Chinese Chipmaker SMIC: Profitability Ahead

China's factories are working nonstop to churn out smartphones, digital cameras, and other silicon-based gadgets, but that hasn't translated into profits for China's biggest chipmaker. Since its first plant opened in 2002, Shanghai-based Semiconductor Manufacturing International (SMI) has lost $1.66 billion. Even in 2010, as the foundry industry (which makes semiconductors on a contract basis for chip-design clients) was on the upswing and rivals had to turn away customers, SMIC fared poorly. It is expected to lose $67.5 million for the year, according to a Bloomberg survey of analyst estimates.

That's changing, says David N.K. Wang, the company's chief executive officer. SMIC reported earnings of $30.4 million for the third quarter, its second consecutive quarterly profit. "We are almost boiling," says Wang. "We just need a little bit [more] heat."

A turnaround at SMIC could help China finally become a player in the global semiconductor industry, now dominated by Intel (INTC), Samsung Electronics, and Taiwanese foundries. China has many young chip-design companies that have difficulty getting high-profile manufacturers to build semiconductors, since chipmakers often reserve capacity for more established companies such as Qualcomm (QCOM) and Nvidia (NVDA). SMIC is supposed to fill the void. "Its sole purpose is not necessarily to make money," says Michael Clendenin, managing director of Shanghai-based RedTech Advisors. Chinese policymakers look to SMIC "to provide wafers to companies that wouldn't otherwise get them," he says.

Some SMIC investors nonetheless expect the company to turn a profit once in a while. "From a commercial point of view," says Clendenin, "it's a glorious failure." Running semiconductor fabrication plants is enormously expensive: They cost billions of dollars to build. Since SMIC's technology isn't as advanced as that of rivals such as Taiwan Semiconductor Manufacturing (TSM) (TSMC), the world's largest foundry, SMIC can't produce chips as cheaply. That puts it at a big disadvantage.

Wang took over in November 2009, at the company's nadir—shortly before SMIC had to pay $338 million in cash and shares to TSMC to settle a trade- secrets lawsuit. (The company admitted no wrongdoing.) Wang has spent the past year focusing on boosting SMIC's chipmaking technology, which lagged several generations behind that of its competitors. He's shifting toward narrower circuit widths, which command higher prices; such chips accounted for 8 percent of revenue in the fourth quarter of 2010 but will be "at least 40 percent" of sales a year from now, he says. He has also overhauled top management, recruiting executives who have worked at Intel, TSMC, and other companies. "We're driving on the freeway at the same time we're repairing the car," he says.

The China-born Wang, who spent 25 years working at Applied Materials (AMAT), the world's top producer of chipmaking equipment, is "very, very focused on delivering the numbers and executing," says Steven Pelayo, regional head of technology in Hong Kong for HSBC Securities. The transformation has been so complete, "The company should have just changed its name."

The Chinese government has chipped in, too: State-owned Datang Telecom Technology & Industry, which paid $172 million in 2008 for 16.6 percent of SMIC, reported in November that it had increased its stake to 19.1 percent. As China's leaders start to promote domestic consumption, sales of electronics should increase, says William Chou, managing partner with Deloitte in Beijing. That should mean more business for SMIC. The company lacks "cutting-edge technology, but they are closer to the market," he says.

Others doubt SMIC will benefit from that growth. The industry is already crowded with bigger, richer foreign companies, including Abu Dhabi's Globalfoundries, which plans to double spending to $5.4 billion on plants and equipment this year. SMIC's Hong Kong-listed shares have slumped 76 percent since its 2004 initial public offering. "The winners have won, and it's going to be tremendously expensive to change the game," says Bill Wiseman, managing partner of McKinsey's Taiwan office.

Still, Wang reminds the skeptics that things are on the upswing. Analysts expect the company to earn a small profit this year, $16.7 million on sales of $1.66 billion. "For the enterprise to grow, you have to make money," he says. "That's what was missing."

The bottom line: SMIC is China's biggest chip manufacturer and, historically, a big money loser. A new CEO says a turnaround is in progress.

Before it's here, it's on the Bloomberg Terminal.