The Increment of Mobile Phones Actually Comes from "Trade-In" Programs? (SMIC 2Q23 Conference Call)

Earnings Report for the Second Quarter of 2023 Released by SMIC (0981.HK/688981.SH)

On the evening of August 10, 2023, Beijing time, SMIC (0981.HK/688981.SH) released its earnings report for the second quarter of 2023 (ending in June 2023) after the Hong Kong stock market closed. The key points from the conference call are as follows:

1. Incremental Information from the Conference Call of SMIC (0981.HK):

a) Downstream Market Situation: In the overall market, the mobile phone and consumer electronics sectors are still in an innovation bottleneck, lacking new highlights. Demand is not increasing but decreasing, and the replacement cycle for mobile phones is getting longer. The personal computer, industrial, and new energy vehicle industries are gradually balancing supply and demand, and the industry downturn has already hit bottom. However, there are still many challenges, including slower destocking than expected, lack of momentum in demand growth, and geopolitical influences.

b) Mobile Phone Market: From the company's order situation, it can be seen that the inventory of chips used in domestic mobile phone terminal consumer electronics is starting to decline, and customers are gradually resuming their demand for orders, such as image sensing, image signal processing, high-voltage driving, microcontrollers, industrial control, and special storage chips.

c) Performance Outlook: SMIC (0981.HK) expects its shipment volume to continue to rise in the third quarter, with higher capacity utilization rate, while the average selling price (ASP) and depreciation will continue to increase. By increasing its market share in a shrinking market, the company's sales revenue for the second half of the year is expected to be better than the first half.

d) Overseas Customer Situation: Overseas customers generally have long-term agreements with OEMs, so their order adjustment time during industry downturns is usually two quarters behind that of local companies. SMIC (0981.HK) only began to see strict management of orders and inventory from European and American customers in Q2. In contrast, Chinese customers may have started adjusting since September last year.

e) Chinese Customer Situation: Chinese customers adjusted their inventory earlier than European and American customers due to long-term agreements with OEMs. Last year, they were unable to reduce their inventory, but this year they are gradually reducing it. Therefore, the Chinese market adjusted earlier and is now recovering. Furthermore, Chinese customers have gained a larger share in the consumer electronics, mobile phone, and new energy vehicle supply chains, driving the demand for SMIC (0981.HK). This is also the reason for the insufficient capacity of 40nm, 28nm, and even expanding to 55nm. The incremental growth mainly comes from the overlooked repair-oriented mobile phone market, which also has a certain impact on SMIC (0981.HK) when industry players recycle old phones through trade-in programs. Processing old phones for circuit replacement is a significant market, with the majority of participants being Chinese customers.

2.1 Management Report

Compared to the previous quarter and May, our view of the market has not changed significantly. Although China and the global economy have returned to normal operation, the demand for electronic products is lower than expected, and the inventory of integrated circuit products remains high. The market lacks confidence, and chip companies are cutting costs. From the perspective of the overall market, the mobile phone and consumer electronics sectors are still in a period of innovation bottleneck, with no new highlights. Demand is not increasing but decreasing, and the replacement cycle for mobile phones is getting longer. The supply and demand in specific industries such as personal computers, industrial sector, and new energy vehicles are gradually balancing out. The industry's downturn has bottomed out, but it still faces many challenges, including slower inventory reduction than expected, lack of momentum in demand growth, and geopolitical influences.

Although the wafer shipments in the second quarter of 2023 increased by 12% compared to the previous quarter, the average selling price decreased by 7% due to price adjustments and changes in product mix. Therefore, the sales revenue increased by 6.7% MoM to $1.56 billion.

In terms of regional classification, due to the time difference in the economic cycle between domestic and foreign markets and inconsistent inventory reduction pace, China's share increased to 80%, with a 13% MoM growth in revenue. Other regions accounted for 20% of the revenue.

In terms of service type classification, wafer revenue accounted for 90%, while other revenue accounted for 10%.

In terms of application classification, smartphones accounted for 27%, IoT accounted for 12%, consumer electronics accounted for 27%, and other categories accounted for 35% of the wafer revenue. Although there is no obvious rebound in overall demand, the company's order situation shows that the inventory of chips used in domestic mobile terminals and consumer electronics has started to decline, and customers are gradually recovering their demand for orders, such as image sensing, image signal processing, high-voltage driving, microcontrollers, industrial control, and special storage chips. Under the influence of this driving force, the company's second-quarter capacity utilization rate increased by 10 percentage points MoM to 78%. Smartphone revenue increased by 20% MoM. Due to the decline in orders for wireless local area networks, routers, and other areas, revenue from IoT decreased by more than 20% MoM, but the demand for mid-to-low-end TWS and Wifi remained stable.

In terms of wafer size classification, the demand for 12-inch wafers is relatively high, accounting for 75% of the revenue. Due to weak customer demand, the revenue from 8-inch wafers decreased to 25%, with a utilization rate lower than that of 12-inch wafers but still better than the industry average. In the second quarter, the company's gross profit margin decreased by 0.5 percentage points to 20.3% due to a decrease in average unit price and an increase in depreciation.

As of the end of the second quarter, the monthly production capacity of 8-inch wafers increased to 754,000 pieces, an increase of 40,000 pieces compared to the beginning of the year.

The company's capital expenditure in the second quarter was $1.7 billion, and the total capital expenditure for the first half of the year was $3 billion.

3Q Guidance:

In the third quarter, the situation of "increased quantity and decreased price" in the second quarter is expected to continue. It is estimated that the sales revenue will increase by 3% to 5% compared to the previous quarter, and the gross profit margin will be between 18% and 20%.

Our main basis for this estimation is that the inventory of major design companies in China is gradually decreasing, especially for some new products that are gradually building up inventory, preparing for shipments of terminal products in the second half of this year and next year.

The company's shipment volume in the third quarter is expected to continue to rise, while depreciation will also continue to increase. Through efforts to increase market share in a shrinking market, the company's sales revenue in the second half of the year is expected to be better than the first half.

2.2 Q&A

Q1: Pricing trends for the second half of this year and next year?

A1: The pricing of small products is very unique and different from the prices of large-volume products. In this industry downturn, when our production capacity truly increases, we have to absorb a large number of bulk standardized products, such as DDIC, PDDI, CMOS, Specialty Memory, etc. Although these bulk standardized products require a lot of new technologies and tools, their prices are relatively lower compared to unique small-volume products. As our production capacity expands, it means that the proportion of bulk standardized products is increasing, resulting in overall price weakness.

The 8-inch wafer market faces three main challenges:

First, with the downturn in the smartphone market, there is excessive inventory. Therefore, for such products, the loading volume is decreasing, and prices will definitely decline.

The second thing is in the area of analog chips, where we see international IDM competing in this market with low prices. The market is declining, orders are decreasing, and prices are getting lower.

The third challenge is the excessive stock of LCD drivers, with weak demand.

In summary, in the second half of this year, we expect to see higher output, higher wafer starts, and higher capacity utilization, but the ASP is expected to decline.

Q2: How to deal with the pressure from competitors? What is the outlook for profit margin?

A2: This year is a downturn year, and we cannot use this year's demand and prices as a reference for the past three to five years, which were the peak of the industry cycle.

Competition from IDM is very intense, but it is mainly in areas where everyone can compete. With over 10,000 product combinations in the market, anyone who can truly manufacture and deliver the highest quality products and update them every year still maintains strong competitiveness in terms of orders and prices. Q3: Is it possible to actively control the utilization rate of production capacity/recover the plan for expanding 8-inch wafers?

A3: The expansion of 8-inch wafer capacity has already been almost completed. The current expansion of 8-inch wafer capacity is based on agreements with customers.

The pressure of underutilization is not a normal situation, but rather a result of the downturn in the industry cycle. Therefore, it cannot be used as the basis for planning in the next 3-5 years. When the market recovers, the utilization rate will return to full capacity.

Q4: Will the underperformance of overseas inventory clearance affect the company's expansion next year?

A4: Overseas customers generally have long-term agreements with OEMs, so when the industry is in a downturn, the adjustment time for orders and inventory of European and American customers will lag behind domestic companies by 2 quarters. The company only began to see strict management of orders and inventory from these customers in Q2, while Chinese customers may have started adjusting as early as September of last year.

The overall market recovery is weaker than expected. With the decline in the impact of the epidemic, the company initially estimated that the market would experience a recovery at the beginning of the year, or even a better rebound. However, the market has not seen further recovery at present, and further macroeconomic recovery is needed. The overall market is estimated to remain stable in 2024. The recovery of consumer electronics requires the joint efforts of the macroeconomy and cannot be changed by the semiconductor industry alone.

In terms of production capacity, the company has long-term cooperation and agreements with customers. Long-term capacity planning is not linear, but based on customer roadmaps. In addition, the company has a certain degree of flexibility in terms of capacity and equipment to cope with uncertainties. In the current capacity planning, 28nm and 40nm are in short supply and need to be expanded to meet the needs of customers' new products. This quarter, the same trend is seen for 55nm and 65nm, and the company must quickly establish capacity to meet the demand for customers' new products.

Q5: Will there be a similar decline in utilization rate in the 28nm and 40nm markets as in the previous cycle?

A5: The applications of 28nm and 40nm chips include screen drivers, CMOS image processors, and MCUs. In addition, there is a driving force for the evolution from 90nm and 55nm products to 28nm and 40nm. The company believes that 40nm is a node with a very good cost structure, and 28nm is a node with excellent planar technology. The company entered the 28nm and 40nm markets later than the industry leaders, but the customer base is more diversified and there are more platforms. The company will fill the production line through a comprehensive and diversified approach and is confident in filling the capacity and demand in the future.

Q6: What are the driving factors behind the increase in the proportion of revenue from the Chinese market/increase in revenue from smartphones?

A6: Regarding the Chinese market:

Firstly, Chinese customers adjusted their inventory earlier than European and American customers. OEMs have long-term agreements, so it was not possible to reduce inventory last year, but they are gradually reducing it this year. Therefore, the Chinese market adjusted early and is now recovering early. Furthermore, Chinese customers have gained a larger share in the consumer electronics, mobile phone, and new energy vehicle supply chains this year, driving the demand for SMIC. This is also the reason for the insufficient capacity of 40nm, 28nm, and even the expansion to 55nm.

In terms of smartphones, the incremental growth mainly comes from the overlooked repair-oriented smartphone market, which also has a certain impact on SMIC. After the company recycles old phones through trade-in programs, it replaces the circuits of these old phones. This is a significant market, and most participants are Chinese customers.

Q7: What is the company's current capital investment focus?

A7: The company's capital expenditure is mainly focused on 12-inch capacity. Currently, continuous expansion is needed to achieve economic scale for 12-inch production. The company is currently investing in multiple locations simultaneously to quickly reach economies of scale. Therefore, the initial years will incur relatively large expenses.

In addition to the fabs, the purchase of equipment requires additional approval processes, which lengthens the delivery cycle. Therefore, there needs to be some buffer in procurement. SMIC generally plans equipment delivery and purchases six months to a year in advance.

Q8: Will there be overcapacity in the coming years?

A8: Firstly, the company will consult with customers and evaluate the sustainability of customer demand before starting production.

Secondly, SMIC's market share in the foundry sector is 5%, and when combined with IDM, it is only 1%-2%. Therefore, the impact of capacity expansion is limited.

There are three principles in the industry: strategic synergy with customers, the ability to convert resource inputs into differentiated technological competitiveness, and experienced management. By adhering to these three principles, the company can ensure that even in a downturn, it will not be eliminated and can maintain capacity utilization.

Q9: Outlook for the utilization rate and gross margin of 8-inch wafers?

A9: Challenges for 8-inch wafers: 1) Weak demand for smartphones, resulting in weak demand for main chips and wafer sets.

Last year, IDM lost market share due to insufficient capacity, and after capacity expansion, industry competition intensified.

There is a surplus of screen inventory, so even without new production, it can meet this year's demand.

In the long run, the demand for 8-inch wafers is sustainable because most products in this field do not require frequent upgrades and it is not cost-effective. The demand for wafer sets for new energy vehicles will drive growth, and the demand for 8-inch wafers may even outperform that of 12-inch wafers.

Q10: Investment in specialty processes at SMIC?

A10: The company entered each node later than the industry leaders, so in reality, most of the major products are no longer standardized but differentiated.

The company generally follows the path of establishing standard logic and then extending it to other processes. For example, a standard logic can develop into 10 platforms such as low-power and RF, and these platforms can further iterate, such as upgrading nor-flash from 65nm to 55nm and 40nm.

Based on this expansion, the company ensures that 80% of the tools on the production line are universal and gradually adds more specialized tools. Since downstream demand for the company is usually diverse but with relatively low volume per category, this deployment helps maintain flexibility. Q11: How is the distribution of production capacity in the factories? What is the production progress of SMIC and Lingang?

A11: In Tianjin, the 8-inch factory is equipped with new equipment and is growing linearly at a rate of 40,000 wafers per year. By the end of this year, our 8-inch production capacity deployment will be basically completed, and future growth will be focused on 12-inch wafers.

The incremental increase in 12-inch wafers mainly occurs in SMIC's Jingcheng and Shenzhen factories.

SMIC Lingang is currently constructing pilot lines and verifying technologies.

Jingcheng has installed equipment this year and has entered mass production. The initial goal is to achieve the minimum scale of breakeven.

Construction is underway at the Tianjin factory.

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