Semiconductor Manufacturing International's (SMI) CEO Tzu-Yin Chiu on Q4 2016 Results - Earnings Call Transcript

Semiconductor Manufacturing International Corporation (NYSE:SMI)

Q4 2016 Earnings Conference Call

February 14, 2017 7:30 pm ET

Executives

En-Ling Feng - VP, IR

Tzu-Yin Chiu - CEO

Yonggang Gao - CFO and EVP, Strategic Planning

Gareth Kung - EVP, Investment and Strategic Business Development, Finance, Company Secretary

Analysts

Randy Abrams - Credit Suisse

Steven C. Pelayo - HSBC Global Research

Roland Shu - Citigroup Global Markets

Leping Huang - Nomura

Sebastian Hou - Credit Agricole Securities

Charlie Chan - Morgan Stanley

Gokul Hariharan - J.P. Morgan Securities

Michael Chou - Deutsche Bank

Operator

Welcome to the Semiconductor Manufacturing International Corporation's Fourth Quarter 2016 Webcast Conference Call. Today's conference call is hosted by Dr. T.Y. Chiu, Chief Executive Officer; Dr. Yonggang Gao, Chief Financial Officer; Mr. Gareth Kung, Executive Vice President of Strategic Business Development, Finance, and Company Secretary; and Mr. En-Ling Feng, Vice President of Investor Relations.

Today's Webcast call will be simultaneously streamed through the Internet at SMIC's Web-site. Please be advised that your dial-ins are in listen-only mode. However, at the conclusion of the management presentation, we will be having a question-and-answer session, at which time 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, Vice President of Investor Relations, for the cautionary statement.

En-Ling Feng

Thank you, operator. Good morning and good evening. Welcome to SMIC's fourth quarter 2016 earnings Webcast conference call. For today's call, our CEO, Dr. T.Y. Chiu, will first provide some remarks. Afterwards, our CFO, Dr. Gao Yonggang, will highlight our financial performance and give guidance on the next quarter. Then, our Executive VP of Strategic Business Development, Finance and Company Secretary, Mr. Gareth Kung, will give the detailed financial commentary. This will then be followed by our Q&A session. As usual, our call will be approximately 60 minutes in length. The earnings press release and quarterly financial presentation are available for you to download at our Web-site under Investor Relations, in the Events & Presentations section.

Before I turn the call over to Dr. T.Y. Chiu, let me remind you that the presentation we'll be making today includes forward-looking statements. These statements and other comments are not guarantees of future performance, but represent the Company's estimates and are subject to risk and uncertainty. Our actual results may differ significantly from those projected or suggested in any forward-looking statements.

For a more complete discussion of the risks and uncertainties that could impact our future operating results and financial condition, please see our filings and submissions with the U.S. Securities and Exchange Commission and the Hong Kong Stock Exchange Limited, including our annual report on Form 20-F filed on April 25, 2016.

During the call, we will make reference to financial measures that do not conform to Generally Accepted Accounting Principles, GAAP. These measures may be calculated differently than similar non-GAAP data presented by other companies. Please refer to the tables in our press release for a reconciliation of GAAP to the non-GAAP numbers we will be discussing. Please note that all currency figures are in U.S. dollars, unless otherwise stated. Please also note that all 2016 full-year figures are based on the summation of the unaudited quarterly results for the year of 2016.

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

Tzu-Yin Chiu

Thank you, En-Ling. Greetings to everyone. We wish every one of you an exciting, prosperous and a healthy Year of the Rooster. We just finished another record year in 2016 with great performance and significant business growth. We recorded historical high revenue of $2.9 billion, an annual revenue growth of 30% over 2015, outpacing the foundry industry average. Operating profit reached an all-time high of $340 million, representing 12% operating margin. Net margin was a high of 11% and the net profit attributable to SMIC reached a record high of $376 million. EBITDA surpassed $1 billion for the first time, $1.1 billion to be precise, and we've achieved an improved annual ROE of 9.6% from 7.6% in the previous year.

In terms of significant accomplishments in the last year, we successfully acquired LFoundry in Italy, thus securing a significant foothold in the auto IC market. I'm also proud of the team's quick ramp-up of Beijing JV fab as well as the Shenzhen fab, while maintaining high overall utilization of 97.5% in 2016.

Over the past few years, we continued to improve productivity with an increase of 8.9% last year, 8.9% revenue per headcount in 2016. In addition, SMIC engaged several dozen new customers and a number of new products [to enter] [ph] risk production increased 50% compared to 2015. In 2016, we also successfully completed 10-to-1 consolidation of our ordinary shares, which we believe has attracted a broader range of investors.

We had another solid quarter in Q4 to wrap up the strong 2016 year. We achieved our eighth consecutive quarter of record-high revenue, $815 million, representing a growth of 33.5% year-over-year and 5.2% quarter-over-quarter. Our Q4 gross margin was 30.2% and annualized ROE maintained a double-digit of 10.1%.

28-nanometer, 40-nanometer and 0.13 micron drove most of the growth in Q4 2016. 28-nm more than doubled sequentially contributing 3.5% of our wafer revenue in Q4. 40-nm grew 92% year-over-year and 9.3% quarter-over-quarter. And 0.13 micron grew 103% year-over-year and 21% quarter-over-quarter.

From an application perspective, specialty technology including [indiscernible], non-volatile memory and sensor together grew about 26% year-over-year and 7% quarter-over-quarter. We are also pleased to see that smart card business has taken off recently as our smart card related revenue tripled year-over-year and grew 48% quarter-over-quarter. From a regional perspective, all regions experienced healthy growth when comparing Q4 2016 to Q4 2015, China 42% year-over-year, North America 36% year-over-year, and Eurasia 14% year-over-year.

We have exited 2016 with strong momentum, and while in short term we see the impact of seasonality, as reflected in our 2017 Q1 guidance, our team has responded quickly to fill in the gaps and we are targeting still 20% annual revenue growth in 2017.

In this year, we'll continue to focus on careful expansion of our existing facilities in response to customers' need, while executing our strategy of keeping a balanced focus on both growth and profitability. In 2017, we target to maintain a mid to high 20% gross margin and an EBITDA margin of high 30s.

With regard to key growth drivers for 2017, 28-nanometer will be one of the primary contributors to growth and we target 28-nm wafer revenue to reach high single-digit contribution by the end of the year on a quarterly basis. We experienced great demand from 40-nano in 2016, and in 2017 we are able to begin to transition some of our 20 and 40 flexible capacity towards 28-nanometer.

Other growth drivers in 2017 include a more diverse variety of mature technologies. This year, we expect revenue growth from – growth will be from various geographic regions, and particular strength from North America based customers. We continue to benefit from our strong position in China, not only the growing domestic fabless industry but also from international customers with a desire to capture more content share in China.

In 2017, we expect to increase absolute dollar of R&D spending to low to mid teens of revenue, the highest as a percentage of revenue among all major pure-play foundries. We continue to follow our technology strategy of diversification and pace advancement, which feed us continuous growth opportunities.

Our R&D spending covers both advanced and specialty technologies, allowing our customers a platform for a longer-term collaborative roadmap. We are preparing the baseline for diversified technology and we are investing much of our R&D this year on 14-nano FinFET, which is still early stage with the process flow and features defined. SMIC is among the world's top five patent filers for FinFET, both domestically and globally.

Meanwhile, given 2016's high utilization of 97.5%, to address the need of more capacity, planned consolidated foundry CapEx of 2016 is $2.3 billion, of which about $850 million is for the Beijing joint venture fab which will be 49% funded by our joint venture partners. We've planned to add an estimated 11% total installed capacity to close out 2017 with 450,000 wafers per month compared to 406,000 at the end of 2016.

In terms of overall annual effective capacity, the planned capacity growth is approximately 25% in 2017 versus 2016. All capacity additions this year will be to our currently running fabs, in addition to the FinFET 12-inch fab which will be still [indiscernible] by the year-end.

With more than $2.1 billion cash on hand as of December 2016 and increasing cash generation from operations, we are in affluent position to fund our 2017 CapEx plans. We will continue to expand carefully as we gauge our demand and overall market.

I would like to take the time now to welcome our newest Board members. We welcome Dr. Chiang Shang-yi, renowned foundry industry R&D veteran; Dr. Tong Guohua, a distinguished businessman, entrepreneur, Chairman and President of Datang; and Dr. Jason Cong, influential professor and a researcher of advanced computing at UCLA. We are very honored to have such prestigious and seasoned experts joining our Board to contribute their valued insight to our Company's vision and direction.

To conclude my remarks, SMIC has delivered excellent performance in 2016 and continues to strive to grow profitably and add value. We reiterate our target of 20% compound annual growth from 2016 to 2019. We have an advantageous position here in China and we continue to work hard to seize opportunities for the benefit of our stakeholders.

In this time of growth, our team strives to perform above par, executing our strategy of differentiation and diversification, serving our customers with excellence, and building value through balancing growth and profitability. We thank you for your continued support and for your time.

I will now hand the call over to Yonggang for the financial highlights and 2017 Q1 guidance.

Yonggang Gao

Okay. Thank you, T.Y. Greetings to all our listeners. First, I will highlight our 2016 full-year unaudited results, which are based on the summation of our unaudited quarterly results for the year of 2016, and our fourth quarter 2016 results, and then we gave out first quarter of 2017 guidance.

Revenue in 2016 was $2.9 billion, a record high, compared to $2.2 billion in 2015. Gross margin in 2016 was 29.2% compared to 30.5% in 2015. Profit for the period attributable to SMIC of 2016 was $377 million, a record high, compared to $253 million in 2015. Net profit margin was 12.9%, a record high, compared to 11.3% in 2015. ROE reached a record high of 9.6% in 2016 compared to 7.6% in 2015. EBITDA reached a record high of $1.1 billion in 2016 compared to $0.8 billion in 2015.

Now, I will highlight our fourth quarter 2016 results. Our revenue was a record high of $815 million. Gross profit was a record high of $246 million. Gross margin was 30.2%. Profit for the period attributable to SMIC was $104 million.

Now a look ahead into the first quarter of 2017, our revenue is expected to decline by 2% to 4% quarter-on-quarter. Gross margin is expected to range from 25% to 28%. Non-GAAP operating expenses are expected to range from $158 million to $164 million. Non-controlling interests of our majority-owned subsidiaries are expected to range from positive $6 million to positive $8 million, which are losses to be borne by non-controlling interests.

The planned 2017 CapEx for foundry operations are approximately $2.3 billion, while the planned 2017 CapEx for non-foundry operations are approximately $70 million.

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

Gareth Kung

Thank you, Gao Yong, and thank you everyone for joining us today. I will now comment on the details of our last quarter financial results. On the income statement, revenue increased by 5.2% Q-on-Q to $815 million, mainly because of an increase in wafer shipments in 4Q 2016 excluding LFoundry and also the revenue contributed from LFoundry. LFoundry only contributed for two months in Q3 2016 whereas it contributed to the full quarter in Q4 2016. Gross margin was 30.2%, above the guided range, mainly due to product mix change.

Operating expenses increased to $197 million in Q4 2016. R&D expenses increased by $36 million Q-on-Q to $118 million. The change was mainly due to higher level of R&D activities. Funding of R&D contracts from the government was $23 million in Q4 2016. G&A expenses increased by $25 million to $61 million in Q4 2016. The increase was mainly due to accrued employee bonus. Excluding the effect of employee accrued bonus, government funding and gain from disposal of living quarters, non-GAAP operating expenses were $193 million in Q4 2016.

Profit from operations was $49 million. Profit for the period attributable to SMIC was $104 million, while the non-controlling interests were $46 million of credit to SMIC attributable profit. The change in non-controlling interests was mainly due to the recognition in Q4 2016 of the contribution to SMIC group's advanced technology R&D expenses incurred in 2015 by the Company's majority-owned subsidiary in Beijing. If excluding the impact of the finance costs, depreciation and amortization, and income tax benefits and expenses, our EBITDA margin was 34% in Q4 2016.

Moving to the balance sheet; at the end of the fourth quarter 2016, cash and cash equivalents increased to $2.2 billion, if including other financial assets. At the end of Q4 2016, our gross debt to equity ratio was 56%, our net debt to equity ratio was at a healthy level of 16%.

In terms of cash flow, we generated $406 million of cash from operations for the quarter. On a full-year basis, we generated $977 million of cash from operations in 2016 compared to $669 million in 2015. Cash used in investing activities was $128 million. Cash from financing activities was $231 million.

To examine our revenue by applications, the communication and consumer segments contributed 44% and 37% of our revenue respectively for the quarter. On a full-year basis, the communications and consumer segments contributed 48% and 38% of our revenue respectively in 2016.

Geographically, revenue from China, North America and Eurasia contributed 48%, 33% and 19% of total revenue respectively for the quarter. On a full-year basis, revenue from China contributed 50% of total revenue, North America contributed 29% of total revenue and Eurasia contributed 21%.

In terms of technology, revenue from 28-nanometer contributed 3.5%, revenue from 40/45-nanometer contributed 23.6%, revenue from 55/65-nanometers and 90-nanometers contributed 19.8% and 1.6% respectively. Meanwhile, 0.11 micron above line-width contributed 51.5% of wafer revenue for the quarter. On a full-year basis, revenue from 45-nanometers and below contributed 24%.

In terms of our overall capacity, total monthly capacity at the end of the fourth quarter increased to 406,000 8-inch equivalent wafers. The increase was mainly because of the capacity expansion in our Beijing 300mm fab as well as our majority-owned fab in Beijing during the quarter.

The planned 2017 CapEx for foundry operations is approximately $2.3 billion, of which about $900 million will be spent for the expansion of capacity in our majority-owned Beijing 300mm fab. The planned 2017 CapEx for non-foundry operations are around $70 million, mainly for the construction of employees' living quarters. Our planned 2017 depreciation and amortization is around $1.1 billion, an increase of about $380 million year-over-year.

I would now like to hand the call to En-Ling for Q&A session.

En-Ling Feng

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

Question-and-Answer Session

Operator

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

Randy Abrams

My first question, I wanted to ask just on the change in guidance from the original expectation to grow in first quarter, could you talk about how broad-based this slowdown you saw in first quarter or whether it was isolated to a few applications, and maybe talk about the rebound, if you see it more a matter of new products being qualified or it's the same applications coming back? And if you could characterize just whether any business was lost at other foundries given you were tight for several quarters last year.

Tzu-Yin Chiu

Yes, we have seen business loss in a few areas. Our customers seem to have gone through some of the marketing difficulties, but we think that is on a few particular areas. So, we are winning additional opportunity to backfill these capacities that are coming up, and actually it is a good opportunity for other customers. During last year, we had very, very constrained supply for them, and now they can freely grow with SMIC. So, we think that eventually we'll be able to backfill completely these downward trends.

Gareth Kung

Actually I think there is a slight correction. Q1 is really in line with what we see in the industry. I won't say it's anything specific about SMIC in this regard.

Randy Abrams

Okay, great. I wanted to ask a follow-up question on the margins. Could you go through the factors on the gross margin dipping to 25% to 28%, maybe how much is the depreciation coming in or ramping through the year? And if you could also talk to the impact of now moving some business from 40 to 28, if there is any headwind at this stage ramping up 28 relative to the mature 40-nanometer? And I guess that margin 25% to 28%, if you think that should be a reasonable range through the full year or any headwind from those factors, depreciation or 28-nanometer?

Gareth Kung

First of all, regarding the dip in the Q1 gross margin, I think there are two impacts here. First of all, you are right to point out, the depreciation is a factor because we could see about $30 million increase in depreciation in Q1 compared to Q4. And secondly, as mentioned by T.Y., we're going to see some slight correction in business in Q1. So you are going to see our utilization is going to drop below about 90% in Q1. So that has some impact on the gross margin for sure.

Randy Abrams

Okay. And I guess a follow-up, can you maybe give a look as we go through the year if you improve utilization but then factoring depreciation in 28, if there is a rough feel for maybe a medium term or through the year how gross margins may trend?

Gareth Kung

As I said, let me just clarify, I think we are looking at a utilization of high 80s, close to 90% in Q1. For the gross margin for the rest of year, as mentioned earlier, we're going to experience I will say an increase in depreciation in 2017 over 2016 to a tune of about $380 million, and that is in line with the expansion in our fab capacity. We continue to ramp up our fab in Beijing and Shenzhen. So, obviously that will have an impact on our gross margin. But we are still guiding – I will say, we are still targeting a mid to high 20s gross margin. But as I said, at this point in time, we don't have a clear picture about 2017, but this is our initial feelings.

Randy Abrams

Okay. And is 28 still dilutive, like as you shift from 40 to 28, or yields are far enough along that it's less headwind now?

Tzu-Yin Chiu

Our yield has actually been along our expectations and it's still doing steady improvement. So, I think that it should not be a significant drag to our margin. I think it's just simply the increase in depreciation.

Randy Abrams

Okay, great. Thanks a lot, T.Y. and Gareth.

Operator

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

Steven C. Pelayo

A few questions. First to all, I guess 2017 growth, you're talking about 20% year-on-year growth with North America outperforming. So, that's about roughly one-third of revenue is growing faster. I guess, does that mean China underperforms, do you think Eurasia actually can decline, or when you think about the other regions for 2017, maybe a little bit of color there? And then also, could you comment a little bit on 2017 from a node perspective? With 28-nanometer ramping too, I think you said high single-digits by the end of the year, does that mean 40-nanometer still grows this year? Help us understand kind of the node outlook for 2017 as well, geographically and by nodes.

Gareth Kung

We commented North America is going to grow pretty well in 2017 for two reasons. First of all, 28-nanometer will be a major growth driver in 2017, and as we know, we have a major U.S. customer for the 28-nanometer. And secondly, for LFoundry we only consolidated the company for about five months in 2016, and for 2017 it will be a full-year consolidation and their customer base are mostly in the North America. So, all that contributed to the growth in the U.S. customers.

In terms of the node perspective, I think the major growth, as we can see it right now across the nodes, there is really not enough visibility to state precisely at this point in time, will be mainly from 28-nanometer, 65-nanometer and 55-nanometers, as well as the growth, as I mentioned, the contribution from LFoundry.

Steven C. Pelayo

And so 40-nanometer node you think will actually decline year-on-year?

Gareth Kung

No, we are saying the major growth. We still think that the 40-nanometer will remain to be a major node for us.

Steven C. Pelayo

Okay. And then we struggle to kind of forecast your model here with your operating expense volatility, with R&D credits and some of the other things that go on, property sales and other benefits that you can get through there, and then now bonus accruals as well. So could you talk just a little bit more, I know you like to guide excluding those things, but could you talk a bit about including those things what kind of expectations you have for those in the first quarter as well as 2017?

Gareth Kung

What we've guided in Q1 in terms of the OpEx, we don't think there are any extraordinary items in Q1 that you should be concerned about. In terms of the full-year OpEx guidance, in terms of the normalized OpEx, we are still looking at the high-teens number relative to the revenue. The main increase will be in the R&D area, as mentioned by T.Y. While we will continue to invest heavily in R&D, but we will continue to maintain very disciplined spending in terms of G&A expenses and sales expenses.

Steven C. Pelayo

See this is the struggle as I think R&D in 2016 was about 13% I think of revenue if I exclude the R&D credits, maybe around 11% including. So I guess on a comparable basis, you talked about that I think going to the low teens, if I remember correctly, R&D. Is that including or excluding R&D credits, do you expect R&D subsidies to increase in 2017, and what kind of number should we think about?

Gareth Kung

Yes, we expect – right now we are guiding the R&D spending probably in the low-teens to mid-teens level, and that is excluding R&D funding. In terms of the R&D funding for 2016, for the whole year is about $52 million. We expect this number would go up in 2017, maybe close to $65 million to $70 million. But this number, as we mentioned earlier, there are some uncertainties depending on the completion of this R&D project as well as the funding availability from the government.

Steven C. Pelayo

Okay. And then the last line item that I also struggle on is the non-controlling interest line. I guess I'm trying to understand, as this fab ramps up, does it ramp up initially where you have more losses and then there's a greater add-back or does that number then decrease over time when you think about that line through 2017 or maybe just on a full-year basis? How do you think that will track this year or contribute this year?

Gareth Kung

So first of all, the Q4 number in terms of the contribution from the non-controlling interests was high because of this sharing of R&D expenses with our majority-owned subsidiary in Beijing, and that part contributed about $29 million for the quarter. So actually, if you remove that number, actually the number is quite consistent quarter-on-quarter. Right now, we are still looking at a similar number in 2017.

Steven C. Pelayo

I'm sorry, similar kind of every quarter, that's kind of $7 million to $8 million I think is what you guided [indiscernible] quarter?

Gareth Kung

Yes, that's right.

Steven C. Pelayo

Okay. All right, I'll get back in the queue.

Operator

Your next question comes from the line of Roland Shu of Citigroup. Please ask the question.

Roland Shu

First question, can you repeat the overall capacity increase in [2017] [ph]?

Gareth Kung

Just give me a second. The increase in the capacity for 2017, we are looking at an annualized capacity increase of about 25%. And then on year-end basis, the increase is about 11%.

Roland Shu

So year-end means your year-end compared with year-end in last year?

Gareth Kung

Yes, that's right. We are talking about year-end over year-end about 11% increase, and on an annualized capacity basis is about 25% increase.

Tzu-Yin Chiu

May I add that…

Roland Shu

So, how about 12-inch and 8-inch increase?

Gareth Kung

It is combined.

Roland Shu

But the increase on the 12-inch, you have the breakdown of 12-inch and 8-inch increase?

Gareth Kung

Obviously the increase in 12-inch is more than 8-inch. I think our major expansion in the capacity will still be in our 28-nano capacity, and also there will be quite a bit of increase in our 65/55-nano capacity.

Roland Shu

Okay, thank you.

Tzu-Yin Chiu

Just to add, the 25% annualized effective capacity increase, also a lot of it is because the full year's LFoundry's capacity will come in.

Roland Shu

Okay, thank you. And also for your utilization in the first quarter, you talk about close to 90%, so how about the 12-inch and the 8-inch utilization specifically?

Gareth Kung

We don't break down the utilization for each fab, but I will say it's quite even.

Roland Shu

Okay, so both 12-inch and 8-inch are close to 90%?

Gareth Kung

I will say 8-inch is still better than 12-inch.

Roland Shu

Okay, thank you. And for the whole year, the first quarter revenue will correct a little bit and the whole-year revenue target still grow by 20%, so what's the quarterly revenue linearity in this year, will it increase gradually or will it be more backend loaded?

Gareth Kung

I think it's too early for us to comment on that. I think the 20% growth is our target, okay. But at this point in time, I think we don't have much visibility beyond the first quarter. So, we'll update the market as we see more visibility.

Roland Shu

Okay, thanks. And I think the last question for you, other revenue by application increased a lot in 4Q last year, so what contributed into this category and was it just a one-off or will it be recurring in this year?

Gareth Kung

That category actually we have put in the revenue from LFoundry. As you know, LFoundry's customers are mostly in the auto industrial sectors.

Roland Shu

Okay, so then, is that the increase meaningful in this year because we have the full-year consolidation number for LFoundry this year, right?

Gareth Kung

Yes, that's correct, yes.

Roland Shu

Okay, thank you.

Operator

Your next question comes from the line of Leping Huang of CICC. Please ask your question.

Leping Huang

So the first question is about your 28-nanometer migration strategy. I remember that you previously [indiscernible] that the competition in 28 was too intense and for the profitability you would prefer to focus on the 40/45-nanometer process which is much better in terms of profitability. So, what has changed that at this time you are starting to migrate into 28-nanometer? It's more customer driven or it's more that you have excess capacity to migrate, and which application you will first migrate?

Tzu-Yin Chiu

I think last year basically we had a very, very tight capacity here and a lot of our 40-nm customers or 40-nm products are single-sourced in SMIC. So any discontinuity in this product supply will really impact a significantly larger economic range. And so, that is the reason that we had actually – even at the beginning of the year, I think of 28, the market was softer than we had thought. That's why our capacity has shifted towards meeting the 40-nano demand. It wasn't a straight economic margin consideration. This year – we had always intended, even last year, to quickly ramp up our advanced capacity so that we can meet both the 40-nano as well as the 28-nano demand. So, in the second half of last year, we have increased our capacity sufficiently at this point in time to meet both the 40 as well as 28-nanometer customer demand. So that's the reason this year we can see a significantly faster 28-nano ramp-up.

Leping Huang

Okay. The second question is that, I think October last year you announced that you – the new factory [indiscernible]. So, can you elaborate what's the plan in [indiscernible]? Also, these days we see that the local government do provide a lot of favorable financial condition to attract the foundry to their local city, like recently [indiscernible] has [indiscernible] GlobalFoundries. So, do you also consider to expand your geographical expansion in China, or I remember you previously were mainly focused on Shanghai, Beijing because of your constrained R&D result?

Tzu-Yin Chiu

Certainly SMIC is exploring all potential opportunities, but I think as consistent with our previous announcements, our main focus will still be in our present production site, that is Shanghai, Beijing, Tianjin and Shenzhen, as well as expanding some of our capacity in Italy. So certainly it doesn't preclude us to consider other opportunities, but I think at this moment, I think that we are still putting in capacity in our present production sites and that is our main focus.

Leping Huang

So the [indiscernible] will not be a factory or it will be – what [indiscernible] will be?

Tzu-Yin Chiu

[Indiscernible] right now we are exploring service centers, we are exploring and converting some of the specialty technology into production and there are a number of conditions that needs to be, how should I say, proven and verified such as a working specialty technology and a very strong customer set base before we start any fab constructions.

Operator

Your next question comes from the line of Sebastian Hou of CLSA. Please ask your question.

Sebastian Hou

First question is on the 28-nanometer. I wonder what's your strategy on 28 for this year, is more on poly SiON or High-k Metal Gate by the end of the year given your high single-digit revenue guidance? And another follow-on on that is, your strategy is more your existing customers' migration need or you're going through again some new applications for new customers?

Tzu-Yin Chiu

Okay, our 28 certainly is focused not only on a single customer, we have a number of customers both globally as well as domestically. So indeed certainly, we are going to first meet our customer demand that is put in front of us right away, but in the same time we are going to – there are a number of customers still interested in poly SiON. Of course, we are also getting MTL's product tape-out in our High-k technology. So, this is also a significant focus for SMIC this year.

Sebastian Hou

Okay. So, in terms of your revenue guidance for 28 of high single-digit by the end of this year, can we assume that most of that or nearly all of that will be poly SiON?

Tzu-Yin Chiu

I think there will be, a significant portion will be poly SiON, but we are targeting some High-k revenue.

Sebastian Hou

Okay. And in terms of your position, what do you compare yourself in terms of performance, pricing versus the other foundries who are offering 28-nanometer for years?

Tzu-Yin Chiu

Competitive.

Sebastian Hou

Competitive performance and pricing, or performance or pricing, both?

Tzu-Yin Chiu

Both.

Sebastian Hou

Okay, thank you, T.Y. My second question is, on your first quarter guidance, you guided to decline by 2% to 4%, and I think you mentioned about some specific customer and some specific area to see weakness, and you also had a comment about that you think that you can backfill the capacity pretty soon. So how soon is that? Can we expect that you can backfill that within one to two quarters, given that right now major 8-inch foundries are [indiscernible] right now?

Gareth Kung

Yes, I think we mentioned that for example we have customers in the fingerprint sensor area, there have been some correction in the business. But we're also seeing other new customers coming in for similar applications and which ramped up this year. At the same time, for example, we are seeing very good orders from our PMIC as well as from our smart card business to fill the gap. So, we are pretty I will say cautiously optimistic in terms of our growth this year.

Sebastian Hou

Okay. So, you mentioned about the – sorry, please go ahead.

Tzu-Yin Chiu

So, I think that – indeed I think that we will be able to, at least we target to, backfill within a few quarters' time.

Sebastian Hou

A few quarters, which means that not one quarter?

Tzu-Yin Chiu

A few quarters, meaning one or a few quarters, right.

Sebastian Hou

So what I'm trying to get a sense is that because you need to backfill that, so your inch capacity came back to 100%, so when do you expect your inch capacity utilization rate to return to your 100% level or close to 100% level, second quarter or third quarter?

Tzu-Yin Chiu

This year we have forecasted – we have targeted 20% growth. And so, to achieve 20% growth, you can project that it still needs to be fairly high utilization.

Sebastian Hou

Okay, thank you.

Operator

Your next question comes from the line of Charlie Chan of Morgan Stanley. Please ask your question.

Charlie Chan

Thanks for taking my question and Happy Chinese New Year. So, first question is regarding your gross margin guidance, because it seems like your depreciation increased at last. So just to put it into perspective, the depreciation was around 20% of last year's revenue, and this year it will increase to 30% of this year's revenue. So, it is like a 10 percentage points increase, and you mentioned that EBITDA margin will maintain at the high 30 percentage but your gross margin guidance impact only 5% decline. And last year, what was the gap here? Are you going to reduce your OpEx significantly or is there any chance for cost reduction in your variable cost?

Gareth Kung

Charlie, I think my calculation is somewhat different from yours, because we are guiding a $380 million increase in depreciation. That is going to have an impact on the gross margin for sure. And then at the same time, we also said that we intend to maintain the OpEx of high teens. So, I think with that I think we are still quite confident about achieving or at least it is our target to achieve a mid to high teens gross margin.

Charlie Chan

Okay, maybe I misunderstood. So what was the $1.1 billion depreciation guidance for?

Gareth Kung

That is including both the total depreciation – the majority of amount goes to the cost of goods sold. A part of it is also relating to R&D spending as well.

Charlie Chan

Got it, I'm sorry. Okay. And next question is regarding your free cash flow. Because you made around $1 billion EBITDA, next year what is the number? But it seems like your CapEx was above $2 billion this year, continues to be above $2 billion. So, it seems like there is ongoing cash outflow. So, how are we going to farm for those cash flow?

Gareth Kung

Yes, you are right. I mean, SMIC is still not in a free cash flow positive situation yet. But what we're seeing right now is that we are continuing our CapEx this year. At the same time, we are increasing our total EBITDA generation. So, that should help to reduce the gap. At the same time, as mentioned by T.Y., we have more than $2 billion cash holding on hand. So, we should be able to fund our CapEx without too much of a problem.

Charlie Chan

Okay, got it. And lastly, 28-nanometer, so when do you think revenue would – significantly went up this year, I think your guidance implies revenue is going to double there, so you think that's 2Q, 3Q or very back loading?

Gareth Kung

Right now we are talking it to increase gradually over each quarter, but maybe we're going to see a more bit increase in the second half.

Charlie Chan

So, I think another topic, I'm not sure if management team has discussed about that, regarding U.S. protection [indiscernible] on the semiconductor industry, and it seems like you on some customer front, North America, and Qualcomm, they also will review on some [indiscernible] R&D like 40-nanometer. So, do you think there is going to be any impact to SMIC in the long-term and do you expect any friction between China and U.S. in terms of semiconductor cooperation?

Tzu-Yin Chiu

I think that indeed we are cautiously optimistic in terms of the market growth and the overall market trend and business of course disregarding the potential trade wars that may really come around, but we think that and hope that the semiconductor industry is a very, very global industry. I think the market here in China is a great opportunity for everyone outside of China as well as in China. I think that anyone that really have a careful study will find that China market and arrangement at this point of time is good for everyone. And so, we hope that there will be a good environment for business for foundry, for fabless as well as all other customers in China.

Charlie Chan

Okay, understood. Thank you very much.

Operator

Your next question comes from the line of Gokul Hariharan of J.P. Morgan. Please ask your question.

Gokul Hariharan

Just wanted to ask first on the R&D spending increase with emphasis on 14-nanometer, is there any change in direction in terms of 14-nanometer development and trying to bring it on production earlier than expected? I think previously I think it was kind of more like a 2020 kind of target. And the second question is, with that increase in R&D spending, how does it affect the operating leverage expectations in terms of operating margins as we target the 20% kind of growth CAGR over the next few years?

Tzu-Yin Chiu

In the 14-nanometer, we are providing a faster turnaround time, a better R&D to support our team, and definitely if possible, we will try to bring up production earlier that – it would be great if we can bring it up before 2020, but I think that in general SMIC's strategy is to continuously have a strong support to our R&D efforts, both in advanced technology as well as in our specialty mature technology as well.

Gareth Kung

Right now, as mentioned earlier, we are targeting low teens to mid-teens R&D spending. And in terms of the OpEx spending, in terms of normalized OpEx, we'll be in the high-teens level. So, I think in terms of on the operating margin, I think the major impact will be coming from the gross margin I think.

Gokul Hariharan

Okay, got it. Can I also ask, what is the status on LFoundry in terms of utilization as well as new customer qualifications? When do we expect some of the new customers to kind of start filling up the capacity?

Tzu-Yin Chiu

We already see the LFoundry utilization increased by about 10% to 15% after the conclusion of our merger. Certainly, right now we are introducing additional customers to bring them into our foundry. So, it would take a few quarters to bring it more than a few customers to fully fill the fab. But we think that this year, we should be able to maintain a reasonably high utilization in LFoundry consistently.

Gareth Kung

And I think just to add on to what T.Y. said, we are also seeing a pretty strong recovery of orders from the auto customers, and I think the major reason for that, of course there's the end market for auto is doing well, and secondly is also the increasing confidence of the customers in terms of LFoundry's future given the fact that they are combined with a much bigger group now than before.

Gokul Hariharan

Okay, great. Thanks.

Operator

Your next question comes from the line of Michael Chou of Deutsche Bank. Please ask your question.

Michael Chou

One question, as you note, fingerprint sensor will shift to 12-inch in the future, so what's your planning for 12-inch fingerprint sensor product roadmap this year and the next year, or do you expect your fingerprint sensor will be still on 8-inch process going forward?

Tzu-Yin Chiu

At this moment, I think the requests to shift from 8-inch to 12-inch are still limited and our traditional customers as well as the new customers are still mainly focused in the 8-inch capacity. Certainly I think that we are preparing additional 12-inch capacity for similar applications if there is such a need. This is already being set up and will come online in Shenzhen at the end of 2017.

Michael Chou

Okay. So, does that mean you will use the 65 nanometer to do fingerprint sensor by the end of this year in fins and FET?

Tzu-Yin Chiu

We will withhold our comment at this point of time. Right now we still have a lot of activities in our traditional technology arena, product application.

Gareth Kung

I think we are seeing most of our fingerprint customers are still focused on 8-inch application at this point in time.

Michael Chou

Okay. So, do you expect that they will shift to 12-inch next year or you think that most of the customers will still stay in 8-inch even next year?

Gareth Kung

I think for 2017 we don't see any migration at this point in time.

Michael Chou

Okay. In terms of [indiscernible], do you think your 12-inch fingerprint sensor will be part of [indiscernible] if you want to [indiscernible] at some point, let's say maybe 2018, if FinFET 65-nanometer fingerprint sensor, [indiscernible] very challenging for some time in early-stage, so what is your view?

Gareth Kung

As I stated right now, most of our customers still require only 8-inch production for this application. So we don't have any experience in the 12-inch yet.

Michael Chou

Okay. My second question is, you guys were high single-digit percentage of sales for 28-nanometer, but the numbers in the press [indiscernible] 28-nanometer sales portion, but do you think that there is some [trench] [ph], so you cannot meet the guidance, but this time what caused the difference or you think you have more customers than before or more product or you do see some type of complication, because [indiscernible] finished 28-nanometer depreciation in the first half of this year, so in theory 28-nanometer pricing competition should be very severe in the second half of this year. And if you can see the UMC situation, there will be more [indiscernible] in 28-nanometer ramp-up in terms of pricing and sales contribution. So what's your inch going forward, because since the UMC will move 28-nanometer to the German fab, so they may have some benefit from the German government, so what's your view, what would you think about your 28-nano sales contribution in the long-term?

Tzu-Yin Chiu

I think again, last year indeed we did not meet our 28-nano forecast. That was basically because we have extremely tight capacities and we had made a strategic decision to do the 40 first because the demand coming first and a lot of the products are single sourced. This year we are able to ramp 28, at the same time maintaining good 40 output. The main reason is that we have expanded our capacity to a situation where we can take care of both 40 as well as 28 customers.

So, as far as the dilemma of coming in with a technology that is slightly behind our competitors, that dilemma we have faced all throughout our last 16 years and we came in with our 40-nano and I guess a lot of our peers would think that 40-nano for SMIC is probably a node that is not worth pursuing, but we had a very, very successful 2016 ramp-up in the 40-nano. So, we believe that as long as we can do good quality of 28, as long as there is customer demand, I think 28 ramp-up is still a very important node for us.

Michael Chou

Okay. One follow-up question…

Gareth Kung

Thank you, I think we've run out of time here. And so, Michael, I think we'll have to stop here.

Michael Chou

Okay, thank you.

Operator

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

Tzu-Yin Chiu

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

Operator

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

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