A proposal from the USA has caused the Hong Kong stocks' semiconductor sector to plummet for multiple days.

As informed by the International Finance News APP, the United States Department of the Treasury recently released a 165-page proposal aimed at limiting Americans' investment in the Chinese market in the fields of semiconductor and microelectronics, quantum information technology, and artificial intelligence, among others. The proposal is expected to take effect after August 4th of this year. Influenced by this event, coupled with market fluctuations, funds fled from the semiconductor sector, and it fell 10% for three consecutive trading days, with Hua Hong Semiconductor (01347) leading the way.

The restricted investment areas in the proposal are all key areas of China's support and development. In these areas, China is very cautious about introducing FDI (Foreign Direct Investment) and has investment restrictions in many key areas. The proposal does not have a significant practical impact on foreign investment in China. However, American capital has been stirring, and institutions holding listed semiconductor companies or those that are more globally accessible on the Hong Kong market have had their emotions stirred, resulting in more or less influence on stock prices.

In fact, the more limitations the United States imposes, the more it can stimulate China's independent innovation capabilities and accelerate the speed of indigenous replacements. It is actually good news for targets in the domestic industrial chain, as they can gain greater market opportunities and performance growth.

Industry recovery accelerates indigenous replacement.

According to the International Finance News APP, the US 'Proposed Rulemaking' proposal is actually a detailed provision for Executive Order 14105 issued by President Biden of the United States in August 2023, 'Executive Order Regarding the Handling of Investments in Specific Domestic Technologies and Products in Sensitive Countries by the United States.' It adds investment restrictions on advanced packaging and EDA and other advanced technologies. However, domestic expectations have long been the case, with continuous investment in key areas, accelerating indigenous replacements.

In May 2024, the third phase of the National Integrated Circuit Industry Investment Fund will be officially established, with a registered capital of up to 344 billion yuan. It is expected that the main investment direction of the future National Large Fund Phase III will focus on key bottleneck areas such as advanced wafer manufacturing, advanced packaging, and AI-related chips. As a future industry that is explicitly written into the development category of new productive forces, the National Large Fund will continue to promote domestic independent innovation.

From an industry perspective, AI is becoming the protagonist of the times, accelerating innovation in electronic devices, including mainstream terminals such as AI smartphones and AI PCs. The wave of upgrading devices and potential demand has greatly boosted the demand in the upstream of the industry chain. Since September last year, the industry has emerged from the negative growth range and entered an upward cycle. Since 2024, the industry has continued an upward trend. Storage and logic circuit terminals have performed the best, and according to WSTS (World Semiconductor Trade Statistics), the global semiconductor market is expected to increase by 16% and 12.46% in 2024 and 2025, respectively, on a year-on-year basis.

Wafers are the most upstream part of the semiconductor industry and will benefit from the drive of the industry chain under demand. According to SEMI, global semiconductor wafer factory capacity is expected to increase by 6% and 7%, respectively, in 2024 and 2025, of which high-technology wafers below 5 nanometers will increase by 13%. China's domestic production capacity growth rate is much higher than the global level, and it is expected to increase by 15% and 14%, respectively, in 2024 and 2025, with a production capacity of 10.1 million (wpm), accounting for about one-third of the industry's total production capacity.

It is worth noting that the industry market is highly concentrated. In the first quarter of 2024, TSMC steadily held the first place with a market share of 62%, Samsung ranked second with 13%, and SMIC ranked third with 6%. Benefiting from the demand of the industrial chain and IC domestic replacement, SMIC (00981) had decent performance in 2024. In Q1, the capacity utilization rate increased significantly to 80.8%, and the revenue achieved by capacity release was USD 1.75 billion, a year-on-year increase of 19.7%.

SMIC is aggressive, and Hua Hong is relatively cautious.

In the past few years, under the strong support of the country, China's semiconductor industry's domestic substitution rate has significantly increased. According to data from SEMI (International Semiconductor Industry Association), in 2022, China's wafer manufacturers' domestication rate of semiconductor equipment reached 35%, an increase of 14 percentage points compared to 2021. In 2023, according to China's bidding data, the proportion of domestic semiconductor equipment winning bids in the production lines of major wafer factories in China will reach 47%.

SMIC is the largest wafer manufacturer in China and plays an important role in domestic substitutions. The company produces 8-inch and 12-inch wafers, and its downstream customers include smartphones, computers and tablets, consumer electronics, the Internet of Things, and the industrial and automotive sectors. In the first quarter of 2024, China's revenue accounted for 81.6%, while overseas revenue accounted for 18.4%. The company has been committed to expanding its goals for many years, with a net investment outflow higher than its annual production capacity utilization rate. However, under improved demand this year, it has increased significantly, with monthly production capacity reaching 814,500 wafers.

However, affected by depreciation and material cost increases, the company's revenue did not increase in Q1 2024. The gross margin was 13.7%, down 7.1 and 2.7 percentage points year-on-year and quarter-on-quarter, respectively, excluding non-operating expenses (depreciation and amortization), the company's EBITDA profit margin was 50.7%, down 14.4 and 9.5 percentage points year-on-year and quarter-on-quarter, respectively. As a leading player, the focus is still on capacity expansion and with the increase in domestic substitution rate, capacity will also be released.

Compared with Semiconductor Manufacturing International Corporation (SMIC), Hua Hong Semiconductor is more cautious in its expansion, so its capacity utilization rate is much higher than that of SMIC under demand orientation. In Q1 2024, Hua Hong Semiconductor's capacity utilization rate was 91.7%, and (200mm) wafer products reached as high as 100.3%, almost at full capacity in recent years. Hua Hong Semiconductor has a smaller volume, and orders are greatly affected by large customer demand. In Q1 2024, the company's revenue fell by 27.1%, turning losses from profits, and the net margin dropped from 22.3% to a loss of 5.5%.

It is worth noting that Hua Hong Semiconductor's revenue compound growth rate exceeded 50% from 2020 to 2022, which is higher than that of SMIC. In 2023, the industry generally declined, and the company's decline was smaller than that of SMIC. Moreover, the company's production base is basically effective capacity. Under the trend of domestic substitution, all participants can benefit, and Hua Hong Semiconductor still has the possibility of increasing production to meet demand.

Institutional investors are bullish and may restart the uptrend.

Industry leaders have market-oriented guidance, and institutions tend to flock to them. But for most investors, what is more important is shareholder returns, including market-cap premium returns and dividend returns. According to Oriental Choice, SMIC has not given any dividends since its listing, while Hua Hong Semiconductor has paid dividends five times, interrupted for four years from 2019 to 2022 due to the epidemic, and plans to resume dividends in 2023. As of now, Hua Hong Semiconductor's market cap is HKD 38.2 billion, accounting for 27.6% of SMIC's.

This year, Hua Hong Semiconductor's market cap has risen by 14%, performing better than SMIC. The PB valuation is basically the same, indicating that the Hong Kong stock market is still rational and has not given any company more valuation premium. Both companies are optimistic to investment banks. Credit Suisse research report believes that SMIC will continue to invest heavily to expand 12-inch capacity, and is expected to add about 30,000 to 35,000 chips by 2024, with a target price of HKD 16.64. Goldman Sachs research report believes that Hua Hong Semiconductor will benefit from the continuous growth of demand for professional technologies such as IGBT, MCU, and logic, with a target price of HKD 30.

Overall, the market response to the US "draft" was excessive, and the global semiconductor industry continues to rebound. AI accelerates product iteration, and AI+ equipment stimulates explosive demand in the industry chain. With the acceleration of domestic substitution under national support, the semiconductor valuation is at a historical low point, and the sector valuation will restart the uptrend when the market returns to rationality. As the two core symbols of upstream wafer foundry, SMIC and Hua Hong Semiconductor will also receive market attention.