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Morningstar | Positive 2H Outlook Overshadows Near-Term Headwinds for TSMC; Raising FVE to $34

TSMC reported first-quarter results in line with the firm’s updated guidance following a bad photoresist material incident in February that had a negative impact on 12- and 16-nanometer wafers. Management noted the incident reduced first-quarter sales by about $550 million, though this will be made up in the second quarter. Furthermore, the firm doubled down on the industry narrative of a second-half recovery in 2019. Although TSMC will benefit from the ramp of its latest 7-nm-plus processors (using EUV lithography) for Apple’s 2019 iPhone models, we believe the foundry's 2019 sales will be effectively flat, as inventory corrections and high-end smartphone weakness plague the first-half of TSMC’s 2019 results. That said, we do anticipate healthy mid- to high-single-digit growth from 2020 to 2023, and after some modest adjustments to our model we are raising our fair value estimate to $34 per share from $32. Nonetheless, we think growth expectations implied by current levels are too lofty and we view shares of narrow-moat TSMC as overvalued.

First-quarter sales were $7.1 billion, down 16% year over year as TSMC faced considerably weaker smartphone and cryptocurrency-related chip sales. We applaud the firm’s new reporting segment structure, as TSMC will now provide its revenue breakdown by platform, instead of application. These platforms include smartphone, high performance computing, Internet of Things, automotive, digital consumer electronics, and other, offering more granular details on the revenue drivers. Broad weakness in the chip space led to smartphone, HPC, and automotive down 10%, 20%, and 12%, respectively, year over year. Gross margins also fell 640 basis points sequentially to 41.3% due to lower capacity utilization and the negative impact from the photoresist defect incident.

Management expects second-quarter revenue to be at a midpoint of $7.6 billion, which is a 7% sequential increase at the midpoint. Gross margins are also expected to expand 270 basis points to 44% thanks to improved utilization and the absence of the photoresist defect issue. Worth noting is that TSMC’s days of inventory increased 12 days to 79 days during the quarter, though this reflects 7-nanometer wafer prebuilds to prepare for greater second half demand from the likes of Apple, AMD, Xilinx, Qualcomm, and others. All in, we view TSMC as a key barometer in the semiconductor space and its positive outlook for the rest of 2019 bodes well for its suppliers and customers.