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Morningstar | Healthy Second-Half 2019 Demand for Industry Bellweather Taiwan Semiconductor; Shares Overvalued

Taiwan Semiconductor Manufacturing reported second-quarter results ahead of the firm’s guidance. Management believes the firm has passed the bottom of its cycle, with strong 7-nanometer demand from the likes of Apple, AMD, and Xilinx set to fuel growth in the coming quarters. Additionally, management cited an acceleration in worldwide 5G development that will drive greater demand for both its 7-nm and 5-nm processes. Consequently, Taiwan Semiconductor's capital expenditures spending for 2019 is expected to exceed the high end of its $11 billion guidance, which bodes well for equipment providers such as ASML, KLA, and Lam Research. We continue to believe the foundry’s 2019 sales will be effectively flat, as inventory corrections and high-end smartphone weakness hampered the first half of its 2019 results. Furthermore, we foresee healthy mid- to high-single-digit growth from 2020-23 and are maintaining our $34 fair value estimate. We think growth expectations implied by current levels are too lofty, and we view shares of the narrow-moat firm as overvalued.

Second-quarter sales were $7.75 billion, up 3% year-over-year. Due to the firm's photoresist defect incident last quarter, some sales that would have taken place last quarter occurred during this quarter, which artificially inflated this quarter’s results, in our view. Smartphone sales rose 5% sequentially, which we attribute to Apple preparing for its upcoming Fall iPhone launch. High performance computing revenue grew 23% over the prior quarter, most likely spearheaded by AMD’s ramp of its Ryzen 3 and EPYC 2 offerings that will combat Intel. Despite the cryptocurrency-related headwinds that have impacted GPU demand for both AMD and Nvidia, we suspect AMD’s newfound resurgence in the CPU arena has been a positive offset for Taiwan Semiconductor.

Gross margins rose 170 basis points sequentially to 43% thanks to greater capacity utilization. However, this fell below guidance of 44% as 7-nm cost improvements fell short of expectations. We think this illustrates the complexity of the latest process technology as well as the cost of EUV lithography insertion. Management showed confidence in getting gross margins closer to their long-term target of 50% in coming quarters (47% next quarter due to greater utilization), but we think greater EUV penetration and more multiple patterning steps will make it more challenging for the firm to reach this target, particularly at its 5-nm process for next year.

Management expects third-quarter revenue to be at a midpoint of $9.15 billion, which is an 18% sequential increase. Commenting on its fabless customers’ overall inventory, CEO C.C. Wei estimated inventory levels are still several days above seasonal levels exiting the second quarter. However, this is a considerable improvement from the beginning of 2019, which should lead to an improved demand environment in the coming quarters as inventories continue to normalize. The firm was less clear on the situation with Huawei, as Taiwan Semiconductor works with its subsidiary HiSilicon and not Huawei directly but did highlight downside risk to its overall smartphone business stemming from geopolitical uncertainties (trade tensions), longer upgrade cycles, and softer smartphone demand in anticipation of 5G launches.