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Morningstar | Taiwan Semiconductor Pushes Envelope With 7-nm Leadership; Strong Revenue Growth Is Not Guaranteed

Taiwan Semiconductor Manufacturing reported third-quarter results consistent with expectations, thanks to 7-nanometer sales related to Apple’s latest iPhones. However, weaker cryptocurrency demand served as an offset, leading to year-over-year top-line growth of only 3.3%. Management reiterated its long-term revenue growth forecast range of 5% to 10%. However, we anticipate the firm will achieve growth closer to the low end of this range, primarily due to a deceleration in smartphone unit growth. We applaud the firm’s 7-nm leadership combined with efforts to ramp 7-nm plus next year with EUV lithography implemented. Although we foresee artificial intelligence and high-performance computing driving average computer segment growth of 22% over the next five years, we think the other segments will lag the corporate average. Consequently, our fair value estimate of $32 per ADR implies shares are overvalued for narrow-moat Taiwan Semiconductor.

Third-quarter revenue was USD $8.49 billion, or NT $260.35 billion, up 1.9% year over year in USD terms and 3.3% year over year in NTD terms due to a favorable exchange rate. In the communications segment, Apple-related sales drove revenue up 3.3% year over year. The aforementioned weaker cryptocurrency-related demand led to computer revenue falling 31% sequentially. This marked the first quarter with contributions from the 7-nm process, accounting for 11% of sales. Gross margins fell 40 basis points sequentially to 47.4% due to the 7-nm ramp and lower utilization in the 28-nm process due to industrywide overcapacity. While we expect the 7-nm-related margin headwinds to mitigate over the next few quarters, we think the 28-nm-related margin detriments could continue over the next few quarters. Worth noting is that the 28-nm process still accounts for roughly 20% of total revenue predominantly for applications in automotive and industrial.

Management expects fourth-quarter revenue to be at a midpoint of USD $9.4 billion, which implies a 10.8% sequential increase nearly identical to the same time frame last year. For the fourth quarter, 7-nm revenue will be over 20% of the sales figure. We note the firm is on track to begin risk production of its 7-nm plus process in 2019 that will utilize EUV for a few process steps ahead of both Samsung and Intel. The much-delayed technology offers superior pattern control and lower cycle time (due to fewer steps to achieve a process layer) and will help drive adoption of the company’s 7-nm plus process for future iPhone chips as well as those in AI and HPC functions from Nvidia, Xilinx, and AMD. Nevertheless, we expect the ramp of EUV tools to be an arduous one (from both a timing and cost standpoint) given the immense complexity of the technology.