Summary

• TSMC is set to increase FY25 capex by 34%. This is a very healthy demand signal, driven by aggressive AI-related spending and augmented by the N2 process node's ramp.

• TSMC may be at peak gross margins as dilution is expected from the ramp-up of additional capacity. But there are structural improvements too, driven by productivity and utilization increases.

• TSMC's discount vs peers has widened a little bit from what it was a few days before the Q4 FY24 earnings release.

• TSM vs SPX500 maintains a bullish structure and there are no signs of sellers despite being near a multi-quarter resistance level.

• Management's abilities to improve the estimated 5-10% gross margins of overseas fabs and elevate the lower-than-company-average margin profile of its advanced packaging facilities are a key risk monitorable.

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Performance Assessment

I maintained a bullish outlook on Taiwan Semiconductor Manufacturing Company Limited aka TSMC (NYSE:TSM) going into Q4 FY24 earnings. And so far, it is playing out well, outperforming the S&P 500 (SPY) (SPX) (IVV) (VOO):

Performance since Author's Last Article on TSMC (Seeking Alpha, Author's Last Article on TSMC)

Thesis

Here are my key takeaways based on the recent quarterly update and why I maintain my bullish outlook despite weaker margin delivery expected in FY25:

1. Strong capex ramp is a healthy demand signal

2. Temporary dilution should be overlooked to focus on structural improvement in gross margins

3. TSMC still trades at an attractive discount vs peers

4. Relative technicals maintain bullish momentum despite being near a resistance level

5. Ramp up in overseas fabs and advanced packaging facilities may dilute margins for longer

Strong capex ramp is a healthy demand signal

TSMC's capex is expected to increase from $29.76 billion in FY24 to $40 billion in FY25. This corresponds to a meaningful 34.4% YoY increase (the chart below shows the figures in TWD):t

TTM Capex (TWD mn) (Company Filings, Author's Analysis)

TSMC doesn't add capacity unless there is strong demand visibility. Hence, I view this as a big green light demand signal. Management attributes this mostly to continued aggressiveness in AI-related spends by its customers:

Revenue from AI accelerators, which we now define as AI GPU, AI ASICs and HBM controller for AI training and inference in the data center, accounted for close to mid-teens percent of our total revenue in 2024. Even after more than tripling in 2024, we forecast our revenue from AI accelerator to double in 2025 as the strong surge in AI-related demand continues.

- CEO C.C. Wei in the Q4 FY24 earnings call, Author's bolded highlights

From a products perspective, the longer-term demand outlook is also boosted by volume production of the company's N2 and N2P processes, which is on-track for H2 FY25 and H2 FY26. The N2 nodes lead to all-round improvements in power efficiency, performance and chip density:

Power Performance Area (PPA) Stats of TSMC Process Technologies (AnandTech)

Management expects N2's ramp to be similar to that of the N3 nodes. This is encouraging because the growth in its 3nm process has been impressive, growing from TWD 484 million in Jun'23 to TWD 197 billion in Dec'24, quickly making up more than a quarter of overall wafer revenue:

3nm Revenue Ramp (Company Filings, Author's Analysis)

At the same time, TSMC has achieved high-volume production in other nodes such as the N4 in Arizona, with comparable yields to their flagship Taiwan fabs. It is also opening up new fabs in Japan, Germany and advanced packaging (CoWoS) facilities in Taiwan. This is all proof of high, sustained demand visibility.

Temporary dilution should be overlooked to focus on structural improvement in gross margins

As expected in my Q4 preview, the company continued to increase gross margins to 59% in the Dec'24 quarter:

Gross Profit Margin (Company Filings, Author's Analysis)

This was due to continued trends of higher capacity utilization driven by higher than expected revenue conversion and productivity gains. From an outlook perspective, TSMC delivering a 117bps beat for Q1 FY25's guidance:

Gross Margin Guidance Surprise vs Consensus Estimate (bps) (Capital IQ, Author's Analysis)

However, Q1 FY25 is still expected to see contraction by around 100bps due to the ramp of N2 production and CoWoS expansions (more on this in a later section below). Moreover, the broader outlook for FY25 suggests more margin-dilutive factors to kick in; the CFO shared that the ramp up in overseas fabs is expected to contribute to another 200-300bps of margin dilution every year for the next 5 years.

Hence, I expect gross margin profile over the next few years to tend back toward the mid 50% range. Still, I think it is important to realize that this dilution is only temporary as its overseas fabs and new node process technologies ramp up toward fuller utilization. Importantly, the margin profile is seeing structural improvements driven by utilization improvement and higher yield productivity:

The dilution impact from our N3 ramp is expected to gradually reduce… And we expect our overall utilization rate to moderately increase in 2025.

- CFO Jen-Chau Huang in the Q4 FY24 earnings call

I think it is wise to focus on these structural margin improvements and tolerate some of the margin headwinds curbing continued expansion of profit margins.

TSMC still trades at an attractive discount vs peers

1-yr fwd PE Comps (Capital IQ, Author's Analysis)

TSMC stock is trading at a 1-yr fwd PE of 18.7x vs the 22.5x median of other semiconductor comps. This corresponds to a 16.6% discount; slightly wider than the 15.9% discount it was trading at a few days before earnings. Hence, I continue to find the stock attractively priced.

Relative technicals maintain bullish momentum despite being near a resistance level

If this is your first time reading a Hunting Alpha article using Technical Analysis, you may want to read this post, which explains how and why I read the charts the way I do. All my charts reflect total shareholder return as they are adjusted for dividends/distributions.

Relative Read of TSM vs SPX500

TSM vs SPX500 Technical Analysis (TradingView, Author's Analysis)

The ratio prices on TSM vs SPX500 show a clean uptrend structure. And although it is at a key 4-monthly (multi-quarter) resistance area, there are no signs of seller pressure yet and hence no good reason to not maintain the bullish bias in my opinion.

Ramp up in overseas fabs and advanced packaging facilities may dilute margins for longer

Analysts in the Q4 FY24 earnings call estimated that TSMC's new overseas fabs may be operating at 5-10% gross margins, which tellingly, management did not deny:

TSMC Overseas Fabs Gross Margins Estimate (Seeking Alpha, Author's Annotations)

In addition to this, I note that TSMC's expansions in advanced packaging (CoWoS) facilities in Taiwan are also margin-dilutive:

advanced packaging accounted for over 8% of revenue last year. And it will account for over 10% this year. In terms of gross margins, it is better. It is better than before but still below the corporate average.

- CFO Jen-Chau Huang in the Q4 FY24 earnings call, Author's bolded highlights

Hence, I identify a slower pace of improvements in margin expansion of TSMC's new facilities to be a material risk to the bullish views.

Takeaway & Positioning

TSMC is projecting a significant 34% increase in capex in FY25. This is a strong signal of sustained demand as the company does not have a reputation for expanding capacity without revenue visibility. This demand is driven by customers' continued aggressiveness in AI-related chip spends, and is likely to be augmented by the volume production of TSMC's new 2nm process nodes in H2 FY25 and H2 FY26.

On the gross margins side, I believe we may be at a multi-year peak as there are some dilutive effects from the initiation of overseas fabs and advanced packaging facility expansions. However, I think it is still worthwhile to be bullish as the dilutive effects are temporary whereas yield, productivity and, to some extent, utilization improvements are more indicative of a structural lift in the gross margins profile of the company.

TSMC stock is also attractively priced at a 17% discount vs peers and the relative technicals vs SPX maintain a bullish trend without any sign of sellers kicking in, despite being at a multi-quarter resistance area.

Hence, I continue to maintain my 'Buy' rating after the Q4 FY24 earnings update.

How to interpret Hunting Alpha's ratings:

Strong Buy: Expect the company to outperform the S&P500 on a total shareholder return basis, with higher than usual confidence. I also have a net long position in the security in my personal portfolio.

Buy: Expect the company to outperform the S&P500 on a total shareholder return basis.

Neutral/hold: Expect the company to perform in-line with the S&P500 on a total shareholder return basis.

Sell: Expect the company to underperform the S&P500 on a total shareholder return basis.

Strong Sell: Expect the company to underperform the S&P500 on a total shareholder return basis, with higher than usual confidence.

The typical time-horizon for my views is multiple quarters to more than a year. It is not set in stone. However, I will share updates on my changes in stance in a pinned comment to this article and may also publish a new article discussing the reasons for the change in view.