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Highlights:
- Semiconductors are the next battleground of US-China tech war
- Backed by Chinese gov’t, but facing tough competition
- Aggressive expansion requires heavy investments
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Revenue breakdown 2021
Share price dropped over the past few months
- The steady fall in the price has caught analyst’s off guard leading to their 50% upside
- Analysts might adjust their target prices
Semiconductors are the next battleground of US-China tech war
- In 2020, the US gov’t placed SMIC on the Entity List, which bans the export of US technology to the companies on the list
- Former US Secretary of Commerce Wilbur Ross said
- “We will not allow advanced US technology to help build the military of an increasingly belligerent adversary”
Domestic market provides ample growth opportunities
- Between 2017 and 2021, the share of revenue from North America has halved
- However, that doesn’t hamper the growth prospects of SMIC as the Chinese demand for chips is rising at an enormous speed
- Given the supply shortages, we expect SMIC to continue delivering high double-digit growth
Backed by Chinese gov’t, but facing tough competition
- China attempts to become self-sufficient in semiconductors for domestic consumption
- It aims to ramp up self-sufficiency rate to 70% within the next 5 years (currently 20%)
- To reach that goal, SMIC secured several fundings from the gov’t to accelerate the rollout of new factories
- On top of that, China granted a corporate income tax break for 10 years
Long way to go to close the gap to the Taiwanese leader TSMC
- With a market share of around 57%, TSMC dominates the foundry market
- Also, having top US companies as customers (e.g., Apple, AMD, Nvidia) secures its #1 rank
- Despite the massive ramp-up of SMIC, it might take very long to converge to the profitability level of TSMC
Aggressive expansion requires heavy investments
- I expect the company to continue spending massively on the rollout of its production capacity
- Therefore, it might take a while until SMIC generates enough cash flow to internally cover its investments
- FCFF likely to stay negative in the short run
Consensus is divided
- While 13 analysts have issued a BUY recommendation, many analysts stay cautious on HOLD
- Analysts predict stronger gross margin but a decline in net margin
- This is in line with our forecast due to increasing R&D expenses which are captured in SG&A
Get financial statements and assumptions in the full report
P&L – SMIC
- Despite strong revenue growth, we are likely to see stagnant net profit due to an increase in R&D and SG&A
Balance sheet – SMIC
- Net fixed assets continue to grow at a rapid pace as SMIC expands aggressively
- SMIC has moderately low leverage and being backed by the Chinese gov’t means financial risk is low
Cash flow statement – SMIC
- Rising dividends following the management’s announcement to increase dividend per share
Ratios – SMIC
- The effective tax rate continues to stay low as the company was granted tax exemptions in the context of China’s race for self-sufficiency
- The company holds 1/3 of its assets in cash, making the net debt-to-equity ratio negative
Stock Picking Checklist
Can this company be a ten bagger?
Free cash flow – SMIC
- Heavy CAPEX requirements means that the company is likely to continue seeing negative FCFF
- However, I think that the company can deliver a positive FCFF in 2024 for the first time
Value estimate – SMIC
- Similar to consensus, I expect that SMIC can realize its growth potential
- Plus, I assume that SMIC can increase its ROIC to 20% from 7% over the next decade
Key risk is geopolitical conflict
- Geopolitical situation may put the company’s access to raw materials and equipment at risk
- Change in preferential tax policy could adversely affect the company’s bottom-line
- Failure to keep up with technological changes and falling behind competitors
Conclusions
- Double-digit growth and backing from the Chinese gov’t
- Aggressive expansion plans could lead to ongoing negative FCFF
- Placing a bet on SMIC might turn out fruitful but it’s risky
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Article by Andrew Stotz, Become a Better Investor.
