TSM - SOXQ ETF: Huawei's Latest Phone And Implication For Semis Stocks

2023-09-07 06:27:55 ET

Summary

• Huawei has unveiled a new smartphone called the Mate 60 with some latest features including 5G only about four years after having faced sanctions.
• Its conception helps to uncover how the Chinese company has been able to fix its supply chain.
• In so doing, the Chinese semis industry has also been strengthened to now constitute competition for SOXQ's holdings.
• In view of the risks, I have a Hold position.

The aim of this thesis is to assess how the Invesco PHLX Semiconductor ETF's ( SOXQ ) holdings will be impacted by the emergence of Huawei's new Mate 60 Pro smartphone whose main specifications are pictured below. Its main chip could have been manufactured by China-based SMIC (Semiconductor Manufacturing International Corporation) using a 5nm-process fabrication process as encircled in red below.

This is cutting-edge technology and other product features like Harmony O.S. (operating system) may appear impressive given the number of restrictions the company has been subject to over the last four years by the U.S. Department of Commerce, and, to this end, the Mate 60's components help to uncover the stakeholders in its supply chain.

Uncovering Huawei's Supply Chain

This homegrown O.S. was developed after Huawei was denied the right to use Android from Alphabet (NASDAQ: GOOG ) on its upcoming smartphones by the U.S. government on security grounds in May 2019. That was a crushing blow to the company and, at that time, many of its suppliers cut off relations including British chip design firm Arm Holdings ( ARM ) which recently filed for an initial public offering that could see valuations of up to $54 billion.

Looking at earlier Mate models, the Kirin 9000 System on chips (SoCs) which powered them was designed by the Chinese group's subsidiary HiSilicon but had to be produced by Taiwan Semiconductor Company ( TSM ). With the loss of the ARM licensing, and the inability to import processors from Intel (INTC) since 2021, again because of restrictions, one could only have expected Huawei to exhaust its existing inventory and cease the high-end smartphone business.

However, as highlighted in red above, inside the Mate 60 Pro motherboard there is the Kirin9000S, and a teardown (disassembly) reveals the abbreviation HiSilicon Hi36A0 which means designed by Huawei's subsidiary, and, on top, the CN0906 logo reveals that it is Chinese-made, most probably by SMIC since both TSMC or Samsung Electronics (SSNLF) have up till now complied with U.S. sanctions aimed at containing the Chinese company.

Therefore, the new Kirin is a completely new edition that is made in China except for the memory (RAM et ROM), which could have been produced by SK Hynix from South Korea. This said it is debatable whether SMIC has used a 5nm or 7nm process node for the SoC chip, but, even then, 7nm is more advanced than its previous generation 14nm process node.

Moreover, the Mate 60 Pro can be used to make satellite calls and, most importantly, supports 5G, which makes it the first in about three years to do so. The reason is that, as a result of restrictions, Huawei has to rely on third-party companies such as Qualcomm (NASDAQ: QCOM ) but the speed is limited to 4G only as the earlier Huawei Mate 50 series features a Snapdragon 8+ Gen 1 SoC.

Therefore, for Huawei, this is quite an achievement as it is not dependent on Qualcomm or MediaTek to run its smartphones, while at the same time, it does not depend on contract manufacturing services from TSMC or Samsung, as is the case for Chinese peer Xiaomi (XIACY) which uses a Snapdragon for 5G.

Now, just imagine the sales repercussions for the Qualcomm-TSMC partnership if Xiaomi and other Android-powered smartphone makers start to purchase 5G modems from HiSilicon and SMIC. Going a step further, Huawei's feat also has wider implications for many of SOXQ's thirty U.S.-listed securities as it tends to show that the Chinese chip industry has not only managed to circumvent restrictions in only about four years but in the process has developed semis that can potentially rival those made using American technology.

The Risks for SOXQ's Holdings

Additionally, the Chinese authorities can also carry out retaliatory actions as exemplified by the ban imposed on Micron's (NASDAQ: MU ) memory chips on the grounds that its products posed network security issues , but this action could have been inspired by the country having alternatives in the form of homegrown Yangtze Memory and ChangXin Memory, in addition to Samsung and SK Hynix.

Now, the move could cost Micron $3.31 billion annually which equals approximately 10.7% of its FY2022 revenues, and its stock lost over 4% when the news broke out. Looking further, there are other U.S. companies that export to that country as shown in the list below, including Intel which generated 27% of its total 2022 revenue in China, or about $17 billion. In this respect, in addition to SoC with its Kirin series, Huawei already has a portfolio of chipsets covering server chips referred to as the Kunpeng series.

The Chinese company also has AI chips with its Ascend series, and given the speed with which it has developed SOCs, it could also develop these to rival Nvidia (NASDAQ: NVDA ) whose China exposure amounted to 21% of its overall sales or $5.67 billion in 2022. There is also Advanced Micro Devices ( AMD ) which produces GPU chips.

Adopting realism, I do not believe that Huawei can develop GPUs with capabilities similar to Nvidia's H100 which are the building blocks for ChatGPT in a short span of time. Also, after the first batch of Mate 60 Pro has hit the market, it is now important to watch for customer reviews for items like battery life, 5G speed performance, and international software developers' support for the Harmony O.S. There are also volume production capabilities where factors like economics come into play, and whether the company can maintain the launch prices of 6,999 yuan ($957) for the 12GB memory and 1TB storage model.

Still, the process technology used for the fabrication, whether it is 5nm or 7nm, may be considered old by companies like Apple (NASDAQ: AAPL ) (which would rather opt for 3 nm), but, nonetheless, it has delivered an end product which is an improvement over the Mate 50. To provide an idea of the market response, Huawei's direct Chinese competitor Xiaomi shares dropped by about 6% after the announcement of the product launch.

In addition, the smartphone has revealed some of the key players in the Chinese semiconductor market like SMIC, which can be considered a competitor of TSMC. Again, to be realistic, SMIC does not have the advanced process node capabilities of TSMC for building cutting-edge chips that power artificial intelligence. However, just like SMIC, the Taiwanese company also manufactures mature (older and less advanced) nodes like the 28nm in its fabs.

To this end, the restrictions on China do not cover chip-making machines for producing 28nm chips and above. Consequently, according to the trade association SEMI, Chinese foundries are expected to build twenty-six older-generation semiconductor factories by 2026, which is much more than the U.S. Now, these chips are still widely used in many devices like smartphones, electric vehicles, and consumer electronics, and, are produced in foundries in Europe, the U.S., and East Asian countries. Here, competition from cheap and state-subsidized Chinese products may prove disastrous for them. For this matter, the Chinese mainland remains the largest single semiconductor market in the world, with total sales reaching $180 billion last year, according to the Semiconductor Industry Association.

Furthermore, in addition to the seven companies I have mentioned above, there are risks to chipmaking equipment producers that have in the past benefitted as a result of China developing its semiconductor. These are ASML Holding N.V. ( ASML ), KLA Corporation ( KLAC ), and Lam Research ( LRCX ) and, in the same way as Micron, they may face retaliatory actions from China as it makes progress with chip-making gear, with the first domestically-made 28 nm lithography machine likely to be ready by year-end.

Valuations and Key Takeaways

Now, Micron's issue and the geopolitical tension escalating were precisely two of the reasons I had a hold position on SOXQ when I covered the ETF back in April this year. Another reason for my cautionary instance was the odds of a recession occurring having gone up to 58% , as a result of interest rates having been raised at a frantic pace by the U.S. Central Bank. I had also highlighted SOXQ's AI prospects, but this was before Nvidia released its mind-blowing outlook for its second-quarter 2024 results where its sales guidance exceeded analysts' by over 50%. As a result, the stock surged, imparting momentum to other names in the Invesco fund, and, at $28.99, its value is 14.4% more than during my last publication.

Looking forward, despite its price-to-earnings multiple of 24.39x being below the category average of 29x, SOXQ is not a buy in view of the risks to future revenue and margins. As such, there could be an estimated impact of nearly $26 billion (3.31 + 17 + 5.67) when combining the individual exposure to China just for Micron, Intel, and Nvidia in case geopolitical tensions escalate and there is a Chinese ban. Lower sales would decrease the ETF's price-to-sales which is currently at 5.33x and already overvalued further.

In these circumstances, I have a hold position which I further justify in view of China's ban on critical metals like Gallium potentially impacting Qorvo ( QRVO ) and Skyworks ( SWKS ) as I covered in a thesis on the iShares Semiconductor ETF (NASDAQ: SOXX ). These two stocks are also held by SOXQ, which tracks the PHLX Semiconductor Sector Index and comes with fees of 0.19%.

In conclusion, this thesis has painted a rather bleak picture of the semis industry in view of Huawei's perseverance in fixing its supply chain problems resulting in the emergence of new competitors. This also shows that there is a whole semis industry that is evolving rapidly on the other side of the Pacific Ocean. In this respect, it would be appropriate to have a response from the U.S. Department of Commerce and guidance from SOXQ's holdings about the demand status before investing.

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