Ladies and gentlemen, welcome to the Semiconductor Manufacturing International Corporation's second quarter 2016 webcast conference call. Today's conference call is hosted by Dr. T.Y. Chiu, Chief Executive Officer, Dr. Yonggang Gao, Chief Financial Officer, Mr. Gareth Kung, Executive Vice President of Strategic Business Development, Finance, and Company Secretary, and Mr. En-Ling 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, www.smics.com. Webcast playback will be available approximately one hour after the event at www.smics.com.
Without further ado, I would now like to introduce to you Mr. En-Ling Feng, Vice President of Investor Relations, for the cautionary statement.
Hello, everyone. Good morning and good evening. For today's call, Dr. T.Y. Chiu will first provide some general remarks. Afterward, Dr. Gao Yonggang will highlight our financial performance and give guidance on the next quarter. 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. Before I turn the call over to Dr. T.Y. Chiu, 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 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 this risk 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 report on Form 20-F filed with the U.S. Securities and Exchange Commission on April 25th, 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 US dollars unless otherwise stated.
I will now turn the call over to our CEO, Dr. T.Y. Chiu, for the opening remarks.
Thank you, En-Ling. 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 million, 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% and then 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 the great demand and the recent acquisition of LFoundry, we now raise our annual revenue, growth percentage target to mid to high 20s this year. We also raise our growth margin target to high 20s for the year, factoring in our increased visibility and confidence in high utilization for the rest of this year. What has been driving SMIC's growth? From a technology node 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 at 27% quarter-over-quarter. With a surging 40 nano demand, in particular for product single source to SMIC, a lot of our new capacity in Shanghai 12-inch 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 low to mid single digit percentage by Q4. We believe this advanced node allocation arrangement is in fact in the best interest of all our customers. Driving our growth from an 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 three 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-top box and others.
They are also innovating new devices for the Chinese consumers and increasingly designing their own ICs and partnering with foundries. Second, Chinese fabless growth is robust and they are capturing contents in an increasingly diverse mix of product. As an example, Bluetooth for headphones, speakers, selfie sticks, and others are now dominated by Chinese players. As a result, SMIC has become the leading suppliers for consumer Bluetooth in China. 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 opportunities. Diversification and the differentiation of our technology continue 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 new and existing customers for fresh product and new tape outs.
Some recent rollouts include SMIC's MEMS for microphone, which has entered risk production in Q2. Our production of microcontrollers using embedded flash for smart cards, for home appliance, hover boards, and e-bikes. We are now working with customers in new area of IoT, auto, AR and VRs. Since the acquisition of LFoundry, we have officially entered into the auto IC market. LFoundry manufactures about 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 $2.5 billion for the year. Shanghai 12-inch 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 it is targeted to attain 18,000 by year end.
We are expanding our B.1 capacity, leveraging on used tools from 37,000 now to 45,000 by the end of the year, mostly in 55nm technology node. Our Shenzhen fab is ramping smoothly, and the capacity will increase from the present 26,000 to the 31,000 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 our foundry 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 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 minimal share dilution. This includes 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 create dilutions. All in all, we are 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 highlight and the 2016 Q3 guidance.
Okay. Thank you, [T.Y]. Greetings to all our listeners. I will highlight our last quarter results first, then give our third quarter 2016 guidance. Last quarter, our revenue, gross profits, operating profits, and net profits were all record high. Revenue was $690.2 million, an increase of 8.8% quarter-over-quarter, exceeding our guided 3%-7% increase. Gross profit was $217.8 million. Gross margin was 31.6%, exceeding our guided rate from 25%-27%. Profit from operations were $115.4 million. Profit for the period attributable to SMIC was $97.6 million, and China region revenue grew to a record high of 52% of overall revenue in 2Q16. Looking ahead into the third quarter of 2016. Our revenue is expected to increase by 8%-11% quarter-over-quarter. Gross margin is expected to range from 28%-30%.
Non-GAAP operating expenses are expected to range from $140 million-$145 million. Non-controlling interests of our majority-owned subsidiaries are expected to range from positive $4 million to positive $6 million, which are losses be borne by non-controlling interests. I will now hand the call over to Gary for more detailed financial commentary.
Thank you, Gao, 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 $690.2 million above the guided range, mainly because of an increase of wafer shipment. Cost of sales decreased to $472.4 million. Gross margin was 31.6% above the guided range, 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. Two, an increase in fab productivity, and three, product mix change. Operating expenses increased to $102.4 million in Q2 2016. R&D expenses increased by $11 million quarter-on-quarter to $64.5 million. The change was mainly due to high number of R&D activities.
Funding R&D contracts from the government was $12 million in Q2 2016 compared to $8 million in Q1 2016. General administrative expenses increased to $33.5 million, mainly due to, first of all, salary increase for some employees in Q2 2016, and also an increase in legal and consulting fee. Excluding the effect of employee bonus accrual, government funding, and gain from disposal of living quarters, non-GAAP operating expenses were $113.4 million, below our guided range. Profit from operations increased to $115.4 million. Profit for the period attributable to SMIC increased to $97.6 million, while non-controlling interests were $3.2 million of credit to SMIC's attributable profit in Q2 2016. Moving to the balance sheet at the end of the second quarter of 2016, cash and cash equivalent increased to $1.6 billion. If including other financial assets, we had approximately $1.9 billion cash on hand at the end of Q2 2016.
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 $1.2 billion, and short-term borrowings decreased to $91 million. 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 million of cash from operations. We are still targeting to generate approximately $900 million of cash from operating activities this year. Cash used in investing activities increased to $1.2 billion. Cash from financing activities was $1.5 billion. To examine our revenue by application, the communications and consumer segments contributed 49.9% and 38.8% to our revenue respectively. Geographically, revenue from China, North America, and Euro-Asia 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 55/65 nanometers and 90 nanometers contributed 20.4% and 2.3% respectively. Meanwhile, 0.13 micron 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 339,000 8-inch equivalent wafers, an increase of 12% quarter-on-quarter. The change was primarily because the capacity expansion of our majority-owned Beijing 12-inch fab, Shanghai's 12-inch fab, and Shenzhen 8-inch fab. We reiterate our plan 2016 capital expenditure for foundry operations to be approximately $2.5 billion. While plan 2016 capital expenditure for non-foundry operations are approximately $50 million. I'll now hand the call back to Anling for the Q&A session.
Thank you, Gareth. I would now like to open up 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 the question, please press star one on the telephone and wait for your name to be announced. If you wish to cancel the request, please press the pound or hash key. As a reminder, please speak into the handset only when asking question. Your first question comes from the line of Randy Abrams from Credit Suisse. Please ask your question.
Yes. Thank you. This is Randy Abrams. First question I wanted to ask, the 8-inch has been doing very well. 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. What is the outlook, just beyond this year for 8-inch, how you see the strength continuing and also the competition there?
I think that there are a number of area which requires 8-inch capacities. 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. We are reasonably optimistic that 8-inch utilization will remain tight and at a high range.
Randy, I just have two point onto what T.Y. said. I think, as mentioned in T.Y. script, I think the other area of strength we see for the 8-inch applications is in the Bluetooth area. This area actually basically dominated by the Chinese design company, and many of them are manufacturing in our fabs.
Okay.
I think that is something that we want to highlight. The other thing is that actually in terms of fingerprint, though I'm sure you know the biggest customer for us, but actually we are also gaining many new customers in the fingerprints area as well.
Okay, great. The other side, want to ask about the 28 nanometers, which is still very small this year. Next, 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 just how that would change your profitability if its 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, that we have said repeatedly, certainly our present allocation is to meet the critical demands of single source of product in the 40 nano. As we ramp up our additional capacities, we will have more resource to ramp our 28 nano products. 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 a 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 fourth quarter, 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. It is difficult to project at this point of time.
Okay. 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. 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%-27%, and the actual result is about 31.6%. I would say about between 1%-2% is actually contributed by the insurance compensation, which we did not factor into our guidance. 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 productivities. Actually, the output came out is actually more than what we anticipated. I think thanks to our strong performance from our fab. 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. I think that contributed to the gross margin outperformance.
Okay. Can you give an update, just depreciation for second half?
Yeah, sure
Next year? Okay, thank you.
There's some changes in our equipment moving schedule. Right now, the new forecast for the full year depreciation to be about $740 million. We're going to see some major increase in the second half this year.
Okay. seven 14, one four, seven one four?
seven four zero.
seven four zero.
seven four zero.
Okay. Is there an early take after spending $2.5 billion 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. Which I think we still have not really finalized. Right now, I don't have the number for next year. Yeah.
Okay. Thanks a lot. Good result.
Your next question comes from the line of Steven Pelayo from HSBC. Please ask your question.
Yeah, guys, 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, because we completed the acquisition end of July, we are starting to consolidate the result from August onwards. They would contribute two months of revenue to us in Q3, which is roughly about $20-$30 million. In terms of their profit contributions, because right now actually they are running at not high utilization right now. We expect their contribution to our profit is quite minimal.
Okay. Gareth, year to date, it looks like you've had about $20 million in R&D subsidies. Last quarter, you talked about that number being $60-$65 million for this year. Do you still think that number? 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, R&D contracts from the government. We were just informed quite recently. This year, we are looking at the total R&D contract funding will reach about $72 million for the whole year.
Okay. How is that going to split in the second half? Because that's pretty significant to the full year, if you've done-
Yeah, I think will be mostly concentrated in the Q4, I think.
In 4Q. All right, just two quick last questions. Help me understand, where do you think SMIC's capital structure's going to be, let's say at year end? I'm trying to understand the-
Yeah
more financing side.
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.
Yes.
The reason we did that is because, just that there is a very good market opportunity this year for us to raise relatively cheap debt. A lot of debt raised this year are actually RMB debt. Right now, there is a market opportunity for us to really swap this RMB debt into US dollar funding at a very low cost. Right now, maybe after swapping into our US dollar funding is about 2%-2.5%. We took this opportunity 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 number 4.
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 million in cash flow from operations, but you are still spending $2.5 billion 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, this is a good question. Maybe I should respond in another way. We believe as we grow our revenue, I think T.Y. already set a target to be over 20% year-over-year. Our CapEx intensity would reduce, even if we maintain, assuming we maintain our CapEx at the same level next year. We feel that, if you ask me about getting into net cash flow positive, including CapEx, I think we are still some time off. 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.
Yeah. 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? Related to that, you said that 4Q is going to grow again. Can you tell me what gives you the confidence looking now 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 August onwards. There's about $20 million-$30 million contribution from LFoundry activities. Our 40 nanometers is still growing very strong, as what T.Y. said, many of them are single source. We also started to ship in greater volume for our 28 nanometers. 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. I think our fab will still be fully loaded.
I guess I'm just wondering what kind of application is driving the Q4 growth?
Maybe let me add a couple of other highlights. Certainly, 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 in the connectivity area as well. Our 40 nano demand, we see that as a continued strong demand that will sustain this high-end growth. Secondly, we see that from Europe, we continue to see a very strong demand that as we expand our 8-inch capacity, that will be fairly highly utilized.
I am just curious, that second connectivity customer, is that Chinese or non-Chinese?
It is a global customer.
Okay. Got it. As 40 continues to drive your growth, at least in the next couple of quarters, I know depreciation is going up, can margin still improve looking out into 4Q?
Yeah, I think, as mentioned in TY script, right now we are targeting for the whole year the average margin to be in the high 20s.
Yeah. 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. It just seems to me like 4Q should even go up a little bit more.
At the same time, actually our depreciation is going to increase quite substantially in this coming up.
Okay.
Yeah.
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?
I think the key variables impacting next year's gross margin is, first of all, the revenue growth and the fab utilizations. Also, as you mentioned, with also the product mix change because we're going to have more 28 nanometers coming into productions. Of course, our depreciation will also goes up next year. But as we increase the revenue base, our OpEx as a % of revenue will come down. 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. Sorry, just one last question. On LFoundry, given that the current utilization rate is fairly low, is it fair to assume that you don't need to spend CapEx on LFoundry, at least not right now?
There will be a limited amount of CapEx in LFoundry to bring in technology that is aligned to SMIC. There are a few missing tools in LFoundry that we need to procure to ensure the technology alignment. The total CapEx for next year will be fairly limited. We'll be trying to leverage the present unused capacities in the most efficient way.
Let me just also comment a little bit more on LFoundry. 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. We believe, actually, this acquisition 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 to take my question. I have two questions. First is that the, I see you expand your capacity very quick. For example, year-over-year grow by 30%, but you still maintain a very high utilization rate, near close to 100%. What's the current, from order situation, you have much stronger orders that you can deliver, or how you can achieve such optimal operations status? Yeah. This is the first question.
I need to pay a 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, all of them are fully utilized as soon as the capacity is made available. At this moment, still that we have a lot of orders that has not been fulfilled. We need to still expedite our tool installations, that's the reason we have to look for external expansion through merger and acquisition. We have been very fortunate to find a good partner such as LFoundry.
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. We feel that this is core to how we can create value for our shareholders.
Okay. Should we expect the incoming few quarter, you still have a very high utilization rate? I think next few quarter, you're still in a very fast capacity expansion phase. Do you expect that the utilization will remain high during the expansion?
It is emphatically yes.
Okay, great. The second question is about the EBIT margin. You guide for the EBIT margin to expand this year versus last year. 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 EBIT margin outlook? Thank you.
I think this, the improvement in the EBIT margin is really a function of the increase in the scale of production. As we increase the revenue base, actually our cash cost, including OpEx, as a % of revenue will come down. Which is reflected in a higher EBIT margin.
Okay. Thank you.
Your next question comes from the line of Gokul Hariharan from JP Morgan. Please ask your question.
Yeah. 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&A. Now, I think some of the Chinese national IC fund, et cetera, 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 $2 billion cash on hand right now. This year we are looking at generating close to $1 billion cash from operations. We expect next year probably will generate similar amount of, if not more, in terms of cash flow from operations. 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. Obviously, we are open to explore, for example, some leasing program with our partners as well.
Is that something that is right now, or is that something that is significantly planned into your cash, use of cash, as well as proceeds of cash in terms of the next couple of years, or that is not something that is built into your planning?
As I said, we are under discussion with a partner for some leasing program. Likely, I think we'll start with a small program, we'll see how it goes. If it worked very well for us, we'll expand the program in the future.
Okay, great. For the 40 nanometer product, there's been a great revenue trajectory. Given that, as you mentioned, the two 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-k metal gate or poly-SiON? Yeah.
Okay. I think in our capacity planning, certainly right now we are making sure that the capacity is used in the 40 nano. Most of it can be also efficiently converted to 28. Our setup will also be able to handle a robust 28 ramp-up. As far as 40 demand is concerned, we see new customer coming in, and there are additional customer lining up in the pipeline. We think this is still a very robust technology node 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 is 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?
Yeah, 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 yet.
Got it. Thanks.
Thank you.
Your next question comes from the line of Charlie Chan from Morgan Stanley. Please ask your question.
Hi. Good morning. Congratulations for great results. My first question is really on the future competition in the 28 nanometer node, because some of your industry peers, like UMC, are doing joint venture in Xiamen. HLMC, they will build up another fab for 28 nanometer in Shanghai. Going forward, how are you going to address this competition, and will 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-inch fabs in China. That has not really impacted our growth and strong demand going into our 8-inch operations. I think that in the same analogy, 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 good business opportunities.
Okay. Thanks for that. My second question is really on the IoT exposure, because China is quite aggressively developing the IoT infrastructure. By your definition, what is your rough revenue exposure to IoT? I guess that could include some sensors, MCU, connectivity, and some power IC business. 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. It is very much depending on how we categorize what product is in IoT.
Yes.
Bluetooth for the earphones, speakers, and a lot of the RF connectivity device can all be used in IoT applications. Really, at this moment, we have not set up a particular category such as IoT for the exact numbers.
I think roughly.
These areas such as Bluetooth, the RF connectivities and sensors are taking up about, let me see, 20%-30% of revenue. It is growing at a very high rate. Yeah. I don't know.
Thank you.
I'm sorry, that is not a very precise number. At this moment, we have not categorized our revenue in that manner.
That's already very helpful. What is the company's exposure in MCU, and would you think that is IoT correlated as well? I want to get a sense how well is the company positioned for IoT and whether it is happening, and when it is going to accelerate or we are already at stable growth. Thank you.
Okay. I think that we have a couple technology prepared for the very low power and low leakage application in IoT. These technologies not only contains low power features, but it has RF and has embedded non-volatile features. These two technology, one is in our 55nm embedded non-volatile, one is our 95nm SPOCULL, are all getting a lot of customer interest and gaining new customer design. We are in the initial phase of demonstration and ramp up. At this moment, the contribution is, if you look at these two new technology, is still at the initial phase. 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 out. Yeah.
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. Europe was actually relatively flattish in second quarter compared to first quarter. Was it due to capacity constraint or some other reason?
Yes, I think that is because of the capacity constraint.
Related to that, regarding your sensor customer, you mentioned that you are also adding more customer. Have you seen meaningful contribution already in second quarter, or is there something going to happen in the second half?
I think it's going to happen in second half because, frankly speaking, we just cannot take on all the customers that we have in the second quarters. As you know, we are still expanding our 12-inch capacity for the mature node in the second half. Hopefully, we are able to meet some of this customer demand, which we could not meet in the first half.
My final question is regarding the leasing program. Also, you talk about the target of achieving double-digit ROE. Would you consider the leasing program as a way to achieve your double-digit ROE? I think I meant, would you consider trying to accelerate your target by being more aggressive in doing discount leasing program? Do you have a timeframe 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 profitabilities. Leasing program, obviously, is one option that we are looking at very seriously. As mentioned, we are already in discussion with some partners that we're going to start some programs in a smaller scale. If it works well for us, we're going to expand the program in the future. You're right. As mentioned by T.Y., it is still a long-term target to achieve a double-digit ROE on a sustained basis.
Thank you.
Your next question comes from the line of Rick Hsu from Daiwa. Please ask your question.
Yeah. Hi, good morning, guys. My first question is regarding your LFoundry, because in Q4, you're going to be fully consolidated in the revenue in Q4. If I were to exclude LFoundry contribution in Q4, how much of your business will I assume it will likely decline, right, 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. Second question is, if I remember wrong, I think your LFoundry right now operates around 40,000 wafers capacity. Last year, utilization rates on average was about 70%. I think you guys told me before in the first half, the utilization rate dropped to about 60% plus. Could you update what's the utilization rate progress right now and in the second half? When do you expect this operation to be margin accretive?
Right now, I think the company is still running about 60% utilization. We're seeing, actually, the customers increasing the loading in the second half. I think this year, to be realistic, I think their profit contribution to SMIC will be relatively modest, okay? 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 two to three quarters. Hopefully, we can gradually bring up the utilization and also improving the profitability for LFoundry.
Okay. Great. One last question, just a quick follow-up. When do you expect LFoundry's operations to meet your corporate average in terms of profit margins? When do you expect this to happen?
Yeah. In our experience, you understand, actually, it takes about three to four quarters to fully qualify a fab for a new process, okay? Expect in about one year, we're able to transfer enough processes and product to the fab in LFoundry to bring up the utilization to close to our other 8-inch fab, okay? At that time, we'll have to think about whether we need to expand the capacity. Because there's still room for us to expand capacity in LFoundry. We believe that, conservatively, I think in about 18 months, we should be able to bring the gross margin for that fab to the average of our 8-inch fabs.
All right. Thank you so much. Just quickly remind me, what's the maximum capacity of this LFoundry that you can drive?
Depending on the number of metal layers, I think it can go to about 45K-50K.
All right. Thank you so much.
Ladies and gentlemen, I would now like to hand the call back to CEO, Dr. Chiu, 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 second quarter earnings conference call. We thank you for joining us today.