TSMC's (NYSE: TSM) stock recently hit an all-time high after Intel (NASDAQ: INTC) disclosed a delay for its 7 nanometer (nm) chips, and AMD posted strong second-quarter earnings. Intel's setback indicated it remained behind TSMC, the world's most advanced chip foundry, in the "process race" to create smaller and denser chips. The impressive numbers from AMD, one of TSMC's top customers, highlighted the robust demand for its 7nm manufacturing process.
Wall Street expects TSMC's revenue and earnings to rise 28% and 34%, respectively, this year, which are impressive growth rates for a stock that trades at 26 times forward earnings. TSMC's future looks bright, but investors shouldn't overlook four key facts about its growing rival in China: SMIC (OTC: SMIC.Y).
1. China's largest chip foundry
TSMC, Samsung, and Intel are currently the world's most advanced chip foundries. TSMC and Samsung both accept orders from fabless chipmakers, while Intel mainly produces first-party chips. SMIC ranks a distant fifth in the contract chipmaker space behind TSMC, Samsung, GlobalFoundries, and UMC -- in that order.
TSMC generated more than eleven times as much revenue as SMIC last year, but SMIC is still the largest chip foundry in China. This makes SMIC a crucial player in the escalating tech war between the U.S. and China, wherein both countries are curbing their dependence on the other's technologies due to national security and trade concerns. Taiwan's close ties with the US and its deteriorating relations with China could also force Chinese chipmakers to cut ties with TSMC, which produces its most advanced chips in Taiwan.
That's why SMIC receives government support equivalent to roughly 40% of its annual revenues, according to an Organization for Economic Co-operation and Development (OECD) report last year. China's state-backed funds also recently increased their stakes in SMIC's Shanghai plant after TSMC cut off Huawei's orders to appease US regulators.
2. It's two generations behind TSMC
SMIC's most advanced foundries can produce 14nm chips, but that's two chip generations behind TSMC, which started producing 10nm chips in 2016 and 7nm chips in 2017.
SMIC only generated 1.3% of its revenues from 14nm chips last quarter, and 6.5% of its revenues came from 28nm chips. The vast majority of its revenue came from older nodes, with 40/45nm and 55/65nm chips accounting for nearly half its top line. SMIC won't catch up to TSMC anytime soon, but an increasing flow of government funds could gradually narrow the gap.
3. TSMC was once SMIC's third largest stakeholder
TSMC previously sued SMIC over its alleged theft of trade secrets. The eight-year legal battle ended with a victory for TSMC in 2009, as SMIC's founder resigned and TSMC gained an 8% stake in its rival.
In 2010, TSMC exercised an option to boost its stake to 10%, making it SMIC's third largest stakeholder. That stake ensured friendlier competition between the two companies, but TSMC sold most of its stake last year after SMIC delisted its shares from the New York Stock Exchange (NYSE) amid escalating trade tensions -- which indicates the temporary truce is likely over.
SMIC retained its listing in Hong Kong and recently went public again on Shanghai's new STAR index, raising $6.6 billion in mainland China's biggest IPO in a decade.
4. It's still dependent on the US
SMIC might be China's most advanced contract chipmaker, but it's still dependent on the US for revenues and chipmaking technologies.
SMIC generated 25.5% of its revenue from US chipmakers last quarter. One of its top customers is Qualcomm (NASDAQ: QCOM), which owns a stake in SMIC via a joint venture. SMIC produces Qualcomm's lower-end Snapdragon chips, while TSMC produces Qualcomm's higher-end 7nm chips.
The US Department of Commerce hasn't placed SMIC on the same trade blacklist as Huawei and other Chinese tech companies yet. However, a new rule bars foreign companies from using American technologies to supply blacklisted companies. Those requirements forced TSMC to drop Huawei's orders and could force SMIC -- which uses American technologies in its supply chain -- to also dump Huawei or defy US regulations and risk being blacklisted.
Should TSMC investors be concerned about SMIC?
SMIC doesn't initially seem like a significant threat to TSMC. It's smaller, less technologically advanced, and more exposed to the trade war. However, the tech war is forcing the Chinese government to ramp up its investments in SMIC, and that cash could upgrade the underdog into a formidable rival for TSMC and Samsung over the next decade.
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Leo Sun has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Qualcomm and Taiwan Semiconductor Manufacturing. The Motley Fool recommends Intel. The Motley Fool has a disclosure policy.
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