Welcome to Semiconductor Manufacturing International Corporation's first quarter 2017 webcast conference call. Today's conference call is hosted by Dr. Tzu-Yin Chiu, Vice Chairman. Dr. Zhao Haijun, Chief Executive Officer. Dr. Gao Yonggang, Chief Financial Officer. Mr. Gareth Kung, Executive Vice President of Strategic Business Development and Finance and Company Secretary. Mr. En-Ling Feng, Vice President of Investor Relations. Today's webcast conference call will be simultaneously streamed through the internet at smic.com. Please be advised that your dial-in are in listen-only mode. At the conclusion of the management presentation, we will be having a question and answer session, at which time you will receive further instructions as to how to participate. The earnings press release is available for download at www.smic.com. Webcast playback will also be available approximately one hour after the event.
Without further ado, I would like to introduce to you Mr. En-Ling Feng, Vice President of Investor Relations, for the cautionary statement. Thank you.
Good morning and good evening. Welcome to SMIC's first quarter 2017 earnings webcast conference call. For today's call, our Vice Chairman, Dr. T.Y. Chiu, will make a few comments first. Our CEO, Dr. Haijun Zhao, will provide some business remarks. Our CFO, Dr. Gao Yonggang, will highlight our financial performance and give guidance on the next quarter. Our Executive VP of Strategic Business Development, Finance, and Company Secretary, Mr. Gareth Kung, will give the detailed financial commentary. This will then be followed by our Q&A session. As usual, our call will be approximately 60 minutes in length. The earnings press release and quarterly financial presentation are available for you to download at our website under Investor Relations in the Events and Presentations section. Let me also remind you that the presentation we'll be making today includes forward-looking statements.
These statements and other comments are not guarantees of future performance, but represent the company's estimates and are subject to risk and uncertainty. Our actual results may differ significantly from those projected or suggested in any forward-looking statements. For a more complete discussion of our risks and uncertainties that could impact our future operating results and financial condition, please see our filings and submissions with the U.S. Securities and Exchange Commission and The Stock Exchange of Hong Kong Limited, including our annual reports on Form 20-F filed with the U.S. Securities and Exchange Commission on April 27, 2017. During the call, we will make reference to financial measures that do not conform to generally accepted accounting principles, GAAP. These measures may be calculated differently than similar non-GAAP data presented by other companies.
Please refer to the tables in our press release for a reconciliation of GAAP to the non-GAAP numbers we will be discussing. Please note that all currency figures are in US dollars unless otherwise stated. I will now turn the call over to our Vice Chairman, Dr. T.Y. Chiu, for some opening comments.
Thank you, En-Ling. Greetings to everyone. As most of you are aware, SMIC yesterday announced that I have stepped down as CEO. Dr. Haijun Zhao, as nominated by me, was appointed by the board as the new CEO to take the company forward. This is a tough personal decision for me, but my family commitments have called for me to devote more time to them. Although I no longer serve in an executive capacity with SMIC, I continue to serve on the board as Vice Chairman and a non-executive director. I will continue to contribute to SMIC's future growth and success. It was an honor to lead the SMIC team in transforming the company these last six years. Challenges were many. As a team, we have overcome those challenges.
We improved our product portfolio, tightened factory operations, raised the fab utilization, strengthening our financial position, earning the respect from our stakeholders. SMIC is now well-positioned as a leading player in the global foundry market. I'm extremely proud of our team's achievement as well as thankful to their dedication. As we move on to our next chapter of growth, the opportunities and challenges in front of us are still many. Both the board and I are highly confident that under Haijun's leadership, the SMIC team can continue to deliver outstanding results for the benefit of all stakeholders. Since joining SMIC seven years ago, Haijun has been an invaluable leader and is critical part of the team, which brought about the transformation in these past few years. Haijun joined SMIC in October 2010 and has moved quickly through the company's rank.
In April 2013, he become the Executive VP and the Chief Operating Officer. In July 2013, he also assumed the role of general managers of SMNC, our joint venture in Beijing, which has been the most significant investment made by SMIC in recent years. I believe in Haijun, his energetic leadership, that he will continue to lead the company as a global, professionally managed, and independent company. In the meantime, I'll stay full-time to support Haijun and ensure smooth and seamless transition. Over the last six years, we have strived to improve our management system and have come to cultivate very strong teamwork. We benefit from outstanding management team with a diverse range of experienced leaders and thousands of dedicated employees. This is a perfect time to make the handover and transition. I will now hand the call over to Haijun for Q1 results and business remarks.
Thank you, T. Y. Greetings to all listeners, and thank you for joining us. I'm greatly honored to have this opportunity to lead SMIC team at this exciting moment in our history. I would like to thank T. Y. for his guidance and mentorship. I look forward to continuing working with SMIC team as we continue to enhance our competitive position in the foundry market. As a global and independent foundry player, we are committed to delivering results benefiting our shareholders, customer, and employees. Now, to address SMIC's business, I will highlight our quarterly performance, the challenges we are facing, how we are tackling these challenges, our long-term opportunities, the preparation for continued long-term sustainable growth. In the face of seasonal weakness and our customers' transitions, our team delivered a good quarter with decent year-on-year growth, improved operating income, and a record high EBITDA in Q1 2017.
Revenue grew 25% year-on-year, representing a sequential decline of 2.7%. Gross margin was 27.8% compared with 24.2% in Q1 last year and 30.2% Q4 last year. Operating profit grew 17% year-on-year and 57.9% quarter-over-quarter. Consolidated net profit was $34.2 million, an increase of 24.1% year-on-year and 10.6% quarter-over-quarter. Net profit attributable to SMIC was at $39.8 million, compared to $31.4 million in Q1 last year, and $104 million in Q4 last year. EBITDA was a record high of $312.4 million, an increase of 42.8% year-on-year and 13.9% quarter-on-quarter, and representing an EBITDA margin of 39.4%. In the first half of 2017, we are confronting the challenges of customer undergoing changes in the market positioning, seasonal inventory adjustment, and overall muted handset market in China.
As such, we have guided Q2 to decline 3%-6% quarter-on-quarter, which however, represents an increase of 17.5%-21.3% year-on-year. We have actively pursued new incremental revenue from a variety of customers and markets to mitigate the impact of such headwinds. In the first quarter of 2017, from a technology node perspective, 28 nanometer and 55 nanometer wafer revenue sequentially grew 39% and 9.1% respectively. By application, smartphone weakness was countered by growth in feature phones, tablets, and other consumer applications. We continue to ramp up 28 nanometer, 55 nanometer, and additional products on 8-inch wafers. From a device perspective, we are pursuing growth in area where we are seeing meaningful demands, such as NOR flash, RF, connectivity, power IC, and others. We acknowledge this year is challenging, but remain confident in SMIC's long-term potential and opportunities.
We believe we are in a great position, both strategically and financially, to weather this cyclical downturn and benefit from some exciting future trends. We strongly believe SMIC is in a great position to benefit from an array of long-term trends. Today, I'd like to highlight the market opportunities in automotive and the Internet of Things. LFoundry serves as a platform for SMIC, providing a more significant presence in the auto and industrial sector, and has opened opportunities for collaboration in the future, both in Europe and in China. Since the acquisition of our foundry, SMIC has become the market leader in auto-related CIS. In addition, situated in China, the largest market for auto, IC design companies have the incentive to explore ways to break into the supply chain, and SMIC may benefit from this in the long term. IoT is another exciting area.
As an example, one of our domestic customers recently reported 1 billion shipments of IoT-related chips, for which SMIC is their primary supplier. Some IoT chips manufactured by SMIC are being utilized in everyday items, such as shared bicycles. There are reportedly millions of shared bikes in China, and they are growing exponentially and are breaking into international markets. Shared bikes are just one example of IoT chips applied in China, and we believe this is only the beginning. We are excited to be part of this trend. In the last two years, utilization was running close to 100%, which eventually make juggling production and R&D requirements a challenge. We are currently taking advantage of the low fab utilizations to accelerate the R&D program for both advanced and mature nodes. The turnaround time for R&D project has accelerated.
R&D-related wafer moves more than tripled in Q1 this year compared to Q1 last year. We believe these activities are vital to the company's long-term sustainable profitability and growth. Our 28 nanometer is ramping up and reached 5% of the wafer revenue in Q1, representing a growth of 39% Q1 to Q2. We continue to work with our customers on 28 nanometer new tape-outs for a diverse set of applications. Going forward, we believe we will see an increasing variety of applications requiring this line width. The R&D activities on 14 nanometer are also well underway and on track. On larger nodes, we continue our efforts in diversification and differentiation of technology. In addition to new technologies, we are working hard on the next generation for a range of existing technologies such as PMIC, CMOS image sensors, and the non-volatile memories. We are also well-positioned financially.
We have more than $2.1 billion cash on hand when including financial assets as of the end of Q1. In addition to stronger liquidity, we completed the conversion of our convertible bonds in March this year. We believe that the company has adequate funding to finance our near-term capacity expansion. To conclude my remarks, SMIC is well-positioned to meet the challenges of this year. We are optimistic about the long-term prospects and continue to work hard in preparing the right technologies and strategic paths to grow the company profitably. Thank you to our loyal customers, supporting investors, hardworking employees, and other dedicated stakeholders. I now hand the call over to Yonggang for the financial highlights and the next quarter guidance.
Okay. Thank you, Haijun. Greetings to all our listeners. First, I will highlight our first quarter 2017 results, and then we'll give our second quarter 2017 guidance. Now I will highlight our first quarter 2017 results. Our revenue was $793 million. Gross profit was $221 million. Gross margin was 27.8%. Profit for the period attributable to SMIC was $70 million. Now, looking ahead into the second quarter of 2017. Our revenue is expected to decline by 3%-6% quarter-over-quarter. Gross margin is expected to range from 25%-27%. Non-GAAP operating expenses are expected to range from $178 million-$184 million. Non-controlling interests of our majority-owned subsidiaries are expected to range from positive $6 million to positive $8 million, which are losses bound by non-controlling interests. I will now hand the call over to Gareth for more detailed financial commentary.
Thank you, Gao, thank you everyone for joining us today. I will now comment on the details of our last quarter financial results. On the income statement, revenue decreased by 2.7% QoQ to $793 million, mainly due to decreased shipments and change in the product mix. On a year-on-year basis, our revenue in Q1 2017 still increased 25%. Gross profit was $221 million. Gross margin was 27.8% at the high end of our guidance range. Operating expenses decreased to $143 million in Q1 2017. R&D expenses decreased by $10.5 million QoQ to $108 million. The change was mainly due to high level of R&D activities in Q4 2016. Funding of R&D contracts from the government was $14 million in Q1 2017. G&A expenses decreased by $22 million to $39 million in Q1 2017. The change was mainly due to a decrease of accrued employee bonus.
Excluding the effect of employee bonus accrual, government funding, and gain from disposal of living quarters, non-GAAP operating expenses were $165 million in Q1 2017. Profit from operations was $77 million. Operating margin was $9.8 million. Profit for the period attributable to SMIC was $70 million, while non-controlling interests were $6 million of credit to SMIC's attributable profit. If excluding the impact of the finance cost, depreciation and amortization, and income tax benefits and expenses, our EBITDA was a record high of $312 million, and EBITDA margin was 39.4% in Q1 2017. Moving to the balance sheet at the end of the first quarter 2017, cash and cash equivalents, plus other financial assets, were $2.1 billion. Our net debt decreased to $663 million at the end of Q1 2017 because of the conversion of $404 million CB into common equities during the quarter.
At the end of Q1 2017, our gross debt to equity decreased to 47%. Our net debt to equity decreased to 11%. In terms of cash flow, we generated $147 million of cash from operating activities. Cash used in investing activities was $849 million. Cash from financing activities was $126 million. To examine our revenue by application, communication, consumer, and computing segments contributed 46%, 37%, and 6% of our revenue respectively. From Q1 onwards, we also highlight our auto industrial segment to improve our transparency. The auto industrial segments contributed 6.6% of revenue in Q1 2017. Geographically, revenue from China, North America, and Eurasia contributed 47%, 30%, and 15% of revenue respectively. In terms of technology, revenue from 20% contributed 5%, revenue from 40/45 nanometers contributed 20%, and revenue from 55/65 nanometers and 90 nanometers contributed 22% and 1.3% respectively. Meanwhile, 0.11 micron above line-width contributed 51.7% of wafer revenue.
In terms of our overall capacity, total monthly capacity at the end of the first quarter increased to 422,000 8-inch equivalent wafers per month. The increase was primarily due to the capacity expansion in our Beijing 300 millimeter fab and our majority-owned Beijing 300 millimeter fab. We reiterate our planned 2017 CapEx for foundry to be approximately $2.3 billion, of which about $900 million is expected to be spent for the expansion of our joint venture fab in Beijing. The planned 2017 CapEx for non-foundry operations are approximately $17 million, mainly for the construction of employee living quarters. Our planned 2017 depreciation and amortization is approximately $1 billion, slightly down from a previous forecast of $1.1 billion, due to some delay in the moving schedule for some equipment.
Thank you, Gareth. We would now like to open up for the call for Q&A. As usual, please be reminded to limit your questions to two per person. Operator, please assist.
Thank you. Ladies and gentlemen, we will now begin the question and answer session. If you wish to ask a question, please press star one on your telephone and wait for your name to be announced. If you wish to cancel your request, just press the pound or hash key. Participants are requested to restrict two questions at each time. Our first question comes from the line of Randy Abrams from Credit Suisse.
Thank you. Yep. First want to congratulate Dr. Chiu on the work you've done, best of luck, also look forward to working with Dr. Zhao. I wanted to ask the first question on the growth outlook. I think you've targeted over long-term 20% year-over-year growth. Maybe in light of the headwinds from mobile and inventory, your updated view for this year. If you could give an initial view on second half, just your outlook, if you see visibility that mobile maybe starts to re-accelerate. Then also from the other areas, what you're seeing from consumer, both from existing and also new applications, to drive some additional growth in second half.
Thanks, Randy. In terms of the growth outlook for this year, we recognize actually this year turned out to be more challenging than what we expect. It would seem that actually achieving the 20% growth target to be extremely challenging. Okay. Obviously, we are still trying our best. I think right now, we still think that likely the growth will be in the double digit, but we cannot give a precise number at this point in time because of the lack of visibility in the second half of 2017.
If you could talk about, for second half, I guess, just your initial view on the communications business, if you still expect, say, the slower trend to persist. Maybe for the other part of the business, where you kind of see the growth coming from in consumer, like newer existing applications.
Yeah. I think it's quite well-known in the market that I think the Android supply chain turned out to be quite weak this year. Right now we don't have much visibility in terms of this business in the second half. We do see pockets of growth in our business. For example, we are engaging new customers in the LED driver area. We're also having new customers in the image processor area. We do see very steady growth in our business for our smart cards, our NOR flash business, our BCD business, as well as in our auto CIS business.
Okay, great. The other second question I wanted to ask, it's probably two-part, but it's the 28 nanometer. If you could give an updated outlook for ramp up. It's making some more progress, 5%. Progression in the second half, both % of revenue and broadening out of customers second half into next year. The second part is more based on that. Depreciation is a bit lower, I'm curious if any potential CapEx, I guess this year is fixed, but if you think maybe CapEx could slow the expansion down a bit, maybe a bit of a change in terms of the CapEx if we're looking out in the next year.
Yeah, I will let Haijun address the question on 28 nanometers, I'll comment on the CapEx.
Hi, Randy. Here's Haijun, thank you for the question. For 28 nanometer, as you might see, has been running and trying the production since the early of last year. Just now from the reports, you saw that we have 5% of the revenue from 28 nanometer. The true production running in the fab is much more than this. You know that the revenue formed in the first quarter mainly come from the very jammed production of last year. We expect to see the
The increasing amounts of data percentage in the next quarter. For the 28 nanometer technology point of view, we already have one fully matured product platform running in full production, almost used up most of the capacity at this moment for 28 nanometer. The CapEx we are spending at this moment merely to pull in the equipment to build up the additional capacity for another more advanced version of technologies. For that technology, currently we have very key customers and running their pilot line products, and the results already demonstrate that we can ramp up the production in the second half of this year.
At this moment, we are very happy to say that we see the promising results of technology development after we allocate so much capacity and efforts to expedite the moves of R&D wafers, and will really benefit the results in the second half year.
Okay. One quick, if there was a fab that you delayed the equipment move-in, like maybe one fab that's ramping up less, I guess with the lower depreciation, was there one area you slowed down?
We are still keeping the CapEx guidance for this year to be $2.3 billion. I think there's some changes in the timing for some moving of some equipment. They have slightly impacted our depreciation schedule, yeah.
Okay, great. Thanks a lot.
Thank you. Your next question comes from the line of Steven Pelayo from HSBC. Please ask your question.
Yeah. I was reviewing the annual report for last year that came out a few weeks ago, it showed two of your top customers represented roughly two-thirds of the incremental dollar growth. I think if you excluded the LFoundry acquisition, maybe more than 75% of the incremental dollar growth last year. It was a very concentrated growth year. I guess as you look out to 2017, what's your outlook for kind of these top customers, and do you see a much more expanding breadth that's going to allow to drive this double-digit growth you're looking at this year?
Hi, Steve. Actually, if you track our performance in the last few years, our top 5 customer consistently contribute about 55%-60% of revenue. Of course, among the top 5, there's some changes in the ranking for different customers, okay? What I'm trying to say is that, our major customer all have been having engagement with us for a long, long time, okay? Their own performance will vary from year to year. Okay. I don't think our customer concentration is a big issue. If you look at our performance historically. Although individual customer performance may vary, but overall, I think our overall customer concentration remain more or less the same.
Maybe just a longer-term question, maybe for Dr. Zhao. Are things changing, I guess, with the management change in terms of strategy longer-term? Are you looking to maybe accelerate maybe some development and move to 14 nanometer and beyond as well? I'm curious just kind of the longer-term strategy. Does it change with management shifts as well?
Thanks, Steve, and thank you for the question. Basically, we should say this way, just now Dr. Chiu addressed the transitions. I have been one of the key members of this team under the leadership of Dr. Chiu. I really believe that the strategy in the past 6 years we formed, and we already verified proof that the strategy works very well for SMIC. I will continue to focus on the careful expansion of the existing facilities and everything. More or less that we will stick to the successful strategy. I don't want to make a drastic change. With the new challenges, like 14 nanometer and moving to even smaller dimensions, that's the area we like to enhance. From the introduction by Dr. Chiu, we also mentioned that SMIC will go for a smooth transition, and in the meantime, we will go for very steady technology.
We already are in practice in the past few years. In a word that we'll stick to the existing strategy, would not make a change. At least we do not make a drastic change in the near term. In the meantime, we have to cope with the new challenges, both inland and on the technology front end. We have to make sure that we have stronger technology competition , and we have a larger scale of capacity to serve our customers. That's the balance. We already tried this balance very well in the past many years, and we will continue that.
Okay, maybe I could just follow up relative to Randy's question and that question. Do you have some targets for 28 nanometer? How much do you think it contributes in the fourth quarter this year? Maybe as you look to maybe end of next year, what is 28 nanometer or even 14 nanometer start to contribute?
I think our target is still the same. We're still looking at high single-digit contribution by Q4 this year.
Do you have 14 nanometer revenue next year? Or is that more 2019?
Right now, for 14 nanometers, we are looking to start risk production in 2019 timeframe. Yeah.
Okay. Thank you very much, guys.
Thank you, Steve.
Thank you. Your next question comes from the line of Gokul Hariharan from J.P. Morgan. Please ask your question.
Hi. Morning. A couple of questions that I had. First of all, congrats, Dr. Chiu, and welcome, Zhao. I want to ask, when you reiterate your long-term growth outlook of 20%, could you now attach some kind of a profitability metric also to that? Are we expecting the EBITDA margins also to stay in this high 30s kind of levels, when you kind of go towards that kind of 20% growth target? How do we manage that growth between your very successful investments that we have seen in the older nodes, versus your recently ramped-up efforts in terms of going a little bit more faster towards the advanced nodes?
Yes. With the challenges that we face this year in terms of growth, right now we're looking at our growth margin guidance, for the average for the whole year, we will target at about mid-20s. In terms of our EBITDA margin, we still target a high 30 EBITDA margin, because at the same time, we are also managing this downturn with very strict, tight control over our cost. Actually, we are also reviewing all the expenses, both in the fab and also in the back office, to make sure that our cost structure is in line with the new growth scenario.
Okay. On the near-term stuff, could you talk a little bit about, I think we've talked previously about 8-inch potentially having a pretty long backlog of customers. How does that backlog look like right now, given that the end demand environment seems to have changed quite a bit? Could you also talk about what is your outlook in terms of re-qualifying some of these fabs for new customers to accommodate that backlog, and when do we kind of expect to get back to near full utilizations on 8-inch?
Yeah. Obviously, the overall business environment is sort of more challenging now. That also impact our 8-inch business as well. The backlog is obviously not as long as last year. We are still qualifying a lot of new products in our 8-inch business, and we are hopeful that some of this new product will start ramping in the second half. At the same time, as you know, through LFoundry, we have entered into the auto CIS business, and that business is going very strong.
Okay. Understood. Just one last question, just to get some more granularity on your 28 comments. Is there any change in terms of the 28 capacity addition plans through the end of the year? Could you also talk a little bit about how many 28 nanometer tape outs that you currently have on hand?
Yes. Yeah, Gokul. Thank you. For 28 nanometer capacity expansion, more or less we stick to the original forecast. We do see the demands are still very strong for these long technology nodes, so-called. We do have both the overseas and the domestic customers, and are working on these technology nodes with SMIC. We see mainly two parts. One part comes from the 40 nanometer and the transition for the existing product transit to 28 nanometers. The capacity for 28 nanometer keep getting higher. The second thing is that we do see on the new applications for 28 nanometer, they use this technology from other part. For example, RF, SOC, this kind of showing up for 28 nanometer capacity. My comment is that for 28 nanometer capacity expansion, we'll more or less stick to the original forecast.
We still have a strong expectation on these technology nodes for growth.
Do you have any details on the number of tape outs that you have? Is it too few to kind of disclose at this point?
I'm afraid I can't disclose too much on that. Yeah. We don't usually disclose such detailed information.
Okay.
Thank you, Gokul.
Thank you.
Yeah. Thanks, Gokul.
Thank you. Your next question comes from the line of Charlie Chan from Morgan Stanley. Please ask your question.
Hi, good morning. First of all, I want to thank the contribution from Dr. Chiu over the past six years, and we look forward to the new leadership from Dr. Zhao, and we hope all the transition will be very smooth. My first question is regarding your main business, because you mentioned that this year, demand is a little bit weak. My question is that whether you consider to fill up the 8-inch fab with some commodity products, for example, the NOR flash, because as you can see, the NOR flash market price continue to go up. This is my first question.
Well, first of all, our NOR flash run on the 12-inch fab, is not on the 8-inch fab. You make a good point that we are also increasing our wafer start on some of what we call the filler products. Like the NOR flash and the NAND flash, to keep our fab at a relatively reasonable utilization. On the 8-inch side, we do have some new product tape-outs, as I said, and that we hope to start ramping in the second half. We have new products in the BCD area. We have new products in the LED drivers area. These are all exciting, large volume business. We are hopeful that, we can transition this downturn quite successfully.
Thanks. Just quick follow-up on this one. For the driver IC offering, when do you think there will be some small production?
I think, actually, we should start shipping in Q3, my understanding.
Okay, thanks. My second question is regarding your depreciation guidance, because you mentioned that some change of tool moving schedule and some impact to the depreciation. Can you give us some numbers? I noticed that actually your gross margin holds up quite well in 1Q, and even for 2Q, the revenue scale is smaller, gross margin still maintain okay. Why you think the full year gross margin guidance will be only 25%?
Yeah. As mentioned in my script, we have lowered the full year depreciation to about $1 billion. I think that is our current estimate for the depreciations. In terms of the gross margin, as I mentioned, we are also looking at our cost structure very carefully, both inside the fab and also outside the fab, means our OpEx. We are trying to control our cost in line with this new growth scenario in our business. We do intend to maintain our profitability, disregarding the slower growth.
Okay, understood. Thank you very much.
Thank you, Charlie.
Thank you. Your next question comes from the line of Rick Hsu from Daiwa Securities. Please ask your question.
Yeah. Hi, good morning, guys. I think one quick follow-up to Peter's question about the 28 nanometer. I think Haijun mentioned about a new product ramp-up in commercialization sometime in second half this year for a new customer. Can I know more about this? What kind of application products this ramp-up is going to be about?
Okay. Hi, Rick.
Hi.
I can't mention the specific type of product applications, but mainly, I have to tell you that on the new technology platform for this 28 nanometer technologies. Currently we're working on three fronts, the wireless terminal, fixed wireless, and consumer . The first ramp-up, currently we are working on the ramp-up, will be a consumer product, relatively on medium size of a volume type of a consumer product. In the meantime, we do working on a fixed wireless, and we have multiple tape out at this moment to ramp up the consumer products and the fixed wireless. As I said, usually we classify the applications to wireless terminal, fixed wireless, and consumer. We have both the consumer and the fixed wireless, yes.
Yeah. Let me just make sure to get this right. You mentioned about three product platform for 28 nanometer, one is wireless, the second one is a consumer, which is going to ramp up in the second half. What's the third one?
Consumer. The wireless terminal and fixed wireless and consumer. More or less, we classify this way. That's the things I can share with you.
Okay, brilliant. Thank you so much. One more question is in the fingerprint space, the fingerprint foundry space. Can you talk about your diversification? Are you diversifying into new customers in this platform, and if so, when are we going to see the real benefit from this diversification?
Yes, we are diversifying. We have new customer engagement in the fingerprint areas. We plan to start to ramp up in the second half.
Ramp up in second half. Okay. All right. Thank you so much.
Thank you, Rick.
Thank you. Your next question comes from the line of Ken Hui from Huatai. Please ask your question.
Thank you for taking my questions. In terms of the full year outlook, you talked about the revenue, you talked about the gross margin. Can you also give us some guidance in terms of the expenses? It seems that in the first half, it is actually growing faster than the revenue.
Yes.
That's my first question. Thank you.
That's right. If we look at our normalized OpEx, Q1 is about 21%. We try to target to keep control of this normalized OpEx in the low 20s for the rest of this year. Yeah.
Can I get more details regarding the reason for the increase in OpEx? Is it because of the 28 nanometer new tape outs, or the 14 nanometer, or even the new 8-inch product that you need to develop in order to fill the fabs?
In general.
Some other reason. Yeah.
In general, we are still increasing our R&D spending. Obviously, we are working on many version of 28 right now. At the same time, 14 nano R&D is well on the way. As a matter of fact, given the fact that right now our fab, actually, the loading has come down, we also take advantage of this opportunity to accelerate the R&D activities so that we'll be better positioned for growth in the near term. Yeah.
Okay. My second question is actually related to the loading. I think you report about 92% utilization in the first quarter. Can you give us some color regarding the utilization specifically for 12 inch and 8 inch? Which part is doing relatively better?
Actually, we don't break down utilization by fab or by 12 or 8 inch. Overall, we are looking at probably mid to high 80s utilization in Q2. Yeah.
I see. The fourth question is, if you are loading up your 8-inch with new products in the second half, should we assume the wafer prices to be impacted as well in the second half?
First of all, let me correct myself. We also have new product in our 12-inch fab as well, okay? I think Haijun mentioned that we have new tape outs in our 28. At the same time, we also have some new products on our mature 12-inch as well. For example, we have new customers in the smarter areas, also we have new customers in the image processes area. Obviously, we also increasing our loading for some of the fab filler products. Okay. I'm sorry, what's the second question? On ASP, yes.
Yes.
ASP, I think is a function of the industry conditions. When overall industry, the loading is down, obviously, there are more pressure from our customer on ASP, I think we are not insulated from this trend. Yeah.
Okay. Thank you very much.
Thank you, Ken.
Thank you. The next question comes from the line of Benson Ho from CLSA. Please ask your question.
Hi. Thanks for taking my question. I want to ask about your 14 nanometers revenue. That has been a major driver for the past few quarters, but notice a drop in this quarter. But we compare that to TSMC and UMC, major foundry, they relatively show still stable 14 nanometers revenue stream, despite the weak seasonality in Q1. I wonder, is there anything change on your 14 nanometers, like customer commitment? How do you see this 14 nanometers outlook for this year and next year?
I think our 40 nano revenues is basically impacted by what we're seeing in the China smartphone supply chain. I think the reason is quite well known in the market, obviously some of our 40 nano customers' product are all transitioning to the 20 nanometers. Yeah.
Okay. All right. If we look at your communication revenues, it seems not as weak as you indicated in terms of the mobile weakness. If you compare that to TSMC, UMC, there's a clear drop in their communication applications. Look at yours, application breakdown is pretty stable, and more of the drop seems to come from other applications. What's the mix, and how do you really categorize these products into this application?
Yeah. The weakness in our 40 is offset by the growth of our 28. Okay, you don't really see the drop in the communication segment. Yeah.
Okay. Last two follow on the NOR flash. I think that this is the first time in the past two years you mentioned about, I think you're excited about NOR flash. I just wonder whether this is just that this market right now is good, and your utilization rate is low, you're desperate for the new business, you see this as good opportunity, you get into there. What's the long-term strategy of your, I mean, the product commitment and who's your customer here and how do you see the NOR flash business to grow for the second half of this year into next year?
Okay, I think this is not a hot strategy. It's not that, because things are bad, we start to do NOR, okay. I think this is a well-planned strategy that we have. We know that industry will go through cycles. Actually, under Dr. Chiu's leadership, we have planned for some of what we call filler products. They include the NOR flash and some of the NAND flash products, okay. As we enter into a downturn in industry, I think, we are able to have some product we can actually fill the fabs, to maintain a stability in the loading for the fab. I think this is a well-planned and well-executed strategy. Yeah.
Okay. Thank you.
Let me add a little bit that this strategy was also employed in the previous, when we had some weaknesses inventory adjustment in the market. This exact strategy was used to really ensure good, continuous business and good loading in the fab.
Okay, understood. Thank you.
Thank you, Benson.
Thank you. Your next question comes from the line of Stephen Chang from Maybank Kim Eng. Please ask your question.
Hi. Good morning. Thank you for taking my questions. Most of the questions are already answered. I just have one follow-up regarding the operating expense. You just previously indicated the normalized OpEx ratio target for this year is low 20s. May I follow up with more details about what is your expectation of the R&D subsidy? If possible, can you provide expectation on this for both Q2 and the full year? For the full year NCI, can you also advise us if you have any preliminary expectation at the current time? Thank you.
Yeah. In terms of the government funding for R&D contracts, right now we are targeting about $75 million-$80 million for this year. In terms of the NCI, we are looking at, you continue to be a credit to our income statement in the next 3 quarters.
Okay, understood. Just to clarify, when you indicate about low 20s operating expense ratio for this year target, that's already after consider the government R&D funding. Is this the case?
No. Our normalized OpEx exclude the R&D funding. Yeah.
Okay, got it. Thank you.
Thank you. Your next question comes from the line of Bill Lu from UBS. Please ask your question.
Yeah. Hi, good morning. First of all, I also want to congratulate Dr. Chiu for a job well done over the last six years. I think we can all see the changes the company has made in terms of technology, financials, et cetera. Thank you very much. I also want to congratulate Dr. Zhao. Looking forward to work some more with you in the future. Couple of follow-up questions. One is on 28 nanometers. Can you give us an update on when you are going to ramp High-K Metal Gate?
Okay. Hi, Bill. You mentioned a specific name, for the 28 nanometer High-K Metal Gate, actually for this technology, we have been running this High-K Metal Gate 28 nanometer actually has developed into general 3 versions. We have been running the first High-K Metal Gate called HPM type of standard platform since last year in a low volume, mainly for the learning curve. Another thing is, last year, you know the IC5 for the 12-inch has been fully jammed. We do not have that much free capacity to give to this new learning. This year, we continue the ramp-up of this 28 nanometer first version, but we also start to do verifications and test runs of the second version. In the third quarter of this year, we'll ramp into the production.
Currently, we are running on a pilot line case, with very small volume for the second version.
To answer your questions that 28 nanometer High-K Metal Gate, we will start to increase the capacity and volume from the third quarter this year. For the running, we have been running the small volume since last year.
Okay. When you mentioned the three new products in the second half of this year, those are, in fact, High-K Metal Gate?
No. Not three products, three platforms.
Right.
High-K Metal Gate. Yes. Actually, the High-K Metal Gate has been divided at a different stage into three or more than three platforms. They can't interchangeable in a certain sense. What I mean is we have been running in a small volume for the first technology platform since last year, and this year we're running both that platform and a new platform.
How should we think about margins as you ramp up these new platforms? I think ASP should be better for High-K Metal Gate. At the same time, there might be some yield improvement, initially a bit of a learning curve. How do we think about margins, in the second half for 28?
Yes, I think as you already point out, I think the margin is tied to the yield, as well as the volume, okay. We don't disclose the margin by technology node, but in general, as we increase the volume and the production scale, the margins improve.
Okay. Second follow-up is on what, I guess we're calling fab fillers in terms of NAND and NOR flash. Can you give me an idea of how much of total revenues this could be, let's say, by the second half of the year?
Actually, obviously, I don't have this number on hand. We will try to feedback to you later on. We are actually increasing the capacity for our NOR flash, and also some of our NAND products right now. Yeah.
Okay, great. Thank you very much.
Thank you, Bill.
Thank you. The next questions comes from the line of Michael Chou from Deutsche Bank. Please ask your question.
Hi. Good morning. I have several follow-up questions. Regarding your High-K Metal Gate, you mentioned Q3 to see ramp up. Does that have the revenue contribution Q3 or Q4 this year? This is my first question.
Hi, Michael. Gao mentioned that 28 nanometer High-K Metal Gate, we have a small volume since last year, and we'll ramp up the second version in the third quarter this year. Because Gao mentioned that we have another version, a high volume mature keep running. They already committed the capacity to one of the long-term customer there. We are in the ramp-up, in the meantime, pulling the machines for 28 nanometer High-K. The High-K for this year, I do not expect a very high volume, but they will continue increase.
Oh. You mean, maybe you have very limited revenue contribution in the second half of this year. Am I right?
Yeah, limited by the existing capacity for the High-K Metal Gate loop.
Okay
The High-K Metal Gate does share most of the common tools with another mature, high-volume production. For the High-K Metal Gate loop, we are pulling the machines, yeah.
Okay. Could you give some updates for your 28 nanometer capacity this year? If majority of your 28 nanometer should be polysilicon this year, could we assume that it could be nearly 100% of your capacity will be for polysilicon this year, or you will have maybe 5% capacity from High-K Metal Gate this year?
I do not have that number exactly on hand. The sharing of the High-K Metal Gate loop capacity, we also use it for the new platform development for the R&D purpose. I do not know that exactly on the assurance of how much gave to the R&D, how much gave to the new products ramp up.
Yeah, I think, as what Haijun said, we are trying to pull in the capacity for High-K right now. I think that some of the moving schedule is not confirmed, so we cannot have the precise number at this stage. As you know, originally, most of the capacities were polysilicon, and right now we're increasing the capacity on High-K. Yeah.
Yes.
Thank you so much.
Thank you, Michael.
The other thing is, Min mentioned before you will use some 28 nanometer to do some 40 nanometer. Is that still the planning for this year?
As I said, our 40 nanometers, of course, we are still running 40 nanometers right now, but we are seeing increasingly, some of this product will be transitioned to 28. Okay. Thank you so much.
Thank you, Michael.
Thank you. Your next question comes from the line of Donald Lu from Goldman Sachs. Please pause for question.
Thank you. First, thank you, T.Y., for successfully turning around SMIC, and also congrats to Dr. Zhao for becoming the CEO of SMIC in a new era. I think this new era, actually, there's both good and bad. The more challenging part is UMC will start 28 production in Xiamen this year, TSMC will start 16 nanometer in Nanjing. My question is, what is the board and you, Dr. Zhao, will do differently next year, and how would you compete with those guys? Also, comparing your comment six months ago and today, clearly the demand is a lot worse, which is actually very natural for SMIC. You have very high customer concentration, and for 28 and 40. Going forward, if you want to grow fast, your ROE will suffer. Would you or board has a bottom line for ROE in the next few years?
Thank you.
Hi, Donald. Just now, I already mentioned that, like Dr. Chiu addresses at the beginning, that we won't change strategy drastically. We will continue our strategy, go for very careful expansion of our capacity. We do have more freedom this year, and from now on, we will continue to do this, that we will allocate more capacity to get faster moves for our TD activities. By doing so, I can expect that our R&D progress will be better than before. Just now, from so many questions and answers that, we will go for 20 nanometer High-K Metal Gate ramp this third quarter this year, and we are putting machines to expand capacity for that. We really want to see a successful, smooth running up of 20 nanometer High-K Metal Gate.
In the meantime, for the future technology development, since our strategy has been there that, we will allocate more capacity and get a faster move for 14 nanometer. We can also see a solid growth on 14 nanometer development.
I think in terms of the competition, as we said time and time again, we welcome competition into China. If you look at our eight-inch business, UMC and TSMC built the eight-inch fab in China almost the same time as SMIC ramped up the eight-inch fab in China. History have proven to us that SMIC can compete very effectively, we do believe that the China market is still growing nicely and is big enough to accommodate all this competition. We are still very confident that we will be able to compete very effectively with our competitors.
Okay, great. Can you give us a guidance for free operating cash flow this year and CapEx? Recently, I think SMIC increased the number of shares, which will give you more flexibility to raise money. Is that something SMIC expects to do in the next 12 months?
In terms of the operating cash flow, we are still targeting high 30s EBITDA margin this year. We will still be generating a lot of cash from operations, which ties to the question that we don't have any plan for any equity or equity-linked financing, because we are actually very well-funded. We have $2.1 billion cash on hand, and our net debt to equity is only 11%. I think that, again, highlight the point that SMIC have always been very prepared in terms of withstanding business cycles. We have been in the business long enough to know that the business is always in cycles, and we always run our business in such a way that, at some point in time, industry will go through cycles, and SMIC will able to go through the cycle smoothly.
Great. Thank you.
Thank you, Donald.
Thank you. Your next question comes from the line of Leping Huang from CICC. Please ask your question.
Thank you. Thank you for taking my question. I have two questions. One is also linked to the competition landscape. You deliver very good growth profile in last two years, but we see a lot of foundry are built in China, supported by either the local government or in the mature edge . UMC and TSMC also come to China. How you look the competition landscape in China's supply demand or whether the foundry market in China? Do you think that the way you develop the business, Dr. Chiu, in next two years, how we should, as investor, look your growth profile in terms of, and the profitability? Maybe a very general question, yeah.
Hi, Leping.
Yeah.
Basically, we will do this way. We believe that the new technology development and the competition will come from the market side. That means SMIC will focus on their market-driven type of technologies. In the meantime, we also set up the baseline, just now, Gareth answered the last questions that, actually, it doesn't make a very big difference to set up the wafer fab locations in China and overseas, because SMIC is an international company. We've always been working with international customers and domestic customers. Probably, the competition, if there's any, has been there, and we will continue our customer-oriented type of strategy to develop the diversified and the differentiation type of technologies to run our wafer fab, and go for very careful expansion of our capacities. This is mainly for the capacity and the technology part.
We do not see a very big difference in the scenario after the new foundry set up in mainland China. We do improve our side that, probably, we have very high utilization, and we do have insufficient allocation to the technology development wafer moves. We already modified it so that we can deliver the things on time and faster. For the profitability and type of things, we will continue the successful strategy for the past six years. We will maintain a very careful and solid move for the CapEx spending, for the ramp-up speed, and for the customer diversifications.
Thank you. The follow-up, I think similar as other question before, people, as our investor, we are still a little bit concerned about your progress in 28 nanometers. Do you think that your 28 nanometer product offering, do you have any timetable what your product offering will be competitive enough with the other fabs in the market? For example, do you have any timetable for the High-K Metal Gate or the metal gate or the other product line? Thank you.
We should say that for 28 nanometer, just now I mentioned that after a couple years already, development into different platforms. We already have one platform running full capacity, full production, very high volume, and that's fully ready to take in all the customers. For the High-K Metal Gate part, we also have the one platform already started the production last year, and we are starting ramp up the second phase, the second platform, the third quarter, this year. We should say that we are still market-driven type, and we know our existing customer and potential customers' needs and the timetable. We just make sure that we allocate more capacity and supporting to R&D timetable to meet our customers' requirements. For 28 nanometer, it's a long node. Everybody mentions this, well, we believe so, and it's also a mature node.
Currently, we are putting the capacity to make sure that we meet the customers' requirements on these nodes.
Thank you.
Yes.
Thank you, Lapin.
Thank you. Your last questions comes from the line of Maurice Chow from Pinpoint Asset Management. Please ask your question.
Hi, good morning. Congratulations to Dr. Zhao for the new role. My question is really about your utilization and EBITDA margin relationship. I noticed in Q1, obviously, your wafer capacity increased by a few percentage to 421,000. Your utilization came down from 96.5 to 91.8. When I calculate the wafer shipment, in the quarter, it was actually down 1.2%. Sorry, it was down 1.2% based on the capacity and utilization. Yet somehow your EBITDA margin went up by almost six point. Can you help us to understand a little bit more of a dynamic of why is it your utilization is down, your wafer shipment is down, and somehow your EBITDA margin way up?
Yeah, just because our OpEx had come down a lot in Q1. EBITDA margin take into account of not just the gross margin, but also the OpEx spending. Yeah.
Let's say if you're able to maintain your OpEx at a relatively lower level, does that imply, let's say, second half, when your utilization, when your shipment of wafer go up, you will see a pretty dramatic bounce back on EBITDA margin?
No, because as I said, we intend to control our OpEx at the low 20s level, which I've said already.
Right.
It's also tied into our, right now we are imposing very strict control on our spending to make sure that we have a cost structure that will be in line with the changes in the growth scenario. Yeah.
In other words, you artificially depressed the OpEx in near term, but it would normalize in the latter part of this year. Therefore, even when your utilization go back up, you don't see the very dramatic go back in EBITDA margin. That's fine. How should we think about, based on your current forecast for the second half, how should we think about range of EBITDA margin in the second half of this year?
As I mentioned, we still target EBITDA margin to be high 30s. Yeah.
High 30s just in the second half or for the full year?
For the whole year, yeah.
For the full year, okay.
Yeah.
Okay. That's great. Thank you so much.
Thank you.
Thank you.
Thank you. I would now like to hand the call back to CEO, Dr. Chao, for closing remarks.
In closing, I'd like to thank everyone who participate today's telephone conference call. Again, thank all of our shareholders, customers, and employees, and the suppliers for their trust and support. Thank you.
This is the end of SMIC first quarter earnings conference call. We thank you for joining us today.