SMIC: Chip Cycle Fails to Hide the Alpha Light

SMIC (0981.HK/688981.SH) released its Q1 2023 financial report after the Hong Kong stock market closed on the evening of May 11, 2023. The key points are as follows:

1. Overall performance: Bottoming out during the downturn. In this quarter, SMIC achieved a revenue of $1.462 billion, a MoM decline of 9.8%, which is within the upper limit of the guidance (-12% to -10%), and it exceeded market expectations ($1.435 billion). The company's gross margin for this quarter continued to decline to 20.8%, which is in line with market expectations (20.4%).

2. Detailed analysis of the three core indicators: revenue, gross margin, and capacity utilization rate. On the revenue side, the decline in this quarter was mainly affected by a significant decrease in shipments for SMIC (SMIC.CN). The structural improvement in the proportion of 12-inch wafers has boosted the average selling price. However, the price increase still cannot cover the increase in unit cost. With the continuous weakness in downstream demand, the company's inventory continued to rise, leading to a decrease in capacity utilization rate. The company's capacity utilization rate for this quarter further declined from 79.5% in the previous quarter to a historical low of 68.1%, directly dragging down the company's gross margin.

3. Business progress: Soft performance in the mobile phone business. The proportion of the smartphone business continued to decline this quarter, mainly due to weak downstream demand, which continued to affect the shipment of smartphone manufacturers. The demand for smart home and consumer electronics in the domestic market showed signs of recovery this quarter, and the revenue contribution from the Chinese market continued to rise to 76%.

4. Guidance for the next quarter: SMIC expects a QoQ revenue growth of 5%-7% in Q2 2023, corresponding to $1.53-1.56 billion, which is better than market expectations ($1.456 billion); the gross margin is expected to be 19-21%, in line with market expectations (gross margin of 19.23%).

Overall, SMIC's financial report for this quarter is quite good. The company met market expectations, especially with slightly higher revenue than expected. This is mainly because the market expects a decline in revenue for both 8-inch and 12-inch wafers in the industry downturn. However, based on SMIC's financial report, although there is a significant decline in revenue for 8-inch wafers, the revenue from 12-inch wafers can still be maintained. Dolphin believes that the decline in 8-inch wafers is mainly due to low barriers to entry and a large number of players, showing a cyclical pattern overall. On the other hand, 12-inch wafer capacity from SMIC is relatively scarce in the domestic market, and it is less affected by the cycle from the perspective of industry chain security. Therefore, SMIC's good performance this quarter is mainly attributed to the 12-inch wafers.

Looking ahead to the next quarter, the company expects a MoM revenue growth of 5%-7% and a continued gross margin of 19-21%. Dolphin believes that the guidance for the next quarter is also positive. With the recovery in revenue, there is hope for improvement in orders for the next quarter. Maintaining a low gross margin is also reasonable, considering the company's current inventory of $2.1 billion, which puts pressure on capacity utilization and gross margin, making it difficult for them to rebound.

With the recovery of orders, the inventory is also expected to gradually decrease. Dolphin believes that SMIC is likely to reach its performance bottom in the first half of 2023. The focus for the next quarter will be on the company's inventory reduction.

Below is Dolphin's detailed analysis:

1. Key indicators for SMIC: Revenue, Gross Margin, and Capacity Utilization

Key Indicator 1: Revenue

In the first quarter of 2023, SMIC achieved a revenue of $1.462 billion, a MoM decline of 9.8%, which was better than market expectations ($1.435 billion). The main reason for the decline in revenue was the continued significant decrease in shipments this quarter.

Analyzing the specific factors affecting the decline in SMIC's revenue from the perspectives of quantity and price:

1) Quantity: The wafer shipments (equivalent to 8-inch) from SMIC this quarter reached 1,252 thousand wafers, a MoM decline of 20.5%.

2) Price: The average revenue per wafer (equivalent to 8-inch) from SMIC this quarter was $1,168, a MoM increase of 13.4%.

From the breakdown of quantity and price, the decline in revenue this quarter was mainly due to the decrease in shipments. The increase in average selling price was not due to industry-wide price increases, but rather due to changes in the company's shipment structure.

This quarter, the shipment of 12-inch wafers from the company remained relatively stable, but the shipment of 8-inch wafers decreased significantly. This is mainly because the 8-inch wafers, with lower barriers to entry, are more affected by the downward cycle. As the proportion of 12-inch wafer shipments increased, there was a certain increase in the average selling price of the company's products.

Under the influence of the industry's downward cycle and the increase in company inventory, the company's capital expenditure decreased this quarter. As of the end of the first quarter, the wafer capacity (equivalent to 8-inch) of the company was 1,838 thousand wafers, a MoM decrease of 7.2%. The actual capital expenditure completed this quarter was only $1.259 billion, a MoM decrease of 37%.

Looking ahead to the second quarter of 2023, SMIC has provided a quarterly guidance of 5%-7% QoQ revenue growth, which corresponds to an expected revenue of $1.53-1.56 billion for the next quarter, surpassing market expectations ($1.456 billion). Dolphin believes that the company is expected to see a recovery in the downstream market starting from the second quarter after experiencing a low point in the first quarter.

Core Indicator 2: Gross Margin

In the first quarter of 2023, SMIC's gross margin was 20.8%, a MoM decrease of 11.2 percentage points, in line with market expectations (20.4%).

Analyzing the cost structure of the company, we can identify the sources of the gross margin improvement in this quarter:

Chip Gross Margin = Chip Wafer Revenue - Chip Fixed Costs - Chip Variable Costs

Chip Wafer Revenue: SMIC's wafer revenue per chip (equivalent to 8 inches) for this quarter was $1,168, a MoM increase of $138 per chip.
Chip Fixed Costs (depreciation and amortization): The fixed costs per chip (equivalent to 8 inches) for this quarter were $381, a MoM increase of $119 per chip.
Chip Variable Costs (other manufacturing expenses): The variable costs per chip (equivalent to 8 inches) for this quarter were $544, a MoM increase of $105 per chip.
Chip Gross Margin: SMIC's gross margin per chip (equivalent to 8 inches) for this quarter was $243, a MoM decrease of $86 per chip.

By analyzing the cost breakdown, we can see that SMIC's gross margin continued to decline this quarter, mainly due to a significant increase in costs.

Specifically, 1) the rise in unit fixed costs: SMIC's total depreciation and amortization for this quarter increased, and the increase in unit fixed costs was mainly due to a decrease in the shipment volume, resulting in a significant increase in costs per chip; 2) the rise in unit variable costs: The total variable costs for this quarter remained relatively stable, as some variable costs are related to the shipment volume. However, there are still some variable costs that do not vary with the shipment volume, leading to an increase in the per chip variable costs for this quarter.

Looking ahead to the second quarter of 2023, SMIC has provided a gross margin guidance of 19-21%, which is in line with market expectations (19.23%). The company is expected to continue facing the drag of industry weakness in the next quarter, with little improvement in gross margin. Considering the recovery in revenue, Dolphin believes that possible factors include some downstream customers resuming orders, but due to the current industry downturn, high inventory levels will still put pressure on the company's gross margin.

Core Indicator 3: Capacity Utilization Rate

The capacity utilization rate not only reflects SMIC's quarterly performance but also reflects the overall trend of the semiconductor wafer manufacturing industry. As the wafer manufacturing industry becomes more prosperous, SMIC and many other manufacturers have been operating at full capacity. However, with the semiconductor industry showing signs of decline, adjustments in downstream orders will directly affect the capacity utilization rate of chip manufacturers. Q1 2023 SMIC Capacity Utilization Rate at 68.1% - The company's capacity utilization rate continued to plummet this quarter. In the previous quarter's financial report review titled "SMIC: Visible Decline, but Is It Good Now?," Dolphin mentioned, "Considering the revenue and gross margin guidance provided by the company, Dolphin expects the company's capacity utilization rate to hit a new low next quarter." Indeed, this quarter's 68.1% sets a new record low for the company's capacity utilization rate.

Looking ahead to Q2 2023, although SMIC's capacity utilization rate hit a new low of less than 70% this quarter, Dolphin believes that the company's shipment situation is expected to improve next quarter. However, due to the company's high inventory of $2.1 billion, the capacity utilization rate will remain low in the short term.

2. Business Analysis of SMIC

After reviewing the three key indicators, let's take a comprehensive look at SMIC's quarterly business situation together:

2.1 Downstream Markets: Smartphone Continues to Decline

This quarter, SMIC's revenue from the smartphone business accounted for a further decline to 23.5%. This is mainly due to the downturn in the smartphone industry directly affecting the demand for related manufacturers. Among the various sectors, the revenue proportion of smart home and consumer electronics has shown a slight recovery this quarter.

Dolphin believes that domestic smart home and consumer electronics manufacturers have started to recover their demand this quarter, while the smartphone sector remains weak. Considering the company's high inventory, it is speculated that a significant portion of it consists of chips for smartphones.

2.2 Wafer Sizes: Sharp Decline in 8-inch Demand

Since Q1 2022, SMIC no longer discloses the revenue proportion of each process node, only the revenue proportion of 8-inch and 12-inch wafers. Therefore, it is impossible to see the detailed changes in revenue for each node.

This quarter, SMIC's revenue proportion from 12-inch wafers surged to 71.9%. However, the increase in proportion is not due to increased demand for 12-inch chips downstream, but rather a decrease in demand for 8-inch wafers.

From the revenue proportion of these two sizes and the company's revenue, there is no significant change in the revenue of 12-inch chips compared to the previous quarter, while the revenue of 8-inch wafers declined by 29% QoQ. With the structured increase in the proportion of 12-inch wafers, the average selling price of the company's shipments increased this quarter.

2.3 Regional Distribution: China's Smart Home and Consumer Electronics Lead the Way

SMIC adjusted the geographical revenue distribution in the previous quarter, changing it from "North America/China Mainland and Hong Kong/Europe and Asia" to the current "China Region/United States Region/Europe and Asia Region." Due to this adjustment, there are slight differences in the data.

Specifically: ①China Region: accounts for 75.5% of the revenue, MoM increase of 6.4pct; ②United States Region: accounts for 19.6% of the revenue, MoM decrease of 5.7pct; ③Europe and Asia Region: accounts for 4.9% of the revenue, MoM decrease of 0.7pct.

Looking at the regional revenue for this quarter, there has been a significant increase in revenue from the China Region. This is mainly due to the recovery in sales of smart home and consumer electronics products, primarily from customers in the China Region. The decline in other areas such as mobile phones has led to a decrease in the proportion of revenue from the United States Region and Europe and Asia Region.

III. SMIC's Business Data

3.1 Operating Expenses: Cost Control Initiatives

From the perspective of operating expenses, SMIC's operating expenses for this quarter amounted to $221 million, with a slight decrease MoM.

Breaking down the operating expenses for this quarter, research and development expenses were $168 million, general and administrative expenses were $100 million, and sales and marketing expenses were $8 million. R&D expenses have decreased compared to the previous quarter, while general and administrative expenses have been declining for two consecutive quarters.

In the face of operational pressure, the company has proactively implemented cost control measures. R&D expenses and general and administrative expenses have both declined this quarter.

3.2 Operating Indicators: Terrifying Inventory, Reaching a New High

From the perspective of operating indicators, we mainly observe the company's inventory and accounts receivable:

①SMIC's inventory for this quarter was $2.116 billion, with a MoM growth of 10.7%;

②SMIC's accounts receivable for this quarter was $1.115 billion, with a MoM decrease of 5.7%.

③Considering the relationship between inventory/accounts receivable and revenue in the balance sheet, the inventory/revenue and accounts receivable/revenue ratios for this quarter were 145% and 76% respectively. From the perspective of operational indicators, SMIC's inventory continues to rise, reaching a new historical high.

Combining the company's inventory and capacity utilization rate data, we can see the company's trend. In the first quarter of 2022, the company's capacity utilization rate was still close to full capacity. As the company's inventory has continued to rise since the first quarter of 2022, the capacity utilization rate has started to decline from the second quarter. Therefore, considering the current inventory situation, it is expected that SMIC's capacity utilization rate in the second quarter of 2023 will remain low in order to prioritize the digestion of the company's existing inventory. **

3.3 EBITDA Indicator: Profit and Depreciation Account for Half

From the perspective of EBITDA, SMIC's pre-tax profit from interest, taxes, depreciation, and amortization reached 950 million US dollars in the first quarter, showing a slight decline.

Breaking down the indicators, SMIC's pre-tax profit from interest, taxes, depreciation, and amortization mainly comes from the release of operating profit and depreciation and amortization. The profit side continued to decline this quarter, while depreciation and amortization still increased. The profit margin (pre-tax profit from interest, taxes, depreciation, and amortization) for this quarter reached 65.1% according to calculations. Due to the heavy asset nature of the manufacturing industry, most of the company's profits have been eroded by depreciation and amortization.