[October.2024] Decoding the earnings of TSMC, the world's top chipmaker

The semiconductor industry is often regarded as the crown jewel of modern technology. Among its key players is $Taiwan Semiconductor (TSM.US)$ , or Taiwan Semiconductor Manufacturing Company, which boasts the most advanced chip foundries in the world. As such, the company's financial health mirrors the cyclical nature of the chip market, with considerable swings in its stock price over the past few years.

Since May, TSMC's stock has hit new highs, nearing a trillion-dollar market cap. This surge is partly fueled by Apple's price cuts boosting high-end smartphone chip demand and the ongoing strong demand from data centers.

In recent months, TSMC's stock has surged, fueled by strong demand for data centers and Apple's price promotions that boosted sales of high-end smartphone chips, bringing its market value close to $1 trillion.

$Taiwan Semiconductor (TSM.US)$ will release its latest earnings results on October 17. Each time a company releases its financial report, it may present a potential trading or investment opportunity. But before diving in, investors need to understand how to interpret their financial statements.

How do we analyze TSMC's earnings reports, and how can we pinpoint its current phase in the business cycle? Key indicators to watch may include revenue growth and gross margin, the composition of its income, capital expenditures, and cash flow.

1. Revenue growth and gross margin

For cyclical industries, shifts in revenue growth and profit margins are key indicators of the cycle's direction. High growth in revenue and improving gross margins usually signal a peak in the cycle, while the opposite could suggest a downturn.

TSMC's revenue, after three-quarters of sequential declines, showed signs of recovery in the third quarter of 2023 with a 10.2% increase, followed by a 14.4% increase in the fourth quarter.

By Q1 2024, $Taiwan Semiconductor (TSM.US)$ reported revenue of NT$592.64 billion, marking a 5.3% decline from the previous quarter, halting its rebound trend. However, compared to the same period last year, TSMC's revenue still saw a growth of approximately 16.5%.

Looking at revenue growth, TSMC's sales finally stopped declining in Q3 2023 after three consecutive quarters of sequential decreases, posting a 10.2% quarter-over-quarter increase. In Q2 2024, $Taiwan Semiconductor (TSM.US)$ continued this upward trend with a year-over-year growth of 40% and a quarter-over-quarter increase of 13.7%.

$Taiwan Semiconductor (TSM.US)$ calculates revenue by multiplying product shipment volume by price. In Q2 2024, the significant revenue growth was driven by both increased shipment volume and higher prices.

Thanks to rising AI demand, TSMC's shipments grew approximately 3% quarter-over-quarter. Additionally, with the ramp-up of 3nm and other advanced processes, the average selling price of their products rose about 7% sequentially. This synergy between volume and price contributed to revenue growth.

Regarding gross margin, TSMC's gross margin in Q2 2024 was approximately 53.2%, still relatively low. This may be due to high depreciation costs associated with the ramp-up of 3nm production. However, driven by the increase in average selling price, the gross margin improved from 53.1% in the previous quarter.

Overall, TSMC's revenue growth is accelerating, which may indicate a recovery in industry demand. The slight rebound in gross margin may also suggest a turning point in profitability. Moving forward, we may monitor whether $Taiwan Semiconductor (TSM.US)$ can maintain this high growth rate and whether its gross margin continues to improve to assess the overall recovery in the cycle.

2. Revenue mix

TSMC's revenue mix is primarily comprised of sales from the smartphone and high-performance computing sectors, which collectively make up over 80% of its total revenue.

Between Q3 and Q4 2023, TSMC's smartphone revenue share rebounded after two consecutive quarters of decline, rising significantly from 33% in Q2 to 43%. This increase indicates a recovery in smartphone market demand. However, in Q1 and Q2 2024, the share of smartphone revenue decreased due to changes in the market share of low-end smartphone chips. In contrast, TSMC's high-performance computing segment benefited from demand in data centers and AI, achieving its highest revenue share in several quarters by Q2 2024.

Moving forward, we may continue to monitor the cyclical changes in smartphone market demand and the sustained robustness of data center demand. These factors will significantly impact TSMC's overall performance.

In terms of chip manufacturing technology, $Taiwan Semiconductor (TSM.US)$ categorizes its revenue into two segments: advanced sub-7nm processes and the less advanced 7nm-and-above processes. The sub-7nm category, which includes the latest and more sophisticated technology, is where TSMC earns the majority of its income.

Historically, TSMC's sub-7nm revenues were dominated by 5nm and 7nm process chips, and there has been a shift towards the even more advanced 5nm process. In the third quarter of 2023, $Taiwan Semiconductor (TSM.US)$ began mass-producing chips using the 3nm process technology, contributing approximately 6% to the overall revenue, with this figure climbing to 15% in the fourth quarter. Meanwhile, in Q2 2024, Apple's sales rallied from the Q1 decline, boosting TSMC's revenue share from the smartphone segment to 15% from 9%.

In the coming quarters, with the launch of new Apple devices and the demand for high-end chips driven by data centers, TSMC's 3nm technology segment is likely to see further revenue growth, which may contribute to overall income expansion.

3. Capital expenditure and cash flow

As the leading semiconductor foundry and second only to $NVIDIA (NVDA.US)$ in market value within the chip industry, $Taiwan Semiconductor (TSM.US)$ occupies a prestigious but challenging position. The company must continuously innovate to stay ahead, as the industry relentlessly pushes for more advanced technologies, spurred by Moore's Law. If TSMC were to fall behind, competitors like Samsung Electronics could quickly surpass it.

TSMC's commitment to innovation has led to high capital expenditures. From 2006 to 2023, its cumulative capital spending totaled 6.7 trillion New Taiwan Dollars, even exceeding its net income of 6 trillion during that period. This investment strategy resulted in a cumulative free cash flow of approximately 3.3 trillion, just 60% of its net income.

Since free cash flow is a key valuation indicator, this discrepancy could negatively affect TSMC's valuation and long-term stock price.

In the short term, TSMC's capital expenditure reflects its outlook on industry cycles. Typically, if a company predicts a downturn, it may cut back on capital spending, whereas a sustained upturn might lead to increased expenditures. Recent quarters have seen $Taiwan Semiconductor (TSM.US)$ reduce its capital spending. However, in Q1 and Q2 of 2024, TSMC's capital expenditure saw a rebound, and it will be important to monitor these expenditures moving forward.

In the long run, however, TSMC's expenditure trends may align with the technological trends in wafer manufacturing. If Moore's Law eventually becomes obsolete and chip process technology reaches a plateau, TSMC's growth in capital expenditures may also slow down. At that point, with competitors possibly catching up and increasing competitive pressure, $Taiwan Semiconductor (TSM.US)$ might improve its cash flow but face potential declines in gross margins, which could present a new set of competitive and valuation challenges.

Having read this far, you may now have a deeper understanding of how to interpret TSMC's financial reports. It's noteworthy that the release of earnings reports from prominent companies may present unique trading opportunities for different types of investors.

For instance, if an investor, after analyzing past reports and considering recent developments, believes a company's latest earnings will send positive signals and boost the short-term stock price, they might consider taking a long position. This could involve buying the underlying stock or purchasing call options.

Conversely, if the investor expects the earnings to be unfavorable and potentially pressure the stock price, they might consider taking a short position, either through short selling or buying put options.

If the report's outcome is unclear but volatility is expected, they might use a straddle strategy, buying both calls and puts.

However, investors should carefully assess their risk tolerance, particularly when considering high-risk trades like short selling or options, before making any trading decisions.

In summary

$Taiwan Semiconductor (TSM.US)$ has seen a sequential rebound in revenue for two consecutive quarters, while their gross margin continued a downward trend. Signs of a cyclical recovery warrant further observation.

Regarding revenue composition, the continued surge in AI demand is likely to bring positive changes to TSMC's revenue. Additionally, the mass production of TSMC's 3nm technology may further drive revenue growth.

TSMC's significant capital expenditures have a substantial impact on its free cash flow and, consequently, its valuation. Capital expenditures should be monitored from both short-term and long-term perspectives.