High depreciation pressures the gross profit rate, improvement needs to be seen in the second half of the year (Summary of SMIC's Q4 2022 Earnings Call)

On the evening of February 10th Beijing Time, SMIC (0981.HK/688981.SH) released its Q4 and full-year financial report for 2022 (ending in December). Here are the highlights:

Quarterly Core Data Vs. Market Expectations:

Revenue: Revenue for the quarter was $1.621 billion, a QoQ decrease of 15%. It barely reached the lower end of the guidance range (-10% to -15%).
Gross margin: Gross margin for the quarter was 32%, meeting market expectations (31.6%).
Capacity utilization: Capacity utilization for the quarter was 79.5%, a significant decrease from the previous quarter.
Guidance for the next quarter: SMIC expects revenue to decrease by 10%-12% QoQ in 1Q 2023 ($1.43 billion to $1.46 billion), significantly lower than market expectations of $1.524 billion. Gross margin is expected to be 19%-21%, significantly lower than the market's expectation of 26%.

1. Conference Call Transcript

1. Management presentation

In 2022, demand in the markets for smartphones, computers, and home appliances has shifted from warm to cold, with significantly weakened client order intentions. The industry chain has entered into a de-stocking cycle from supply shortage. At the same time, changes in the international geopolitical situation have brought more far-reaching impact on the integrated circuit (IC) globalization pattern. This creates a never-before-seen challenge for the industry.

The company had sales revenue of $1.621 billion in Q4, a QoQ decrease of 15%, and a gross margin of 32%, which is consistent with the company's judgment and guidance to the industry.

Looking at the overall situation in 2022, according to the unaudited financial data, the company's total revenue reached $7.2 billion, with a YoY growth of about 34%, which has achieved consecutive growths of more than 30% for two years from 2021 to 2022. In 2022, the gross margin increased to 38%, which is a historical high.

In terms of revenue distribution by region throughout the year, China, the United States, and Eurasia accounted for 74%, 21%, and 5% respectively. Revenues from China and the United States increased by 42% and 24% YoY.

In terms of wafer revenue distribution by size, 8-inch and 12-inch wafers accounted for 33% and 67% respectively. Revenue increased by 24% and 42% YoY.

In terms of wafer revenue distribution by application, revenue from smartphones, consumer electronics, smart homes, and other applications accounted for 27%, 23%, 14%, and 36% respectively. Revenue increased by 14%, 32%, 48%, and 54% YoY. The growth in consumer electronics and smart homes mainly came from large growth in appliances, wired and wireless connectivity applications, industrial IoT, and other applications in automation, industry, power management applications, and wearable devices. At the same time, as the company actively promotes car-grade verification and production-level power management, body control, and in-car entertainment systems, relevant revenue growth has been significant.

The company's capital expenditure in 2022 was $6.35 billion. By year-end, the 8-inch monthly capacity reached 714,000 pieces, a YoY increase of 15%. Capacity utilization reached 92% throughout the year amid the gradual release of new capacity. From the perspective of the four mature 12-inch new fab projects, by the end of 2022, SMIC Shenzhen will enter the production phase, SMIC Beijing will enter the trial production phase, SMIC Lian Gang has completed the main structure topping out, ZTE Xiqing will begin civil construction, and Zhongxin Beijing is expected to delay production time by 1-2 quarters due to the delivery delay of the base.

Looking forward to 2023, the recovery of the smartphone and consumer electronics industries will take time, while the industrial sector is relatively stable, and the incremental demand for electronics in the automotive industry can offset some of the negative impact of the weakness in smartphones and consumer electronics. The industry cycle is still at the bottom in the first half of the year, and the impact of external uncertainties is still complex. Although visibility remains uncertain in the second half of the year, the company has already felt some recovery in customer confidence, and reserves of new product flow are relatively full.

Taking into account the above factors, the company's guidance for the first quarter is that revenue is expected to decrease by 10%-12% compared to the previous quarter, and the gross profit margin is expected to decrease to between 19% and 21% due to lower production capacity utilization and increased depreciation.

Based on the relatively stable external environment, the company expects a low double-digit year-on-year decline in sales revenue for the full year 2023. The gross profit margin is around 20%, with a year-on-year increase in depreciation of more than 20%, and capital expenditures are roughly in line with the previous year.

Regarding the above guidance, two explanations should be made. First, in the process of continuing high investment, the gross profit margin will bear high depreciation pressure, which is an industrial law. The company will always aim to achieve sustainable profitability, strive to grasp the pace of capacity construction and expansion, and ensure a certain level of gross profit margin. Second, the company's capital expenditures this year will mainly be used for expanding production capacity for mature factories and new factory infrastructure. The company will push forward the capacity construction of four mature 12-inch fabs. Since construction plans for local fab projects have been launched in various regions around the world, the supply chain of key equipment is still tight. It is expected that the monthly production capacity by the end of the year will increase compared to the previous year.

In the long run, in the era of increasingly widespread digitization, intelligence, and greenization, the demand for chips continues to grow. The company will seize the industrial law and consolidate its leading advantages in the subdivided fields, strengthen medium and long-term binding cooperation with global clients and system companies, and promote upstream and downstream cooperation in the industrial chain.

2. Q&A

Q1: What is the current inventory level in the industry? How do we view the approximate decline in the first and second halves of the year?

A1: In fact, the industry can be distinguished. We now differentiate it into the smartphone industry, the consumer electronics industry, industry, the automotive industry, and others. The inventory of the smartphone industry is still relatively high at present. We think the inventory of the consumer electronics industry may be consumed within half a year. The industrial sector currently has no inventory, and the automotive industry, especially new energy vehicles, is in short supply.

Specifically for individual companies, in the smartphone and consumer electronics categories, the highest inventory is related to display driver circuits, whether it is large-screen televisions, medium-sized monitors, or small screen smartphones and panel driver ICs. The inventory is very high, possibly exceeding three quarters. Of course, some individual companies may have enough for the whole year. The next most significant and bulk product is like CMOS, image, and PC, which are also relatively high. Below that are more generic products, such as dedicated memory, which has stock for more than six months. Currently, there are small amounts of stock for MCU types, but they vary widely, and we are gradually seeing a recovery. We need to see if the macroeconomic situation will continue to decline because the consumption of mobile phones, whole cars, and electronic terminals is driven by the entire economy's recovery.

Q2: What is the plan for talent reserve considering the development of new factories in the future?

A2: Currently, SMIC has over 20,000 employees, with more than 10,000 engineers and over 2,000 full-time R&D personnel. We have a sufficient reserve of talents these past few years. The employee turnover rate in SMIC is below the industry average, and is also the lowest in recent years. SMIC is the largest IC manufacturing enterprise in mainland China, and we have a great business platform. We offer employees and excellent engineers good living and welfare conditions, and I believe that talent in mainland China will prioritize platforms like SMIC that have good development prospects and welfare treatment. We also have new projects in Beijing, Tianjin, Shanghai, and Shenzhen, and some recruitment measures. Judging from the recruitment situation last year and this year, applications are enthusiastic, and the quality of talent, including the university where they graduated from, has improved.

Q3: Regarding the outlook for gross margin in the first quarter, apart from the utilization rate and depreciation, are there any pricing reasons or other mixed factors?

A3: The decline in gross margin may be due to two factors. The first is mainly due to the reduction in wafer testing and cutting (affected by last quarter's old orders). The second is the increase in new depreciation-we have expanded capacity, and we have capital expenditures, which will generate depreciation regardless of whether you have orders. These are the main factors. Due to the combination of product mix and ASP, the first quarter (gross margin) erosion is still at its lowest level.

When we expect the market's recovery to be consistent with the overall economic situation, we know that many new orders may come from various types of products, such as non-flash, MCU, CMOS, ISP, and so on. The price of these large-order products will be relatively low. Basically, when the market returns to the level two years ago, we will find that the total supply capacity has increased significantly. Therefore, the price may not recover to the profitability level. Given this factor, we will say that even if we generate revenue, our capacity utilization rate guidance may increase in the second half of the year, but the gross margin may not recover that much.

Q4: Regarding the utilization rate of capacity, are there any specific areas that are expected to recover to full utilization during the economic recovery? A4: If you look at the numbers we just gave, the mobile phone department accounts for only 27% of the total revenue, while the consumer electronics department accounts for roughly 23%. Together, these two departments make up 50% of the total. However, previously, the mobile phone department accounted for about 35-45%. This means that the department's work is very difficult, and consumer electronics have also declined a lot. When we see a rebound, because the original equipment manufacturing business is a very large industry (from mobile phones and consumer electronics), we can expect that mobile phones and consumer electronics will recover to their previous levels. At that time, our utilization rate will definitely reach around 90%. The health recovery of the overall market depends largely on the recovery of these two markets.

Q5: Are there stable signs of rolling forecasting for customers?

A5: The market is clear and the overall economic situation is not so good. It probably affects the overall volume of the end terminals more or less. So first we look at the macro economy.

Second, if the macro economy recovers to the level of 2020, there was actually a panic sentiment among the demand of many products in 2021 and 2022, maybe he needs 100, and he ordered 150 or something. By the second year, he felt that there was no panic, so he only ordered 50, so the total for two years is still 200. But the first year was 150, and the second year was 50. As you can see, the difference between the two years is quite large. If you average it out, it will return to 100. I think the real demand for the industry averaged out in 2020 or 2019. Using this demand to divide the inventory currently announced by everyone, you should be able to see that it should start to be replenished normally in the second half of this year. It should return to the total amount of orders in 2020 and 2019, plus some new demand in the new energy vehicle industry. So the amount of this quantity estimated by us when communicating with our customers, we think there should be such a recovery in the second half of the year.

But let me say one more thing here. The entire market's production capacity is now much larger than it was at that time, so the demand and wafer out volume should come back, but the entire price may not return to the original high. This is what we all have to do. Our products and technology should be more competitive, and we need to be more tightly bound to end customers, so as not to enter a low-end price competition.

Q6: Regarding the income in the United States, we see quarter-over-quarter growth every quarter. How should we look at this year?

A6: We just announced that the United States accounts for 21% of SMIC's revenue, and it should maintain this proportion. Because many of our customers, in fact, their products are very closely related to the Chinese market, such as mobile phones and consumer cars. So when the Chinese market returns, the orders of American customers will also return, and the ratio should be roughly maintained at around 20%. At that time, the Chinese market will return, the denominator of Chinese customers' orders will increase, and the denominator of American customers will also increase, and the percentage will be about 20% or so. Q7: How does exchange rate fluctuations affect income and gross profit margin?

A7: Our income settlement is in both RMB and USD, and the same cost and expense settlement is also in both RMB and USD. The impact of exchange rate fluctuations on income and cost is opposite in direction. Therefore, the impact of exchange rate fluctuations on our gross profit margin depends on the proportion of USD settlement in our income and cost structure, which is variable and relative. Therefore, the impact has a certain degree of uncertainty. In terms of income alone, looking at the situation of the fourth quarter, the depreciation of the RMB has a negative impact on income.

Q8: What is the pace of the increase in production capacity and the average unit price?

A8: We do not talk about the price of SMIC, but rather the price of products currently sold in the market. In the past, when the supply was insufficient, the prices were very high, especially for bulk products such as CMOS, non-flash, specialty memories, and LCD drivers.

We already know that compared with the price in the third quarter of last year, the random terminal price has dropped by about 30%. So, we can roughly calculate that if we want to return to the level of 2019 and 2020, there should not be such a large drop.

We expect that the price should meet everyone's demand for gross profit margin, and at the same time, be able to survive and grow. If you ask me what the price will be when it comes back, I really can't predict what the price will be, because the current orders for these bulk products are very small, and the price when it returns is not completely predictable.

Q9: Can you share the approximate situation of prepayments in the capital expenditure for 2023? What will be the situation of actual cash spending on delivery of equipment in the end of 2022 and 2023?

A9: Last time we announced that we had considered a prepayment operation, and the upper limit we would do for capital output was $6.6 billion, but in fact, we only did $6.35 billion, which means that some prepayment operations did not occur last year, so they will be delayed until the first quarter. You know that the delivery time, price, and different equipment of this device are different, so the delay will continue to this year. This year we will have prepayment happening again, but it will be different from last year. Our capex this year is about the same as last year, and the amount of prepayment may be slightly less. Our infrastructure products will have a little more to them. Last year, we didn't have as many factories closing down, but this year we will have a little more. We need to build clean factory buildings, buy production equipment, but this year we will have a little more in this regard. This is what I just said, infrastructure construction to build factory buildings to buy products for decoration, the clean room will be higher than last year, subtracting the two main parts is the arrival of mature equipment.

Q10: Regarding the disclosure of quarterly data for different regions, it seems that the disclosure standards for the China region and the Eurasia region have been adjusted. The proportion of revenue in the US region has actually increased. I would like to ask what is the reason for this?

A10: The market impact in the United States followed changes in the Chinese market by about four to five months. The Chinese market underwent changes in May of last year, at which time it was actually recovering in the US and European markets. When the US market was basically no longer growing and no longer adding orders, it was the end of last year. Therefore, we see no significant changes in the fourth quarter, and **any changes that may occur may occur in the first quarter of this year, ** which is the first lag phenomenon.

The second is the US market, and these customers have a smaller decline. The characteristic of Chinese customers is that their volatility is relatively large. Regarding your first question, the proportion in the China region seems to look different from the previous record, right? Originally, we merged Taiwan with the Eurasia region because its business is very similar to Japan and South Korea, so we divided it into the Eurasia region. But now we have changed the company's sales practices and classified it into the China region, so we will find that the numbers will increase compared to before.

Dolphin SMIC historical article retrospective:

Financial report season

February 9, 2023, Financial report review《 SMIC: Visible downturn, but now the difference is good?》

November 11, 2022, conference call《 Even though semiconductors are going downhill, capital expenditures are not reduced (SMIC 22Q3 conference call)》

November 11, 2022, financial report review《 [SMIC: Long-term faith, also unable to escape the "cyclical curse"] (https://longbridgeapp.com/en/topics/3634321)》

August 12, 2022,《 Entering the down cycle of semiconductors, how does SMIC respond? (22Q2 conference call minutes)》

August 11, 2022,《 [The Price Cannot Rise Anymore, SMIC Holds on to the "Cyclical Plunder"] (https://longbridgeapp.com/topics/3297694)》

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