South Korea, both of which are home to some of the world’s largest chipmakers such as TSMC (NYSE:TSM), Samsung and SK Hynix. 

Only a handful of people are familiar with the name Semiconductor Manufacturing International Corporation (SMIC), a mid-sized pure-play foundry based in Mainland China. But with the Chinese government announcing big plans to develop its semiconductor industry, we think that it is time investors paid more attention to SMIC (HKEX:981), the company that lies at the heart of China’s chip-making ambitions. 

Related Article: China’s semiconductor industry: A sleeping giant that has been awakened

Largest and most advanced foundry in Mainland China

Founded in the year 2000, SMIC is Mainland China’s largest and most advanced foundry. It operates a total of six fabs, providing foundry services not just for domestic clients, such as Huawei, but also foreign customers, such as US-listed Qualcomm (NASDAQ:QCOM). 

With respect to manufacturing technology, SMIC has made significant progress in the recent years. In 2019, the company announced that its first advanced node – the 14nm process – has entered volume production and is ramping up well. 

As of today, the company has already commenced small-scale trial production for its next generation node, which it dubs N+1. The N+1 node has similar features to the 7nm process technology from other foundries, but its production does not require the use of extreme ultraviolet lithography (EUV) machines, which SMIC is currently banned from purchasing. 

Even though it is the largest chipmaker in China, the company has a relatively small presence in the global foundry market, with a market share of just 5%. However, we believe that SMIC has plenty of opportunities to grow its market share, especially at a time when China is determined to build up its semiconductor capabilities while global chip demand continues to rise. 

Despite the negative impact caused by the pandemic and the sanctions from the US, SMIC ended the year strong. In 2020, the company’s revenue was just shy of USD 4 billion, which marks an increase of 28% over the previous year (Figure 1).

Figure 1: SMIC managed to deliver its highest ever revenue despite a rough 2020

The record high revenue achieved in 2020 was largely due to the unprecedented surge in customer orders, as the stay-at-home economy resulted in heavy demand for semiconductors. Although SMIC has consistently added capacity throughout the year and maintained utilisation rates at a high level, it was still unable to keep up with the growing demands of its customers (Figure 2). 

Figure 2: SMIC increased its capacity by more than 16% across 2020

Looking forward, we think that SMIC should continue to deliver strong revenue growth, driven by China’s push to localise chip production together with an increase in domestic demand.

Rising domestic demand benefits SMIC

Despite being the largest global producer of electronic gadgets in the world, domestic production only accounts for roughly 20-30% of all the semiconductors China requires each year. The remaining demand is fulfilled by importing from other countries, mainly the US. 

Last year, China’s chip imports reached a record high of approximately USD 380 billion, a number that has been increasing every year as global demand for electronics continues to rise (Figure 3). 

Figure 3: China imported close to USD 400 billion worth of semiconductors last year

However, with the US constantly threatening to cut off China’s access to these critical components, Chinese fabless companies now realise that they can no longer safely rely on imports, and will eventually have to start shifting orders back to domestic foundries to meet their semiconductor needs.

The massive amount of chips that Chinese companies import each year is a tremendous market opportunity for its local chipmakers, especially SMIC. This is because the majority of China’s chip imports consists of high-end chips, which most, if not all of the other Chinese chipmakers are unable to produce at this point in time. 

As China’s leading foundry, we believe that SMIC is in the best position to capitalise on the rising domestic demand as it continues to expand capacity and improves its manufacturing capabilities. If SMIC is able to supply just 1% of China’s total chip imports in 2020, its revenue could double.

As a matter of fact, the percentage of SMIC’s total revenue coming from Mainland China has started to inch upwards in the recent years (Figure 4), a trend which we think should continue thanks to the greater domestic demand and the government’s push to localise chip production.

Figure 4: The percentage of revenue coming from Mainland China should continue to rise

Supportive government policies to localise chip production may add to future growth 

Although the idea to localise chip production was first mentioned as early as 2014, it was only until recently when the government started making arrangements to do so. As part of the “Made in China 2025” plan, China aims to produce 70% of all the semiconductors it requires by 2025, with a longer term goal of becoming completely self-sufficient.

To achieve this goal, the government has laid out several policies. The first is to establish a national fund (China Integrated Circuit Industry Investment Fund) to help promote the growth of the local semiconductor industry. 

The fund, which was first set up in 2014, has invested close to CNY 350 billion in various projects and companies within China’s semiconductor industry to-date. It is estimated that roughly 67% of the monies went to manufacturing firms, which includes both integrated device manufacturers and foundries (Figure 5).

Figure 5: China’s national fund made huge investments in the chip manufacturing space

SMIC has been a recipient of the fund’s monies on several occasions, either through direct investment or in the form of joint ventures. In 2015, the fund made its first investment in SMIC, snapping up 4.7 billion new shares for a total consideration of close to HKD 3.1 billion. More recently, it entered into a joint venture with the company, contributing USD 1.2 billion to build a 12-inch fab in Beijing.

Secondly, the government has also made significant adjustments to its tax policies last year. Under the new policy, chipmakers that have been in operation for more than 15 years and produce chips using a 28nm and below process will be exempted from corporate income taxes for up to 10 years (Table 1).

Table 1: Summary of the major tax policy changes for semiconductor companies

This means that SMIC, which meets the criteria stated above, qualifies for the preferential tax treatment. With a lower tax burden, SMIC should have more resources for capital expenditure as well as research and development, which should allow it to improve its technological capabilities quicker, enabling the company to grow at a faster pace. 

Key investment risks

One of the biggest risks SMIC is facing right now is the potential tightening of export controls by the US. Currently, the company is prohibited from purchasing advanced manufacturing equipment (e.g. EUV machines) that is essential for producing 10nm and below chips. 

This has proven to be a major hurdle for the SMIC, hindering its progress as it tries to move up the technology ladder. In the event that the restrictions are extended to cover older equipment as well, SMIC could face significant disruptions to its operations. 

On the other hand, should these restrictions be removed, or if China’s equipment makers are able to produce advanced manufacturing equipment, SMIC’s share price could experience a significant upward re-rating.

Strong balance sheet and undemanding valuations  

Compared to its peers, SMIC has a much healthier balance sheet, boasting a net debt-to-equity ratio of -39.6% (Table 2). Because chip-making is a capital intensive industry, maintaining a low debt level is advantageous as it gives a company more headroom to raise funds in the future. This is particularly important in the case of SMIC as it plans to continually expand capacity in order to meet the growing domestic demand.

Table 2: SMIC has the lowest net debt-to-equity ratio among its peers

Based on a fair PE ratio of 32X, we arrive at a target price of HKD 32 for SMIC (HKEX:981). This translates to an upside potential of approximately 28% (Table 3). 

Table 3: Higher expected earnings growth driven by rising domestic demand and capacity expansion 

A key assumption regarding our valuations is that SMIC will continue to be subjected to US export restrictions for the foreseeable future. Thus, in the event that the sanctions are lifted, SMIC could experience a significant upward re-rating in its share price, driven by better earnings growth numbers as well as multiple expansion. 

All in all, we think that investors should not be overly concerned about the negative impact caused by the sanctions. Taking into account the rising domestic demand and extensive state support, we think that SMIC (HKEX:981) is in a good position to benefit from the rapid development of China’s semiconductor industry. 

For investors who are betting on the growth of China’s semiconductor industry, SMIC is certainly a company worth looking at. Alternatively, you may also consider the Global X China Semiconductor ETF (HKEX:3191) should you prefer a more diversified approach. 

Figure 6: In the long run, share prices are driven by earnings

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) holds a NIL position in the abovementioned securities. The analyst who produced this report holds a position SMIC.

The Research Team is part of iFAST Financial Pte Ltd.