China Semiconductor Industry – Hot Sector to Invest

Capital Magazine       www.topcapital.com.cn

May, 2006

By Dr. QY Ma, MD, Time Innovation Venture

1. Status of Investment in China Semiconductor Electronics Industry

China semiconductor industry is a hot area for investment.  Since 2000, the sector has attracted foreign direct investment up to 20 billion USD.  The broad electronics sector has accounted about 50% of total FDI. According to IC Insight data, China became the world largest IC market in 2005, with 21% of the world market share.

In past five years, the investment of Chinese semiconductor sector relied heavily on overseas/Taiwan semi companies and overseas private equity funds. The former denotes direct facility investment by overseas or Taiwan based semiconductor and electronics companies. The latter denotes new established IC companies in China, especially those semiconductor startups initiated by overseas returnees, funded by overseas private equity or VC funds and investment banks.

a)   Direct Investment from Overseas Semiconductor Companies

According to the statistics, many of the overseas IDM companies have set up their subsidiary semiconductor packaging/marking/testing lines in mainland China, including Intel, TI, AMD, Micron, RENESAS, SAMSUNG, STMicroelectronics, Fairchild TOSHIBA, Infineon, as well as 8～12 inch fabs set up by TSMC、Hynix-ST Micron. In addition, more and more overseas IC design houses and fabless companies have founded their R&D centers or subsidiaries in Mainland. Most of the companies are located in Yangtzi River Delta Region, where semiconductor and related electronics industry has accounted for up to 50% foreign direct investment over the past five years. By extending along Yangtze River from Shanghai to Suzhou, Wuxi, Changzhou, Nanjing, Hangzhou and Ningbo, The region has become the largest electronic industry band in China as well as the global electronics manufacturing base.  

Overseas companies moving Electronic/Semiconductor sector to China are mainly focused on labor-intensive packaging/testing and field applications engineering branch in order to reduce the cost and to be close to the fastest growing IC consumption market.  The cost saving for IC manufacture in China is up to 30%-40%, compared to US and Japan.

b)    Investment by Overseas Private Equity Funds 

Those semiconductor companies invested by overseas investment funds have primarily focused on IC design and manufacturing service. Currently, there are approximately 30 active Venture Capital or Private Equity firms in China, including GS, Cartyle, H&Q Asia Pacific, Walden, WP, IDG, Legend, Acer, Jafco, PVG, TDF, DFJ, NEA, AsiaTech, GAP, Granite, Intel Capital, Qualcomm venture, Motorola venture, Samsung venture and Nokia venture. All those funds are mainly interested in IC design companies at middle/later stages, or manufacturing projects which has potential to become the top 3 players in Chinese marketplace.

Most VC invested IC design houses are located in Beijing, Shanghai and the neighborhood area.  Many companies have raised series B investment from overseas VCs, including DaTang, Vimicro, Spectrum, Comlent, AIC, Huaya, Apexone, etc. The deal size is between several millions and a few tenth millions USD. Those VC backed startup companies were mostly founded by overseas returnee teams.

As for large-scale IC manufacturing projects, overseas funds are usually investing the company which has potential to become top 3 players and has a strong founding teams. Those cases include SMIC, Suntech Power, Heijian, BCD, Zhongwei and Nanotech, etc.

SMIC is a successful example. SMIC was established in June 2000 and raised series A investment about 1 billion USD in Sep. 2000 from well known funds like Goldman Sachs, H & Q, Walden, GIC, etc. SMIC established first 12 inch fab in Beijing in 2003 after closing series B investment about 630 million USD from over 30 overseas big investment firms like NEA, GM fund, Stanford fund, etc. The company went IPO on Mar. 18, 2004 in HKSE and NYSE simultaneously and raised about 1.8 billion USD. SMIC becomes a unprecedented large scale deal with the shortest period to IPO (less than 4 years) from a business plan.

The most recent successful IPO case is Suntech Power, which develops and manufactures semiconductor photovoltaic cells and modules for solar electric power applications. Suntech Power also attracted investment from 5 overseas VC funds and went IPO in NYSE within 4 years. Its current P/E ratio is more than 100 times.

2.  Features of Semiconductor Investment

The average time from start-up to product is 3 years, to breakeven is 5 years for a semiconductor company, regardless of design house, manufacturing line, assembly and testing, or equipment service. It is between the Internet and software projects with average investment duration of 2~3 years and biotech cases with duration 5~8 years.

3.   “Hot” Sector for Investment

In the past 5 years, Chinese semiconductor sector has become a hot sector for investment, and the total investment amount during this period is about 5 times than the last 50 years’ sum. Big market, and low cost are two major factors for Chinese semiconductor sector to attract investment. However, this “hot” investment wave has been driven mainly by foreign investment.  The domestic investors are basically missed such wave.  Not like other sectors such as auto, steel and real estate which are mainly driven by Chinese local investment.

Chinese investors have two concerns towards semiconductor investment. One is the over capacity. In fact, this concern is due to the unfamiliarity with semiconductor industry. Chinese IC import was increasing 50% annually from 2001 to 2004, and reached 62 billion USD in 2004 resulting in trade deficit over 50 billion USD. Figure 1 illustrates Chinese IC supply and demand status and forecast for the following several years, and the supply-demand gap in 2010 will expand to 490 billion RMB or equivalent 60 billion USD. What China is facing is not the IC capacity surplus, but the huge IC trade deficit number due to the large supply-demand gap and capacity shortage.

The other concern for local investors is the fear of failure associated with the early stage development of the Chinese semiconductor industry. However, many successful startup stories (e.g. SMIC, Suntech, BCD, Vimicro, Spectrum, Comlent, etc.) have brought great confidence to the investment community. So far there are 7 semiconductor electronics companies listed on overseas capital market with total market cap over $8.5 billion, including SMIC, Suntech, CSMC, Vimicro, Actions, Fudan Micro, JadeBird.  In the past, investors in US, Japan, Korea, Singapore have obtained great returns from investing IC industry in the long term. In US, the ROI for IC IDM companies can be as high as 1000 times. Even in Taiwan, ROI is as high as 100 times for a foundry company or 300 times for a design house.

For long term investment, semiconductor electronics is surely one of the sectors with best return. According to E*Trade analysis, semi’s current average P/E ratio is 26 times, exceeding S&P 500’s P/E.  The sector’s average gross margin in the past 5 years was 49%, contrasting with S&P 500’s 45%. The sector current net margin is 17% and ROE 15%, both exceeding 3% than S&P 500. Table 1 illustrates that Semi sector’s return rate is far beyond real estate sector (6 times) and auto sector (4 times).

In conclusion, with the great demand-supply gap in Chinese semiconductor electronics market and the lower manufacturing cost, more and more overseas IDM companies is moving their facility bases to China, and more and more overseas private equity funds are entering this sector.  China semiconductor industry is now just into the Spring session.

Table 1：inter-sector and index contrast in 2005 US capital market

Data resource：ETrade Financial

Figure 1:  China semiconductor market trend forecast