China’s top chipmaker’s second-quarter results matched market expectations, but it warned of a cyclical slowdown in the global semiconductor industry

Key Takeaways:

  • SMIC’s second-quarter revenue rose by 40% year-on-year and 3.3% quarter-on-quarter, but the company forecast possible flat sequential growth in the third quarter
  • The U.S. has tightened restrictions on semiconductor equipment exports to China, which will reportedly impact SMIC’s 12-inch fab construction

By Ken Lo

As a leading force in China’s drive to build up its chip sector, Semiconductor Manufacturing International Corp. (SMIC, 0981.HK; 688981.SH) has become a lightning rod for U.S. politicians, who have taken numerous steps to limit the company’s access to foreign technology. That’s made SMIC extremely cautious about releasing information on its advanced manufacturing processes, leading to continual guessing by outsiders of what’s going on technologically inside China’s largest chipmaker.

When it comes to financials, the company, which is listed in both Shanghai and Hong Kong, is a bit more forthcoming. Its latest quarterly report released last week shows SMIC’s revenue reached $1.9 billion in the second quarter, a tad higher than the $1.89 billion expected by the market. That was up by a strong 41.6% year-on-year and a more modest 3.3% quarter-on-quarter.

The company said a two-month pandemic-induced lockdown in its hometown of Shanghai prevented it from performing annual maintenance to its factories during the second quarter that normally results in production pauses. As a result, the impact on its output was less than expected. Despite the revenue gains, its net profit for the quarter fell by 25.2% year-on-year to $514 million, mainly the result of $86.95 million in losses related to foreign currency conversion.

Sagging shares

SMIC forecast flat to 2% revenue growth for the current quarter on a sequential basis, as management warned investors of the potential for a double-dip downturn in the global semiconductor sector, with an uptick not expected until the first half of next year at the earliest. That downcycle follows two years of extremely tight supply for chips, leading to a major shortage that severely crimped the global auto industry.

SMIC’s shares fell 3.6% the day after its latest results announcement and another 7.1% in the next two trading days. It closed at HK$15.84 on Thursday, near its 52-week low, suggesting investors are cooling on the company as the global chip sector takes a pause.

The U.S. enacted the “Chips and Science Act” in August, committing $52.7 billion in subsidies and tax deductions to eligible chipmakers worldwide with the caveat that such companies cannot build manufacturing facilities in China in the next decade. That continues a recent U.S. stance of hostility towards China’s chip sector, which could have a negative impact on companies like SMIC.

Even before the act, SMIC was already one of the Chinese tech firms most targeted by the U.S. for sanctions apart from embattled telecoms equipment maker Huawei. It was included on the U.S. Commerce Department’s entity list as early as in December 2020, severely impeded its access to advanced products and services provided by U.S. semiconductor suppliers. That compelled the company to shift its focus from designing manufacturing processes for cutting-edge 10-nanometer chips and smaller to more mature technologies for making 28-nanometer and higher chips.

Things got even worse for SMIC this year. According to Bloomberg, the White House has tacitly tightened its restriction on the supply of U.S. semiconductor equipment to Chinese companies, and any equipment needed for the production of 14-nanometer or smaller chips is barred from export to China. Previously such restrictions only applied to 10-nanometer or lower technology. The updated policy has reportedly already impacted the construction of SMIC’s 12-inch wafer fabs, though the company didn’t make any related disclosures in its latest quarterly report.

To avoid disclosing too much on its advanced manufacturing processes and inviting more U.S. sanctions, SMIC has put revenue data related to its 14-nanometer or less chips under the entry for 28-nanometer or less since 2020 instead of listing it separately. What’s more, it stopped stating revenue for all of its different semiconductor technologies this year, and instead has published revenue figures for its 8-inch and 12-inch wafer fabs, which accounted for 31.7% and 68.3% of its second-quarter revenue, respectively.

Recent market rumors have said that SMIC has developed processes to produce 7-nanometer technology semiconductors using deep ultraviolet lithography (DUV) systems. But the defective product rate is still too high and mass production is still out of reach at the moment.

The company may also be maintaining a low profile on its 7-nanometer process due to the potential for conflict with leading global contract chipmaker Taiwan Semiconductor Manufacturing Co. (TSMC, TSM.US; 2330.TW) since the latter was among the first to develop the technology and one of SMIC’s current co-CEOs was once an important member of its research team. Thus, SMIC’s mass production of 7-nanometer semiconductors could open it to IP infringement claims from TSMC.

Trouble inside China

As if its external troubles weren’t enough, SMIC is also facing troubles inside China from a recent anti-corruption drive against some of the massive government-led funds designed to build up the chip sector. The Chinese Central Commission for Discipline Inspection, the Communist Party’s anti-corruption watchdog, noted last month that the general manager of the China Integrated Circuit Industry Investment Fund, Ding Wenwu, was being investigated for corruption. Before that, two top officials of another fund came under similar investigations.

While the battery of investigations don’t implicate chipmakers like SMIC directly, the movement could signal the state might diminish its support for the company and its many peers while trying to overhaul the industry.

Francis Lun, CEO of GEO Securities, believes that with the U.S. intensifying its efforts to contain China’s high-tech development, SMIC’s efforts to upgrade even its more mature processes could face difficulties if Washington tries to contain the company’s development of such older technology.

“In addition, the slowdown in global smartphone sales recently, including in China, has reduced demand for microchips and added to the uncertainties faced by the company, thus it might not be wise to invest in the company now,” Lun said.

Kenny Wen, head of investment strategy at KGI Asia, pointed out two causes of concern for SMIC. First, the industry is undergoing a double-dip downturn, as SMIC management put it. Second, Tudor Brown, co-founder of semiconductor design firm  Arm Ltd., just resigned as one of SMIC’s independent directors. Those two developments have made the market concerned about the company’s prospects and added volatility to its shares, limiting its appeal to investors.

Such investor concerns could be weighing on SMIC’s shares, giving the company a meager forward price-to-earnings (P/E) ratio of just 1.8 times, according to Yahoo Finance. By comparison, TSMC trades at a much higher premium with a ratio of 14.5 times. The valuation disparity also indicates the market is concerned about the huge challenges SMIC is facing both at home and especially from abroad, which may ultimately relegate it to being a maker of lower-tech, lower-margin microchips.

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