Semiconductor Manufacturing International's (SMI) CEO Tzu-Yin Chiu on Q2 2014 Results - Earnings Call Transcript

Semiconductor Manufacturing International Corporation (NYSE:SMI)

Q2 2014 Earnings Conference Call

August 7, 2014 8:30 PM

Executives

En-Ling Feng – Senior Director, Investor Relations

Tzu-Yin Chiu – Chief Executive Officer

Gao Yonggang – Chief Financial Officer & Executive Vice President, Strategic Planning Executive Director

Gareth Kung – Executive Vice President, Finance & Company Secretary

Analysts

Randy Abrams – Credit Suisse

Daniel Heyler – Bank of America Merrill Lynch

Steven Pelayo – HSBC

Ken Hui – Jefferies & Co.

Chris Yim – Mizuho Securities Asia Ltd.

Gokul Hariharan – JPMorgan Securities

Leping Huang – Nomura

Sze Ho Ng – BNP Paribas Securities

Operator

Ladies and gentlemen, thank you for standing by. And welcome to Semiconductor Manufacturing International Corporation's Second Quarter 2014 Webcast Conference Call. Today's conference call is hosted by Dr. T.Y. Chiu, Chief Executive Officer; and Dr. Yonggang Gao, Chief Financial Officer; Mr. Gareth Kung, Executive Vice President of Finance and Company Secretary; and Mr. En-Ling Feng, Vice President of Investor Relations.

Today's webcast conference call will be simultaneously streamed through the internet at SMIC's website. Please be advised that your dial-ins are in a listen-only mode. However, at the conclusion of the management presentation, we'll be having a question-and-session, at which time you will receive further instructions as to how to participate.

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

Without further ado, I would like to introduce you to Mr. En-Ling Feng, Vice President of Investor Relations, for cautionary statement. Thank you. Please go ahead.

En-Ling Feng

Good morning and good evening. Welcome to SMIC's second quarter 2014 earnings webcast conference call. For today's call, our CEO, Dr. T.Y. Chiu will first provide some business remarks. Afterwards, our 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 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 those tables in our press release for a reconciliation of GAAP to the non-GAAP numbers we will be discussing. Please note that all currency figures are in U.S. dollars unless otherwise stated.

I will now turn the call over to Dr. T.Y. Chiu, our CEO, for the business remarks.

Tzu-Yin Chiu

Thank you, En-Ling. Greetings to you all and thanks for joining us.

We have some very good news to report in Q2. Excluding Wuhan contribution, SMIC achieved record high revenue in Q2, which is our ninth consecutive profitable quarter. We reached a gross margin of 28%, also our highest since 2005. Compared to Q1 2014, utilization was up more than 10% up; while revenue increased 13.4% sequentially. Our Q2 gross margin increased 6.7 percentage points, profit from operations nearly doubled, and the net profit tripled.

We continue to emphasize the priority of sustained profitability and carefully planned growth. Overall, we are optimistic about 2015 as we prepare our capacity and the technology for many new and exciting opportunity.

One of the growth drivers for 2015 will be 28 nanometer. We are happy to work with our long-time customers and partner as we ramp up this new technology. We are on track to reach our target to have production ramp up in 2015. We are also working with other customers who are targeting to capture the LTE handset IC market in China, AP for tablets, and RF applications on 28 nanometer.

The strong demand and interest for our 28 nanometer has compelled us to accelerate our expansion of 28 nanometer next year. We target to have more than 15,000 wafer per month capacity by the end of 2015.

Our 40/45 nanometer and 65/55 nanometer wafer revenue has rebounded in the second quarter to 13% and 26% respectively from products such as Wi-Fi, Bluetooth, smartphones, tablets, DTV and others.

We target 40 nanometer revenue contribution, we will reach mid-teen percentage at the end of this year. Some of the revenue loss due to product transition from 45 nanometer to 28 nanometer has been made up by new influx of customers, as well as, new products from old customers. And we continue to receive strong 40 nanometer NTO.

Our other growth driver for this year and more so in 2015 is our differentiated product offering. SMIC continues to experience high demand for 8-inch product capacity for PMIC, CIS, embedded non-volatile, and the sensors. It makes PMIC, CIS and our NVM, non-volatile technology, accounts for around one-third of our wafer revenue and the growth is currently constrained by limited 8-inch capacity.

We believe this growth will resume as we are able to expand our capacity in sensors. Our technology for Vanguard IC [ph] has been quantified and it's in early production. The effort in 12-inch specialty process development has recently yielded the industry’s leading 55 nanometer embedded non-volatile solution. Our customer has entered into high volume production based on this technology. And this new 55 nanometer low power embedded flash platform has already been recognized by our customers for its excellent performance and includes – and it includes a comprehensive IP library.

We are therefore accelerating our effort to expedite on 28 nanometer, both PolySiON and high-K, as well as a number of new specialty technology into production phase. In response to overall strong capacity demand we are squeezing more capacity out of our existing facilities and accelerating to ramp up of our new facility. We have allocated funds to expand Tianjin from 39,000 wafers to 42,000 wafers per month.

We still target Xinxin fab to reach 10,000 wafer per month installed capacity by year-end. Meanwhile, Beijing JV's project logistics are taking a little bit more time than expected, so we have adjusted the estimated installed capacity in Beijing JV to above 1,000 wafer per month by the year end.

To meet our customers' strong and urgent 28 nanometer need, we target to set up 6,000 per month 48 nanometer capacity by the end of 2014 in our Shanghai facility. To address and – to address the added capacity on both 8-inch and converting 40 nanometer to 28 nanometer, we have increased our foundry CapEx by an additional $100 million.

The strong IC demand in China is continuing to drive our growth. For the first time in SMIC’s history, our China revenue has exceeded all other regions in the second quarter. Revenue from China now accounts for more than 44% of our total revenue.

Recently, China's central government introduced guideline to promote the development of the industry – of the IC industry, in which the government expressed its intention to promote robust and healthy growth in the semiconductor and IT industry. As the largest semiconductor enterprise and the most advanced foundry in China, we are looking forward to a period of accelerated industry growth, and to prepare to materialize all the opportunities that will be presented in China.

We believe the opportunity for a continued growth will be plentiful. In conclusion, the second quarter recovery ended with strong financials and profitability for SMIC. The growth in 2014 is constrained by power capacity. However, we are opportunistic – no, we are optimistic about 2015 as we prepare for the growth on 8-inch and 28 nanometer. We continue to have confidence in our strategy to capture growth opportunity here in China, and we stay committed to sustainable profitability and building value for all stakeholders.

Thank you for your time. I will now hand the call over the Dr. Gao Yonggang for the financial highlights and the Q3 guidance.

Gao Yonggang

Okay. Thank you, TY. Greetings to all our listeners. I will now highlight our second quarter results and third quarter guidance.

Our revenue was $511.3 million in 2Q 2014, an increase of 13.4% quarter-over-quarter. Meanwhile, our non-GAAP revenue excluding wafer shipments from Wuhan Xinxin, was record high of $511.3 million in 2Q 2014, an increase of 1.9% year-over-year compared to $501.8 million in 2Q 2013.

Gross margin was 28% in 2Q 2014, compared to 21.3% in 1Q 2014. And profit for period attributable to SMIC was $56.8 million in 2Q 2014, compared to $20.3 million in 1Q 2014. Our China-region revenue grew to 44.4% of overall revenue becoming the largest contributor to revenue regionally in 2Q14.

Now, look ahead into the third quarter of 2014.

Our revenue is expected to increase 1% to 5% quarter-over-quarter and gross margin is expected to range from 24% to 26%. While non-GAAP operating expenses excluding the effect of employee bonus accrual, government funding and gain from the disposal of living quarters are expected to range from $96 million to $101 million.

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

Gareth Kung

Thank you, Gao Yonggang. And thank you, everyone, for joining us today. I will comment on the details of our financial results.

On the income statement, revenue increased $511.3 million in 2Q 2014, mainly because of the increase in wafer shipment. Revenue decreased 5.5% year-over-year, from $541.3 million in 2Q 2014, mainly because there were no wafer shipment from Wuhan Xinxin since first quarter of 2014.

Cost of sales increased to $368.3 million in 2Q14, up only 3.8% Q-on-Q from $355.0 million in 1Q14. Gross margin increased to 28.0% up from 21.3% in the previous quarter, mainly due to an increase in fab utilization. Operating expenses in 2Q 2014 were at $84.9 million, compared to $66.5 million in Q1 2014.

R&D expenses increased to $41.1 million in Q2 2014 from $36.7 million in Q1 2014, mainly due to, one, a decrease in funding of R&D contracts from the government, which was $7.6 million in Q2 2014 compared to $11.7 million in the previous quarter, and two, an increase in R&D activities cost in current quarter.

General and administrative expenses increased to $35.5 million in Q2 2014, up 53.2% Q-on-Q from $23.2 million in the previous quarter, mainly because accrued employee bonus increased by $7.1 million, and two, government tax charges increased by $2.4 million in Q2 2014.

Other operating income was $4.8 million in 2Q 2014, an increase from $3.0 million in the previous quarter, mainly because of the gain arising from the disposal of part of the living quarters in Beijing. If excluding funding R&D contract from government, income arising from the disposal of living quarters and employee bonus accrual the non-GAAP OpEx was $86.6 million in Q2 2014, compared to $79.4 million in the previous quarter.

Profit from operation in Q2 2014 was $58.2 million, compared to $29.6 million in Q1 2014. Other expenses was $1.1 million in Q2 2014, compared to $9.2 million in Q1 2014, which it was mainly due to larger foreign exchange losses arising from devaluation of RMB against U.S. dollar in the first quarter of 2014.

Moving to balance sheet, at the end of the second quarter 2014, cash and cash equivalent increased to $573.3 million in Q2 2014 from $437.6 million from the previous quarter. And other financial assets increased to $358.4 million in Q2 2014 from $178.4 million in the previous quarter. In both cases, the increase was due to the net proceeds we received from the issuance of convertible bonds and new shares issued in the second quarter of 2014.

Our long term borrowings decreased $81.6 million and short term borrowing increased $52.1 million compared to the previous quarter. At the end of the second quarter 2014, our total debt to equity ratio increased to 39.7%, compared to 38.5% in the previous quarter. In terms of cash flow, we generated $118.6 million cash from operating activities in the second quarter of 2014, compared to $169.4 million in the previous quarter, mainly because of the changes in the working capital and others in the second quarter of 2014.

Cash used in investing activities increased to $339.8 million in the second quarter 2014, compared to $24.9 million in Q1 of 2014, mainly because of additional investment in financial assets in the second quarter of 2014.

Cash flow from financing activities changed from the inflow of $168.4 million in Q1 2014 to –changed from outflow of $168.4 million in Q1 2014, with inflow of $357.2 million in Q2 2014, mainly because of the net proceeds received from the issuance of convertible bonds and new share issues in the second quarter of 2014.

To examine our revenue by application, the consumer segment was still our single largest contributor to our revenue this quarter. Revenue from this sector contributed 48%. Revenue from the communicator sector contributed 41.4%. Geographically, China region revenue grew to 44.4% of the overall revenue, becoming the largest contributor to revenue regionally in Q2 of 2014.

In terms of technology, our 45/40 nanometer and 65/55 nanometer's revenue has rebounded in the second quarter to 13% and 26% respectively of recent revenue.

In terms of our overall capacity, total monthly capacity at the end of the second quarter was 247,500 wafers compared 243,500 in the first quarter. The change was due to the expansion of capacity in our Shanghai and Tianjin 8-inch fab. The overall utilization was 94.6% in the second quarter of 2014 compared to 84.2% in the previous quarter.

We raised our 2014 capital expenditures for foundry operation to approximately $1.1 billion from $1 billion. The increase is mainly for the product mix change including the conversion of 40/45 nanometer to 28 nanometer in our Shanghai 12-inch fab and expansion of capacity in our Tianjin 8-inch fab from 39K to 42K. Around $570 million of the total estimated 2014 CapEx is expected to be used for our new Beijing majority-owned subsidiary, which is 55% funded by SMIC and 45% funded by the other shareholders of the subsidiary.

As previously announced, 2014 CapEx for the non-foundry operations is approximately $110 million, which is mainly for the construction of living quarters. We plan to rent out or sell these living quarter units to employees in the future.

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

En-Ling Feng

Thank you, Gareth. I would now like to open up for the call for Q&A. As usual please be reminded to limit your question to two per person. Operator, please assist. Thanks.

Question-and-Answer Session

Operator

Ladies and gentlemen, welcome to the question-and-answer session. (Operator Instructions) Thank you. Your first question comes from the line of Randy Abrams from Credit Suisse. Please ask your question.

Randy Abrams – Credit Suisse

Hi, good morning. And my first question just on the demand outlook for the guidance, the one that's 5% percent, you also talked about supply constraints. So I just want to see if any part of that was due to the supply constraint on 8-inch and for the demand side, if you could talk about with 1.5 [ph] it's a little bit below some of the historical years, if there's any area, you're seeing protect your weakness and if you expect at least at this early stage for that to continue into fourth quarter for same – a modest decline into fourth quarter as we head toward low season?

Tzu-Yin Chiu

First of all, happy birthday, Randy. We heard that this is your big day.

Randy Abrams – Credit Suisse

Thanks. I appreciate celebrating with you guys.

Tzu-Yin Chiu

Okay. Yes, we have a very, very strong second quarter for the 8-inch capacity and this particular strength in the 8-inch demand will continue and we are doing everything possible to address this customer demand through a capacity expansion in the 8-inch in Xinxin, okay, and as well as, adding capacity to our present facility as much as possible.

As far as 12-inch is concerned that we are also – there will be a strong demand when our 28 nanometers comes into production and we are doing as quickly as possible to also meet our customers capacity requirement. As far as Q3 is concerned I think that there is still a growth and but indeed we are noticing that there are some slacking of the demand. And so that is indeed what we are seeing.

Randy Abrams – Credit Suisse

Okay. And for the second question, if I could ask on the Beijing fab, where now some of the 28 nanometer will ramp in Shanghai first. Could you give a new update for Beijing, how you plan to ramp that up through 2015 and then an update for progression of 28 nanometer, as we move through next year, like how you expect it to ramp toward 5% and 10% of sales? And how profitability looks if from next year with the 28 nanometer ramp if you could achieve similar gross margins to what you just achieved in the recent quarter, if that's a similar type of attainable goal?

Gareth Kung

For the Beijing fab, as mentioned by TY we are looking at about 1K capacity in the end of the year. And we will continue ramp up the fabs throughout 2015 to meet the customer demand, likely to be probably maybe close to a more than 10K per month by end of 2015. In terms of the profitability, I think it's a bit too early to comment on it at this point on time. But as you can understand, this is a new note for us as well the new fab. So I think realistically, I think initially the gross margin will be relatively week, but as we're going to increase – in the production in scale that should increase in terms of our profitability.

Randy Abrams – Credit Suisse

Okay. And maybe, if you could take it just factoring 28 nanometer starts at low margin for overall corporate which you're doing on 8-inch and your continued [ph] just mentioned 40 nanometer tape out, are you expecting kind of a similar type of gross margin level or I mean, you actually shown improvement in the last few years. So how do you – how should we at least early stage expect gross margin into next year. And I guess, if there's any impact of depreciation, if that would increase next year with the recent investments?

Tzu-Yin Chiu

Yes, Randy, obviously, we always target to achieve better gross margin, but I think at this point in time it's too early for us to comment on the gross margin for next year. It all depends on the market situation and also that the fab utilization. So I think we will update the market as we progress.

Randy Abrams – Credit Suisse

Okay. Thank you. Can you given an early view on depreciation if there's a big increase, at least on the base CapEx, you're assuming if there's any real headwind from depreciation next year?

Gareth Kung

Yes, honestly the depreciation of 2015, will also depend on the CapEx for 2015, which obviously we have not finalized the plan yet. But I'll just give you an early indication. If let's say, assuming our CapEx for 2015 is around the same both our number as the current year, we probably looking at an uptick in the depreciation in the range of $70 million to $100 million.

Randy Abrams – Credit Suisse

Yes, I believe that. Okay. All right, thanks a lot. Hey, thanks for the wishes.

Operator

Thank you. Your next question comes from the line of Daniel Heyler from Bank of America. Ask your question, please.

Daniel Heyler – Bank of America Merrill Lynch

Hi, thanks. Good morning, gentlemen. I had a question on just the last comment that you made TY, because you guys had raised your second quarter margin guidance on the rising, loading and utilization in June and then you recently mentioned that there is some slacking in demand. Could you elaborate where, what areas you're seeing and what type of – what nodes are you seeing that in?

Tzu-Yin Chiu

Okay. We are still seeing the Q3 the revenues to go up, of course, but there are some slowing down in terms of the ours 12-inch as 65/55 node, this is because much of our, one of our significant customers has shifted from the 65/55 to 40 and we already captured their 40 to fab [ph]. So whatever, there we are looking forward to a ramp up of our new technology in 65/55. So, for example, our embedded non-volatile technology is coming online and it's ramping and it just take a little bit time to accumulate enough of our product in the – also different applications to feel back this slight decrease in the loading.

Daniel Heyler – Bank of America Merrill Lynch

Okay, great. And just a quick follow-up on that. So, what's the linearity in orders been like, I know that things got really very, very busy and very heated end of the second quarter, are you sensing the same kind of extended lead times or things slacking off a bit generally across the board?

Tzu-Yin Chiu

I think the lead time in the 8-inch loading is still very, very extensive. And indeed in the 12-inch loading that we are seeing a reduction of the lead time.

Daniel Heyler – Bank of America Merrill Lynch

Okay. My second question relates to the growth prospects for next year. I'm just wondering how much capacity growth we would expect on $1 billion in CapEx which you spent this year. What kind of capacity growth do you think you can achieve overall, because I know you are adjusting existing fabs, you're making, improving your throughout, you're adding new capacity and you're migrating technology so there is a lot of moving parts.

I just wondered if you can give us a sense of the total wafer capacity growth roughly you would expect next year, say, under like a $1.1 billion or $1.2 billion kind of number?

Gareth Kung

The immediate growth in capacity next year as we can see right now, of course, also it could change this amount condition to be the growth in our new fab in Beijing in terms of capacity to grow to a list about 10K by end of 2015. And then we also see growth, we see growth in our centimeter capacity. From the – by the end of 2014 we are talking about 10K installed capacity. By the end of 2015, we should look at about 20K per month.

Daniel Heyler – Bank of America Merrill Lynch

And no other increases elsewhere in your facility so it'd just be those two fabs?

Gareth Kung

Well, I think there will still be some marginal increase in our 8-inch capacity but I think the increase will be quite limited.

Daniel Heyler – Bank of America Merrill Lynch

Okay. That's all. Thank you.

Operator

Thank you. Your next question comes from the line of Steven Pelayo from HSBC. Go ahead, please.

Steven Pelayo – HSBC

Yes, first question is I guess, on margin, obviously you're guiding down sequentially here in the third quarter. I'm trying to understand what the normalized level of gross margins. Obviously, you had a very, very strong Q2 number, let me understand what's pulling down the third quarter gross margins and should I be thinking the 28% level is achievable on a long-term basis or should I be thinking now down more than 300 basis points? I think at the midpoint of guidance is being more in the normalized run rate.

Gareth Kung

Well, Steve, as you can understand, the biggest driver for gross margin is the fab utilization. The big increase in the Q2 gross margin actually is all attributable to the 10% increase in the fab utilization now in Q2 compared to Q1. And likewise we are guiding down our gross margin in Q3 marginally. As TY mentioned, we are seeing some softening in the demand that could impact our fab utilization in Q3.

Steven Pelayo – HSBC

Okay. So then, remind me what the utilization rates were in kind of 200 millimeter versus 300 millimeter, in the second quarter versus your expectations in the third quarter?

Gareth Kung

We are still looking at the very still loading in 8-inch fab in Q3, but we are seeing a load utilization for our 12-inch fab especially for the 65 nano – 65 node (inaudible).

Steven Pelayo – HSBC

Okay. Last question I just want to ask is relative to margins a bit more, 45 nanometers, I think about mid-teens percent of revenue in the second-half last year. I think you mentioned at the time that was about break-even on the gross margin level. It’s currently, getting back to that kind of level, so could you just remind me is, is 45 nanometer, you're profitable at the gross margin level on an absolute dollar basis?

And it sounds like you are going to be transitioning some of this 45 nanometer to 28 nanometer, so cumulatively I'm just wondering is the 45 nanometer node never really going to get above 20% of total revenue and if it’s never really going to contribute within our earnings. Could you help me understand the margins on kind of 45 nanometer and the plan contributions going forward?

Gareth Kung

Yes, right now you have seen low gross margin for our 45 node at this point in time. But as we – we are seeing a high utilization. We are hopeful, we are marketing a high utilization in the second-half, so hopefully that will bring up our gross margin for that node. Yes, we are actually building more visibility in the fact by converting part of this capacity of 28 nano, but that is basically to just create more visibility for the fact. So we are not giving up on the 45 node revenue.

Steven Pelayo – HSBC

Okay. And then last question for me is just on the share account going forward. So you did equity offering, you have a couple of convertibles, I think in the last couple of quarters as well. At least we thinking about your share account on the – in the third quarter, as well as if the profit inversely converted as well?

Gareth Kung

Steve, we can e-mail you in a certain time exactly after the call, yes.

Steven Pelayo – HSBC

Okay.

Tzu-Yin Chiu

Maybe let me give you a little bit color, in the past, we have done couple of tranches of convertibles, and one tranche of equity. Much of these cash is used to pay down our higher interest domestic loans, and so, yes, so that we can reduce some of our interest payments. And so that this is – in the past that we are trying to restructure our debt the next year, so that you can see that we are lowering our debt to equity ratio and also getting an overall lower interest rate.

Steven Pelayo – HSBC

Okay. I'm sorry, if I can just sneak one more, do you see anything on the R&D funding property sales one-time benefits or charges in the third quarter?

Tzu-Yin Chiu

Yes, in terms of the R&D funding from the government, so far in 2014, we have recorded about $19 million. Based on our most recent outlook, we should be looking about – close to about US$40. I think you can use it for your modern purpose. In terms of the gain from the disposal of living quarters, I think it gives some marginal amount to be both in the second-half, but it would not be material.

Steven Pelayo – HSBC

Okay. Thank you very much.

Operator

Thank you. Your next question comes from the line of Ken Hui from Jefferies. Go ahead please.

Ken Hui – Jefferies & Co.

Thank you for taking my question. Nanometer capacity in Shanghai, is it going to be temporary or is it going to be permanent there, and if it is going to be permanent how are you going to assure proper synergy with your Beijing fab going forward?

Tzu-Yin Chiu

Okay. This capacity will be permanently be part of a Shanghai fab 8, because our R&D physically is located in 8. So that ware top is the smoothest if we initially ramp up phase. The – we will take a copy exact approach to transfer this technology to Beijing. And so, we expect that transfer to be relatively smooth as well.

Ken Hui – Jefferies & Co.

Okay. And then my second question is, you mentioned that the 3Q in such as many on 65 nanometer, can you give a more color regarding your current capacity for 65?

Tzu-Yin Chiu

Could you repeat again?

Ken Hui – Jefferies & Co.

Can you give us some details on your current capacity on the 65 nanometer?

Gao Yonggang

Right now the 65 nano capacity is all representing our challenge from Beijing is around 24K per month. But actually has no, to what you have mentioned, even though some of the products migrated into 40 nanometers. We are actually at this point in time qualifying some new products to (inaudible) in the fab. So hopefully, we are good to see some improvement in the utilization down the road.

Ken Hui – Jefferies & Co.

Would you expect your 4Q already or you would be too early to see that in 4Q?

Gao Yonggang

Right now, I think you – allowed for us to qualify on those products. And as you understand for this business, the visibility is quite limited to about three months. I think it’s too early for us to comment.

Ken Hui – Jefferies & Co.

Okay. Thank you.

Operator

Thank you. Your next question comes from the line of Chris Yim from Mizuho Securities. Please ask your question.

Chris Yim – Mizuho Securities Asia Ltd.

Hi, good morning. Can you quickly comment on your customer inventory level at the current moment especially in China, will you – do you expect the China strength to continue in the second-half?

Tzu-Yin Chiu

Chris, can you repeat your question, please?

Chris Yim – Mizuho Securities Asia Ltd.

Yes. Would you be able to quickly comment on your customer inventory level at the current moment and especially your Chinese customer, what do you think the strengthens in China will continue in the second-half?

Tzu-Yin Chiu

Yes, Chris, I think what we have seen in the second quarter is that, they are rebuilding of restocking among some of our customers in terms of inventory level. Right now I think you expect to a more reasonable level. And I think in Q3, you are going to see, customer will be more cautious in terms of managing the inventory.

Chris Yim – Mizuho Securities Asia Ltd.

Okay. Thank you. You mentioned earlier that you're moving some of your specialty to 12-inch, is that an ongoing effort, we will see more of your specialty products using 12-inch wafers.

Tzu-Yin Chiu

There is indeed some specialty development – specialty technology development in 12-inch. And in areas, where we think is appropriate, we definitely will also develop, unique technological solution for our customers. And I think that at this moment, our embedded non-volatile, for example is ahead of the or at least leading in the industry, and we are getting quite a bit of customer attractions in this area. And we have fairly high expectations that this particular technology can add numerous applications both in the smart card, as well as in the MCU area.

Chris Yim – Mizuho Securities Asia Ltd.

Thank you. That’s all the questions I have.

Operator

Thank you. Your next question comes from the line of Gokul Hariharan from JPMorgan. Go ahead, please?

Gokul Hariharan – JPMorgan Securities

Yes, hi, thanks for taking my question. My first question is on your 8-inch capacity in the plan to expand capacity. Should we think that the capacity expansion plan is limited primarily to filling up the Shenzhen fab over the next couple of years, or are you also going to be looking to buy some fully depreciated 8-inch fabs at some point in time, should we expect more aggressive plan in terms of the 8-inch capacity expansion given the capacity tightness? And I have another question after that?

Tzu-Yin Chiu

Okay. At this moment, our focus is in bringing up our Shenzhen fab. Of course, SMIC is only ready to cover the market for a good asset and entering in other market segments, which we do not have at the moment. That’s still part of the reason that we also in the past done a number of these either convertible bond or the equity, so that we have enough financial resources when opportunity comes along.

Gokul Hariharan – JPMorgan Securities

Okay. So, you don’t consider integrating full fab from somewhere else a big challenge, that is not the issue to consider, that is not a big issue that would prevent you from going out and buying 8-inch capacity?

Tzu-Yin Chiu

SMIC had – it's no stranger to merger and acquisition. For example, our Shenzhen fab is a merger from a former Motorola fab.

Gokul Hariharan – JPMorgan Securities

Okay.

Tzu-Yin Chiu

And that have been executed in a very excellent way. And right now I think our Shenzhen fab is doing extremely well and very, very partner with our customers. So we believe that although it’s not small cap to absorb the mill entity especially a large entity like us whole fab. But SMIC is confident that we can undertake such efforts too firstly.

Gokul Hariharan – JPMorgan Securities

Okay, great. My second question is on the non-GAAP OpEx guidance of around $96 million to $101 million in Q3, is it a pretty big jump from the Q2 levels, is it primarily be R&D expense for 28-nanometer and how should we think about this going forward into Q4 and Q1 of next year as well? Is it going to stay at this elevated level or – do you see some stepping down after that?

Tzu-Yin Chiu

Yes, I think the growth in the non-GAAP OpEx in Q3 is mainly for two reasons. One is because, obviously, we are increasing our R&D spending, not just for trading on node, not just for trading other products, but also on many objective, especially the processor that we are going to launch in the next one or two years.

And then secondly, we have also increase expenses right now to pay for the amount of the new Beijing fab and Shenzhen fab. So yes, you may see some elevated OpEx in the fourth quarter.

Gokul Hariharan – JPMorgan Securities

Okay. And on the Beijing fab, you mentioned there is a little bit of a delay, could you elaborate a little bit of – little bit on that, is it something that there is beyond the quarter, or is it just a small timing issue?

Tzu-Yin Chiu

Let me answer that question. Basically, that is a small timing issue. And as you can see that, we are actually trying to accelerative the path – accelerative the pace, so that we can catch up the delivery to our customers. And by the end of the next year, we will have a 10,000 wafer per month in storage capacity to meet our 28 demand.

Gokul Hariharan – JPMorgan Securities

Okay. Thank you.

Operator

Thank you. Your next question comes from the line of Lin Chen [ph] from Daiwa. Please ask your question.

Unidentified Analyst

Yes. Thanks for taking my question. My first question is about going – looking forward into 2015, how should we expect combined revenue contribution from (inaudible) includes 28 nanometer and 40 nanometer? Thanks.

Tzu-Yin Chiu

Right now, I think it’s a bit too earlier for us to comment precisely in terms of the revenue contribution on 28 nano and for 40. We think that no, that should be increased from the current year, probably it’s too early for us to comment on the contribution at this point in time, yes.

Unidentified Analyst

Okay. So could you give us some color about the – like the customer tape-out progress of 28 nanometer process? Thank you.

Tzu-Yin Chiu

Okay, thank you, Lin [ph]. We already have a number of customer tape-out. And in the 28, in addition that we have a six or seven customers engaged with us in the – in both PolySiON as well as High-K technology. This will take a bit of time to fully qualify the product, but all of these activities are ongoing, and this is on track as well.

Unidentified Analyst

Okay, thanks. That’s all.

Operator

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

Leping Huang – Nomura

Thank you for taking my questions. I have two questions. The first question best to the gross margin issues, can you help me to understand your second quarter revenue is in line with our original guidance in – but your gross margin was up much higher than the original expectation and then your second – third quarter margin declined. Again, so why your revenues is still in line, but you say your utilization rates was higher than expected, can you clarify these one issues? Thank you.

Tzu-Yin Chiu

Yes. I think, obviously, there is some correlation between the revenue and in the fab utilization. But I understand, actually the cycle time for our fab is about six weeks. So there is some delay in terms of the revenue increase compared to the utilization. But to comment on our gross margin fluctuation in Q2, as mentioned, our Q1 utilization compared to Q2 is up, Q2 utilization from Q1 is 40% higher. And that is the main reason for the slightly higher gross margin in Q2. And as mentioned earlier, we are looking at our utilization to come down in Q3 and that also explains why we're guiding down our Q3 gross margin.

Leping Huang – Nomura

Okay. And second question is about your operation with Qualcomm. So when do you expect to be Qualcomm's LTE chipsets revenues to contribute from, can you expect – can we expect from the revenue – from next year or how big is where EBITDA revenue contribution? And also related to CapEx, you raised your CapEx by 10% this time, have you taking into the additional CapEx for Qualcomm's the 20 nano chipset? Thank you.

Tzu-Yin Chiu

Okay. Our CapEx this year has included the taking into account of our customer demand. And so secondly, as far as I cannot comment exactly what are the customers tape-out situation is. But we do have a – we are working very closely with our long-term partner. Qualcomm have been working with us both inventory node as well as all the advanced node. And so is a very close partner, as well as very long-term customers. And so whether, we expect to have a 28 revenue, yes, we would definitely expect to have 28 revenue by 2015.

Leping Huang – Nomura

So, we expect 28 nano revenues from – by 2015 from Qualcomm, can we say that or?

Tzu-Yin Chiu

Yes. I think we are expecting 28 nano to contribute to our revenue in 2015, yes.

Leping Huang – Nomura

Okay. Thank you.

Operator

Thank you. Your next question comes from the line of Sze Ho Ng from BNP Paribas. Please ask your question.

Sze Ho Ng – BNP Paribas Securities

Hi. Good morning, gentlemen. And if we start to the embedded non-volatile memory, is it the technology you develop in-house, or you license from third-party, and what's the loss revenue outlook you can offer for e-NVM, yes.

Tzu-Yin Chiu

Okay. The embedded non-volatile technology is developed – technology wise is developed in-house. But this is a piece-slice [ph] structure in which is bought up by ISSI. So therefore, we have been working very closely with ISSI. We are responsible for the technology development and ISSI is responsible for the IP development. Of course, SMIC do have the IP design right. So technology wise, let me say again, technology wise it is developed fully within SMIC. And – but how do I say, the device structure and some of the fundamental IPs is still owned by ISSI.

Gareth Kung

And I think actually what do I think, we do expect very broad application for this technology improving by things like project application and MCU application.

Sze Ho Ng – BNP Paribas Securities

I see. And how about the revenue outlook for this technology?

Gareth Kung

We have restarted (inaudible) for this technology, so we should expect some meaningful contribution from this technology for this year.

Sze Ho Ng – BNP Paribas Securities

This year, all right.

Gareth Kung

Yes.

Sze Ho Ng – BNP Paribas Securities

Okay, all right. And for the finance cost in Q2, it picked up quite a bit quarter-on-quarter, is it just a one quarter issue, and we should expect it to come down in Q3?

Gareth Kung

The finance cost should be around the same in Q3 compared to Q2, yes.

Sze Ho Ng – BNP Paribas Securities

Okay. Last the jump, yes, because I believe that you are doing quite a bit of refinancing at lower costs?

Gareth Kung

Actually the – I think the reason for the lowest finance cost in Q1 was due to some double funding we have received in respect to our finance expenses.

Sze Ho Ng – BNP Paribas Securities

Okay. So on a steady basis, you should be around $8 million on a quarterly basis going forward?

Gareth Kung

Yes, I think the finance cost should stay right in the middle of (inaudible).

Sze Ho Ng – BNP Paribas Securities

I see, okay. All right. Thank you very much.

Operator

Ladies and gentlemen, unfortunately that’s all the time we have for questions. I will now hand back to our CEO, Dr. Tzu for closing remarks.

Tzu-Yin 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 suppliers for their trust and their support. See you next time.

Operator

Ladies and gentlemen that dose conclude our conference today. Thank you for your attendance. You may all now disconnect.

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