SMIC: U.S. Sanctions Aimed At This Chinese Foundry Aren't Working

Summary

• U.S. sanctions against China's SMIC haven't worked in the last 18 months as SMIC continues to exhibit strong revenue growth at the 14nm node and above.
• As with the Russian sanctions, where Biden strongly stated "sanctions never deter," questions are raised about the impact of these sanctions.
• The only company impacted is equipment supplier ASML, from The Netherlands, not China.
• U.S. semiconductor equipment suppliers Applied Materials and Lam Research have had little to no impact.
• This idea was discussed in more depth with members of my private investing community, Semiconductor Deep Dive. Learn More »

Yakobchuk/iStock via Getty Images

The U.S. government seems to be leading from behind when it comes to imposing sanctions on Chinese foundry Semiconductor Manufacturing International Corporation (SMIIC) (OTCQX:SMICY). For example,

• On July 17, 2020, prior to the U.S. sanctions, I published a Semiconductor Deep Dive Marketplace subscription article entitled "China: Who Needs TSMC When They Have SMIC?"Six weeks later on Sept. 4, 2020, Reuters reported the Trump administration was considering whether to add China's top chipmaker SMIC to a trade blacklist, as the U.S. escalated its crackdown on Chinese companies.

The result? China was the leading region for semiconductor equipment revenues in 2020.

• On Aug. 11, 2021 I wrote a Seeking Alpha article entitled "SMIC Is Closing The Gap With Industry Leaders Despite U.S. Sanctions." Less than three months later, on Dec. 15, 2021, an article was published in Fortune with the title "Shares of China's largest chipmaker sink to lowest close in nearly a year as Biden team considers tougher sanctions."

The result? China was the leading region for semiconductor equipment revenues in 2021.

Coincidence? I don't know. Further sanctions would hurt U.S. suppliers Applied Materials (AMAT) and Lam Research (LRCX), as it did ASML (ASML) with a blockade on its EUV lithography exports to China.

Three months after this Dec. 15 article, nothing has been done on further sanctions, except for U.S. Commerce appeasing ASML by adding 33 Chinese entities to its Unverified List on Feb. 8, 2022. One of these companies is SMEE, the China home-grown company that's developing advanced lithography systems, particularly DUV immersion, that will enable 7nm production. SMEE is the company I was referring to in my last bullet of my Aug. 15, 2021, article noted above.

Are Sanctions Working?

Despite the intentions of sanctions, we need to consider the comment by President Joe Biden on the Russian sanctions imposed after their invasion of Ukraine:

"Sanctions never deter," Biden said during a Thursday press conference at a NATO summit in Brussels, Belgium.

According to the Newsweek article, this comment was counter to comments by the White House Security Advisor and the U.S. Secretary of State that sanctions were intended to deter. Biden was right about Russia because sanctions didn't deter, and it appears that this comment has resonated with China.

In an earnings release, SMIC reported that:

• Revenue was $5,443 million, record high - Compared to $3,907 million in 2020
• Gross margin was 30.8%, record high - Compared to 23.6% in 2020
• Profit from operations was $1,393 million - Compared to $312 million in 2020
• Profit attributable to SMIC was $1,702 million - Compared to $716 million in 2020

SMIC's guidance was strong, and the company has earmarked US$5 billion for capital expenditure this year, up from US$4.5 billion in 2021. The investment could boost its monthly capacity by 130,000 to 150,000 8-inch equivalent wafers.

SMIC's revenues have increased consistently since the sanctions, which may have had a minor impact in Q4 2020 after the July 2020 imposition, as shown in Table 1.

SMIC

SMIC plans to increase capex spend to $5 billion increasing overall capacity by 130-150 kwpm (8" equivalent) in 2022.

SMIC is the only leading foundry that plans to increase 8-inch wafer capacity, as shown in Table 2.

SMIC

In addition, SMIC intends to construct three mega fabs that will 240 kwpm total capacity addition at the 28/40nm nodes, as shown in Table 3.

SMIC

Table 4 shows total wafer shipments between 4Q 2020 and 4Q 2021 for SMIC, again showing expansion despite sanctions.

SMIC

Table 5 shows capex spend for the leading foundries. SMIC cut capex spend in 2020 following U.S. sanctions, but after recognizing their ineffectiveness, will increase spend in 2022, according to the report entitled "Mainland China's Semiconductor and Equipment Markets: Analysis and Manufacturing Trends."

The Information Network

One of the contributing factors in the increase in QoQ revenues shown above in Table 1 is an increase in output by smaller nodes, which command higher chip prices. Chart 1 shows that at the smallest dimensions (top of each column), SMIC increased output consistently over the past five quarters while decreasing output at the largest nodes (bottom of each column).

SMIC

Chart 1

Investor Takeaway

Because of U.S. sanctions, SMIC is blocked from purchasing EUV systems. Does it matter? SMIC has exhibited strong growth since sanctions were imposed, and YoY revenue growth of 39.3% was more than twice that of leading foundry TSMC's (TSM) 12.5%.

Equipment sales to China are another thing. In 2021, China maintained the top position of equipment purchases, as it did in 2020. However, according to the report entitled "Global Semiconductor Equipment: Markets, Market Share, Market Forecasts," Taiwan is expected to regain the top position in the sector in 2022 and 2023. But China will be a strong third behind South Korea, as Taiwan and S. Korea ramp up capex spend for <7nm chips using EUV lithography.

Chart 2 shows equipment sales to China by type by quarter for 2020 and 2021. The chart shows that the trend on a QoQ basis does not reflect any negative impact of sanctions on equipment purchases by China.

The Information Network

Chart 2

SMIC isn't the only Chinese foundry that has grown strongly. Another Chinese foundry, Hua Hong, also has its most advanced technology with a mature 28-nm process and it is working on advanced 14-nm technology - an area where SMIC has already achieved scaled production.

According to its latest financial figures, the company's revenue in the fourth quarter increased 88.6% from a year ago to an all-time high of $528.3 million while its net profit surged 212.8% to $88.2 million.

In 2021, Hua Hong's revenue grew by 70% YoY to $1.63 billion, while its net profit for the year reached a record high of $182 million.

In short, as with the Russian sanctions, where Biden strongly stated "Sanctions never deter," questions are raised about the impact of these sanctions on Chinese semiconductor equipment other than the blockage of EUV lithography systems limiting nodes to 7nm.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Comments

[typecheck]

I don't know how the sanction on semiconductor will play out in the future but in areas where US has imposed absolute sanctions like space technology, nuclear technology, aerospace technology, China has made its own inroad and developed its own industrial footprint that can stand on its own.

To China, it is matter of time and determination to develop a particular industry. EUV lithography is not an absolute barrier that China cannot overcome. It is just not economical to invest in this when the risk/reward ratio is not favorable.

[zver11]

@typecheck Almost certainly, Chinese manufacturers of DUV equipment are already looking at developing EUV. Only SMIC in China is at the point of becoming a potential buyer. At this point, more practical to perfect DUV machines which have a much larger market. A Chinese made EUV system would be expensive given that SMIC would be the only customer for the next few years. It is still perfecting 7nm. First want to get low defect DUV even with a lot of printing steps. Once this is perfected, can experiment with an EUV machine for a stretch. Companies using EUV generally started with a single machine until processes and supporting components work well. Takes a while to perfect pedicles and other accessories needed to work with EUV. Without the full ecosystem it is a just a very expensive toy. For Chinese equipment manufacturer, even priced at $200 million, first machine likely to be a loss leader to build business.

As an aside, the greatest weakness of China, at this point in time, if they are trying to become totally self-reliant, is their ability to manufacture blank wafers! Chinese wafers are not near good enough quality to print 28nm circuits without a huge defect rate! SMIC is still dependent on west for a variety of key components including wafers. China's push to require government entities to only use Chinese made computers and Chinese origin software in two years will cause a lot of progress. The big question is whether they are detail oriented to fill in all the details like high quality wafer production.

[Robert Castellano]

@zver11 Yes agree. They're looking at a lot of different methodologies, including Changchun Institute of Optics, fine Mechanics and Physics, Chinese Academy of Sciences(CIOMP).
Interesting point on wafers. Thank you.

[rodness]

Robert, the purpose of the sanctions against Russia isn't to deter. It's to cripple Russia's ability to wage war. The US honed sanctions as an economic tool after the first Gulf War and successfully (though ironically, given our invasion) neutered Saddam's ability to build WMD by 2003. The US has more or less moved away from using sanctions broadly to coerce civilian populations to overthrow their governments. Sanctions are now tailored to deny the adversary's capabilities.
My understanding is that sanctions against China are far far less comprehensive and are intended to prevent China from narrowing the technological gap with the West. So the question you should be answering is not whether sanctions have broken China's semiconductor industry or profits but rather whether they have hindered China's ability to build more sophisticated semiconductors.

[Robert Castellano]

@rodness This is a joke comment right? I see how the sanctions crippled Russia going into Ukraine.
The sanctions in China to prevent China from narrowing the technological gap with the West are a byproduct of the U.S. attempts to limit and restrict advanced chips going into military products.

[rodness]

@Robert Castellano As I stated, the purpose of the sanctions was *not* to deter. The sanctions undermined Russia's ability to modernize its military. Why do you think the Armata combat system has not yet entered into mass production?

[zver11]

While, I do not consider Chinese stocks a safe investment for a foreigner(political as much as economic issues), I expect SMIC to grow into a major world class foundry. China's 2025 goals of total domestic semiconductor supply chain probably will not catch up to TSMC top nodes by then, but it will be competitive for most products. Sanctions up the motivation for Chinese(and other sanctioned entities) to buy from Chinese suppliers and developing a home grown supply chain. Electronics sanctions have more disruptive effect on small economies such as Iran or Russia, but China is a large enough market that it can support its own semiconductor industry. The fact that most advanced countries have outsourced most of their manufacturing to China, strengthens the ability of Chinese foundries as they are near their customers and these customers are subject to both formal and informal government pressure to favor the Chinese sourced electronics over imports in all their manufacturing operations.

[Inquiring_Mind]

People don't want to believe this and have little inner knowledge but SMIC is advancing at a better and faster clip than their competitors... still a sleeper and dirt cheap of a stock, but of course with all the noisy risk factors swirling non stop, such as sanctions threat that has only served to push SMIC further and faster along.

[jeffk100]

For those that need product, sanctioning suppliers never works and is stupid to a fault. Both dems and repubs have been stupid enough to have imposed sanctions and wound up hurting their own far more. Yet still they do it. Insanity