12-inch rush order, semiconductor begins to structurally recover (SMIC 1Q23 conference call)

1. Overview of 1Q23 Financial Report

1. Revenue: SMIC.HK's revenue was $1.462 billion, YoY-20.6%, beating market expectations (1.9% beat).

2. Gross Margin: SMIC.SH's gross margin was $305 million, YoY-59.4%; gross margin was 20.8%, YoY-19.9ppt, in line with market expectations (+0.4pct inline).

3. Performance Guidance:

(1) 2Q23: The company's capacity utilization and shipment volume are expected to be better than 1Q23; sales revenue will increase by 5%-7% QoQ; due to changes in product mix, the average wafer price will decrease QoQ; gross margin will be 19%-21%.

(2) 2023:

Capital expenditures in 2022 were RMB 43.24 billion, and capital expenditures in 2023 are expected to be roughly the same as in 2022, exceeding 10% of the company's most recently audited net assets.
YoY decline in sales revenue is in the low double digits, and gross margin is around 20%.

Dolphin Analyst's financial report review can be found in "SMIC: Chip Cycle Cannot Hide the Alpha Light".

Full of valuable information:

1) Revenue adjustment starting from 1Q23: First, IoT is listed separately under other categories; second, sub-items such as smart TVs, smart locks, set-top boxes, etc. are classified under consumer electronics, and sub-items related to LAN network connections and modems are classified under IoT.

2) Some downstream markets are starting to recover: Embedded non-volatile memory and NOR Flash platforms have seen signs of recovery, with revenue increasing by more than 20% QoQ.

3) Capacity utilization and prices: 1Q had lower capacity utilization and revenue, but higher ASP - because more wafer orders were lost from low-end standard products, especially in 8-inch, such as low-end CIS, fingerprint IC, large-size LCD driver chips, etc.; 2Q's capacity utilization will rebound, and some urgent orders come from 12-inch new products, especially 40nm, 28nm are already fully loaded.

2. Performance Conference Transcript

(1) Management Remarks

[1] Overall Performance1. Performance Highlights

In 1Q23, the overall integrated circuit industry was at the bottom, with the industrial and automotive sectors relatively stable, while the inventory of mobile phones and consumer electronics remained high, and the demand for existing old products, especially large-volume and low-priced standard products, further declined. The company actively optimized its revenue structure by adjusting its product mix, increasing its average selling price, and achieving sales revenue of $1.462 billion, a 9.8% decrease from the previous quarter, slightly better than guidance. The gross margin was 20.8%, at the upper end of guidance.

2. Demand Situation

Starting from 1Q23, the application categories for revenue have been adjusted:

First, the Internet of Things is listed separately under other categories;

Second, sub-items such as smart TVs, smart locks, and set-top boxes are classified under consumer electronics, while network connection sub-items related to modems and LANs are classified under the Internet of Things.

Regardless of the classification, there are still some common products that cross large application scenarios, but we still hope to strive for classification optimization.

Looking at the classification after the 1Q adjustment, smart phones, consumer electronics, the Internet of Things, and other categories accounted for 23%, 27%, 17%, and 33% of revenue, respectively. Smart phone revenue decreased by more than 20% compared to the previous quarter, while consumer electronics and the Internet of Things remained stable. Revenue related to car use in other categories continued to grow, and 40-nanometer embedded storage technology and other automotive platforms were launched one after another, with the expectation that related platform revenue will gradually increase with the growth of the new energy vehicle industry.

Looking at platforms, there are signs of a rebound in the embedded non-volatile memory and NOR Flash platforms, with revenue increasing by more than 20% compared to the previous quarter.

Looking at regions, China, the United States, and Eurasia accounted for 75%, 20%, and 5%, respectively.

[2] Performance Guidance and Future Plans

1. Capital Expenditure

Capital expenditure in 2022 is expected to be RMB 43.24 billion, and capital expenditure in 2023 is expected to be roughly the same as in 2022, exceeding 10% of the company's most recently audited net assets.

2. Overall Performance

In 2Q23, the company's capacity utilization and shipment volume are expected to be better than in 1Q23; sales revenue is expected to increase by 5%-7% compared to the previous quarter; due to changes in the product mix, the average wafer price is expected to decrease compared to the previous quarter; and the gross margin is expected to be 19%-21%. Based on the following:

(1) Compared with three months ago, although the global market is still at the bottom, China's customer confidence has recently rebounded in different fields.

(2) Some standard product demand has bottomed out, and there are signs of improvement in the high-voltage drive camera chip and dedicated storage areas that were the first to enter the destocking phase last year.

(3) Domestic terminal machine companies are actively innovating, seeking market breakthroughs, promoting the realization of new products and first-time new performance, and driving the company's rapid growth in urgent orders.

In order to better serve the production of new products for customers, the company has taken multiple measures, increased resource investment, ensured technical support, minimized product waiting time, processed online abnormal situations at the fastest speed, accelerated the speed of new product production, and strived to enable customers to obtain products earlier. Currently, the 40 and 28 nanometer nodes have resumed full load status.However, in the short term, due to the problems of long-end corners such as production capacity and platform support, it will take time to achieve rapid revenue growth for new products.

The company is advancing corresponding capital expenditures based on the expansion plan. According to the pace of capacity construction, based on a standard factory with a monthly production of 50,000 12-inch wafers, one factory will start construction and one factory will enter production in one year.

Regarding how to deploy production capacity on the platform and improve competitive advantages, the arrangement is as follows: for stock production capacity, that is, old factories, relying on their research and development advantages, continue the model of old factories leading new factories, further exert the radiation effect of the parent factory, and improve the learning curve and operational efficiency of new factories. As for incremental production capacity, that is, new factories, they will each have their own focus and give full play to their production-intensive advantages. SMIC Shenzhen focuses on high-voltage drivers, camera chips, and power electronics. SMIC Xiqing focuses on analog and power management products. The product platforms of SMIC Beijing and SMIC Shanghai are relatively more diversified to fill market gaps. SMIC Shenzhen has entered mass production, SMIC Beijing is expected to enter mass production in the second half of the year, SMIC Shanghai is expected to be online by the end of the year, and SMIC Xiqing is under construction.

Looking forward to the full year of 2023, although 2Q revenue has bottomed out and rebounded, the extent of the recovery in the second half of the year is still unclear. Overall, the market has not yet seen a comprehensive recovery, so the guidance for the whole year remains unchanged, that is, the year-on-year decline in sales revenue is in the low single digits, and the gross profit margin is around 20%.

The company will strive to do better on the existing basis: facing the rapid changes in the market, it will continue to follow a market-oriented, customer-centric strategy, strengthen dialogue with end markets, fully cooperate with the highlights of new products, and do a good job in adjusting the length of the production line to meet the next round of growth cycles.

(II) Q&A

Q: The decline in shipments in 1Q indicates that the average unit price is better. Which applications for 12 inches, including 40 and 28nm, have driven the increase in average unit price, and what about the situation for 8 inches? Will there be similar combinations and unit prices in 2Q, and will we see improvements in 8 inches?

A: [1] Average unit price

In 1Q, there was lower capacity utilization and revenue, but the ASP was higher-because more wafer orders were lost from low-end standard products with low unit prices, especially on 8 inches, such as low-end CIS, fingerprint ICs, and large-size LCD driver chips. The orders for these standard products were very low in 1Q, making the 8-inch capacity utilization rate the lowest; 12 inches were also affected, but not as much as 8 inches.

In 2Q, the recovery of revenue and capacity utilization, and the urgent orders mainly come from new products, 12 inches, especially 40 and 28nm, have been fully loaded; applications include mobile phone DDIC, CIS, LED drivers, etc. Many of the recoveries occurred in China, and the industry chain has changed: new suppliers have entered the industry chain and obtained orders and market share, and these new manufacturers are the company's customers.

[2] Future trends

The whole year is still unclear, but it is indeed seen that the industry chain has changed and new opportunities for specific customers have emerged, and they have obtained a larger market share. Overall, the overall recovery requires the entire market to recover. New products have no inventory, so they can continue throughout the year, but it is uncertain whether there will be further additional increases on the basis of the current capacity utilization rate, and further observation is needed.Q: Customer inventory and willingness, and whether prices are under pressure

A: The market for standard old products, including company customers, still has relatively high inventory.

This type of inventory is at a healthy level and is not as high as before. Although it is similar to the water level in 2017 and 2018, which was 5-6 years ago, the current production capacity is higher. Currently, the pre-built inventory is quite safe.

The recovery of production capacity utilization depends on the following two aspects:

(1) The inventory of the old product market is quite high, and it is necessary to calculate when customers can consume such inventory and ensure that their inventory is safe;

(2) Urgent orders, mainly new products, new functions, and new performance, do not have inventory, so this type of inventory is low. Establish a safe level of inventory for existing products and old products, and make the greatest effort to establish inventory for new products.

The company's challenge is that there are many new products, and it takes time to make masks, produce wafers, and obtain qualification certification with customers. Therefore, the efficiency of running these products is the key to SMIC's recovery in the second half of the year.

Q: End-demand areas for urgent orders from customers, and the sustainability of demand

A: [1] End-demand areas

(1) The industrial and new energy vehicle categories have always been in short supply, but cannot be produced in large quantities because there are more than 1,600 types of automotive products, and the company's product models are not so many. Many models need to be made and verified slowly.

(2) The majority of capacity filling comes from mobile phones, consumer electronics, and smart homes. Overall, smart homes are rebounding, but mobile phones and consumer electronics are not. SMIC is expanding its market share in a shrinking market.

[2] Sources of urgent orders

(1) The mobile phone industry chain is adjusting its supply chain. The original major suppliers did not get a share this year, but smaller suppliers got a lot, and many of them are SMIC's customers, so they have to place a lot of orders. Some are mature products, but the inventory models and proportions are not correct and need to be replenished. More are new products without inventory. If an order is for 1,000 pieces per month, 5,000 pieces need to be produced because a certain amount of inventory is required.

(2) In the consumer electronics category, there is a clear rebound in global low- to mid-end WIFI interconnection demand that is in short supply.

(3) After the epidemic, real estate construction has resumed, and there is a considerable demand for driving circuits for lighting lamps, LED lamps, energy-saving circuits, or building exterior decoration and lighting lamps. Other small products are being replenished one after another. Not all products have a 5-6 month inventory. Some have less replenishment and more inventory to be cleared.

Q: Reasons for the decrease in ASP and price competition pressure

A: Some products are price-sensitive, and lowering prices can gain more market share. The utilization rate of the company in 1Q is relatively low because it did not chase the bottom of the price competition. Low-priced orders were gone once they were gone, so the utilization rate of production capacity decreased by 30%. Mainly low-priced orders, the rest are high-priced orders, so ASP has increased. In 2Q, the utilization rate increased, and all kinds of orders returned, so ASP will decrease slightly.But for the same product, the price has not changed much, within 5%.

LCD Driver, CIS, Memory are the standard products that can be obtained by reducing prices; the price reduction may not be sustainable, and the order can be obtained for this price reduction, but not necessarily for the next order, so SMIC did not do this in this round.

Q: Is R&D based on revenue ratio?

A: No.

(1) Evaluate based on long-term cooperation established with customers and the estimated product market share, product design capability, delivery time, and monthly quantity of customers - in other words, evaluate based on customer priority.

(2) Based on the proportion of SMIC's future leading products and bulk products, which must be invested to increase the percentage of leading products, plus the annual increase in SMIC's future production capacity and the need for new orders - according to these requirements, all projects are determined, and these projects are given sufficient resources, arranged in order of priority, and invested in for a total of 1 year or 3 years. This is how R&D is determined.

Q: R&D investment efficiency

A: There are internal assessments and standards, but they are not convenient to disclose and are also strictly evaluated by customers.

At present, R&D is still done according to the highest industry standards. The main concern used to be that due to resource considerations, it was not possible to start everything that needed to be done and talent needed to be cultivated and introduced. Now that resources are guaranteed, the main focus is on R&D efficiency and delivery efficiency.

Q: Is the trend of Q2 capacity utilization rate rebound sustainable or intermittent?

A: [1] Reasons for insufficient orders in foundries

(1) Reduced demand in the overall environment.

(2) Too many orders were placed last year. Even in areas where demand has not decreased, there is too much inventory, so the number of orders placed this year is less than last year.

[2] Reasons for the rebound in 2Q

(1) Make new products with all your strength, and there is no inventory of new products. It takes 3-5 months of inventory to enter a balanced state.

(2) To increase market share in a shrinking market, it mainly relies on the joint efforts of customers and the company. That is, the customer's share in the supply chain has increased this year, which has driven an increase in both new and old products.

[3] Sustainability

New products last for a long time, and customers increase their market share, such as whole-machine mobile phones, cars, TVs, displays, industry, and mid-to-low-end WIFI interconnection. Once they enter, they are only stocking up. The real investment and delivery will take at least one year, and future growth is unpredictable. The orders received now are continuous.

Q: Capital expenditures and equipment bidding pace

A: Because the market has seasonality, there will be seasonal orders. Because more factories were built last year, suppliers have more orders in hand, and the priority given to SMIC in 1-2Q is relatively low. However, many people do not need them at the end of the year, so there will be more deliveries in 3-4Q. The amount is more than 1.2 billion in 1Q, and the annual average is 5 billion. However, in order to maintain balance, there will be more deliveries in 3-4Q.Currently, there are no cancellations or significant adjustments to orders, and the speed of increasing production capacity of a large factory that produces 50,000 12-inch wafers per month is being planned for annual growth.

If SMIC's recovery is sustainable, especially if 40nm and 28nm are already fully loaded, there will be great pressure on long and short lead times, and suppliers will be urged to deliver long and short lead times and 40nm and 28nm equipment as soon as possible.

Q: Changes in process platforms and structures this year

A: (1) Customers this year require new performance, whether it is at 40nm, 28nm, 0.11μm, or 0.13μm. This year's focus is on supporting new demands, such as achieving existing 40nm products at 28nm, such as embedded flash, high voltage, and special memory; original 90nm BCD at 65nm, customers hope that existing products will be more competitive, from 40nm to 28nm, 90nm to 55nm, 0.18μm, and 0.15μm with higher voltage resistance and lower power consumption. The largest products of SMIC in the past must have new platforms launched.

(2) Originally, products in consumer electronics and industry could be compatible with automotive grade. Customers also do not want to make many types of products. After the car is qualified, customers sell a large number of automotive products, sell industrial products, and sell the remaining consumer products. Customers hope that one product can be promoted in several fields. SMIC's focus this year is to verify all consumer and industrial products as automotive products.

(3) There is also one thing that SMIC used to do but was very small, such as power electronics. There are about 1,600 products in 11 categories of electric vehicles, but now it is always impossible to meet the requirements of car factories. The main reason is that the products are too few. We need to produce more power electronic products to try to make up for and support the requirements of large customers.

Dolphin SMIC historical article review:

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