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Semiconductor Manufacturing International Corporation (NYSE:SMI)

Q1 2011 Earnings Call

May 19, 2011 8:30 pm ET

Executives

En-Ling Feng – Director, IR

Dr. David N. K. Wang – President and CEO

Gary Tseng – CFO

Analysts

Randy Abram – Credit Suisse

Bill Lu – Morgan Stanley

Steven Pelayo – HSBC

Dan Heyler – Banc of America/Merrill Lynch

Operator

Welcome to the Semiconductor Manufacturing International Corporation's First Quarter 2011 Webcast Conference Call. Today's conference call is Chaired by Dr. David N. K. Wang, Chief Executive Officer and President; Mr. Gary Tseng, Chief Financial Officer; and Mr. En-Ling Feng, Director of Investor Relations.

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

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

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

En-Ling Feng

Good morning and good evening. Welcome to SMIC's first quarter 2011 earnings conference call. For today's call we will have our CEO, David Wang and our CFO, Gary Tseng. 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 the Financial Information section in the Investor Relations tab.

Please also be reminded of the Safe Harbor statement which provides as follows. SMIC's statements of its current expectation are forward looking statements, subject to significant risk and uncertainties.

The actual results may differ materially from those contained in such forward-looking statements. Information as to those factors that could cause actual results to vary can be found in SMIC's Form 20-F filed with the United States Securities and Exchange Commission on June 29, 2010.

For today's agenda, our President and CEO, Dr. David N.K. Wang will speak on SMIC's key initiatives and comment on our business. Following that, CFO, Gary Tseng will walk us through our first quarter 2011 financial results and followed by second quarter 2011 guidance. Then we will open the call for questions-and-answers.

I will now turn the call over to our CEO, Dr. David Wang.

Dr. David N. K. Wang

Thank you, En-Ling. Good morning and good evening to everyone. Thank you for joining us. Today, I’m going to highlight our first quarter performance, our outlook for 2011, several of our recent events, our technology progress and our position in the strengthening Chinese market.

Highlighting our first quarter performance, revenue increased 7% year-over-year and decreased 9% quarter-over-quarter to US$371 million. The quarter-over-quarter revenue decline was largely due to first quarter seasonality and our key customer transition through 65 and 45-nanometer. Despite these situations, China is placed resilient and in the first quarter, China sales grew 54% year-over-year and 3% quarter-over-quarter, and now account for 36% of our revenue.

Looking into the second quarter, as mentioned previously, our customer transition to 65-nanometer and 45-nanometer were also impact our second quarter revenue, for the well rebound in the second half of the year.

As we have a large percentage exposure for the communications market, Q2 is also in part – impacted by communication customers experiencing paradigm shifts in the T&T [ph] sector. Due to this paradigm shift the Japan earthquake disruption for semiconductor supply chain, sound continued adjustment to inventory levels, as well as our continued customer transition to 65-nano and 45 nanometers, we expect our Q2 revenue to decrease as guided.

We do not believe the market adjustment and the supply chain issues will carry significantly into the second half, cautiously optimistic about growth in the second half of this year.

In recent event we are happy to have announced an agreement with China Investment Corporation or CIC, a sovereign wealth fund investment institution, to invest in SMIC for convertible preferred shares and warrants.

Following this announcement, Datang, our largest shareholder also supported us by expressing their intention to exercise its pre-anti right by investing additional cash for convertible preferred shares and pre-anti warrants.

We welcome our new and existing shareholders and greatly appreciate their confidence in our future execution. These capital intentions will further help SMIC to expand its technology roadmap and strengthen our good hope as one of the leading boundaries globally.

Another significant event I would like to highlight, on May 12th, we announced the signing of a joint venture with Hubei Science & Technology Investment Corporation, to jointly invest in and manage the 12-inch wafer production line of Wuhan Xinxin.

Xinxin currently has both 90-nanometer and 65-nanometer in volume production with 45-nanometer production expected in 2012. This joint cooperation will serve as a strategic component in our expansion plan over the next five years and will allow us to quickly expand and increase market share on advanced technology capacity.

Now, let me move on to our advanced technology developments. Our 65-nanometer revenue increased by more than one-third quarter-over-quarter to over 13% of revenue, 65-nanometer continues to be a key revenue driver for us this year, continued growth is expected as planned more takeout for 65-nanometer will more than double in second quarter, compared to first quarter of 2011.

Customers are also taking advantage of our costs enhanced to 55-nanometer process. As an example in early March we announced entering 55-nanometer production with our Chinese customer RDA. Our 45 and 40-nanometer is also progressing and we have a leaving custom takeouts scheduled for this quarter.

We continue to target mass production in the later part of 2011 and we aim to run up 45/40-nanometer capacity from 1K to 4K 12-inch wafers per month by the end of 2011. This continues the ramping through 2012.

Our 32 and 28-nanometer are in research and development stages, and our target is to reach process qualification to meet 2013.

To address the China market, some Chinese IC design houses have successfully positioned themselves in various specialized market and are gaining market share against other global players in applications, such CDMA, GSM, Bluetooth, MP4, eTV, CIs, IF and Smartcard.

Most of the leading players in each market dimensions are our customers. Of the top 10 Chinese fab by revenue nine are our customers. Two of these are already working with us on 45 and 40-nanometer and three are currently in 65-nanometer mass production with us.

With the largest share in Chinese foundry market we believe SMIC is in an advantages position to capture the Chinese market opportunity with strategic location and the most advanced to Semiconductor Manufacturing capability, as well as a leading position in China’s advanced process development.

In summary, despite the short-term set backs, we look forward to gaining growth in the second half of 2011. The short-term customer transitions will continue to impact our business performance in second quarter 2011. But given our successful funding, capacity ramping enhanced the technology mix, operational improvement and China positioning, we are on track in executing sustainable competitiveness for the long-term.

I will now hand the call over to our CFO, Gary Tseng to update us on the financial results.

Gary Tseng

Thank you, David. Good morning and good evening to everyone. I will now take a few moments to outline our first quarter 2011 financial results and then follow with our second quarter guidance. You may also refer to our quarterly financial presentation on our website. Please note that all currency figures are in U.S. dollars unless otherwise stated.

Before looking at our first quarter financial data, please note that, on March 1, 2011, we had divested our ownership in AT, the assembly and test joint venture in Chengdu with United Test & Assembly Center from holding 56.3% to 10%.

Effectively after that, we no longer have controlling financial interest in AT, therefore, we have reclassified old revenues and expenses related to AT as gain or loss from discontinue operations for the first quarter of 2011.

In the previous to enable a sale comparison overtake, thus you would see the some of reported number from previous quarter have been changed to refresh the reclassification. As we are no longer the majority shareholder of AT going forward, the profit and loss of AT will not be consolidated into our book.

Now, looking at our first quarter of 2011, total revenue decreased 9.3% quarter-over-year to $370.6 million, due to decline in wafer shipment and fab utilization. Wafer revenue from Tianjin and Zhangjiang totaled 25.5 million in the first quarter contributing 6.9% of our total revenue.

Excluding wafer revenue from the managed fabs for both quarters, the company’s revenue decreased 11.7% quarter-over-quarter, primary due to some of our customer’s transition to the best mode as well as first quarter weak seasonality.

Gross margin in the first quarter was 18.6%, compared to 24.3% in the fourth quarter. This decline is primary due to low utilization in the first quarter and I will address this later.

Looking into our revenue expenses, we had originally guided for an OpEx range of $82 million to $86 million. However, in the first quarter the recorded OpEx was $76.6 million. Due to the receipt of $8.6 million in management fee payment or Wuhan fab management and this payment offsets our G&A expenses. In addition, we received a 5.7 million necessity of which 5.5 million was used to offset our R&D expenses and the $0.2 million was classified as other operating income.

Therefore, in the first quarter we resolved the management fee of $8.6 million and a government necessity of $5.7 million our total operating expenses would be $90.9 million compared to $82.4 million in the fourth quarter when excluding the $28.5 million cash payment from Chengdu government, $5.1 million from government subsidies, $6.8 million in foreign exchange loss and the $1.7 million from Wuhan management income offsets.

The OpEx increase of 8.5 million quarter-over-quarter was mainly due to the increase in personnel related expenses including a one-time charge of $5 million for organization realignment, but again accretive to all to holder of ordinary share was $10.2 million in the first quarter of 2011 driven by again a $14.7 million which was a result of our divestment in 82 effectively on March 1.

Fully diluted EPS was $0.02 per ADS in the first quarter 2011 compared to $0.13 per ADS in the previous quarter. Let’s move to the balance sheet.

At the end of the first quarter 2011, our debt-to-equity ratio increased to 49.9% compared to 40.7% in the fourth quarter 2010 as we increased our short term loan from $706 million to $910 million. We are also working on two long-term syndication loans for Beijing and the Shanghai future expansion funding needs. We target to complete these loans in the next few months; this would readily improve our loan structure.

On April 18, we are pleased to announce an investment agreement with Country Hill Limited, a wholly owned subsidiary of China Investment Corporation, namely CIC. We agree to issue convertible preferred shares of CTS to CIC at Hong Kong $5.39 per share to raise US $250 million. This investment includes a two year lock up period. Each EPS can be converted into ten ordinary shares within one year of issuance.

Now interest would be paid to the EPS holders.

In addition, warrants would be issued at the same price for an additional US $50 million to be exercised within a year. The facility, our major shareholder China Telecom confirmed their decision to exercise their preemptive right to invest around US $17 million including $58.3 million for CPS and $11.7 million for warrants.

All these equity were held to lower our debt ratio. Upon the conversion of CPS and FSI COG warrants CIC could own 13.25% approximate shares, and its outcome would retain their majority shareholding of 19.07%. This transition of pending shareholder approval at their coming AGM on May 27.

In terms of cash flow, we can rate it to $73.4 million operating cash compared to $248.6 million in the fourth quarter 2010. Typically, our cash flow operation should be around $150 million per quarter. The operating cash drop in the first quarter was due to prepaid VIT [ph] expenses of $27 million resulting from equipment purchase, and a decrease in working capital. The change in working capital is mainly attributed to a $45 million increase in accounts receivable and a $20 million prepayment.

Cash used in investing activity increased mainly due to our CapEx spending to ramp up our Beijing fab. Meanwhile cash flow from financial activity increased as we drawn new short-term loans. Net in net, cash and cash receivable at the end of the first quarter was 394 million compared to $560 million for the previous quarter.

Regarding our revenue breakdown by application due to customer product transition, our communication revenue recorded a quarter-on-quarter drop of about 20% contributing 44.1% to our total revenue, but consumer revenue recorded a slight 1% decrease quarter-over-quarter contributing 43.1% of total revenue.

Regionally, again, due to customer product transition revenue from North America declined about 18% quarter-over-quarter, contributing 51% to our total revenue.

China remained solid with a (inaudible) rose of 3% quarter-over-quarter contributing 35.6% of revenue while in Russia recorded a 5% revenue decreased in the first quarter. In terms of technology, 65 mm momentum continued with our trend up and the 65 mm revenue grew 36% quarter-over-quarter contributing 13.3% to our wafer revenue in the first quarter 2011.

Overall, 90 mm and below revenue percentage increased 1.6% points quarter-over-quarter contributing 25.6% to our wafer revenue. In the first quarter, our utilization rates was above 72% and our total monthly capacity at the end – at the quarter end increased 8%, compared to the first quarter – four quarter of 2010 to a rough 186,000 inch equipment wafer plan.

In terms of the technology, our Beijing fab monthly capacity went up to 33,300 12 inch equivalent wafers per month to 27,800 with 10,000 65 mm capacity from 5,500 last quarter.

We plan to further ramp our Beijing fab to around 31,000 per month by the end of second quarter and this is including 14,000 65 capacity. In the first quarter we spent a 332.10 million on CapEx while our planned $1 billion CapEx for full year 2011 remained unchanged.

Looking ahead, at the second quarter of 2011 we are guiding revenue to 3% to 7% compared to the first quarter as customers brought up transition is still undergoing. Revenue from Xinxin would be around 7% to 9% of our total revenue.

Gross margin is expected to ranging from 15% to 18%. We expect our operating expenses to range from $82 million to $86 million.

I will now hand the call back to En-Ling for the question and answer session of this call. Thank you.

En-Ling Feng

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

Question-and-Answer Session

Operator

(Operator Instructions) Your first question is coming from the line of Randy Abrams with Credit Suisse. You may not proceed.

Randy Abram – Credit Suisse

Yes. Good morning. I am wondering if you could arrive a bit more on the impact you are getting in the first quarter and second quarter on this transition that you mentioned 65 to 40 mm, was that an issue of because you were tied on capacity? Was that a capacity availability or a technology readiness or customer mix, if you could elaborate on that impact?

And maybe as we go in the second half and other capacity, if you think you can gain back share out our peers, as we’re going into second half after that?

Dr. David N. K. Wang

Good morning, Randy. We are increasing the capacity for 65 and the 55 nanometers. I think the two – you mentioned our product transition, I think it relate to two reasons, two problems. One is the technology readiness and that the customer qualification readiness. It takes a little bit longer time than what we expected.

This is one issue.

And the second issue is one of our key customers, they are customer (inaudible) changed with direction in the communication area. So that hurts their business – therefore also hurts our loading. But, however, because we are having many new take outs of 65 and the 55 nanometer customer devices. So we believe once this materialized as a product for producing volume getting into the second half, I think we’ll stop to recover to increase the utilization of the 12 inch new capacities.

And our estimation, since our 65 nanometer devices accounts for 13.3% of our Q1 revenue which is 36% of growth over Q4, last year and I believe with this momentum getting into second half at the end of 2011 we should reach mid or high 20% of our entire revenue from 65 and the 55. So it’s kind of temporary setbacks today and it will just take a little bit more time.

Randy Abram – Credit Suisse

Okay. I appreciate that. And if I can, your guidance for second quarter, is it the same mix, I guess impacting your civic communications declined in first quarter, is that case in second quarter? And I guess from the China business are you still seeing momentum in that business or is there any positive in terms of the momentum that’s there from the Chinese customers?

Dr. David N. K. Wang

Okay. Okay. China business will be about the same level in terms of dollars for Q2 compared to Q1. However, I believe the U.S. business will pick in 2Q, so therefore the 36% of China business will drop roughly to maybe 32%. And the first question of the second question, first part you ask is the Q2 also minus gross is because the same issue of communication market for last years.

Operator

And your next question is coming from the line of Bill Lu with Morgan Stanley. You may proceed.

Bill Lu – Morgan Stanley

Yeah. Hi. I’m sorry, just a follow-up to Randy’s question just now. I’m not sure I heard what you said David, did you say that general purchase going to be flat quarter-over-quarter in Q2, but it’s going to down as percentage, I’m sure – I’m not sure that make sense maybe since the all the revenue is still declining?

Dr. David N. K. Wang

No. What Gary mentioned is, in the China market sectors, cash will be somewhat flatten, but hopefully we will recover our U.S. market sales in the second quarter. So the percentage of China market in the first quarter is 36%, while in the second quarter, maybe we’re coming down to 32%.

Bill Lu – Morgan Stanley

So it will be a full percentage on an overall declining revenues basically?

Dr. David N. K. Wang

Yes.

Bill Lu – Morgan Stanley

Okay. So, I guess, so that we are clear, so why is that flattening?

Dr. David N. K. Wang

Why?

Bill Lu – Morgan Stanley

That for me sounds like it’s a pretty drop off, pretty big drop off quarter-on-quarter?

Dr. David N. K. Wang

Our guidance is minus 3% to minus 7%, compared to Q1. So, why, I will say the reason is more or less the same as the reason for Q1. Q1 certainly has the seasonality issues, but beside the seasonality is, as I just said, the product transition takes longer than our ex-practice from our customer.

And also another key customer change, they have direction in the communication industry, so they are customer change the demand, so therefore we change the loading from our customer.

And since, we are doing to takeouts a many, many of takeouts, so we believe it takes a little bit longer time getting into the second half the situation will become better. Bill is okay, that’s answers your question?

Bill Lu – Morgan Stanley

Yeah. I think that’s fine. I try to – maybe I’ll take it offline. The second part of my question is, David, you talked about a ramp in the leading edge, in the second half of the year. What happen – can you talk about what could happen to your ASP margin? If I look at your first quarter, 65-nanometer was up pretty nicely quarter-on-quarter and yet your ASP was flattish quarter-on-quarter and this one, if you have to translate in the second half to the year?

Gary Tseng

Lu, this is Gary. Firstly, in the 55-nano definitely in the first quarter we are doing quite well. But on the other hand our customers transit their product from 130 and 90 which from the ASP perspective we’re doing okay. This transaction defers also when we are ranking up our set in Wuhan and we received the revenue from there when combining to all ASP listed not held our ASP improve further. So this is mainly, these two reasons that our ASP is dropping. Last, at quarter-over-quarter mentally ASP erosion is also impact as well.

Bill Lu – Morgan Stanley

Thank you.

Operator

And you next question is coming from the line of Steven Pelayo with HSBC. You may proceed.

Steven Pelayo – HSBC

Yeah. You guys got a lot of cash coming in and maybe going out, I guess with this Wuhan investment and sounds like some debt restructuring going on. Could you just talk about free cash flow for 2Q, what do you think your cash balance will be at the end of 2Q? And then, that $1 billion CapEx budget you have this year, does that include any investment for this joint venture Wuhan, is that all likely to come in 2012?

Gary Tseng

Okay. Steve, firstly, if I can talk about the loan structure, definitely we right now using too much short-term loan, so the main task is we’re trying to convert the short-term loan into the long-term loan and I would expect this is should be able to achieve no later than third quarter.

From there, I believe this company in terms of loan structure will be much healthier. On the other hand in the equity side, after the May 27 EGM I would expect SMIC should receive the investment from the CIC $250 million.

Datang investment $50 million will be taking little bit longer time because they need to have approval procedure, which I expect will be toward the end of third quarter and popping the fourth quarter. So, this will be able to improve our debt ratio in a greater way.

Moving forward in Wuhan, while the joint venture will be still at a few quarters before the government approved and I will expect it will happen sometime later this year or even move to the next years.

How fast we will need to invest into Wuhan and how fast the fab will (inaudible) up is really depends on the next few quarters’ development in the customer side. If the customer demand is strong then we will probably, will be the faster or the other way.

The contract we have with Wuhan government mainly we should invest appealing in the next two year, but this is really a topic, we meant to be pressure than the situation coming, we may invest in earlier time or we may need to move it in the later stage.

So all-in-all the company trying to match its CapEx to work with the customer demand in the tightly way, so we could use of our capacity.

In terms of the free cash flow, this company is still under heavy CapEx mode, so basically we probably still need to have external funding and $250 million from CIC would be the main source, definitely we will still need to use the leverage in terms of the syndication loan funding to help our future occasion needs. Thank you.

Steven Pelayo – HSBC

And can you be a little bit more specific, because you had what negative $320 million or so free cash flow this quarter; you’re modeling obviously down revenue margins next quarter, you still want to spend $1 billion in CapEx. So, I guess, I’m a little unclear that you may burn that $250 million CIC just in the next 90 days or so. So help me to understand what the cash balance will be at the end of the second quarter?

Gary Tseng

At the end of second quarter we are probably somewhere around US$350 to US$400 million. Again, beyond the CIC’s investment, we are also looking on the syndication loan and some part of that will be available toward the end of this quarter.

Steven Pelayo – HSBC

Okay. And then remind me on the equity dilution, what’s the share count going to be doing here in 2Q and then, I guess, as Datang comes and it get their pre-anti right exercised as well?

Gary Tseng

Well, if (inaudible) cross check the CPS part which has two years lock up and one years conversion, this together will be somewhere around $300 million so it will be somewhere around 10% to 12% dilution to our all equity share, if CIC invest $250, they probably will be own 11% of our share.

Operator

(Operator Instructions) Your next question is coming from the line of Dan Heyler with Banc of America/Merrill Lynch. You may proceed.

Dan Heyler – Banc of America/Merrill Lynch

Good gentlemen. I had a couple of questions. First, one of the three reasons that you had mentioned for the soft guidance and margin pressure was the Japan earthquake impact, could you elaborate on that, that’s my first question?

Dr. David N. K. Wang

Yeah. Earthquake is actually feels impact, certainly one is to our supply chain, which we results, I went to Japan two weeks after the earthquake, talking to all the material, chemical supply as well as the equipment supply in the substrate. So we will not have a problem in those areas.

For the material for high priority, sponsoring target, CNP Solaris [ph] although saw then we already qualified domestic supply and also qualified with our customer device, so all this including full resist we are not having any problem.

And I think for revenue from Japan customers, since we have very significant amount of business from Japan, so therefore there is no really impact. The only good thing is while our custom transfer the sale of their products to our fab, from their fab in Japan and also the facing the all fab maker also transfer their 45-nanometer product to our Wuhan fab we will start manufacturing of 45-nanometer product in 2012 for the company.

And I think another thing which we don’t know is uncertain is since Japan provides high quantity of components to all the 3G end products in the supply chain. And this may affect the end market which we don’t know that’s why we are forecasting very conservatively for the second half of 2011.

Dan Heyler – Banc of America Securities-Merrill Lynch

Okay. Thank you. And so the direct, what was a direct impact on your business on margins in the second quarter is going to be fairly minimal and was minimal in the first quarter, is that what you’re saying?

Dr. David N. K. Wang

Yes.

Dan Heyler – Banc of America Securities-Merrill Lynch

Okay. Great. And on the second question, you could elaborate on technology readiness issue, with regarding to the Beijing fab, I understand that Beijing fab originally was a DRAM fab, so to what extent do you think this technology readiness and yield and efficiency is structural or to what extent is that short-term in nature and if – and this structure what does mean you’d want to ramp of your other facilities more quickly? Thank you.

Dr. David N. K. Wang

Because the last year we given the increase capacity in Beijing and also market was very strong, so we push, to utilize Beijing rates to over 95% in Beijing and our line yield was very high, is over 99% in that.

So in terms of the operation efficiency and the quality there’s actually no problem there. The issue challenge this year is we are increasing capacity, so we are ramping for example from Q4 to Q1, we increased 4.5K wafers per quarter, that’s pretty big. Also the people are not really experienced doing a ramping in meantime ship older capacity products out and also doing the takeout at the same time simultaneously.

If you get the new equipments, we have to do a stop of the equipment, quantify the equipment to basic process, testing our wafers. So, today’s challenge is very different from last year. We are planning to solve this challenge. I am having a better organization, communicating and transfer, people from different places to support Beijing ramping.

I think all of those will cost the readiness of the 65-55 our product. And another thing is the customer are not very searching for the market, not everybody thinks Q2 is wonderful quarter, yet and people are cautious.

And another thing is some people are in the process of deciding they want to skip 65 to 45 or not. So, I think the whole market is not totally settled. Thus become a challenge for us. But we believe we can overcome this giving some time.

Operator

Your next question is coming from the line of Steven Pelayo with HSBC. You may proceed.

Steven Pelayo – HSBC

Great. I want to talk a little about, I guess, kind of breakeven rate you touched like OpEx and some of the personnel attritions that are going on there. Maybe, you also didn’t see as much of benefit on the ASPs from the mix shift increasing. It looks like at the midpoint of your guidance, you maybe guiding about a $25 million EBIT loss operating profit. You had a side loss in Q1 as well?

So, first of all, I guess, I need to know, just of the forecast kind of the ongoing structure, you are going to have cash payments from governments subsidies, sanction payments, anything like that to offset in Q2?

And then secondarily, can you just talk a little bit about kind of what your breakeven run rate is based today and what it will be, when you measure having this capacity?

Gary Tseng

Thank you, Steve. This is Gary. At this point of time, with our infrastructure plus the technology and capacity. I would say our breakeven point will be somewhere around 85%, which, if I look at last year, we’d be improve a few percentage further.

However, it’s also related to the utilization rate, currently, as David had addressed earlier. The few of our top customer suddenly change in whatever reason and cause us a short-term longing problem from the first quarter and it will expand to the second quarter.

We are fighting very hard to get it back, although we hope in the second half that we will have a brighter picture. But, as David also mentioned, we are cautionary optimistic because there is a still a lot of things we need to make it done.

In terms of the government necessity, we are talking about R&D side, sometime it’s very difficult to predict because they are go through to a very long bureaucratically process to get the money done. So, we'd never be able to forecast this in an exact amount. But, from the last few quarter, we gradually fund out with patent, which we will be able to do it well into the future.

In terms of the sanctioned money, we are working very hard. We still hope that we will be able to get the money back in this quarter or so, but there is no guarantee, because, again, when we are dealing with government, the variable is coming to play and we just cannot predict that yet.

Steven Pelayo – HSBC

Okay. And just as a follow-up question. Yes, it’s, thank you. As a follow up, I was looking at my notes from 90 days ago on last conference call. We were thinking then that maybe you get to a low to mid 20s kind of gross margin in Q2 and obviously the topline has changed a bit.

But, I’m curious if the targeted ASPs that you were thinking on 65-nanometer that you’re going to capture. Are you realizing that? Are they falling? What you thought they’d be a year ago, six months ago, 90 days ago, whatever it is and if not, is that what’s impacting gross margins or do you have any thoughts there? I’m just asking on nanometer pricing, you’re following schedules?

Gary Tseng

Yeah. The problem from my perspective is two fold. The first fold is 65 ASP, we did see a seasonal drop in or I would say it secular erosion in ASP, but it’s in a very critical way. So, I didn’t see that, it is a key problem for us at least for now.

The major problem for our margin decrease is really the loading. Something changed (inaudible) especially in the 130 and the 90-nanometer loading. It is not just a pillar, it has reduced substantially and we just cannot get it back to recover all of its variants. So these were our margins and this will be coming to the second quarter as well.

Steven Pelayo – HSBC

Okay. And then last question for me. You guys have said that you want to spend or you need to spend, I think kind of this one, there was much as $2 billion a year to get kind of your longer term five year targets or so.

I guess, I want to ask if, your thoughts have changed on that in anyway. I also want to know that does that include what you’d be investing in a joint venture in Wuhan if you’re going to spend $1 billion over the next couple of years there.

Gary Tseng

This year, we are still tracking for $1 billion and this is not including, Wuhan, if including, Wuhan the number will be higher. But, we still trying to finalize the Wuhan fabs situation with a major customer, which will – it will be longer term. But still, this year, we’ve got everything. We are talking about some around $1.5 billion in total including, Wuhan.

The long-term, the 2 billion market would still be there. We are working with a major consulting company to draw our five years plan and this will give us a solid ground on which direction, what customer, optical analogy enrollment, we need to have in order to achieve our original five years plan. So, the talk is still there, but I need to address, we need to work in much harder in order to pick up to lead ahead.

Operator

Your next question is coming from the line of Dan Heyler with Banc of America/Merrill Lynch. You may proceed.

Dan Heyler – Banc of America/Merrill Lynch

Yeah. Thanks. I had a follow-up question on OpEx for Gary. Gary, in your guidance of OpEx for the second quarter, you are excluding I presume the R&D credits and payments on other fabs. Could you give us what you would expect those items to be in the second quarter if you have any clarity there?

Gary Tseng

Second quarter, if I normalized everything out, not excluding any R&D subsidy then I would still target 82 to 86 in our current infrastructure. I don’t expect the number will be moving higher. We are confirming our R&D expenses. By when we spill up our 45 and 40-nanometer development, it’s a tough challenge, but I guess, we are doing well in this part.

It varies government subsidy, such as R&D or the Chengdu, the money pack, we will be able to reduce that in a substantial way, but again, we still have a few weeks before the quarter end, which we would be able to realize it.

Moving forward, this year there is inevitably, we would increase our OpEx in quarter three and quarter four, because we increasing our R&D expenses, again, for 40 and 45-nanometer development. At the same time, we’re over tuned the whole organization business process. We are implementing our ELP or SAP program in the company. This will be taking a whole year until the end of this year, after that I hope, by the time of early next year, we will be have much more efficiency organization process moving forward.

And this work is not only working on the organized – we are also working hard on the fab level as well, including improved the fab automation level and trying to utilize or best utilized our fab work. So, this year to SMIC is still reorganization year and hopefully, after this year we will be able to have a strong organization moving forward. Thank you.

Dan Heyler – Banc of America/Merrill Lynch

Okay. And this is a quick follow-up on that, your normalized OpEx for the first quarter was about $90 million, but over $90 million – $90.9, that’s normalized. So this implies that you are reducing your OpEx pretty significantly on a normalized basis to $82, $86, yet, it sounds like your takeouts are increasing and your qualifications are increasing. So where is the cost reduction coming from?

Gary Tseng

Let me clarify one thing. For the OpEx $90 point – $90 million in the first quarter, that would include one-time charge in the organization alignment for US$5 million. If you take this way, it is still going compared to a normalized level at $85 million, which I still target for this, for the whole organization in the OpEx. In the second quarter, again, I was trying to keep this number as long as possible.

Dan Heyler – Banc of America/Merrill Lynch

Okay.

Gary Tseng

Still, $82 to $87 is our normalized level.

Dan Heyler – Banc of America/Merrill Lynch

Okay. Great. Thanks. I appreciate the clarification.

Gary Tseng

Thank you.

Operator

You have an additional follow-up question from the line of Steven Pelayo with HSBC. You may proceed.

Steven Pelayo – HSBC

Yeah. Last question, it looks like your free cash flow this year based on – what I’m looking here, maybe it’s about negative $0.5 billion or so. I’m curious as to, as you transition from kind of an investing mode to more consistent profitability mode. When you look at to 2012, if you’re going to spend another $1 billion or more in CapEx, do you think 2012 is going to be a positive free cash flow year for you?

Gary Tseng

Well, it depends on whether we will have the big growth, depends on the customers demand side. At this point of time in Penging [ph] horizon, we are quite optimistic for the 2012 and basically, is because the customer takeouts in 65-nanometer now and also there’s fully 40-nanometer discussion with our customer give us lot of confidence.

If that is the case, then both of the syndication we are working on, which together will be US$1.2 billion and beyond that, we probably need to still have an equity infusion in order to finance our 2012 expansion.

Steven Pelayo – HSBC

Yeah. Great. Thanks a lot, Gary. I appreciate it.

Gary Tseng

Thank you.

Operator

And with no further questions in queue, I’d like to hand the call back to Dr. David Wang, CEO for closing remarks.

Dr. David N. K. Wang

I would like to take this opportunity to especially thank all of our shareholders, customers and employees, and the suppliers for their trust and support. We are counting on your continued support in advancing SMIC. Thank you for joining us.

Operator

Ladies and gentlemen, thank you for your participation in today's call. The presentation has now ended. You may now disconnect. Have a good day.

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