Silicon rally

Semiconductor industry stocks see surging valuations.

In 1933, one of the most lauded stock pickers of all time famously declared that, “the four most costly words in the annals of investment” are “this time it’s different.” John Templeton, who went on to found the Templeton Growth Fund, concluded that investors are always seeing the “repeat of an earlier situation.”

That’s certainly been the case throughout the history of the semiconductor industry. Over the past few decades, equity market investors have found it all too easy to be on the wrong side of some pretty spectacular peaks and troughs.

The enormous capital expenditure needed to drive technological advancements from one manufacturing node to the next, have frequently been out of sync with underlying demand. Right now, the world is in the throes of a global chip shortage that’s particularly acute in China.

Global semiconductor manufacturers like Taiwan’s TSMC, South Korea’s Samsung Electronics, America’s Intel and China’s SMIC are all executing record-breaking capex spending to try and catch up with demand. Past experience suggests that this will create excess supply, prompting falling stock prices.

However, current equity valuations do not reflect expectations that history will repeat itself anytime soon. Pure play semiconductor stocks are breaching 10-year valuation highs.

The situation is even more extreme in China where domestic investors clearly believe in SMIC’s ability to achieve self-sufficiency for the nation in the manufacturing of advanced chips. Its A-shares in Shanghai are trading around 185 times forwards earnings, more than double the level of its H-shares in Hong Kong where valuations are more guided by international investors.

SMIC’s soaring share price has encouraged China’s third largest foundry (companies that make chips for others) to fast forward its listing plans, a year ahead of schedule according to the domestic press. Anhui-based Nexchip has filed a prospectus with Shanghai’s STAR market to raise Rmb12 billion ($1.86 billion) in one of the tech boards largest IPOs.

The company is hoping to achieve a valuation of Rmb48 billion, almost three-and-a-half times higher than its last fundraising round in September 2020. This pre-IPO financing was led by white goods manufacturer, Midea, which purchased a 5.85% stake on a valuation of Rmb14 billion. Other recent investors include BYD co-founder, Yang Longzhong, through his private equity firm Hui Capital.

Why do investors think this time is different?

Two big shifts in the industry’s tectonic plates are creating a global chip shortage. Both suggest that history may potentially follow a different pattern and timeline to the recent past. High valuations could, therefore, remain for longer and the downturn, when it comes, might be a lot shorter.

Firstly, there is a major new industry (electric vehicles) suddenly competing for chip supply against the previously all encompassing smartphone and PC sectors. Secondly, Sino-US tech rivalry means that existing international semiconductor manufacturers are being forced to set up new supply chains outside of China, while a whole slew of mainland producers are trying to establish domestic ones and break America’s stranglehold.

Over the short-term, Covid-19 has also played havoc with supply and demand calculations. The unprecedented nature of the global pandemic made it all but impossible for end user industries to forecast chip demand with much accuracy for most of 2020. Then at the end of the year, there was a re-bound that came sooner, stronger and more globally syncronised than anyone expected.

This year, new lockdowns across Asia and the ensuing production disruptions have further sharpened European and US minds about the benefits of establishing supply chains that are far closer to home. Geopolitics had already been pushing foundries in that direction and a growing number of semiconductor firms are announcing plans for leading-edge fabs in the US rather than in mainland China or Taiwan.

TSMC has a $100 billion three-year capex plan. In 2020, it signed off on its first US fab: a 5nm plant in Arizona. The Taiwanese giant has also said that it’s considering plans for 3nm and 2nm manufacturing plants in the US as the industry moves to these highest-spec nodes over the coming years.

Samsung Electronics is purportedly finalising a $17 billion plan to set up a new fab in Texas. Intel is also now spending $20 billion to build two fabs in Arizona.

The US chipmaker is revitalising its foundry operations (after starting to lag TSMC) spurred by the Biden administration’s plan to mirror China’s Big Fund with a tech investment scheme of its own. The $250 billion US Innovation and Competition Act passed the Senate on June 9. Some $52 billion has been earmarked for the domestic chip industry including incentives to establish seven to 10 semiconductor fabs.

As WiC has reported, end-user industries in China have been hit by a double whammy: a global chip shortage, plus Washington’s efforts to stymie semiconductor manufacturers from moving up the value chain. The auto industry has been among the worst affected by the chip shortage. In 2020, Chinese consumers accounted for 20% of global car purchases. However, Chinese vendors accounted for 5% of auto semiconductor supply.

The problem is most acute for electric vehicle (EV) manufacturers, which have surging demand for all manner of chips from: power management chips (PMICs), display driver chips (DDI), CMOS image sensors and microcontroller units (MCUs), which convert battery power into mechanical energy.

This need is forcing auto producers to move away from their previous reliance on just-in time manufacturing processes to establish long-term agreements (LTA) with chip suppliers. In late May, the Nikkei Asia reported that Volkswagen had established an LTA with TSMC to ensure it gets the parts it needs.

How quickly is China catching up?

The ABC of China’s own semiconductor supply lines are starting to take shape with: chip designers like Huawei’s HiSilicon comprising the A, chip manufacturing equipment suppliers like Shanghai Microelectronics (SMEE) the B and manufacturers like SMIC the C.

The main issue China faces is progressing from 28nm manufacturing process nodes to 14nm and smaller – the high-end segment of the market where global chip manufacturers like TSMC are already active. One crucial missing piece of the jigsaw is domestically produced lithography equipment - the most technically complex aspect of the chip manufacturing process.

The global market is currently controlled by Holland’s ASML. But it no longer exports its leading-edge EUV machines to China following US pressure.

SMEE is trying to develop the first Chinese-made 28nm immersion lithography machine. It had previously published posts anticipating achieving this goal by the end of 2021. iNews says these have now been deleted.

The Hong Kong news site also notes that late last year, SMIC also talked about trialling 7nm chip production this April. Since then, it’s also gone quiet.

iNews wonders whether this is because both companies are finding the necessary technological breakthroughs difficult to achieve now that they can no longer rely on overseas equipment. But it also suggests that they may well be keeping quiet about any progress they’ve made for fear of the US trying to tighten the screws even further.

Certainly SMIC’s first quarter earnings indicate that it still has some way to go in reaching more advanced levels of production, with 28nm and 14nm processes accounting for only 6.9% of revenues.

Another company to watch in the lithography space is Beijing RSLaser Optoelectronics Technology (BOET). It produced China’s first 193nm argon fluoride (ArF) excimer laser, one of only three companies in the world able to do so.

Huawei has just become the seventh largest shareholder of the group, which emerged from collaboration between the Institute of Optics and Electronics and the Institute of Microelectronics under the Chinese Academy of Sciences. It purchased a 4.76% stake through its investment arm Hubble Technology. In fact, Huawei has now acquired stakes in 28 domestic semiconductor companies in a bid to find domestic manufacturers for the high-end chips it needs to power its products.

Founder Securities says that investors should pay close attention to the emerging lithography supply chain. The broker flags a number of unlisted companies to watch out for in the future. These include Guowang Optics (lenses), Changchun National Extreme Precision Optics (exposure systems), Beijing U-Precision (nanoscale ultra precise measurements) and CheerTech (immersion systems).

Meanwhile, Huawei’s continues to invest in its chip design arm, HiSilicon, which now reports a workforce of 7,000 staff. It has been focusing on the design of more complex chips, even though Huawei is having problems finding foundries to make them at scale. Local champion SMIC doesn’t yet have the capability for instance, while Taiwan’s TSMC isn’t a production partner because of political pressure from Washington.

Next off the HiSilicon design board will be a chip for the 3nm process node, likely to be called the Kirin 9010. In the meantime, it has had to fall back on US companies for the chips it needs. The new MatePad Pro, for example, will feature Qualcomm’s Snapdragon 870 processor chip for its 10.8-inch version.

Other Chinese companies are also vertically integrating their operations by establishing chip design arms. In April, for example, 36kr reported that EV start-up XPENG has set up an R&D team to develop its own chips. It expects the first designs to be rolled out by year-end.

New chip manufacturers are also coming to the fore alongside SMIC and perennial bridesmaid, Hua Hong Semiconductor, China’s second largest foundry. Many specialise in chips for the auto sector such as GigaDevice, which has become a growing force in MCUs.

The list also includes China Microelectronics, which recently deepened its relationship with the Big Fund to tackle the chip shortage. Together with its second largest shareholder, the China Resources group subsidiary has set up a company called Runxi Microelectronics to expand further into 12-inch wafers.

The Shanghai-listed group is starting to eat into the market share of global giants such as Infineon and ON Semi when it comes to EV power discrete chips. Investors are intrigued: its share price has risen 25% in the past few weeks alone.

However, that’s minor excitement compared to Shanghai-listed Will Semi whose shares have jumped 43 fold since its 2017 IPO thanks to its success making car sensor chips. It’s aiming for a 40% global market share by 2025, mirroring its current 40% domestic one.

Forthcoming listing candidate Nexchip specialises in DDI chips that are mainly used in smartphones, notebooks and TVs. IPO proceeds are being used to construct a second 12-inch fab in Hefei, the capital of Anhui province.

The city government is currently the majority shareholder of the group with a 53% stake. Nexchip was set up as a joint venture with Taiwan’s Powerchip Semiconductor, the world’s seventh largest foundry, which owns 27%.

All this effort is based on the belief that the Chinese semiconductor sector can close the gap on its international rivals. If China can overcome its chip production hurdles at the advanced end of the market, there are strong signs that it might dominate in EV chips. But it won’t be tomorrow.

Longstanding efforts from policymakers to buoy local chipmaking have had an impact but not a transformative one. In 2015, Beijing set a goal of sourcing 70% of its semiconductor needs locally by 2025. Local sourcing has been lifted from about 10% to 16% so far, making the goal look unlikely.