The country's 14th Five-Year Plan highlights the need to develop its semiconductor industry.
Suffering from the US-initiated restrictions, Semiconductor Manufacturing International Corporation (SMIC, 00981:HK) is prohibited from utilizing software and hardware tools with a certain degree of American technology. This limits the largest mainland-based semiconductor foundry's capability to go beyond 14 nm.
As of 2020, China accounted for around one-third of global semiconductor demand, but the country can only produce nearly 10% of this volume locally. The key dilemma for SMIC and the country's entire chipmaking domain now is whether to strive for building a profitable, optimized business or for catching up with the leading-edge technology.
Pouring capital into R&D – with mixed results
SMIC has been dedicated to chasing up the leading-edge technology by increasing its R&D expenses in recent years. In 2016, SMIC's R&D spending was USD 371 million, accounting for 12.72% of its revenue. By 2019 R&D expenses had risen to USD 687 million – or 22.06% of revenue. The significant increase in R&D budget and capital expenditure indicate the company was trying to catch up with the technology lag and the increasing demand for foundry capacity in China. Its gross margin, however, plunged from 29.2% in 2016 to 23.6% in 2020. The company's revenue grew by 25.39% in 2020, hitting USD 3.91 billion. Specifically, SMIC launched its 14 nm in 2019 but the proportion of 28/14 nm in 2020 only reached 9% of its total outputs.
Chips shortage across all nodes
The increasing penetration of new technologies across industries and the growing popularity of gadgets among global users are driving demand for semiconductor devices. According to World Semiconductor Trade Statistics (WSTS), global semiconductor sales are expected to reach USD 551 billion by the end of 2021. In the midst of an industry boom cycle, the leading and trailing-edge nodes are both facing a shortage. The PCs and smartphones are the two main products requiring the most cutting-edge technology since the high demand can offset the increase in costs resulting from different manufacturing structures. The trailing-edge chips are widely used across consumer goods, automotive, and industrial equipment, offering better value for money by striking the balance between performance and cost. Therefore, the mature nodes are still at the core of the industry. Take TSMC, the global foundry market leader, as a proxy. Although its sales structure has shown a gradual decrease in mature nodes, those still took up nearly 40% of its revenue in Q2 2021. TSMC further plans to develop new production facilities for the mature nodes, which may lead to fiercer competition in SMIC's traditional business space.
Mimicking UMC's latest strategic move
In 2018, GlobalFoundries and UMC both announced a pause in the research for sub 12 nm nodes aiming to build a more profitable business.
In this overly monopolized market, the first-mover advantages are shared by the duopoly of Samsung and TSMC – both with established client networks. Billions of dollars invested in advanced technology by a smaller foundry operator do not receive reasonable returns.
As a result of this strategic move, the R&D expenses did not show a boom compared to those striving for technology leadership. But UMC has shown impressive financial results since halting R&D in advanced technology, with the obvious progress in gross margin.
In 2020, SMIC's R&D expenses over revenue declined for the first time since 2016. Last month the company announced it would invest USD 8.87 billion for a new chip plant in Shanghai, and earlier this year that it would build a new fab in Shenzhen for USD 2.35 billion, both focusing on process nodes for 28 nm and above in response to the national policy amid the restrictions from the US. It may be more pragmatic for SMIC to combine its foundry expertise and the advanced IC packaging technology to retain competitiveness within the industry since the domestic demand for microelectronic devices built at the mature nodes is growing. The shift of expanding SMIC's capacities at the mature nodes, in some aspects, looks like UMC's move, so to the mainland foundry may achieve somewhat similar financial results in the foreseeable future.
Growth drivers – old and new
SMIC holds the largest semiconductor market in the world. China consumes around 60% of the global semiconductor outputs, and SMIC's local network of committed clients and partners is extensive. In Q3 2020, more than 65% of SMIC's revenue came from China, with 20% of revenue contributed by Huawei; meanwhile, the revenue from the North American markets was only 18%. Demand for chips in the domestic market will keep rising in the years to follow.
Secondly, investment from the 'Big Fund' allows the China-based foundry to expand its capacity at a faster speed by building or acquiring new fabs (L foundry deal). On the other hand, these capital injections help SMIC build a better industry ecosystem through M&A and strategic investment within the supply chain (Wingtech acquired Nexperia). On top of the funding projects, the new tax incentives are also aimed to spur the growth of the industry. The Finance Ministry has also announced that China's chipmakers can import machinery and raw materials tax-free through 2030.
Lastly, semiconductor companies in China have recently enjoyed favorable market valuations, with some new public capital sources launched. As of Q2 2021, nearly 20% of the companies listed on The Shanghai Stock Exchange Science and Technology Innovation Board (the STAR Market) were representing the semiconductor industry, including SMIC. Moreover, funds raised by semiconductor companies in the Chinese stock market soared to CNY 87.6 billion in 2020 from CNY 14.9 billion in 2019, a 488% growth in a year. SMIC raised CNY 46.29 billion in its STAR Market debut, with its shares surging 245% on the first trading day. The number of companies listed, and the funds raised both align with the current Five-Year Plan (link in Chinese) and show that semiconductor companies in China have ample resources to access.