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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Ladies and gentlemen, thank you for standing by, and welcome to Hua Hong Semiconductor's Third Quarter 2019 Earnings Conference Call. Today's call is hosted by Mr. Junjun Tang, President and Executive Director; and Mr. Danny Wang, Executive Vice President and Chief Financial Officer. [Operator Instructions] The earnings press release and third quarter 2019 summary slides are available to download at our company's website, www.huahonggrace.com. Without further ado, I would now like to introduce you to Mr. Danny Wang, Executive Vice President and Chief Financial Officer. Thank you.
Good afternoon, everyone. Thank you for all for joining our third quarter 2019 earnings conference. Today, we will first have Mr. Junjun Tang, our Executive Director and President, make remarks on our third quarter performance. President Tang will address in Chinese and Kathy Chien, our Deputy Director of Investor Relations, will be the translator. After that, I will discuss our financial results and provide guidance for the next quarter. This will be followed by our question-and-answer session.
I'll now turn the call over to our Executive Director and President, Mr. Tang.
[Foreign Language]
[Interpreted] Good afternoon, everyone. Thank you for joining our earnings call.
[Foreign Language]
[Interpreted] Despite challenges and uncertainties in our business during the past quarter, Hua Hong Semiconductor continued to strive with laser-focused execution. The company achieved USD 239 million in revenue, representing a 3.9% increase quarter-over-quarter and virtually flat year-over-year. This strong revenue performance was largely attributable to increased demand from China and other parts of Asia for many of our products, particularly MCU, super junction, IGBT, general MOSFET, power management IC and analog. This shows again the strength and quality of our specialty technology offering. The company was able to deliver strong performance despite less than desirable market conditions.
Gross margin was maintained at 31%. This performance, nonetheless, was not without challenges. In general, there has been pricing pressure for finished wafers throughout the year due to market conditions. While substrate costs increased significantly, in the last quarter, these challenges were offset by a quarter-over-quarter increase in overall utilization rate to 96.5%. Additionally, significant government subsidies was received within the quarter, which offset some depreciation expense.
[Foreign Language]
[Interpreted] Our Wuxi 300-millimeter manufacturing facility, Fab7, started production this quarter. Our team qualified a number of customers' products for Fab7 production. For two of these products, the yield has already ramped up to 90%. This fab will give us tremendous growth opportunities in the next several years as part of our overall expansion plan. Clearly, it will be our focus going forward, and our management team understands the importance and urgency of bringing this fab to profitability in the shortest possible time.
[Foreign Language]
[Interpreted] We continue to be extremely positive about the direction and strategy of the company. We believe 5G will be the next wave driving opportunities for semiconductor companies. As a result, there will be a surge in demand for various semiconductor devices, including microcontrollers, sensors, radio frequency, power management and memory. As a leader in specialty technologies, Hua Hong Semiconductor will be an important player in 5G innovation.
[Foreign Language]
[Interpreted] Now I would like to hand the call over to our CFO, Mr. Danny Wang for his comments.
Thank you, Mr. Tang, for the [indiscernible]. Now let me begin with a summary of our financial performance for the third quarter followed by the outlook, our revenue and margin for the fourth quarter 2019. And then, we will move on to the question-and-answer session.
First, let me summarize financial performances of the third quarter. Revenue reached USD 239 million, 0.9% lower than the prior year but 3.9% above Q2 2019. Cost of sales was $165 million, 3.6% above Q3 2018 primarily due to increased unit cost of raw wafers, and 4% above Q2 2019, largely due to increased wafer shipments.
Gross margin was 31%, 3 percentage points below Q3 2018, mainly due to lower capacity utilization and the increased unit cost of raw wafers and flat to Q2 2019.
Operating expenses were $40.2 million, 26.4% above Q3 2018 and 13.7% over Q2 2019 largely due to increased expenses for labor and engineering wafers for Hua Hong Wuxi.
Other income net was $23.5 million, 64.2% up year-over-year primarily due to increased general subsidies, foreign exchange gain, share of profit from associates and 4.5% lower quarter-over-quarter primarily due to decreased: one, foreign exchange gain; two, interest income; and three, fair value gains of financial assets at fair value through profit or loss, partially offset by increased: one, general subsidies; two, share of profit from an associate.
The income tax expense was $12.9 million, 4.6% lower than Q3 2018 due to decreased taxable profit. Profit for the period was $44.4 million, 12.8% below Q3 2018 and 11% lower than Q2 2019.
Net profit margin was 18.6%, 2.5 percentage points below Q3 2018 and 3.1 percentage points below Q2 2019.
Basic earnings per share was $0.035, $0.011 lower than Q3 2018 and $0.001 above Q2 2019. Annualized ROE was 8.4%.
Now please let me provide you with the more details on our revenue from Q3 2019.
From geographical perspective, revenue from China was $148.6 million, contributing 62.2% of our total revenue, an increase of 8% compared to Q3 2018 mainly driven by increased demand for MCU products.
Revenue from the United States was $35.3 million, a decrease of 11.9% compared to Q3 2018, chiefly due to decreased demand for general MOSFET and flash products. Revenue from Asia was $29.6 million, a decrease of 3.3% compared to Q3 2018, chiefly due to decreased demand for logic products partially offset by the increased demand for MCU and the general MOSFET products.
Revenue from Europe was $17.3 million, a decrease of 7.1% compared to Q3 2018, chiefly due to decreased demand for smart card ICs. Revenue from Japan was $8.1 million, a decrease of 43.3% compared to Q3 2018, mainly due to decreased demand by a certain customer.
With respect to technology platform. Revenue from embedded nonvolatile memory was $88.2 million, a decrease of 1.5% compared to Q3 2018 primarily due to decreased demand for smart card ICs partially offset by increased demand for MCU products.
Revenue from discrete was $90.3 million, an increase of 10.9% compared to Q3 2018, mainly driven by increased demand for super junction and IGBT products partially offset by the decreased demand for general MOSFET products.
Revenue from analog and power management IC was $36.5 million, a decrease of 3.5% compared to Q3 2018, mainly due to decreased demand for LED lighting products partially offset by the increased demand for analog products.
Revenue from logic and RF was $22 million, a decrease of 15.6% compared to Q3 2018, mainly due to decreased demand for logic products partially offset by increased demand for RF products.
Revenue from standalone nonvolatile memory was $1.8 million, a decrease of 72.1% compared to Q3 2018 primarily due to decreased demand for flash and the EEPROM products.
Now let's take a look at the cash flow statement. Net cash flows generated from operating activities were $70.7 million, down by 3.1% year-over-year, but up by 242.1% quarter-over-quarter primarily due to income tax payment for 2018 in second quarter 2019, and increased receipt of government subsidies.
Capital expenditures were $459.8 million in Q3 2019, including $427.5 million for Hua Hong Wuxi and $32.3 million for HHGrace.
Other cash flow generated from the investing activities were $38.1 million, including payout of $35.4 million of investment in financial assets at fair value through profit or loss and $2.7 million of interest income. Net cash flows used in financing activities were $0.2 million, including: one, $0.1 million of lease payments; and second, $0.1 million payment of interest expenses for bank borrowings.
Now let's move to the balance sheet. Cash and the cash equivalents decreased to $474.7 million on September 30, 2019 compared to $834.7 million on June 30, 2019. Restricted and time deposits decreased from $14.7 million on June 30, 2019, to $0.8 million on September 30, 2019, primarily due to payments for dividends.
Other current assets increased from $76.4 million on June 30, 2019 to $110 million on September 30, 2019 primarily due to increased VAT deductible tax partially offset by decreased advanced payments to suppliers.
Property, plant and equipment increased from $1.0377 billion as of June 30, 2019 to $1.5634 billion as of September 30, 2019. Other noncurrent assets decreased from $363.2 million on June 30, 2019 to $276.4 million on September 30, 2019 primarily due to decreased advanced payments for capital expenditures.
Tax -- total assets increased from $3.5449 billion on June 30, 2019 to $3.5765 billion on September 30, 2019. Our total bank borrowings were $27.6 million on September 30, 2019. Total liabilities increased to $556.1 million on September 30, 2019 from $485.5 million on June 30, 2019 primarily due to increased payables for capital expenditures. Debt ratio increased to 15.5% on September 30, 2019 from 13.7% on June 30, 2019.
Now finally, let me give you a very top-level outlook for the fourth quarter 2019. We expect revenue to be approximately $242 million and gross margin to be between 26% and 28% largely due to the start of production in Wuxi.
[indiscernible] my financial remarks. Now I would like to open up the floor -- the call for question and answer. Operator, please help. Thanks.
[Operator Instructions] Your first question comes from the line of Sunny Lin from UBS.
Daniel. So I have 2 questions. So number one, from cycle perspective, I think 8-inch foundries began inventory digestion from Q1 this year. And now we are in the fourth quarter of the slowdown. Based on your current visibility, when do you expect customers to start restocking? And for 2020, what do you think will be the key growth drivers for the company? And my second question is regarding the Wuxi 12-inch fab.
As you started to ramp in this quarter, I wonder if you could give us more guidance on the expected revenue contribution for 2020, the utilization rate, the gross margin dilution and the impact on earnings, et cetera.
That is a pretty long -- it's a pretty big question. First quarter -- first part, I think you're absolutely correct. I think the inventories level has come down quite significantly. I think people start to making orders in Q2 and Q3, and this is exactly why our utilization rate has come up. Now basically at the 96% to 98% utilization rate, okay?
I think -- I mean it's pretty clear that the growth driver for this year has been MCUs and power discrete, okay? They have been very, very strong. Smart cards has been, not a very attractive segment, but I think MCU has been very, very strong. Even for Q3, there was a basically 25% growth quarter-over-quarter just on MCU.
And when you look at power discrete, overall, basically, for super junction, IGBT even split-gate trench, everything has been going up, anywhere from single-digit to double-digit growth, okay?
The general MOSFET is still a big -- a pretty significant share of our overall revenue. It was basically about 14%, if you don't count the split-gate trench. So that was slightly down this quarter. But everything else has been very, very strong.
The analog and power management also has been strong. It has a growth of 9%, okay, besides largely driven by power management IC and analog. Okay? So these -- we believe these things will continue. I mean they just don't stop. I think the momentum are still there. It will definitely continue into 2020.
I was wondering if Mr. -- President Tang has any things to add.
[Foreign Language]
[Interpreted] Thank you for your question. In 2019, with future effort from company and our customers, we have achieved a shipment within this year. And our second and shared product is included in the process of R&D process.
[Foreign Language]
[Interpreted] So Wuxi fab is now taking our IC plus power strategy. With respect for IC, we are aiming to [ pursue ] shipment by the end of the year 90-nanometer embedded nonvolatile -- eFlash, sorry. And as for the BCD 55-nanometer logic, and we are in R&D process now.
[Foreign Language]
[Interpreted] We are also in process of the power management development. As for the DMOS, will be some shipments in the first quarter 2020. And as for the IGBT and super junction, there will be some shipment by the end of third quarter or the beginning of the fourth quarter. So with the ramp-up of the various products, we will have decent utilization rate next year.
Just so that I will give you some information from a financial perspective. The production planning for the Wuxi fab will be roughly -- we're talking about, in average, about 10,000 per month throughout the year average, okay? So you'll start a few hundred thousand wafers -- I mean a few hundred wafers up to eventually, towards the end of the year, it's about 20,000 wafers, okay? So by that, at that point, by end of the year, we'll definitely have 20,000 wafer capacity. Okay?
So we're looking at average, the output will be every month average probably roughly around 10,000 wafers a month. So we also expect we'll command a pretty respectable ASP. So I think we would have a pretty nice sort of revenue output for next year.
Certainly, the depreciation expense were a [ star ], but that is just a process. That's part of the process. And I think the key Mr. Tang has, basically, said in his remarks that, it's very important for [indiscernible] to profitability in the shortest possible time. That is very, very important for us.
So we're still on target. So starting from now, we just started production and we will see in Q4. And hopefully, within 2 years, we'll reach the breakeven level. And from that point, we should only have profit. Sunny?
Got it. So in terms of the gross margin dilution, in Q4, you are guiding gross margin to decline to 26% to 28%. So into first half of 2020, should we model another maybe 2% or 3% dilution from Q4 level?
So I mean the depreciation expense for next year from Wuxi, I would expect it would be somewhere around -- let me look at the number here. It'll be around -- so it'd be about -- yes, so it's going to be $120 million, $130 million. That's something that we would expect for next year, okay?
So we certainly also expect that we will have pretty decent revenue to start for the year for 2020. Somewhere on the north of $100-plus million. So I think that, with that sort of model and some fixed operating expenses, it should be pretty easy for you to put a combined model together.
I think for the 8 inch, for the 3 8-inch fabs, I think we'll continue to excel. We'll continue to thrive. Hopefully, if the market truly come back next year, I think we should be able to continue to maintain at a pretty high gross margin, above 30%. Okay. So that is our model. I think we should be able to have some growth from the 3 8-inch fabs as well for the next -- for 2020. And then plus the Wuxi fab, I think we should have a pretty good year.
Yes. Daniel. So just one very quick follow-up. So you just mentioned that the target is to turn around the new 12-inch fab within 2 years. But for 2020 and 2021, although gross margin level, it could be in loss-making, but government should also offer some subsidy. So on the operating level or on the pretax level, should we expect like 0 earnings dilution from this fab? Or there would still be some loss dilution from this plant?
You're talking about the first 2 years?
Yes.
Well, I mean naturally, the first 2 years is going to be very, very challenging, okay? It is very important for us, as I said earlier, okay, very important for us to bring this basically to production level to 20,000, 30,000 wafers capacity. You need to basically make that happen in the next 2 years. And at that point, we expect the 25,000 wafers to around 30,000 wafer capacity to company -- to accomplish and we become profitable. Okay? The company [ working ] -- everything we can, okay.
Your next question comes from the line of Randy Abrams from Crédit Suisse.
Okay. First, if you may just follow-up on the previous line from Sunny. On the Fab 7, just wanted to see, is the plan all-new products and applications? Or would you also, some of the business in the 8 inch, would you plan to transfer some applications to create space in the 8 inch?
No. I will turn to Mr. Tang for that -- to answer your question.
[Foreign Language]
[Interpreted] Thank you for your question. As for the Fab 7 production, from the beginning it's -- automatically, it's a technology transfer from 8-inch specialty technologies with strong market demand. But as long as the 55-nanometer eFlash and 55 logic and power management, they will be based on the Fab 7's own R&D platform.
[Foreign Language]
[Interpreted] Based on the customers' demand and the marketing demand as, for example, 5G and a new energy optimal view.
Okay. Great. And maybe to clarify, would it -- I mean since it is some applications in 8 inch, would it cannibalize? I mean I think you mentioned suggesting to grow the 8 inch. But with some of the same like initial applications, would it, I guess, maybe come at the expense of the 8-inch growth like where now it'll be qualified aggressively onto the 12 inch?
Yes. Randy, all along, the Wuxi fab is basically part of our expansion plan, okay? So additionally, there'll be some, for example, SIM cards, or some of the BCD or larger [indiscernible], that sort of technology platforms will be migrated to 12 inch. Especially for SIM cards, that would be the first applications. First product that will be migrated to the Wuxi fab, okay? So for the space that become available on the 8 inch, we're going to be doing other things. We can do more MCUs. We can do some discrete applications. So all along, we have been having issues with our capacity. We were out of capacity for all this time. So it's not going to be an issue for us to fill that fab, the 8-inch space.
Okay. Great. Okay. And if I could follow-up. Year-to-date, I think the CapEx -- and I think we're roughly thinking about $600 million or so per year on a new fab. I guess now it looks like it's spending a bit faster as you start moving toward 20,000 wafers? Like, how do you expect, overall, 2019 to end up? And then maybe an initial view on 2020 as you build out to the 20,000, like what the CapEx may be for next year.
Right. Randy, so for Wuxi, this year, on cash basis, we have spent close to $900 million. That's the expectation for forecast. Now we're not there yet, but we expect we'll spend about $900 million in total on cash basis.
For Shanghai, it's about close to -- slightly under $150 million. So just between the 2 of them, it's over $1 billion slightly, okay, less than $1.1 billion. We expect 20 -- so that would get us to -- basically, we have 10,000 plus part of the 20,000. And for 2020, the plan is we're going to be spending another Wuxi probably another $850 million. So that will get us to 20,000, 30,000 wafer capacity. It's going to be, as Mr. Tang said, it's going to be IC plus a combination of IC and some power discrete. But exactly what sort of ratio? We had to wait. That's going to be part of the after -- we have to find out. Eventually I think, based on market conditions, we'll figure out what the ratio is.
But overall, I think this is going to be the rate, $850 million for next year. We get to $20 million, $30 million. And then we still end up with another -- about $640 million, $650 million left to expand the capacity to its fullest, which is as we initially planned, 40,000 IC or IC plus power at some sort of capacity.
Okay. No, that's helpful. And the depreciation, the $120 million to $130 million. The past quarter, you had a bit of subsidies. For next year, would that full amount be into cost of goods sold? Or would there be some offset on subsidy to the depreciation increase?
I think that was just a onetime event, that's a one-off. Basically -- it was basically, we complete a R&D project. So it was about $6 million. So that -- which offset the depreciation expenses was roughly -- were running about $32 million a quarter. So this quarter was down by $6 million. So it's largely because we -- the company completed the R&D project, so we're basically -- we're qualified to use the subsidy to reduce the depreciation expense. But that's one-off.
Again, I think there are other projects they're working on. But we, at this point, we don't have a specific schedule, okay?
Okay. And if I can ask about the OpEx, I think you mentioned you're doing like more of the new project activity for Wuxi. So -- but then I guess there will be some costs as you bring up the fab. What is the way to think about the OpEx increase, like from here, like either absolute, or as sales ramps?
So for Wuxi, I think the OpEx should be eventually pretty stable. I think we're talking about is -- I'm looking at this model we have. It is still -- when we do these numbers, we're pretty conservative. And at the end of the day, we always do better. But I'm looking at there less than $30 million a quarter, just on OpEx, okay? So mostly, we're spending more than 2/3 of that on R&D expenses and very little on sales, marketing expenses. But the rest will be just general administration -- administrative.
So I would say you know, yes, go ahead.
No. Go ahead. Go ahead, Danny. I'm sorry, I cut you off.
Yes. No. No, I was just saying that it's going to be -- eventually, the head count we get -- we have a head count target, which is about by end of next year, it's going to be around 1,000 people for Wuxi and we're [indiscernible] the -- our operating expense is going to be, as I said, it's less than $30 million. We're going to keep it that way. And I think most likely will be lower.
Okay. And last one, I just want to ask the pricing environment. I think you mentioned in the remarks, it's been -- because of a slow environment, a bit of ASP softness. And I think the blended price is probably some mix where it came down a bit. I guess how you're seeing the pricing environment? And then on the other side, you mentioned that the substrate, the raw wafer was up a bit. Just the view, if also that side, if you have maybe contract lock-in that you may get some help on that side into next year.
Yes. On pricing, there's -- I mean Randy, this has not been the greatest year. I mean you know that. I mean if anybody's telling you it's -- this is a fabulous year for semiconductor, I think they're lying, okay? So basically, I think all the companies, I mean, unless you are the really on the leading edge stuff, I think you're facing some sort of pricing pressure. So did we, okay? I think there are pricing pressure virtually on all segments. For some of the stuff, for example, SIM cards, we're not doing too much because largely because the price has not been good. [indiscernible] so we give that manufacturing corridor to base it -- to MCUs. Okay, that's what we've been doing. That's why exactly you see why the -- you see MCU has been going up.
But now our wafer substrates, this year, we actually had a pretty big price hike in the beginning of the year. And then because the overall market condition has not been great, so we went back to the vendor, vendors. I think we would negotiate. So we're able to get some -- basically, be able to negotiate. We'll be able to get the price down a little bit. But overall, I think for the year, we're still up a little bit, still up by 5%, 6%.
Okay. And you expect that to come down, I mean, into next year?
Honestly, we wish the market will come back, okay? If you go back to this 100% utilization rate, even if the substrate is up a little bit, I think, that would be good for everybody.
Our next question comes from the line of Leping Huang from CICC.
[Foreign Language] The first question is the, as your announcement at the cooperation between Hua Hong Semi and Huali, so can you share some insight on how this Huali and Hua Hong cooperate in the future since we have -- now basically, we have a full-product offering from 14 and 28 inch? So yes.
[Foreign Language]
[Interpreted] So Huali is our technology partner. It's from the point of view of the Hua Hong Group as a whole group strategy and how to escalate the strength of both Hua Hong Grace and Huali.
[Foreign Language]
[Interpreted] In the process of the cooperation, it's helpful to escalate our R&D progress.
[Foreign Language]
[Interpreted] And it's helpful to provide more capacity to our customers.
[Foreign Language] The second question is, I want to know that the -- if we look at the Hua Hong Wuxi fab 2 years down the road, so if 2 years from now, what will be the mix, roughly the mix between the technology platform, whether it's mainly the power or nonvolatile memory and see how will there be any new technology platform? So do you think that the -- how Hua Hong can differentiate in this Chinese foundry business because we see quite a few fabs just newly introduced these days.
[Foreign Language]
[Interpreted] So our capacity in Wuxi Fab 7 is mainly IC and power. At current stage, majority is IC and some very limited amount for R&D purpose for the power discrete.
[Foreign Language]
[Interpreted] With respect of the IC, it's mainly for 90-nanometer eFlash. And going forward, 50-nanometer eFlash, 50-nanometer logic and RF and BCD.
[Foreign Language]
[Interpreted] [indiscernible] the technology development of the semiconductor industry is very fast. We also consider some new platform strategy.
[Foreign Language]
[Interpreted] With respect for the permit mentioned, we are aiming to continue the strength on our power discrete on the 8-inch platform.
[Foreign Language]
[Interpreted] We want to have some shipments in the mid- and high-level power management.
[Foreign Language]
[Interpreted] So we'll fill our capacity as soon as possible.
Our next question comes from the line of Szeho Ng from China Renaissance.
My question regarding the Q4 revenue guidance. Could you share some insights regarding discrete or contribution from the Wuxi fab?
Okay, it's -- we're looking at roughly -- we're going to make some shipment from the Wuxi fab. So I would say, roughly around $5 million to $6 million, okay, from Wuxi. The rest will be -- all be from the 3 8-inch fabs.
Okay. Got you. And then going down the line, when we look at the minority interest or the noncontrolling stake part, any guidance for Q4?
For Q4?
Right, right, right. Yes.
I mean, exactly what you mean?
Oh, the minority interest part, any guidance because the numbers has been fluctuating for the last 2, 3 quarters.
Yes, yes, yes. Well, I mean I think, in Q4, I think we're talking about, there's going to be -- overall, there's going to be a -- I mean there's some depreciation expenses, okay? I think overall, for the quarter, there will be about roughly close to $12 million depreciation expenses. There will be some revenue, okay? There's some costs. So overall, there will be slight loss, okay? I hope that has answered your question.
Yes, in a subtle away. Yes, right. Okay, yes. And also for modeling purpose vendor, Wuxi fab ramping up in shape in 2020 and 2021. What would be the package rate we should use for modeling for the entire group?
For the Wuxi fab?
I mean...
For what part?
For [ high ] group, yes. For the entire Hua Hong.
For Hua Hong Semiconductor, right? For...
Yes, yes.
For the combination of 8 plus 12 for next year?
Right, right. Yes.
I mean are you talking about top line?
Oh, no. I mean the tax rate.
Well, tax rate. I see. Well, Wuxi is not going to be -- I mean we're not going to be paying any tax for Wuxi for the next -- I mean even if it becomes profitable for the first 5 years, there will be 0 tax, okay? So this is the -- we're going to be able to enjoy the tax holiday once the company become profitable for the next 5 years, okay?
And before that, assuming the company will probably could be a loss for a few years, 1, 2, okay, so I would imagine there's not going to be any tax. So for the 8-inch, we're talking about, roughly around 19% effective tax rate.
Thank you. Ladies and gentlemen, that's all the time we have for questions. I'll now hand back to Mr. Danny Wang for closing remarks.
Well, again, thank you all for joining us today, and it was a very informative conversation. We hope that you will join us again next quarter. We wish you all have a very nice day. Thank you.
Ladies and gentlemen, thank you for your attendance. You may all disconnect.
[Portions of this transcript that are marked [Interpreted] were spoken by an interpreter present on the live call.]