TSMC financial report review: Performance recovery is on the way

On January 18, 2024, TSMC released its Q4 financial report for 2023, which exceeded Bloomberg's consensus expectations in both revenue and net profit. In Q4 2023, TSMC achieved a revenue of NT$ 625.5 billion (US$ 19.62 billion), a decrease of 20% year-on-year but an increase of 13% quarter-on-quarter, exceeding the market's expected NT$ 618.3 billion. Its net profit was NT$ 238.7 billion (US$ 7.49 billion), a decrease of 19% year-on-year but an increase of 13% quarter-on-quarter, exceeding the market's expected NT$ 224.13 billion.Currently, the market is most concerned about two aspects of TSMC:How is the progress of TSMC's performance recovery? This is mainly affected by the recovery of consumer electronics and the sustainability of AI demand.What is the progress of TSMC's production capacity, especially its advanced process production capacity?

From the revenue end, TSMC's revenue has been continuously increasing for two quarters since bottoming out in Q2 2023. This quarter's revenue increased by 13% quarter-on-quarter, further accelerating from the previous quarter. In 2023, the revenue of the semiconductor foundry industry decreased by 13% year-on-year, while TSMC's revenue decreased by 9% year-on-year, continuing to outperform the industry level.Chart: TSMC’s quarterly revenue and quarter-on-quarter growth (USD million)

Smartphones and high-performance computing (HPC) are TSMC's largest sources of revenue, accounting for more than 80% of total revenue, with HPC mainly including AI-related demands such as graphics cards and data centers. In the past four quarters, due to strong demand for AI-related demands and relatively sluggish smartphone markets, the proportion of HPC revenue has exceeded that of smartphones for consecutive periods.However, from the revenue structure changes this quarter, we can see that the proportion of high-performance computing revenue has remained relatively stable this quarter, while the contribution of smartphone revenue has rapidly increased from 39% in the previous quarter to 43%, with a quarter-on-quarter growth rate of 27%.Chart: 23Q4 TSMC revenue share and growth rate by industry

TSMC's largest customers include Qualcomm and Apple, and its revenue is closely related to the demand in the smartphone market. According to Canalys data, the global smartphone market grew by 8% in Q4 2023, ending seven consecutive quarters of decline and beginning to stabilize and rebound. Apple's release of the new iPhone 15 in Q3 contributed to more revenue growth.Although facing negative factors such as intensified competition, Apple's smartphone sales performed well last year under the promotion of price cuts and promotions. In 2023, the shipment volume of iPhones approached 235 million units, surpassing Samsung to become the world's best-selling smartphone brand.This indicates that as consumer electronics gradually recover, the main driving force for TSMC's revenue growth is shifting from AI-driven HPC demand to the dual factors of AI and smartphones. We believe that as the inventory of the consumer electronics industry chain is cleared, the orders from the company's smartphone customers are expected to continue to recover in future quarters.Chart: Global smartphone shipments in the quarter (million units)

We further break down revenue from the perspectives of shipment volume and single wafer revenue:From the perspective of shipment volume, TSMC's wafer shipments in Q4 2023 were 2,957 thousand pieces, with a quarter-on-quarter growth rate of 1.9%. The growth in shipments also improved inventory turnover, with inventory turnover days decreasing from 96 days in the previous quarter to 85 days this quarter.Due to the continuous strong demand for advanced packaging brought by AI chips, and the first wafer factory in Arizona being delayed until the first half of 2025 due to a lack of skilled labor and high costs, the current situation is still that capacity cannot meet strong customer demand, and the supply-demand imbalance may continue into 2025.Chart: TSMC shipments (thousands of wafers) and revenue per wafer (USD)

From the perspective of single wafer revenue, the Q4 single wafer revenue continued to rise to $6,651, with a quarter-on-quarter growth rate of 12% and a year-on-year growth rate of 23%, marking the 16th consecutive quarter of year-on-year growth.The increase in unit price is related to changes in process structure, and TSMC's revenue from advanced processes remains the company's largest source of revenue. Specifically, the proportion of 3nm revenue increased significantly this quarter, mainly due to the seasonal drive of Apple's new products, with 3nm currently only used in the iPhone A17Pro/M3 Mac. Meanwhile, the demand for the 7nm process has increased due to the release of AI-related demands.Chart: TSMC’s sub-process operating revenue (NT$ billion) and proportion

Despite the upward pressure on gross margin due to the increase in unit price, TSMC's gross margin this quarter still decreased by a quarter-on-quarter basis to 53%. This gross margin performance was not surprising and was basically in line with market expectations of 51.5% to 53.5%. The decline in gross margin was mainly due to the increase in depreciation and amortization expenses driven by the mass production of 3nm. Depreciation and amortization expenses increased quarter-on-quarter, thereby increasing the company's unit fixed costs.Chart: TSMC quarterly gross profit (USD million) and gross profit margin

Taking into account the capital expenditure situation, TSMC's capital expenditure in Q4 was $5.24 billion. Despite the overall weak demand, capital expenditure in the quarter continued to decrease. TSMC's capital expenditure in 2023 was $30.45 billion, which was lower than the guidance of $32 billion and was mainly due to the company's appropriate tightening based on market conditions. The decrease in capital expenditure led to a significant rebound in free cash flow in Q4.Chart: TSMC free cash flow (NT$ billion)

We calculateTSMC's investment returns based on "EPS growth * valuation + shareholder return":EPS growth: We split EPS growth into quantity and price dimensions.In terms of unit price, due to the structural improvement of advanced processes below 7nm, the year-on-year average price increase levels for Q1-Q4 were 12%, 12%, 17%, and 23%, respectively. We expect this trend to continue in 2024, with a conservative estimate of a 10% increase in average single wafer prices in 2024, for the following reasons:① With the upcoming release of the N3E, N3P, and N3X series of the N3 family (N3E for lowering costs, N3P for enhancing performance and chip density, and N3X for higher voltage tolerance), 3nm revenue is expected to more than double year-on-year in 2024 (with a revenue share of 6% in 2023), and the proportion of 3nm revenue is expected to increase to double digits.② The demand for AI remains strong, and the company expects long-term CAGR of AI-related sales to be around 50%, which will bring an increase in demand for 5nm and 7nm. Some of the high-performance computing capacity is expected to shift from 7nm to 5nm. The 2nm process is planned to begin mass production in 2025, and the 2nm process technology will help TSMC capture future AI-related opportunities.In terms of production capacity, we look at it from the perspectives of demand and supply. On the demand side, Q1 2024 will be mainly driven by HPC growth due to seasonal declines in smartphone sales, but the recovery of smartphone demand growth can still be expected throughout the year.Looking at the company's supply capability, although the company's current capacity is still unable to meet demand, the latest quarter's shipment volume level shows signs of gradual improvement with a consecutive quarter-on-quarter growth rate after four consecutive quarters of decline. With the continuous commissioning of production lines in the future (Tainan N3 Fab expansion, Japanese production line for 12/16/22/28nm processes, expected to begin mass production in 2024 Q4, US Arizona production line for advanced process, expected to begin mass production of 4nm chips in 2025 H1), shipment volume is expected to continue to increase.According to Gartner's forecast, wafer shipments will increase by 15% year-on-year in 2024. We conservatively estimate TSMC's shipment volume level for 2024 based on the industry's average shipment volume growth rate of 15%.However, the profit margin is still suppressed by the expansion of production capacity. The company expects capital expenditure in 2024 to be between $28-32 billion, with a median level that is flat year-on-year, and 70-80% will be used for advanced technology. This means that as capital expenditure increases in the future and 3nm mass production climbs, it will continue to affect depreciation and amortization, thereby affecting the company's gross margin. However, the company's leading advantage in wafer manufacturing has further expanded. Based on the above assumptions, it is expected that driven by the demand for AI high-performance computing and the recovery of consumer electronics, along with the expansion of production capacity and the increase of unit price, TSMC will enter the performance recovery track of quantity and price increase in 2024. It is expected that revenue will increase by 27% in 2024, and net profit will increase to $32.4 billion, a year-on-year increase of 20%.Shareholder returnTSMC paid a total of $9.35 billion in dividends in 2023, with a dividend yield of around 1.6%. Free cash flow in 2023 was NT$292.15 billion, or $9.25 billion, which is equivalent to distributing all of the free cash flow in 2023 as dividends. In recent years, TSMC has greatly increased its capital expenditure, but it has now entered a stable stage, and it is expected that dividends will steadily increase with improved cash flow in the future. As TSMC increased its dividend per share from NT$3 to NT$3.5 in Q3 2023, it means that cash dividends in 2024 will increase by at least 20%, and the dividend yield will increase from 1.6% to 1.9%. Overall, TSMC's financial report once again confirms the industry's recovery, and also indicates the long-term strong demand for AI.Finally, let's take a look at TSMC's valuation.As of January 19, 2024, TSMC's market value was $586.2 billion, with a PE (TTM) of 22x. Assuming no change in valuation, investing in TSMC means at least a return of around 22% (EPS growth of 20% + shareholder return of 2%). The current valuation corresponds to 18x net profit in 2024, and after deducting the impact of variable cash assets and liabilities, the current valuation corresponds to 16x net profit in 2024. If future shareholder returns continue to increase and profit margins are higher than expected, there is room for further valuation repair. However, it should be noted that there are risk factors such as geopolitical risks, capacity expansion by competitors such as Samsung and Intel, unexpected changes in advanced processes, and delayed commissioning of production lines.