Restrictions on Chip Sales to China Handcuff High-End U.S. Suppliers
The rules of the game keep changing.
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Tech investors, beware: The recent restrictions on high-end chip exports to China are disrupting the sector and already shaking stalwart stocks such as Nvidia NVDA .
I need to make clear that I'm an interested party. I have a small stake in Nvidia that I've held for a number of years and intend to continue to hold. That is the case even though Nvidia took a bit of a dent in the markets when the last set of restrictions was unveiled in mid-October.
Those new rules go into effect next week. Nvidia sold off 16% from a mid-October peak into the end of last month, but since then has recovered the lost ground.
Clearly, the rules are meant to hurt China's military capability and enhance the U.S. advantage in high-end semiconductors. But they also hurt U.S. companies selling chip designs, technology and equipment, as well as chips themselves, into China.
The administration of U.S. President Joe Biden has been dancing a tricky two-step, as I said today on the Money Talk podcast, a half-hour show that's the most popular business radio show here in Hong Kong. Here's the link in case you care to listen as we tackle topics from "natural monopolies" to the film "Jerry Maguire."
On the one hand, the Biden administration is restricting Chinese access to the kinds of advanced semiconductors that go into artificial intelligence and other purposes that could be used either by the Chinese military or for human-rights abuses through the use of facial recognition software and the like.
On the other, the administration has opened diplomatic overtures to China, which is responding positively now that Beijing isn't being quite so defensive over any investigation into the origins of Covid-19. High-level ministerial communication between China and the United States at a top level had all but stopped.
Chinese President Xi Jinping is due to dine with top U.S. executives when he heads to San Francisco for the APEC Summit next week, no doubt with Silicon Valley CEOs to the fore.
Meanwhile, U.S. Treasury Secretary Janet Yellen is set to meet with Chinese Vice Premier He Lifeng today and tomorrow to talk both about unfair state subsidies and areas for cooperation on issues such as climate change.
In terms of the new rules on semiconductors, the U.S. Commerce Department said the measures imposed as of next week are an update on a previous set of restrictions introduced a year ago. And U.S. Commerce Secretary Gina Raimondo said the rules probably will be updated "at least annually."
It is an evolving situation, which makes it hard to read. The concern is that advanced chips fuel supercomputers and artificial intelligence that can help with the speed and accuracy of military decision-making. That's an area where the United States and its democratic allies also have a big lead in this sliver of the market.
Nvidia, Intel INTC , Advanced Micro DevicesAMD and Microchip Technology MCHP made nearly all the AI chips ordered by the Chinese People's Liberation Army for use in training their advanced machine-learning systems, according to a 2022 policy brief by the Center for Security and Emerging Technology at Georgetown University.
When the original rules were put in place, both Nvidia and AMD said they would comply. And as you'd expect, they then made China-specific chips that stayed within the regulation but were as good as possible -- and better than the competition.
Their non-military customers in China include the all-stars of Chinese Big Tech -- the likes of Alibaba Group Holding (HK:9988 and BABA ), Tencent Holdings (HK:0700 and TCTZF ) and Baidu (HK:9888 and BIDU ).
Tech analysts say the downgrades imposed on the China-specific chips make them slower at training machine-learning systems, and slower and therefore more expensive to run at chip-to-chip data transfer. Over the long term, it's expected that commercial Chinese users can make do. The rules also exempt chips for use in laptops and smartphones and for gaming.
China is attempting to develop its own superchips. For the moment, though, it has a foothold in the low end of the chip design and manufacturing ladder. The mainland is mainly home to facilities for the assembly, packaging and testing of chips as well as manufacturing facilities making stuff for those assembly plants.
Electronic design and the core intellectual property of chips are still concentrated in the United States, Europe and Japan, and it's clear the United States would like it to stay that way.
Demand for high-end chips currently far outstrips supply. Nvidia, for instance, sells every chip it can make, so there's no near-term impact from losing Chinese customers, or at least rejigging chip sets so they can be sold there.
The worry is that China is a major focus for certain industries such as data centers. With cities such as New York and Singapore placing moratoriums on the construction of new data centers due to concern over energy usage, China accounts for around one-quarter of Nvidia's sales to that segment of the market. Because the Chinese data-center specialty sector likely will expand at a fast clip, it will hurt not to be able to sell high-end chips such as the A800 and H800 that were specifically tailored for those customers.
Standard & Poor's maintains in a new report that Nvidia will face a shortfall from Chinese sales. But its sales to the United States, Europe and the rest of Asia eventually will more than make up for that dent to revenue. S&P believes Nvidia's revenue will almost double in fiscal 2024 and rise another 30% to 40% in fiscal 2025.
AMD and Intel are also feeling their way around the new rules. The restrictions should not have a major impact in the next couple years but could hurt if China leaps ahead in a segment such as data centers, meaning they're missing out on customers that have the most massive growth.
The impact could be more significant for chip fabricators such as Taiwan Semiconductor Manufacturing Co. (TW:2330 and TSM ), which is literally stuck in between the China-U.S. trade dispute. It has been making the bulk of the chips it produces in Taiwan, but is also now building chip-fab facilities in Japan and on the outskirts of Phoenix.
Those plants are incredibly expensive. Taiwan Semiconductor said last December that it was expanding its plans in Phoenix from an original US$12 billion investment to US$40 billion. It aims to start U.S. production next year.
Taiwan Semiconductor is not allowed to use U.S. technology when it makes chips for Chinese customers that are on the U.S. "entity list," a rising roster of companies mainly focused on AI. The company therefore will lose such customers, mainly Chinese integrated circuit companies, which will be forced to shift orders for mature chip technology to domestic Chinese foundries.
This is a boon to the Chinese state-owned enterprise Semiconductor Manufacturing International Corp., or SMIC (HK:0981). It is the main domestic hope and a big producer of mature (i.e. older tech) chips. Overseas revenues made up 20% of its total sales in the second quarter of 2023, and while that percentage is falling -- down from 37% in the second quarter of 2021 -- the company will find happy customers in the form of the kind of Chinese integrated circuit companies that Taiwan Semiconductor can no longer easily serve.
S&P said it believes the United States will sustain a policy that's "small yard and high fence." The winners will be Western companies that can successfully shift their customer base away from China, as well as Chinese chipmakers such as SMIC.
At the time of publication, McMillan was long NVDA.
