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Semiconductor Manufacturing International Corporation (NYSE:SMI)

Q1 2014 Earnings Conference Call

April 28, 2014 8:30 p.m. ET

Executives

En-Ling Feng – Senior Director, IR

T.Y. Chiu – CEO

Yonggang Gao – CFO

Gareth Kung – EVP, Finance & Company Secretary

Analysts

Randy Abrams – Credit Suisse

Steven Pelayo – HSBC

Bill Lu – Morgan Stanley

Andrew Lu – Barclays Capital

Leping Huang – Nomura

Sujeeva de Silva – Topeka Capital Markets

Szeho Ng – BNP Paribas

Ken Hui – Jefferies & Co.

Gokul Hariharan – JPMorgan

Nelson Wang – Goldman Sachs

Eric Chen – Daiwa Securities

Chris Yim – Mizuho Security

Bill Lu – Morgan Stanley

Operator

Welcome to the Semiconductor Manufacturing International Corporation's First Quarter 2014 Webcast Conference Call. Today's conference call is chaired by Dr. T.Y. Chiu, Chief Executive Officer; Dr. Yonggang Gao, Chief Financial Officer; Mr. Gareth Kung, Executive Vice President of Finance and Company Secretary; and Mr. En-Ling Feng, Senior Director of Investor Relations.

Today's webcast conference call will be simultaneously streamed through the internet at SMIC's website. [Operator Instructions]

The earning press release is available for download at www.smics.com. Webcast playback will also be available approximately one hour after the event at www.smics.com

Without further ado, I would like to introduce you to Mr. En-Ling Feng, Senior Director of Investor Relations, for the cautionary statement.

En-Ling Feng

Good morning and good evening. Welcome to SMIC's first quarter 2014 earnings webcast conference call. For today's call, our CEO, Dr. T.Y. Chiu will provide some general remarks first. Afterwards, CFO, Dr. Gao Yonggang, will highlight our financial performance and give next quarter's guidance. And then our Executive VP of Finance and Company Secretary, Mr. Gareth Kung, will give the detailed financial commentary. This will then be followed by our Q&A session.

As usual, our call will be approximately 60 minutes in length. The earnings press release and the quarterly financial presentation are available for you to download at www.smics.com, 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'll be making today includes forward-looking statements. These statements and other comments are not guarantees of future performance, but represent the company's estimates and are subject to risk and uncertainty. Our actual results may differ significantly from those projected or suggested in any forward-looking statements. For a more complete discussion of the risks and uncertainties that could impact our future operating results and financial condition, please see our Form 20-F filed with the United States Securities and Exchange Commission on April 14, 2014.

Also during the call we will make reference to financial measures that do not conform to Generally Accepted Accounting Principles, GAAP. This information 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 that 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, Dr. T.Y. Chiu, for the opening remarks.

T.Y. Chiu

Thank you, En-Ling. Greetings to everyone. Today I would like to address this quarter's performance, this year's plan and our future outlook.

To begin, we are excited to see that our overall profitability has improved despite hitting a seasonal trough in the first quarter, which is our eighth consecutive profitable quarter. Even with utilization and revenue down, all our measures of profitability were improved compared to Q4 last year.

When comparing Q1 2014 to Q4 2013, gross margin increased 2.4 percentage points. Profit from operation more than tripled. Profit attributable to SMIC grew 38%. Meanwhile our capital structure also improved as our debt to equity ratio decreased 6.7 percentage points.

We have gone through up seasons and we have gone through down seasons and SMIC has demonstrated the ability to maintain profitability throughout. We continue to emphasize the priority of sustained profitability and carefully planned growth. Overall we are optimistic about 2014 as we prepare our capacity and technology for many new and exciting opportunities.

[Indiscernible] we see our first tape-out from some of our customers [indiscernible] product tape-out from one of our customers [indiscernible] 40-nanometer by the end of 2014 to ramp up and revenue generation is expected in 2015. We believe our progress on 28-nanometer is in line with some of our customers targeting to capture the LTE handset IC market in China. Our 28-nano technology is now also expanding to RF applications.

Our 40/45 revenue decreased in the first quarter, but we believe we are seeing the beginning of a recovery in the second quarter. Meanwhile, we are seeing a strong new tape-out and a new 40 nano product for Wi-Fi, Bluetooth, smartphones, tablets, DTV and other new tape-out continue. And we expect a number of such products to enter production this year. This will enrich the product portfolio in our 40 nano offering and the expansion of products and customers will reduce the volatility in the future. We continue to target overall mid-teen percentage revenue contribution from 40 nano this year.

When looking at our differentiated products, SMIC has been experiencing a very strong demand for 8-inch production capability -- capacity sorry. We have made advancements in new feature offering on special technologies.

To highlight recent achievements, we have made good progress in fingerprint sensor technology and CMOS MEMS technology which are both now in production. Power management IC also continued to see large demand and new -- from new and existing customers. PMIC, CIS and our non-volatile memory technology now accounts for more than one-third of our wafer revenue and has a compounded annual growth rate of about 40% in the past four years.

To respond to the strong 8-inch customer demand, we have been pushing up the capacity of our existing facilities and launching our Shenzhen fab. For our existing fabs this year, our plan is to expand our Shanghai 8-inch fab from the current 94,000 wafer per month to 96,000 wafer per month, and our Tianjin 8-inch fab from 37,000 per month to 39,000 per month.

We are also excited to announce that we have secured sufficient used equipment for our Shenzhen fab. And we target 10,000 wafer per month capacity installed in Shenzhen by the end of this year to be ready for production in 2015.

Also this year, our new Beijing majority-owned subsidiary also plan to install 5,000 to 6,000 wafer per month capacity by the end of this year.

We continue to have a positive outlook on China semiconductor market. Situated in the world's largest consumer ICs, SMIC's position in China allows us to benefit from China's policy which encourages the growth of Chinese domestic IC industry. With the launch of LTE in China, SMIC is working with customers to provide ICs required for LTE handsets. And as China's bankcard adopts IC solutions, we are collaborating with China's design house to capture this new market opportunity. Revenue from China now accounts for more than 40% of our total revenue.

To conclude my remarks, the first quarter was a low quarter due to seasonality and inventory correction. However, we have improved our profitability and SMIC has demonstrated eight quarters of continuous profit over high and low seasons.

As is reflected in our guidance, we believe we are positioned for a robust recovery in the second quarter and are optimistic about the second half of this year. We continue to have confidence in our strategy to capture growth opportunity in China. We will work diligently with our new and existing customers to capture opportunities in 2014 and onwards to build value for all our stakeholders.

Thank you for your time, and I will hand over the call to Yonggang for financial highlights and the Q2 guidance.

Yonggang Gao

Thank you, T.Y. Greetings to all our listeners. I will now highlight our first quarter results and second quarter guidance.

Revenue was $451.1 million in 1Q 2014, a decrease of 8.3% quarter over quarter and a decrease of 6.7% quarter over quarter when compared to the non-GAAP revenue, if excluding wafer shipments from Wuhai Xinxin.

Gross margin was 21.3% in 1Q 2014 compared to 18.9% in 4Q 2013 and compared to the non-GAAP gross margin excluding wafer shipments from Wuhan Xinxin of 19.2% in 4Q 2013. Profit from the period attributable to SMIC was $20.3 million in 1Q 2014 compared to the $14.7 million in 4Q 2013.

Looking ahead into the second quarter of 2014, revenue is expected to increase 12% to 15% quarter over quarter. Gross margin is expected to range from 22% to 24%.

Non-GAAP operating expense excluding the effect of employee bonus accrual, funding of R&D contracts from the government and the gain from the disposal of living quarters are expected to range from $89 million to $93 million.

I will now hand the call over to Gareth for a more detailed financial commentary.

Gareth Kung

Thank you, Gao-sung [ph] and thank you everyone for joining us today. I will now comment on the details of our financial results.

On the income statement, revenue decreased in the first quarter of 2014, mainly because of, one, a decrease in wafer shipments; two, the absence of revenues from Brite semiconductors as we have deconsolidated Brite due to loss of control on December 30, 2013. Also revenue from Wuhan Xinxin was zero in Q1 2014 compared to $8.2 million in Q4 2013. There will not be any wafer shipments from Wuhan Xinxin going forward.

Cost of sales decreased to $355 million in Q1 2014, down 11% Q-on-Q from $398.9 million in Q4 2013, mainly due to a decrease in wafer shipments and lower provision for customer claims.

As a result of these reasons and also due to product mix change and the improvement in the fab efficiency, gross margin increased to 21.3%, up from 18.9% in the previous quarter, despite a drop in the fab utilization.

Operating expenses in Q1 2014 were $66.5 million compared to $84.8 million in Q4 2013. R&D expenses decreased to $36.7 million in Q1 2014 from $46.3 million in Q4 2013, mainly due to an increase in the funding of R&D contracts from the government which was $11.7 million in Q1 2014 compared to $4.7 million in Q4 2013. General and administrative expenses decreased to $23.2 million in Q1 2014, down 36.6% Q-on-Q, from $36.6 million in Q4 2013, mainly due to one, a decrease in bad debt expense, two, a decrease in accrued employee bonus, and three, a decrease of government charges.

Other operating income was $3 million in Q1 2014 compared to $6.4 million in Q4 2013. The change was mainly due to gain arising from the -- gain arising from the deconsolidation of Brite due to loss of control recorded in Q4 2013. If excluding the funding of R&D contracts from the government, gain from the disposal of living quarters and employee bonus accrual, the non-GAAP OpEx was $79.4 million in Q1 2014 compared to $86.5 million in Q4 2013.

Profit from operations in Q1 2014 was $29.6 million compared to $8.1 million in Q4 2013.

Other expenses was $9.2 million in Q1 2014 compared to an income of $7.8 million in Q4 2013. The change was mainly due to foreign exchange losses arising from the devaluation of RMB against U.S. dollar in Q1 2014.

Moving to the balance sheet at the end of the first quarter 2014, total current assets decreased 8%. Meanwhile, total current liabilities decreased 9% [ph], translating into a slight improvement in our current ratio. Other financial assets decreased to $170.4 million in Q1 2014 from $240.3 million in Q4 2013, mainly because some short-term investments matured.

Our long-term borrowing decreased $89 million and our short-term borrowing decreased $77.4 million compared to the previous quarter. At the end of Q1 2014, our total debt to equity ratio decreased to 38.5% compared to 45.2% in the previous quarter.

In terms of cash flow, we generated 196 -- we generated $169.4 million cash from operations in the first quarter of 2014, compared to $205.4 million in the fourth quarter of 2013. Cash used in investment activities decreased to $204.9 million in Q1 2014 compared to $269.1 million in Q4 2013, mainly because of additional short-term investments made in the previous quarter.

Cash flow from financing activities changed from an inflow of $52.7 million in Q4 2013 to an outflow of $168.4 million in Q1 2014, mainly because we repaid some short-term borrowings. Cash and bank balances at the end of the first quarter 2014 was $437.6 million compared to $462.5 million in the previous quarter.

To examine our revenue by application, the consumer segment was our biggest contributor to revenue this quarter. Revenue for this quarter contributed 48.8%. Revenue from communications contributed 39.1%. Geographically, revenue from North America contributed 46.6% of our total revenues. Revenue from China contributed 40.6% of total revenues. Eurasia contributed 12.8%.

In terms of technologies, revenue from 45/40 node contributed 9.8%. The drop in the revenue contribution from the 45/40 node was mainly due to inventory correction and seasonality. Revenue from the 65/55 mode and 90 nanometers decreased 4.6%. Meanwhile, revenue from 0.13 micron and above was flat quarter over quarter.

In terms of our overall capacity, total monthly capacity at the end of the first quarter was 243,500 wafers compared 234,000 in the fourth quarter. The change was due to the expansion in capacity in our Shanghai 12-inch fab and our Shanghai -- Tianjin 8-inch fab. The overall utilization was 84.2% in the first quarter of 2014 compared to 87.4% in the fourth quarter of 2013.

The planned 2014 CapEx for our foundry operations are raised to approximately $1 billion from the previous $880 million. The increase in CapEx is for the purchase of used equipment for our Shenzhen 8-inch fab. Of the total CapEx of approximately $1 billion, around $570 million is for our Shanghai -- is for our Beijing joint venture fab which is 55% funded by SMIC and 45% funded by the other shareholders. In addition, we have budgeted CapEx for non-foundry operation of approximately $110 million, mainly for the construction of the employee living quarters.

I will now hand the call back to En-Ling for the Q&A session.

T.Y. Chiu

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 questions per person. Thank you. And operator, please assist.

Question-and-Answer Session

Operator

Certainly. [Operator Instructions]

Your first question comes from the line of Randy Abrams from Credit Suisse. Please go ahead.

Randy Abrams – Credit Suisse

Thank you. The first question I wanted to ask, on the 40-nanometer business, where you mentioned the decline was due to inventory and seasonality. I just want to see now, looking forward, the view and I think snapback from there, like from seasonality reversing and getting past inventory correction.

And if you could talk more about the design wins. I'm not sure if I heard it correctly. Is it one high volume Wi-Fi win for multiple applications or is this multiple design wins? But if you could I guess give a look at how 40 will ramp and kind of scope of design wins.

T.Y. Chiu

Okay. Hi Randy. Thanks for the question.

I think the 40-nano we are seeing a robust recovery in the quarters to come. There are a number of design wins and new products going into production, which include a very high volume of Wi-Fi, as well as the coupled baseband products.

And so we are also seeing a very strong NTO. Our new tape-out for the first two quarters is almost equal to the whole last year's tape-out. So we see this new tape-out trend continue throughout this year. So it will give us a much wider product portfolio and we will be having also a much wider customer base. And so this will definitely look [ph] to reduce the volatility due to a smaller number of customer base.

Gareth Kung

Just to add on what T.Y. say, I think we are still targeting above mid-teens revenue from this node for the whole of 2014.

Randy Abrams – Credit Suisse

Okay, great. And my second question, maybe moving on from that, I think when you look at 2015, I'm curious when you look at the year, if you think 40 would continue to grow into next year as a percent of sales or from next year, I think from customers you're seeing a lot more shift to 28? And if you could talk within 28, is it now moving more to High-K metal gate or do you see equal strength or strength still for PolySiON as well for 28 and how significant you think 28 versus 40 could be next year?

T.Y. Chiu

Okay. We see that there are still a lot of new tape-out in 40, and so in that sense we continue to think that the 40 amount will be good streaming of new product and customers. As far as the 28 is concerned I think roughly 50/50 -- it's a 50/50 split. So we have just as much customer interest in PolySiON as well as the High-K metal gate. And so that's why we were actually quite happy that we have both technology to offer to -- for our customers.

Randy Abrams – Credit Suisse

If I could ask a quick follow on. For the 28, will High-K come after PolySiON or at the stage where you come in would you be able to have product and revenue for both or is there a delay for the High-K?

T.Y. Chiu

Our technology ramping up is roughly the same, that we do not, you know, they are only months apart. However, the first product to ramp indeed is the PolySiON.

Randy Abrams – Credit Suisse

Okay, great. Thank you.

Operator

Your next question comes from the line of Steven Pelayo from HSBC. Please go ahead.

Steven Pelayo – HSBC

Yes. First just a follow-up, 40-nanometer was less than 10% of revenues in the first quarter and you're talking about mid-teens, so I guess that would imply you're going to have a quarter above 20%. So maybe your visibility is into the second half of the year, but just looking at the second quarter, is 40-nanometer going to be able to snap back to a mid-teens run rate, so we can get the full year kind of on that trend? Or what are we thinking about just for second quarter 40-nanometer contribution?

T.Y. Chiu

Yes, I think for the second quarter we think there'll be recovery in our 40 nano revenue to the mid-teens level.

Steven Pelayo – HSBC

Okay, so it is that sharper snapback. Okay, great.

And then the gross margin upside in the March quarter, I think you guys had originally guided to 16% to 19%, if I remember correctly. So there was a couple of 100 basis points. And I understand you guys talked about a few different things here. But one would have expected I think with the 4X node falling off that margins would have had much, much more pressure. So can you maybe help us quantify what really drove -- how much came from lower provisions for customer claims, how much came from product mix? Some more details behind that? Because I must admit your margins are quite good and I just need a little bit more clarity on how we arrived at that.

Gareth Kung

Well, a number of things happened in the first quarter impacting our gross margin. I think in terms of importance, the product mix change is one. The other one is the lower claim for the customer -- lower customer claim, and also our fab has been a lot more efficient in the first quarter, that bring down the cost. Now cost, you know, the negative impact from gross margin is on the, you know, as we mentioned, the drop in the fab utilization. So all together, it came out that actually with impact on our gross margin than what we thought.

Steven Pelayo – HSBC

Okay. If I could just sneak in one more follow-up on the 40-nanometer, I did see that your Shanghai 300 millimeter fab capacity I think increased about 15% or so. So that must mean your utilizations were significantly lower. So I'm curious, where is that fab running and where do you expect it to be in the second quarter if it's I guess mid-teens percentage of the revenue?

Gareth Kung

Actually we don't break down the utilization by fab or by node. But obviously the utilization was lower in Q1, but we, as I mentioned, we do see a recovery in Q2.

Steven Pelayo – HSBC

Okay, I'll get back in the queue. Thank you.

Operator

Your next question comes from the line of Bill Lu from Morgan Stanley. Please go ahead.

Bill Lu – Morgan Stanley

Yes, hi. Good morning. On the Shenzhen fab, you talked about the client used equipment that will ramp in 2015. Can you talk about, as that fab begins to ramp, is the gross margin going to be comparable to your other 30-inch fabs? What node is that equipment going to be good for?

T.Y. Chiu

Hi, Bill. Thanks for the question. As we ramp, and we see that this particular 8-inch fab will achieve the corporate margin quite soon after the ramp and this is an advantage of the used equipments. Yes, I think that's -- what technology that we are preparing to ramp. Okay.

The equipments, we have equipments that is fully capable for down 0.13, 0.11. And there are actually some clearly advanced equipments that can bring the lithography capability below 0.11. So we have at this moment quite a mix of products that will go into Shenzhen that probably requires 0.13 and above technology.

Bill Lu – Morgan Stanley

Great. Sorry, I should probably know this, but I don't. For used equipment, how many years do you depreciate?

Gareth Kung

We have the same policy of our existing 8-inch fab which is using five years -- six years I'm sorry.

Bill Lu – Morgan Stanley

Okay. My second question is, did you disclose China as a percentage of the revenues for 1Q? I'm curious if you can give us some hints for 2Q as well.

Gareth Kung

Yes, the China revenue contributed about 40% in the first quarter. We do expect the contribution from China will remain around the same percentage in the second quarter.

Bill Lu – Morgan Stanley

Okay, so China kind of growing in line with the non-China regions in 2Q.

Gareth Kung

That's correct.

Bill Lu – Morgan Stanley

If you look at the ramp at 40, is that really more China-driven or non-China driven?

T.Y. Chiu

Actually right now we're seeing that in both our 40 as well as 28 they are driven equally from the global -- our global customers as well as our domestic customers. So we have a fairly wide spectrum of customers from both sectors.

Bill Lu – Morgan Stanley

Okay, great. Thank you very much.

Operator

Thank you. Our next question comes from the line of Andrew Lu from Barclays. Please go ahead.

Andrew Lu – Barclays Capital

Thank you. Good morning. Two questions for me. Earlier you guide the first quarter operating expenses $88 million and $92 million and now it's $70 million. So what's make a big gap from the guidance versus the actual result?

Gareth Kung

Yes. What we have said, we do have -- we have been through tight cost control in the first quarter. So in fact so both our R&D expenses and G&A expenses all came down below our budget. So --

Andrew Lu – Barclays Capital

Shouldn't be the cost control should be in the guidance already?

Gareth Kung

Well, yes. But I think we did -- we are more aggressive than what we planned for.

Andrew Lu – Barclays Capital

So isn't the second quarter guidance again to be conservative, $89 million to $93 million operating expenses?

Gareth Kung

Yes, I think -- so what happened is that I think if you look at our past record, I think we have been quite conservative in the way we guide, yes.

Andrew Lu – Barclays Capital

So, should we just take a more conservative number rather than $89 million to $93 million for modeling purpose?

Gareth Kung

I think you should stick to our guidance, yes. We want to surprise -- no, we want to beat our guidance.

Andrew Lu – Barclays Capital

Okay.

T.Y. Chiu

Andrew, also in our guidance, our guidance specifically spelled out, it does not including the R&D funding and does not including some -- yes.

Andrew Lu – Barclays Capital

Yes, yes. Second question I have is the depreciation cost. Earlier you guide about $20 million at above 3.7% year-over-year increase, but that's based on $880 million CapEx, seems that the CapEx is being revised up. Are we going to see the change on depreciation cost?

Gareth Kung

I don't think so, because actually the increase in the CapEx mainly for the purchase of the used equipment for a Shenzhen fab, and for that portion of CapEx, because the production will only start only in 2015, so it would not impact the current year depreciation.

Andrew Lu – Barclays Capital

So, we still use a $20 million add compared to last year.

Gareth Kung

That's right. Yes.

Andrew Lu – Barclays Capital

Thank you.

Operator

Our next question comes from the line of Leping Huang from Nomura. Please go ahead.

Leping Huang – Nomura

Thank you for taking my questions. Just one question. Can you comment on the -- your customers' inventory correction situation. I mean in Q2 has this already finished or did you guide for the recovery of your 40 nano process. Have you seen your -- basically your customer already finished order inventory correctly issue? Thank you.

T.Y. Chiu

Hi, Leping. Thanks. Yes, indeed, we are seeing a fairly robust customers demand and so in most of the part, we think that our customers have come through and burned out their inventories and, so this is what we are seeing second quarter and the third quarter.

Leping Huang – Nomura

Okay, thank you.

Operator

Your next question comes from the line of Sujee de Silva from Topeka Capital. Please go ahead.

Sujeeva de Silva – Topeka Capital Markets

Hi, good morning. Thanks for taking the question. A couple of maybe detailed questions on the 40 nanometer. Last quarter you gave 10 tape outs and four to five additional customers, can you give those same metrics for the current -- for the quarter you just reported?

T.Y. Chiu

I think it's also -- let me see, let me check the number exactly, okay? Okay. Yes, first quarter we will have 10 tape-out as well.

Sujeeva de Silva – Topeka Capital Markets

And about four to five additional customers?

T.Y. Chiu

Additional customers, let me see. I'm actually aware of at least two in my mind and there may be other smaller customers I do not know myself.

Sujeeva de Silva – Topeka Capital Markets

Okay. I appreciate that detail. And the second question is around the revenue per wafer. It's down sequentially in year over year. What are the puts and takes there for revenue per wafer as we progress through the rest of the year given that you're ramping the high-end and the trailing edge? Thanks.

Gareth Kung

Yes, I think the drop in the ASP per wafer in Q1 is because of the lower contribution from the 40/45 node. But as we mentioned, we're going to see some recovery in terms of the revenue contribution from that node from Q2 onwards. So, we do expect the ASP per wafer increase in second quarter and remain stable throughout this year.

Sujeeva de Silva – Topeka Capital Markets

Okay. Thank you guys.

Operator

Your next question comes from the line of Szeho Ng from BNP. Please go ahead.

Szeho Ng – BNP Paribas

Hi, good morning, gentlemen. Could you give us some update on the JV, the rate of bump in JV with J-Set [ph] in terms of the amount to be spent, capacity scale and also the timing of ramp up?

Gareth Kung

Okay, I'll comment on the spending and ask T.Y to comment on the progress.

T.Y. Chiu

Sure.

Gareth Kung

For the JV, the total investment, $150 million, of which about $50 million will be from the capital contribution, and we own 51% of the JV. So we'll contribute about $26 million to the capital of this JV.

T.Y. Chiu

Okay. Right now this JV, the whole plan is going through the government approval process and so we hope that everything is smooth and so we can start the installation by the end of the year, but as in the government approval process, sometimes the whole timing is difficult to predict.

Szeho Ng – BNP Paribas

Okay. And that installation would be in which fair location?

T.Y. Chiu

At this point of time, we are not ready to disclose until the government approval is fully granted.

Szeho Ng – BNP Paribas

Okay, all right. And my next question on CapEx, could you comment about your quarterly and impact for this year, because Q1, your CapEx is definitely quite low. So more clarity from you would be helpful, yes.

Gareth Kung

Yes, I think the [indiscernible] would be probably you would see more of the CapEx in the second half because of the -- a lot of this CapEx for the B2, Beijing fab. So more will happen in second half.

Szeho Ng – BNP Paribas

Okay. Any number, ballpark number in terms of the split between first half, second half?

T.Y. Chiu

I think probably you're talking about, at least about 60% in second half.

Szeho Ng – BNP Paribas

Okay. Okay, all right. Thank you very much. Nice quarter. Yes.

Operator

Your next question comes from the line of Ken Hui from Jefferies. Please go ahead.

Ken Hui – Jefferies & Co.

Thank you for taking my questions. First of all, again on 40 nanometer, as you rent your production throughout the year, what is your expectation on the 40 nanometer gross margin as you exit this year compared to corporate average? This is my first question.

Gareth Kung

Yes, in terms of 40 nanometers, right now we're still in the course of ramping the production. So the gross margin is a bit lower. But we do expect the gross margin to improve as we bring up the fab and achieve a high utilization.

Ken Hui – Jefferies & Co.

So, would you expect the gross margins on 40 to be on par with corporate average or you compared to the corporate average by end of this year?

Gareth Kung

Likely.

Ken Hui – Jefferies & Co.

Okay, thank you. And then second question, as you have raised your CapEx budget for this year, do you see higher pressure for your cash position?

Gareth Kung

As mentioned in our my management script, I think we a have very strong position right now both in terms of cash balances and also our debt equity ratios. So, for the current year CapEx I think we can fully fund it with our current financial resources.

Ken Hui – Jefferies & Co.

Okay, thank you very much.

Operator

Your next question comes from the line of Gokul Hariharan from JPMorgan. Please go ahead.

Gokul Hariharan – JPMorgan

Yes, hi. Thanks for taking my questions. My first question is on the 8 inch capacity progress in Shenzhen. So, now that you have 10K ready by end of this year, could you also outline how do you plan to ramp it up further from 10K or is it around 10K that you'll peak out? And I have a follow-up question also.

T.Y. Chiu

Okay, at the moment we have sufficient equipments, used equipment to go up 90K -- to go up to 30K and with only a very small amount of the shortage we still need to acquire.

Now some of the used equipments will have sufficient capacity to go up to 50K. So anyway, that is a longer term -- our longer term target. So in Shenzhen, we still target eventually to go up to 50K.

Gokul Hariharan – JPMorgan

Okay, and given that a lot of the spend is coming towards the end of this year, in I think the CapEx that you see it as seems to be above EBITDA levels. Could you talk a little bit about how we should think about depreciation next year? Is that a big step up from this year level? Is it like 10%, 15% step up from this year levels in terms of depreciation expense next year?

Gareth Kung

Obviously if you look at our CapEx this year, we do think there will be a slight increase in our depreciation in 2015, yes.

Gokul Hariharan – JPMorgan

So, would that be a slight increase or is it like a 10%, 15%, that kind of increase, given that most of the capacity will come online next year and you'll probably start to depreciate them?

Gareth Kung

I don't have either number with me because the CapEx will contribute to the high depreciation, at same time it's being offset by some of this existing equipment that will go offline next year. But we can get back to you later on, on this point, yes.

Gokul Hariharan – JPMorgan

Okay, thank you.

Operator

Your next question comes from the line of Nelson Wang from Goldman Sachs. Please go ahead.

Nelson Wang – Goldman Sachs

Hi, this is Nelson. My first question is about the Beijing new fab. I think you mentioned about 5,000 to 6,000 by the end of this year, and I was just wondering how about the capacity expansion for next year and I saw there was a news saying that the new fab will achieve 35K and do you think this is the goal for next year? Thank you.

T.Y. Chiu

Yes. Next year we will have continue to ramp. But this 35,000 wafer is a ramp over three -- around three years' timeframe. So, it's a paced ramp unless there is a significant increase in customer demand. So, in the short term that too this year we will ramp to 6K and we have a customer demand to ramp further 4K now sometime next year. But overall, to achieve the 35K, that's over above three years' timeframe.

Nelson Wang – Goldman Sachs

Okay, sorry, so you say additional 4K next year, right?

T.Y. Chiu

Yes, we can already see additional 4K, yes.

Nelson Wang – Goldman Sachs

Okay. And I think my next question is about the gross margin because I saw that the utilization rate has been decreasing, but the gross margin has been increasing and you already mentioned this is due to the products mix change and some like lower customer claims, and do you think this is ongoing slightly trend or this is just a one-time event because your utilization is really highly correlated with gross margin, but with such a low utilization like -- sorry, relatively lower utilization you achieved a relatively higher gross margin. So just wondering is this a one-time event or an ongoing trend?

Gareth Kung

Yes, our outlook right now we are quite hopeful about in terms of the business recovery from Q2 onwards. So, we are hopeful that our gross margin should continue to improve throughout this year.

Nelson Wang – Goldman Sachs

Okay, okay. Thank you.

Operator

Your next question comes from the line of Leping Huang from Nomura. Please go ahead.

Leping Huang – Nomura

Okay, thank you to take my question. So my question is, I see a big jump of your R&D the government subsidy which -- can you comment on what's your guidance for this year, for the full year and do you see a continuous, I mean what's the trend of the R&D the government grant looking forward 2015. It seems in the financial statement, in your annual report, I see you have $140 million recognized R&D subsidy, also can you comment on. So can we in the future two to three years, when you fully ramp up the 28 nanometers, can we assume that this will be fully recognized on your P&L? Thank you.

Gareth Kung

Okay, let me get back to you on your question about the R&D funding be recognized on income statement. In 2013, we recognized about %28 million R&D funding on an income statement and for 2014, we do see a slight increase this year. I think for the modeling purpose you should model about $30 million or $35 million that will be recognized on income statement. Okay.

On the -- on your question of what you see on our annual report, $140 million, this is the whole amount of the cash that we received from the government in terms of the funding, but because some of this actually for the purchase of equipment, and in terms of recognition on the income statement, not a full amount will be recognized on income statement. So there is some differences in the accounting treatment, so we should pay attention to.

Leping Huang – Nomura

Okay. Can you also, since there is lot of articles say the government are increasing the government support on the IC industry, do you think -- have you seen the actual benefit to your business, to your panel, from this government policy? Also, we also -- another related thing is, I think you set out a venture capital to do the I thin IC capitals, can you comment on what's the purpose or what's the objective of this IC venture capital. Thank you.

T.Y. Chiu

Okay. Let me answer on this question. So, we also have been seeing a lot of pressure on this potential new government policy. We welcomed any government policy that encourages R&D and encourages a robust semiconductor business in China. At this moment, this is a policy and we have not seen the actual implementation of this policy as yet. Therefore we have not actually received any direct benefit from this policy at this moment.

And as far as the venture is concerned, that we have set up this venture actually to complete, to encourage the completeness of the semi-conductor ecosystem here in China. So we'll be trying to do some small amount of the investments in companies that's on both the upstream as well as downstream from the foundry as well as potentially in some of the mute enterprises that come up around semiconductors. So this is actually to encourage a robust semiconductor ecosystem. I don't know whether Gao-sung [ph] has anything to add.

Okay. Thanks.

Operator

Your next question comes from the line of Eric Chen from Daiwa. Please go ahead.

Eric Chen – Daiwa Securities

Hi, good morning. I've got two questions. The first, the [indiscernible] you are talking about ecosystem, and you're talking about the SMIC probably will do some investment, and then from a sound semiconductor company. And could you give us an idea the income of the year [indiscernible] the investment size and how much money you plan to put in, and also the direction on what kind of company are you looking to have a more cooperation or more investment, and what kind of the product, the area? And then that's my first question.

Gareth Kung

Okay, I'll comment on the funding side. I'll ask T.Y. to comment on the directional investment.

We have incorporated a new subsidiary call capital corporation which is mainly for the venture investment. The initial capital we have set up is RMB500 million. Right now potentially we can attract more capital from third parties in the future, but initial investments from us is RMB500 million.

T.Y. Chiu

Okay. As I have said --

Eric Chen – Daiwa Securities

Okay. I'm sorry. That's the total fund size, right, from SMIC --

Gareth Kung

No, that is the amount that we have put into the fund as an income investor. But we do expect we get more investment from the third parties.

Eric Chen – Daiwa Securities

Okay. What kind of third party you're talking about? Is it local venture capital or any [indiscernible] you're talking about --

Gareth Kung

That could be from a number of sources. That could be from a number of sources, from government or from other interested parties.

Eric Chen – Daiwa Securities

I see. Okay, thank you. And then [indiscernible] please.

T.Y. Chiu

Yes, I think that we are at the initial stage on investigating on what are the targeted -- our investment targets. Potentially that includes various hardware to -- the parts producers and as well as the for example potentially design service area and also potentially mute startup, with the new technologies. And so this is a fairly wide potential investments around semiconductor areas.

Eric Chen – Daiwa Securities

Okay, the [indiscernible] that you're talking about the start of the new technology. Can I assume that's the IC design house and the local IC design house and mainly you're talking about, right?

T.Y. Chiu

There are -- I think IT design house is part of the potential portfolio, but there are many others such as, as I said, chemical suppliers, parts suppliers that will help to complete ecosystems in China.

Eric Chen – Daiwa Securities

Okay, and [indiscernible] how you balance the or say how you handle the conflict of interest for the [indiscernible] you do the sound investment, probably [indiscernible] but for the other semi -- local semiconductor maker, they probably will have a [indiscernible] and that because of conflict of interest. So how you handle this kind of conflict of interest and from your SMIC investment? Thank you.

T.Y. Chiu

Okay. Yes, I think that we are keeping away from this kind of issues and SMIC will not take any controlling stake and we will keep our investment slow and this type of similar investment fund are fairly common in the foundry industry, so that all of us feel the same thing but all of us have the same intention to encourage the activity of various innovations in this industry.

Eric Chen – Daiwa Securities

Okay, I see. Thank you. My second question regarding to the CapEx that probably means the how much money for full year 2014 CapEx, is that $1.1b and I would like to get an idea for the CapEx number this year and also the depreciation expenses, how many percent year-on-year growth and also about a capacity wise and how many percent year-on-year growth. Thank you.

Gareth Kung

Yes, in terms of the total CapEx for 2014, for the foundry operation as I mentioned has been raised to $1b and we have budgeted $110 million for the non-foundry operation. So, altogether it's about $1.1b for the current year CapEx. In terms of the depreciation for this year compared to 2013, in 2013 is about $545 million in terms of depreciation. And for this year, we are looking at about $560 million.

Eric Chen – Daiwa Securities

So, more like the 5% year-on-year growth, right?

Gareth Kung

Yes.

Eric Chen – Daiwa Securities

Okay. Then how about the capacity expansion, how many percent year-on-year growth? Thank you.

Gareth Kung

Yes, comparing 2014 against 2013, the growth is about 8.5%.

Eric Chen – Daiwa Securities

Okay, 8.5%.

Gareth Kung

For the annual capacity.

Eric Chen – Daiwa Securities

Okay. So I remember you also mentioned the revenue per wafer will rebound from second quarter and will have a quarter-on-quarter growth sequentially on yearend. So, I assume the revenue per wafer this year will have the positive year-on-year growth and based on your capacity, the 8.5% year-on-year growth, that pretty much can get to an idea why is your gross margin will improve and from a year-on-year point of view, the other one is your revenue growth is highly likely to reach over 10% year on year and once your utilization rate now decline, right? Does that make sense for you?

Gareth Kung

Yes, I think so far I think you're right. But to correct on point, in terms of the ASP, what I mentioned is that because of the recovery of the 40, 45 node revenue in Q2, so we should see a recovery in our ASP per wafer in Q2 and then for the rest of the year, we should be relatively stable.

Eric Chen – Daiwa Securities

Okay, how about year-on-year base? Can I assume that growth?

En-Ling Feng

Eric, you have more than two, three questions now.

Eric Chen – Daiwa Securities

Okay. I'm sorry.

En-Ling Feng

We need to go to the next one.

Eric Chen – Daiwa Securities

Okay, thank you.

Operator

Your next question comes from the line of Chris Yim from Mizuho Security. Please go ahead.

Chris Yim – Mizuho Security

Hi. Thanks for taking my question. Only got one question, on your China LTE ramp-up outlook. Can you give me more color as to what type of products, what type of semiconductor components, so for the customers you see demand from and just in general, as we look at more color on this new demand driver. Thanks.

T.Y. Chiu

Yes, we are actually looking forward to the LTE opportunities. There are among our customers who are very strong in the baseband in the power management and as well as the RF as well as the CIS. So, we see that the LTE ramp in China will benefit as my fee in the next few years.

Chris Yim – Mizuho Security

Okay, thank you.

Operator

Your next question comes from the line of Bill Lu from Morgan Stanley. Please go ahead.

Bill Lu – Morgan Stanley

Yes, hi. Dr. Chiu, just one quick question. Can you talk about your outlook beyond 28 nanometers? I think some people in the industry are talking about 20 as more of a transition node and maybe 14/16 being more long lived. How do you think about that?

T.Y. Chiu

Okay. Right now we are focusing very much on the 28 ramp up. Beyond 28, we already have effort in doing our 14, 16 FinFET. So this is our two major R&D effort in terms of the advanced technology work.

Bill Lu – Morgan Stanley

So, I see you're doing 14 and 16?

T.Y. Chiu

No, this is FinFET, so it's only one generation.

Bill Lu – Morgan Stanley

Okay. So are you doing 14 or 16? I'm sorry.

T.Y. Chiu

Fourteen.

Bill Lu – Morgan Stanley

Okay. I guess related to that, how does the tie up in global foundries Samsung effect you at 40 nanometers?

T.Y. Chiu

Well, no we do not try to comment on the -- our competitors' activity and so at this moment we are still proceeding our direction fairly steadily.

Bill Lu – Morgan Stanley

Okay, great. Thank you.

Gareth Kung

Thank you.

Operator

I will now like to hand the call back to CEO, Dr. Chu for closing remarks.

T.Y. Chiu

In closing, I would like to thank everyone who participated in today's call and again, thank all of our shareholders, customers, employees and the suppliers for their trust and their support. Thank you. See you next time.

Operator

This is the end of SMIC's first quarter earnings call. We thank you for joining us today.

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