China vs. USA – Capital Call

Recreation is really expensive.

• Deteriorating financial performance and large capital raises are the flavour of the day in the Chinese semiconductor sector as manufacturing at low yields and recreating technology that it no longer has access to is taking a big toll on the sector.
• Semiconductor Manufacturing International Company (SMIC) reported weak results where its gross margins were below 20% and where capital expenditure is rising without any real recovery in sight.
• Yangtze Memory Technologies Corp (YMTC), China’s answer to Micron or SK Hynix is also experiencing difficulty having raised billions more dollars after burning through $7bn in the last 12 months.
• There are two main difficulties that the Chinese semiconductor sector faces:
  • First, competitiveness, where the increasing difficulty of going beyond the 20nm node will make it very hard to compete.
  • At 5nm and below, it is pretty easy to see how Moore’s Law has ground to a halt but at 20nm, it is very much alive.
  • This means manufacturing at 20nm and trying to compete on cost against a foreign company that is manufacturing the same product at 10nm will be impossible without incurring huge losses.
  • Furthermore, producing leading-edge semiconductors using older equipment is possible but also very uneconomical.
  • This is because the yield (number of chips made with no defects) is very low meaning that all of the cost has to be recouped via the sale of far fewer chips.
  • This is what I think is happening to some degree at SMIC which claims to have made chips at 7nm (for which there is some evidence) but it has not said how high its yields are.
  • I suspect that they are very low meaning that sales of these chips will be being made at significantly negative margins.
  • This is only a small part of SMIC, and it looks like the majority of the weakness being observed in gross margins is due to lower revenues as a result of the weakness in the consumer electronics market that everyone is struggling with.
  • Either way, this means lower cash flow and potentially, a requirement for more capital.
  • Second, recreation which is where attempts are made to build the missing technology from scratch to plug the gaps where China is unable to import equipment.
  • This is cripplingly expensive, and it will almost certainly require substantial state support.
  • This is why I suspect that almost all of the investors who participated in YMTC’s latest round have some connection to the Chinese state.
  • China is determined to make sure that it becomes technologically self-sufficient and while this is a viable proposition in AI, robotics, The Metaverse, Quantum computing and so on, in semiconductors this is going to be almost impossible.
  • This creates a big problem because self-sufficiency in other areas will be hampered as silicon chips sit at the heart of almost every technology being developed.
  • This fact is not lost on the USA, and I think that it is the hampering of other technologies that the USA is seeking to achieve with its limitations on semiconductor technology.
• The net result is that the Chinese semiconductor sector is going to be a financial blackhole unless it decides to give up on advanced semiconductors and focus on legacy nodes at 20nm and above.
• The problem here is that the Chinese economy is not doing particularly well at the moment and looks to be at great risk of stagnation or recession which will make finding the cash for state support for this and all of the other projects increasingly difficult.
• SMIC is already focusing on legacy and there will be plenty of business to be done at these nodes, but it will be increasingly competitive and commoditised.
• Furthermore, foreign investors appear to have almost no interest in investing in China at the moment despite the rock-bottom valuations meaning that all of the support will have to come from within.
• All of this means that the days of global standards are numbered and going forward we are likely to see one standard outside of China and another, competing, and non-compatible standard inside China.
• This is bad news for everyone as two incompatible networks will generate much less value than one global network.
• Consequently, long-term growth for the entire technology sector over the next 10 to 20 years will be lower than it otherwise would have been.