After only four years of development, Semiconductor Manufacturing International Corp. (SMIC) (NYSE: SMI and HKSE: 981) has moved from nowhere to become the leader of the Original Equipment Manufacturing (OEM) industry on the Chinese mainland.

March 2004 witnessed the great leap of SMIC into the era of public offerings, amid great celebration. SMIC went public in both New York and Hong Kong, raising a total of $1.7 billion, making it the third largest initial public offering (IPO) worldwide so far this year. The company, that only set up its first stake in Shanghai's Zhangjiang High-Tech Park in April 2000, had arrived.

According to the publicized result of SMIC's IPO, its Hong Kong retail tranche is oversubscribed 272 times, with the offering price between HK$2.39 and HK$2.69 per share. The issue price was finally fixed at a surprisingly high price of HK$2.69 per share. In the U.S., SMIC has altogether issued 97.9 million American Depository Shares (ADS) at the price of $17.5 per share.

But in the following several months after the IPO, SMIC's stock plummeted below the issue price. Although the share price showed some signs of rebounding, momentum was not strong. On June 4, SMIC closed at HK$1.875 in Hong Kong and $12.04 in New York respectively, a clear indication of the trouble SMIC is now facing.

Successful Start-up

Over two decades ago, a young Taiwanese, who is a graduate of Southern Methodist University as well as a PhD in Electrical Engineering, started his 20-year-long career at Texas Instruments, a renowned U.S. semiconductor company. In the following two decades, he traveled the world to set up Integrated Circuit (IC) foundries. Along the way he also became the initiator, Chairman of the Board and CEO of SMIC. His name is Richard Ru Gin Chang.
 
Many business insiders perceive Chang as a typical adventurer, who is actively developing the Chinese mainland market. When Chang arrived in 2000, what he had was several millions of dollars plus a market which showed huge potential, but was still taking shape. A shrewd businessman, Chang took full advantage of the opportunities before him, even resorting to the preferential policies of the Chinese Government and investing aggressively when the whole industry was in a downturn. Using the Chinese mainland as a manufacturing base, SMIC has leapt into top spot in the global OEM industry.

According to SMIC's financial report, its net profit in the first quarter of 2004 totaled $27.5million. Moreover, according to the report issued by the prestigious investment bank, Goldman Sachs, SMIC has already been regarded by Taiwan Semiconductor Manufacturing Company Ltd (TSMC), the largest global chip manufacturer, and United Manufacturing Company (UMC), the second largest chip manufacturer, as their strongest competitor.

The overnight rise to success of SMIC is perceived by many as a miracle. Many people attribute it to the timing of building plants when the global semiconductor industry was in a trough and the cost of purchasing equipment was really low. Yet many Taiwanese business insiders believe SMIC's profitability is largely due to the upturn of the industry as a whole.

While there are many theories explaining the company's success, what really worries SMIC's competitors is price and the effect its production expansion will have on the future global semiconductor market. As SMIC has disclosed, its monthly output will increase to 125,000 pieces by the end of 2004, and this figure is going to reach 170,000 by the end of 2005, as opposed to only 49,000 in 2003.

At the same time, Richard Chang is trying to expand the territory of SMIC by building new facilities in Beijing, Tianjin and Shanghai. On June 2, 2004, a piece of news appeared on SMIC's website, reporting that SMIC has started installing equipment at its first 12-inch fabrication facility (Fab) in Beijing, also the first of its kind in China. With this production line put into operation, the output will be 2.5 times that of the 8-inch production line, while the cost will be 30 percent lower. Generally speaking, the investment on a 12-inch wafer foundry should be more than $1.2 billion. In order to reap higher profit, increase proportion of high-end of products in product mix and lower the cost along with the continual expansions, SMIC decided to gamble on going public.

A Rocky Road

Business insiders conclude that SMIC's poor performance in the stock markets is due to its handling of two sensitive issues: refinancing and the lawsuit filed against it by TSMC. Since the public statement from the company's senior management is contradictory to the company's prospectus, they were required to explain the variance to the American Securities and Exchange Commission and the Hong Kong Stock Exchange. This is partly responsible for the weakness of SMIC's stock.

Immediately before becoming listed, the company's chief financial officer, Jenny Wang, made a statement in a press conference that the net proceeds from the global offering, cash from operating activities, borrowings under its existing available banking facilities and cash on its balance sheet at the end of 2003 would be sufficient to meet the company's planned capital expenditures through 2005. However, according to SMIC's prospectus, the anticipated capital expenditures in 2004 and 2005 are $1.95 billion and $1.373 billion respectively, totaling $3.323 billion, which will be primarily used to expand its operation in Shanghai and Tianjin and upgrade the equipment in its three foundries in Beijing. Therefore, besides anticipated proceeds from the offering of $970 million, there is a gap of $2.353 billion to be filled by income from operations and external financing, including bonds and bank loans.

Later, SMIC made a quick clarification, reporting, "Actual cash flow from operating activities and amounts available under our existing banking facilities can be difficult to predict." Just as the prospectus has disclosed, SMIC denies that the sources referred to by Jenny Wang can be sufficient to meet the company's capital requirements. Thus, they think to fund the company's planned capital expenditure and working capital needs through 2005, the pursuit of external financing is needed. In spite of all this, the fate of SMIC stocks falling below the issue price seems to be irreversible.

The much-anticipated IPO has already disappointed many people, while the lawsuit with TSMC adds fuel to the fire. On March 23, 2004, TSMC filed a lawsuit against SMIC to U.S. District Court of Northern California, alleging SMIC misappropriation of trade secrets. It claimed that SMIC head hunted TSMC's technical experts with promises of stock options.

The filing of this lawsuit plus TSMC investment in Songjiang and UMC's investment in Suzhou is for the same goal: in terms of management strategy, to check SMIC's expansion on the mainland market and add to the difficulty of its IPO. Anyhow, SMIC succeeded in going public, while the judicial procedures are still underway. Many people believe this lawsuit will end in reconciliation. Even if the prediction is true, SMIC would still incur great loss in the process nevertheless.

Optimism Despite Gloom

America has accused China of charging discriminative taxes on semiconductor imports and will turn to the WTO for arbitration. Many people believe this has a major impact on the performance of SMIC's stock.

Anyhow, we still have not seen any trace of rebounding for SMIC in the stock market so far. Investors and analysts in the U.S. believe that the semiconductor industry will reach its height in 2005, but the market before the peak seems gloomy. Thus they have tuned down the expectation on the global semiconductor industry, which gave rise to the falling of stock price of semiconductor companies, including Intel, TSMC and SMIC.

Although SMIC's situation is far from satisfactory, many people are still quite optimistic about its future, due to the great potential of the semiconductor industry. The growth rate of Chinese semiconductor market is far above the world average, making China a market many global semiconductor manufacturers compete head-to-head for. It is estimated that by 2006 the total output value of the Chinese semiconductor market will have reached $22 billion and China will have become the world's largest semiconductor market by 2008 at the latest. Business insiders project that the total output value of Chinese mainland's chip manufacturing industry will reach $4.18 billion in 2005, a minimal part of the global semiconductor industry, yet 20 percent of the global pure-play OEM market. This figure will undoubtedly greatly shake Taiwan's monopoly in this field.

"The development of SMIC is synchronizing with that of China's domestic market," said Xu Xiaotian, chief of the department of electronics and information product administration of the Ministry of Information Industry (MII). He believes that China is now becoming the world's top manufacturing base for quite a number of electrical goods. As far as the semiconductor industry is concerned, the closer to the manufacturing base, the shorter will be the circulation and the more convenient will be transportation and communication.

Katsumasa Shinozuka, the president of OKI, a famous Japan telecom-equipment company claims that since they are targeting the Chinese market, the cooperation with local companies is of vital importance. He believes that this is not simply about downsizing the cost; more importantly, they want to get closer to the market and clients.

Zhang Qi, the director general of the department of electronics and information technology from MII, points out that with the rapid development of the OEM industry and China's semiconductor industry, lack of products with China's own Intellectual Property Rights (IPR) will become the bottleneck for further development of China's semiconductor industry. Therefore, the forming of the industry's core competitiveness requires the creation of a batch of advanced products with its own IPRs. As for SMIC, the creation of a new miracle must be preceded by the breakthroughs in technical exploration and breaking their rival's containment.

(Beijing Review June 25, 2004)