SMIC: A Crash on the Horizon?

On October 10, as one of the benchmarks in China’s stock market bullish run, Semiconductor Manufacturing International Corporation (SMIC), listed as 688981.SH, experienced a sharp decline, closing the day down by an alarming 10.57%. Such drastic fluctuations in share prices, while common in volatile markets, have raised eyebrows in the financial community and left investors speculating whether this is a signal of a crashing stock or merely a temporary setback.Despite the panic that often accompanies a significant drop like this, some market analysts argue that this isn’t necessarily a sign of collapse but rather a correction after a period of excessive gains. Between September 30 and October 9, SMIC saw its stock price surge with two consecutive "20CM" limit-up days, resulting in an astonishing increase of 67.81% and boosting its market capitalization by over one hundred billion yuan. Given the scale of the previous rapid ascent, a subsequent pullback seems almost inevitable.The trading sentiment leading up to this downturn can be traced back to the significant investment SMIC attracted prior to the National Day holiday in China. On September 30, there was an influx of over 6.2 billion yuan in capital on the same day the stock hit its first 20CM limit up. During the subsequent week-long market closure, the Hong Kong-listed SMIC shares skyrocketed by 57.45% over just two trading sessions. This wealth effect from the Hong Kong market likely intensified the anticipated sell-off by short-term investors who had profited handsomely from their earlier investments, thus capitalizing on this success by realizing their profits post-holiday.Amidst this tumult, a more profound trend is emerging within the semiconductor industry, one that analysts regard as a fundamental recovery surpassing expectations. Much of this recent increase in the semiconductor sector is being driven by global demand, particularly fueled by advances in artificial intelligence technology.To evaluate the cyclical nature of the semiconductor market, it is essential to consider the growth rates of revenues from equipment manufacturers. Semiconductor fabs typically expand production based on demand, where capital expenditures are heavily weighted towards purchasing equipment. Equipment vendors only recognize income once they deliver their machinery, often giving them a leading edge in revenue recognition compared to fabs’ output. Consequently, the revenue growth of equipment suppliers serves as a forward-looking indicator for the overall industry climate.Recent data from the first half of the year indicates a rebound in revenues for international companies such as ASML, Lam Research, and Applied Materials. Simultaneously, domestic giants like North Huachuang and Zhongwei have experienced continuous revenue growth. This data suggests a positive trend in semiconductor equipment demand both domestically and internationally.The downstream clients of these equipment manufacturers include industry stalwarts such as Taiwan Semiconductor Manufacturing Company (TSMC), SMIC, and Hua Hong Semiconductor. Notably, TSMC announced optimistic data for September, suggesting that they are poised for a fruitful third quarter, defying expectations.Therefore, from the current perspective, the fundamental improvement within the semiconductor sector, especially in the wafer foundry segment in which SMIC operates, is still very much in progress. However, it is important to examine the specific scenarios and operational strategies of SMIC itself.SMIC, it must be acknowledged, currently faces a technological gap when compared to its industry leader TSMC. Due to sanctions and restrictions imposed by the United States and the Netherlands on advanced manufacturing equipment, SMIC's production primarily leverages mature process nodes of 28nm and above. This hampers the company’s ability to significantly enhance its product pricing through advanced technologies, compelling it to improve operational efficiency to leverage scale effects within its existing processes.Interestingly, over the past several years, SMIC has been reducing its R&D expenditure as a percentage of revenue, which is a rational move given the current circumstances. Research and development expenses accounted for 21.55% of revenue in 2019, but this figure has diminished to just above 10% in the subsequent three years. However, the company’s aggressive growth in production capacity suggests a proactive approach to taking advantage of market recovery.For instance, in the second quarter of 2024, SMIC is expected to ship over 2.11 million pieces equivalent of 8-inch wafers, marking a remarkable 17.7% increase from the previous quarter, and a staggering 50.5% year-on-year growth compared to shipments of 1.403 million pieces in the second quarter of 2023.Additionally, the capacity utilization rate has shown significant improvement, climbing to 85.2% in the second quarter of 2024, a jump of 4.4 percentage points from the prior quarter. These metrics suggest that SMIC’s strategic maneuvers are proving effective.Despite the decline in average selling prices, which decreased by 8% in the second quarter of 2024, SMIC’s sales gross margin (13.65%) remains only slightly lower than the previous quarter (14.19%). Strikingly, the net profit margin saw an increase from 3.57% to 8.71%. This uptick can be largely attributed to the nature of wafer fabrication costs, where manufacturing expenses represent over 85% of total costs, which are fixed in nature. Consequently, as sales volumes increase, the per-unit cost allocated is lower.With these developments, it is reasonable to conclude that SMIC's strategy, despite its challenges, aligns well with benefiting from the ongoing semiconductor recovery. Even though the company reported a 45.07% decline in net profit for the first half of the year, guidance estimates a revenue growth of 13% to 15% for the third quarter, with gross margins expected to fall between 18% to 20%. This indicates a positive trajectory in overall performance.Moreover, the anticipated shift toward high-value products in the third quarter is likely to provide a significant boost to margins. Reports suggest that the proportion of 8-inch wafers is slated to decrease, while the percentage of 12-inch wafer production will increase, coupled with a gradual rise in the prices of 12-inch wafers. This technology transition appears promising for SMIC's projected performance in the near term.It is apparent that SMIC's recent stock valuation remains high, particularly when considering the remarkable historical peak reached during the recent rally. As of October 10, the closing P/E ratio was an impressive 172.25 times earnings, highlighting concerns regarding the sustainability of such valuations despite the comparatively lower current valuation norms in the tech sector. The question remains whether such elevated multiples during speculative seasons lead to disproportionately high risks for investors.In summary, the complex and dynamic nature of semiconductor manufacturing, particularly in light of the ongoing tension between technological advancement and international trade policies, presents both challenges and opportunities for SMIC. While there may be fluctuations that induce uncertainty within the stock market, the fundamentals appear to remain robust, suggesting potential for recovery and growth. Investor sentiment, however, remains cautious amidst speculation and the need for continuous adjustments in strategy to navigate through an increasingly challenging landscape.These observations reflect personal perspectives and should be considered by the reader accordingly.