TSMC's Thunder, Not Even Buffett's Buying Can Stop It

Taiwan Semiconductor (TSM) released its fourth quarter earnings report (ending in December 2022) on the Longbridge US stock market on the afternoon of January 12, 2023 Beijing time. The key points are as follows:

1. Revenue End: Risk of Order Adjustments Begins to Show. In Q4, TSM's US revenue was $19.93 billion, just above the lower limit of its guidance range ($19.9-20.7 billion). Quarterly revenue declined, with shipments contributing to a -6.8% decline and average selling price contributing to a +5.8% increase. The price increase is mainly due to the increase in the proportion of 5nm process, while the decline in shipments is mainly due to customer cancellations.

Although the proportion of revenue in North America has declined this quarter, this is mainly due to the impact of customer order adjustments, North America still has a key impact on TSM. TSM's factory in the US has further deepened its cooperation with North America. To cope with uncertainties, China's chip industry still needs to rely on controllable and domestically available lines, rather than U.S. production lines.

2. Gross Margin: Unsustainable Record High Gross Margin. TSM's gross margin in Q4 was 62.2%, above the upper limit of the guidance range (59.5-61.5%). The main reason for the increase in gross margin this quarter is the increase in shipments of the more profitable 5nm process. Although the unit cost of the company has also increased this quarter, the increase in price has fully covered the increase in unit cost items. However, it should be noted that the risk of order reductions will affect the company's capacity utilization and pose a hidden danger to its gross margin.

3. Downstream demand remains crucial, 3nm is still difficult to produce in large quantity. Smartphones and high-performance computing account for the largest part of the company's revenue, and demand for both is currently weak. The earliest projections for 3nm were for Apple's new phones this year, but due to high costs, neither Apple nor Qualcomm will use it this year. Production has been delayed again this quarter, with major customers expected to start using it in the second half of next year.

4. TSM's performance guidance: expected revenue for Q1 2023 is $16.7-17.5 billion (market expectations are $17.9 billion), and gross margin is 53.5-55.5% (market expectations are 55.1%). Revenue is lower than market expectations and may also experience a YoY decline, mainly due to weak downstream demand and continued order adjustments by some customers. Although the gross margin meets market expectations, it has declined significantly QoQ mainly due to the impact of order adjustments on the company's capacity utilization, which has eroded the company's gross margin.

5. Inventory of the Industry Chain: TSM's inventory increased to over $7 billion this quarter. Overall semiconductor industry chain inventory has also climbed due to poor end demand. Faced with the rising trend of inventory, the company also faces a certain risk of impairment.

Dolphin Analyst's overall view:

Market expectations for TSMC's fourth-quarter revenue performance were in line with predictions due to the company's disclosure of monthly operating data. However, the market's attention is more focused on gross profit margin in the quarterly report, and this quarter's gross profit margin performance exceeded expectations, mainly due to the continued increase in the high gross profit margin 5nm process.

A closer look at this financial report, TSMC's fourth quarter performance was actually quite good. The intuitive feeling is that the revenue side is below expectations while the gross profit margin exceeds expectations. In fact, revenue performance is partly influenced by the appreciation of the US dollar. After excluding exchange rate effects, this quarter's revenue performance is actually in line with market expectations. Therefore, both TSMC's revenue and gross profit margin for this quarter were not "disappointing."

The reason for saying "disappointing" is mainly because, as Dolphin Analyst previously mentioned in the weekly strategy report, one should focus on the company's guidance for the next quarter during a new financial reporting season, and this time the "disappointment" occurred in this area:

The company has given guidance for next quarter's revenue of $16.7 billion to $17.5 billion and a gross profit margin of 53.5% to 55.5%, a significant decrease compared to this quarter, and there may even be a year-on-year decline. This is mainly caused by some of the company's customers reducing orders under the pressure of rising inventory, which not only affects revenue but also reduces the company's capacity utilization rate.

In this regard, Dolphin Analyst also depicted a "semiconductor industry chain transmission diagram" in the report "Semiconductor Avalanche? There Will Be True Elasticity After the Most Severe Decline," showing "semiconductor industry chain: chip company orders decrease - > reduces the flow of chips in the semiconductor manufacturing plant - > the capacity utilization rate of the semiconductor manufacturing plant decreases, and the company begins to reduce its capital expenditure." Now, TSMC has also encountered the phase of "reducing chip flow and lowering capacity utilization rate."

Although Buffett is constantly increasing his holdings, he is still unable to hold back TSMC's disappointment. From this quarter's financial report, the company is likely to bear the pressure of the industry's downturn. The company's management also expects a high single-digit decline in the first half of 2023, and a rebound may not occur until the second half.

From TSMC's financial report, Dolphin Analyst believes that the company will also be dragged down by the current downward cycle and will continue to face pressure from order adjustments in terms of performance. The previous frequent declines in the stock price have also partly reflected the market's concerns about the company's performance. The landing of "order adjustments" can also promote the continued inventory digestion of the semiconductor industry chain and accelerate the return to reasonable levels of supply and demand.

From an investment perspective, although the semiconductor cycle will always usher in a bottoming rebound after going downhill, buying at the current point may still face the pressure of poor company performance in terms of holding experience. Regarding grasping the timing of investment, Dolphin Analyst believes that one should continue to pay attention to the inventory digestion situation on the semiconductor industry chain. When downstream inventory is digested, TSMC will also usher in the growth of new orders.Specific financial report performance-wise, Dolphin Analyst focuses on the following aspects:

In the downward cycle of the semiconductor industry, how did TSMC achieve record-high revenue? What contribution did the shipment volume and price of its wafers make?
Can TSMC's gross profit margin continue to maintain above 60%? How did the prices and costs of this quarter affect the gross profit margin?
How did TSMC's downstream applications perform this quarter? With the delay of 3nm mass production, what is the proportion of TSMC's various processing nodes? How did the proportions of downstream applications change under weak demand and policy pressure?

Dolphin Analyst came to the financial report with these questions to find answers:

I. Revenue end: Risk of order adjustment begins to surface

TSMC achieved revenue of US$19.93 billion in the fourth quarter of 2022, which is at the lower end of the performance guidance range of US$19.9-20.7 billion, and the quarterly revenue began to decline. This quarter's revenue decreased by 1.5% from the previous quarter, mainly due to exchange rate fluctuations and the impact of the downturn in the industry's business climate.

If the impact of the appreciation of the US dollar is excluded, the company's revenue in this quarter still increased on a month-on-month basis in terms of Taiwan dollar-calculated figures, but the growth rate has obviously slowed down, mainly due to the overall downturn in the industry.

TSMC's quarterly revenue has been fully expected by the market due to the publication of monthly operating indicators. As for the performance of prices and shipment volume, how can we observe the main driving force behind the revenue growth of TSMC in the fourth quarter from the perspective of quantity and price?

Dolphin Analyst observed the main driving force behind the revenue growth of TSMC in the fourth quarter from the perspectives of quantity and price:

Quantity dimension: TSMC's wafer shipments in the fourth quarter were 3,702,000 pieces, a decrease of 6.8% from the previous quarter. The main reason for the decrease in TSMC's shipment volume this quarter was the impact of customer order adjustment due to the downturn of some downstream markets. Combined with the capital expenditure, the capital expenditure of TSMC this quarter was $10.82 billion, an increase from the previous quarter. The total capital expenditure for the whole year of 2022 amounted to US$36.2 billion, which is in line with previous expectations after adjustment. For 2023, the company's capital expenditure plan is relatively conservative (US$32-36 billion), mainly due to its cautious planning based on the industry's situation.
Price dimension: TSMC's wafer revenue per wafer (equivalent to a 12-inch wafer) in the fourth quarter was US$5,384/piece, an increase of 5.8% from the previous quarter. The wafer shipment price of TSMC continued to rise this quarter, mainly due to the structural impact brought by the increased proportion of 5nm revenue on the overall shipment price of the company.

Under the exclusion of exchange rate fluctuations, the company's overall revenue for this quarter still met market expectations on the revenue aspect. The stable revenue of this quarter is mainly due to the increase in the proportion of high-end processes. However, in terms of shipments, it was the first sequential decline in 15 quarters, which also means that the downward cycle of the overall semiconductor has spread to TSMC. Considering the capital spending investment that the company continues to make for expanding production, the decline in shipments indicates that the company's capacity utilization rate has declined significantly starting this quarter.

Dolphin Analyst has been tracking the situations of important clients of TSMC, such as Apple, Nvidia, Qualcomm, etc. All three manufacturers have experienced the slowing of demand and the increase of inventory, and it is actually a matter of when the problem will occur that they respond to inventory issues through order adjustments. The decline in TSMC's capacity utilization rate this quarter also confirms the impact of downstream order adjustments.

Looking back, the last time TSMC's shipments declined sequentially was in 17-18, which was also when the overall semiconductor market demand was weak and the industry suffered a significant decline. The decline in shipments this quarter indicates that TSMC cannot escape from the current semiconductor downward cycle.

Second, gross profit and gross profit margin: The unsustainable record high gross profit margin.

TSMC achieved a gross profit of USD 12.4 billion in the fourth quarter of 2022, a month-on-month increase of 1.4%, while the month-on-month decline in revenue was due mainly to the increase in gross profit margin. TSMC's gross profit margin for the fourth quarter was 62.2%, exceeding the upper limit of the guidance range (59.5-61.5%).

TSMC's gross profit for the fourth quarter increased by 1.5% sequentially, with revenue contributing -1.5% and gross profit margin contributing +2.9%.

The two most important data that the market cares about for TSMC are revenue and gross profit margin. Since the monthly operating data is announced, quarterly revenue has basically been anticipated by the market. Gross profit margin is one of the focal points of this quarter's report. Dolphin Analyst will analyze the main drivers of the improvement in gross profit margin this quarter:

"Profit = Wafer Revenue - Fixed Cost - Variable Cost"

Wafer Revenue (equivalent to 12 inches): In the fourth quarter, TSMC's wafer revenue was about USD 5384 per piece, a month-on-month increase of USD 293, mainly due to the increase in the proportion of 5nm which lifted the overall wafer product's average selling price.
Fixed Cost (Depreciation and Amortization): In the fourth quarter, TSMC's average fixed costs were about USD 926 per piece, a month-on-month increase of USD 51. The decline in shipments this quarter has caused the fixed costs to increase on a per-piece basis due to depreciation and amortization.3) Variable Costs (Other Manufacturing Expenses): In Q4 2021, TSMC's average variable cost was about $1,108 per wafer, down $32 per wafer from the previous quarter. The decrease in variable cost per wafer was mainly due to the decline in raw material costs, which helped reduce cost pressures that had accumulated in the past.

Combining the above data, TSMC's gross profit per wafer in Q4 was $3,350, up $273 on a quarterly basis. The Q4 gross profit margin was 62.2%, up 1.8% on a quarterly basis. Looking at Q4 financial reports, as the proportion of 5nm technology continues to increase, the prices and costs of TSMC's products have both increased, but the increase in prices has been higher than the increase in costs, resulting in a continuing improvement in gross profit margin.

In Dolphin Analyst's view, TSMC's Q4 gross profit margin performance is the only highlight, mainly due to the continuing improvement in the proportion of high gross margin 5nm products. The proportion of TSMC's high-end processes continued to increase in Q4, and while the unit cost also increased, the increase in price covered the increase in unit cost. However, the current high gross profit margin is unsustainable, and if the company's customer orders adjust and capacity utilization decreases, the company's gross profit margin will also be affected.

3. Wafer Structure: Downstream Demand is Still Key, 3nm is Still Difficult to Mass Produce

3.1 Wafer revenue share (by application type)

Smartphones and high-performance computing have always been the biggest sources of revenue for TSMC, accounting for more than 80% of the total, and also having the greatest impact on the company's performance.

Looking at the breakdown of each application, the **change in structure has always shown a trend of declining smartphone market share, mainly because the demand for smartphones has been consistently weak since 2022, and high inventories of terminal manufacturers have reduced demand for chips. Although the proportion of smartphones increased on a quarterly basis in the previous quarter, Dolphin Analyst also mentioned in the previous review "TSMC: How Long Can the Lone Courageous "Hero" Hold On in the Dark Night?” that "this is a short-term impact of seasonal factors driven by new machine inventory of major customers." The overall smartphone market is still in a stage of inventory digestion, and the proportion has declined again this quarter.

Meanwhile, the proportion of high-performance computing returned to the top spot this quarter, mainly due to the structural increase brought about by the downturn in other areas. The high-performance computing sector mainly includes the demand for graphics cards and data centers. The graphics card market is still affected by the weak PC market, and the high-growth of data centers in the past is no longer the case. Therefore, looking solely at the high-performance computing sector is also not optimistic, which can be seen from the constantly rising inventory in the financial reports of TSMC's major customer, Nvidia.

Due to factors such as the epidemic, the market performance of the promotion season such as "Double Twelve" and Christmas in Q4 was also not ideal. The weak demand will continue to require chip manufacturers to handle inventory, and TSMC has clearly been affected by order adjustments since this quarter.**

3.2 Proportion of Wafer Revenues (By Process Node)

TSMC's proportion of advanced processes continues to increase, with 5nm node revenues accounting for 32% this quarter, while demand for high-performance computing on the 7nm node has eased and revenues have fallen to 22%. Revenues from processes below 7nm advanced nodes remain at around 54%.

This quarter, TSMC's 5nm process proportion continued to increase, exceeding 30%. Looking at historical trends, TSMC typically introduces new process nodes after the proportion of the latest advanced process reaches around 30%. However, due to the higher price of the 3nm process, major customers have delayed their adoption of it. The start of mass production of the 3nm process is expected to have a positive impact on the company's product prices, but starting mass production will also result in some loss of gross margin for the company. Major customers are expected to adopt the 3nm process in the second half of 2023, providing an opportunity for significant volume production of 3nm. The company still plans to achieve mass production of 2nm chips in 2025.

The Dolphin Analyst believes that the overall chip process will continue to advance towards higher process nodes. The demand for smart phones and high-performance computing will shift to 3nm and 5nm processes, while other chip demands will move back to the 7nm process. The overall progression of chip processes towards the high-end is expected to further increase the proportion of advanced processes revenue, thereby increasing the average selling price of the company's products.

3.3 Proportion of Wafer Revenues (By Region)

In terms of revenue by region, North America is still TSMC's largest source of revenue, accounting for around 70%. Major customers such as Apple, Qualcomm, Nvidia, and AMD have created strong commercial ties between TSMC and the United States. With more than 20% of its revenue in the last quarter coming from Apple's new machine inventory, North American revenues continued to increase. However, this quarter, the coronavirus pandemic and other factors had an impact on the adjustment of orders by some North American customers, affecting the region's revenue.

Outside of North America, China and the Asia-Pacific region are the other two major sources of revenue, accounting for 12% and 7% respectively this quarter. There was a significant change in the proportion of revenue from China this quarter, which fell from 8% in the previous quarter to 12% in this quarter. As production capacity was adjusted due to major customers' inventory in the previous quarter, Chinese customers returned to their previous proportion of revenue this quarter.

Looking at the proportion of revenue from the United States to TSMC, US policies have had a significant impact on TSMC, driving the company's process of building production lines in the US. If the US semiconductor policy continues to deepen in the future, the relationship between the Chinese semiconductor industry and TSMC's business could still be affected.From the perspective of independent controllability, China's semiconductor chips mainly rely on self-improvement of the production line.

This article is the research of Dolphin Analyst on TSMC and the wafer manufacturing industry.

TSMC

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TSMC earnings call on July 14, 2022: How can TSMC sustain growth in a semiconductor downturn? (TSMC earnings call)

TSMC Q2 2022 financial review on July 14, 2022: TSMC: "Alternative" backbone amid order cuts

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