Ladies and gentlemen, welcome to the Semiconductor Manufacturing International Corporation's Second Quarter 2016 Webcast Conference Call. Today's conference call is hosted by Doctor. P. Y. Chu, Chief Executive Officer Doctor.
Yonggang Gao, Chief Financial Officer Mr. Gareth Kong, Executive Vice President of Strategic Business Development, Finance and Company Secretary and Mr. An Lin Feng, Vice President of Investor Relations. Today's webcast conference call will be simultaneously streamed through the Internet at SMIC's website. Please be advised that your dial ins are in listen only mode.
However, 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.smics.com. Webcast playback will be available approximately 1 hour after the event at www.smics.com. Without further ado, I would now like to introduce to you Mr. An Lin Feng, Vice President of Investor Relations for the cautionary statement.
Hello, everyone. Good morning and good evening. For today's call, Doctor. T. Y.
Qiu will first provide some general remarks. Afterwards, Doctor. Gao Yonggang will highlight our financial performance and give guidance on the next quarter. And then Mr. Garrett Kang will give the detailed financial commentary.
This will then be followed by our Q and A session. As usual, our call will be approximately 60 minutes in length. The earnings press release and the quarterly financial presentation are available for you to download at our website under Investor Relations in the Events and Presentations section. Before I turn the call over to Doctor. T.
Y. Chu, let me remind you that the presentation we're making today, including forward looking statements, these statements and other comments are not guarantees of future performance, but represent the company's estimates and are subject to risks and uncertainty. Our actual results may differ significantly from those projected or suggested in any forward looking statements. For a more complete discussion of these 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 Hong Kong Stock Exchange Limited, including our annual reports on Form 20F filed with the U. S. Securities and Exchange Commission on April 25, 2016. 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 U. S. Dollars unless otherwise stated. I will now turn the call over to our CEO, Doctor.
T. Y. Chu for the opening remarks.
Thank you, Erling. Greetings to everyone. Thank you for joining us. For SMIC, Q2 was another excellent quarter with record high revenue, record high gross profit and operating profit as well as record high net profit. It marks our 17th consecutive quarters of profitability.
Revenue reached a historical high of $690,000,000 a growth of 26.3% year over year and 8.8% quarter over quarter. Gross profit and operating profit both hit all time highs, growing 23.5% 90.2% year over year and 41.7% and 74.5% quarter over quarter. On a quarterly basis, Q2 ROE hit 10% and our utilization was 98%. We are guiding another strong quarter of growth in Q3. In addition, we foresee continued growth in Q4 contrary to seasonality and target another record year for 2016.
Demand continues to be exceedingly strong. POs are not slowing down and customer continue to demand more capacity. With a great demand and the recent acquisition of LFoundry, we now raised our annual revenue growth percentage target to mid to high 20s this year. We also raised our gross margin target to high 20s for the year, factoring in our increased visibility and confidence in the high utilization for the rest of this year. So what has been driving SMIC's growth?
From a technology perspective, it is clear that most of the revenue growth this quarter came from 40 nano. Wafer revenue from 40 nano grew 92% year over year and 27% quarter over quarter. With a surging 40 nano demand, in particular for products single source to SMIC, a lot of our new capacity in Shanghai 12 inches and Beijing JV fabs are allocated to ensure our customers' successful product launch. As SMIC continues to bring on new capacities, we are now targeting 28% revenue to surpass 1% in Q3 and reaching lowtomidsingledigit percentage by Q4. We believe this advanced note allocation arrangement is in fact in the best interest of all our customers.
Driving our growth front and application point of view, This past quarter was primarily from applications, including set top box, Bluetooth, sensors, smartphones and networking. From a regional perspective, growth in Q2 was primarily from our China region clients. Our China revenue grew 28.5% year over year and 20.1% quarter over quarter. There are 3 components to this large growth in China. Chinese system houses are winning end product market share.
They are capturing market globally from their branded smartphones and networking in emerging countries to consumer set up box and others. They are also innovating new devices for the Chinese consumers and increasingly designing their own ICs and partnering with foundries. 2nd, Chinese fabless growth is robust and they are capturing content in an increasingly diverse mix of product. As an example, Bluetooth for headphones, speakers, selfie sticks and others are now dominated by Chinese players. And as a result, SMIC has become the leading suppliers for consumer Bluetooth in China.
And third, SMIC is increasing market share with diversified technology portfolios being the preferred foundry partner in China and a strong China positioning, SMIC has effectively captured many, many opportunities. Diversification and the differentiation of our technology continued to be a priority. We believe that this has already proven to be the right strategy for SMIC, feeding us numerous new opportunities for growth. We continue to work with the new and existing customers for fresh product and new tape outs. Some recent rollouts include SMIC's MEMS for microphone, which has entered risk productions in Q2, our production of microcontrollers using embedded flash for smart cards, home appliance, hoverboards and e bikes.
We are now working with customers in new area of IoT, auto, ARs and VRs. Since the acquisition of LFoundry, we have officially entered into the auto IC market. LFoundry Manufacturers above 25% of world's auto CIS. By combining our resources, we can continue to expand our presence in the fast growing auto IC market. We maintain our consolidated CapEx of $2,500,000,000 for the year.
Shanghai 12 inches fab has already reached its installed capacity of 20,000 wafers per month. The Beijing JV fab hit 15,000 wafer per month at the end of Q2 and is targeted to attain 18,000 by year end. We are expanding our B1 capacity, leveraging our used tools from 37 ks now to 45 ks by the end of the year, mostly in 55 technology node. Our Synthes fab is ramping smoothly and the capacity will increase from the present 26 ks to the 31 ks by the end of the year. We anticipate that all our newly installed capacity will have higher utilization and better productivity than anticipated throughout this year, leading to our record high net margin.
On the merger and acquisition front, we are pleased to report that we have closed LFoundry acquisition at the end of July. The challenge ahead are to identify the right products and the process to be transferred into this new JV and bring up the utilization as soon as possible as well as in the longer term to bring in technology and system alignment. We will keep you updated on this effort. As always, we are committed to the increase of shareholder value through sustainable and profitable growth. In Q2, our quarterly ROE reached 10%.
It is our long term target to achieve a double digit ROE on a sustainable basis. Secondly, we are increasing value through increasing our cash generation. Our EBITDA is in fact getting stronger. In 2015, our EBITDA margin was around 35%. We are now targeting EBITDA margin to increase over the full year of 2016 compared to 2015.
Thirdly, we have an efficient funding strategy to finance our capital need, aiming for low cost and the minimal share dilution. This include the use of JV Partnership for the expansion of advanced logic fab such as our Beijing JV. Another method we have utilized is taking advantage of low cost debt from domestic bond, low interest bank loans and others. Fourthly, we are also exploring share buyback. In terms of share buyback, if our share price is below book value, we will consider share buyback through a trust for issuing employee RSUs instead of issuing new shares, which will cause create dilutions.
All in all, we're doing our best to expand our shareholder value through profitable growth, cash generation and careful funding selections. In conclusion, SMIC is encountering an exciting time of great demand and growth. We are witnessing strength across the board with robust revenue growth, strong cash position, advantageous market position, enormous demand and great opportunities. We are working hard to balance our profitability, growth, building share value and servicing our customers for the benefit of all stakeholders. We will be on the road to continue to communicate our strategy and status.
To elicit our comments, we continue to appreciate your ongoing support. Thank you. I will now hand the call over to Yonggang for the financial highlights and their 2016 Q3 guidance. Okay. Thank you, Difei.
Greetings to all our listeners. I will highlight our last quarter results first and then
give our Q3 2016 guidance. Last quarter, our revenue, gross profit, operating profit and net profit were all record high. Revenue was 600 and $90,200,000 an increase of 8.8 percent quarter over quarter, exceeding our guided 3% to 7 percent increase. Gross profit was $217,800,000 Gross margin was 31.6 percent, exceeding our guided range from 25% to 27%. Profits from operations were 115,400,000 dollars Profit for the period attributable to SMIC was 97,600,000 and channel region revenue grew to a record high of 52% of overall revenue in 2Q 2016.
Now looking ahead into the Q3 of 2016. Our revenue is expected to increase by 8% to 11% quarter over quarter. Gross margin is expected to range from 28% to 30%. Non GAAP operating expenses are expected to range from $140,000,000 to 100 and $45,000,000 And non controlling interest of our majority owned subsidiaries are expected to range from positive $4,000,000 to positive $6,000,000 which are losses borne by non controlling increase. I will now hand the call over to Gary for more detailed financial commentary.
Thank you, Gaozong, and thank you, everyone, for joining us today. I'll now comment on the details of our last quarter financial results. On the income statement, revenue increased to $690,200,000 above the guided range mainly because of the increase of wafer shipment. Cost of sales decreased to 472,400,000 Gross margin was 31.6% above the guided range, primarily due to an increase primarily due to an insurance compensation recognized in Q2, 2016 in respect of the losses incurred in Q1, 2016 as a result of the power failure suspension at our Beijing fabs 2, an increase in fab productivity and 3, product mix change. Operating expenses increased to $102,400,000 in Q2 2016.
R and D expenses increased by $11,000,000 quarter on quarter to $64,500,000 The change was mainly due to high number of R and D activities. Funding of R and D contracts from the government was $12,000,000 in Q2, 2016 compared to $8,000,000 in Q1 2016. General and administrative expenses increased to US33.5 million dollars mainly due to, first of all salary increase for some employees in Q2 twenty sixteen and also an increase in legal and consulting fees. Excluding the effect of employee bonus accrual, government funding and gain from disposal of living quarters, non GAAP operating expenses were $113,400,000 below our guided range. Profit from operations increased to $115,400,000 Profit for the period attributable to SMIC increased to $97,600,000 while non controlling interest were $3,200,000 of credit to SMIC's attributable profit in Q2, 2016.
Moving to the balance sheet at the end of the Q2 of 2016, cash and cash equivalent increased to RMB1.6 billion. If including other financial assets, we had approximately RMB1.9 billion cash on hand at the end of Q2, twenty sixteen. The increase was mainly due to first of all capital contribution from non controlling interest of Semiconductor Manufacturing North China Corporation in Q2 2016 as well as other capital raising activities completed during the quarter. Our long term borrowings increased to $1,200,000,000 and short term borrowings decreased to 91,000,000 dollars At the end of Q2 2016, our gross debt to equity was 50.9% and our net debt to equity ratio was 12.9%. In terms of cash flow, we generated $246,000,000 of cash from operations.
We are still targeting to generate approximately CAD900 1,000,000 of cash from operating activities this year. Cash used in investing activities increased to CAD1.2 billion. Cash from financing activities was RMB1.5 billion. To examine our revenue by application, the Communications and Consumer segments contributed 49.9% 38.8% to our revenue respectively. Geographically, revenue from China, North America and EuroAsia contributed 52%, 26.5% and 21.5% of total revenue respectively.
In terms of technology, revenue from 28 nanometers contributed 0.6%. Revenue from 40, 45 nanometers contributed 23.1%. Revenue from 5565 nanometers and 90 nanometers contributed 20.4% and 2.3% respectively. Meanwhile, 0.13 micron and above line width contributed 53.6% of total revenue. In terms of overall capacity, total monthly capacity at the end of the second quarter increased to 339,008 inches equivalent wafers, an increase of 12% quarter on quarter.
The change was primarily due to the change was primarily because the capacity expansion of our majority owned Beijing 12 inches fab, Shanghai 12 inches fab and Shenzhen 8 inches fab. We reiterate our planned 2016 capital expenditure for foundry operations to be approximately RMB2.5 billion. While planned 2016 capital expenditure for non farm operations are approximately RMB50 1,000,000. Will now hand the call back to Erling for the Q and A session.
Thank you, Gareth. I would now like to open up the call for Q and A. As usual, please be reminded to limit your questions to 2 per person. Operator, please assist.
Thank you. Ladies and gentlemen, we will now begin the question and answer session. Your first question comes from the line of Ronald Abrams from Credit Suisse. Please ask your question.
Yes. Thank you. This is Randy Abrams. First question, I wanted to ask the 8 inches has been doing very well. I wanted to see how the sustainability looks.
Just from the front, you've been tight on capacity for an extended time. Some of your Taiwan foundries are not as tight and seem to be targeting some of the applications you've had strength, such as the fingerprint sensors. So I want to see outlook, just beyond this year for 8 inches how you see the strength continuing and also the competition there?
I think that there are a number of area which requires 8 inches capacity. Fingerprint is one of them and PMIC, Power Management IC as well as CIS. I think that there are a number of customers, new customers still requiring additional capacities in this area. So we are reasonably optimistic that 8 inches utilization will remain tight and at a high range.
Randy, just have 2 points on to what T. Y. Said. I think as mentioned in T. Y.
Script, I think the other area of strength we see for the 8 inches applications is in the Bluetooth area. And this area actually basically dominated by the Chinese design company and many of them are manufacturing our fabs. So I think that is something that we want to highlight. The other thing is that actually in terms of fingerprint,
I'm sure you
know the biggest customer for us, but actually we're also gaining many new customers in the fingerprint area as well.
Okay, great. And the other side, I want to ask about the 28 nanometer, which is still very small this year. And Nexstar, I think one strategy is
to take your customers as they
migrate from 40 down to 28. I'm curious if you see that happening next year, if you have an early view on ramp up pace for next year. And how that just how that would change your profitability if it's existing applications migrating, if you can ramp that at near similar margins or we should expect some gross margin dilution with 28 less mature?
As a matter of fact, we have said repeatedly, certainly, our present allocation is to meet the critical demands of single source product in the 40 nano. As we ramp up our additional capacities, we will have more resource to ramp our 28 nano products. And we think that it should have a very minimal impact on our overall profitability as we ramp the 28 since I think that we are seeing an improving performance of our 28 along the path of our expectation.
Okay. Is there an early expectation for ramp on 28? I think this year you said low to mid single digit by Q4, for maybe timing to get to 10% of revenue?
Right now, it depends very much on the trade off on the demand of 40% and as well as the how fast we can increase our new capacities. So it is difficult to project at this point of time.
Okay. And my last question about the gross margin. First, if you could quantify those three factors for gross margin, the insurance claim and the productivity, just to have a feel for the baseline excluding the insurance claim? And then if you could provide an update on the depreciation ramp following this CapEx for second half and for next year?
Yes. I think last quarter we guided the gross margin to be 25% to 27%, and the actual result is about 31.6%. I would say about between 1% to 2% is actually contributed by the insurance compensation, which we did not factor into our guidance. And then the other major reason for the improvement in gross margin is that actually our fab right now is very full, but because of this pressure actually we see a very tremendous improvement in our fab productivity. Actually the output came out is actually more than what we anticipated.
So I think thanks to our strong performance from our fabs. And the other reason is also because of the there's some margin there's some product mix changes. Actually, we have shipped out more higher margin product compared to what we forecast earlier. So I think that contributed to the gross margin outperformance.
Okay. And then can you give an update just depreciation for second half and next year? Okay. Thank you.
We are looking at there's some changes in our equipment moving schedule. We are looking at bring out the new forecast for the full year depreciation to be about US714 million dollars So we're going to see some major increase in the second half this year.
Okay. 714-14, 714 or 740? 740. 740. Okay.
And is there an early take after spending 2 $500,000,000 this year, a rough feel for how much it may increase next year?
I don't have the number with us. Also depends on the CapEx for next year as well, so which I think we still have not really finalized. So but right now, I don't have the number for the QFPL.
Okay. Okay. Thanks a lot and good result.
Your next question comes from the line of Stephen Pelayo from HSBC. Please ask your question.
Yes, congrats on the results. I guess I first want to know the LFoundry impacts in your guidance from a revenue and a margin and maybe ASP perspective?
Yes.
LFoundry, we because we completed the acquisition end of July, so we are starting to consolidate the results from August onwards. So they will contribute 2 months of revenue to us in Q3, which is roughly about RMB 20,000,000 to RMB 30,000,000 In terms of their profit contributions, because right now actually they are running at not high utilization right now. So we expect their contribution to our profit is quite minimal.
Okay. And Garrett, year to date, it looks like you've had about $20,000,000 in R and D subsidies. Last quarter, you talked about that number being $60,000,000 to $65,000,000 for this year. Do you still think that number? Because if so, we're going to double in the second half of the year versus the first
half of the year. The good news is that actually we have get more contracts out of the contract from the government. We were just informed quite recently. So this year, we are looking at the total R and D contract funding. We reached about $72,000,000 for the whole year.
Okay. How is that going to split in the second half? Because that's pretty significant for the full year.
Yes, I think it will be mostly concentrated in the Q4, I think.
In 4Q. All right. And then just two quick last questions. Help me understand where do you think SMIC's capital structure is going to be, let's say, at year end? I'm trying to understand the more financing set.
Yes.
I think we are done with most of the capital raising this year. As you can see from our balance sheet, actually, we took on quite a lot of new debt this year. And the reason we did that is because there is a very good market opportunity this year for us to raise relatively cheap debt because a lot of debt raised this year are actually RMB debt. But right now, there's a market opportunity for us to really swap this RMB debt into U. S.
Dollar funding at a very low cost. Right now, maybe after swapping into our U. S. Dollar funding is about 2% to 2.5%. So we took these opportunities to really to lock in some of this low cost funding to refinance our CapEx this year next year.
Okay. My last question.
That's a number.
I'm impressed with I'm sorry, last one, I promise. You guys have this greater than 20% revenue growth goal for the next few years with high 20s this year. You're generating 900,000,000 dollars in cash flow from operations, but you are still spending $2,500,000,000 in CapEx. I think you've been negative free cash flow for the last couple of years. When do you think you could maybe be positive free cash flow?
Well, just a good question. Maybe I should respond in another way. We believe as we grow our revenue, I think TY for you set a target to be over 20% quarter on quarter year over year. Our CapEx intensity was reduced even if we maintain assuming we are maintaining our CapEx at the same level next year. So we feel that if you ask me about getting into net cash flow positive, including CapEx, I think we are still sometime off, but we do think that the capital intensity would come down in next few years.
Okay.
I'll get back in the queue. Thanks guys.
Thank you.
Your next question comes from the line of Bill Lu from UBS. Please ask your question.
Yes. Hi, good morning and congrats on the good results. Can you give me some help as far as 3Q is going to grow by about 10%. What application is driving the growth? And related to that, you said that 4Q is going to grow again.
Can you tell me what gives you the confidence looking out into 4Q?
On Q3, let me detail for you the growth drivers here. First of all, as mentioned, we're going to consolidate LFoundry from OpEx onwards. So there's about RMB 20,000,000 to RMB 30,000,000 contribution from LFoundry activities. And then our 40 nanometers is still growing very strong. And as what T.
Y. Said, many of them are single source. And then we also started to ship in a greater volume for our 28 nanometers. So all this will contribute to growth in Q3, okay. In terms of the Q4 outlook, right now based on the forecast from our customers, we still think that it's still going to be a growth quarter for us.
And I think our fab will still be fully loaded.
I guess, I'm just wondering what kind
of applications is driving the Q4 growth?
Maybe let me add a couple of other highlights. Certainly, and we have a very strong system house driving the 40 nano, and this is not only just in the smartphone, but also in the other areas such as connectivity infrastructures. In addition, we are also ramping up a second very large customers and in the connectivity area as well. So our 40 nanode demand, we see that as continued strong demand that will sustain this high end growth. Secondly, we see that in the front Europe, we continue to see a very strong demand that as we expand our 8 inches capacity, that will be fairly highly utilized.
I'm just curious. That second connectivity customer, is that Chinese or non Chinese?
It's a global customer.
Okay. Okay, got it. So as 40 continues to drive your growth, at least in the next couple of quarters, I know depreciation is going up, but can margin still improve looking out into 4Q?
Yes. I think as mentioned in TUI script, right now we are targeting for the whole year the average margin to be in the high 20s.
Yes. But
I'm just thinking logically, right, why shouldn't it go up in 4Q?
I'm sorry? I'm
just thinking that mix should get better and better. So it just seems to me like 4Q should even go up a little bit more?
Yes. But at the same time, actually our depreciation is going to increase quite substantially in the same number.
Okay. I guess related to that, what is your margin outlook for 2017?
We are still optimistic, but I think it's too early for us to guide for 2017 gross margin.
Okay. Can you at least help me with the moving pieces? I would assume that 28% is going to start contributing, so that would be maybe somewhat negative. We should probably assume that CapEx stays at current levels. I don't know what the outlook is for your other businesses.
Can you maybe just kind of run me through the key variables for you?
Well, I think the key okay, key variables impacting next year's gross margin is, first of all, the revenue growth and the fab utilizations. And then also, as we've mentioned, with also the product mix change because we're going to have more tran8 nanometers coming into production. And also, of course, our depreciation ratio also goes up next year. But as we increase the revenue base, our OpEx as a percentage of revenue will come down. So I think there will be some positive and negative impact, and we'll see how it's going to work out for the overall net margin.
Great. Just one last question on LFoundry. Given that the current utilization rate is fairly low, is it fair to assume that you really need to spend CapEx on our foundry, at least not right now?
There will be a limited amount of CapEx in LFoundry to bring in technology that is aligned to SMIC. So there are a few missing tools in LFoundry that we need to procure to ensure the technology alignment. But the total CapEx for next year will be fairly limited. We'll be trying to leverage the present unused capacity in the most efficient way.
Yes. Let me just also comment a little bit more on LFoundries. Right now, we actually have identified some technology and products that we're going to transfer to LFoundry that hopefully would help to bring up the utilization in the next 3 to 4 quarters. At the same time, we are also leveraging the strength of LFoundry in the auto and CIS area to re cross sell their technologies to our own customer set in China. So we believe actually this acquisition will be would create good value for us.
Great. Thank you very much.
Thank you.
Your next question comes from the line of Leping Huang from Nomura. Please ask your question.
Okay. Thank you for taking my question. I have two questions. First is that I see you expand your capacity very quick year over year growth by 30%, but you still maintain a very high utilization rate near close to 100%. What's the current order situation?
You have much stronger orders that you can deliver? Or how you can achieve such optimal operations status? Yes. So this is the first question.
So I need to say pay tribute to our sales marketing team as well as our operation team. This is the first time in our history where when we build our capacities and all of them are fully utilized as soon as the capacity is made available. So at this moment, still that we have a lot of orders that has not been fulfilled. And so we need to still expedite our tool installations as well as look and that's the reason we have to look for external expansion through merger and acquisition. And we have been very, very fortunate to find a good partner such as LFoundry.
So I think we want to emphasize that I think despite the increase in the CapEx in the last one year, I think the management team have not changed our philosophy, which is highly efficient in use of capital. And we feel that this is core to how we can create value for our shareholders.
Okay. So should we expect in coming few quarters you still have a very high utilization rate? I think next few quarters, you're still in a very fast capacity expansion phase. So that the so do you expect that the, yes, utilization will remain high during the expansion?
It
is emphatically yes.
Okay. Great. So the second question is about the EBITDA margin. So you guide for the EBITDA margin to expand this year versus last year. So can you also share some insight which product line or which process actually drive the margin expansion for this year?
And how we should look for the next year's EBITDA margin outlook? Thank you.
Yes, I think this the improvement in the EBITDA margin is really a function of the increase in the scale of production. As we increase the revenue base, actually our cash cost included OpEx as a percent of revenue will come down, so which is reflected in a higher EBITDA margin. Okay. Yes. Thank you for that.
Thank you.
Your next question comes from the line of Gokul Hariharan from JPMorgan. Please ask your question.
Yes, hi. Congrats on the great results. My first question is on the CapEx needs and potential funding programs. As Gareth mentioned, I think we're expecting CapEx to at least stay at the similar level and potentially some added funding for M and A. Now I think some of the Chinese national IC fund, etcetera, have talked about potential equipment leasing programs and stuff like that.
Would you consider that as a significant component in terms of satisfying your funding requirements or potentially aligning your timing of CapEx to revenue a little bit better, especially given we are still running at negative operating cash flow for at least looks like the next near term future? That's my first question.
Yes. I think we are in a very comfortable cash situation right now. We have about CNY 2,000,000,000 cash on hand right now. And this year, we are looking at generating close to CNY 1,000,000,000 cash from operations. And then we expect next year probably will generate similar amount of if not more in terms of cash flow from operations.
So at the same time, we are actually open to consider different types of financial opportunities so as it is low cost and value added to us. And obviously, we have we do we are open to explore, for example, some leasing program with our partners as well.
And is that something that is right now or is that something that significantly planned into your cash use of cash as well as proceeds of cash in terms of the next couple of years? Or is that is not something that is built into your planning?
As I said, we are under discussion with a partner for some leasing program. But likely, I think we'll start with a small program. And as we and we'll see how it goes. It worked very well for us. We'll expand the program in the future.
Okay, great. For the 40 nanometer product, it's been a great revenue trajectory. Given that, as you mentioned, the 2 customers were driving a bulk of that growth, Could we have a little bit of more detail in terms of what your view is in terms of when they are eventually going to migrate to 28 nanometer as well as that eventual migration would be going to high gamma gate or polycyon and yes.
Okay. I think the in our capacity planning, certainly, right now, we're making sure that capacity is used in 40 nano. Most of it can be also efficiently converted to 28. And so this will our setup will also be able to handle a robust 28 ramp up. As far as 4 d demand is concerned, we see new customer coming in, and there are additional customer lining up in the pipeline.
So we think this is still a very robust technology note here. Certainly, a lot of the customers using the 40 nano are working with us in the 28 transitions. And indeed, most of the 28 transitions into the high k metal gate technology.
Okay, great. Just one quick one on inventories. Some of your peers have commented about seasonal inventory correction going into Q4, whereas you have a view that Q4 could be still a growth quarter. I just wanted to understand whether you are factoring in overall inventory correction in the industry still into your assumption and most of your Q4 growth is coming primarily from your own market share gains. Is that how we should read it?
Yes, I think so. I think as far as our own customer group is concerned, we are still seeing a very strong demand from customers, and we don't notice any inventory issues here.
Your next question comes from the line of Charlie Chan from Morgan Stanley. Please ask your question.
Hi, good morning. Congratulations for great results. So my first question is really on the future competition in the 28 nanometer node because some of your industry peers like UMCs are doing joint venture in Xiamen and HLMC. They will build up another fab for 28 nanometer in Shanghai. So going forward, how are you going to address this competition and that ROI from your 28 nanometer investment would be similar to your thought previously?
Thank you.
Okay. I think that indeed, we constantly have to work within this competitive environment in the foundry scenario. We always believe that the competition will be here, but the market is big enough for all to grow profitably. This is in a similar situation from the early 2000s, there are very strong and respectable competitors set up 8 inches fab in China. But that has not really impacted our growth and strong demand going into our 8 inches operations.
So I think that in the same analogy, as well as long as SMIC can deliver on the right technology with the right service and with good quality, I think we will be able to have a good customer set and a good business opportunities.
Okay. Thanks for that. And my second question is really on the IoT exposure because China is quite aggressively developing the IoT infrastructure. So by your definition, what is your rough revenue exposure to IoT? I guess they could include some sensors, MCU, connectivity and some power IC business.
And if you compare this revenue exposure this year versus last year, what is the growth trajectory? Thanks.
Yes. I think the IoT definitely is a very fragmented market segment. So it is very much depending on how we categorize what product has been IoT. I presume that the Bluetooth for the earphones, speakers and a lot of the RF connectivity device can all be used in IoT applications. So really, at this moment, we have not set up a particular category such as IoT for the exact numbers.
But I think roughly, these areas such as Bluetooth, the RF connectivities and sensors are taking up above let me see, about 20% to 30% of our revenue and that is growing at a very, very high rate. Yes. I don't know sorry, that is not a very precise number, but that is not at this moment, not a we have not categorized our revenue in that manner.
That's already very helpful. So what is the company's exposure in MCU? And would you think that is IoT correlated as well? So I just want to get a sense how well is the company positioned for IoT and whether it is happening and when it's going to accelerate or we are already at stable growth? Thank you.
Okay.
I think that we have a couple technology that prepared for the very low power and low leakage application in IoT. These applications these technologies not only contains low power features, but it has RF and has embedded nominal tile features. And these are 2 technology, 1 is in our 55 embedded novel top, 1 is our 95 sparkle are all getting a lot of customer interest and gaining customer new customer design. So we are in the initial phase of demonstration and ramp up. So at this moment, the contribution is if you look at these 2 new technology, it's still at the initial phase.
But we think that from our feedback from the customers, all of them are giving good comments and good credit to these new technology that is coming up.
Okay. Thanks.
Your next question comes from the line of Ken Hui from Jefferies. Please ask your question.
Thank you for taking my question. Looking into 3Q, I think you mentioned that you expect growth driver, one of them is actually from Europe, but Europe was actually relatively flattish in Q2 compared to Q1. Was it due to capacity constraint or some other reason?
Yes, I think that is because of the capacity constraint.
And then
related to that regarding your sensor customer, you mentioned that you are also adding more customer. Have you seen meaningful contribution already in the second quarter or it is something going to happen in the second half?
Yes, I think it's going to happen in the second half because frankly speaking, we just cannot take on all the customers that we have in the 2nd quarters. But as you know, we are still expanding our 12 inches 8 inches as well as 12 inches capacity for the mature NUCs in the second half. So hopefully, we are able to meet some of this customer demand, which we could not meet in the first half.
Okay. And then my final question is regarding the leasing program and also you talked about the target of achieving double digit ROE. Would you consider the leasing program as a way to achieve your double digit ROE or I think I meant if you consider trying to accelerate your target by being more aggressive in doing this kind of leasing program? And
do you
have a time frame on when you're going to achieve double digit ROE?
As I said, we are exploring different kind of financing program that could improve our profitability. Leasing program obviously is one option that we are looking at very seriously. And as mentioned, we are already in discussion with some partners that we're going to start some programs in a smaller scale. And if it finally works well for us, we're going to expand the program in the future. So you're right, I mean, as mentioned by T.
Y, it is still a long term target to achieve a double digit ROE on a sustained
basis. Okay. Thank you.
Your next question comes from the line of Rick Su from Daiwa. Please ask your question.
Yes. Hi. Good morning, guys. My first question is regarding your LFoundry, because in Q4, you're going to be fully consulted in the revenue in Q4. So if I were to exclude LFoundry contribution in Q4, then how much of your business will I assume it will likely decline seasonally in Q4, by how much?
No, actually we're looking at even excluding LFoundry contribution, we're still looking at growth.
All right. Wonderful. That's good. All right. Then second question is, if I remember wrong, I think your LFoundry right now operates around 40,000 wafers capacity.
And last year, utilization rates on average was about 70%. And I think you guys told me before in first half, the utilization rate dropped to about 60% plus. So could you update what's the utilization rate progress right now and in second half? And when do you expect this operation to be margin accretive?
Right now, I think the company is still running about 60% utilization. Although we're seeing actually the customers increasing the loading in the second half. But I think this year, I think to be realistic, I think the profit contribution to SMIC will be relatively modest, okay. But as what I said earlier, we already have an active program in terms of transferring our processes and also our product to LFoundry over the next 2 to 3 quarters. And hopefully, we can gradually bring up the utilization and also improving the profitability for LFoundry.
Okay. Great. So one last question, just a quick follow-up. When do you expect this company sorry, LFoundry's operations to meet your corporate average in terms of profit margins? When do you expect this to happen?
Yes. In our experience, in terms of if you understand, actually, it take about 3 to 4 quarters to fully qualify a fab for a new process, okay. So expect in about 1 year, we're able to transfer enough processes and product to the fab in LFoundry to bring up the utilization to close to our 8 inches fab, okay? And at that time, we have to think about whether we need to expand the capacity. There's still room for us to expand capacity in LFoundry.
So we believe that conservatively, I think in about 18 months, we should be able to bring the gross margin for the fab to our the average of our 8 inches fabs.
All right. Thank you so much. And just quickly remind me, what's the maximum capacity of this LFoundry that you can join?
Depending on the number of metal layers, I think you can go to about 45 ks to 50 ks.
All right. Thank you so much.
Ladies and gentlemen, I would now like to hand the call back to CEO, Doctor. Qiu, for closing remarks.
In closing, I would like to thank everyone who participated in today's call and again thank all of our shareholders, customers, employees and suppliers for their trust and support. Thank you.
This is the end of SMIC's 2nd quarter earnings conference call. We thank you for joining us today.