SMIC is the fourth largest wafer foundry in the world and the largest in the Chinese mainland. It is currently at the bottom of the industry's cycle. We anticipate a rebound in its capacity utilization rate in 2Q23 and are optimistic about the cyclical recovery and incremental demand driven by import substitution. SMIC's H-shares and A-shares have a large price difference. We assign 1.5x 2023E PB to its H-shares, corresponding to a target price of HK$30, and 3.8x 2023E PB to its A-shares, corresponding to a target price of Rmb65. We reiterate "BUY" on both its A- and H-shares.
　　 Still at a cyclical trough.
　　On Jun 28, 2023, SMIC held its annual general meeting （AGM） and reiterated its assessment that the industry remained at a cyclical trough in the first half of the year, with high inventories in the mobile and consumer electronics industry. Demand for existing products, especially low-priced standard ones, further decreased; industrial and automotive sectors showed relative stability but lacked the scale to prop up the growth of the whole industry. Based on its 1Q23 earnings and the midpoint of the 2Q23 guidance, we estimate SMIC’s 1H23 revenue at around US$3bn. During the AGM, SMIC maintained its forecast that the 2023E revenue will decline by low-teens. Additionally, the Company forecast a gross profit margin （GPM） of approximately 20%, an increase of more than 20% YoY in depreciation, and capex similar to the previous year. The full-year guidance remains consistent with the briefing during its earnings call in May.
　　 Capacity utilization may rebound in 2Q23.
　　In 1Q23, SMIC’s capacity utilization rate was 68.1%, the lowest in nearly 11 years （the previous trough was 61% in 3Q11）。 The Company anticipates a recovery in 2Q23, with our projections suggesting a capacity utilization rate surpassing 70%. This indicates a potential establishment of a trend-driven reversal. In 1Q23, SMIC achieved a historical high average selling price （ASP） of US$1,076 per wafer, showing a 14.7% YoY increase compared to US$926 in the same period last year. This was mainly due to structural factors, namely, the very low 8-inch utilization rate due to lower demand for 8-inch CMOS Image Sensor （CIS）， fingerprint integrated circuit （FPIC）， and large-size display driver integrated circuit （DDIC） in the first quarter, while 12-inch 40nm and 28nm capacity utilization rates were full. The Company mentioned at its earnings call in May that there may be a moderate QoQ decrease in ASP in 2Q23.
　　 Capacity ramp-up advances successively across four major cities, making SMIC well-poised to fully benefit from the next upcycle.
　　1） Beijing: In Jul 2020, SMIC signed a framework agreement for the SMIC Jingcheng Phase I project, planning to invest US$7.6bn, with a registered capital of US$5bn. It aims to achieve a monthly capacity of 100k 12-inch wafers, focusing on the 28nm node and above processes. The project was initially scheduled for mass production in 1H23. However, delayed deliveries of critical equipment have pushed the anticipated start to 2H23.
　　2） Shenzhen: In Mar 2021, SMIC signed a framework agreement that proposes to invest US$2.35bn in the SMIC Shenzhen project, targeting a monthly capacity of 40k 12-inch wafers, focusing on 28nm and above nodes. According to the May 2023 earnings call, the SMIC Shenzhen project has already commenced mass production.
　　3） Shanghai: In Sep 2021, SMIC signed a cooperation framework agreement with the Lin-gang Special Area in Shanghai, planning to invest US$8.87bn for the SMIC Oriental project, with a registered capital of US$5.5bn, to build a wafer foundry with a monthly capacity of 100k 12-inch wafers. It will focus on technology nodes of 28nm and above, and SMIC expects the project to be fully operational by the end of 2023.
　　4） Tianjin: In Aug 2022, SMIC signed a framework agreement with the Xiqing Economic-Technological Development Area in Tianjin, planning to invest US$7.5bn in the new project in Xiqing, with a registered capital of US$5bn. The planned capacity is 100k 12-inch wafers per month, targeting technology nodes from 28nm to 180nm. The products will be mainly used in communications, automotive electronics, consumer electronics, and industrial sectors, with a focus on analog and power chips. We anticipate the project to be completed by 2024 with capacity ramping.
　　 Potential risks:
　　Macroeconomic fluctuations or continuous industry downturns; equipment and raw material supply disruptions; adjustment of export control policies in the US and other related countries; slower-than-expected expansion of production; brain drain; the Company's new technology R&D risks, etc.
　　 Investment strategy:
　　As the largest wafer foundry in the Chinese mainland, SMIC is well-poised to benefit from the trend of import substitution and localization. The downturn in the current industry cycle may significantly affect its capacity utilization rate and ASP in 2023, which, in turn, will also significantly affect the gross profit margin and net profit margin. In its earnings presentation in May 2023, SMIC predicts that the annual gross profit margin will be around 20%. We lower our 2023E/24E net profit forecast to US$570mn/1,026mn, corresponding to HK$4,444mn/7,997mn （vs prior forecast of Rmb12,971mn/15,569mn, corresponding to approximately HK$14,637mn/17,569mn）。 We put the 2025E net profit forecast at US$1,368mn, corresponding to HK$10,670mn. This corresponds to 2023E/24E/25E EPS forecast of HK$0.56/1.01/1.35 and book value per share （BVPS） forecast of HK$19.60/20.80/22.35. SMIC is dual-listed on the A-share and H-share markets. Due to the differences in investor structure, trading mechanism, and liquidity between the two markets, the price difference between its A-shares and H- shares is relatively large. For the H-shares, foreign institutions have low trading activity because SMIC is restricted by the US entity list, and the average PB in the past three years was 1.7x. We conservatively set a target price of HK$30 based on 1.5x 2023E PB, and reiterate the "BUY" rating. For the A-shares, we take reference from its average valuation of 3.8x PB over the past three years and consider the core strategic value of the Company as a leader in domestic chip manufacturing. We assign A-shares 3.8x 2023E PB, a higher valuation than H-shares, to derive a target price of Rmb65, and also reiterate the "BUY" rating.