China’s semiconductor industry: Strong performance year-to-date, but share prices could still rise

• Chinese semiconductor companies have done well this year, rising by more than 20% year-to-date even as the regulatory crackdown on the tech sector continues. 

• The government has identified semiconductors as one of the seven strategic technologies that China will focus on over the next five years. President Xi also appointed Vice Premier Liu He to spearhead the country’s chipmaking ambitions.

• China is starting to make good progress on its goals. Domestic IC production has increased substantially since 2018, a trend that is likely to continue as China pushes to localise chip production. 

• Our target price for the Global X China Semiconductor ETF is HKD 93, which represents an upside potential of close to 40% based on the closing price of HKD 67.14 as of 8 Nov 2021. 

Undeterred by the regulatory crackdown on the broader tech sector, Chinese chipmakers have managed to eke out gains this year, with the Global X China Semiconductor ETF (HKEX:3191) rising by more than 20% year-to-date (Figure 1).

On the other hand, the iShares Hang Seng TECH ETF (HKEX:3067) – an ETF which tracks the performance of 30 of the largest tech companies in China – has fallen by more than 25% over the same period. The decline was led by a selloff in the shares of internet companies such as Alibaba (NYSE:BABA) and Tencent (HKEX:700), a direct result of the government’s campaign that began late last year to rein in its tech giants.

Figure 1: Chinese semiconductor stocks have outperformed the broader tech sector year-to-date 

Even as the crackdown on internet companies intensified towards the middle of the year, sentiment surrounding Chinese chipmakers remained positive as the government has declared multiple times before that developing the nation’s semiconductor capabilities is one of its top priorities.

Related Article: Here’s one segment that could benefit from the crackdown on China’s Big Tech firms

At one point, the shares prices of chipmakers climbed as much as 40% year-to-date on aggregate as investors piled into the sector. However, the rally did not last for long as regulators swiftly issued a warning against speculation in share prices, which quelled investors’ optimism on the sector. 

But unlike the case of internet companies, in which regulators took further action by launching a large-scale crackdown on the sector, we believe that it is extremely unlikely that we will see similar curbs implemented on the semiconductor industry as recent polices have been nothing but supportive, and the government has not showed any signs that it has changed its stance. 

China will likely spare no expense in building up its semiconductor capabilities 

Since the US-China tech war broke out in 2018, the Chinese government has started to play a more active role than before in building up the nation’s technology sector, particularly its semiconductor industry. Semiconductors, which are the bedrock of all technology is at the forefront of the tech war as the US tightened export controls to keep the tech out of China’s hands. 

These export controls have caused considerable damage to Chinese hardware manufacturers such as Huawei, as they are unable to procure vital components from US semiconductor firms to manufacture their products. Aside from hardware manufacturers, even foundries like SMIC (HKEX:981) are also denied access to the latest manufacturing equipment such as EUV machines, hindering China’s chip ambitions.

China views this as a concerted effort by the US to undermine the nation’s development, and has vowed to vigorously support the development of its domestic semiconductor industry through various policies and initiatives as the country strives to achieve self-sufficiency in chip production. 

So far, policies that are already in place include tax incentives, such as allowing semiconductor companies to pay less, or even no taxes should they meet certain criteria, and the establishment of a national fund to help promote the growth of the local semiconductor industry.

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

This year, the government has continued to step up its support for the chip industry. For instance, China’s 14th Five-Year Plan (2021-2025), a series of social and economic development initiatives released in March, has identified semiconductors as an independent category, one of the seven strategic technologies that China plans to focus on over the next five years (Table 1).

Unlike the previous Five-Year Plan which ran from 2016 to 2020, the development of its domestic semiconductor capabilities was not explicitly identified as a priority. Instead, it was seen as just a part of China’s broader plan to build up its tech sector. The changes in the latest Five-Year Plan demonstrates that China recognises the importance of this sector, and is likely to prioritise its growth going forward.  

Figure 2: Semiconductors are one of the seven strategic technologies China plans to focus on

Source: State Council of the PRC

In a further show of support for China’s chip ambitions, Chinese president Xi Jinping has appointed his right hand man – Vice Premier Liu He – to spearhead China’s chipmaking ambitions. Liu will oversee the development of China’s semiconductor industry, including the formulation of industrial and financial policies for the sector. 

The appointment of such a high ranking official sends a clear message to the world that China’s plans are not just tall talk, but instead, the country is dead serious on following through with its plans.

Even academia is pitching in, with a number of prestigious universities such as TsingHua (清华大学) establishing new schools dedicated to the field of semiconductors. This comes as China’s Ministry of Education has designated semiconductor science as a priority academic program in a bid to address the shortage of local talent as China works towards achieving its goal of self-sufficiency in chip production.  

All in all, these policies and initiatives demonstrate that China is fully committed to building up its semiconductor capabilities, and it will spare no expense in doing so. 

Domestic IC production has increased substantially 

Although China is still ways away from becoming entirely self-sufficient, there are promising signs that it is starting to make progress already. Since the tech war started, domestic IC production has increased substantially, thanks to the growing demand from local companies and an increase in production capacity. 

As of September 2021, China’s IC output stood at 30.4 billion units, slightly below the record high of 32.1 billion units produced in August (Figure 3). This figure represents a year-on-year growth rate of nearly 30%. But even with output near an all-time high, domestic production alone remains insufficient to meet the roaring demand. 

Figure 3: China’s IC output has increased substantially since the tech war started

China, along with Taiwan, leads the way in terms of new fab construction, with both markets expected to break ground on eight new fabs each between 2021 and 2022. The number of new fab starts for China far outpaces other markets like the US and South Korea, a trend that is expected to continue as China pushes to localise chip production (Figure 4).

Figure 4: China leads the way in new fab starts

SMIC, China’s largest and most advanced foundry, is involved in a number of these projects. Earlier in September, the company announced that it has entered into a joint venture with the Shanghai Municipal People’s Government to build a USD 9 billion fab in the city’s free trade zone. The new fab is expected to have a production capacity of 100,000 12-inch wafers per month.

Besides this, SMIC also has two other fabs that are currently under construction: one in Beijing, which has a similar capacity as the one in Shanghai, and another one in Shenzhen, with a smaller capacity of 40,000-12 inch wafers per month. Both fabs are expected to be operational in 2024 and 2022 respectively. 

We are confident that China’s IC output will continue to increase over the next decade as more capital is injected into the sector and productivity levels increase. During this period, Chinese semiconductor companies across the entire supply chain should benefit from the industry’s growth. 

Expect further upside from Chinese chipmakers 

Based on a fair PE ratio of 35X, our target price for the Global X China Semiconductor ETF (HKEX:3191) is HKD 93. This translates to an upside potential of close to 40% based on the last traded price of HKD 67.14 as of 8 Nov 2021. 

Table 1: Expect strong earnings growth from chipmakers

Right now, the biggest challenge facing China’s chip industry is US sanctions (something that we have already factored into our valuations), which we think is one of the key reasons why share prices have not yet re-rated. That being said, the lifting of these sanctions is a potential catalyst that could drive share prices even higher. 

While China is still years away from achieving its goals, it is making good progress in doing so. Thanks to the pressure from the US, China now has more motivation than before to build up its semiconductor capabilities. This would likely lead to more opportunities and greater earnings growth for its domestic chipmakers.

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 and the Global X China Semiconductor ETF.

The Research Team is part of iFAST Financial Pte Ltd.