Rating: OUTPERFORM (maintain) 

Semiconductor stocks had a good run last week, significantly outperforming the main indexes. The SWS Semiconductor Index rose 8.34% and the ChiNext Index fell 0.86%. The Shanghai Composite Index fell 4.31%, the Shenzhen Composite Index fell 3.70%, the SME board index fell 3.77% and Wind A-Shares fell 3.56%. 

Weekly industry view 

The manufacturing, material and equipment segments were among the top performers in the semiconductor industry, and we are optimistic about a valuation recovery opportunity in the industrial foundry segment. Among the semiconductor segments in the past week, manufacturing rose 14.7%, materials rose 12.2%, equipment rose 11.3%, packaging and testing rose 6.0%, discrete devices rose 5.8%, IC design rose 4.9%, while the other segments rose 2.5%. 

Equipment, materials growing; we anticipate valuation recovery in wafer foundries 

In PB terms, SMIC Hong Kong and Hua Hong Semiconductor are at relatively low valuation levels. SMIC (both A and H shares) and Hua Hong have underperformed chip ETFs since 2Q21. As of 30 July 2021, SMIC-H share PB was only at 1.80x, the lowest PB among global wafer foundry assets. Hua Hong’s PB was low at 3.22x while SMIC-A’s PB was at 5.07x. 

Price and UTR rises, and better product structure and fundamentals lifted manufacturing gross profit margin in 1Q21; we expect 2Q21 to keep growing 

Semiconductor manufacturing capacity was in short supply and it became a seller's market. Related products such as 5G, HPC, PMIC, DDIC and automotive ICs were in strong demand in 1Q21, intensifying competition in the global foundry segment. Among A-shares, China Resources Microelectronics, Hangzhou Silan Microelectronics and SMIC raised the prices of some products in different ranges in 1Q21. Amid full capacity utilization, each company prioritized large and long-range orders, high-end orders, which optimized the product structure and raised gross profit margin qoq. 

Future trends for mainland China fabs 

Demand drivers include the Internet of Everything and domestic substitution, while technology growth benefits from a continuous increase in the yield of advanced processes. Short-term expansion in wafer capacity in mainland China was affected by a series of external factors such as US export controls, but it did not change long-term semiconductor market trends. Silicon wafer fabrication for the upstream segment of the supply chain benefits from the widespread popularity of new applications, as represented by AIOT, spawned by 5G. 

SMIC and Hua Hong on expansion track as Sino-US rivalry focuses on foundries; we expect growth to continue in the next five years  

Wafer fabrication is the most asset-heavy segment in the industry. It drives the development of semiconductor equipment materials in the upstream and affects the product capabilities of design companies in the downstream. It has attracted much attention in the Sino-US trade conflict. Amid the continuous global digitalization process, the importance of foundry capacity has gained prominence and become a strategic asset. Based on Gartner data, TSMC accounted for 55.5% of global foundry capacity in 2019. SMIC and Hua Hong combined accounted for 6.5% of the global market, so the mainland foundry self-sufficiency rate is still low, suggesting rich potential growth. 

Large gap between foundry supply and demand in mainland China; we are optimistic about foundry assets and a valuation restoration  

In the short term, current price increase cycles are led by a foundry capacity shortage. We would expect foundry companies to take the opportunity to optimize their product mix, and raise their ASP and gross margin. In the long run, growth rates would be prioritized over industry cycle considerations. We are optimistic about the development of local foundry lead companies such as SMIC. 

Recommendations 

Wafer foundries 

Semiconductor Manufacturing International Corporation (SMIC) (688981 CH, BUY) 

Semiconductor equipment materials  

Naura Technology Group (002371 CH, BUY), Jiangsu Yoke Technology (002409 CH, BUY), Advanced Micro-Fabrication Equipment Inc China (688012 CH, BUY), Wuhan Jingce Electronic Group (300567 CH, BUY), Beijing Huafeng Test & Control Technology (688200 CH, BUY) 

Semiconductor design 

Unigroup Guoxin Microelectronics (002049 CH, BUY), Gigadevice Semiconductor (Beijing) Inc (603986 CH, BUY), Amlogic (Shanghai) (688099 CH, BUY), Allwinner Technology (300458 CH, BUY), Rockchip Electronics (603893 CH, BUY), Sino Wealth Electronic (300327 CH, BUY), Maxscend Microelectronics Company (300782 CH, BUY) 

SG Micro Corp (300661 CH, BUY), StarPower Semiconductor (603290 CH, BUY) 

Other related companies (not rated) 

Hua Hong Semiconductor, Shanghai Sinyang Semiconductor Materials, Hangzhou Changchuan Technology, Grinm Advanced Materials, Jiangyin Jianghua Micro-electronic Materials, Shanghai Fudan Microelectronics Group, Shanghai Fullhan Microelectronics, Will Semiconductor Shanghai, Wuxi Nce Power, Montage Technology 

Risks include: worsening of the pandemic; adverse impact of the US-China trade war; and demand being less than expected. 

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