Li Feng of Frees Capital: Opportunities for the development of China's integrated circuits under the new pattern

The "2020 Hardcore China Chip Leaders Summit and Selection and Award Ceremony" hosted by Xinshiye, sponsored by Shenzhen Fubao Group, and co-organized by Munich South China Electronics Show was held at the Shenzhen International Convention and Exhibition Center. At the summit, many top industry experts shared their insights, including founders/product marketing executives of 80 chip companies, more than 20 investment/park executives, experts from scientific research institutes, 300 R&D and procurement executives of electronic terminal factories, etc. A total of more than 400 guests gathered in Shenzhen to witness the phased growth of China's chips in 2020 and discuss the unlimited future of China's chips.

Speaker Li Feng is the founding partner of Frees Capital , focusing on investments in the technology and consumer sectors, and has unique insights and judgments on long-term economic trends. At this summit, he delivered a keynote speech entitled "China's Integrated Circuit Development Opportunities under the New Pattern" . The following is the transcript of his speech.

In the past five years, Frees Capital has invested in nearly 20 chip-related companies. We are their earliest institutional investor. At that time, the chip industry was not as popular as it is today. Since we are not engaged in technology, how did we consider this issue when we decided to enter this industry five years ago, which was neither hot nor had large-scale policy encouragement and stimulation? How did we convince fund investors to invest in this industry five years ago? This includes our macro considerations on the domestic industrial structure.

This picture shows a rough industrial chain structure. China has a relatively special economic phenomenon: China has become the largest industrial chain in every link, not only in terms of total scale, but also in terms of the most complete chain links. China is the only country in the world that has all the industrial categories listed in the United Nations industrial classification, with 41 major industrial categories and 207 medium industrial categories, and is in a leading position in many categories; more than 70% of the main production capacity of consumer goods is in China. However, high value-added products and industrial products are a focus of our discussion in 2015, and China's industrial chain has encountered challenges.

Let's look at how other countries that have experienced similar bottlenecks as China, such as Japan, have developed at specific points.

This chart shows the industrial structure of Japan during its fastest 20 to 30 years of development. 1970 to 1972 was a very special period for Japan, with its economy developing rapidly and its population exceeding 100 million. In the 50 years since then, its population has fluctuated between 100 million and 120 million, so this is when its population began to peak.

This chart is taken 50 years later, in 2010. The total population has not changed much, but the proportion of people engaged in the labor force has decreased slightly. In terms of the labor force, the employment situation in the primary and tertiary industries has been adjusted. The biggest difference is that its manufacturing industry still accounts for a large proportion of employment and GDP contribution.

This is very similar to the situation in China, because China's manufacturing industry also accounts for nearly 30% of employment. If we count the workers who are counted as agricultural population but are employed in the manufacturing industry, it accounts for more than 35%. From the 1950s to today, Japan has ensured the proportion of employment and contribution to GDP in the manufacturing industry. The United States is different. Since World War II, the proportion of manufacturing value added in GDP in the United States has dropped from 30% to 11% (data from October 2019). This is the biggest difference, so we are more like Japan.

In 2015, China’s challenge was that, although no country had ever made all these chains the most complete and largest, the rate of increase in manufacturing value-added was only 21% in China. In countries like Japan and Germany, where manufacturing still accounts for a large proportion of GDP, their rate of increase in manufacturing value-added eventually reached 33% to 36%.

Therefore, China's biggest challenge is to increase the added value of manufacturing by about 12% to 13%, and this proportion must be added from high value-added products. If the added value is not enough and labor costs rise, we will face the problem of these links that have been accumulated with great difficulty and accumulated to a large extent being removed one after another. This will also bring about the social problem of structural unemployment, because China's manufacturing industry accounts for nearly 40% of employment. In this sense, this problem must be solved. This was a macro judgment we made at the time.

In the past six months or ten months, two social phenomena have attracted great attention. The first is to think about what exactly represents high value-added products and high value-added industrial products ? Taking the smartphone industry chain as an example, because of the existence of companies like Huawei, we basically keep the smartphone industry chain around it or in China. Huawei is a high value-added industrial product, mainly because it can design from top to bottom, of course, including HiSilicon. Because of the existence of this type of company, the supply chain in front is retained. This is a simple way to upgrade the manufacturing industry and increase the added value of the manufacturing industry.

Another phenomenon is the focus on high value-added services . The most typical international companies or companies with the largest market value in the United States today, in simple terms, represent the characteristics of the industrial chain in which they export or sell basically all technologies, intellectual property rights, and professional experience without physical products. These companies, whether Facebook, Google or Microsoft, do not sell products, but they still obtain high added value.

Simply put, if the two links with the highest added value of the industrial chain are also done well, China will form a complete industrial chain with a large structure in each link, which is unprecedented. So it is understandable that in today's environment, companies represented by Douyin and Huawei have encountered some challenges in the process of internationalization, because some developed countries are still unwilling to accept the emergence of international companies in China that represent the two links with the highest added value of the industrial chain, even though everyone has accepted that China is the world's manufacturing center, the world's industrial products or intermediate products center. These are some of the economic and international phenomena we have seen in the past six months.

So the most basic judgment we made at that time was that due to the problems of employment structure and industrial structure, China must increase the added value of the industry and must do these things related to technology . When investing in these technologies in the past few years, I was often asked another question: Can China really do it? Whether it is chips or other related technology industries. Although the policy encourages it, the country encourages it, the industry needs it, and the capital market encourages it, but can it really be done?

This chart shows the opportunities in China's consumer market. China's total retail sales of consumer goods last year was about 41 trillion yuan, ranking second in the world, while the United States ranked first in the world. The United States's retail sales in RMB is about 42 trillion yuan, about 1.5 trillion yuan more than China. But China will catch up this year. In the first nine months of this year, China's total retail sales of consumer goods finally tied with the United States, while the United States is still falling. At a certain point in time, China will become the world's largest single market.

This picture can also explain how the United States has come to a relatively strong position in the chip industry. 70 years ago or more than 60 years ago, Silicon Valley was more or less a true full industry chain. Even silicon chips and wafers were there, so it was called Silicon Valley. Simply put, during the first large-scale development of chips, its demand was caused by the first popularization of integrated devices or smart devices (that is, computers). At that time, in the application and product of computers, the United States had always been the number one since World War II. The United States was the single largest consumer market, and when chips first developed, it happened to be a full-production, full-supply chain country. On one side, there was the greatest demand, and on the other side, there was a relatively complete industry chain that was developing rapidly. In the 30 years from the 1960s to the 1990s, there were countless iterations and rapid developments, and a rapid cycle between demand and supply. The United States produced the first wave of giant companies representing chips, including companies that made general-purpose chips, computing chips, and CPUs.

The second large-scale popularization of smart devices was the telephone. Every large-scale popularization and rapid development of smart devices has brought about the development of chips. When mobile phones began to develop rapidly in the 1990s, the United States was still the single largest market. Although part of the medium-value supply chain has shifted to Taiwan and Europe, and Japan has also developed rapidly during the same period, the United States is still the largest single market and has the best companies on the supply side (chip design, technology iteration), that is, the second wave of chip companies related to communications, including Qualcomm, Broadcom and other companies related to communications and RF, which have transferred part of the production and manufacturing industry chain to related countries.

The third large-scale emergence of smart devices is the smartphone that everyone holds in their hands today. China has become the world's largest single consumer market for smartphones since the second quarter of 2012. Since then, we have always been the world's largest single consumer market for smartphones and have more than half of the industry chain. For example, after Sino-US relations became tense in 2018, from 2018 to 2020, the proportion of Apple suppliers in China (including Taiwan, China and Hong Kong, China) in Apple's top 200 core supplier list increased from more than 20% to 40%. This is a situation where the proportion of Chinese suppliers has increased despite the poor Sino-US relations, which means that China has become better in the supply chain or production links.

Finally, when it came to the third time, China happened to become the largest market, and from the data point of view, it also owned most of the production chain. The connection between demand and supply chain was translated into production technology. Whether these technologies are sensors, chips, algorithms or designs, they all began to iterate rapidly in China. The iteration of technology produced the following phenomena. The first one was that in 2015, no one would have believed that an international Chinese smartphone brand would emerge in five years, whether it was Huawei, vivo, oppo or Xiaomi. But another phenomenon is that now we already have some related technology companies, such as Huawei or HiSilicon.

This phenomenon can be linked to the history of technological iteration in the United States. The reason why the United States produced famous chip companies was that when it came to the first generation of smart devices, the United States had both market demand and a complete industrial chain. Therefore, during the iteration process, the technology upgrade was done well. If, when it came to the second generation of smart devices, the United States still had the greatest demand and controlled the technology and design capabilities of the core industrial chain, it would be able to produce a batch of chip companies after rapid iteration.

Back to today’s era of smartphones, China has become the largest market, with most of the industry chain. Technology is rapidly iterating in the process of connecting the market and the industry chain, so we have not only produced the brands mentioned above, but also many chip technology companies. This is our thinking on “Can China really do it?”

For example, we can look at the upgrade of China's supply chain in the most important precision link from the supply chain. Before 2000, China had a lot of Sino-foreign joint ventures, with the Chinese side holding 51% and the foreign side holding 49%, hoping to transform communication technology, but the transformation was unsuccessful. In 1999, China made adjustments and allowed many manufacturing companies to produce mobile phones, so it took a very short time to become a major assembly industry country.

Among them, there is a famous company Luxshare Precision that went public in 2010. It was a very inconspicuous assembly company when it went public. The prospectus stated that nearly 50% of its sales came from Foxconn. Simply put, Foxconn threw orders that it was too lazy to do to them. Coincidentally, 10 years later, about a month ago, there was an unofficial news that Luxshare Precision dumped part of its Apple orders to Foxconn. This incident shows that China's mobile phone manufacturing industry has changed from ordinary assembly industry to precision manufacturing.

We also have two more questions. Will more and more devices in China's consumer electronics market become intelligent? If more and more devices become intelligent, it will require the production of more and more sensors or chips, or the production of integration capabilities. When the devices become intelligent, will China be the largest market? This is the first question. The second question is whether China's corresponding industrial chain or industrial chain structure can be quickly upgraded to meet these demands? If the answer to both questions is yes, China will have technology companies and typical technology-driven companies in the process of rapid iteration and upgrading, including the chip companies we are discussing today.

The policy-related things outside this picture are to enable the logistics network and industrial chain network to achieve global digitization and digitalization of all supply and demand efficiency matching. Digitalization is very related to hard-core technology and chips. After we put this global digitization on the industrial chain network and logistics network in the middle, can it solve China's problems? When we invest in consumer Internet, we have a simple observation. In fact, all the big companies we see today in consumer Internet are only related to chips, sensors, and data.

Let's talk about one or two simple examples. The new companies that have emerged in the mobile Internet, whether it is food delivery, taxi-hailing, or short video platforms, each of them is just because new sensors and chips are installed on your smartphone. Simply put, because GPS, high-definition optical zoom camera and image processing unit are installed, and other types of sensors are also installed on it. Why did these big companies come into being? Because they translated information into data. Because of the existence of these chips and sensors, a large amount of information quickly turned into data. Matching at the data level will produce much larger platforms or benefits than matching at the information level. Just now we explained that these new giant companies and historical giant companies are probably all due to the development of certain technologies, which has enabled us to install new chips or sensors in some commonly used or everyone's devices. Their function is to turn information into data. Once it becomes data, the matching effect is improved.

Can our country's policies, China's industrial chain structure and dataization, solve the problems of China's economic development and economic development efficiency?

We can look at these three statistics, which only prove one thing. In the last cycle, that is, since the 1970s when the United States emerged from the economic depression, the main productivity gains in the past 50 years have come from the use of computers in all walks of life, whether in industry, services or other industries. The meaning of these three pictures is that although the computer industry accounts for a relatively small absolute proportion of the US GDP, it has contributed a large proportion of the total factor productivity of all industries in the United States for as long as 40 to 50 years. The reason why the technology war has become like this today is very simple. The largest countries are looking for who will be the next most important driver of productivity. Whoever has that factor can obtain these developments or economic progress in the long term.

This is what we were thinking about five years ago when we discussed why to invest in technology and chips. As an outsider, we could only discuss and argue from a macro and non-technical perspective. Of course, many of these things seem to have become policies, economic structures, and capital market demands today. Therefore, there are many more supporting factors than five years ago, and the prospects will become increasingly clear.

This article is originally created , and the pictures are from Xinshiye and Frees Capital. The content represents the personal opinions of the interviewed guests and is for communication and learning purposes. If you have any questions, please contact us at info@gsi24.com.