China's SMIC Hopes to Climb Into the Black During 2010

A combination of factors, including an economic recovery and lower depreciation expenses, should propel Semiconductor Manufacturing International (SMIC), China's largest chip maker, into the black after years of losses, the company's top executive said Thursday.

"We expect to become profitable in 2010," Richard Chang, SMIC's president and chief executive officer, said during a telephone interview.

Last year, SMIC posted a loss of US$440 million on revenue of $1.35 billion and 2009 has been just as rough. SMIC posted a loss of $98 million during the second quarter, a slight improvement over the loss of $178 million it recorded during the first quarter. The company has not reported an annual profit since 2004.

As a sign of how serious SMIC's financial problems are, the company recorded a negative gross margin for each of the last three quarters, which means it cost the company more to produce chips than they generated in revenue before other costs, such as sales and general administration expenses, are taken into account.

But underneath all this red ink there are signs that SMIC's fortunes could finally improve. SMIC's capacity utilization rate rose from 34.9 percent during the first quarter of 2009 to 75.4 percent during the second quarter. By doubling the number of wafers produced, the company saw an improvement in its gross margin, which was -4.8 percent during the second quarter, up from -88.3 percent during the previous period.

Based on order forecasts given to SMIC from its customers, the chip maker's utilization rates will likely improve further next year. "Our utilization rate for the entire year should be high, maybe around 85 percent," Chang said.

Any improvement in SMIC's utilization rate ultimately depends on a wider economic recovery, which may or may not be in the offing.

"I'm cautiously optimistic about the recovery," Chang said, adding that China's economy showed signs of a recovery during the first quarter which strengthened during the second quarter. He also noted that observers have predicted the economic downturn in the U.S. may bottom out during the third quarter before beginning a slow but steady recovery.

If a recovery spurs higher demand for chips, SMIC will benefit from lower depreciation expenses that help improve its gross margin.

The cost of building a single chip plant and fitting it out with manufacturing equipment can easily total $2 billion or more. These costs, which are depreciated over time under accounting rules that aim to match revenue with expenses, are considered part of the cost of sales for accounting purposes and directly affect the company's gross margin.

SMIC reported depreciation expenses of $147 million during the second quarter of 2009. But next year, that figure should be significantly lower as some of SMIC's older plants, which make chips using 200-millimeter wafers instead of larger 300 mm wafers, become fully depreciated. That means no further depreciation expenses will be incurred for their use.

"We expect depreciation will be reduced maybe more than $100 million, so that's going to help us a lot," Chang said. The lower depreciation expense will help improve SMIC's overall profitability, even as higher demand allows remaining depreciation expenses to be spread over more chips.

"If that all happens, plus we migrate to more advanced technology nodes, like 65 nanometer and we start to serve customers with 45 nanometer, then we have a high probability of becoming profitable in 2010," he said.

Because the 65 nanometer and 45 nanometer technologies are on the leading edge, they command higher selling prices and better margins than older process technologies. Chips produced using 65 process technology accounted for 0.1 percent of SMIC's revenue during the second quarter. The company didn't generate revenue from the 45-nanometer process during that period.

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