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Semiconductor Manufacturing International Corporation (NYSE:SMI)

Q3 2012 Earnings Call

November 6, 2012 7:30 p.m. ET

Executives

En-Ling Feng – Senior Director of IR

T.Y. Chiu – Chief Executive Officer

Gareth Kung – Chief Financial Officer, SVP

Analysts

Randy Abrams – Credit Suisse

Steven Pelayo – HSBC

Apurva Patel – S&P Capital

Rick Hsu – J.P. Morgan

Patrick Liao – Nomura Securities

[David Yu] – Private Shareholder

Operator

Welcome to the Semiconductor Manufacturing International Corporation's third quarter 2012 webcast conference call. Today's conference call is chaired by Dr. T.Y. Chiu, Chief Executive Officer; Mr. Gareth Kung, Chief Financial Officer; 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. Please be advised that your dial-ins are in a listen-only mode. However, at the conclusion of the 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 playback will also be available approximately one hour after the event at www.smics.com.

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

En-Ling Feng

Hello, everyone. Good morning and good evening. Welcome to SMIC's third quarter 2012 earnings conference call. For today's call, our CEO Dr. T.Y. Chiu will first provide some general remarks. Then our CFO Gareth Kung will present the financial commentary. This will be followed by our Q&A session. As usual, our call will be approximately 60 minutes in length. The earnings press release and quarterly financial presentations are available for you to download at www.smics.com under Investor Relations in the Events & Presentations section.

Please also be reminded of the Safe Harbor Statement which provides as follows. SMIC's statements of its current expectations are forward-looking statements subject to significant risks 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 April 27, 2012.

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, everyone. Good morning and good evening. Thank you for joining us for our third quarter earnings webcast.

Let me begin by saying SMIC has demonstrated another quarter of significant improvement. This management team came onboard Q3 2011, and since then our capacity had grown 6% with 50% revenue growth. Our gross margin improved from 1.4% to 27.5%. And we are back in the block. We are now three quarters through the year and we anticipate 2012 to mark a year of record-high revenue.

In the past two quarters we successfully achieved our short-term goal, that is to fully utilize our existing capacity and improve efficiency. Our median-term goal of technology differentiation is on track. We have already seen the fruit of some initial results. We expect this strategy of leveraging existing assets for differentiated application to bear bountiful fruits as the time progresses.

We are on track with our long-term objective, that is to continue advanced technology development and offering and to service the expanding demand from the fast-growing China market while deepening our relationship with leading customer through quality and services.

Now in detail, I'm very pleased to report that we achieved our record-high quarterly revenue in the third quarter with a sequential growth of 9.3%, which exceeded our original guidance. Revenue growth was mainly driven by increased demand for our 65nm and 0.18 micron processors. This was a result of smartphone, feature phone and tablet growth.

Enhancing our efficiency and maintaining a good utilization resulted in better Q3 gross margin of 27.5% versus Q2's 24.1%. Despite a relatively lowered amount of R&D contract payment of $2.2 million compared to $60 million in the previous quarter, we again achieved a profitability in the third quarter at both the operating and the net income level. When excluding the above factor, net income improved by $18.7 million in the third quarter sequentially. Notably, we have effectively lowered our breakeven utilization rate from 90% last year to the current level of around 85%. As we ramp up our 45nm/40nm capacity in our Shanghai 12-inch fab, the breakeven point will be further lowered. We anticipate flat to slight growth for the fourth quarter sequentially also as a result of our 65nm and 0.18 micron strength. [inaudible] add that [inaudible] in the right market, benefiting from the rapid growth of the communication and the consumer sector in China. Because of SMIC's weight in the communication and consumer sectors, we are less sensitive to PC weaknesses.

For the near term, we have achieved full production and we are still focused on maintaining high utilization and improving our overall efficiency, quality and service. As a result of this effort, we continue to see good loading into the fourth quarter.

We continue to execute on our midterm strategy of finding differentiation on our technology offering. In September we announced the availability of our 0.13 1.2-volt low-power embedded E-square prompt platform. This technology will allow us to address the high-endurance, very low-power market, include i.e. bank cards.

On the advance technology front, our 45nm/40nm process will ship in volumes starting in the fourth quarter. We have more than a dozen tape-out in the pipeline over six customers on our 45nm/40nm technology and a number of these we have recently engaged. 45nm/40nm is now 0.8% of the revenue, and we will continue to ramp up to low single-digit percentage contribution in Q4. This is somewhat lower than expected due partly to a large revenue basis -- a larger revenue basis. In addition, one of our leading customer has continued to suffer a drop in their end-market demand. Fortunately, our team has identified replacement loading within a very compressed schedule.

Although our 45nm/40nm momentum has been temporarily reduced, we are still very, very confident that our 45nm/40nm capability will significantly contribute to our total revenue in 2013. And we are observing that our US and China customers continue to design into our 45nm/40nm technology with enthusiasm. Our 28nm offering, including both high-k, metal gate and poly/SiON processes, is on track to be ready by the fourth quarter of 2013.

Now, regarding the China market, our China revenue continue to grow sequentially by 18% in the third quarter, accounting for 35.3% of our total revenue in the third quarter. Of our top 10 customers, five are now from China region. Our China customer strength and revenue growth was primarily due to our customers' increased market presence in smartphone, feature phone and tablet business.

Feature phone made from China are rapidly penetrating into emerging countries in Asia, Africa, Central America and Eastern Europe. Leading Chinese fabless are the key player in supplying such feature phone IC demand and thus benefiting SMIC greatly. According to iSuppli, Chinese companies will ship an estimated 480 million feature phone units this year. Although feature phone shipment would decrease to estimated 260 million units in 2016, the absolute number is still relatively large.

Meanwhile iSuppli data also shows Chinese companies' smartphone shipment will expand from 148 million units this year to 321 million in 2016. SMIC is currently supporting China's leading IC player with diverse solution for baseband, Bluetooth, WiFi, flash, CIS, RS, AP, and more. We believe we are well-positioned to benefit from these growing market opportunities. For many of these applications, SMIC is the sole supplier as a result of long-term collaboration with our partners. In addition to mobile phones, set-top box, data cards, smart grid and smart cards in China are also driving growth for SMIC's China revenue.

Apart from benefiting from high-growth Chinese customers, we also have successfully deepened the relationship with US leading customers and successfully engaged new customers. In the third quarter, the US region experienced 7.2% growth, and was strengthened in the fourth quarter, primarily due to smartphone, set-top box and tablets. We have won a good pipeline of tape-out on both 65nm and 45nm from new and existing customers. With our advanced technology ramp-up, we have wider capability to service our customers, especially those who are aggressively targeting the China mobile phone market.

Chinese mobile phone vendors are growing to be some of the largest seller in the world. And as SMIC is the obvious leader in capacity and technology amongst Chinese foundries, it's the clear the partner of choice for fabless trying to penetrate the Chinese mobile phone supply chain.

In conclusion, we are proud of our progress to date in 2012 and I am very proud of the very capable SMIC team that has been executing our strategy with speed and precision. We will continue to capture growth opportunities in China and worldwide via technology advancement and value-added differentiation.

Looking forward, our revenue for 2012 is projected to reach a historical record for SMIC, representing more than 25% year-over-year growth. This is a strong testimony of our enhanced competitive position in value creation through improved quality, enhanced operational efficiency, product differentiation, as well as strengthened partnership with both global and domestic customers.

I thank you for your continued support, and looking forward to update you again in the future. I would now hand over the call over to Gareth for overall business and financial commentary.

Gareth Kung

Thank you, T.Y., and thank you everyone for joining us today. I will now take a few moments to summarize our third quarter 2012 financial results and provide our fourth quarter 2012 guidance. You may also refer to our quarterly financial presentation on our website. Please note that all currency figures are in US dollars unless otherwise stated.

We are pleased to report an exciting third quarter. We achieved record revenue of $461.2 million, representing an increase of 9.3% from the previous quarter and an increase of 50.3% year over year. The strong revenue growth exceeded our original guidance, mainly driven by our 65nm and 0.18 micron processors.

We also achieved significant improvement in the operating income, which increased from $15.7 million in the previous quarter to $20.4 million. Similarly, net profit greatly enhanced from $7.1 million in the second quarter to $12 million in the third quarter.

Wafer revenue from Wuhan Xinxin was $47.4 million in the third quarter, contributing 10.3% to our total revenue. Excluding the wafer revenue from Wuhan Xinxin for both quarters, our revenue increased 8.9% quarter over quarter.

Gross margin expanded by 340 basis points to 27.5%, a seven-year high. This was mainly the result of our continued improvement in manufacturing efficiency.

In terms of operating expenses, the overall OpEx was $106.5 million, which was offset by R&D grants of $2.2 million. Therefore, the normalized OpEx for the third quarter $108.7 million compared to $104 million normalized OpEx in the second quarter. This was due to increased R&D cost.

Compared to our OpEx guidance for the third quarter, there is a $12 million difference. Our original guidance assumes that 45nm/40nm mass production will begin in September. However, the schedule was pushed to October. Therefore, in Q3 all expenses related to Shanghai 12-inch fab, including depreciation and other manufacturing costs, were all booked in R&D expenses as part of the OpEx. However, when Shanghai 12-inch fab enters volume production in the fourth quarter, all the production-related costs will be removed from the R&D expense line and treated as manufacturing cost.

Looking closer to our operating income, R&D grants totaled $2.2 million in the third quarter as compared to $16 million in the second quarter. If excluding this grant, operating income increased from negative $2.3 million to a positive $18.2 million in the third quarter. All in all, the gain attributable to holders of ordinary shares was $12 million in the third quarter of 2012. The fully diluted EPS was $0.02 per ADS.

Moving to the balance sheet, at the end of the third quarter 2012, our debt to equity ratio was 48%, compared to 50% in the second quarter. The ratio slightly decreased as we repaid a portion of our short-term debt.

In terms of cash flow, we generated $190 million of operating cash compared to $109.4 million in the second quarter of 2012. Cash and cash equivalents, together with restricted cash, at the end of the third quarter was $475.9 million compared to $514.8 million in the previous quarter.

To examine our revenue per application, the communications sector was our biggest contributor to revenue growth this quarter. Revenue from this sector increased to $215.4 million, representing a sequential growth of 24.2%. Revenue from the consumer segment was flattish quarter over quarter, contributing $198.8 million, approximately 43.1% of revenue in the third quarter.

Geographically, revenue from the China region recorded a strong quarterly growth of 15%, while US grew 7.2% quarter over quarter. In terms of technology, revenue from 65nm and below increased 18.4% sequentially, contributing 35.6% to our wafer revenue for the third quarter.

With regard to capacity, our Shanghai 8-inch fab increased from 84.6k 8-inch wafers per month to 90k by the end of the third quarter. This increase enhance our capacity for more specialty processors such as PMIC and E-squared proms. At our Shanghai fab, overall capacity increased slightly from 34k 12-inch wafers per month in the second quarter to 35k in the third quarter, mainly from the addition of de-bottleneck equipment. In the third quarter, there was no change to our Tianjin fab capacity. The overall utilization was 92% in the third quarter compared to 95.2% in the second quarter as we had a 5.6% increase in overall capacity in the third quarter compared to the second quarter.

Looking ahead at the fourth quarter of 2012, we are guiding a flat to 2% increase in revenue. Gross margin is expected to range from 18% to 20%. We are guiding down our gross margin due to several factors.

Firstly, as Shanghai 12-inch fab enter into modern production in the fourth quarter, all the production-related costs will be removed from the R&D expense line and through to manufacturing cost. If we exclude this change, the gross margin in the fourth quarter will be in the range of 22% to 24%. The second reason for the decreased gross margin is lower utilization in the fourth quarter.

Operating expenses is expected to range from $70 million to $74 million, excluding foreign exchange effect and R&D grants.

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

En-Ling Feng

Thank you, Gareth. Before we go to the Q&A session, I want to make one correction, regarding 12-inch capacity, from 34,000 to 35,000, that's for our Beijing fab. And so I want to make that correction.

And now I'd like to open up for the call for Q&A. Operator, please assist.

Question-and-Answer Session

Operator

[Operator Instructions]. Your first question comes from the line of Randy Abrams from Credit Suisse. Please ask your question.

Randy Abrams – Credit Suisse

Yes, hi. Good morning. I wanted to I guess start by clarifying on the guidance. First, for the OpEx where you're guiding to $70 million to $74 million. Is that decrease -- I think you quantified in gross margin, but is the full decrease coming from the Shanghai fab expenses? And maybe a look forward to gross margins, I guess that's in the area of mid-90s utilization, if you think now with the Shanghai fab, it would be low to mid 20s or you see a potential to get back to that high 20s as you ramp up that fab?

Gareth Kung

Hi, Randy. The reduced OpEx guidance, as we mentioned, is mainly because of the change in the way we account for the Shanghai 12-inch fab. So, before end of Q4, other expenses in running the fab was considered R&D cost. But going forward, as we start mass production for the 40nm/45nm production, all the production-related cost goes into manufacturing cost, and that will be impacting our gross margin.

Randy Abrams – Credit Suisse

Okay. And if you could clarify then gross margins, should we think then the new range is low to mid 20% gross margin at these 90s utilization, now that you have the Shanghai fab? And could you clarify too the amount of capacity? It's not -- I guess it will show up in the capacity metrics, but in fourth quarter and maybe your plans to ramp up the Shanghai 12-inch fab?

Gareth Kung

We are guiding the gross margin for the fourth quarter to be 18% to 20%. And I think that has to be looked at in context, because [inaudible] our 12-inch revenue Shanghai right now still running at very low utilization due to just starting the mass production for the 40nm/45nm production. So, obviously you could appreciate that right now those gross margin is actually in negative region. So as we gradually ramp up the fab and ship more for the 40nm/45nm, we should see our improvement in the gross margin.

Randy Abrams – Credit Suisse

Okay. And if I can follow up then for the, I guess, your capacity rollout plans, and maybe it gets into the Shanghai fab, your plans to ramp up capacity, and if you could think how you're thinking about CapEx, do you plan to fund it from operating cash flow so that operating cash flow is pretty close to what your CapEx spending, which I guess would put it at similar levels to this year. Or given some of the growth opportunities, could we see you start to get more aggressive on CapEx?

Gareth Kung

I think the two boundary conditions in terms of our CapEx for the full will only expand CapEx based on customer demand. And secondly, our target right now is still continue to fund our CapEx through operating cash flow. So within these two boundary conditions, I think we are looking at our CapEx probably the same as the current year.

Randy Abrams – Credit Suisse

I'm sorry. That last comment, CapEx?

Gareth Kung

I'm saying, within these two boundary conditions, we are looking at our CapEx in the near future will be almost the same level as this year.

Randy Abrams – Credit Suisse

Okay. Thank you. And the last follow-up, if you could mention, because you talked about tablet, feature phone, smartphone, what's the percent of contribution you would estimate from these end-markets? Or is that most of the communications revenue? If you could quantify that.

T.Y. Chiu

Yeah. I think the increase we are seeing, about 50% from the communications sector, another 50% is from the consumer sector, maybe 50/50 to maybe 60/40, yeah.

En-Ling Feng

Randy, this is En-Ling. One thing is we respect our customers' classification, operator that's customer, or communication. And so a lot of our device are sharing between those two applications.

Randy Abrams – Credit Suisse

Okay. Thanks a lot for the clarification. Thank you.

Operator

Your next question comes from the line of Steven Pelayo from HSBC. Please ask your question.

Steven Pelayo – HSBC

Yeah, just a couple of quick ones here. First, on your fourth quarter guidance being flat to up a bit, your peers, TSMC, UMC are kind of down high single digits or so. Could you help me understand where that strength is coming from, how much is China fabless, how much is kind of US customer related, how much is maybe getting the Shanghai fab, moving into volume and then also having revenue on it as well as COGS? Could you just try to help me understand the fourth quarter guidance with a little more detail?

Gareth Kung

Yeah, I think the -- you can see -- actually our guidance is a little bit different from our peers. I think there are two main reasons for that. First of all, as mentioned by our CEO, we are overweight in the communication/consumer sectors. As a result, we are less affected by the weakness in the PC sectors. And secondly, we're also starting major shipment for our 40nm/45nm in the fourth quarter. They have also helped in our fourth quarter results. In terms of the breakdown, I think the strength in the fourth quarter was mainly in the 65nm and 40nm shipments. And in terms of application, it will be mostly in the communication sector.

Steven Pelayo – HSBC

And just curious by region as well, do you expect growth in your China fabless business and your US business and down elsewhere? Help me understand --

Gareth Kung

I think in the fourth quarter the strength will be mostly in our US customers.

Steven Pelayo – HSBC

Okay. All right. And then a question on your capacity, I mean, because you guys are really de-bottlenecking to create capacity, you're finally now moving Shanghai up as well. So it starts the big question that if you're running over 90% utilized, where are you out of capacity? So, could you talk a little bit about your utilization rates by node? And then you just mentioned also in answering Randy's question about a negative gross margin because of low utilization rates in Shanghai. Help me understand what is that running at today, what does it need to be at to break even or to drive a better than corporate average gross margin?

Gareth Kung

In Q3, basically all fabs are running at pretty high utilization. So they're breakeven for all the fabs for Q3. In terms of your -- the question on the fab 8, right now, as we're just starting mass production for 40nm/45nm, so the -- so in terms of the gross margin, it's in the negative territory. But we think that as we go into -- ramp into production, we will be able to achieve a little breakeven gross margin for our fab 8.

Steven Pelayo – HSBC

Can you quantify a little bit at what utilization levels or timing, when do you think you're going to break even there, give me a little bit more detail on -- because that's obviously going to be a big drag on gross margins until it's really contributing. Could you help us time that a little bit more or size that a little better?

Gareth Kung

Well, as we mentioned earlier, our fab 8 capacity grew to about 12k to 15k by the end of next year. We think that by then, on a monthly and quarterly basis, it should be breakeven.

Steven Pelayo – HSBC

Okay. Okay, great. I'll get back in the queue.

Operator

Your next question comes from the line of Apurva Patel from S&P Capital. Please ask your question.

Apurva Patel – S&P Capital

I would like to ask about the gross margin, at what point do you need 40nm/45nm in terms of percentage of sales, all else being equal, gross margin to move higher?

Gareth Kung

As I mentioned just now in the call, we think that as we ramp up the fab to about 12k to 15k, we should be able to achieve a breakeven on the gross margin level for the fab. And that will be, based on our estimation, contributing to about mid to low-teen revenue on a quarterly basis.

Apurva Patel – S&P Capital

Okay. Thank you. And in terms of your OpEx, I know you mentioned that you're going to move some of the costs into the manufacturing. Is this one-time or is it going to be ongoing? How should we think about going forward as you start to ramp your capacity down the road for 40nm/45nm? Are we going to see the same kind of movement or is it going to be a step-down in terms of your operating cost?

Gareth Kung

Well, the switch in terms of [inaudible] is one time. As I mentioned, before end of Q3, the entire fab was considered R&D fab, as a result all the running costs have come to R&D expenses. But from October 1 onwards, the fab is designated to be a production fab. As a result, all the production related costs will be moved from the R&D line into the manufacturing cost line. So it is a one-time that could affect the way we account for the fab going forward.

Apurva Patel – S&P Capital

Just to follow then, how should we think about your operating expenses going forward? I know it's [inaudible] don't ask about next year, but how should we think about your operating expenses next year? I assume it might go -- it might -- should increase, but what's the linearity? Is it going to be a step up or is it going to be gradual? Thank you.

Gareth Kung

I think the increase will be gradual. I think the main increase will be in the R&D because we'll continue to invest our new resources. So I think you will see gradual increase in our OpEx expenses throughout this year.

Apurva Patel – S&P Capital

Thanks.

Operator

[Operator Instructions]. Your next question comes from the line of Rick Hsu from J.P. Morgan. Please ask your question.

T.Y. Chiu

Hello, Rick?

Operator

Your next question comes from the line of Steven Pelayo from HSBC. Please ask your question.

Steven Pelayo – HSBC

One of your prior answers there. You talked about low-teens percent of revenues for Shanghai contribution to breakeven gross margin. To me that really seems like this is really going to be hurting corporate average margins all through 2013. So the question was also asked, when do you think it actually is margin additive? So if you're doing a blended average today of roughly 18% to 20% gross margins, when is Shanghai doing more than 18% to 20% gross margins?

Gareth Kung

Steve, let me clarify. I think we're not about Shanghai as a whole, it's just about the Shanghai [inaudible]. Okay.

Steven Pelayo – HSBC

I understand, yeah.

Gareth Kung

Let me just clarify my comments. What we're seeing is that as we continue to ramp our -- ramp up the 40nm/45nm production to about 12k to 15k, at this point in time we think that -- we are pretty confident that we can achieve at least gross margin neutral for that fab.

Steven Pelayo – HSBC

Okay. So, gross margin neutral to the current reported gross margin, not breakeven as in zero percent gross margin in that fab? Do I understand that correctly?

Gareth Kung

That's our target, yeah.

Steven Pelayo – HSBC

Okay. I just want to make sure that was correct.

And then the last question I wanted to ask was a little bit about on customer concentration. Could you help me understand what's your maybe top three customers represent as a percentage of revenues in the third quarter?

Gareth Kung

Our top five customers currently account for about 55% to about 60% of our total revenue.

Steven Pelayo – HSBC

Okay. And how did that change versus the second quarter? What was second quarter?

Gareth Kung

I think if we look at all our top 10 customers, it had been quite consistent through the last few quarters. Of course, second quarter, one customer would be higher, another customer is lower. But in terms of mix, it's pretty consistent.

Steven Pelayo – HSBC

Okay. And then if I could just sneak one final one, you guys have very little PC exposure, you also have good exposure to some of the leader guys in smartphones, Qualcomms, Broadcoms of the world. But it does appear more recently that this kind of non-branded white box market in China is quite strong. So if I just ask you to try to quantify your percentage of revenue that is specific to that area, what would you say is the percentage of revenues that are coming from China non-branded white box market?

T.Y. Chiu

Steve, actually we will have to do a little bit study to get a number to you next time. That part, I don’t think we have done a very thorough study as yet.

Steven Pelayo – HSBC

You did make an interesting comment recently though about maybe being I think the number one supplier of like CMOS image sensors to that type of market. So I don’t know, maybe you can just provide some color a little bit about what you do provide to that market and maybe how much each one of those segments represent. Can you just maybe talk a bit about it?

T.Y. Chiu

Yes. We do believe that right now, our CIS volume is very, very high, and this -- our customers in the non-branded cell phone area. I think they should have a market share in the range of 50% of the worldwide brands area.

Steven Pelayo – HSBC

Okay, fair enough. Last quick question, just Wuhan contribution in the fourth quarter, what are you thinking there? Is there much change in what they did in the third quarter?

T.Y. Chiu

Right now actually we are still working in active partnership with Wuhan -- we are still working in active partnership with the Wuhan fab. We are still managing the sales and marketing, and we are still -- they are still using our technologies.

Gareth Kung

And the revenue contribution will maintain the same, above 10% of our total revenue come from Wuhan. And that part we do not see a change in the coming quarters.

Steven Pelayo – HSBC

Okay. So, Wuhan actually goes from 8% to 10%, so it does grow sequentially as well, it's tracking kind of line with the rest of your flat-top guidance?

Gareth Kung

That's right.

Steven Pelayo – HSBC

Excellent. Thank you.

Operator

Your next question comes from the line of Patrick Liao from Nomura Securities. Please ask your question.

Patrick Liao – Nomura Securities

Hi. Thanks for taking my question. First question is about the strength in 65nm/55nm and the 0.18 micron technology. Could you please give some color about what kind of products is likely that those strengths fall?

T.Y. Chiu

Okay. The 65nm/55nm technology is mainly in the WiFi and mobile phone and as well as maybe set-top box. Okay. Our 0.18 strength comes from the power management IC. And we continue to see a very robust loading from these areas.

Patrick Liao – Nomura Securities

Okay. Then maybe a very, very high-level idea that I think the current trends for your peers and even your OSAT, your assembly testing companies, looking in the first quarter are going to have some kind of correction and the second quarter will come back good growth. So [inaudible] and anything important for SMIC in the next one or two quarters?

T.Y. Chiu

Okay. The first quarter is still a bit far away and we do not have complete visibility. However, we are seeing a, perhaps, a slight decline to more or less a flat quarter in the first quarter 2013.

Patrick Liao – Nomura Securities

Sounds great. My last question is about your breakeven level utilization idea there. You [inaudible] is improving from 90% level to 85% level and see further lower down the breakeven level, and 40nm/45nm will be the driving force. I'm not quite -- quite understand because I think there will be certain time for the learning curve for the U rate for the new technology. And could you help to understand how it works? Thanks.

T.Y. Chiu

Okay. I think you can understand it this way. In the past, our fab 8 costs, basically they are -- basically generating a lot of cost without much revenue generation. As we ramp up our 45nm/40nm technology, we are actually generating revenue much faster than incurring the cost. That's why we are saying that as we ramp up our 40nm/45nm, that we will see a better net profit. Okay?

As far as the learning curve is concerned, we already are seeing good yields from the various pilot as well as from our initial delivery to our customers. And this is not just limited to a small sample. We have already got four or five different customers' feedback, as well as some initial volume delivery. And we are seeing a very, very comfortable yield improvement.

Patrick Liao – Nomura Securities

Okay. Sounds great. Thanks.

Operator

Your next question comes from the line of [David Yu]. Please ask your question.

[David Yu] – Private Shareholder

[Chinese language spoken]. Congratulations for achieving best operational results in years based on net revenue, gross profit and gross margin, are all records in [ADS]. Thanks for the very good management delivery here. Thanks for your leadership.

By the way, I'm just a private shareholder of your company, holding about 100 million shares. So actually my questions are coming both from a shareholder side. Your Q4 guidance implies about [$10 million] operating results, if I work out the margins and expenses. And your guidance for Q3 are both in the low end and the higher end of your guidance range. So, can we expect that your actual results to be also implying about $10 million operating results in Q4? As for the bottom line, we have a net loss of about $23 million year to date. Your Q4 guidance could imply that we breakeven or be profitable for the full year. Could you confirm on that?

Second question, we are running interest rate expense about $8 million to $10 million on a quarterly basis. Could we replace this with equity finance such that the firm can enjoy $30 million higher operating results on a yearly basis, improving the outlook of our profitability?

Third quarter, the company and management is doing a great job fundamentally and the firm needs finance with regard to capacity and also for the Beijing fab as well. Why we are so silent as a company and management in news flows and company activities? I'm saying, are we expecting any updates about shareholders, any one of them increasing stake, buy more shares in the market, or any financing activities?

And also, as for TSMC, when will it go below 5% in the stake, when they would stop making noise in the equity market there, causing volatilities in the share price?

Last question, last one but this is important, Beijing phase two has started, could you give us a little bit details on the current capital range for that facility? Because there's huge investments over there. Thank you both.

Gareth Kung

All right. [David], thank you so much to being a private shareholder, first of all. Let me try to answer first on your question about the guidance. I think we have given the guidance for Q4 and I think it is based on our current outlook, and saying we're going to stick with that guidance for now.

Second question about CapEx, actually our plan is continue to fund our CapEx through operating cash flow. So we don't have any -- we don’t have any other plan at this point in time.

[David Yu] – Private Shareholder

Okay. And for the Q4 guidance, because if I work out all the -- from top line to the expense line to the bottom line, operating results and all of that, your guidance implies actually $10 million higher operating results than your guidance for Q3. So if I work all that out, if you had the Q3 guidance and you get $12 million operating profit or something net profit, so if you are guiding for $10 million higher results for Q4, I reckon that you might deliver something like $24 million even net profit for the fourth quarter, so, making the whole year like the first breakeven year for the company and for the investors. Could you give more light on that or just answer me yes or not.

Gareth Kung

[David], I'm sorry, I think we can only provide what we provide as Q4 guidance. We can't recommend --

[David Yu] – Private Shareholder

Your guidance works out to be $10 million better than Q3 anyway. Okay.

Now, the financing side, we only have done $9 million interest rate expense. Can we somehow replace with equity finance? As an investor I'm willing to do. Because that could lower our interest rate -- the interest expense by $30 million per annum.

Gareth Kung

Thank you for your comments. We'll take your comments and we'll consider internally.

[David Yu] – Private Shareholder

Yeah. Okay, thank you. Great.

Operator

Your next question comes from the line of Steven Pelayo from HSBC. Please ask your question.

Steven Pelayo – HSBC

Yeah, a couple of follow-ups. Your last comment about kind of a Q1 not having much visibility but suggesting flat to slightly down really impresses me here. [Morshang] is talking a lot about kind of a two-quarter inventory correction and you're not seeing any of it. So I certainly understand PCs are partially to blame, but, heck, expectation has been low there all year long. So I'm curious, your confidence has to be coming I guess from somewhere else. Is this just share gain? Can you give me some more on how you're really relatively outperforming the two-quarter inventory correction that the industry leader is talking about?

Gareth Kung

Steve, I think as mentioned, the two reasons that our guidance may be slightly different from our -- than our peers, one is that we're overweight on the communications sector and the consumer sector. And we are not affected by the PC business as such. And secondly, Q4 we just started, you know, major shipment for 40nm/45nm, and they will continue to ramp in Q1. So that will also have a positive impact on our Q1 outlook as well.

Steven Pelayo – HSBC

Okay. And just two more quick questions. The niche markets that you're going after, a little bit more stable, things like some of the smart cards and some of the things you're doing with some leveraging more trailing-edge capacity. Could you help us understand I guess what percentage of revenue this is, what are the largest component product types that are within there? And help me understand where you think it'll be a year from today, let's say.

T.Y. Chiu

At this point of time, our mature technology still accounts for probably 50% or greater of our revenue. As we ramp up 45nm/40nm and we will see an increase in our advance technology revenue, surpassing the mature technology. That is inevitable.

But as we -- our new specialty technology come out of line from the mature fabs, we will also see an enhanced mature technology revenue, again, probably later part of next year. And so we will generally maintain maybe 40% mature technology to -- 40% to 50% of the revenue coming from mature technology. But we expect that they are going to be increasing in terms of the margin. Okay? Does that answer your question?

Operator

We have time for one more question. Your next question comes from the line of [Ray Chen]. Please ask your question.

Unidentified Participant

Hello [inaudible]. Regarding the mature technology, could you elaborate more on the gross margins? Are they better than the corporate average or lower than the corporate average? And can we say that SMIC's success in [inaudible] is actually taking shares from the local foundries like [Quahong] and [Hong Li] in the sector? Thanks.

T.Y. Chiu

Actually I think our mature technology margin is actually going to be better than the corporate average. As we gradually offer more and more of them into a better and better market segment. However, we see that we are still in a different market segment as compared to [Quahong UMC]. And so we do not believe that we are competing with [Quahong UMC] in this particular area.

Unidentified Participant

Great. Thank you.

T.Y. Chiu

Okay.

Operator

I would now like to hand the call back to the CEO, Dr. Chiu, for closing remarks.

T.Y. Chiu

In closing, I would like to take this opportunity to thank all of our shareholders, customers, employees and suppliers for their trust and support. Thanks also to the analysts who participated today for their questions and comments. And we will see you next quarter. Thank you. Bye-bye.

Gareth Kung

Bye.

Operator

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

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