Although 4Q23 revenue fell short of expectations, the positive impact of government subsidies on net profit exceeded expectations; the median value of the 1Q24 revenue/gross margin guidance indicates a month-on-month improvement.
High capital expenses drag down profit margins; government allowances/subsidies help Huahong Semiconductor maintain profits.
Maintain the “hold” rating and reduce the target price to HK$17.00 (corresponding 0.6 times 2024 P/BV)
The 4Q23 net profit of $35.39 million exceeded our agreed loss expectations of 35.39 million, although revenue was 3% lower than expected due to: 1) the positive impact of non-operating government subsidies and 2) the increase in operating losses from 12-inch joint venture fabs, and listed companies only needed to share 51%. Huahong expects 1Q24 revenue to change -1% to +10% month-on-month, taking into account its early price reduction (the average sales unit price of 8 inch/12 inch was 27%/28% lower in 4Q23 than the respective peaks of 4Q22/3Q22). The median value of 3-6% of the gross margin guide also indicates a month-on-month improvement (4.0% compared to 4Q23). The reasons are as follows: 1) Inventory impairment had a 3.9 percentage point impact on gross margin in 4Q23, leading to a lower comparison base; 2) the increase in shipment/order volume in 1Q24 still helps to share fixed costs. We have noticed that the company's listing on the Science and Technology Innovation Board also helps to cushion its temporary operating losses.
We believe that after Huahong completes the production line expansion project (N55-65 process) with a monthly production capacity of 95,000 sheets at the 12-inch joint venture fab in Wuxi, the company's production capacity will remain stable for most of this year. Management said that in 2024, the company will focus more on the construction of the second 12-inch fab in Wuxi. The project scale is 6.7 billion US dollars, with a total monthly production capacity of 83,000 wafers (which means a capital expenditure of about US$81 million per 1,000 wafers, aimed at improving the utilization rate of domestic equipment), and part of this production capacity will be applied to the N40/45 process. Huahong said that the company's second 12-inch fab will expand production capacity by 10,000 to 10,000 tablets in the fourth quarter of this year, and production capacity will expand at a pace of 2 billion US dollars per year for the next three years.
Maintaining the “hold” rating, the target price was lowered to HK$17.00 (previously HK$19.50). Our new price target is based on 0.6 times 2024 P/BV (previously 0.7 times 2024 P/BV). We think the valuation ratio is reasonable because we expect Huahong Semiconductor's return on net assets ROE to be at a low single-digit level after listing on the Science and Technology Innovation Board of the Shanghai Stock Exchange on August 7, 2023. Listed capital raising will also help cushion its temporary operating losses. We maintain our “hold” rating because we expect Huahong Semiconductor's 2024 revenue growth rate to be the lowest among the foundry companies we cover, and there are no recent share price catalysts, although we expect the company's pioneering price reduction to successfully boost demand elasticity (the median value of the 1Q24 revenue and gross margin guidance indicates an improvement over the previous month).
Downside risks: Demand in the terminal market falls short of expectations; power discrete device technology transformation is slower than expected; competition intensifies; and political tension between China and the US intensifies. Upside risks: Demand in the terminal market exceeds expectations; the transition from 8 to 12 inches is faster than expected; competition is slowing; and political tension between China and the US is slowing down.