Huahong Semiconductor invests 12 billion yuan to enhance its 12-inch special process, betting on the hidden risks of the automotive market cycle?

The Huahong Company (688347.SH), which was once questioned for investing 21 billion yuan in wealth management shortly after its IPO, has finally made a major investment move.

On September 20th, Huahong Company, the leading specialty process wafer foundry, announced its plan to use 12.632 billion yuan of IPO funds to increase the capital of its wholly-owned subsidiary, Shanghai Huahong Hongli Semiconductor Manufacturing Co., Ltd. (referred to as "Huahong Hongli"), accounting for nearly 60% of the total IPO funds.

According to the announcement, part of the 12.631 billion yuan will be invested in the 12-inch specialty process production line project of Huahong Manufacturing (Wuxi), and the rest will be used for the optimization and upgrading project of the 8-inch plant, specialty process technology innovation and research project, and supplementary working capital.

According to the prospectus of Huahong Company, the Huahong Manufacturing (Wuxi) project focuses on automotive-grade chip products, and the monthly production capacity is expected to reach 83,000 wafers after production. With the rapid expansion of the downstream photovoltaic and new energy vehicle markets, and the overall capacity utilization rate of Huahong Company exceeding 102%, the expansion of the 12-inch capacity in Wuxi project is particularly important.

A person familiar with Huahong Company, TradeWind01, said that thanks to the rapid growth of downstream product demand in the industry, the company's advantages in diversified specialty process platforms, technical level, and business scale, as well as sufficient and stable growth in hand orders, the company's production lines are operating at full capacity. The strong demand in the downstream market provides ample market space for the company's expansion plans.

Leap to 12-inch capacity

In August this year, Huahong Company set a record for the largest IPO in the A-share market this year, and its fundraising activities have also attracted much attention.

The prospectus shows that Huahong Company plans to invest 12.5 billion yuan of the raised 18 billion yuan in the Huahong Manufacturing (Wuxi) project, accounting for nearly 70%. Another 2 billion yuan, 2.5 billion yuan, and 1 billion yuan are planned to be used for the optimization and upgrading project of the 8-inch plant, specialty process technology innovation and research project, and supplementary working capital.

Huahong Company expects the total investment of the Huahong Manufacturing (Wuxi) project to be 6.7 billion US dollars (approximately 49 billion yuan), of which 4.02 billion US dollars will be invested by the shareholders of the project implementation entity to Huahong Manufacturing through capital increase. The source of Huahong Company's investment is the raised funds from the IPO; the remaining 2.68 billion US dollars will be raised through debt financing, and relevant banks have issued letters of intent for loans.

The continuous expansion of the 12-inch wafer capacity is the main driving force for Huahong Company's future revenue growth.

Currently, Huahong Company's 12-inch capacity is contributed by the first phase of Huahong Wuxi, mainly producing automotive-grade chips. As of the first half of this year, the capacity reached 75,000 wafers per month, contributing 3.63 billion yuan in revenue, but also incurring a loss of 1.158 billion yuan.

The construction of the new production plant for the Huahong Manufacturing (Wuxi) Phase II project is expected to start in early 2023, and the basic completion of the plant construction and equipment installation will begin in the fourth quarter of 2024. Production is expected to start in 2025, with the capacity gradually increasing to a final target of 83,000 wafers per month. According to the research report by Yuan Hang, an analyst at Shenwan Hongyuan, he believes that Huahong Company is "about to complete the transition from primarily producing 8-inch wafers to primarily producing 12-inch wafers, opening up revenue opportunities." Currently, Huahong Company's 12-inch wafer capacity is close to the total capacity of 8-inch wafers. Based on Yuan Hang's profit forecast, he gives Huahong Company a 50x PE ratio for 2023, with a target market value of 102.4 billion yuan.

However, according to the research report by Yan Fan, an analyst at China Merchants Securities, insiders at SMIC (688981.SH) believe that the real incremental demand brought about by the transformation of electric vehicles lies in the 8-inch wafer market, and the demand for 12-inch wafers has not seen such a large multiple growth.

From the performance in the secondary market, Huahong Company is not highly sought after by investors and experienced a first-week drop in its stock price. As of the close on September 21st, the market value of Huahong Company is approximately 80 billion yuan, with a trailing P/E ratio of 23x.

Expanding in sync with the new energy market

Unlike many of its peers who are striving to "stay far ahead" in the race of Moore's Law, Huahong Company is somewhat of an "outlier." It has taken a different approach by establishing a barrier in the field of specialty process foundry services within mature processes.

In 2014, when Huahong Semiconductor (1347.HK) was listed on the Hong Kong Stock Exchange, its market share ranked ninth among global wafer foundries. By the time it returned to the A-share market in 2023, Huahong Company's market share had risen to sixth globally, making it the largest wafer foundry enterprise in mainland China specializing in specialty processes. It is often referred to as one of the "Chinese semiconductor giants" alongside SMIC.

However, Huahong Company and SMIC are not in the same race.

In the chip foundry industry, the leading players in advanced processes take the lion's share of the profits before the followers catch up. For example, TSMC (TSM.NASDAQ), which has already mass-produced 3nm chips, has a net profit that is 17 times that of SMIC, which mass-produces 14nm chips, with a net profit margin approximately 13 percentage points higher.

Huahong Company mainly covers process nodes from 0.15um (1um=1000nm) to 90nm, focusing on products that do not require high operating speeds but emphasize customized specialty processes.

Insiders at Huahong Company stated that specialty processes test the company's flexibility in customization, quick customer response, process maturity and stability, diversity of process platforms, and the richness of product offerings, which will be the key to competitive advantage.

"After years of deep cultivation and development in the industry, the company has accumulated a rich product portfolio in the fields of embedded/independent non-volatile memory, power devices, analog, and power management specialty processes, and can provide customers with diversified products and system solutions. With the steady growth of market demand, the further manifestation of economies of scale, and the increasing recognition of our products in the market, the company's gross profit margin has growth potential in the long term," the aforementioned insider said.

In terms of revenue contribution by foundry platforms, power devices and embedded non-volatile memory are the two largest platforms for Huahong Company, contributing 5.226 billion yuan and 5.205 billion yuan in revenue in 2022, accounting for 31.36% and 31.23% respectively. According to the research report by Yuan Hang, an analyst at Shenwan Hongyuan, Huahong Company ranks first in power device capacity among wafer foundries and is the only company with both 8-inch and 12-inch power device manufacturing capabilities.

The main products of Huahong's power devices include the conduction resistance of the Super Junction MOSFET process platform, which can be applied to high-power fast charging power supplies, LED lighting power supplies, data center power supplies, and new energy vehicle charging stations. Another main product, the IGBT chip, is known as the "CPU of power electronic devices" and is widely used in new energy vehicles, photovoltaics, wind energy, and other new energy fields.

Embedded non-volatile memory mainly includes automotive MCU, industrial control MCU, consumer MCU, and smart card chips.

In the field of smart card chip manufacturing, Huahong Company is a dominant player. It supplies 75% of the national ID card chips and 80% of the social security card chips, making it the world's largest smart card chip foundry.

According to the research report by Jiang Gaozhen, an analyst at Zhejiang Securities, automotive MCU, as the core chip for body control, intelligent cockpit systems, automotive batteries, and motors, has a very broad application prospect.

According to IC Insights, the global MCU market size increased from $16 billion to $20.7 billion from 2015 to 2020. At the same time, the Chinese MCU market size increased from 18 billion yuan to 26.8 billion yuan, growing at a faster rate than the global market.

According to industry insiders in the semiconductor industry, the chips used in new energy vehicles are about 3 to 5 times that of traditional vehicles, and the largest demand for chip manufacturing compared to traditional gasoline vehicles is power semiconductors.

Huahong Company officials also stated that the expansion of the new energy industry will drive the growth of the company's related products such as power devices, MCUs, analog chips, and sensors. For example, the semiconductor value of new energy vehicle systems will be twice that of traditional vehicles, and the application of power semiconductors will increase significantly, benefiting the company's power device sector.

Opportunities and Risks

Although the leading manufacturers supplying automotive-grade chips mostly adopt the IDM production model, such as Infineon, Mitsubishi, and ON Semiconductor, with a combined market share of 51%,

However, as the largest consumer market for new energy vehicles globally, due to the late entry of domestic chip design companies and a lack of manufacturing capabilities, they have to rely on external foundries for production. The "chip shortage" in 2021 was an opportunity for domestic manufacturers to enter the supply chain of automakers, as well as an opportunity for foundries like Huahong Company to take on the outsourcing demand of some domestic manufacturers.

The Huahong Manufacturing (Wuxi) project, which the company plans to invest in, is a 12-inch wafer fab for the production of automotive-grade chips.

According to the research report by Jiang Gaozhen, most of Huahong's customers are from China, with system companies and fabless chip design companies accounting for 91.6% in 2022. Under strong demand, Huahong Company's capacity utilization rate remains high. In the second quarter of this year, Huahong Company's 8-inch wafer capacity utilization rate reached an impressive 112.0%, while the 12-inch wafer capacity utilization rate reached 92.9%. The overall capacity utilization rate reached 102.7%.

However, the downstream market for new energy vehicles is showing signs of weakness, and the inventory risk downstream may force upstream production to become more cautious, adding uncertainty to Huahong Company's expansion prospects.

According to the China Automobile Dealers Association, although sales in September increased by double digits compared to the same period last year, they were significantly lower than expected. The survey shows that 64.6% of dealers believe that September sales were lower than expected. The inventory warning index for Chinese automobile dealers in September was 55.2%, an increase of 4.3 percentage points compared to the same period last year and an increase of 0.5 percentage points compared to the previous month. The inventory warning index is above the boom-bust line.