Taiwan Semiconductor Manufacturing Company Ltd.

Good afternoon, everyone, and welcome to TSMC's second quarter 2023 earnings conference call. This is Jeff Su, TSMC's Director of Investor Relations, and your host for today. TSMC is hosting our earnings conference call via live audio webcast through the company's website at www.tsmc.com, where you can also download the earnings release materials. If you are joining us through the conference call, your dial-in lines are in listen-only mode. The format for today's event will be as follows. First, TSMC's Vice President and CFO, Mr. Wendell Huang, will summarize our operations in the second quarter of 2023, followed by our guidance for the third quarter of 2023. Afterwards, Mr. Huang, TSMC's CEO, Dr. C.C. Wei, and TSMC's Chairman, Dr. Mark Liu, will jointly provide the company's key messages. Then we will open the line for a question and answer session. As usual, I would like to remind everybody that today's discussions may contain forward-looking statements that are subject to significant risks and uncertainties, which could cause actual results to differ materially from those contained in the forward-looking statements. Please refer to the safe harbor notice that appears in our press release. And now, I would like to turn the call over to TSMC CFO, Mr. Wendell Huang, for the summary of operations and the current quarter guidance.

Thank you, Jeff. Good afternoon, everyone, and thank you for joining us today. My presentation will start with financial highlights for the second quarter of 2023. After that, I will provide the guidance for the third quarter. Second quarter revenue decreased 5.5% sequentially in NT, or 6.2% in U.S. dollars, as our second quarter business was impacted by the overall global economic conditions, which dampened the end market demand and led to customers' ongoing inventory adjustment. Gross margin decreased 2.2 percentage points sequentially to 54.1%, mainly reflecting lower capacity utilization and higher electricity costs, partially offset by more stringent cost control and a more favorable foreign exchange rate. Despite the industry's cyclical downturn, we continue to invest in R&D to support our N3 and N2 development, Thus, operating margin was 42%, down 3.5 percentage points sequentially. Overall, our first quarter EPS was 7.01 NT, and ROE was 23.2%. Now let's move on to revenue by technology. Five nanometer process technology contributed 30% of our welfare revenue. in the second quarter, while 7 nanometer accounted for 23%. Advanced technologies, defined as 7 nanometer and below, accounted for 53% of wafer revenue. Moving on to revenue contribution by platform, HPC decreased 5% quarter over quarter to account for 44% of our second quarter revenue. Smartphone decreased 9% to account for 33%. IoT decreased 11% to account for 8%. Automotive increased 3% to account for 8%. And DCE increased 25% to account for 3%. Moving on to the balance sheet. we ended the second quarter with cash and marketable securities of 1.5 trillion NT, or 48 billion U.S. dollars. On the liability side, current liabilities decreased by 62 billion NT, mainly due to the net decrease of 87 billion in income tax payable, as we pay 120 billion for 2022 income tax, offset by 33 billion accrued tax payables for the second quarter. Long-term interest-bearing debt increased by 53 billion NT, mainly as we raised 41 billion in corporate bonds. On financial ratios, accounts receivable turnover days decreased two days to 32 days, while days of inventory increased three days to 99 days, primarily due to N3 ramp during the quarter. Regarding cashflow and KPACs, During the second quarter, we generated about $167 billion NT in cash from operations, spent $251 billion in CAPEX, distributed $71 billion for third quarter 2022 cash dividend, and raised $41 billion from corporate bond issuances. Overall, our cash balance decreased by 109 billion to 1.3 trillion NT at the end of the quarter. Free cash flow was negative 83 billion NT during the quarter as operating cash flow was more than offset by capital expenditures, partly due to the income tax payment 120 billion. In US dollar terms, our second quarter capital expenditures total 8.17 billion. I have finished my financial summary. Now let's turn to our current quarter guidance. Based on the current business outlook, we expect our third quarter revenue to be between 16.7 billion and 17.5 billion US dollars, which represents a 9.1% sequential increase at the midpoint. Based on the exchange rate assumption of one US dollar to 30.8 NT, Gross margin is expected to be between 51.5% and 53.5%. Operating margin to be between 38% and 40%. This concludes my financial presentation. Now, let me turn to our key messages. I will start by making some comments on our second quarter 23 and third quarter 23 profitability. Compared to first quarter, our second quarter gross margin decreased by 220 basis points sequentially to 54.1%, primarily due to a lower capacity utilization. Compared to our second quarter guidance, our actual gross margin slightly exceeded the high end of the range provided three months ago, mainly due to more stringent cost control efforts and a slightly more favorable foreign exchange rate. We have just guided our third quarter gross margin to decline by 1.6 percentage point to 52.5% at the midpoint, primarily as a higher level of capacity utilization rate is offset by two to three percentage points margin dilution from the initial ramp up of our three nanometer technology. Looking ahead to the fourth quarter, we expect the continuous steep ramp up of our three nanometer to dilute our fourth quarter gross margin by about three to four percentage points. In 2023, our gross margin faces challenges from lower capacity utilization due to semiconductor cyclicality, The ramp-up of M3 oversees fab expansion and inflationary costs, including higher utility costs in Taiwan. To manage our profitability in 2023, we will work diligently on internal cost improvement efforts while continuing to sell our value. While we face near-term challenges, we continue to forecast a long-term growth margin of 53% and higher is achievable. Next, let me talk about our 2023 capital budget and depreciation. Every year, our CAPEX is spent in anticipation of the growth that will follow in future years. Given the near-term uncertainties, we continue to manage our business prudently and tighten up our capital spending where appropriate. We now expect our 2023 capital budget to be towards the lower end of our range of between 32 and 36 billion U.S. dollars. Our depreciation expense is now expected to increase by mid-20s percent year-over-year in 2023, mainly as we ramp our 3-nanometer technologies. Despite near-term inventory cycle, our commitment to support customers' structural growth remains unchanged, and our disciplined CAPEX and capacity planning remains based on the long-term market demand profile. We will continue to work closely with our customers to plan our long-term capacity and invest in leading-edge specialty and advanced packaging technologies to support their growth while delivering profitable growth to our shareholders. Now, let me make a few comments on our cash dividend distribution policy. The objectives of TSNC's capital management are to fund the company's growth organically, generate good profitability, preserve financial flexibility, and distribute a sustainable and steadily increasing cash dividend to shareholders. As a result of our rigorous capital management, in May, PSMC Board of Directors approved the distribution of a 3 NT per share cash dividend for the first quarter of 2023, up from 2.75 NT previously. This will become the new minimum quarterly dividend level going forward. First quarter 2023 cash dividend will be distributed in October 2023. For 2023, TSMC shareholders will receive a total of 11.25 NT per share dividend and at least 12 NT per share cash dividend for 2024. Going forward, as our capital intensity begins to decline in the next several years, the focus of our cash dividend policy is expected to shift from a sustainable to a steadily increasing cash dividend per share in the next few years. Now let me turn the microphone over to C.C.

Thank you, Wendell. Good afternoon, everyone. First, let me start with our near-term demand and inventory. We concluded our second quarter with revenue of $15.7 billion in line with our guidance in US dollar terms. Our business in the second quarter was impacted by the overall global economic conditions, which dampened the end market demand and customers' ongoing inventory adjustment. Moving into third quarter 2023, while we have recently observed an increase in AI-related demand, it is not enough to offset the overall cyclicality of our business. We expect our business in the third quarter to be supported by the strong ramp of our three nanometer technologies, partially offset by customers' continued inventory adjustments. In the last quarterly conference, we said we expect fabulous semiconductor inventory to rebalance to a healthier level exiting the third quarter. This statement continues to hold true. However, due to persistent weaker overall macroeconomic conditions, slower than expected demand recovery in China, and overall soft-end market demand conditions, customers are more cautious and intend to further control their inventory into 4Q23. Thus, while we maintain our forecast for the 2023 semiconductor market excluding memory to decline mid-single-digit year-over-year, we now expect the foundry industry to decline mid-teens and our four-year 2023 revenue to decline around 10% in U.S. dollar term. With such inventory control, we also forecast a fabulous semiconductor inventory to exit 4Q23 at a healthier and lower level as compared to our expectation three months ago. Next, let me talk about HPC and TSMC's long-term growth outlook. As we have said before, the massive structural increase in demand for computation underpinned by the industry megatrend of 5G and SPC continues to drive great need for performance and energy-efficient computing, which require use of leading-edge technologies. These megatrends are expected to fuel TSMC's long-term growth. Even with a more challenging 2023, Our revenue remains well on track to grow between 15 and 20 kegels over the next several years in U.S. dollar terms, which is a target we communicated back in January 2022 investor conference. The recent increase in AI-related demand is directionally positive for TSMC. Generative AI requires higher computing power and interconnected bandwidth, which drives increasing semiconductor content. Whether using CPUs, GPUs, or AI-accelerated and related ASICs for AI and machine learning, the commonality is that it requires use of leading-edge technology and a strong factory design ecosystem. These are all TSMC's strengths. Today, server AI processor demand, which we define as CPUs, GPUs, and AI accelerators that are performing training and inference functions, accounts for approximately 6% of TSMC's total revenue. We forecast this to grow at close to 50% CAGR in the next five years and increase to 0.10% of our revenue. The inaccessible need for energy-efficient computation is starting from data centers, and we expect it will proliferate to edge and end devices of time, which will drive further long-term opportunities. We have already embedded certain assumptions for AI demand into our long-term CAPEX and growth forecasts. Our HPC platform is expected to be the main engine and the largest incremental contributor to TSMC's long-term growth in the next several years. While the quantification of the total addressable opportunity is still ongoing, Generative AI and large language model only reinforce the already strong conviction we have in the structurally megatrend to drive TSMC's long-term growth, and we will closely monitor the development for further potential upside. Now let me talk a lot about our N3 and N3E status. Our 3 nanometer technology is the most advanced semiconductor technology in both PPA and transistor technology. N3 is already in volume production with good yield. We are seeing robust demand for N3 and expect a strong ramp of N3 in the second half of this year, supported by both HPC and smartphone applications. N3 is expected to continue To contribute a mere single-digit percentage of our total wafer revenue in 2023, N3EE further extend our N3 family with enhanced performance, power, and yield, and provide complete platform support for both HPC and smartphone applications. N3E has passed the qualification and achieved performance and yield targets, and will start volume production in the fourth quarter of this year. With our continuous enhancement of 3 nanometer process technologies, we expect strong multi-year demand from our customers and are confident that our 3 nanometer family will be another large and long-lasting node for TSMC. Finally, I'll talk about our N2 status. Our N2 technology development is progressing well and on track for volume production in 2025. Our N2WAR adopts narrow-sheet transistor structure to provide our customers with the best performance, cost, and technology maturity. Our narrow-sheet technology has demonstrated excellent power efficiency, and our N2WAR delivers full-node performance and power benefits to address the increasing need for energy-efficient computing. As part of N2 technology platform, we also develop N2 with backside power rail solution, which is best suited for HPC applications. Backside power rail will provide 10% to 12% additional speed gain and 10% to 15% larger density boost on top of the baseline technology. We are targeting backside power rail to be available in the second half of 2025 to customers with production in 2026. We are observing a high level of customer interest and engagement at N2 from both HPC and smartphone applications. Our two nanometer technology will be the most advanced semiconductor technology in the industry in both density and energy efficiency when it is introduced, and to further extend our technology leadership way into the future. This concludes my prepared remarks, and now let me turn the microphone over to Mark.

Thank you, C.C., and good afternoon, everyone. Today I want to talk about TSMC's global manufacturing footprint status update. TSMC's mission is to be the trusted technology and capacity provider of the global logic IC industry for years to come. Our strategy is to expand our global manufacturing footprint to increase customer trust and to expand our future growth potential and to reach for more global talents. Our overseas decision are based on our customer's needs and the necessary level of government support. That is to maximize the value of our shareholders and to fulfill our fiduciary duty. In Arizona, we are building a first FAP to provide US most advanced semiconductor technology in mass production. to support the needs for US semiconductor infrastructure. Our fab in Arizona started construction in April, 2021 with an aggressive schedule. We are now entering a critical phase of handling and installing the most advanced and the dedicated equipment. However, we are encountering certain challenges as there is an insufficient amount of skilled workers with those specialized expertise required for equipment installation in a semiconductor-grade facility. While we are working on to improve the situation, including sending experienced technicians from Taiwan to train the local skilled workers for a short period of time, we expect the production schedule of N4 process technology to be pushed out to 2025. In Japan, we are building a specialty technology factory, which will utilize 12, 16, and 22, 28 process technologies. Volume production is on track for late 2024. In Europe, we are engaging with customers and partners to evaluate building a specialty fab in Germany, focusing on automotive-specific technologies, based on the demand from our customers and the level of government support. In China, we are expanding 28 nanometer in Nanjing, as we planned, to support our customer in China. and we continue to follow all rules and regulations fully. At the same time, we continue to invest in Taiwan and to expand our capacity to support our customers' growth. From a cost perspective, the initial cost of overseas fab are higher than TSMC's fab in Taiwan. due to one, the smaller FAFSA scale, two, higher costs throughout the supply chain, and three, the early stage of semiconductor ecosystem on those overseas sites, as compared to a matured ecosystem in Taiwan. In our recent meetings with senior government officials in the U.S., Japan, and Europe, we discussed our plans to expand our global manufacturing footprint to them. We also emphasized one of our major responsibilities is to manage and minimize the cost gap to maximize return for our shareholders. Those discussions went very well. All sides understand the critical and integral role TSMC plays in the semiconductor industry. and we appreciate all the government's ongoing support in working with TSMC to help narrow down the cost gap. We will continue to work closely with all the governments to secure the further support. Our pricing will also remain strategic to reflect our value, which includes the value of geographic flexibility. At the same time, we will leverage our fundamental competitive advantage of manufacturing technology leadership, large volume, and economies of scale to continuously drive our costs down. By taking such actions, TSMC will have the ability to absorb the higher costs of overseas fab, while remaining the most efficient and cost-effective manufacturer, no matter where we operate. Thus, even as we expand our capacity overseas, TSMC's long-term gross margin of 53% and higher and sustainable ROE of greater than 25% is achievable, and we will continue to maximize the value for our shareholders. This concludes our key messages. Thank you for your attention.

Thank you, Chairman. This concludes our prepared statements. Before we start the Q&A session, I would like to remind everybody to please limit your questions to two at a time to allow all the participants an opportunity to ask their questions. Should you wish to raise your question in Chinese, I will translate it to English before our management answers your question. For those of you on the call, if you would like to ask a question, please press the star then one on your telephone keypad now. If at any time you would like to remove yourself from the questioning queue, please press star two. Now let's begin the Q&A session. Operator, can we please proceed with the first caller on the line?

The first one to ask questions from Jackie Morgan. Go ahead, please.

Yeah, thank you. Good afternoon. And thanks for a lot of the clarity on the AI-related exposure. My first question is on the AI front. A lot of GSMC's customers have been talking about capacity shortage and having to kind of queue up for capacity for AI accelerators, including GPUs and ASICs. Could TSMC talk a little bit about what TSMC is doing on the capacity side, especially on the advanced packaging, but also on other areas? And when do you expect to get back to some degree of demand and supply balance for these AI accelerators? Is it going to be only sometime next year, or do you think it could happen quicker based on what you see on demand from your customers and the capacity plan?

Okay, Gokul, thank you. Please allow me to summarize your first question. So first question from Gokul is that he notes that customers are seeing strong demand from AI related, but they're facing capacity tightness or shortage. So his question is, what are we doing in terms of the capacity side, maybe both in terms of the advanced packaging, as well as the logic. And then when do we see the demand supply imbalance returning to a better, healthier balance level? Is it sometime next year? Is that correct, roughly, Gokul?

Yeah, thank you.

Okay, Gokul, this is CC Wei. Let me answer your question. For the AI right now, we see a very strong demand, yes. For the front-end part, we don't have any problem to support. But for the back-end, the advanced packaging side, especially for the co-workers, We do have some very tight capacity to very hard to fulfill 100% of what customer needed. So we are working with customer for the short term to help them to fulfill the demand. But, you know, we are increasing our capacity as quickly as possible. And we expect that these Titanis will be released in next year, probably towards the end of next year. But in between, we're still working closely with our customer to support their goals.

Okay. CC, maybe one follow-up. Could you let us know what kind of capacity expansion is it like? Like how much capacity are you expanding on the co-op side?

Okay, so Goku, just an additional to the first question, how much capacity are we going to increase in terms of co-ops?

Well, let me give you, you know, I will not give you the exact number, but let me give you roughly a property 2x of the capacity will be added. Okay, Goku? Thank you.

Goku? Okay, Goku, are you there? If not, operator, maybe we move on to the next participant. Goku, are you there? Okay, I think there was a disconnect. All right, let's move on to the next caller, participant, please.

Next one to ask question, Bruce Lou from Goldman Sachs. Go ahead, please.

Thank you for taking my question. I still want to know about like the, you know, the TSMC maintenance 15 to 20% revenue taker when we cut this year's revenue to minus 10%, right? If we use that 15% revenue taker to 2026, that's implied about like 25 plus percent revenue taker from the coming two years. which means that the overall semi-growth is going to increase like a lot for the next two to three years. And you just mentioned that the AI only accounts for 6% with low teams potentially. That is not big enough to get back to the trend. So what is the underlying growth you have with the global semi in the coming years, and what are the key assumptions for the growth for each segment?

Okay, Bruce, let me try to summarize your first question. So Bruce's first question is on our long-term growth CAGR, which we have said is to be between 15% to 20% from 21% to 26% CAGR period. So Bruce's question, this year, you know, CC just said we will decline around 10%. Under his calculation, I think he's saying, well, this implies you should grow 25% the next several years, which of course this is a CAGR, but nonetheless. And so Bruce's question is that therefore, if that's the type of growth, then shouldn't that imply a much higher growth level for the overall semiconductor excluding memory industry? I think that is your question, Bruce, am I correct?

Yes, what are the key assumptions for this concept?

Okay, let me handle this question. Your rationale is correct. However, some of the factors may not be totally included. For one thing, in your model that the customer's gross margin is 60% or plus, I don't think that would represent the average customer's gross margin, and maybe some specific ones. However, the other one is the market share. The market share factor, you assume the constant. That is one thing that could be different than in your formula. So the semiconductor growth right now, we are forecasting 4% to 5%. It may increase, but definitely, as you said, it won't increase to 10%. But those longer-term semiconductor, excluding memory growth, is still yet to be evaluated.

Did I answer your question? Yes, but the reason I do that is I'm assuming that you have, like, dominant market share in the advanced node, and also that the growth is mostly coming from the advanced node, which your customer's growth length is supposed to be higher. So I still think that the gap is wide enough. That's what I'm wondering, right, whether... whether I missed anything which might be big enough to move the needle that might, you know, the management might, can give us some color.

I don't, this is a factor, as far as the market share value, you might not totally included all the factors. That's my perspective. but I cannot dig into the numerical comparison at this point. What I mean, the market share is not just the advanced leading edge technologies, but also the share of the outsourcing.

So maybe, Bruce, if I summarize again, TSMC's growth is driven by both the underlying structural megatrends, but also by our technology leadership and differentiation. So our CAGR is a combination of those two factors.

Okay, thank you.

Do you have any... Yeah, sorry, go ahead.

Yes, my next question is regarding to the guidance changes. You know, the previous guidance for the four-year was you know, low to mid single digit. Now it's about like 10% decline. So the gap is like 5% of the total revenue, which is like, you know, quite sizable in terms of the revenue. Well, we're like 3, 4 billion highly concentrated in the second half or fourth quarter. Can you give us like what is the, what are the changes in terms of this shortfall? You know, where are the weaknesses come from?

Okay, so Bruce's second question is looking at our 2023 full year guidance. He knows this last time we had said low to mid single digit decline. This time we have guided to around 10%. So his question is the delta of this seems to be all, a lot of it also in the fourth quarter. So what, is there any particular segment or market that is driving this? And what are the factors behind this? Is that correct, Bruce?

Okay, Bruce, let me answer the question. Yes, we did see something different. First, the macro is weaker than what we thought. You know, three months ago, we were probably more optimistic, but now it's not. Also, for example, China's economy's recovery is actually also weaker than what we thought, and so the yen market demand actually did not grow as we expected. So put all together, even we have very good AI processes that demand, it's still not enough to offset all those kind of macro impact. So now we expect that the whole year will become minus 10%. That's what we thought.

And in terms of by particular segment or is there a particular market? It's almost...

Well, thank you. You are asking me the question. It's almost an impact.

I don't understand my question.

Yeah, it's overall, you know, market segment is being impacted because of its combination of the macroeconomics.

So can we conclude that other than AI, almost every application sees some weakness in the second half?

You got it.

Thank you.

Okay, thank you, Bruce. Operator, can we move on to the next participant, please?

Next one to ask question is Goku Harihalan from JP Morgan.

Goku, you're back.

Okay.

Yeah, sorry about that. Next question, just wanted to ask about TSMC management's view on the current inventory cycle. It looks like this cycle is taking it much longer to get through the down cycle compared to 19 and 2015. When do you think we kind of bottom out, and do you feel that the recovery next year is going to be a strong recovery or do you think it's going to be a more gradual recovery? What are the kind of plans that you're putting in place as you think about next year's recovery once inventory situation . Thank you.

Okay, so Goku's second question is about the inventory correction cycle. He notes this cycle seems to be taking much longer to get through as compared to 2019 and 2015. So his second question is, when do we think this cycle can bottom out? What will 2024 next year look like? Do we expect a strong recovery? And what factors are we looking at? Is that correct, Goku?

Yes, thanks. Thank you. Okay. Goku, this is a good question. Let me answer it in a short one sentence. It's all about the macro. I mean, I just say the macroeconomics is not so – it's become weaker than we thought. In fact, high inflation and interest rate impact and demand in all market segments in every region in the world. As we said, under such situation, our customers are more cautious in their inventory control in the second half of this year. So while we expect the fiberless semiconductor industry, their inventory to be cleaner and healthier, existing this year, but much closer to the seasonal level. But our expectation for them, they will continue to manage their inventory. And 2024, it still depends on the macro situation. Goku?

Okay. So that's It sounds like you're still expecting at least early part of next year to still be a little bit challenging, similar to what it is looking like right now. Is that fair to say?

We will give you our comment. Goku, we will give you our comment next time. For 2024.

Okay, thank you. Thank you, Goku. Operator, can we move on to the next participant, please?

Next one, we have Charlie Chan from Morgan's Landing.

Charlie Chan, Morgan's Landing. Hi, gentlemen. Good afternoon. Thanks for taking my question. So, my first question is about the overseas FAB cost seems to get higher. So, would the TSNC consider to further adjust your pricing to absorb those increased costs? And also, Major mentioned that your double in or more than double in your LFS packaging given an AI rush order, would that give you a chance to reprice the back-end foundry service? Because I remember there was kind of below company's gross margin average. Would that be a chance to bring that back to the corporate average? Thank you.

Okay, Charlie. Charlie's first question is, I guess, regarding pricing. Two parts or two angles. First, on the overseas FAB, given that the costs are higher, would TSMC consider to further adjust our wafer price? And also along similar lines related to advanced packaging, given we are, you know, CC said doubling roughly the capacity, would we consider to also charge more or higher? given that the returns of the back end are lower?

Let me answer the first question first. Yes, the overseas fab will cost higher, at least for the near future, where their supply ecosystem is not mature yet. And the labor cost is, from our experience, actually is a little bit higher than we expected. But to answer your question, yes, as we try to get the maximum government subsidy, and we also really look at how the price value for the overseas geographical flexibilities. These are all considered. The aim is to, one, to increase our customer trust make them continue to work with us going forward under the geopolitical concerns. Secondly is to maximize the shareholders' value. To answer your question of price, is it strategically yes? CC, can you answer the second question?

I think the second question is about the pricing on the cohorts. As I answered the question, we are increasing the capacity in a, you know, as soon as possible manner. Of course, that includes the actual cost. So, in fact, we are working with our customer, and the most important thing for them right now is supply assurance. It's a supply to meet their demand. So we are working with them. We do everything possible to increase the capacity. And, of course, at the same time, we share our value.

Thanks. May I ask a second question? It's a different topic. Is that okay?

Sure. You get two questions, so sure.

Thank you. Thanks, Jeff. So another question is about the AI semi-demand, right? Thanks for providing your contribution, growth assumption. That is super helpful. But I'm wondering how TSMC can judge the AI demand, because right now, it's arms race right now. Customers are very aggressive, booking capacity. So, I'm wondering how the company can judge whether those AI-saving demand is for real. And also, in terms of breakdown, I'm wondering whether the company sees that ASIC, the custom chips, are growing I think the more important one should be the first part of question, especially investors are concerned whether AI is cannibalizing the CPU server demand. So those are kind of questions in our mind. Thank you.

Okay, let me summarize your second question, Charlie. Charlie's on AI demand. He wants to know, you know, how do we judge the demand properly because customers are very aggressive, but how, in his words, how do we know that this demand is real? And then also, how do we see the demand specifically for ASICs as it relates to AI? Okay.

Okay. You want to answer?

Let me try first, and you probably follow up. This is a very deep question. Of course, we have a model, basically. The short-term frenzy about the AI demand definitely cannot extrapolate for the long term, and neither can we predict the near future, meaning next year, how the sudden demand will continue or will flatten out. However, our model is based on the data center structure. We assume a certain percentage of the data center processor are AI processors. And based on that, we calculate the AI processor demand. And this model is yet to be fitted to the practical data later on. But in general, I think our trend of a big portion of data center processor will be AI processor is a sure thing. Will it cannibalize the data center processors? In the short term, when the CAPEX of the cloud service provider are fixed, yes, it will. It is. But as for the long term, when their data service provider When the cloud service having the generative AI service revenue, I think they will increase the CAPEX. That should be consistent with the long-term AI processor demand. And I mean, the CAPEX will increase because of the generative AI services. Anything more for you?

Yeah, Charlie, I think part of Charlie's question is also how do we see ASIC related in AI development?

Well, actually, the customer also have a high demand on the ASIC parts for the AI application. And as Mark pointed out, a short-term sudden increase, you cannot extrapolate it to be long-term. But, again, let me emphasize that. Those kind of application in the AI application, be it CPUs, GPUs, or AI accelerator, or ASIC, they all need leading-edge technologies. And they all have one symptom. They are using the very large die size, which is TSMC's strength.

Thank you. Okay. Thank you, Charlie.

Thank you very much. Thank you. Operator, can we move on to the next participant, please?

Next one to ask questions, Randy Abrams for this week.

Yes, thank you. I wanted to shift to the profitability, maybe more for Wendell. In a look at the fourth quarter, you mentioned the three to four points dilution from N3. I think that is two to three points in third quarter. Is that what you're suggesting, the directional change could be a little bit down margin profile, or do you have positive offsets? that could keep it more stable. And then a follow-up on the margin where you discussed it's a tough year for margins on these factors like the energy ramp of three. But could you discuss 2024? Do you think we're going into a period of a bit more challenging profitability where you see factors that we could comfortably get back to the 53 and above next year?

Okay, thank you, Randy. So Randy's first question is on gross margin. Fourth quarter, with the N3 dilution of 3% to 4%, does that mean directionally fourth quarter margin is sequentially down? Are there any positive offsets? And then for looking to 2024 for the full year, if Wendell can give some comments about 2024 gross margin, will it also be challenging or do we still feel confident in a 53% and higher gross margin?

Okay, Randy. Starting from the second half of this year, as we said, we face certain cost challenges, including the ramp of M3, which will dilute about two to three percentage point in third quarter and three to four. in the fourth quarter, plus the higher electricity costs. But we're not giving our guidance on the fourth quarter at this moment. We're just spelling out some of the challenges that we're seeing. And, of course, we are going to continue to drive down our costs and sell our value to ensure that we will have a good return on the note. That's for this year. For next year, we're not talking about the whole growth margin, but we'll still see that N3 will dilute about 3% to 4% of next year's growth margin. And although the yield... yield rate will be better next year. At the same time, the percentage of revenue contributed by N3 will be bigger. So net-net, we also see some dilution from the N3 next year. But the margin, the guidance will be given out next year.

Okay, quick follow up to the 1st question. I think the last few notes was 2 to 3 point dilution in the 1st year or 2 of ramp. The factor for it larger is the higher capital intensity or or something different with 3. Versus 5 and 7, or it looks like a little bit more dilution.

Yeah, the increasing process complexity does add on to the challenges of a newer node. However, the other important factor is that our corporate averages has become higher than before. We used to have 50% gross margin. We're now talking about 53% and higher gross margin.

Okay.

Yeah, right there. Okay, and the second question, I wanted to ask how you're thinking about CapEx, just netting a few things, the geographic expansion, the three and then the start of two nanometer, the first ramp-up or tool move-in. Versus the mixed outlook you're looking at for macro for a ballpark CapEx into next year. And if I could maybe within it ask if the Arizona fab delays, does that push out where you mentioned the low end of guidance, push out some of this year to get some lift to next year?

Okay, so Randy's second question is on CapEx. He wants to know, basically focusing on 2024 CapEx, do some of the delays in the Arizona FAB push out CapEx from this year to next year? As we expand overseas, as we invest in N2, but at the same time as the macro remains uncertain, how does this impact 2024 CapEx? Okay.

Yeah, Randy, the push-out of FAB does push out some part of the CAPEX, but that doesn't affect a big part. For 2024, it's too early to talk about the overall CAPEX. However, our CAPEX, as we said before, every year we spent the CAPEX to capture the future growth opportunities. In the past few years, our capex has risen very fast to capture the megatrend. And going forward, the next few years, when we start to harvest those investment, we believe the capex will begin to level off in terms of dollar amount. And that will lead to start to lower the capital intensity in the next several years.

Okay. Sorry, Randy. Sorry.

My quick follow-up, I think you mentioned the path you could use your five nanometer to support the ramp of three. Given the AI and some of that pickup, do you still see that potential that could help optimize CapEx, or do you need to keep it for existing nodes? And that's my final one. Thank you.

Yeah, so Randy's just also asking then how does tool commonality play a role in our future cap-outs?

We always build the tool capability between nodes to provide a greater flexibility. We mentioned last time the strong multi-year demand from M3. We are able to support that using some of the tools from M5. We're not going to comment on the CAPEX beyond this year. However, as I just mentioned, every year the CAPEX spent to capture the future growth opportunities.

Thank you. Okay. Thank you, Randy. Operator, can we move on to the next participant?

Next one to ask questions, Laura Chen from Citi.

Thank you very much for taking my question. Good afternoon, gentlemen. I very appreciate Cece and Mark sharing TSMC's view on the longer-term outlook in AI. So I'm just wondering how does TSMC evaluate your backend capacity expansion to sync up with the front-end wafer side? Since there is no problem in the front-end foundry space, were you kind of concerned about potential overcapacity in the back-end side beyond next year? Or actually, we may see more upside at the foundry wafer side, so our, say, like advanced node iteration rate may go higher into next year? Thank you. That's my first question.

Okay, so Laura's first question is looking at our expansion of advanced packaging or back-end versus the front-end wafer. As we are expanding the back-end but not the front-end, does that imply that first that our front-end wafer, particularly leading node, we expect the utilization to increase next year? And then conversely, or is there a risk that we are overexpanding or overcapacity risk for the packaging side?

Okay, Laura. Let me answer the question. AI today is a very hot topic. A lot of my customers right now increase their demand, and that will increase their front-end demand, of course. TSMC almost have the major share or the largest share, let me say that, in the front-end wafer. According to that finance loading, or we really work closely with our customer and to decide what is the back end that they need. And so on that perspective, we... planning our co-workers' capacity, although probably still not enough, but we're working very hard to increase it. Overcapacity, not today's concern. Today's concern is that not enough capacity to support all the very strong demand.

Okay. Thank you, C.C.

Thank you. That's very clear. Thank you very much, Cece. And my second question is also about the growth margin outlook. If I'm wrong, please correct me. I recall that the previous cycle, like a seven or a five nanometer, the capacity usually will be three times in the third year of the new technology ramping. So I'm wondering, is still the case for N3? In particular, we are seeing that a significant capacity intensity increase may lead to some margin pressure, particularly in the first few years. So I'm just wondering how does TSMC balance your technology leadership and also the margin saturation? Thank you.

Laura, you said three times. Sorry, are you referring to the revenue contribution? Sorry, you said N7?

The capacity. Oh, okay. The capacity, yes.

Okay, so all right, let me try to summarize your question. I think Laura is asking N7 and N5, we substantially expand the capacity. So what is the case for N3? And then also in terms of the profitability of N3 or gross margin, to be more specific, as it compares to N5 and N7 previously. Is that roughly correct, Laura?

Yes, thank you, Jared.

Okay, Laura, let me answer this question. As I just mentioned, the N3, due to the increasing process complexity, is becoming more challenging than the previous nodes. But at the same time, we will continue to sell our value and drive down the cost. at the same time. But we still believe that N3 will be a long lasting or a large node for TSMC. With all the efforts and we still believe that the whole company's gross margin will be 53% and higher.

Okay. Laura, does that answer your question? Yes. Okay. Thank you, Laura. Operator, let's move on to the next participant, please.

Yes. Right now, we have a rowboat from New Street Research.

Go ahead, please. Thank you for taking my question. The score to URF using the legacy node, 16 and 28 nanometer in particular, were down around 15 to 20% QMQ. And my question is, were there any particular end markets that caused this decline? And how do you think about the recovery of those legacy nodes? Should we expect a recovery in the course of this year? Or is that more 2024?

Thank you. Okay, so Rolf's first question is looking on the mature notes, such as 16 and 28. He notes that those all saw sequential declines in the second quarter. So his question is, what is driving this, you know, what end markets are driving this decline, and what is the expectation for this in the second half?

Well, let me answer that question. The mature notes... waiver actually or the product actually try to be companionship for the smartphone or for the PC market or for the HPC. So while the total unit of smartphone become weaker and PC become weaker. So is the leading edge technology node being also demand dropping and so the mature node. That's together. Did I answer your question?

Yes, thank you. That's very clear. For my second question, given your focus on co-ops and advanced packaging in general, and also the weakness that you see in the remainder of your business, would you maybe comment on the percentage of your capex spending that will go towards leading nodes, specialty nodes, and packaging this year compared to last year?

Okay, so Rolf's second question is for 2023 CapEx, which our CFO has said towards the lower end of the 32 to 36 range, can we give a breakdown between leading edge specialty technologies and then the packaging, testing, mask making, and others?

Leading-edge technology accounts for between 70% to 80% of our total CAPEX in a year. Specialty technology, between 10% to 20%. And the remaining are split between advanced packaging and EBO and some others.

Okay. Thank you. Rolf? Perfect. Thank you. All right. Operator, let's move on to the next participant, please.

Next one we have Sonny Lin from UBS.

Thank you very much. Good afternoon. Thank you for taking my questions. So my number one question is on 3 nanometer ramp up. We are going through several quarters of misproduction. I think you must have pretty good visibility for customer engagement for the coming few years. So I wonder now how should we think about the overall ramp of 3 nanometer if we compare with 5 and 7 nanometer? If we look at five, you reach toward 18% of revenue in the second year of mass production and then about 24% of revenue in the third year. Whereas for 3 nanometer, I think the concerns by smartphone customers have been on cost. Then the question will be if HPC is significant enough to still drive a meaningful pickup of 3 nanometer. We really appreciate if you could provide us any kind of thoughts. Thank you very much.

Okay, so Sunny's first question is on the ramp of three nanometers. Her question really, I believe, is coming from a percentage of revenue contribution. She wants to know how is the ramp of three nanometer, and then can it contribute to the revenue like N5, N7 in the past? Yeah.

As I just said, we believe N3 will be a long-lasting and large note for TSMC. Now, in terms of percentage, I think it's sometimes less important because our overall corporate revenue is much, much bigger these days than before. So I think you should also take that into consideration. But dollar amount-wise, it's a much bigger note, yeah.

And CC also said it's multi-year strong structural demand. Yeah. Sorry. Okay.

Got it. Well, so I have a quick follow-up on 3 nanometer profitability. And so Wendell has provided pretty good insight about the dilution for 2024. But historically, a new null would take about seven to eight quarters to get to corporate average after mass production. I understand now corporate average growth margin is also higher, but any expectations that NC would become in line with corporate average growth margin?

So Sunny's question is looking at the three nanometer. Her question is really that with three nanometer and process complexity, Sunny, you're asking really can it reach the corporate average over time?

Or is there a timeline that you are expecting?

And a timeline to reach?

Yeah, Sunny, as I just mentioned, it's becoming more challenging for the leading nodes because of the process complexity increases a lot. It applies to M3. So it will be challenging for M3. We actually mentioned that at the beginning of last year already. It will be challenging that for M3 to reach the corporate average in the in seven to eight quarters timeframe like before. Yeah, but however, part of it is really because of the higher corporate margin that we currently have.

Got it, thank you. My second question is on two nanometers. And so if we look at your target for two nanometers improvement over three nanometers in terms of speed actually less than 3 nanometers over 5 nanometers. So I wonder what's actually the implication of GAA transition to cost versus performance? Is the target somewhat conservative or there's other technological challenges that we need to consider?

Okay, Sunny's second, well, it's really her third, but the question is on N2. She notes that the performance and the improvement seem to be less than 3 nanometers versus 5 nanometers. So could we talk more about that?

Yeah, let me answer the question. Sunny, you have a very good observation. Yes, you are right. As I compare node to node, from five to three, the improvement, it become less from three to two. But let me point it out, usually we are talking about the performance, the speed, and also the density, so that the geometry shrinkage. Now we focus on the power consumption reduction. which is still a full node as a performance because as time goes by, more and more customers, really they are increasing toward greater power efficiency. This is very important for the data center, very important for the server. And that's what we are working on. So did I answer your question, Sunny? Yes.

Got it. Thank you for the color and good to know that you are on track to deliver a second generation of 2 nanometer in 2026. Thank you.

Thank you, Sunny. Operator, let's move on to the next participant, please.

Next one to ask question, Brett Simpson from Aerotain.

Yeah, thanks very much. The first question is for CC. I was interested in getting a read on the customer reception you're getting for the new variants for N3. I think you talked about N3P, N3X. Are customers still as focused on N3E, or are you seeing a preference for them to migrate to the new variants such as N3P, N3X, rather than the N3E? And this is a follow-on. For AI, when do we actually start to see N3 adoption for N3? Thank you.

Okay, so Brett's first question is looking at our three nanometer families and the continuous enhancements that we always have. He is asking, what is the customer reception of N3P and N3X? How does this compare or cannibalize N3? And when do we expect AI-related to adopt three nanometer family solutions?

Let me answer the last one first. AI application already adopting that our N3 technology node. We continue to improve our technology as we always do. So we have a N3E, N3P, N3X. X is the actual performance. That's for the very high speed, very high performance. let me say, performance computing for some of the CPUs application. But N3E is widely accepted by all my customers, and they design starting from N3E, and we help them, for some of them, go to the N3P. So all together, every version, every variation, there's a lot of customer engagement right now.

Okay. Thank you, CC. Okay.

And maybe just my second question for Mark. Mark, you were talking about the building up the ecosystem in some of the overseas markets like the U.S., and you were talking about skill shortage. But can you talk about what you think the like-for-like wafer cost difference is to operate in the U.S. versus Taiwan? I think your TSMC founder talked previously about a 50% premium to operate in the U.S. Can you just clarify if it's likely to be that high? And then when would you expect the cash support from the U.S. CHIP Act to be made available to TSMC? Thank you.

Okay, so Brett's second question is for Chairman. He wants to know, basically, the cost gap. How big is the cost gap of FAB in the U.S. versus in Taiwan? Founder has said, you know, 50% or more. Is it that high? And then concurrently with the CHIPS Act, when or how and when do we expect to receive the incentives to support?

Yes, Simpson. I think the founder is right. I mean, at this point, if we're using the current supply chain and labor cost, indeed, that's the difference. However, we try to work with the U.S. administration. First of all, On the subsidy, cash subsidy and investment tax credit, that is to cover the gap in the first five years approximately. When the tool is depreciated, then the ecosystem becomes prominent. That is, what is the material cost, chemical cost, and the labor cost. And we are working with our supplier to set up some of the more efficient supply sites and to be lower. And the U.S. administration has decided also to subsidize our suppliers. So that is still in the work. How much it can further decrease, I don't know. But I think either way, we will. we will strengthen our pricing values and be able to keep the corporate profitability as we forecast it now.

Thank you, Chairman. Okay, thank you, Brett. Thank you. In the interest of time, Operator, we'll take questions from the last two participants in the queue, please.

Yes. Next one to ask question, Madi Husseini from SIG.

Yes. Thanks for taking my question. I'm going to go back to the gross margin, and I think you highlighted the fact that for 23, you're still tracking to 53% gross margin on a USD basis. That would imply that Q4 could be flat to up. And I just want to better understand how this tracking, I'm not asking for a guide on Q4, but if 2023 gross margin is going to be 53% plus, that would imply Q4 flat to up. Is that correct?

All right, Madi. I think we'll let Wendell answer this question. But Madi is asking, basically, you know, are we saying that 2023 will be 53% and higher?

Madi, we're not giving our guidance beyond this third quarter, so we're not saying what Jeff just said. What we're saying is only some of the negative factors will affect the second half of the year. As to 53% and higher, that's a long-term growth margin target for TSMC.

Yeah, we did not provide a guidance for 2023 specifically, Madi. As Wendell just said, 53% or higher is our long-term target, which we believe is achievable. Do you have a second question?

Okay. Thank you. Yes. Your updated guide suggests the revenues in the second half would be up 10% to 12% versus the first half, obviously that step up is lower than prior expectation. What I want to better understand is how should we think about continued inventory correction among your customer versus new product ramp by some of the other customers? Is there any way you can differentiate these two trends?

Okay, Madi is asking, with our full year guidance, it implies a more mild second half seasonality. So he wants to know how much strength of the new customer product launches is offset by continued inventory correction, sort of if we can provide more color on that.

Oh, that's a tough question to answer. Madi, your observation is right. Our second half seasonality is more mild than previous years. But, of course, we have N3 ramped up for the new product launch. But what is the impact, how to separate them? No, I cannot share too much of the detail of that.

Okay, Maddy. Thank you. Thank you. Operator, then, let's move on to the last participant, please.

Yes, the last one on cue is Qiao Shi from Mingham.

Thanks. Hi, thanks for squeezing me in. I have two questions. The first question is I want to ask about AI, especially around TSMC's monetization of the AI trend. We did hear some commentary that for certain AI applications, TSMC selling shifts for a few hundred bucks, but the TSMC customers can actually sell for tens of thousands of dollars to their end customers. I mean, some investors I spoke with really feel it pains them to see TSMC create advanced technology. They probably deserve a greater value than this. So the question really is, how does TSMC think about maybe better monetization going forward for the capability to produce all these AI chips? And really, I want to tie back to one thing management mentioned in the prepared remarks. the AI growth 50% tethered. How much of that is volume and how much of that could be the pricing achievement in terms of a TSMC's expected growth over the next few years in AI? Thank you.

Okay, Charles' question first is on AI. Again, basically he's asking about monetization or capturing value, let's say. He notes that TSMC, we may be selling chips for a few hundred dollars, but our customers are able to sell it for tens of thousands or even more. So is TSMC giving away too much of the value? Can we better sell our value or monetize to capture greater value with the AI trend?

Well, Charles, I used to make a joke on my customer, say that I'm selling him a few hundred dollars per chip, and then he sold it back to me with 200,000 U.S. dollars. But let me say that we are happy to see customers doing very well. And if customers do well, TSMC does well. And, of course, we work with them and we share our value to them. And fundamentally, we want to say that we are able to address and capture a major portion of the market in terms of a semiconductor component in AI. Did I answer your question?

Yes. What about the part about 50% cable, how much of that volume, and should we expect some pricing element in that long-term growth?

The first tip, I'm sorry. Yeah, so the second part is about close to 50% CAGR for AI, sorry, server with AI processor. How much of that is volume? How much of that is price?

We cannot separate it out, but let me share with you again. We talked to... the customers, because we have a major share of that all the leading edge technology node. So we know that we can make our judgment. And so we forecast a 50% CAGR. How much of that is, you know, on the front end, back end, or others, you know, I am not able to share with you about it. But let me assure you that TSMC is going to capture a major portion of the market in terms of semiconductor component.

Okay, Charles.

Thank you.

Can I ask you a second question?

Last question.

Yeah, no problem. Last one. May I ask about the CapEx? I think I heard a comment maybe from Wendell about a dollar amount CapEx is going to level off from here. And I think the management used to point us analysts to look at the 2010 to 2013 period with a high capital intensity. CapEx actually went up from $3 billion, $4 billion per year to $10 billion. And actually, after that, TSMC capped at a state level of around a $10 billion level for roughly five years until 2019. By telling us the CapEx is probably going to level off, are you telling us or are you alluding to maybe there will be some steady-state CapEx numbers going forward, maybe starting from 24 or 25, around $30 billion-ish level? That's just a clarification on that comment on leveling off. Thank you.

Okay. So Charles' second question is on our CapEx. He wants to know capital spending starting to level off. I think Wendell said in the next several years. So not any specific, but what does that mean? Is it going to stay around the 30-some level? Or what does that mean by spending leveling off?

Yeah, Charles, as I mentioned, in the past few years, our CAPEX increased dramatically from $10 billion to $36 billion last year. As we start to harvest those investments, the increase in CAPEX will be slower than before. That's what I mean by leveling off.

Okay. All right, Charles. Okay. Yes. Thank you.

Yes, thank you.

Okay. Operator, this concludes our Q&A session. Before we conclude today's conference, please be advised that the replay of the call will be accessible within 30 minutes from now. The transcript will become available 24 hours from now, both of which you can be find and available through TSMC's website at www.tsmc.com. So thank you for joining us today. We hope everyone continues to stay well. Have a good rest of the summer, and we hope you will join us again next quarter. Goodbye and have a good day.