Semiconductor Manufacturing International's CEO Discusses Q2 2013 Results - Earnings Call Transcript

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Semiconductor Manufacturing International Corporation (NYSE:SMI) Q2 2013 Earnings Conference Call August 8, 2013 10:30 PM ET

Executives

En-Ling Feng – Senior Director, IR

TY Chiu – CEO

Gareth Kung – CFO

Analysts

Randy Abrams – Credit Suisse

Daniel Heyler – Bank of America Merrill Lynch

Sezho Ng – BNP Paribas

Steven Pelayo – HSBC

Miles Xie – BOCOM

Roy Shen – SWS Research

Eric Chen – Daiwa Capital Markets

Jeffrey Toder – CIMB

Operator

Welcome to Semiconductor Manufacturing International Corporation's Second Quarter 2013 Webcast Conference Call. Today's conference call is hosted by Dr. TY Chiu, Chief Executive Officer, Mr. Gareth Kung, Chief Financial Officer and Mr. En-Ling Feng, Senior Director Investor Relations.

Today's webcast conference call will be simultaneously streamed through the internet at SMIC's website. (Operator instructions). However at the conclusion of management's presentation, we will be having a question-and-answer session at which time you will receive further instructions on 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. Without further ado, I would like to introduce you to Mr. En-Ling Feng, Senior Director, Investor Relations for the cautionary statements.

En-Ling Feng

Hello everyone. Good morning and good evening. Welcome to SMIC’s second quarter 2013 earnings conference call. For today’s call, our CEO, Dr. TY Chiu will first provide some general remarks on our business, then our CFO, Gareth Kung will present the Q2 financial commentary. This will be followed our Q&A session. As you know, our call will be approximately 60 minutes in length.

The earnings press release and quarterly and quarterly financial presentation are available for you to download at www.smics.com under investor relations in the events and 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 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 April 15, 2013.

I will now turn the call over to our CEO, Dr. TY Chiu for the opening remarks.

TY Chiu

Thank you, En-Ling. Greetings to everyone. Thank you for joining us for our second quarter 2013 earnings webcast. I would like to begin today’s call by highlighting our Q2 2013 achievements.

I am very pleased to report that SMIC has exceeded expectations and at the end, achieved record high revenue of $541.3 million in the second quarter of 2013, representing year-over-year growth of 28.3% and a sequential growth of 7.9%. This growth was primarily driven by demand for smartphone related applications as handset makers prepare for new product launches.

In addition, gross margin improved to 25% in the second quarter, compared to 24.1% in the second quarter 2012 and 19.6% in the first quarter 2013. The enhanced gross margin was mainly due to higher utilization from both 8 inch and 12 inch. The utilization has increased to 98.5% compared to 95.2% in the second quarter 2012 and 89% in first quarter 2013.

Both gross profit and profit from operations reached record high of 135.2 million and 79.1 million respectively. This is the fifth consecutive quarters of positive profit from operations when excluding other income from property disposals.

Furthermore profit attributable to SMIC was 75.4 million in the second quarter compared to $7.1 million in the second quarter last year and 14.6 million in the first half 2013, a growth of 960% year-over-year and 85% quarter-over-quarter. In addition, I am glad to highlight that SMIC has surpassed a net income of $100 million for the first half of 2013.

In detail, revenue growth was driven by the following factors; first, revenue from our China customers grew 14.3% sequentially and 60.6% year-over-year contributing 40.9% of total revenue in the second quarter of 2013. This is an all-time high.

The demand from our China customers was driven primarily by low end smartphone related applications. Customers expressed strong demand for our 45/40 services indicating a very strong new product tape out in the third quarter.

As a result our 40/45 revenue grew 71.9% sequentially contributing 10% of total wafer revenue compared to 6.4% in the first quarter of 2013. The key product for 40/45 node are again smartphone related applications. We see continued momentum for 40/45 as planned new plans will increase significantly in Q3. Even with IT supplier’s inventory correction by smartphone manufacturers. We are targeting continuous growth of this technology node for the rest of the year, reaching 15% of revenue in the second half of this year either in Q3 or Q4.

Besides advanced technology nodes, in Q2 utilization across all fabs are in very high. In particular 8-inch demand continues to be a key growth driver of our business. Demand for our differentiated applications continues to be strong especially in the area of power management, CIS and embedded non-volatile.

SMIC continued to hold a strong position in some differentiated technology by being the first source supplier for these products. Revenue from our differentiated technology specifically PMIC, CIS and the embedded non-volatile grew 83.6% year-over-year in second quarter 2013 compared to second quarter 2012.

In order to further capture the market opportunities and to enhance our position in the differentiated technology, we're looking into various opportunities to expand our 8-inch capacity. For the 12-inch advanced technology development we continue to work hard in R&D while carefully investing in advanced node capacity.

Along the same lines, our 28 nano for both polyfion and high K Metal Gate development continued to be on target and is on track to be process ready by the fourth quarter of 2013.

In terms of advanced capacity for future expansion as announced in June, SMIC will jointly establish a fab in Beijing focusing on 45-nano and finer technology with planned manufacturing capacity of 35,000 wafers per month, ramped over the next three to five years. The equipment should be ready for moving around the first quarter of 2014.

Meanwhile, we are also actively discussing with our customers in the testing their demand for advanced nodes. In addition we are expanding our living quarters as part of our employee retention program.

We believe the living quarters has been a very important component to SMIC’s successful employee retention by providing our employees with comfortable close net communities that is not only conveniently located near our factories and offices but also family-oriented and the near location-wise to our very, very competitive top notch school.

Before I provide the outlook for 2013, I would like to share some overall market outlook, courtesy of Gartner. Overall semiconductor growth is estimated to be 6.8% in 2013 compared to 2012 and for foundry revenue it is expected to grow 13.3% this year compared to last year.

Despite the inventory adjustment reported for the industry in the second half of the year, our goal is to significantly outgrow the semiconductor industry projection and we will be well above the foundry average as well this year. Our original Q2 revenue guidance was a sequential growth of 3% to 5%.

In fact, revenue growth reached 7.9% as customers put in orders earlier contributing to our stronger second quarter and a flattish third quarter. We currently guide Q3 to be flat sequentially and we believe we will have a solid second half performance, of course taking the Wuhan dis-engagement into account.

In conclusion, the second quarter of 2013, SMIC beat multiple records in terms of revenue and profitability. Despite the fact that the weather is sizzling in Shanghai, unfortunately the market has fizzled a bit. Nevertheless, we are expecting a good second half and – when the contribution from the dis-engaged Wuhan is removed.

The management is keenly focusing on continuous efficiency improvement and a vast technology introduction, mature technology enhancement and improved profitability to our prescribed differentiation strategy and proven investments for future growth.

Before I close the session, I would like to thank our customers for their support and our employees for their hard work and dedication. Thank you for your time. I will now hand the call over to Gareth for overall business and financial commentary.

Gareth Kung

Thank you, TY and thank you everyone for joining us today. I will now take a few moments to summarize second quarter 2013 financial results and our third quarter guidance. You may also refer to our quarterly financial presentation on the website. Please note that all currency figures are in US dollars, unless otherwise stated.

We are pleased to report another strong quarter. In the second quarter 2013, we achieved our fifth consecutive quarter of record high revenue of $541.3 million, representing an increase of 283% year-over-year an increase of 7.9% quarter-over-quarter.

Revenue from China-based customers increased to 40.9% of overall revenue in the second quarter of 2013, an all-time high compared to 32.7% in the second quarter of 2012 and 38.6% in the first quarter of 2013. Gross profit of 135.2 million in 2Q 2013, was a record high compared to 101.7 million in 2Q 2012, and $98.3 million in 1Q 2013.

Gross margin improved to 25% in 2Q 2013 compared to 24.1% in 2Q 2012 and 19.6% in 1Q 2013. Profit attributable to SMIC was $75.4 million in 2Q 2013 more than 10 times the profit of $7.1 million. In 2Q 2012, and 85.7% increase compared to the profit of $40.6 million in 1Q 2013.

Now looking into the details of our income statement. Revenue growth in the second quarter of 2013 exceeded our original guidance, mainly due to the increase of 40/45 nano on 18.15 micron wafer shipments. Wafer revenue from Wuhan Xinxin was $39.5 million in 2Q 2013 compared to $29.2 million in 1Q 2013.

This portion of revenue will gradually be phased out starting third quarter 2013. Cost of sales in 2Q 2013 was $406.1 million comparable to $403.3 million in 1Q 2013 despite an increase in shipments. This is primarily due to the significantly higher fab utilization and as a result depreciation expense was distributed a larger amount wafer produced and to inventory costs. Our 2Q 2013 gross margin was guided 20% to 22% and resulted in 25% compared to 19.6% in 1Q 2013 primarily due to significantly higher fab utilization in 2Q 2013.

Operating expenses in 2Q 2013 were $56.1 million which was offset by funding from R&D contracts with the government or $3.8 million and other operating income was $33.1 million. OpEx increased compared to $47 million in 1Q 2013 which are offset by funding from R&D contract with the government of $10.9 million in other operating income of $20.2 million.

Including funding from R&D contract with the government and other operating income which is mainly from asset disposal, the normalized OpEx would be $92.9 million in 2Q 2013 compared to $70.1 million in 1Q 2013 mainly resulting from higher employee staff accruals. R&D expenses increased to $36.7 million in 2Q 2013 from $24.8 million in 1Q 2013 mainly due to, one, a $7.5 million decrease in funding from R&D contract with the government in 2Q from $10.9 million in the previous quarter. And two, higher employee bonus accrual in 2Q 2013.

General and administrative expenses increased to $42.6 million in 2Q 2013 up from $34.2 million in 1Q 2013, also mainly due to higher employee bonus accrual in 2Q 2013. Other operating income of $33.1 million in 2Q 2013 included one, the team arriving from disposal of living quarters in Shanghai and two, the gain arising from disposal of the company to the ownership interest in SMIC Wuhan Development Corporation which was mainly engaged in the construction, operation and management Wuhan living quarters and schools.

Profit from operation in 2Q 2013 was a record high of $79.1 million compared to $51.3 million in 1Q 2013. If excluding funding from R&D contracts with the government, other operating income which is mainly from asset disposal and employees' bonus accrual, the normalized profit from operations will also be a record high of $67.9 million in 2Q 2013 compared to $35.9 million in 1Q 2013 and $3.5 million in 2Q 2012.

Other expenses in 2Q 2013 was $3.3 million compared to $8.3 million in 1Q 2013, mainly due to a decrease in the finance costs and the payment of land idling tax charge by local governments in 1Q 2013. Income expenses were $0.5 million in 2Q 2013 compared to $2.5 million in 1Q 2013. Due to a decrease in the number of living quarter units disposed in 2Q 2013, compared to the previous quarter, resulting in decreased income tax. Profit attributable to SMIC was $75.4 million in the second quarter of 2013, compared to $40.6 million in the previous quarter.

Moving to the balance sheet. At the end of the second quarter 2013, our cash and bank balances together with restricted cash was $477.4 million compared to $478 million in the previous quarter.

Trade and other receivables increased $117.1 million due to increased revenue. Debt to equity ratio was 44.1% compared to 41.3% in the first quarter of 2013. The ratio increased as our long-term debt increased by $45.7 million and short-term borrowing increased by $57 million compared to the end of the first quarter 2013.

In terms of cash flow, we generated 1$108.4 million of cash from operating activities compared to $154.6 million in the first quarter of 2013. This decrease was mainly as a result of changes including capital as trade and other receivables increased.

Cash used in investing activities increased by $159.5 million in the second quarter of 2013, compared first quarter of 2013 due to higher cash CapEx payments. Cash flow from financing activities increased from an outflow of $137.5 million to an inflow of $104.2 million as we increased our borrowings in second quarter while we paid down debts in the first quarter.

Our cash and bank balances at the end of 2Q 2013 decreased by $30 million sequentially to $263 million. To expand our revenue by application, the Communications segment was again our biggest contributor to revenue this quarter. Revenue from this segment increased to $246.8 million representing a sequential growth of 4%. This growth is mainly from increase in handset-related products.

Revenue from the Consumer segment grew 15% quarter-over-quarter contributing $245.2 million mainly from Bluetooth, gaming devices and set-top-box. Geographically, revenue from China grew 40.3% an increase of $27.8 million contributing $40.9% of total revenue. Revenue growth from China contributed the most to the total revenue; increased in second of 2013 mainly revenue growth from China contributed the most to the total revenue growth in the second quarter of 2013 mainly due to increased shipment from mobile related applications.

Revenue from North America increased 1.4% sequentially contributing $48.3% of total revenue. Asia grew 16.5% contributing 10.8% of total revenue, an increase also mainly from mobile related shipments.

In terms of technology, revenue from 40/45 nano increased 71.9% sequentially contributing 10% of wafer revenue in the second quarter 2013. Revenue from 65/55 nano and 90 nano increased 1.1%. Meanwhile, 20 micron above grew 9.7% with strength from power management, CMOS image sensor and e-script for our applications.

In terms of overall capacity, total monthly capacity at the end of second quarter was 223.5000 wafers compared to 219.6000 wafers. The change was primarily due to increased 45/40 nano capacity in our Shanghai 12-inch Fab.

The overall utilization was 98.5% in the second quarter of 2013 compared to 89% in the first quarter of 2013. The significant utilization increase was across all fabs.

Looking ahead at the third quarter of 2013, excluding wafer shipments from Wuhan Xinxin, which is expanded to gradually space out starting in the third quarter of 2013, revenue expected to be down 1% to up 2% quarter-over-quarter. Including Wuhan, total revenue expected to be down 3% to Fab quarter-over-quarter.

Gross margin excluding wafer shipment from Wuhan is expected to range from 18.5% to 21.5%. Including Wuhan, gross margin is expected to range from 17.5% to 20.5%. Operating expenses expected to range from $81.mln to $85 million excluding the effect of foreign change funding from R&D contracts with the government and gain from the disposal of living quarters.

We reiterate our 2013 CapEx guidance estimated for our foundry operation to be approximately $675 million. In addition, the company had budgeted CapEx of another $130 million. In 2013, for construction of living quarters for employees, a key component of our long-term employee retention program. The company plan to either rent out or sell those units to employees in the future.

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

En-Ling

Thank you Gareth. I would now like to open up the call for Q&A as usual to be reminded and please limit your questions to two per person. Thank you and operator, please assist.

Question-and-Answer-Session

Operator

(Operator Instructions) And the first question comes from the line of Randy Abrams coming from Credit Suisse. Please ask your question.

Randy Abrams – Credit Suisse

Yes, hi good morning, thank you. My first question on the third quarter for the latest guidance, if you could talk about what areas are continuing to grow and the areas you're seeing some slowdown and any implications into fourth quarter, if there is anything that could offset some of the trends we're seeing from other foundries that are guiding a bigger decline into fourth quarter?

TY Chiu

Okay, we are guiding a flattish for the following reason. First of all, that we are still aiming to – at a further increase in the 40/45 nano revenue and, secondly, we are still seeing some strength in some of the differentiated technologies that we are actually emphasizing. So an area for the power management CIS and embedded non-volatile on top, we are still seeing some of the growth.

Gareth Kung

Randy, just want to add more color to the Q3, I think we are seeing continued growth in our China revenue in Q3, I think there will be a slight decline in our North American revenue. In terms of technology, I think we are seeing strong growth in the 40/45 nano in the third quarter.

Randy Abrams – Credit Suisse

Okay, and for – and I guess the second question, the – if you could talk about how CapEx will phase in for Beijing, the $3.6 billion overall I guess, in your annual spending commitment that you expect from that? And then how much CapEx for the rest of the business, like outside of Beijing you'll need to spend as we look going forward?

And if you could do a quick comment on the first question, the fourth quarter, what are your expectations relative to the foundry group, if some of these things like the specialty or 40-nanometer could offset the trends that we're seeing in broader foundry group?

TY Chiu

We do not give a very clear guidance on the fourth quarter number, but if you ask for the general sentiment for us, we are seeing – if we look at the core revenue that is without Wuhan. It is staying relatively flat. We are getting a strong new tape out in the 40-nano technology node and we believe that will translate into additional revenue in that technology node.

As to the CapEx for the B2, we have reported that B2 will ramp over three to five years depending on the customer demand. So if you take an average of four years, you know that on average what is the CapEx, okay?

Gareth Kung

Randy, just want to mention that for the new plant in Beijing is a joint venture with investment company and the Beijing government. So we are contributing only 55% of the investment and our joint venture partner will contribute about the other 45%. And total investment for the project is $3.6 billion and as what TY mentioned, we are going to ramp that over three to five years. So, I think the CapEx was still being very manageable from our point of view.

Randy Abrams – Credit Suisse

Okay, so your expectation of the run rate per (Inaudible) for CapEx.

TY Chiu

As far as the question, whether there will be significant CapEx outside of Beijing that is our primary investment for the next four to five years. Certainly, we might have smaller investments to upgrade our 8-inch fabs and our present Fab in Shanghai. But the major investments will be in Beijing.

Randy Abrams – Credit Suisse

Okay, thanks a lot.

Operator

And the next question comes from the line of Daniel Heyler calling from Bank of America Merrill Lynch. Please ask your question.

Daniel Heyler – Bank of America Merrill Lynch.

Yeah, thanks guys. I have just two questions, one relating to the mature technology and one to the advanced technology. So I was wondering on the mature technology front, you've done very well with your derivative technology strategy. Congratulations, and you've been growing the business.

Capacity seems pretty full at this point and as you said you're keeping your fabs full and it looks like for most of the year. So as you look to 2014 to try to grow that business, you are trying to find capacity, but it looks as though a lot of others are also trying to seek 8-inch capacity. How viable is it that you can secure 8-inch capacity at an attractive price and maybe give us some color on your strategy there to build out your 8-inch derivative technologies?

TY Chiu

Okay, I think that we have a number of opportunities and we have a fab that’s already built but not to outfit of what the equipment that is in Shenzhen. That is a one fab that we can quickly bring into production certainly and we have already secured a number of tools to initiate that work but we are also exploring other opportunities and so we will react at those opportunities.

Gareth Kung

Hey, Dan and the other thing is actually I think there is still room for us to incrementally increase our capacity in our Shanghai fab in also our in Beijing Fab. So I think we are still growing that business.

Daniel Heyler – Bank of America Merrill Lynch.

Could you give us a sense of the magnitude there in both the internal expansion for 2014, are we talking maybe we can squeeze out another 10% of the number? And then, how much – how can you get – are you planning to get mature equipment, used equipment, or at this point you have to find new sources of equipment?

TY Chiu

I think for all these build-up we are actively looking at used equipment and there is an active 8-inch used equipment market out there. And we believe that there are actually a number of 8-inch fabs that will be coming into the market soon.

Daniel Heyler – Bank of America Merrill Lynch.

Okay, great. And then on your advanced technology strategy, the handset market appears to be pretty strong. Now moving into the mid to low-end cell phone market we've noticed a rapid conversion to 28-nanometer, from 40-nanometer. So I'm wondering how you can sustain growth in 40-nanometer next year? What some of the applications for 40-nanometer would be?

TY Chiu

Actually, there are migrations, products migrating from 40 to 28 but there are also quite a few products migrating into the 40-nano technology node. So actually, we are still seeing a very strong new products tape out in the 40-nano. So, this is an area that we feel that it is not an extreme worry at this moment. In addition, we have the plan for our Shanghai fab a significant portion up to 40% of our equipment are 28 compatible. So as the product moves to 28 a lot of our capacity will be again fully utilized.

Daniel Heyler – Bank of America Merrill Lynch.

Okay, so a quick follow-up. So as you're migrating people from 65 to 40, that's keeping your 40 going Maybe explain how you're going to backfill your 65 and 90-nanometer, what some of the applications will be at 65-nanometer because you are migrating business forward, so you still have other fabs to fill?

TY Chiu

Right, right, right. There will be products going from the older from 1.3 that are going into the 60 as well. So, as you can see that some of our mature technology fab actually the utilization is fairly high. If you do the proper planning and the migration, I think it is possible to maintain a fairly good utilization across the board. The 8-inch. I think the other one is that we will see a very dramatic drop-off in the 8-inch capacity utilization.

Daniel Heyler – Bank of America Merrill Lynch.

Okay, so it sounds like derivative technology will be filling those fabs of 65 and 90 fabs?

TY Chiu

Yes.

Daniel Heyler – Bank of America Merrill Lynch.

Thank you, thank you.

Operator

Next question comes from the line of Sezho Ng calling from BNP Paribas. Please ask your question.

Sezho Ng – BNP Paribas

Hi, good morning gentlemen. Two questions from my side. First one for 28 nano, when should we expect that to be revenue generating?

TY Chiu

Excuse me, could you…

Sezho Ng – BNP Paribas

For 28 nano, when should we expect it to be generating revenue?

TY Chiu

Revenue generating, we expect to start it have revenue generation from the – maybe end of third quarter, the beginning of fourth quarter 2014.

Sezho Ng – BNP Paribas

Okay. And I believe that would be for the PolySiON version first, right?

TY Chiu

Yes, it is first PolySiON.

Sezho Ng – BNP Paribas

When should we expect the High-K/Metal Gate business to come in at?

TY Chiu

Maybe second half of 2014.

Sezho Ng – BNP Paribas

Okay all right, and second question for the management of Xinxin. When should we expect that part of business to be fully ramped up, because it has been maintaining at a pretty high level even going into Q2?

Gareth Kung

Starting Q3, you will see that our revenue start to ramp up and I think sometimes at very low level in Q4.

Sezho Ng – BNP Paribas

Okay, all right, okay, thank you very much.

Operator

Next question comes from the line of Steven Pelayo calling from HSBC. Please ask your question.

Steven Pelayo – HSBC

Yes guys, congratulations on the good quarter in second quarter, but the gross margins were far above expectations for me. However when we do look in third quarter a kind of flattish guidance, all in including Wuhan may be slightly downsized, maybe flat to down slightly.

The gross margin maybe at the midpoint, down about 600 basis points I guess, if I'm doing the math right? I understand utilization rates I think are relatively staying fully loaded. I understand there's some depreciation spreading going on, but still a 600 basis point decline seems very severe. So is there something else going on in the third quarter gross margins there?

Gareth Kung

The gross margins in Q3 will become lower – because of the lowest utilization of our fabs. We are looking at the utilization in the mid-80s in Q3 which is about more than 10 points decrease in the utilization.

Steven Pelayo – HSBC

I guess, I'm trying to understand then the linearity and the shape here, you guys are talking about kind of second half opportunities and in the fourth quarter maybe outperforming what we're seeing from everybody else.

But you'd expect then, I don't know, do you just have a big drop in utilization rates that are now going to ramp back up again so you can keep the fourth quarter relatively flattish, or I'm trying to understand how you keep flat revenue when your utilization rates are falling 10 points in the third quarter, as you go into the fourth quarter?

Gareth Kung

I think as what TY said, I think we are seeing a lot of new development in Q3 and we are hoping that it will translate into revenues one quarter from now. So we are seeing – as what you might say right now based on our current visibility excluding Wuhan it’s more like flattish quarter in Q4 I will caution that this be based on very limited visibility at this point in time and as move into Q3 we will have more visibility on the Q4 revenue.

Steven Pelayo – HSBC

Okay, Gareth, if I can just ask two housekeeping questions really quick. I am a little confused with the second quarter report since you have property sales and R&D and tax rates, assets as well. Can you help us understanding maybe just what's ongoing excluding all those kind of items, net profit, EPS? I'm trying to get a better understanding of what the ongoing EPS would have been, if I was able to skew all of those and get more of normalized tax rate?

Gareth Kung

I am sure I don’t quite – get your question.

Steven Pelayo – HSBC

Well, I want to think about SMIC's second quarter results on an ongoing basis excluding R&D credits, excluding property sales, asset disposals, Wuhan and any other tax changes that impact because of those one-time gains. So, if I was thinking about your second quarter results on a continuing basis or an ongoing basis, then what was the impact to the bottom line in EPS or in net profit? Can you help me do that math?

Gareth Kung

I think I mentioned that in the second quarter if we exclude, we have – what we call a normalized operating income.

I think we are talking at – yeah we mentioned that if we exclude our funding from R&D contract with government and other operating income which is from asset disposal, and employee bonus, the normalized profit from operation would be above $68 million in the second 2013 compared to $36 million in first quarter 2013 and $2.5 million in second quarter 2012. So actually we can refer to the PPT, well, page six of the PPT that shows the trend in our last eight quarters.

Steven Pelayo – HSBC

Great, I appreciate that. For the last one I could just sneak in on housekeeping, customer concentration. I'm curious how many customers are above 10% of revenues and also even specifically in that 40% of revenue that are coming from China, are any of those above 10% of total revenues as well? Can you talk a little about customer concentration? And that's the last question from me. Thank you.

Gareth Kung

Yeah, in terms of customer concentration, I think it is pretty stable although it appeared over the period and right now our top five customers contribute about 50% to 60% of our revenue.

Steven Pelayo – HSBC

How many customers are above 10% of revenue and are any of those China fabless?

Gareth Kung

No, no, not yet above 10% but a number of them are exceeding 5%.

Gareth Kung

Okay, and then otherwise I think you guys just have two customers that are above 10%, is that correct?

Gareth Kung

Yes, two customers are at above 10%.

Steven Pelayo – HSBC

Excellent thank you guys.

Gareth Kung

Thank you.

Operator

Next question comes from the line of Bill Lu calling from Morgan Stanley. Please ask your question.

Unidentified Analyst

Good morning. Leslie Tino calling in for Bill. I have two questions on follow-up. One is about our guidance about utilization rate in the third quarter, because we still seem very strong 40-nanometer demand into the third quarter. So I want to understand why the utilization rate will go to mid-80%s, so which node has lower utilization rate in the third quarter?

Gareth Kung

I think, in terms of Q3 utilization, we are seeing high utilization for our 8-inch fab compared to our 12-inch fabs.

Unidentified Analyst

Okay, okay. I got it. So one quick follow-up, in our 40-nanometer, is there our China customer base is higher than average in the 40-nanometer?

TY Chiu

Okay for the last two quarters, the China contribution to the 40-nano revenue is very significant but we are seeing quite a strong ramp up in new tape outs from the global customer base in this quarter, third quarter.

Unidentified Analyst

So for the third quarter.

TY Chiu

I think that part of it, yeah, third quarter. So, part of it I think is because people are seeing that it might be shipping a significant amount of the 40-nano wafers and still are coming in and actually are convinced that we have a good technology and a stable profits.

Unidentified Analyst

Okay, okay, I got it. So when you migrate in the 28-nanometer, is the client in the 28-nanometer is an existing client in the 40-nanometer we you have new customers in the 28-nanometer?

TY Chiu

We do have a number of new customers that are using our 28 process. This is as well as certainly existing customers that is in the 40-nano.

Unidentified Analyst

Okay, I got it. One final question is that I want to ask for more color by – the margin by each node, because like TSMC comment about that actually they have similar gross margin for each node including the – leading edge node. Is that the same case in our fab?

TY Chiu

Right now, I think our 40-nano node, I think probably final in particular the 40-nano, 40-nanao node has been ramping up in the last two quarters and our margin is improving steadily and significantly. But we are not able to release the exact number at this point of time.

Unidentified Analyst

So is that higher than the corporate average in the 40-nanometer or is it still below?

Gareth Kung

I think let me explain, I think overall, I think our mature node gross margin will be higher than our new advanced node at this point in time.

Unidentified Analyst

Okay, I got it. That's all from me, thank you so much.

Gareth Kung

Thank you.

Operator

The next question comes from the line of Miles Xie calling from BOCOM. Please ask your question.

Miles Xie – BOCOM

Hi, thank you for taking my question. Gareth you just mentioned about the inventory, can you help me understand more about it? Is the inventory issue coming more from the high-end smartphone customers, or more from the low-end smartphone customers? From the current situation, can we see when the inventory will be back to normal level? Will it be in the fourth quarter or the first quarter in next year? Thank you.

Gareth Kung

The inventory that we are seeing a number of our customers and reporting an increasing inventory level. Some of them are reporting that the inventory and telling us the inventory problems will be resolved within a quarter, but some of them are – or others are thinking that they will digest their inventory in two quarters time. So, we think it would be somewhere in between the fourth quarter and the first quarter where this – our broad base of customers will be able to resolve this issue.

Miles Xie – BOCOM

Okay, okay. Thank you. So my second question is the China market, actually there will be two things, one we know the issue of the 4G license, I think will be issued very soon. So what will be the implication to SMIC? The second in the China market is, if the release of the Xiaomi, I think that's a quite low priced smartphone, priced at RMB799 and also the cheap iPhone introduced. So what will that impact on the low-end smartphone market, how that will – what's the implication to SMIC as well? Thank you.

TY Chiu

Okay, our customer actually covers actually mostly low-end smartphone and some of them are trying to get into a high-end as well and so but robust growth in the low-end smartphone definitely will benefit our customer base and certainly that will carry over to SMIC. As far as 4G LTE license, we are excited that China will grant a few license this year. That would also increase the additional – stimulates additional market for the smartphones and we believe that we will expect benefit from all these groups.

Miles Xie – BOCOM

Okay, thank you.

Ty Chiu

Thank you.

Operator

And the next question comes from the line of Roy Shen calling from SWS Research. Please ask your question.

Roy Shen – SWS Research

Thank you. Thank you for taking my questions and congratulations on a strong second quarter results. If you look at the future growth drivers and the niche market, my question is, do the management see the orders from the smartcard business, such as bank card and social security card others surge in third quarter? And what's the percentage of revenue contribution from the smartcard business in the second quarter? Thank you.

Ty Chiu

We don’t give specific breakdown on the one specific market segment, but – our business it is a large business for – and a brilliant business for SMIC. We – as we have reported, half of the customers that have passed the bank card initial qualification, half of these qualified vendors are SMIC customers.

So, we expect that a number of markets that is emerging will actually benefit our customers and SMIC will actively participate in those card segment and we are also actually working on new technology on the and we will be coming out with a more advanced technology sometime later next year.

And so, we are preparing this – our technology roadmap for this card segments continuously and we believe that we have some of the best technology to be offered in the market.

Roy Shen – SWS Research

Okay, thanks.

Operator

And the next question comes from the line of Eric Chen calling from Daiwa. Please ask your question.

Eric Chen – Daiwa Capital Markets

Hi gentlemen. The first I would like to clarify, you talked about the demand quite strong, and for the power management, the CMOS sensor and the (inaudible). And how about for the smartphone and the tablet PC, the IC and how's it going on, the demand there?

Ty Chiu

I think we are going to see very strong demand from the mobile related application which is why we are seeing very strong tape out in the current quarter for the 40/45 node that’s what we said earlier. We are hopeful that this new tape would translate into very strong revenue one and two quarters down the road.

Eric Chen – Daiwa Capital Markets

Okay, so my follow-up question is, I assume the business mainly came from China and how about your revenue, the percentages from China – and your expectation at the year end and even like the next year, roughly idea?

Ty Chiu

Yeah, for Q3, we are seeing stronger growth in our China based customers as compared to our North American customers. So we will see a slight increase in our China revenue contribution in the third quarter.

Eric Chen – Daiwa Capital Markets

How about the revenue percentage? In Q2 it's already reached 40%. Can I assume the 45% at the year end, or like the 50%, 55% for the whole year next year, roughly?

Ty Chiu

Yeah, roughly I will say in the second half it will be around 40% to 45%.

Eric Chen – Daiwa Capital Markets

Okay. Also you talk about the CMOS, the image sensor business quite strong. And the node the Omnivision just invest the Wuhan fab. And so I'm wondering the business you talking about the CMOS image sensor is now related to the Wuhan business or any of the business relationships going forward you will have with Omnivision?

Gareth Kung

Our CIS business is really on own without any relationship with the Wuhan fabs Actually we are – we actually announced earlier that we have already in the BSI technology and I think right now, customer didn’t tape out and we are going to see some revenue towards the end of the year.

Eric Chen – Daiwa Capital Markets

Okay, so can I assume that when you talk about CMOS sensor business quite good, let’s not talking about Wuhan site.

Ty Chiu

It’s not anything related to Wuhan.

Eric Chen – Daiwa Capital Markets

Okay, thank you, very clear. And my last question regarding to the – your investment for the Beijing fab. I may be lost, but from my understanding you mentioned about a $3.6 billion for the five years investment. So I would like to know the annual rights issue plan, or how you deal your cash flow decide?

Gareth Kung

Yeah, as I mentioned, this is a joint venture project that SMIC owns 55% and our joint venture partner which the investment company and the Beijing government will own 45%. So, we only contribute 55% investment and that spread over three to four years, I think the CapEx investment is very manageable from our operating cash flow.

Eric Chen – Daiwa Capital Markets

So $3.6 billion, that's the total amount you are going to do the investment or you are going to do the investment is 55% of the $3.6 billion US dollars?

Gareth Kung

Yes 55% – our share of investment is 55% of the $3.6 billion

Ty Chiu

Okay, let me say that the cash flow required actually is even less than the 55% of the $3.6 billion because, maybe one-third of it will come from the bank loan. So, while you calculate that, let’s say if you take four years as a total investment, on the average there will be 900 million per year and one-third will come from the bank.

And so it will be $600 million per year fund actually that we will be putting into actual cash and 55% of that $600 million will come from SMIC. And if you go through that calculation, you can see that that cash flow will be no higher than our present cash flow required to do the investments.

Eric Chen – Daiwa Capital Markets

So in – unable, you don't have any plans for the rights issue, right?

Gareth Kung

We don’t comment on this asset as a practice, so it’s a little company. We will always consider our future even some time and also look at our funding needs. But we don’t have any immediate plans at this point in time.

Eric Chen – Daiwa Capital Markets

I see, thank you very much for your clear statement and again, congratulations for your second quarter results. Thank you.

Gareth Kung

Thank you.

TY Chiu

Thank you Eric.

Operator

Next question comes from the line of Jeffrey Toder calling from CIMB. Please ask your question.

Jeffrey Toder – CIMB

Hi, good morning, two questions. One, just following up on what you were saying about the financing for B2. You were talking about one-third being covered by debt. Will that company hold the debt? Or will SMIC take the debt out on the own books to finance their portion?

Gareth Kung

The joint venture company will borrow to fund part of the investment. But because of joint venture companies, 55% owned by SMIC. So that will be consolidated into our financial statement as well.

Jeffrey Toder – CIMB

So SMIC will carry 100% of the debt on the liability side with your balance sheet, and then that will be removed later, but the non-owned on a proportion. Is that correct?

Gareth Kung

Yes, that’s on a basis that, this joint venture company is a majority-owned subsidiary of SMIC. So that will be consolidated into our balance sheet.

Jeffrey Toder – CIMB

Okay, got it. Okay and the other question just going back to your comment on the utilization rate. Can you tell us how much capacity will be increasing in third quarter?

Gareth Kung

Our major increase in capacity will still be 40/45 node capacity and we are still targeting to raise it to above 15,000 wafers per month by the end of the year.

Jeffrey Toder – CIMB

Okay, but, I mean specifically how much capacity increase do you expect in third quarter, which is embedded in your 80% guidance?

Gareth Kung

I think for the – I should say the only increase in capacity in the third quarter and fourth quarter will only be for our 12-inch fab in Shanghai. Right now, the capacity for that fab is that above 8000 wafers per month at the end of the second quarter and that should go to above 11K to 12K by the end of the third quarter and that is covered and targeting to reach to above 15K by the end of the year.

Jeffrey Toder – CIMB

Thanks, great. We'll run some numbers. Thank you very much.

Gareth Kung

Thank you.

Operator

I would now like to hand the call back to Dr. TY Chiu, Chief Executive Officer for closing remarks.

TY Chiu

In closing, I would like to thank everyone for participating in today’s call and again thanks to all of our shareholders, customers, employees and suppliers for their trust and the support and have a good summer. See you next time.

Operator

Ladies and gentlemen, that concludes our conference for today. Thank you for your participation. You may all disconnect.

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