Earnings recovery does not eliminate elevated valuation pressure; maintain Underperform

Overview

Bank of America maintains its Underperform rating on Hua Hong Grace. The report acknowledges earnings recovery driven by mature-node demand, wafer shipment growth, and ASP improvement, but believes improvements in earnings quality and return on capital will remain limited and that the current valuation is clearly elevated.

Core views

2Q26 revenue, gross margin, and EPS were all slightly better than expected, while operating margin turned positive after a prolonged period of losses.Demand for NOR Flash, MOSFETs, general logic, and power-management products was strong, with AI and automotive applications serving as the main drivers.The company's capacity utilization is expected to approach full utilization in 2H26 through 2027, benefiting both 8-inch and 12-inch wafers.The improving pricing environment is expected to continue through 2027, but depreciation pressure from the ramp-up and full utilization of Fab 9A/9B will constrain margin expansion.With expected 2027 gross margin of around 20%, operating margin of 6% to 7%, and ROE of around 4% to 5%, a valuation above 4x P/B lacks support.

Analysis framework

The report draws conclusions based on quarterly results, management guidance, wafer shipment and ASP assumptions, peer commentary on mature-node pricing, earnings forecasts, and forward P/B valuation.

Methodology notes

• Valuation analysisPrice-to-book valuation method

  The target price is determined based on expected 2027 book value per share.

  The HK$69 target price is based on 2x expected 2027 P/B and book value per share of US$4.4; this multiple is below the average valuation of approximately 3x to 4x for China A-share foundry and OSAT companies, reflecting the H-share discount and lower ROE.

• Fundamental analysisEarnings forecast revision

  Earnings expectations are adjusted based on forecasts for shipments, ASP, gross margin, and expenses.

  Revenue and margin assumptions for 2026–2027 are raised due to improved demand visibility, but higher interest expense and taxes limit the extent of EPS revisions.

• Industry analysisPeer pricing comparison

  Compare pricing and capacity trends among Asian mature-node foundries.

  Peers generally expect higher 3Q26 ASPs and tightening supply, supporting Hua Hong's assumption of a moderate pricing recovery.

Asset mapping & comparison

Structured mapping from thesis to named assets (strengths, weaknesses, peers, risks).

• Hua Hong Grace（1347.HK）

  Covered company

  Strengths

  Solid mature-node demand; driven by AI, automotive, and localization demand; shipments, ASP, and gross margin are all improving; the company maintains a net cash position.

  Weaknesses

  Profitability and ROE remain low; depreciation pressure is rising; free cash flow is under pressure during the period of large-scale capital expenditure.

  Comparison

  The current P/B of more than approximately 4x is significantly above its historical range; the report believes its ROE is below the approximately 5% to 10% level of China's foundry and OSAT peers.

  Risks

  Downside risk from elevated valuation, domestic peer capacity expansion, weakening end demand, and constraints on access to key equipment and materials.

Key data

• 2Q26 revenueUS$718mnUp 9% QoQ and 27% YoY, slightly above the upper end of company guidance and the research team's expectation.
• 2Q26 gross margin16.5%Up from 13% in 1Q26, driven by ASP growth and lower costs.
• 2Q26 operating margin1.5%Turned positive for the first time since 4Q23.
• 2Q26 net profit attributable to shareholdersUS$39mnUp 85% QoQ and 386% YoY.
• 3Q26 revenue guidanceUS$770mn–780mnThe midpoint of guidance implies approximately 8% QoQ growth.
• 3Q26 gross margin guidance16%–18%Reflects continued growth in shipments and ASP.
• 2026–2027 ASP growth assumptionApproximately 7%/yearThe report expects a moderate pricing recovery to continue through 2027.
• Current price-to-book ratioApproximately 4.3x–4.4x P/BAbove the company's historical range of 0.5x to 2x for most periods.
• 2026E ROE2.9%The report considers returns on capital low and insufficient to support the elevated valuation.
• Capital expenditureUS$1.8bn in 2026; approximately US$1.5bn/year in 2027–2028Primarily for Fab 9A installation and Fab 9B construction and ramp-up.

Impact & implications

In the short term, improving shipments and ASP may continue to support revenue growth and margin recovery; however, in the medium term, depreciation, capital expenditure, and low returns on capital associated with new capacity may constrain valuation re-rating. The report believes the fundamental recovery is insufficient to offset the risk of valuation de-rating.

Risks

• Domestic peers such as SMIC, Nexchip, and United Nova expand capacity faster than expected, resulting in increased supply and intensified competition.
• Macroeconomic or trade factors cause end demand to be weaker than expected.
• Restrictions on the supply of key equipment and materials.
• Depreciation pressure from the Fab 9A/9B capacity ramp-up is greater than expected.
• Upside risks include stronger-than-expected chip demand, acquiring Huali Microelectronics at a discount, and increased government support through subsidies, localization policies, or industry consolidation.

What to watch

• Whether actual 3Q26 revenue falls within the US$770mn to US$780mn guidance range, and whether gross margin can reach 16% to 18%.
• Whether the contributions of wafer shipments and ASP to revenue growth align with management's estimates of approximately 40% and 60%, respectively.
• Whether 8-inch and 12-inch capacity utilization can remain near full utilization from 2H26 through 2027.
• The installation, production start-up, and ramp-up progress of Fab 9A and Fab 9B, as well as the impact of depreciation on margins.
• Price increases, supply tightness, and China semiconductor localization demand trends among mature-node peers.
• Whether improvements in ROE and operating margin are sufficient to narrow the return gap with peers.