Ladies and gentlemen, thank you for standing by, and welcome to Hua Hong Semiconductor's third quarter 2019 earnings conference call. Today's call is hosted by Mr. Junjun Tang, President and Executive Director, and Mr. Daniel Wang, Executive Vice President and Chief Financial Officer. Please be advised that your dial-ins are in the listen-only mode. However, at the conclusion of the management's presentation, there will be a question and answer session, at which time you will receive instructions on how to participate. The earnings press release and third quarter 2019 summary slides are available to download at our company's website, www.huahonggrace.com. Without further ado, I would now like to introduce you to Mr. Daniel Wang, Executive Vice President and Chief Financial Officer. Thank you.
Good afternoon, everyone. Thank you all for joining our third quarter 2019 earnings conference. Today, we will first have Mr. Junjun Tang, our Executive Director and President, make remarks on our third quarter performance. President Tang will address in Chinese, and Kathy Chien, our Deputy Director of Investor Relations, will be the translator. After that, I will discuss our financial results and provide guidance for the next quarter. This will be followed by our question and answer session. I now turn the call over to our Executive Director and President, Mr. Tang.
Good afternoon, everyone. Thank you for joining our earnings call. Despite challenges and uncertainties in our business during the past quarter, Hua Hong Semiconductor continued to thrive with laser-focused execution. The company achieved $239 million in revenue, representing a 3.9% increase quarter-over-quarter and virtually flat year-over-year. This strong revenue performance was largely attributable to increased demand from China and other parts of Asia for many of our products, particularly MCU, super junction, IGBT, general MOSFET, power management IC, and analog. This shows again the strength and quality of our specialty technology offering. The company was able to deliver strong performance despite less than desirable market conditions. Gross margin was maintained at 31%. This performance, nonetheless, was not without its challenges. In general, there has been pricing pressure for finished wafers throughout the year due to market conditions, whilst substrate costs increased significantly.
In the last quarter, these challenges were offset by a quarter-over-quarter increase in overall utilization rate to 96.5%. Additionally, significant government subsidies were received within the quarter, which offset some depreciation expense. Our Wuxi 300 millimeters manufacturing facility, Fab7, started production this quarter. Our team qualified a number of customers' products for Fab7 production. For two of these products, the yield has already ramped up to 90%. This fab will give us tremendous growth opportunities in the next several years as part of our overall expansion plan. Clearly, it will be our focus going forward, and our management team understands the importance and urgency of bringing this fab to profitability in the shortest possible time.
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We continue to be extremely positive about the direction and strategy of the company. We believe 5G will be the next wave driving opportunities for semiconductor companies. As a result, there will be a surge in demand for various semiconductor devices, including microcontrollers, sensors, radio frequency, power management, and memory. As a leader in specialty technologies, Hua Hong Semiconductor will be an important player in 5G innovation.
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Now, I would like to hand the call over to our CFO, Mr. Daniel Wang, for his comments.
Thank you, Mr. Tang, for the intro. Now let me begin with a summary of our financial performance for the third quarter, followed by an outlook on revenue and margin for the fourth quarter of 2019, and then we'll move on to the question and answer session. First, let me summarize financial performances of the third quarter. Revenue reached $239 million, 0.9% lower than the prior year, but 3.9% above Q2 2019. Cost of sales was $165 million, 3.6% above Q3 2018, primarily due to increased unit cost of raw wafers, and 4% above Q2 2019, largely due to increased wafer shipments. Gross margin was 31%, three percentage points below Q3 2018, mainly due to low capacity utilization and the increased unit cost of raw wafers, and flat to Q2 2019.
Operating expenses were $40.2 million, 26.4% above Q3 2018, and 13.7% over Q2 2019, largely due to increased expenses for labor and engineering wafers for Hua Hong Wuxi. Other income net was $23.5 million, 64.2% up year-over-year, primarily due to increased general subsidies, foreign exchange gain, share of profit from associate, and 4.5% lower quarter-over-quarter, primarily due to decreased foreign exchange gain to interest income, and fair value gains of financial assets at fair value through profit or loss, partially offset by increased general subsidies to share of profit from associate. Income tax expense was $12.9 million, 4.6% lower than Q3 2018 due to decreased taxable profit. Profit for the period was $44.4 million, 12.8% below Q3 2018 and 11% lower than Q2 2019. Net profit margin was 18.6%, 2.5 percentage points below Q3 2018 and 3.1 percentage points below Q2 2019.
Basic earnings per share was $0.035, $0.011 lower than Q3 2018 and $0.001 above Q2 2019. Annualized ROE was 8.4%. Now, please let me provide you with more details on our revenue from Q3 2019. From geographical perspective, revenue from China was $148.6 million, contributing 62.2% of our total revenue, an increase of 8% compared to Q3 2018, mainly driven by increased demand for MCU products. Revenue from the U.S. was $35.3 million, a decrease of 11.9% compared to Q3 2018, chiefly due to decreased demand for general MOSFET and flash products. Revenue from Asia was $29.6 million, a decrease of 3.3% compared to Q3 2018, chiefly due to decreased demand for Logic products, partially offset by the increased demand for MCU and general MOSFET products.
Revenue from Europe was $17.3 million, a decrease of 7.1% compared to Q3 2018, chiefly due to decreased demand for smart card ICs. Revenue from Japan was $8.1 million, a decrease of 43.3% compared to Q3 2018, mainly due to decreased demand by a certain customer. With respect to technology platform, revenue from embedded non-volatile memory was $88.2 million, a decrease of 1.5% compared to Q3 2018, primarily due to decreased demand for smart card ICs, partially offset by increased demand for MCU products. Revenue from discrete was $90.3 million, an increase of 10.9% compared to Q3 2018. Mainly driven by increased demand for super junction and IGBT products, partially offset by the decreased demand for general MOSFET products.
Revenue from analog and power management IC was $36.5 million, a decrease of 3.5% compared to Q3 2018, mainly due to decreased demand for LED lighting products, partially offset by the increased demand for analog products. Revenue from Logic and RF was $22 million, a decrease of 15.6% compared to Q3 2018, mainly due to decreased demand for Logic products, partially offset by increased demand for RF products. Revenue from a standalone non-volatile memory was $1.8 million, a decrease of 72.1% compared to Q3 2018, primarily due to decreased demand for flash and EEPROM products. Now, let's take a look at the cash flow statement. Net cash flows generated from operating activities were $70.7 million, down by 3.1% year-over-year, but up by 242.1% quarter-over-quarter, primarily due to income tax payment for 2018 in second quarter 2019, and increased receipt of government subsidies.
Capital expenditures were $459.8 million in Q3 2019, including $427.5 million for Hua Hong Wuxi and $32.3 million for HHGrace. Other cash flow generated from investing activities were $38.1 million, including payout of $35.4 million of investment in financial assets at fair value through profit or loss, and $2.7 million of interest income. Net cash flows used in financing activities were $22 million, including $1.1 million of lease payments and second, $0.1 million payment of interest expenses for bank borrowings. Now, let's move to the balance sheet. Cash and cash equivalents decreased to $474.7 million on September 30, 2019, compared to $834.7 million on June 30, 2019. Restricted and time deposits decreased from $14.7 million on June 30, 2019 to $0.8 million on September 30, 2019, primarily due to payments for dividends.
Other current assets increased from $76.4 million on June 30, 2019 to $110 million on September 30, 2019, primarily due to increased VAT-deductible tax, partially offset by decreased advanced payments to suppliers. Property, plant, and equipment increased from $1.037 billion as of June 30, 2019, to $1.563 billion as of September 30, 2019. Other non-current assets decreased from $363.2 million on June 30, 2019 to $276.4 million on September 30, 2019, primarily due to decreased advanced payments for capital expenditures. Total assets increased from $3.544 billion on June 30, 2019 to $3.576 billion on September 30, 2019. Our total bank borrowings were $27.6 million on September 30, 2019. Total liabilities increased to $556.1 million on September 30, 2019 from $485.5 million on June 30, 2019, primarily due to increased payables for capital expenditures. Debt ratio increased to 15.5% on September 30, 2019 from 13.7% on June 30, 2019.
Now, finally, let me give you a very top-level outlook for the fourth quarter of 2019. We expect revenue to be approximately $242 million and gross margin to be between 26% and 28%, largely due to the start of production in Wuxi. This is my financial remarks. Now I would like to open up the call for question and answer. Operator, please help. Thanks.
Thank you. Ladies and gentlemen, we will now begin the question and answer session. If you wish to ask a question now, please press star one on your telephone and wait for your name to be announced. If you wish to cancel your request, please press the pound or hash key. Your first question comes from the line of Sunny Lin from UBS. Please ask the question.
Hi, Daniel. Thank you for taking my questions. I have two questions. Number one, from cycle perspective, I think 8-inch foundry began inventory digestion from Q1 this year, and now we are in the fourth quarter of the slowdown. Based on your current visibility, when do you expect customers to start restocking? For 2020, what do you think will be the key growth drivers for the company? My second question is regarding the Wuxi 12-inch Fab. As you started to ramp in this quarter, I wonder if you could give us more guidance on the expected revenue contribution for 2020, the utilization rate, the growth margin dilution, and the impact on earnings, et cetera. Thank you very much.
Hey, that is a pretty long It's a pretty big question, no? First part, I think, you are absolutely correct. I think the inventories level has come down quite significantly. I think people start to making orders in Q2 2019 and Q3 2019, and this is exactly why our utilization rate has come up. Now, basically at the 96%-98% utilization rate. It's pretty clear that the growth driver for this year has been MCUs and power discrete. They have been very strong. Smart card ICs has been not a very attractive segment, but I think MCU has been very strong. Even for Q3 2019, there was basically a 25% growth quarter-over-quarter, just on MCU. When you look at the power discrete, overall, basically, for super junction IGBT, even split gate trench, everything has been going up. Anywhere from single digit to double digit growth.
The general MOSFET is still a pretty significant share of our overall revenue. It was basically about 14%, if you do not count the split gate trench. So that was slightly down this quarter, but everything else has been very strong. The analog and power management also has been strong. It had a growth of 9%. Besides, largely driven by power management IC and analog. We believe these things will continue. They just do not stop. I think the momentum are still there. It will definitely continue into 2020. I was wondering if President Junjun Tang has any things to add.
Thank you for your question. In 2019, with future effort from company and our customers, we have achieved a shipment within this year, and our second and third product is in the process of R&D process. So Wuxi Fab is now taking our IC plus power strategy. With respect for IC, we are aiming to achieve shipment by the end of the year on 90 nanometer embedded eFlash. As for the BCD 55 nanometer logic, we are in R&D process now. We are also in process of the power management development. As for the DMOS, will be some shipment in the first quarter 2020. As for the IGBT and super junction, there will be some shipment by the end of third quarter or the beginning of the fourth quarter. So with the ramp-up of the various products, we will have decent utilization rate next year.
Just so that I will give you some information from financial perspective. The production planning for the Wuxi Fab will be roughly, we are talking about It average about 10K per month, throughout the year, average. So it will start a few hundred wafers up to eventually towards the end of the year, is about 20,000 wafers. So at that point, by end of the year, we will definitely have 20,000 wafer capacity. So we are looking at average, the output will be every month average, probably roughly around 10,000 wafers a month. So, we also expect we command a pretty respectable ASP. So I think, we would have a pretty nice sort of revenue output for next year. Certainly, the depreciation expense will start, but that is just a process. That's part of the process.
I think the key, Mr. Tang has basically said in his remarks that it is very important for us to profitability in the shortest possible time. That is very important for us. We are still on target. Starting from now, we just start production in Wuxi in Q4, and hopefully within two years we will reach the break-even level. From that point, we should only have profits. Sunny?
Got it. Thank you very much. In terms of the growth margin dilution, in Q4, you are guiding growth margin to decline to 26%-28%. Into first half of 2020, should we model another maybe 2%-3% dilution from Q4 level?
The depreciation expense for next year, from Wuxi, I would expect it would be somewhere around. Let me look at the number here. Let me look at the number here. It is going to be $120 million-$130 million. That is something that we would expect for next year. Okay? We certainly also expect that we will have pretty decent revenue to start for the year for 2020. Somewhere on the north of $100 plus million. Okay? I think, with that sort of model and some fixed operating expenses, it should be pretty easy for you to put a combined model together. I think for the three 8-inch fabs, I think we will continue to excel. We will continue to thrive. Hopefully, if the market truly come back next year, I think we should be able to continue maintain at a pretty high gross margin, above 30%. Okay?
That is our model. I think we should be able to have some growth from the three 8-inch fabs as well for 2020. Plus the Wuxi Fab. I think we should have a pretty good year.
Yeah. Thank you, Daniel. Just one very quick follow-up. You just mentioned that the target is to turn around the new 12-inch Fab 7 within two years. But for 2020 and 2021, although our gross margin level, it could be in loss-making, but government should also offer some subsidy. On the operating level, or on the pre-tax level, should we expect zero earnings dilution from this Fab 7, or there would still be some loss dilution from this plant?
You are talking about the first two years?
Yeah.
Well, naturally, the first two years is going to be very challenging. It is very important for us, as I said earlier, very important for us to bring this basically to production level, to 20,000, 30,000 wafers capacity. You need to basically make that happen in the next two years. At that point, we expect a 25,000 wafer to around 30,000 wafer capacity to comfortably become profitable.
Got it. Okay. That is very clear. Thank you very much, Junjun and Daniel. Okay.
We are comfortable, we will do everything we can.
Thank you. Your next question comes from the line of Randy Abrams from Credit Suisse. Please go ahead.
Yes. Thank you. First, if you may just follow up on the previous line from Sunny Lin. On the Fab7, just wanted to see, is the plan all new products and applications, or would you also, some of the business in the 8-inch, would you plan to transfer some applications to create space in the 8-inch?
No, I will turn Junjun Tang for that, to answer the question.
Thank you for your question. As for the Fab 7 production, from the beginning, automatically, it's a technology transfer from 8-inch specialty technologies with strong market demand. But as long as the 55 nanometer eFlash and 55 Logic and power management, that will be based on Fab 7's own R&D platform. They're based on the customer's demand and the market demand, for example, 5G and new energy automobile.
Okay, great. Maybe to clarify, since it is some applications in 8-inch, would it cannibalize I think you mentioned suggesting to grow the 8-inch. But with some of the same initial applications, would it, I guess, maybe come at the expense of the 8-inch growth? Like where now it'll be qualifying aggressively onto the 12-inch.
Randy, all along, the Wuxi Fab is basically part of our expansion plan. Additionally, there'll be some, for example, SIM cards or some of the BCD or Logic and RF. That sort of technology platforms will migrate to the 12-inch. Especially for SIM cards, that'd be the first applications, first product that would be migrating to the Wuxi Fab. For the space that become available on the 8-inch, we're going to be doing other things. We can do more MCUs. We can do some discrete applications. All along, we have been having issues with our capacity. We were out of capacity for all this time. It's not going to be an issue for us to build a fab, the 8-inch space.
Okay, great. If I could follow up. Year-to-date, I think the CapEx, I think we're roughly thinking about $600 million or so per year on the new fab. I guess now it looks like it's spending a bit faster as you start moving toward 20k wafers. How do you expect overall 2019 to end up? Then maybe initial view on 2020 as you build out to the 20k, like what the CapEx may be for next year?
Right. Randy, for Wuxi this year on cash basis, we have spent close to $900 million. That is the expectation. It is a forecast. We are not there yet, but we expect to spend about $900 million in total on cash basis. For Shanghai, it is about close to slightly under $150 million. Just between the two of them, it is over $1 billion slightly. Less than $1.1 billion. That would get us to, basically we have 10K plus part of 20K. For 2020, the plan is we are going to be spending Wuxi probably another $850 million. That will get us to 20,000, 30,000 wafer capacity. As Mr. Junjun Tang said, it is going to be a combination of IC and some power discrete. But exactly what sort of ratio, we have to wait. That is going to be part of the effort, where to find out.
Eventually, I think based on market condition, we will figure out what that ratio is. But overall, I think this is going to be the rate. $850 million for next year, we get to $2,030 million, and then we still end up with another about $640, $650 million left to expand the capacity to its fullest, which is as we initially planned, 40,000 IC or IC plus power at some sort of a capacity.
Okay. No, that is helpful. The depreciation, the $120 million to $130 million. The past quarter, you had a bit of subsidies. For next year, would that full amount be into cost of goods sold, or would there be some offset on subsidy to the depreciation increase?
I think that was just a one-time event. That is one-off, basically. It was basically we complete an R&D project, so it was about $6 million. That which offset the depreciation expenses was roughly we are running about $32 million a quarter. This quarter was down by $6 million. It is largely because the company completed R&D project. Basically, we qualify to use the subsidy to reduce the depreciation expense. But that is one-off. Again, I think there are other projects they are working on, but at this point, we do not have a specific schedule.
Okay. If I could ask the OpEx, I think you mentioned you are doing more of the new project activity for Wuxi, but then I guess there will be some costs as you bring up the Fab 7. What is the way to think about the OpEx increase from here, either absolute or as sales ramp?
For Wuxi, I think the OpEx, it should be eventually pretty stable. I think we are talking about this. I am looking at this model we have. When we do these numbers, we are pretty conservative, okay? At the end of the day, we always do better. But I am looking at their less than $30 million a quarter, just on OpEx. Okay? It is mostly we are spending more than two-thirds of that on R&D expenses, and very little on sales marketing expenses, but the rest will be just general administrative.
Okay. One last question.
I would say, yeah, go ahead.
Okay.
Go ahead.
No, go ahead, Daniel. Sorry. Go ahead.
No. I just saying that it's going to be eventually the headcount will get We have a headcount target, which is about by end of next year, it's going to be around 1,000 people for Wuxi. The operating expense is going to be, as I said, it's less than $30 million. We're going to keep it that way, and I think most likely it'll be lower.
Okay. The last one, I just want to ask the pricing environment. I think you mentioned in the remarks it's been, because of a slow environment, a bit of ASP softness. I think the blended price was probably some mix where it came down a bit. I guess how you're seeing the pricing environment. Then on the other side, you mentioned the substrate, the raw wafer was up a bit, just the view if also that side, if you have any contract lock in, that you may get some help on that side into next year.
Yeah. On pricing, Randy, this has not been the greatest year. You know that. If anybody telling you this is a fabulous year for semiconductor, I think they're lying, okay? Basically, I think all the companies, unless you are really on the leading edge stuff, I think you're facing some sort of pricing pressure. So did we, okay? I think there are pricing pressure virtually on all segments. For some of the stuff, for example, SIM cards, we're not doing too much, largely because the price has not been good. So we give that manufacturing corridor basically to MCUs. That's what we've been doing. That's why exactly you see MCU has been going up. But now on wafer substrates, this year, we actually had a pretty big price hike in the beginning of the year.
Because the overall market condition has not been great, so we went back to the vendors. I think we negotiate. So we're able to get some, basically be able to negotiate, we'll be able to get the price down a little bit. But overall, I think for the year, we're still up a little bit, still up by 5%-6%.
Okay. You expect that to come down into next year?
Honestly, we wish the market would come back. Okay?
Okay.
We can go back to this 100% utilization rate, even if the substrate is up a little bit, I think that would be good for everyone.
Yeah, that makes sense. Okay, then. Thanks a lot, Daniel.
Thank you. Our next question comes from the line of Leping Huang from CICC. Please go ahead.
Okay. The first question is that I see an announcement that the cooperation between Hua Hong Semi and Hua Li. Can you share some insight how this Hua Li and Hua Hong cooperate in the future since now basically we have a full product offering from 14, 28 to 8-inch. Thank you.
Hua Li is our technology partner. It is from the point of view of the Hua Hong Group as a whole group strategy, and how to escalate the strength of both Hua Hong Grace and Hua Li. Hua Li is our technology partner. It is from the point of view of the Hua Hong Group as a whole group strategy, and how to escalate the strength of both Hua Hong Grace and Hua Li.
In the process of the cooperation, it is helpful to escalate our R&D progress.
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It is helpful to provide more capacity to our customers.
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[Non-English content] The second question is I want to know that if we look at the Hua Hong Wuxi fab two years down the road.
With two years from now, what will be the mix, roughly the mix between the technology platform, whether it is mainly the power or non-volatile memory, MCU, or will there be any new technology platform? Do you think that how Hua Hong can differentiate in this China's foundry business? Because we see quite a few fabs just newly introduced these days. Thank you.
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Our capacity in Wuxi Fab7 is mainly IC and power. At current stage, majority is IC and some very limited amount for R&D purpose for the power discrete.
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With respect of the IC, it is mainly for 90 nanometer eFlash, and going forward, 55 nanometer eFlash, 55 nanometer Logic and RF and BCD.
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By view technology development of the semiconductor industry is very fast. We are also consider some new platform strategy.
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With respect for the power management, we are aiming to continue the strength on our power discrete from the 8-inch platform.
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We want to have some shipment in the mid and high level power management.
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We'll fill our capacity as soon as possible.
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Thank you. Our next question comes from the line of Szeho Ng from China Renaissance. Please go ahead.
Oh, hi. Good afternoon, gentlemen. My question regarding the Q4 revenue guidance. Could you share some insight regarding the split or contribution from the Wuxi Fab?
Okay, Szeho. We're going to make some shipment from the Wuxi Fab. I would say roughly around $5 million-$6 million from Wuxi. The rest will all be from the three 8-inch fabs.
Okay, got you. Going down the line, when we look at the minority interest or the non-controlling stake part, any guidance for Q4?
For Q4?
Right. Yeah.
I mean, exactly what you meant?
The minority interest part. Yeah. Any guidance? Because the number has been fluctuating for the last two, three quarters.
Yeah.
So-
Well, I think in Q4, we were talking about, there's going to be some depreciation expenses. I think overall for the quarter, there will be about roughly close to $12 million depreciation expenses. There will be some revenue. There's some costs. So overall, there will be a slight loss. I hope that has answered your question.
Yes, in a subtle way. Yeah. Right. Okay. For modeling purpose, when Wuxi Fab ramping up in shape in 2020 and 2021, what would be the tax rate we should use for modeling for the entire group?
For the Wuxi Fab? For 2020?
I mean for the entire group, yeah. For the entire Hua Hong.
For Hua Hong Semiconductor, right?
Yeah.
For the combination of 8+ 12 for next year?
Right. Yep.
Are you talking about top line?
Oh, I mean their tax rate.
Oh, tax rate. I see. Wuxi, we're not going to be paying any tax for Wuxi. Even if it become profitable, for the first five years, there will be zero tax. We're going to be able to enjoy the tax holiday once the company become profitable for the next five years. And before that, assuming the company will probably be in a loss for a few years, one, two. So I would imagine there's not going to be any tax. So for the 8-inch, we're talking about roughly around 19%.
Right.
effective tax rate.
Okay. Got you. Okay. All right. Thank you, Daniel Wang.
Thanks.
Thank you. Ladies and gentlemen, that's all the time we have for questions. I'll now hand back to Mr. Daniel Wang for closing remarks.
Well, again, thank you all for joining us today, and it was a very informative conversation. We hope that you will join us again next quarter. We wish you all have a very nice day. Thank you.
Ladies and gentlemen, thank you for your attendance. You may all disconnect.