TSMC: AI Boosts Insanity, 3nm Finally Landing (2Q23 Conference Call)
TSMC released its Q2 2023 earnings report (ending in June 2023) before the US stock market opened on the afternoon of July 20, 2023. The key points are as follows:
Quarterly Core Data vs. Market Expectations:
1) Revenue: Taiwan Semiconductor.US achieved $15.7 billion in revenue for the quarter, a MoM decrease of -6.2%, within the guided range of expectations ($15.2-16 billion).
2) Gross Margin: The quarterly gross margin reached 54.1%, a MoM decrease of -2.2 percentage points, exceeding the guided range of expectations (52-54%).
3) Business Situation: High-performance computing became the largest source of revenue, with 5nm+7nm accounting for 53%.
4) Guidance for the Next Quarter: The revenue for Q3 2023 is expected to be $16.7-17.5 billion (lower than the market expectation of $17.5 billion), with a gross margin of 51.5-53.5% (in line with the market expectation of 53%).
For detailed financial information, please refer to Dolphin's analysis report "TSMC: NVIDIA Rescues, AI Supports the 'Cyclical' Bottom".
I. Incremental Information from the Conference Call:
1) Gross Margin: The initial growth brought by the 3nm technology in Q3 will be offset by a dilution of 2 to 3 percentage points in profit margin. Looking ahead to the fourth quarter, it is expected that the impact of 3nm on gross margin will be 3 to 4 percentage points.
2) Industry and Company Forecasts: The forecast for the semiconductor market (excluding memory) in 2023 has decreased by single digits, while the wafer foundry industry is expected to decline by tens of percentage points.
3) High-Performance Computing: The revenue, when calculated in US dollars, is still expected to grow in the coming years. The demand for server AI processors accounts for 6% of TSMC's total revenue and is expected to drive growth in the low double-digit percentage range.
4) N2/N3: It is expected that the growth of N3 in the second half of this year will be stronger with the support of HPC and smartphone applications. By 2023, N3 is expected to contribute a single-digit percentage to our total wafer revenue. N2 technology is progressing well and is expected to enter mass production in 2025.
5) 2023 Capital Expenditure: Advanced process technology accounts for 70%-80% of our total capital expenditure for the year. Mature specialty technologies account for 10-20%, with the remainder allocated to Advanced Packaging and EBO, among others. II. Telephone Conference Transcript:
1. CFO Wendell Huang:
2Q23 Quarterly Financial Information:
Revenue decreased by 5.5% QoQ in New Taiwan Dollars and 6.2% QoQ in US Dollars. The decline was due to the impact of the global economic conditions on our second-quarter business, which suppressed demand in the end-market and led to customer inventory adjustments.
Gross margin decreased by 2.2% to 54.1%, primarily reflecting lower capacity utilization and unfavorable exchange rates, partially offset by stricter cost controls and favorable foreign exchange rates.
Operating margin was 42%, a decrease of 3.5% compared to the previous quarter.
Earnings per share were NT$7.01, with a return on equity (ROE) of 23.2%.
Revenue Breakdown by Process Division:
5nm process accounted for 30% of wafer revenue, while 7nm accounted for 23%. Advanced technologies (7nm and below) accounted for 53% of wafer revenue.
Revenue Composition by Platform Division:
HPC accounted for 44% of revenue, a decrease of 5% QoQ.
Smartphone accounted for 33% of revenue, a decrease of 9% QoQ.
IoT accounted for 8% of revenue, a decrease of 11% QoQ.
Automotive accounted for 8% of revenue, an increase of 3% QoQ.
DCE accounted for 3% of revenue, an increase of 25% QoQ.
Balance Sheet:
As of the end of the second quarter, our cash and marketable securities amounted to NT$1.5 trillion or US$48 billion.
Current liabilities decreased by NT$62 billion, mainly due to a net decrease of NT$87 billion in income tax payable. This was offset by the payment of NT$120 billion in income tax for 2022 in the second quarter, which offset NT$33 billion in accrued taxes payable.
Long-term interest-bearing debt increased by NT$53 billion, primarily due to an increase of NT$41 billion in corporate bonds.
Days sales outstanding decreased by 2 days to 32 days, while days inventory increased by 3 days to 99 days.
Capital Expenditure:
In US Dollars, our total capital expenditure for the second quarter was US$8.17 billion.
3Q23 Guidance:
Based on the current business outlook, we expect revenue for the third quarter to be between US$16.7 billion and US$17.5 billion, representing a 9.1% QoQ growth.
Assuming an exchange rate of 1 US Dollar to 30.8 New Taiwan Dollars, we anticipate gross margin to be between 51.5% and 53.5%, and operating margin to be between 38% and 40%.
Operational Performance Commentary:
Gross Margin: Our gross margin for the second quarter decreased by 220 basis points to 54.1%, primarily due to lower capacity utilization. We guide our gross margin for the third quarter to decrease by 1.6 percentage points to a median of 52.5%.
In 2023, our gross margin faces challenges from the semiconductor industry's cyclical decline in capacity utilization, the increase in N3 process, expansion of overseas wafer fabs, and inflationary costs (including rising utility costs in Taiwan). To manage profitability in 2023, we will strive to improve internal costs while continuing to monetize our value. Although we are facing short-term challenges, we still anticipate that our long-term gross margin will reach 53% or even higher.
Capital Budget: Every year, our capital expenditure is allocated for expected growth in the coming years. As mentioned earlier, given the short-term uncertainties, we will continue to prudently manage our business and tighten our capital expenditure when appropriate. Nevertheless, our commitment to supporting customer-driven growth remains unchanged. Our disciplined capital expenditure and capacity planning are still based on long-term market demand.
We now expect the capital budget for 2023 to be close to the lower end of the range of $32 billion to $36 billion. Despite the short-term inventory cycle, our commitment to supporting customer-driven growth remains unchanged. Our disciplined capital expenditure and capacity planning are still based on long-term market conditions.
Dividend Distribution Policy: TSMC's capital management objective is to provide capital with funds, generate sustainable and steady profitability for the company's growth, maintain financial flexibility, and distribute sustainable and steadily growing cash dividends to shareholders. This is the result of our rigorous capital management. In May of this year, the TSMC Board of Directors approved a cash dividend of $3 per share for the first quarter of 2023, higher than the previous NT$2.75. This will become the new minimum quarterly dividend level in the future.
The first quarter cash dividend will be distributed in October 2023. TSMC shareholders in 2023 will receive a total dividend of NT$11.25 per share, and in 2024, they will receive at least NT$12 per share in cash dividends. Looking ahead, as our capital intensity begins to decline in the coming years, the focus of our cash dividend policy is expected to shift from sustainability to steadily increasing cash dividends per share.
2. CEO C.C. Wei
1) Market and Industry Outlook:
Second-quarter revenue met our expectations. Our second-quarter business was affected by the overall global economic conditions, which suppressed end-market demand, and customers were adjusting their inventories. As we enter the third quarter of 2023, although we have recently observed growth in demand for artificial intelligence-related applications, it is not sufficient to offset the overall loss in our business. We expect our third-quarter business to be supported by our 3-nanometer technology, partially offset by continued inventory adjustments by customers.
In the previous quarter's conference, we stated that we expected foundry inventory to rebalance to a healthier level. This statement remains valid as we enter the third quarter. However, due to macroeconomic constraints, we see customers becoming more cautious and intending to further control inventory in the fourth quarter of 2023.
For the full year of 2023, we have lowered our forecast for the semiconductor market excluding memory by a low single-digit percentage, while the wafer foundry industry is expected to decline by a low double-digit percentage.
We anticipate a decline of approximately 10% in revenue (in USD) for the full year of 2023. 2) High-Performance Computing (HPC):
The substantial and structured growth in computational demands continues to drive the significant need for high-performance and energy-efficient computing. The utilization of cutting-edge technologies is expected to fuel TSMC's long-term growth, even in the face of more challenging conditions in 2023. We aim to achieve a 15%-20% CAGR in our revenue in the coming years, as communicated during our investor conference in January 2022, when measured in US dollars.
Currently, the demand for server AI processors accounts for approximately 6% of TSMC's total revenue. We anticipate a CAGR of nearly 50% over the next five years, driving growth in the low double-digit percentage range.
3) Progress on N3/N3E/N2:
Our 3nm technology is the first production-ready technology in the semiconductor industry. N3E is already in mass production with good yields.
We have observed strong demand for N3 and expect its growth to be even more robust in the second half of this year, supported by HPC and smartphone applications. By 2023, we anticipate that N3 will continue to contribute a single-digit percentage to our wafer revenue.
The development of N2 technology is progressing well and is expected to enter mass production in 2025. Our N2 technology will feature nanosheet transistor structures, providing customers with optimal performance, cost, and technological maturity. Our nanosheet technology has already demonstrated outstanding efficacy, and our goal is to deliver complete node performance and power advantages to address the growing demand for energy-efficient computing.
With regards to N2 technology, we are observing high interest and engagement from HPC and smartphone customers. Our aim is to provide customers with backend power rail in the second half of 2025 and commence production in 2026.
4) Global Expansion:
In Arizona, USA, we have encountered some challenges due to a shortage of skilled workers with the expertise required for equipment installation. As a result, the production plan for N4 process technology is expected to be delayed until 2025.
In Japan, we are establishing a specialized technology factory that will adopt 12, 16, 22, and 28 (nm) process technologies, with production scheduled to commence by the end of 2024.
In Europe, we are collaborating with customers and partners to evaluate the feasibility of constructing a specialized factory in Germany for automotive-specific technologies.
In China, we are expanding our 28nm capacity in Nanjing as planned to support our customers in China. We will continue to fully comply with all regulations and requirements.
Meanwhile, we continue to invest in Taiwan and expand our capacity to support customer expansion.
From a cost perspective, the initial costs of overseas fabs are higher than those of TSMC's fabs in Taiwan due to:
- Smaller fab scale.
- Higher costs across the entire supply chain.
- Compared to the mature semiconductor ecosystem in Taiwan, the semiconductor ecosystem in overseas factories is still in its early stages.
Even as we expand our capacity overseas, TSMC can achieve a long-term gross margin of 53% and an ROE of over 25%, creating maximum value for our shareholders.
3. Q&A:
Q1: There is strong demand for artificial intelligence, but currently there is a capacity shortage. What has TSMC done in terms of capacity expansion? What has been done in advanced packaging and logic? When can we expect the supply-demand imbalance to reach a better and healthier balance?
A1: We are seeing very strong demand for artificial intelligence. For the front-end part, we have no problem supporting it. However, for the back-end processes such as advanced packaging like CoWoS, we do face capacity constraints and it is difficult to fully meet the customers' demands. Therefore, we are working closely with our customers in the short term to help them meet their needs, but we are also increasing our capacity as quickly as possible. We expect this tight situation to ease by the end of next year. During this period, we will continue to collaborate closely with our customers to support their development.
Q2: How much capacity expansion has been achieved due to the demand for AI, such as in the CoWoS segment?
A2: Capacity has increased by approximately twice the original amount.
Q3: What are the driving factors behind the CAGR guidance of 15%-20% for the next five years and the 10% decline in revenue this year?
A3: Some factors in the CAGR guidance may not be fully included in your model, such as the gross margin of specific customers. Another factor is market share, where you assume it to be constant, not only for advanced cutting-edge technologies but also for outsourcing. Currently, we expect the growth rate of the semiconductor market to be around 4-5%, which may increase, but as you mentioned, it will definitely not reach 10%.
TSMC's growth is driven by infrastructure and trends, as well as our technological leadership and differentiation. Therefore, the CAGR is driven by a combination of these two factors.
Q4: What is your comment on the downward revision of this year's revenue guidance to a decline of around 10%?
A4: The macro environment is weaker than what we anticipated three months ago. We may have been more optimistic, but the recovery of the Chinese economy is actually weaker than we imagined. So the demand has not grown as much as we expected. Overall, even though we have strong demand for artificial intelligence, it is still not enough to offset all these macro impacts. Apart from the AI field, we have seen weakness in all other areas due to macro influences. Therefore, we now expect a 10% decline in annual revenue.
Q5: What is your view on the current inventory cycle? Will the recovery next year be strong or slow? What are your plans when the recovery occurs next year?
A5: The macro economy is weaker than we anticipated. In fact, higher inflation and interest rates have affected the demand in all segmented markets worldwide. Specific plans for next year will be provided in the guidance for next year, giving more details. Q6: What considerations are there for wafer pricing? Will factors such as overseas costs and differences in front-end and back-end returns affect pricing decisions?
A6: At least in the near future, overseas wafer fabs will have higher costs because their supply ecosystems are not yet mature. Based on our experience, labor costs are actually higher than we expected. To answer your question - yes, when we try to maximize government subsidies, we also genuinely consider the flexibility of overseas value and pricing. All of this is to increase the trust of our customers and encourage them to continue working with us and move forward despite geopolitical concerns. Another consideration is maximizing shareholder value. Pricing cautiously has strategic significance.
Regarding pricing and back-end factors such as CoWos, as I answer this question, we are increasing capacity as quickly as possible, which incurs additional costs. We are working with our customers, and for them, the most important thing right now is to ensure a stable supply to meet their demands.
Q7: How do you determine genuine AI-related demands? How do you view the relationship between AI and ASICs development?
A7: We have an evaluation model. The short-term AI demand frenzy certainly cannot infer the long-term situation, and we cannot predict whether the sharp increase in demand will continue or stabilize in the near future. Our model is based on the structure of data centers, assuming a certain percentage of data center processors are AI processors. Based on this, we calculate the AIS process of demand, but this model has not been matched with subsequent actual data. However, overall, I believe that a significant portion of data center processors will be AI processors, which is a definite trend. As it eats into data center processors in the short term, when the capital expenditure of cloud service providers is fixed, yes, it will have an impact. But in the long run, when their data services and cloud services generate revenue from AI services, I believe they will increase capital expenditure, which should align with the long-term demand for AI processors. What I mean is that capital expenditure will increase due to generative AI services.
In fact, customers also have high requirements for ASIC components in AI applications. Let me emphasize again that in the field of AI, whether it's CPUs, GPUs, AI accelerators, or ASICs, they all require cutting-edge technology, and they all use very large mold sizes, which is where TSMC's capabilities lie.
Q8: How do you evaluate the dilution of gross margin caused by N3/N3E? Will the gross margin in 2024 be affected or maintain the full-year 53% gross margin?
A8: Starting from the second half of this year, we face certain cost challenges - the volume ramp-up of N3, which will dilute the gross margin by approximately 2 to 3 percentage points in the third quarter and 3 to 4 percentage points in the fourth quarter, in addition to higher electricity costs (which also dilute the gross margin). However, we have not provided expectations for the fourth quarter at this time; we are just stating some challenges that we see. For next year, we're not talking about overall gross margin, but we still see that N3 will dilute next year's gross margin by about 3 to 4 percentage points. And since N3 will contribute a larger proportion of revenue next year, we also see some dilution in N3 for next year, and specific profit margin guidance for next year will be provided.
Q9: What makes the higher dilution level of N3 different from the 2-3 point dilution caused by other processes?
A9: The increasing complexity of the process does pose challenges for the new nodes. However, another important factor is that our company's gross margin level is higher than before. Our previous gross margin was 50%, and now we're talking about a gross margin of 53% or even higher.
Q10: What headwinds could there be for capital expenditure in 2024, such as delays in the Arizona factory?
A10: Delaying the production of the wafer fab will indeed reduce some capital expenditure, but it won't have a significant impact on 2024. It's too early to discuss overall capital expenditure now. Every year, we allocate capital expenditure to seize future growth opportunities. In the past few years, our capital expenditure has grown rapidly to keep up with the trend of growth. Looking ahead, in the coming years, when these capital investments start to pay off, we believe that the capital intensity, measured in US dollars, will begin to stabilize, leading to a reduction in capital intensity in the future.
Q11: Will N5's support for N3 production help optimize capital expenditure?
A11: Some tools of N5 can indeed be used to support N3. Specific comments on capital expenditure are not made. As I mentioned earlier, capital expenditure is made every year to seize future growth opportunities.
Q12: Is there a risk of overexpansion or excess capacity in packaging?
A12: AI is a very hot topic today. Many customers are now increasing their demand, including front-end demand. TSMC almost occupies the major or largest share in the front-end and wafer market. In the front-end and wafer, we really work closely with customers to determine what back-end they need. So from this perspective, we are planning to enhance our existing capacity without considering overexpansion.
Q13: How does TSMC balance its technological leadership and fluctuating profit margins?
A13: With the increasing complexity of the process, N3 is more challenging than our previous nodes, but at the same time, we will continue to sell our value while reducing costs. We still believe that TSMC's long-term gross margin will reach 53% or even higher.
Q14: What drives the trend changes in the mature nodes in the second quarter?
A14: In fact, all mature nodes are partners of smartphones, PCs, or HPC. And the overall strength of smartphones and PCs is declining, so the demand for advanced technology nodes is also decreasing, and mature nodes are declining along with it. Q15: Can you provide a breakdown of the capital expenditure guidance for 2023 by different divisions?
A15: Advanced process technology will account for 70% - 80% of our total capital expenditure for the year. Mature professional technology will be between 10% - 20%, with the remaining allocated to Advanced Packaging and EBO, among others.
Q16: How does the ramp-up of N3 capacity and its contribution to revenue compare to N5/N7?
A16: We believe that N3 will be a long-lasting highlight for TSMC. In terms of percentages, I think it becomes less important because our overall corporate revenue is much larger now compared to before.
Q17: Is it achievable for the profitability of N3 to eventually reach the company's average gross margin, considering the complexity of its process?
A17: It will be challenging for N3 to reach the company's average profitability level within a timeframe of 7 to 8 quarters, but part of the reason is that we currently have a higher profit margin base.
Q18: The performance improvement from N3 to N2 seems less significant compared to the improvement from N5 to N3. Any comments on this?
A18: You have observed it well, the improvement from N3 to N2 is less compared to the improvement from N5 to N3. I want to point out that usually, we talk about geometric shrinkage in terms of performance, speed, and density. Now we are focusing on reducing power consumption. Over time, more and more customers are really improving power efficiency - which is very important for data centers and servers, and that's what we are doing.
Q19: How is the customer reception for the 3-nanometer family, N3P, and N3X? How do they compare or cannibalize each other? When can we expect AI-related adoption of the 3-nanometer family solutions?
A19: AI applications have already adopted our N3 technology node. We continue to improve our technology as always. N3 has been widely accepted by all of my customers, starting from N3E, and there are many customers involved in every version and variant now.
Q20: What is the difference in wafer costs between operations in the United States and Taiwan? When can we expect incentives/subsidies from the government?
A20: There is indeed a difference if we compare with the current supply chain and labor costs. We are trying to work with the U.S. government, primarily in terms of subsidies, cash grants, and tax incentives for investment, which is about bridging the gap in the first five years. When the tool depreciates, the ecosystem becomes prominent, which is the material cost, chemical cost, and labor cost. We are working with suppliers to establish more efficient supply sites to reduce costs, but they and the U.S. government also decide to subsidize the suppliers who supply us, so this is still a work in progress. I don't know how much further it can be reduced, but I think in any case, we will strengthen our pricing value and be able to maintain the company's profitability as we currently forecast. Q21: Will the gross margin in 2023 be 53% or higher?
A21: We haven't provided specific guidance for 2023. The mentioned gross margin of 53% is our long-term target, and we believe it is achievable.
Q22: Regarding the more positive revenue guidance for the second half of the year, to what extent will the impact of continued inventory adjustments offset the momentum from new customer product releases?
A22: Your observation is correct. The seasonality in the second half of the year is milder compared to previous years, and we have the upward trend of N3 and the launch of new products. However, I cannot share too many details about the specific impacts and how they are being separated at this moment.
Q23: Has TSMC compromised too much value in terms of the monetization of AI? Can we better sell our value or monetize it to gain greater value through AI trends?
A23: I once joked with my clients that I sold them chips for a few hundred dollars, and then they sold them back to me starting at $200,000. But what I want to say is that we are pleased to see our customers doing well. If our customers do well, TSMC will also do well. Of course, we work together with them and share our value with them. Fundamentally, what we want to say is that we are able to address and occupy a significant portion of the AI semiconductor component market.
Q24: Regarding the guidance of capital expenditure trending towards stability, will it remain above 300? What does it mean for capital expenditure to trend towards stability?
A24: As mentioned earlier, our capital expenditure has increased dramatically from 10 billion in the past few years to 36 billion last year. As we start to reap the benefits of these investments, the growth of capital expenditure will be slower than before. That's what I mean by stability.
Dolphin's Research on TSMC and the Semiconductor Manufacturing Industry
TSMC
July 20, 2023, Earnings Report Review: "TSMC: NVIDIA Comes to the Rescue, AI Supports the 'Cyclical' Bottom"
April 20, 2023, Conference Call: "Clear Bottom in the Second Quarter, 3nm Mass Production Imminent (TSMC 23Q1 Conference Call)"
April 20, 2023, Earnings Report Review: "TSMC: The Strongest Player, Yet Difficult to Escape the Cyclic Ups and Downs"
January 12, 2023, Conference Call: "Inventory Adjustments to Continue for Six Months, Growth to Wait Until the Second Half of the Year (TSMC 22Q4 Conference Call)"
January 12, 2023, Earnings Report Review: "TSMC's Thunder, Buffett's Increased Stake Can't Hold It Down" 2022 October 13 TSMC Conference Call "Despite the impressive financial report, TSMC cannot avoid the industry downturn (Q3 conference call)"
2022 October 13 Financial Report Review "TSMC: How long can the "lone warrior" last in the dark night?"
2022 July 14 TSMC Conference Call "How can TSMC sustain growth in the semiconductor downturn? (TSMC conference call)"
2022 July 14 Financial Report Review "TSMC: The "alternative" backbone in the wave of order cuts"
2022 April 14 TSMC Conference Call "On schedule for 2nm (TSMC conference call)"
2022 April 14 TSMC Financial Report Review "TSMC: Strong "faith" unaffected by the cycle"
2022 April 8 TSMC Stock Deep Dive "TSMC (Part 2): Price discounts, unwavering faith"
2022 March 16 TSMC Stock Deep Dive "After the market crash, let's talk about the ashes of the semiconductor king TSMC"
2022 January 13 TSMC Conference Call "After providing strong quarterly guidance, what did TSMC management discuss?"
2022 January 13 TSMC Financial Report Review "TSMC is too good at playing, avoiding the "cycle""
2021 October 14 TSMC Financial Report Review "TSMC: Leading the pack, still in the limelight"
Semiconductor/Wafer Manufacturing Industry
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2021年9月3日Wafer Manufacturing Industry Overview "Performance Up, Stock Price Down: Are SMIC and Others "Deserved to be Killed" or "Wrongly Killed"?"
2021年7月16日SMIC Individual Stock In-depth Analysis "SMIC (Part 2): Undervalued Chinese "Core""
2021年7月9日SMIC Individual Stock In-depth Analysis "SMIC (Part 1): The Strategy of the Leading "Core""
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