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Morningstar | TSM Updated Forecasts and Estimates from 25 Jul 2018

Taiwan Semiconductor Manufacturing delivered mixed second-quarter results. Even though the top line was within guidance, management cut its full-year revenue forecast and now expect sales in U.S. dollars to increase by high single digits, previously 10%. The firm attributed the decreased forecast to expected weakness in demand from the cryptocurrency mining market. Shares traded as much as 4.5% higher on the news. While management delivered positive third-quarter guidance, the market reaction is likely predicated on the commentary surrounding the foundry’s progress with its 7-nanometer and 5-nm technology, as well as further optimization of the existing 28-nm node. After incorporating the updated guidance, we are maintaining our fair value estimate of $32 per ADR and our narrow moat rating for this pure foundry player.

With regards to the 7-nm node, management pointed to good yields from tape-outs completed during the quarter and expect roughly 50 tape-outs by the end of the year. TSMC expects 7-nm to ramp to 10% of sales in the third quarter. As it relates to cryptocurrency demand, we are pleased to see that management has fallen more in line with our thesis. However, with the advanced processing nodes, we maintain our belief that the yield ramp from the 7-nm process will be more difficult than management anticipates, hindering margins. Additionally, with 7-nm technology representing only 1% of wafer revenue in the second quarter, it is possible that the target product mix may come to fruition more slowly than the company expects. Ultimately, we do not believe the market is placing enough of a premium on these risks, as shares drift further into overvalued territory.

The firm reported sales of $7.85 billion, or TWD 233 billion, representing a year-over-year increase of 11% in U.S. dollar terms and 9% in Taiwan dollar terms. Operating margin fell sequentially by more than 250 basis points to 36.2% due to adverse operating leverage effects from the 7-nm node.

Management delivered positive third-quarter guidance, as revenue is expected to increase sequentially by 8% to $8.5 billion, while the gross margin is expected to expand 100 basis points. The improvement is expected to come from better capacity utilization and foreign exchange tailwinds from the continued strength of the greenback, offset by the mix of its product offerings, as the margin-dilutive 7-nm process increases as a percentage of total wafer revenue. Additionally, the company reduced its full-year guidance for capital expenditures by $1.5 billion to a range of $10 billion-$10.5 billion. Much of this decrease is attributable to cash flow timing, with a scheduled payment associated with its 7-nm node investments being pushed into 2019. The remainder is due to a combination of U.S. dollar strength and efficiency initiatives reducing equipment needs.

While we deem the efficiency initiatives as admirable, our fundamental view of the competitive landscape has not changed. With the economics of down-node migration becoming increasingly prohibitive and less linear, and with competition from the likes of Samsung and Intel becoming more robust, we see TSMC’s foundry dominance as increasingly tenuous.