China's SMIC mandates HK/NY flotation

One of the more important equity mandates out of China in recent years draws to a conclusion.

Following bake-offs in San Francisco just over a week ago, Semiconductor Manufacturing International Corp (SMIC) has mandated two bookrunners for its Hong Kong and New York Stock Exchange listing. The foundry manufacturer has appointed Credit Suisse First Boston and Deutsche Bank for two of the slots and may yet appoint a third bookrunner from a shortlist, which is said to comprise: Bear Stearns, Citigroup, JPMorgan, Merrill Lynch and UBS.

The deal is expected to net proceeds of about $750 million and is said to be at least six months away, with most tech specialists expecting an early 2004 listing pending market conditions. But the size of the flotation belies its true significance.

For investment banks, the deal was hard fought for two reasons. Firstly, the Chinese government attaches huge importance to making its electronics industry the world leader and secondly, the capital intensive nature of the foundry sector means that SMIC will be a frequent and sizeable repeat issuer.

The intense competition between the world's leading foundry manufacturers also explains why a number of investment banks were absent from the shortlist. Goldman Sachs, for example, is a private equity investor in SMIC, but would not have been able to compete for the IPO mandate because of its "house bank" status to TSMC. Likewise, both Lehman Brothers and Morgan Stanley would have been precluded because of their close relationship with UMC.

SMIC was founded in 2000 by Richard Chang, who formerly worked at Texas Instruments before running World Semiconductor Manufacturing ahead of its acquisition by TSMC. Chang is a devout christian, who is renowned for peppering emails with religious allusions and ends most with the words, "God bless SMIC."

Some tech specialists comment that Deutsche's close relationship with the group was cemented at bible study groups attended by Chang and the head of the German bank's Asian technology group. Within CSFB, John Mack, regarded by many as God, is said to have pitched heavily for the mandate.

SMIC currently has three fabs in operation and has rapidly come to the forefront of China's semiconductor sector with output expected to ramp up to 85,000 wafers per month by the end of 2003, up from just over 30,000 at the beginning of the year. According to tech experts, the company has similarly ambitious pricing targets where its IPO is concerned. In particular, it wants to price the deal at three times book value, in line with the valuation it achieved for its recent series C funding.

At Friday's close only TSMC was trading over three times book. The foundry giant closed at NT$58.5 equating to 3.67 times 2003 book, while UMC was quoted at NT$24.5 (1.65 times book) and Chartered at S$1.1 (1.86 times book).

Bankers say SMCI has a current book valuation around the $2 billion mark. Towards the end of 2001, it sourced $1.1 billion from its series A funding, which bought a number of institutions on board including: Shanghai Industrial, which now has a 17% stake and Goldman Sachs (4.5% stake), plus venture capital companies Walden International, H&Q Asia Pacific and Vertex Management.

Since then, it has secured $480 million in local debt financing from a number of domestic banks and a further $400 million through its series C funding. It is at this point that the Chinese government took a more direct stake in return for SMIC owning and running a 12" fab in Beijing.

Some believe this fab is fraught with difficulties because the location is wrong. As one commentator argues, "It's a purely political decision and makes no economic sense whatsoever. Beijing is not a good place to build a fab because there are water shortages in the summer and dust from Mongolia is a problem in the winter."

But what ambitions to construct a 12" fab have shown is that the Wassenaar Agreement is no longer being strictly applied where China is concerned. This agreement, signed by over a dozen nations including Taiwan, limits advanced technology transfers to Communist countries or those know to harbour terrorists. It is one of the main reasons why both TSMC and UMC have previously been unable to proceed with plans for 12" fabs on the Mainland.

Earlier this year, however, Infineon blew the agreement apart by announcing it had signed an agreement with SMIC to equip the 12" fab in Beijing.

So far, China has made a name for itself with "trailing edge" technology. This means that many local semiconductor companies have stuck to four or six inch fabs, where they can easily import the technology they need and develop a niche servicing customers or older product lines that TSMC or UMC are no longer interested in. CSMC, ASMC, Shanghai Belling and Shougang NEC, for example, all run four to six inch fabs with process technologies of 1.0 to 0.25 micron compared to the 0.13 micron being developed by the foundry giants at their 12" fabs.

But what worries TSMC and UMC is that SMIC and to a lesser extent GSMC and Hua Hong NEC are not only developing high-end process technologies, but also undercutting them on price, bringing down the profitability of the entire industry. SMIC now has a number of agreements with a range of foreign strategic partners such as Elpida and analysts estimate it will supply about 50% of the Japanese DRAM manufacturer's output by 2004.

As UBS wrote in a research report earlier this year, "The good news is that unprofitable semiconductor capacity continues to be rationalized in Japan. The bad news is that it is re-appearing in China."

But for many the key question is whether SMIC can one day rival and eclipse TSMC and UMC, or whether it is doomed to resemble the rise and fall of Chartered Semiconductor. In its favour, few doubt the Chinese government's intention to create the world's leading foundry centre supplying chips to an ever growing numbers of electronics manufacturers setting up on the Mainland.

According to Gartner Dataquest research, chip demand in China has been showing double-digit growth over the past few years. In 2003, the research house is forecasting demand to grow 19.47% to $26.69 billion. This compares with a global industry forecast of $167 billion by year-end, up 8.9% from 2002.

On the surface, there would also appear to be plenty of room for semiconductor manufacturers, since Chinese fabs have only been able to supply 11% to 15% of domestic demand, with expectations of the figure growing to roughly 30% by 2005.

SMIC, for example, is preparing to build a further seven fabs in Shanghai to complement its two existing fabs and the one being constructed in Beijing. However, with each 8" fab costing $1 billion to $.15 billion and its 12" fab, $3 billion to $3.5 billion, the company needs continual access to funding.

"SMIC has undergone a very aggressive capex build-out and is running out of cash," concludes one observer. "Historically the company has found it very easy to raise money because it leads the industry and was the first to initiate a well developed business plan. But there is a question mark over whether it can continue this way."