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M FOUNDATION March 12, 2019 09:00 PM GMT China's Industrial Evolution Global Semis – How China Will Chip In We lay out four scenarios for the future evolution of China's semiconductor industry in this report. We also examine what those scenarios could mean for the global semiconductor supply chain. Morgan Stanley does and seeks to do business with companies covered in Morgan Stanley Research. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of Morgan Stanley Research. Investors should consider Morgan Stanley Research as only a single factor in making their investment decision. For analyst certification and other important disclosures, refer to the Disclosure Section, located at the end of this report. += Analysts employed by non-U.S. affiliates are not registered with FINRA, may not be associated persons of the member and may not be subject to NASD/NYSE restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account. M FOUNDATION Contributors MORGAN STANLEY TAIWAN LIMITED+ MORGAN STANLEY ASIA LIMITED+ MORGAN STANLEY & CO. LLC Charlie Chan Shawn Kim Joseph Moore Equity Analyst Equity Analyst Equity Analyst +8862 2730-1725 +8523963-1005 +1212 761-7516 [email protected] [email protected] [email protected] MORGAN STANLEY & CO. LLC MORGAN STANLEY MUFG SECURITIES CO., LTD.+ MORGAN STANLEY TAIWAN LIMITED+ Craig Hettenbach Kazuo Yoshikawa, CFA Daniel Yen, CFA Equity Analyst Equity Analyst Equity Analyst +1212 761-6435 +813 6836-8408 +8862 2730-2863 [email protected] [email protected] [email protected] MORGAN STANLEY TAIWAN LIMITED+ MORGAN STANLEY TAIWAN LIMITED+ Eric Chao Jeff Hsu Research Associate Research Associate +8862 2730-1723 +8862 2730-2864 [email protected] [email protected] M FOUNDATION China's Industrial Evolution Global Semis – How China Will Chip In We lay out four scenarios for the future evolution of China's semiconductor industry in this report. We also examine what those scenarios could mean for the global semiconductor supply chain. Industry View We believe the direction of China's semiconductor industry will be shaped by two questions: 1) Will the industry aim to advance Greater China Technology Semiconductors - through localization or globalization? and 2) Will the focus be on Cautious high-value design or low-margin manufacturing? These questions inform the four scenarios we outline in this report. the 16% self-sufficiency ratio in 2018 also suggests China's IC design The best-case scenario for China is 'Industry Upgrade', triggered industry has ample room to grow. by technology breakthroughs in both chip design and manufacturing, Investment opportunities in China semis: In this report, we pro- while Chinese companies collaborate more with the global tech vide a preliminary guide to China's local semiconductor supply chain. supply chain. The worst case is 'Budget Substitute', in which Over the long term, we are optimistic on Chinese IC design compa- Chinese companies cannot innovate and the local supply chain is nies. In terms of manufacturing, we are more positive on the scala- used to produce low-value semiconductors. bility of backend foundries than wafer foundries, but the former's Under the 'Global Commoditization' scenario, China breaks into profitability needs to improve. We are Overweight Goodix (IC design) global semiconductor manufacturing through joint ventures and and USI (backend foundry). On memory, we think private company overseas M&A but with limited innovation. Finally, our base-case YMTC could become relevant in the NAND Flash industry by 2020. scenario is that a 'New Breed' of semiconductor company emerges, We think the key challenges facing China's semiconductor industry propelled by technologies like software-driven chip design and are IP acquisition and local industry consolidation. X-stacking NAND. Global implications: The potential emergence of China's semicon- Self-sufficiency is more than just the trade balance: The usual ductor industry could challenge IC designers in the US, Korea, and way to measure China's self-sufficiency in semiconductors is through Taiwan, and be a long-term threat to the global memory industry a simple comparison of imports and exports. However, we think the (particularly NAND and NOR). Growing investment in production resulting deficit – around US$227bn in 2017 – makes the situation would be positive for semi caps, photomasks, and chemicals, but look worse than it is, because China imports most of those semicon- 2019 demand from China needs to be discounted given the slow ductors for use in products that are then exported again. To address progress of Chinese memory fabs. this deficiency, we have developed a 'China Tech Hardware Ecosystem' framework. This measure shows that demand from Chinese system brands (e.g. Lenovo, Xiaomi) is only US$77bn, while M FOUNDATION Contents 5 Four Scenarios for China's Semiconductor Evolution 6 A New Take on China's Semiconductor's Future Development 7 Key charts 8 Executive Summary 14 China's journey so far 17 China's Semi Companies vs. Global Peers in 2018 21 Four scenarios for the future 31 Defining effective self-sufficiency 35 China semi investment perspective 39 Implications for global semis 43 Appendix 1: Potential breakthrough points for China semis 45 Appendix 2: US/China/Taiwan semiconductor policy 48 Appendix 3: Exploring China's semi companies - our tour guide 49 #1 China's wafer foundries 51 #2 China's backend foundries 53 #3 China memory 55 #4 China IC design M FOUNDATION Four Scenarios for China's Semiconductor Evolution Exhibit 1: Possible outcomes in China's semiconductor industry evolution Source: Morgan Stanley Research M FOUNDATION A New Take on China's Semiconductor's Future Development Exhibit 2: Our perspective versus the conventional view of China's semi industry development Morgan Stanley's perspective Conventional view Industry strategy Self-sufficiency measure Tech ecosystem Trade balance Core of industrial policy Products Production Focus sub-sector IC Design, OSAT Wafer Foundry, Memory Relevant technology benchmarks System-level integration (e.g. SiP) Moore's Law IC design expertise Software-driven ASIC design Large-scale integration (LSI) for SoC Corporate strategy Main operation High-value design Low-margin manufacturing Spending focus R&D Capex Operational KPI Value creation Market share Financial KPI ROE Revenue scale Partnerships with foreign companies Global collaboration JV/M&A, technology transfers Main founding source Capital market Government funds Source: Morgan Stanley Research M FOUNDATION Key charts Exhibit 3: Exhibit 4: China's semiconductor consumption at different stages of the tech Our estimates of China's self-sufficiency in semiconductor compo- supply chain nents 300 70% 243 250 60% 50% 200 40% 150 30% 27% (US$bn) (US$bn) 100 91 100 20% 16% 12% 50 10% - 0% China factory China system brand China end-user China factory self- China system brand self- China end-user self- consumption consumption consumption sufficiency % sufficiency % sufficiency % Source: Gartner, company data, Morgan Stanley Research estimates Source: Gartner, IHS Markit, IDC, company data, Morgan Stanley Research estimates Exhibit 5: Exhibit 6: China Semiconductor Index market capitalization and stages of devel- Sales of China-based semiconductor companies opment 800 Rmb bn % 50% 700 40% 600 30% 500 20% 400 10% 300 0% 200 100 -10% 0 -20% 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019e Sales (LHS) YoY (RHS) Source: TrendForce, Morgan Stanley Research Source: Bloomberg, Morgan Stanley Research Exhibit 7: Exhibit 8: China semiconductor margins, by sector China's self-sufficiency ratio by end-device 60 Industrial and others 50 Drone Gameconsole 40 Basestation 30 Networking equipment Home Appliances 20 Surveillance 10 Auto - TV Server (10) PC (20) Feature phone Smartphone (30) Mar-05 Apr-06 May-07 Jun-08 Jul-09 Aug-10 Sep-11 Oct-12 Nov-13 Dec-14 Jan-16 Feb-17 Mar-18 - 5,000 10,000 15,000 20,000 25,000 30,000 35,000 40,000 45,000 Foundry IC Design OSAT (US$ mn) China self produced value Produced by other regions Source: Gartner, company data, Morgan Stanley Research estimates Source: Gartner, IHS Markit, IDC, Morgan Stanley Research estimates MORGAN STANLEY RESEARCH 7 M FOUNDATION Executive Summary Why write this report now? …will shape four possible outcomes We are taking a step back from recent noise about China/US trade Regarding the first question, we think the key to advancing the evolu- tension to assess the structural evolution of China's semiconductor tion of China's semiconductor industry clearly lies in chip design industry. Our aim with this report is to provide long-term perspective rather than pursuing large-scale, low-margin manufacturing. To put to investors who wish to participate in the capitalization of the it another way, Chinese semiconductor firms must prioritize owning industry in China. Global semi investors may also want to know what 'the product' over the means of production. the potential rise of Chinese semi companies could mean for their peers around the world. As for the second question, the current tendency is toward localiza- tion (investing in and depending on China's own technology) over Two critical questions... globalization (leveraging foreign technology through M&A, joint ventures, and licensing). Localization could prove very rewarding but also carries significant risks. We believe China has the potential to increase local production of semiconductors given its large end market and abundance of capital. With all this in mind, we see four potential scenarios for the industry's It also has the motivation given the importance of semiconductors to evolution, ranked from what we view as most favorable to least almost every aspect of modern life. However, compared to technolo- favorable: gies such as solar PV modules and LEDs, the semiconductor industry is much harder to crack given the long supply chain and highly-pro- l 'Industry Upgrade' – China achieves technology breakthroughs tected intellectual property.