TSMC: How long can the "lone warrior" last in the dark night?

Taiwan Semiconductor (TSM) released its Q3 2022 earnings report (ending September 2022) before the Longbridge U.S. stock market on the afternoon of October 13th. The highlights are as follows:

1. Revenue side: Alpha in the down cycle. In Q3, TSM's revenue realization was $20.23 billion, in line with expectations ($19.8-20.6 billion). Quarterly revenue growth was driven by a contribution of +4.6% from shipment volume and a contribution of +6.5% from shipment average price. The rise in both quantity and price of the revenue side was mainly due to Apple's new machine cargo boosting demand for the 5nm process.

2. Gross profit side: 5nm significantly improves the company's gross profit margin. In Q3, TSM's gross profit margin was 60.4%, exceeding the upper limit of the guidance range (57.5-59.5%). The main reason for the increase in gross profit margin this quarter was due to the higher gross profit margin of the 5nm process. Although Apple did not adopt the 3nm process this quarter, it increased its inventory of the 5nm process. The increase in the proportion of 5nm not only increased the cost per chip, but also brought about an increase in product prices, resulting in a gross profit margin of over 60%.

3. Smartphones are still weak, domestic chips need to be self-controllable. The proportion of the smartphone business increased this quarter due to the effects of Apple's new machine cargo, but it is still significantly lower than the same period in history, and the overall trend of weak smartphones remains unchanged. This quarter, the proportion of revenue in North America increased to 72%, and TSM's business relationship with the United States continued to deepen. Under the influence of U.S. semiconductor policies, the business proportion in China has fallen sharply to single digits. The business relationship between China's semiconductors and TSM continued to weaken, and domestic chips still need to rely on the self-controllable beautification of the production line.

4. TSM's performance guidance: expected revenue for Q4 2022 is $19.9-20.7 billion (market expectations are $19.3 billion), and the expected gross profit margin is 59.5-61.5% (market expectations are 57.9%), both of which exceed market expectations. The quarterly revenue is expected to remain flat compared with the previous quarter because Apple's new machine market response was average and there are signs of weakness in several downstream markets. Although gross profit margin reached 60.4% in Q3, it is not expected to increase significantly in Q4. However, the proportion of advanced processes in shipments will remain high.

Overall, TSM's Q3 revenue situation was in line with market expectations, as the company discloses operating data every month. In contrast, the market pays more attention to gross profit margin when it comes to quarterly reports, and the reason why the gross profit margin performance once again exceeded market expectations this quarter is mainly due to the increase in the proportion of high gross margin 5nm process.

Although Apple's new machine did not use the 3nm process this time, adding inventory of the 5nm process further increased the proportion of advanced processes and profitability of the company. Affected by weak downstream demand for smartphones and high inventory, the company's Q4 revenue guidance is expected to remain basically flat. However, with the start of mass production of 3nm at the end of the year, TSM's overall production capacity structure will continue to shift towards advanced processes, which is expected to push up product prices and gross profit margin. Dolphin Analyst believes that the weakness in downstream demand in multiple fields such as smartphones and graphics cards is pushing the semiconductor cycle to a downturn. TSMC, which is also in the semiconductor industry, cannot avoid the impact of the downturn. However, since more than half of TSMC's current revenue comes from advanced processes, the impact on advanced processes is relatively smaller. As chip production capacity gradually shifts to 5nm and 3nm, the company's product prices are expected to receive structural improvements, thereby obtaining relative alpha in the semiconductor downturn.

TSMC expects to start mass production of 3nm at the end of 2022 and N3E process by the end of 2023. Although Apple has adopted a 5nm process for its new products this year, the proportion of 3nm mass production at the end of the year will remain low. Next year, Apple's new machine is expected to use N3E process, which will greatly increase the proportion of 3nm process. Although TSMC has relative stability on the performance side due to process leadership, the company's overall business is greatly affected by the US semiconductor policy risk due to the huge proportion of revenue from North America (72%). Under the risk of macroeconomic recession, there is a risk of prolonging the replacement cycle of high-end machines, which will also put some pressure on the company's performance. This quarter's unexpected performance will boost investor confidence, but stocks are mostly based on expected transactions. However, the outlook has risks, which will suppress stock performance.

As for the specific financial performance, Dolphin Analyst pays close attention to the following aspects:

1. In the semiconductor downturn, how can TSMC's revenue achieve new highs, and how much do wafer shipment volumes and prices contribute respectively?
2. How did TSMC break through the 60% mark in gross profit margin, by price increase or cost reduction?
3. How did TSMC's downstream applications perform this quarter? Apple's new machine did not use 3nm, what is TSMC's current share of each process node? Under the situation of weak downstream demand and policy pressure, how did the proportion of downstream applications change?

Dolphin Analyst seeks answers to these questions in the financial report:

I. Income end: alpha in the downturn

TSMC achieved a quarterly revenue of 20.23 billion U.S. dollars in the third quarter of 2022, in line with performance guidance expectations (18.8-20.6 billion U.S. dollars), setting a new record in quarterly revenue. This quarter's revenue increased by 11.4% month-on-month, mainly due to the pull of Apple's new machine stocking and the seasonal rebound in the proportion of smartphone business.

TSMC's quarterly revenue has been adequately expected by the market due to the disclosure of monthly operating indicators. However, one point to note in this quarter is that although this quarter's revenue has set a new historical high, the monthly revenue in September has shown a month-on-month decline, which is the first time in nearly 3 years that revenue has shown a month-on-month decline in September. This is mainly due to the further advance release of the new Apple devices, which caused the company's performance to be released ahead of the same period last year.

The semiconductor cycle is starting to decline, and the revenue of TSMC is still growing this quarter, mainly due to price increases or increases in shipments?

Dolphin Analyst observes the main driving forces behind TSMC's revenue growth in the third quarter from the perspective of quantity and price:

1. Quantity: In the third quarter, TSMC shipped 3974 thousand wafers, a QoQ increase of 4.6%. The increase in TSMC shipments this quarter was mainly affected by the seasonal cargo pulling of major customers, but the magnitude of the increase was lower than the historical same period. Dolphin believes that on the one hand, affected by the weakness of the smartphone market, major customers' new machine stocking did not meet high expectations, and on the other hand, due to the industry downturn and policy risks, the company’s shipments have slowed down. Combined with capital expenditure, TSMC’s capital expenditure this quarter was US$8.75bn, an increase from the previous quarter, but still conservative. Due to industry downturn, policy risks and other factors, the company has lowered its capital expenditure plan for the full year of 2022 from US$40-44 billion to US$36 billion.

2. Price: In the third quarter, TSMC’s single wafer revenue (equivalent to 12-inch wafers) was USD 5,091/piece, a QoQ increase of 6.5%. TSMC's wafer shipping price continued to rise this quarter, mainly because Apple's new device continues to use the 5nm process, and the proportion of 5nm revenue has a structural impact on the overall shipment price of the company.

TSMC's quarterly revenue hit a new high again, and Dolphin Analyst believes that this quarter’s growth is still driven by the boost of rising quantity and price, mainly driven by the Apple new machine stocking. At the same time, concerns about the first monthly decline in September's revenue in three years were noticed, which was mainly due to the advance of the launch of the new Apple device, while the growth of shipments slowed down under the situation of weak downstream demand. From the company's guidance for the next quarter, it can also be seen that the company's revenue growth in the next quarter is basically flat. Dolphin Analyst believes that this year's new Apple device using the 3nm process was lower than expected, but the increase in the proportion of 5nm has also boosted the company's product shipment price to a certain extent. Although the shipment volume of TSMC’s products will be affected by industry cycles and policy risks, the company will still move towards higher processes, thereby improving the average selling price of the company's products.

II. Gross profit and gross margin: 5nm significantly improves TSMC's gross margin

In the third quarter of 2022, TSMC achieved a gross profit of US$12.22bn, a QoQ increase of 14%. The reason for the QoQ growth rate being higher than that of revenue growth (11.4%) is mainly due to the unexpected increase in gross profit margin. TSMC's gross profit margin in the third quarter was 60.4%, exceeding the upper limit of the guidance range (57.5-59.5%). In Q3, TSMC's gross profit increased by 14% QoQ, with revenue contributing to a 11.4% increase and gross margin contributing to a 2.3% increase.

The two most important figures that the market cares about with regards to TSMC are revenue and gross margin. With monthly operating data being released, quarterly revenue is already expected by the market. Therefore, gross margin is one of the key focus points for this quarter's report. Dolphin Analyst will analyze the main drivers behind the increase in gross margin for this quarter:

"Gross profit = Wafer revenue - Fixed Costs - Variable Costs"

"1) Wafer revenue (equivalent 12-inch):" In Q3, TSMC's wafer revenue was approximately $5,091 per piece, with a QoQ increase of $310 per piece. "This was mainly due to the increase in the proportion of 5nm, which raised the overall shipping price of wafer products."

"2) Fixed costs (depreciation and amortization):" In Q3, TSMC's average fixed costs were about $875 per piece, with a QoQ decrease of $139 per piece. "Total depreciation in this quarter decreased and, with the release of production capacity, the fixed cost per wafer further decreased."

"3) Variable costs (other manufacturing costs):" In Q3, TSMC's average variable costs were about $1,140 per piece, with a QoQ increase of $196 per piece. "The increase in variable costs per wafer was mainly due to the increase in the proportion of 5nm, which increased unit costs while also increasing unit prices."

Taking the above factors into account, TSMC's single chip gross profit for this quarter was $3,076 per piece, with a QoQ increase of $253 per piece. "This quarter's gross margin (60.4%) increased by 1.3% QoQ." Looking at this quarter's financial report, with the continued increase in the proportion of 5nm process, both the company's product prices and costs have increased, but the increase in prices outweighed the increase in costs, resulting in the gross margin breaking through 60%.

"The Dolphin Analyst believes that the above-expectation increase in TSMC's gross margin this quarter is due to the continued increase in high-gross-margin 5nm product proportion." Through the breakdown of TSMC's single wafer costs this quarter, we can see that as the company's high-end manufacturing capacity increases, the unit material costs have increased, but the increase in prices has covered the increase in costs.

"3. Wafer Structure End: Smartphones are still weak, and domestic chips still need to be self-controlled"

"3.1 Wafer Revenue Proportion (By Application Type)"

Smartphones and high-performance computing are still the largest application sources for TSMC, with the two combined accounting for more than 80% of the company's performance.

From the perspective of each specific application, there has been a trend of declining proportion towards smartphones due to the continuing low demand in the smartphone market since 2022 (which can be referred to in Dolphin's "Consumer Electronics Mature, Apple Holds Out, Xiaomi Struggles"). The high inventory of terminal manufacturers has led to a decrease in demand for chips. The proportion of smartphones has increased this quarter compared to the previous quarter, mainly due to the pull of new machine stocks from major customers, which is a seasonal factor, but the overall proportion is still significantly lower than historical levels.

However, there was no significant growth in high-performance computing this quarter, mainly due to the high inventory of graphics cards and the trend of large factories shrinking capital expenditure (refer to the Dolphin Analyst's "Thunder Rolling, Nvidia Performance 'Free Fall'"). coupled with recent U.S. policy risks directly affecting customer demand.

From the sales situation in the three quarters since "618", Dolphin Analyst believes that the inventory of smartphones has not been fully digested, and Apple's new machines this year have not brought optimistic expectations. In the second half of the year, the smartphone market will continue to digest inventory, and the overall market demand will still be weak.

3.2 Wafer Revenue Share (By Process Node)

TSMC’s advanced processes accounted for an increasing proportion, with 5nm nodes accounting for 28% of revenue this quarter, while demand for high-performance computing mainly on the 7nm node slowed and revenue share fell to 26%. Revenue from advanced processes below 7nm continued to increase to 54%.

The company's 5nm process accounted for an increasing proportion this quarter, reaching nearly 30%. From the historical rhythm, TSMC generally launches a new process node when the current most advanced process is upgraded to about 30%. In this case, due to the higher price of the 3nm process, major customers have delayed their use of the 3nm process but are expected to start mass production by the end of 2022. The start of mass production of 3nm chips will have a positive impact on the company's product prices, but the proportion of initial production is small. In the second half of 2023, major customers are expected to use the latest N3E process, which will provide an opportunity for 3nm to achieve mass production. The company still plans to start production of 2nm chips in 2025.

Dolphin Analyst believes that the overall chip process will move toward higher processes, and that demand for smart phones and high-performance computing will shift to 3nm and 5nm processes, while other chip demands will shift back to 7nm processes. The overall evolution of chip processes toward high-end is expected to further increase the revenue share of advanced processes, thus improving the average selling price of the company's products.

3.3 Wafer Revenue Share (By Region)

From the perspective of revenue by region, North America is still TSMC's largest source of revenue, accounting for more than 70% this quarter. With major customers such as Apple, Qualcomm, Nvidia, and AMD in North America, there is a strong commercial tie between TSMC and the United States. **This quarter, with Apple's new machine inventory accounting for over 20% of the company's revenue, revenue in North America continued to rise.

Apart from North America, China and the Asia-Pacific region are the other two major sources of revenue, accounting for 10% and 8% respectively this quarter. There has been a significant change in the revenue share from China this quarter, from 13% in the previous quarter to 8% this quarter. This is mainly due to the impact of the US semiconductor policy, and the significant decrease in China's investment in TSMC.

From the proportion of revenue from the US region, it can be seen that US policy has a significant impact on TSMC. If US semiconductor policy is further deepened in the future, the degree of business connection between the Chinese semiconductor industry and TSMC may further decrease. From the perspective of self-controllable, China's chips still mainly depend on building its own production lines.

Dolphin Analyst on TSMC and the wafer manufacturing industry

TSMC

July 14, 2022 conference call "Semiconductor downturn, how can TSMC sustain growth? (TSMC conference call)"

July 14, 2022 earnings review "TSMC: The "Alternative" Backbone in the Cutback Wave"

April 14, 2022 TSMC conference call "2nm on schedule (TSMC conference call)"

April 14, 2022 TSMC earnings review "TSMC: Strong "Faith", Irrelevant to the Cycle"

April 8, 2022 TSMC stock in-depth "TSMC (Part II): Discounted Price, Unwavering Belief"

March 16, 2022 TSMC stock in-depth "After the Market Crash, Talking About the Ashes Leader of the Foundry, TSMC"

January 13, 2022 TSMC conference call "After providing strong quarterly guidance, what did TSMC management talk about?"

January 13, 2022 TSMC earnings review "[TSMC is Too Good at Fighting, "Cycle" Goes Around It](https://longbridgeapp.com/topics/1795375? channel=t1795375&invite-code=294324)"]"]

Semiconductor/Wafer Manufacturing Industry

A review on the semiconductor industry on June 24, 2022: "[Kan Dan Kan Dan Kan, Will the Semiconductor Market Change?"](https://longbridgeapp.com/topics/2971045)

A review on wafer manufacturing industry on September 3, 2021: "[Performance Increase vs. Stock Price Decrease: Is SMIC Worth Investing?"](https://longbridgeapp.com/topics/1112565?invite-code=032064)

An in-depth look at SMIC on July 16, 2021: "[SMIC (Part 2): The Underrated Chinese "Chip"]"(https://longbridgeapp.com/news/40257302)

An in-depth look at SMIC on July 9, 2021: "[SMIC (Part 1): The Strategy of the Leading "Chip"]"(https://longbridgeapp.com/news/39746631)

Risk Disclosure and Disclaimer of this Article: Dolphin Analyst Disclaimer and General Disclosures