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Morningstar | TSMC's Forward 1Q Guidance Echoes Weakness Articulated by Key Customers Apple and Nvidia

TSMC reported fourth-quarter results in line with its prior guidance, benefiting from advanced 7-nanometer mobile chips primarily for Apple’s iPhone. However, this same beneficial exposure negatively affected the firm’s first-quarter guidance, illustrating TSMC’s significant reliance on Apple (which we estimate accounts for 20%-25% of the foundry’s total revenue). Consistent with recent commentary from Apple and Nvidia, management cited high levels of inventory in the semiconductor supply chain along with an overall weaker macroeconomic climate and worse-than-typical mobile product seasonality as all key contributors to TSMC’s feeble outlook for 2019. Specifically, management forecasts the overall semiconductor market (excluding memory) will grow 1%, the foundry market flat, and TSMC up modestly. Our fair value estimate of $32 per ADR remains intact, as our five-year revenue compound annual growth rate remains in the midsingle digits as a softer 2019 is offset by a recovery in 2020 and thereafter. We’d recommend prospective investors wait for a wider margin of safety before committing capital to narrow-moat TSMC, as we view firms such as Apple and Intel boasting more attractive entry points.

Fourth-quarter sales were $9.4 billion, up 2.0% in U.S. dollar terms and 4.4% in new Taiwan dollar terms thanks to a more favorable exchange rate. Advanced process technologies (28-nm and below) accounted for 67% of wafer revenue, led by 7-nm products for the latest iPhone. By segment, communications, computer, and consumer were all up year over year, while industrial and other was down for the quarter. Total revenue in 2018 was $34.2 billion, up 6.5% in U.S. dollar terms and 5.5% in new Taiwan dollar terms.

Nvidia’s GPUs are characterized as computing products, and along with cryptocurrency mining cards drove full-year computer revenue up 61% year over year. We have been expecting a steep drop-off in crypto-related demand, and we anticipate this headwind to hinder computer segment sales for 2019, partially offset by strength in high-performance computing for GPUs used in artificial intelligence. For 2018, gross margins were 48.3%, down 230 basis points from 2017 due to lower capacity utilization and an unfavorable technology mix skewed more to the 7-nm process that is initially margin-dilutive.

Management expects first-quarter revenue at a midpoint of $7.35 billion, which implies a 13% decrease from the same period in 2018. For 2019, the firm reiterated its plan to ramp its 7-nm-plus process with EUV lithography during the second quarter for high-end smartphone application processors (Apple). However, based on the aforementioned elevated inventories, 7-nm utilization will be considerably lower during the first half of 2019 (even when factoring in normal seasonality), before ramping up in the second half for Apple’s latest iPhone. In aggregate, while 2019 will be a challenging year for TSMC, it will remain the clear leader in the foundry space as 7-nm should contribute greater than 25% of total wafer revenue for the year. Nevertheless, we think the firm will operate at the low end of its 5% to 10% long-term revenue growth target range, versus current market levels that imply otherwise.

Regarding capital expenditures, management has outlined a range of $10 billion to $12 billion to support its revenue growth targets. Based on the weaker expectations for 2019 (modest growth), the firm’s 2019 capital spending target is $10.5 billion at a midpoint. This is not significantly lower than 2018, during which TSMC achieved solid growth, thus illustrating the rise in capital intensity required to support its customers’ product roadmap with leading-edge process technologies. This capital expenditures target is consistent with our broader expectations for wafer fab equipment spending during 2019, which we expect to be more logic/foundry slanted.