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Semiconductor Manufacturing International Corp (981 HK) Summary

Core Content

Semiconductor Manufacturing International Corp (SMIC) is a leading foundry company in China, offering semiconductor wafer fabrication, masking, packaging, and testing services. It operates multiple fabrication facilities, including 8" and 12" plants in Shanghai, Beijing, and Tianjin, and has a significant presence in the Chinese semiconductor market.

Main Points

• Profitability Concerns: SMIC's profitability, which had turned around after a management reshuffle in 2011, is expected to slow down in the coming quarters due to the ramp-up of its 28nm process technology.
• Margin Drag: The initial phase of 28nm ramp-up will likely drag on margins, with SMIC's gross margin expected to reach its corporate average only in 2H16.
• Earnings Forecast: We forecast SMIC's operating profit to dip into the red in 1Q15 (excluding subsidies), with a significant drop in 2015E EPS compared to the Bloomberg consensus.
• Valuation Issues: SMIC's current PBR is 1.4x (2014E), which is 70% higher than UMC's, and is not justified by fundamentals. We set a target price of HKD0.65, implying a 23.5% downside from the 17 Nov price of HKD0.850.
• Investment Recommendation: We initiate coverage with a Sell (5) rating, as we believe the valuation is too high relative to its fundamentals. We prefer TSMC (2330 TT, TWD133, Buy [1]) for its stronger technological position and better earnings outlook.
• Long-term Potential: SMIC is well-positioned to benefit from the growing Internet of Things (IoT) market, which could offer long-term growth, but this will take time to materialize.

Key Information

Financial Highlights (2014E - 2016E)

Earnings Revisions

• Bloomberg consensus EPS for SMIC has been cut following the 5 November 2014 results call.
• Our 2015 EPS forecast is 57% below the consensus, indicating a significant downward revision.
• We expect further earnings cuts due to the 28nm ramp-up and its impact on margins.

Capital Expenditure and Capacity

• SMIC is increasing capital expenditure to support the 28nm process.
• 28nm capacity is expected to reach 6,000 wpm by end-2014 and 15,000 wpm by end-2015.
• The company's 28nm revenue contribution is projected to start in 2Q15 at 1-2%, increasing to 10% by 4Q15 and 17-18% by 2H16.

Valuation Methodology

• We use an ROE-adjusted PBR method for valuation, as it better captures structural profitability.
• SMIC's projected ROE (5-7% pa) is significantly lower than TSMC's (22-23% pa), leading to a 69% discount.
• This results in a target PBR of 1.1x for SMIC, yielding a target price of HKD0.65.

Risks

• Primary Risk: If SMIC's 28nm ramp-up occurs faster than expected, margins could improve sooner than forecasted.
• Secondary Risk: Stronger-than-expected demand from China could benefit SMIC's wafer loadings beyond the 28nm node.

Conclusion

SMIC is currently facing a challenging period due to the margin drag from its 28nm process ramp-up and its overvalued PBR relative to UMC. While the company has a solid foundation and long-term growth potential in the IoT market, its current valuation does not reflect its fundamentals. We therefore initiate coverage with a Sell (5) rating, recommending investors to avoid SMIC in favor of TSMC for better returns.