Can expanding production capacity serve as an antidote for HUA HONG SEMI (01347, 688347.SH) to counter the industry's headwinds and prevent its market value from evaporating by nearly 60%?

Since the third quarter of this year, with the successive release of new phones by Huawei and Apple, it has sparked a wave of stocking frenzy in the consumer electronics industry chain, signaling a recovery in the industry chain. Guosen pointed out that according to the industry chain tracking, the peak season for consumer electronics stocking has begun, and data from various sectors such as panels, storage, and passive components have shown a comprehensive increase in temperature. The improvement in the consumer electronics industry under low inventory is significant. Data from the industry association SIA also indicates that the global semiconductor industry has achieved six consecutive months of sequential growth since March of this year. However, the performance of the chip industry in the third quarter did not meet expectations. Taking Hua Hong Semiconductor (01347, 688347.SH) as an example, one of the leading wafer foundry companies, the company's third-quarter revenue was 4.109 billion yuan, a year-on-year decrease of 5.13% and a sequential decrease of 8.08%; net profit attributable to shareholders was 95.83 million yuan, a year-on-year decrease of 86.36% and a sequential decrease of 82.40%. This news has further worsened the already tight stock price and market value of the company. It was observed that on November 10th, the company's H shares fell sharply by 15.83% to HKD 16.96, reaching a new low in nearly a year. Although the company's stock price rebounded slightly on the 13th, it still remained at a historical low. Looking at the longer time frame, since reaching a new high of HKD 38.80 in mid-April this year, the company's stock price has been in a downward trend, and it has now fallen by nearly 60% compared to the high point of the year, evaporating nearly HKD 38 billion in market value. Facing a double blow to profitability in the third quarter, institutions have successively lowered their target prices. According to public information, Hua Hong Semiconductor is a leading global specialty process wafer foundry company with the most comprehensive specialty process platform in the industry, providing customers with products ranging from 0.35 micrometers to 65/55 nanometers and other process nodes. The company is based on the strategic goal of advanced "specialty IC + power devices" and provides wafer foundry and supporting services for diversified specialty process platforms, including embedded/independent non-volatile memory, power devices, analog and power management, logic, and radio frequency. Looking at the performance in recent years, benefiting from the high prosperity of the new energy vehicle market, the company's revenue has continued to increase, and although net profit has fluctuated, it has shown an overall increasing trend. However, in the first three quarters of 2023, the company experienced a situation of "revenue growth without profit growth". Specifically, in the first three quarters of this year, Hua Hong Semiconductor achieved revenue of 12.953 billion yuan, a year-on-year increase of 5.64%; net profit attributable to shareholders was 1.685 billion yuan, a year-on-year decrease of 11.61%. At the same time, the company's profitability has also declined significantly. The company's gross profit margin for the first three quarters of this year was 25.61%, a decrease of 7 percentage points compared to the same period last year. Looking at each quarter, the company's gross profit margin has dropped from 32.1% in the first quarter to 27.7% in the second quarter, and it was only 16.1% in the third quarter. Management explained that the decline in gross profit margin was mainly due to the increase in depreciation and power costs and the downward adjustment of average selling prices. According to the company's guidance, the decline in gross profit margin will continue, and the range for the fourth quarter of this year may further decline to 2%-5%. If the median of 3.5% is calculated, the sequential decline will expand by 12.6 percentage points. It can be seen that the overall profitability of the company in 2023 is not optimistic. After the financial report was released, many domestic and foreign institutions, including UBS, Jefferies, Huatai, and Goldman Sachs, have successively lowered their target prices for the company. UBS pointed out that in the third quarter of this year, the company's sales revenue only reached the lower limit of its guidance, with the decline in MCU, smart card integrated circuits (ICs), NOR flash memory chips, logic, and other power management (PMIC) products slightly offset by the growth of IGBT and super junction structure businesses. Affected by the continued weak terminal demand, the utilization rate of Wuhan's 12-inch wafer fab, a subsidiary of Hua Hong, dropped significantly from 93% in the second quarter to 78% in the third quarter. UBS estimates that the average selling price of the company's overall products has decreased by about 10% quarterly, with an 8% decline for 8-inch products and a 12% decline for 12-inch products. Coupled with the increase in depreciation costs, this directly dragged the gross profit margin down to the lower limit of 16.1% guidance. UBS continued to point out that considering the relatively high inventory levels in China's customer and consumer markets, it expects Hua Hong Semiconductor's performance in the second half of this year to be worse than other foundry peers, and it has lowered its full-year revenue forecast for this year to a 6% annual decline. Jefferies believes that Hua Hong Semiconductor may turn from profit to loss next year. However, Goldman Sachs remains optimistic about the long-term trend of Hua Hong Semiconductor. It pointed out that with the development of electric vehicles, new energy, and industrial applications, local customers have an increasing demand for Hua Hong Semiconductor's IGBT, MCU, analog, and other professional technologies, so it maintains a positive view on long-term growth. However, considering the third-quarter performance and fourth-quarter guidance, Goldman Sachs has appropriately lowered its profit expectations, reducing the revenue forecast for 2023 to 2028 by 3% to 7% and lowering the target price from HKD 37.1 to HKD 31.8. Expanding production while waiting for opportunities However, while the performance and capacity utilization rate are declining, Hua Hong Semiconductor has not stopped expanding its production capacity. It is worth noting that the company successfully landed on the Science and Technology Innovation Board in August this year, achieving an "A+H" listing. Subsequently, in September, Hua Hong Semiconductor used the raised funds to increase capital to its wholly-owned subsidiary, Hua Hong Macro Portal, with a total of 12.632 billion yuan, mainly used for capital increase of Hua Hong Semi Manufacturing (Wuxi) Co., Ltd., the implementing entity of Hua Hong Macro Portal, and the rest will be used for the optimization and upgrading of the 8-inch wafer fab, specialty process technology innovation and R&D projects, and others. The company stated that the 12-inch production line project in Wuxi is still climbing, and as of the end of the third quarter, the monthly capacity of the equivalent 8-inch production line has increased to 358,000 wafers. At the same time, Hua Hong Semiconductor's second 12-inch production line is also under construction, aiming to further expand its production capacity and enhance its core competitiveness. However, the expansion of production capacity has also increased the company's capital expenditures, and the return on investment needs to be verified by market demand recovery and business performance improvement.The project of Wuxi manufacturing line of SMIC is also progressing rapidly, and it is expected to be completed and put into operation before the end of 2024. Within the following three years, it will gradually reach a monthly production capacity of 83,000 wafers.Actually, from the perspective of market demand, the prospects of the wafer foundry industry are not optimistic. From the industry market perspective, according to WSTS, the global semiconductor market is expected to decline by 10.3% in 2023 due to inflation and weakened terminal demand. According to Counterpoint data, in the third quarter of this year, global PC shipments decreased by 9% year-on-year, and global smartphone sales decreased by 8% year-on-year, marking the ninth consecutive quarter of decline. Specifically in the wafer foundry industry, Open Securities predicts that by 2024, China's wafer foundry industry will face a situation where supply exceeds demand, especially in the competitive landscape of HUA HONG SEMI's core business - power devices, which may limit the company's price performance in the next demand recovery cycle. Zhao Haijun, the co-CEO of Semiconductor Manufacturing International Corporation, stated that due to geopolitical influences, many countries and regions are expanding their production capacity individually. However, global overall demand is not keeping up with the pace of capacity expansion. He personally believes that global capacity may become surplus and it will take a long time to absorb the excess capacity. However, for large markets such as China and the United States, local production alone is not enough. He believes that the future demand for semiconductors in China still requires significant local manufacturing capacity. However, some institutions also point out that the global semiconductor industry is expected to enter a recovery cycle in 2024. Pacific Securities believes that with the sustained recovery of consumer electronics and the driving force of new demand such as generative artificial intelligence, the trough of the semiconductor industry cycle is approaching, and a recovery is expected to follow. Similarly, Zheshang indicates that with the recovery of the semiconductor industry cycle and the increase in downstream capacity utilization rates, domestic semiconductor industry capital expenditures are expected to increase. Additionally, the verification of mature and advanced process equipment at various process stages will accelerate, the localization rate is expected to increase comprehensively, and this will drive the growth of semiconductor equipment orders in 2024. According to SEMI's forecast, global semiconductor equipment sales will rebound to $100 billion in 2024, a year-on-year growth of 14%. Overall, the "chill" in the semiconductor industry continues, and HUA HONG SEMI, which has experienced a double blow in profit and valuation, still has difficulty finding "light at the end of the tunnel." In the short term, the oversupply situation in the wafer foundry industry continues, and the extent of demand recovery in the semiconductor market needs to be verified over time. The turning point for HUA HONG SEMI is still unknown. However, in the long run, once the industry's turning point arrives, HUA HONG SEMI, which continues to expand its capacity, has strong expectations for performance growth and is worthy of continuous attention from investors.