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Executives

Tzu-Yin Chiu - CEO & Executive Director

Gareth Kung - EVP & CFO

Analyst

Harlan Sur - JPMorgan Securities

Semiconductor Manufacturing International Corporation (SMI) JPMorgan TMT Conference 2013 May 15, 2013 2:10 PM ET

Harlan Sur - JPMorgan Securities

Okay, why don’t we go ahead and get started. Good afternoon. I’m Harlan Sur, semiconductor analyst here at JPMorgan. We’re very pleased to have the team from Semiconductor Manufacturing International Corp. or SMIC here with us today. We’ve got Dr. TY Chiu, Chief Executive Officer and Gareth Kung, Chief Financial Officer. Actually, the team has been responsible for driving six consecutive quarters of sequential revenue growth and four consecutive quarters of sustainable profitability, so fairly solid results in what has been a pretty difficult semiconductor environment.

I’ve asked Dr. Chiu to provide us with a brief overview of SMIC and we’ll follow that with Q&A. So, with that, let me go ahead and turn it over to Dr. Chiu.

Tzu-Yin Chiu

Okay, good afternoon. I’m very happy to be here. Let me introduce a little bit about SMIC. We are the most advanced semiconductor manufacturing service company in China. We have a global customer base, global investor base as well. Our management team is quite international. We are the publicly owned, independent and listed in Hong Kong and New York. Our last year’s revenue was 1.7 billion. This is number fourth in the pure foundry ranking, I mean pure foundry, okay?

Our technology portfolio standing from 0.35 micron to 40-nanometer and with 28 nanometer to ready for customer design by the end of the 2013, okay. So, SMIC has employee base above 10,000 and we are headquartered in Shanghai. So next time when you have a chance to pass by Shanghai, please come visit us, okay? So, this is my brief introduction.

Harlan Sur - JPMorgan Securities

Great, No, thank you Dr. Chiu. Maybe what you can do before we get started is, I was looking at your background. You’ve been in the semiconductor industry for over 29 years. Maybe you could just tell us a little bit more about yourself?

Tzu-Yin Chiu

Okay. I got my Ph.D. from UC, Berkeley and my EMBA from Columbia. For the first 12 years of my career, I worked in AT&T Bell Labs in High Performance Semiconductor Technology. After 1996, I started to work in foundry industry ever since. So I worked in small foundry like Silterra and Hua Hong EC as well as TSMC and been working with SMIC in the last two years. So, I kind of appreciate the challenges and opportunity in a foundry. So, yeah, if you have questions about the challenges and opportunity, we can discuss out for that.

Harlan Sur - JPMorgan Securities

Yeah, exactly. So, I noticed that as you were telling us your background, you mentioned a number of different other foundries that you’ve headed up and actually I think three of those foundries, it was a very successful turnaround on the leadership. So, please share with us your thoughts on what are the success factors for running a good foundry business today versus let’s say looking back five years to 10 years ago?

Tzu-Yin Chiu

Okay. I think these days; there are opportunity as was challenges. Let me first focus on the opportunities. We continued to see a strong growth in the fabless semiconductor industry. And it’s growing at a faster rate and the semiconductor industry at average, so that’s one opportunity.

Secondly, the IDMs, there are going into fab light strategy. So, this is another big growth opportunity for foundry.

But the challenges are ample as well, the IDMs, because foundry is growing at a faster rate, also than general to semiconductor. So IDMs and the foundry used to be fairly too distinct troops and now I see that IDMs are looking into opportunity to enter foundry area, so that’s one challenge.

The second challenge is that of the pace and the intensity of investments, capital investments as well as the R&D investments in the advanced technologies. So there are the opportunities and there are a lot of opportunities and there are also a lot of challenges as well.

Harlan Sur - JPMorgan Securities

So, let’s talk about SMIC specifically. Since you joined the company back in the third quarter of 2011, like I said, the team has delivered six consecutive quarters on quarter-on-quarter revenue growth with improvements in profitability as well, very impressive track record, talk about what are some of the key initiatives, key focus areas by SMIC that has enabled this kind of growth and turnaround.

Tzu-Yin Chiu

Okay. I think we have three-pronged strategies, being executed in tandem. The short-term strategy is to improve our quality service, our speed so that we can have a very happy set of customers. This will, overall objective of this short-term strategy is to really bring the loading of our fabs into full loading, okay. And we have achieved that over the last year and half and so far, the financial numbers really reflects the better operational discipline, operational efficiency of this particular short-term strategy.

The second strategy we have is the developing differentiation in our technology. In the past, most of the SMIC’s technology portfolio were a plain vanilla technology, going head-to-head with most of the other foundry competitors. ever since the new management came in, we have decided that in China, there are huge market opportunity; especially there are areas of application that is very unique to China.

Let me give you one example that is example embed novel technology. This particular technology is used in the smartcard applications. In China, there are applications in the healthcare smartcard, in the social security, in the transportation and also in the bank, credit cards. By 2015, all the credit card in China will switch from magnetic strip to a smartcard based credit card. Okay. A lot of the other applications are very, very local, very specific and there are good Chinese design hubs that can specifically tailor to these applications and we feel that by working with these very capable design hubs, we have some local advantage.

Second area that we have to point out in the past is, for example, the CIS; CMOS Image Sensors. SMIC already is the second largest CIS foundry in the world. Some of our customers, they have about 60% to 70% of market share in the feature phone. We are doing further investment in this area so that we can move from the feature phone CMOS Image Sensor into the high end 5 megapixel and 8 megapixel. So, we have recently, okay, last year, we have announced successful demonstration of our back sight illumination that is a technology in conjunction with the CIS to move into the high CMOS Image Sensor. So, these are only couple of the several other opportunities that we have in China.

So, in the second strategy, we are picking areas where there are very large applications in China and they have some local specific applications. And looking at the whole value chain, our production chain, most of it is fully in China. So, by working closely with a partner in China, we do think that we have that local advantage.

So, the third strategy is continual investments in the high end technology. So this year, we are ramping up our 40, 45 technologies and by the end of this year, we will have our 28-nano technology ready for customer design. So we will continue to focus in the advanced technology as well. So, these are some of the strategies we have to ensure our long-term profitability.

Harlan Sur - JPMorgan Securities

Can you just articulate to us what your revenue mix today is by geography and I know that the team has a focus to capture more share from the China fabless semiconductor companies and so, as you look out longer-term what sort of mix, ideal kind of geographical mix are you kind of targeting?

Tzu-Yin Chiu

Okay. The situation has been shifting quite rapidly over the last five years. At this moment, above 50% or slightly greater than 50% of revenue from last quarter is from the U.S. And the Chinese design house has grown to about 39% of our revenue. The rest of the revenue comes from Europe and the Taiwan, okay. So, I said that the things are shifting is because from 2007 to last year, the China design house has grown from about 17% of the revenue component to the overall last year, its 34% of the revenue. So a very, very rapid growth.

What’s interesting is that we are seeing the China design house able to move up the designed chain, going from the few generations behind to the most advanced technology, very rapidly during the last five years. The product and the sophistication level of the product they are designing is also moving up a lot faster. So, I say five years ago, SMIC’s technology portfolio and local Chinese design houses’ technology need are quite different. Recently as I said, in the last five years, they have been moving up that design capability so the overlap between SMIC’s portfolio and their technology is almost perfect enough. So, we are seeing that our 40-nano technology, the driver used to be only U.S. or European customers. Now, we have local driver as well. In 28-nanometer we are seeing, basically, both the U.S. as well as China customer will be driving that technology.

Harlan Sur - JPMorgan Securities

does the team have a long-term goal for – we want the China fables guys to be X% of our revenue on a go forward basis?

Tzu-Yin Chiu

Our objective is to maintain a global customer base. And we see value in maintaining both the U.S. as well as China customers. So, the China revenue will probably still grow somewhat but we think that probably they will grow up to, almost equal to that of U.S customers.

Harlan Sur - JPMorgan Securities

So we’ll get to your question. So as you continue to grow your China fabless space, I can see two ways for the team to get there. One, right, as you mentioned just the business and the success of the China fables semiconductor companies and their growth is just much faster than the overall semiconductor market right, so that’s one. But the other is keeping these customers from going through your other competitors like the TSMC or UMC or so on and so forth and so, what are the differentiators, what is it that SMIC brings to the table that makes it easier for your China-based customers to want to work with you versus working with the UMS or versus working with the TSMC?

Tzu-Yin Chiu

Okay. I think there are several advantages for our China customers, they may be much smaller a customer in light there to TSMC’s viewpoint whereas to us, there are significant partners. And also, we work because they are practically next door to us, so our feedback loop is a lot shorter and so we can resolve issues when the product ramp up a lot faster than going on a one day trip to Taiwan. So, we are actually very proud that recently our speed of bringing our customers’ product to production is much more enhanced, improved overtime. I think last year, I was reporting to some of the investors conference that our track record have shown that we are able to bring our customers a new product from tape out, from going into new tape out into the fab to production in about six months to nine months. But now, we have our track record, even down to four months from tape out to production. So that is a very, very fast cycle time for our customers and that really enhanced their competitiveness.

Question-and-Answer Session

Harlan Sur - JPMorgan Securities

Great. I think we have questions from audience.

Unidentified Analyst

[Question Inaudible]

Tzu-Yin Chiu

Okay. I think that's a very good question and we continue to emphasize that the market is so large that there are a lot of opportunity even just in the mature technology area. And we are investing in our capacity specifically to tailor our customers’ need and a lot of our customers are not asking for that bleeding edge, 40-nanometer or 10-nanometer because most of our customers is in the mobile device area as well as consumer area. And so, there are people in the server area or in the FPGA area that probably is in need of that really bleeding edge. At this moment, they are not our market segments, yes. So, we think that there are plenty of opportunities in the 28, in the 40 and even in the mature technology area.

Unidentified Analyst

TSMC to a Chinese-based company, the process in which you went public, what level of government involved and is there in terms of ownership or direction of the company?

Tzu-Yin Chiu

Okay. So, I guess, let me first answer the government ownership. I think more than 64% of our stocks are hold by international shareholders. There are three significant China shareholders. For example, (inaudible) owns 19%, there is CIC which is a sovereign fund, has about 12%. Shanghai Industrial is another also investment company, has about 6% yes. So, these are the big shareholders. Basically, they are our board members but they have no operational or management control. So the management team operates quite independently on a day-to-day basis, okay. So…

Unidentified Analyst

[Question Inaudible]

Tzu-Yin Chiu

The process of…

Unidentified Analyst

[Question Inaudible]

Gareth Kung

The company had been public since 2004 and we are listed in both Hong Kong exchange and New York Stock Exchange. Hong Kong and New York Stock Exchange, yes.

Unidentified Analyst

[Question Inaudible]

Tzu-Yin Chiu

Yes, yes. I think that in terms of our engagement with customers, the top 10 U.S. foundry are mostly our customers as was top 10 China design house are our customers. Now, we are – every quarter we got audited by the major auditing firms.

Unidentified Analyst

[Question Inaudible]

Tzu-Yin Chiu

About -- last quarter, about 39% of our business is from China.

Unidentified Analyst

[Question Inaudible]

Tzu-Yin Chiu

TSMC.

Unidentified Analyst

[Question Inaudible]

Tzu-Yin Chiu

Oh no, no, that’s much smaller.

Harlan Sur - JPMorgan Securities

Smaller, yeah. May be Dr. Chiu, what you could do is may be list some of your top customers here in the U.S. that takes advantage of your wafer capabilities?

Tzu-Yin Chiu

Oh yes. We have customers such as Broadcom, Qualcomm and TIs. We have been working with them over the last 10 years, very, very loyal and steady customers. They have helped us in developing our technology and quality systems.

Harlan Sur - JPMorgan Securities

Well, I think if I could interject here. So Broadcom I think is a good example of where, when we – I covered Broadcom and when we tend to think about a company like Broadcom, we don’t tend to think about them as leading edge. I mean, yeah, they’ve got designs that they’re focused on at 28-nanometer. But if you look at Broadcom’s core connectivity and mobile and wireless business, that’s really been the growth engine of the company. It’s actually really been more like 65-nanometer designs and so I think that’s part of what Dr. Chiu is talking about in terms of lot of companies out there, not necessarily needing a leading edge technology relying more on kind of core competencies of design expertise.

I guess, my question would be as it relates to again, sort of comparing SMIC relative to some of your competitors, talk about SMIC’s capabilities as a one-stop shop for your customers, now shop capability, is your IT portfolio and any other value add that you provide to your customers?

Tzu-Yin Chiu

Okay. I think in the last year and half, basically, a lot of our operational execution is to compress the development cycle time for our customers. And so, the fact that SMIC not only have the foundried wafer fab capability but we also make the mask for our customers. We have certain amount of testing. We have also certain amount of backend capabilities such as bumping, helps in compressing the whole production time. In addition, and in the past few years, we’ve been increasing our deign IP investments so that our IP is very complete and this can be demonstrated by the fact that our customer nowadays can come in and design using proven IP, proven in SMIC and going through using those IPs and going through what we call new tape out of process, and going through the demonstration, a lot of times, the wafer come out, first try, it is working, demonstrates that all these IPs are well proved and the fact that we are able nowadays to demonstrate major projects working within four months of NTL to production. It’s a clear data that a lot of these things in place working well and so that we can compress the whole product development cycle time.

Harlan Sur - JPMorgan Securities

Why don’t we switch over to our technology? So from a technology perspective, I was looking at your portfolio of process technology offerings and I noticed that it’s a plethora of obviously advanced digital CMOS. You’ve got, as you mentioned, image sensor processes, you have RF mix signal processes, you have embedded non-volatile and you’re starting to get into the power management space. So you offer a plethora of technologies to your customers and on the other hand, there is just consistent need to continue to drive Moore’s Law with one of your advanced digital technologies. How does the company sort of balanced that decision making process?

Tzu-Yin Chiu

Okay. I think the way we pick a particular technology to focus is first of all whether there is a customer need? Secondly, whether there is a specific application in China and that especially it gives us some specific competitive advantage. Third, also it will give us a kind of a balancing in load so that during the high seasons and low seasons, during the low seasons, we can have some of the technology have filled a fab and so to keep our loading or utilization rate at fairly high level. And so these are the combination of the considerations in our development technology strategies. So, so far, it’s being working out pretty good.

Harlan Sur - JPMorgan Securities

A question here.

Unidentified Analyst

(Inaudible)

Harlan Sur - JPMorgan Securities

So the question was to Dr. Chiu. Good growth in the white box, tablets and Smartphone markets. If Dr. Chiu has a sense for what the growth rates are in that market and how does SMIC plan to benefit form that trend?

Tzu-Yin Chiu

Okay. The non-branded product is still a significant part of the China’s semiconductor market. But these successful companies are actually transforming themselves into branded names. This is very much like PC clones in Taiwan. They move from the clone to Acers, to Asus and so nowadays we have a lot of these new branded companies that have in the past, in the Shanghai area. But, I also want to point out that we see that there is a change in the market conditions. The outside market condition indicates that a Chinese design house, it will grow at twice the rate as compared to the global design house, and this is for the following reasons.

And during the depth of financial crisis, the end users are under tremendous quasi pressure and so, by 2008 or 2009, that timeframe, we are seeing that some of these are first tiered companies, are starting to try out some of the product that’s being put out by the Chinese design house. And during that time, they find out that actually the product has a very competitive pricing but the performance and quality were actually fairly good. And so, by the 2010, you are seeing that some of this design house revenue is growing tremendously because they are breaking into new market areas such as Sony Ericson, we see some of our customers are going into Samsungs, going into HTCs and so in the past they were only in the non-branded market. Now, they are going into these local branded market.

Secondly, another area is in the local system house. In the past, system house like Huawei or ZTE, they would follow, a TCL some of the consumer guys. They would see what outside brands, what components they used and basically they would take a very little risk and just follow those traditional components. But nowadays, because of cost pressure, they are starting to use, again, the local design house. Again, so these are design houses are also breaking into the local Chinese system house. So they are keeping the non-branded market, getting into the local system house as well as the global brand. So that’s the reason they are growing tremendously fast and we are riding on that growth term. Okay, so that external factors will also help SMIC to grow in the next five years or after 10 years.

Harlan Sur - JPMorgan Securities

Great. And then, from a financial perspective Gareth, maybe you could just articulate what are SMIC’s near-term and long-term ROE targets, as well as their long-term margin targets. And if there are any CapEx requirements, major CapEx requirements required to hit our long-term goals?

Gareth Kung

Right. Even a foundry business is the capital intensive business. We think that ROE is appropriate financial measure for us to measure how we’re delivering return for our shareholders. Our near-term target is to achieve a 5% ROE and that hopefully would happen in the 12 months to 18 months. And beyond that, they will be looking at 10% ROEs. In terms of the gross margin, we have guided the market for Q2 to be 20% to 22% gross margin. Our Q1 gross margin was 20.4%. But as we – to you, our production for 40, 45 this year, we expect the gross margin will continue to improve throughout this year.

Harlan Sur - JPMorgan Securities

Great. Well, we’re just about out of time. Dr. Chiu I want to thank you very much, Gareth, thank you much for coming today. And best success for 2013.

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