Taiwan Semiconductor Manufacturing Co Ltd Q4 FY2023 Earnings Call

Good afternoon, everyone, and welcome to TSMC's Fourth Quarter 2023 Earnings Conference and Conference Call. It's great to see everyone in person once again. This is Jeff Su, TSMC's Director of Investor Relations and your host for today. Today's event is being webcast live through TSMC's website at www.tsmc.com, or you can also download the earnings release materials. 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 fourth quarter of 2023 and full year of 2023, followed by our guidance for the first quarter of 2024. Afterwards, Mr. Huang, TSMC's CEO, Dr. C. C. Wei, and TSMC's Chairman, Dr. Mark Lu, will jointly provide the company's key messages. Then TSMC's Chairman, Dr. Mark Lu, will host the Q&A session, where all three of our executives will take your questions. As usual, I'd 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 on our press release. And now I would like to turn the microphone over to TSMC's CFO, Mr. Wendell Huang for the summary of operations and the current quarter guidance.

Thank you, Jeff. Happy New Year, everyone. Thank you for joining us today. My presentation will start with financial highlights for the fourth quarter and a recap of full year 2023. After that, I will provide the guidance for the first quarter of 2024. Fourth quarter revenue increased 14.4% sequentially in NT dollars, or 13.6% in U.S. dollars as our fourth quarter business was supported by the continued strong ramp of our industry-leading 3-nanometer technology. Gross margin decreased 1.3 percentage points sequentially to 53%, primarily due to margin dilution from the 3-nanometer ramp. Operating margin decreased 0.1 percentage points sequentially to 41.6%, slightly ahead of our guidance, mainly due to operating leverage on higher revenue. Overall, our fourth quarter EPS was NT$9.21 and ROE was 28.1%. Now let me move on to revenue by technology. The 3-nanometer process technology contributed 15% of wafer revenue in the fourth quarter, while 5-nanometer and 7-nanometer accounted for 35% and 17% respectively. Advanced Technologies, defined as 7-nanometer and below, accounted for 67% of wafer revenue. On a full-year basis, 3-nanometer revenue contribution came in at 6% of 2023 wafer revenue. 5-nanometer was 33% and 7-nanometer was 19%. Advanced Technologies accounted for 58% of total wafer revenue, up from 53% in 2022. Moving on to revenue contribution by platform, HPC increased 17% quarter-over-quarter to account for 43% of our fourth quarter revenue. Smartphone increased 27% to account for 43%. IoT decreased 29% to account for 5%. Automotive increased 13% to account for 5% and DCE decreased 35% to account for 2%. On a full-year basis, Smartphone, IoT and DCE decreased 8%, 17%, and 16% respectively. HPC remained flat while automotive increased 15% in 2023. Overall, HPC accounted for 43% of our 2023 revenue. Smartphone accounted for 38%, IoT for 8%, and automotive for 6%. Moving on to the balance sheet, we ended the fourth quarter with cash and marketable securities of NT$1.7 trillion or US$55 billion. On the liabilities side, current liabilities decreased by NT$56 billion mainly due to the decrease in accounts payable. On financial ratios, accounts receivable days decreased four days to 31 days while days of inventory also declined 11 days to 85 days, primarily due to a higher 3-nanometer wafer shipment. Regarding cash flow and CapEx, during the fourth quarter, we generated about NT$395 billion in cash from operations, spent NT$170 billion in CapEx, and distributed NT$78 billion for the first quarter 2023 cash dividend. Overall, our cash balance increased NT$154 billion to NT$1.47 trillion at the end of the quarter. In U.S. dollar terms, our fourth-quarter capital expenditures totaled NT$5.24 billion. Now let's look at the recap of our performance in 2023. 2023 was a challenging year for the global semiconductor industry, but our technology leadership enabled TSMC to outperform the foundry industry. Our revenue decreased 8.7% in U.S. dollar terms to US$69 billion or decreased 4.5% in NT terms to NT$2.16 trillion. Gross margin decreased 5.2 percentage points to 54.4%, mainly reflecting lower overall capacity utilization and the 3-nanometer ramp, partially offset by a more favorable foreign exchange rate. To extend our technology leadership, we continued to expand our R&D investment in 3-nanometer and 2-nanometer development, despite a lower revenue base in 2023. Thus, operating margin decreased 6.9 percentage points to 42.6%. Overall, full-year EPS declined 17.5% to NT$32.34 and ROE was 26.2%. On cash flow, we spent US$30.45 billion or NT$950 billion in CapEx, while generating NT$1.7 trillion in operating cash flow and NT$292 billion in free cash flow. We also paid NT$292 billion in cash dividends in 2023. I have finished my financial summary. Now let's turn to our current quarter guidance. We expect our business in the first quarter to be impacted by smartphone seasonality, partially offset by continued HPC-related demand. Based on the current business outlook, we expect our first-quarter revenue to be between US$18 billion and US$18.8 billion, which represents a 6.2% sequential decline at the midpoint. Based on the exchange rate assumption of US$1 to NT$31.1, gross margin is expected to be between 52% and 54%. Operating margin between 40% and 42%. This concludes my financial presentation. Now let me turn to our key messages. I will start by making some comments on our fourth quarter 2023 and first quarter 2024 profitability. Compared to the third quarter, our fourth quarter gross margin decreased by 130 basis points sequentially to 53%, primarily due to the margin dilution from the continued ramp-up of our 3-nanometer technology. We have just guided our first quarter gross margin to be flat sequentially at 53% at the midpoint, primarily as a less favorable foreign exchange rate assumption is offset by product mix changes due to smartphone seasonality. Looking at full year 2024, given the six factors that determine our profitability, there are a few puts and takes I would like to share. On the plus side, we expect our utilization rate to rise in 2024 as our business recovers. However, as we move forward, as we have said before, the 3-nanometer is expected to dilute our gross margin by about 3 percentage points to 4 percentage points for the full year of 2024 as the revenue contribution will be much higher than in 2023. In addition, we have a strategy so that some of our N3 capacity can be supported by N5 tools, given the strong multiyear demand. Such a plan will enable higher capital efficiency in the mid to long-term but requires cost and effort in the near-term. Most of this conversion will occur in the second half of 2024 and we expect it to dilute our gross margin by about 1 percentage point to 2 percentage points in the second half of 2024. Finally, we have no control over the foreign exchange rate, but that may be another factor in 2024. Long-term, excluding the impact of foreign exchange rates and considering our global manufacturing footprint expansion plans, we continue to forecast a long-term gross margin of 53% and higher is achievable. Next, let me talk about our 2024 capital budget and depreciation. Every year, our CapEx is spent in anticipation of the growth that will follow in future years. In 2023, we spent US$30.4 billion lower than our prior guidance of approximately US$32 billion as we continued to tighten up our capital spending where appropriate given the near-term uncertainties. In 2024, our capital budget is expected to be between US$28 billion and US$32 billion as we continue to invest to support customers' growth. Out of the US$28 billion to US$32 billion CapEx for 2024, between 70% and 80% of the capital budget will be allocated for advanced process technologies. About 10% to 20% will be spent for specialty technologies and about 10% will be spent for advanced packaging, testing, mask making, and others. Our depreciation expense is expected to increase close to 30% year-over-year in 2024, mainly as we ramp up our 3-nanometer technologies. Finally, let me make some comments on our long-term CapEx and cash dividend distribution policy. At TSMC, a higher level of capital expenditures is always correlated with higher growth opportunities in the following years. In the past few years, we have sharply increased our CapEx spending in preparation to capture and harvest the growth opportunities from HPC, AI, and 5G megatrends. Despite a challenging 2023, our revenue remains well on track to grow between 15% and 20% CAGR over the next several years in U.S. dollar terms, which is the target we communicated back in January 2022 investor conference. With our 2024 CapEx guidance of US$28 billion to US$32 billion, the rate of increase of our capital spending has begun to level-off as we capture and harvest the growth. The objectives of TSMC'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 November, TSMC's Board of Directors approved the distribution of a NT$3.5 per share cash dividend for the third quarter of 2023, up from NT$3 previously. This will become the new minimum quarterly dividend level going forward. Third quarter 2023 cash dividend will be distributed in April 2024. In 2023, TSMC's shareholders received a total of NT$11.25 cash dividend per share, and they will receive at least NT$13.5 per share cash dividend for 2024. In the next few years, we expect the focus of our cash dividend policy to continue to shift from a sustainable to a steadily increasing cash dividend per share.

Thank you, Wendell. Good afternoon, everyone. First, let me start with our 2024 outlook. 2023 was a challenging year for the global semiconductor industry, but we also witnessed the rising emergence of generative AI-related applications, with TSMC as a key enabler. In 2023, weakening global macroeconomic conditions and high inflation and interest rates exaggerated and prolonged the global semiconductor inventory adjustment cycle. Concluding 2023, the semiconductor industry, excluding the memory industry, declined about 2%, while foundry industry declined about 13% year-over-year. TSMC's revenue declined 8.7% year-over-year in U.S. dollar terms. Despite the near-term challenges, our technology leadership enables TSMC to outperform the foundry industry in 2023 while we are positioning ourselves to capture the future AI and high-performance computing-related growth opportunities. Entering 2024, we forecast fabless semiconductor inventory to have returned to a higher level exceeding 2023. However, macroeconomic weakness and geopolitical uncertainties persist, potentially further weighing on consumer sentiment and end market demand. Having said that, our business has bottomed out on a year-over-year basis, and we expect 2024 to be a healthy growth year for TSMC, supported by the continued strong ramp of our industry-leading 3-nanometer technologies, strong demand for the 5-nanometer technologies, and robust AI-related demand. Coming off the steep inventory correction and low base of 2023. For the full year of 2024, we forecast the overall semiconductor market, excluding memory, to increase by more than 10% year-over-year, while foundry industry growth is forecast to be approximately 20%. For TSMC, supported by our technology leadership and a broader customer base, we are confident to outperform the foundry industry growth. We expect our business to grow quarter-over-quarter throughout 2024 and our full-year revenue expects to increase by low-to-mid 20% in U.S. dollar terms. Next, let me talk about our N3 and N3E ramp-up and progress. Our 3-nanometer technology is the most advanced semiconductor technology in both PPA and transistor technology. As a result, almost all the world's smartphone and HPC innovators are working with TSMC on 3-nanometer technologies. Our N3 successfully entered volume production and enjoyed a strong ramp in the second half of '23, accounting for 6% of our total wafer revenue in 2023. N3E further leveraged the strong foundation of N3 to extend our N3 family with enhanced performance, power, and yield. N3E has already entered volume production in the fourth quarter of 2023. Supported by robust demand from customers in both smartphone and HPC applications, we expect revenue from our 3-nanometer technology to more than triple in 2024 and account for mid-teens percentage of our total wafer revenue. We also continue to provide further enhancement of our N3 technology, including N3P and the N3X. With our strategy of continuous enhancements of our 3-nanometer process technologies, we expect strong multiyear demand from our customers and are confident that our 3-nanometer family will be another large and long-lasting node for TSMC. Now I will talk about the AI-related demand and our N2 status. The surge in AI-related demand in 2023 supports our already strong conviction that the structural demand for energy-efficient computing will accelerate in an intelligent and connected world. TSMC is a key enabler of AI applications. No matter which approach is taken, AI technology is evolving to use more complex AI models, as the amount of computation required for training and inference is increasing. As a result, AI models need to be supported by more powerful semiconductor hardware, which requires the use of the most advanced semiconductor process technologies. Thus, the value of TSMC's technology position is increasing and we are well-positioned to capture a major portion of the market in terms of semiconductor components in AI. To address the unassessable AI-related demand for energy-efficient computing power, customers rely on TSMC to provide the most leading-edge processing technology at scale with a dependable and predictable cadence of technology offerings. At the same time, as process technology complexity increased the engagement lead time with customer also started much earlier. Almost all the AI innovators are working with TSMC and we are observing a much higher level of customer interest and engagement at N2 as compared with N3 at a similar stage from both HPC and smartphone applications. Our 2-nanometer technology will adopt a narrow sheet transistor structure and will be the most advanced semiconductor technology in the industry in both density and energy efficiency when it is introduced in 2025. Our N2 technology development is progressing well with device performance and yield on track or ahead of plan. N2 is on track for volume production in 2025 with the ramp similar to N3. As part of our N2 technology platform, we also developed the N2 with a backside power rail solution, which is better suited for specific HPC applications based on performance, course, and maturity considerations, and we expect that power rail will be available in the second half of 2025 to customers with production in 2026. With our strategy of continuous enhancement, N2 and its derivatives will further extend our technology leadership position and enable TSMC to capture the AI-related growth opportunities going forward. Finally, let me talk about our specialty technology strategies at mature nodes. For TSMC, today around 70% of our total revenue is from 16-nanometer and more advanced nodes, which will range in contribution from 3-nanometer and 2-nanometer technologies in the next several years. This number will only increase. Our mature node exposure is about 20% of our total revenue. TSMC's strategy at mature nodes is to closely work with strategic partners to develop specialty technology solutions to meet customer requirements and create differentiated and long-lasting value to customers. Our focus is to pursue higher capacity for specialty technologies rather than just nominal capacity. Given the development of differentiated specialty technologies, the profitability of our mature nodes can be around our corporate average gross margin. Looking ahead, we forecast 28-nanometer will be the sweet spot for our embedded memory applications and we expect our long-term structural demand at 28-nanometer to be supported by multiple types of specialty technologies. Thus, we are expanding our 28-nanometer specialty manufacturing capacity overseas to support the long-term structural market demand. We believe the demand for differentiated specialty technology will remain steady despite the potential industry capacity increase and our utilization rate and structural profitability will be well protected in the future. This concludes my prepared remarks. And now, let me turn the microphone over to Mark.

Thank you, C.C. Good afternoon, everyone. First, let me talk about our global manufacturing footprint update. TSMC's mission is to be the trusted technology and capacity provider for the global logic IC industry for years to come. In today's fractured globalization environment, our strategy is to expand our global manufacturing footprint to increase our customer trust, expand our future growth potential, and reach for more global talent. Our overseas decisions are based on our customers' needs and a necessary level of government subsidy or support. This is to maximize the value for our shareholders. Firstly, in Japan, we are building a specialty technology fab in Kumamoto, which will utilize 12-nanometer, and 16-nanometer, and 22-nanometer, and 28-nanometer process technologies. We will hold an opening ceremony for this fab on February 2024, next month, and volume production is on track for the fourth quarter of 2024. In Arizona, we are in close and constant communication with the U.S. government on incentive and tax credit support and making strong progress in facility supply chain infrastructure, utility supply, and equipment installation for our first fab. We continue to work closely and develop strong relationships with our local union and trade partners in Arizona, including recently signed an agreement with the Arizona Building and Construction Trades Council for our new framework for cooperation. This agreement extends our collaboration across enhanced workforce training and development, shared commitment to site safety, hiring local workers, and establishing regular communication. It is a win-win for all parties. We are well on track for volume production of N4 or 4-nanometer process technology in the first half of 2025 and are confident that once we begin operations, we will be able to deliver the same level of manufacturing quality and reliability in Arizona as from our fabs in Taiwan. In Europe, we plan to build a specialty technology fab in Germany, focusing on automotive and industrial applications with our joint venture partners. We continue to be in close communication with the German federal, state, and city governments, and their commitment to this project remains strong and unchanged. Fab construction is scheduled to begin in Q4 2024 this year. In Taiwan, of course, we continue to invest in and expand our advanced technology capacities to support our customers' needs and their growth. Given the robust multiyear demand for our 3-nanometer technologies, we are expanding our 3-nanometer capacity in Taiwan Science Park. We are also preparing for our N2 volume production starting in 2025. We plan to build multiple fabs or multiple phases of 2-nanometer technologies in both Hsinchu and Kaohsiung Science Parks to support strong structural demand from our customers C.C. just mentioned. In Kaohsiung Science Park, the government approval process is ongoing and is also on track. While the initial cost of overseas fabs I previously mentioned are higher than TSMC's fabs in Taiwan, we are confident to manage and minimize the cost gap and remain committed to deliver profitable growth and maximize the value for our shareholders. Now let me talk about my retirement. On December 19th last year, I announced that I have decided not to seek nomination of Board members for the next term, and will retire from the company after the 2024 Annual Shareholders Meeting in June. Allow me to say this, over the past 30 years, I have been incredibly fortunate to work at and contribute to TSMC. I started at TSMC 30 years ago as a leader of a small four-person fab construction team. It has been my privilege to serve as Chairman of TSMC after our legendary Founder, Dr. Morris Chang, over the last six years. During this time, we have reaffirmed our commitment to our mission to be the trusted technology and capacity provider to the global logic IC industry for years to come while adhering to our core values of integrity, commitment, innovation, and customer trust. TSMC's success is predicated on providing the industry's most leading-edge processing technology at scale, in a cost-effective manner, to enable all the innovators to successfully offer their best products to the world. Together, we have worked diligently to enhance our focus on our technology leadership, competitiveness, global manufacturing footprint, digital excellence, sustainability, and corporate governance to maximize the value for our customers and our shareholders. The past 30 years with TSMC has been an extraordinary journey for me, and I want to extend my sincerest thanks to our incredible, talented team and all of TSMC's colleagues whose diligence, dedication, and can-do spirit have made the company into what it is today. Now, TSMC's nomination, corporate governance, and sustainability committee of the board has recommended Dr. C. C. Wei to succeed as the company's next Chairman, subject to the election of the incoming board in June 2024. If Dr. Wei is elected to be Chairman, he should also continue in his current role as CEO. Supported by a deep and experienced team of Senior Executives, many of whom have been with TSMC for many years, I remain fully confident in TSMC's strategy, leadership, and execution and firmly believe TSMC will continue to perform outstandingly in the years ahead. Thank you for your trust in TSMC, and the best is yet to come for the company and its shareholders. This concludes my messages and our key messages together.

Thank you, Chairman. This concludes our prepared statements. So, before we begin the Q&A session, I would like to remind everybody to please again limit your questions to two at a time, so we can allow all the participants an opportunity to ask their questions. Questions will be taken both from the floor and from the call online. Should you wish to raise your questions in Chinese, I will translate it to English before our management answers your question.

It's great to see you again in person, Happy New Year. Allow me to remain seated. I have some long questions for you. So, the first question is to C.C. I am very curious about your comments about the technology leadership, because your competitor claims that their PPA is ahead of your 2-nanometer, even the cost is lower. So, I want to consult your opinion on why there's a different story and how do we judge. And given these debates, how is TSMC going to plan the future capacity for this customer and also competitor? We want to seize this opportunity but also avoid any overexpansion.

Charlie, you named my customer's name, that’s my customer and my competitor. Let me repeat the last time when I commented on their technology. The comment stays the same, so their technology would be very similar or equivalent to TSMC's N3P. We further checked again with all the specs or the possible published in technology, transistor technology, and everything. My comment stays the same with a significant advantage in technology maturity. Because in 2025, when they say that their newest technology will go into production, for TSMC, that will be the third year with very high-volume production in the fabs. So again, I don't want to make too much of a comment on my customer's claim, but let me assure you we continue to have technology leadership, and we continue to have a broader base of customers who are almost all working with TSMC.

In that case, would you aggressively spend on capacity because outsourcing is more likely?

Certainly. We are expanding our capacity with US$28 billion to US$32 billion. That's a significant amount which we will use for our 3-nanometer and 2-nanometers capacity.

Let me add some color to this. I think C.C. has been very modest. I think he has claimed that N3P is comparable to their 18A. We still affirm our statement. But I would like you to look at a different perspective. What C.C. and the other side claim might be right, but it's only for their own product, and IDN typically optimizes their technology for their product. We, as a foundry, optimize our technology for our customers' products. So, that's a significant difference. What you use for the high-power server could be very different than what is used for the smartphone or even the large data edge AI processors. So, you should look at this through a broader perspective.

Thanks, Mark. So, Jeff, can I go to the second one? Yes. So, Mark, first of all, I really appreciate your leadership. I believe our global investors appreciate your past six-year contribution, creating a lot of shareholder value. Thank you. My question is about the content of your speech in November. The speech was about TSMC in the era of AI. You mentioned some very interesting data points. You used AI technology to improve the defect classification, and also the EUV throughput by, for example, 10%. Now with generative AI, can it be a significant breakthrough in terms of technology? Do you think Samsung or Intel, by leveraging generative AI, can really break through and catch up to your technology? And also, before your retirement, any kind of big unfinished goals or targets for TSMC?

Thank you, Charlie. The talk I gave in last November was to audience members from Taiwan's industry companies. The purpose I want to convey was that I see artificial intelligence as a great opportunity for the industry in Taiwan. Just like Taiwan is a big country for semiconductors, it can also become a prominent player for artificial intelligence in the future; that was how I aimed to encourage them. As far as whether our competitors are using AI, of course, they use AI. Just look at all the AI companies in Silicon Valley or the U.S., that's not a secret. But on the other hand, AI is only in its nascent stage. Only last November, the first large language model, ChatGPT, was announced. We are only beginning to see the tip of the iceberg. I want to offer an optimistic note that, even though 1-nanometer or sub-1-nanometer could be challenging, we have a new technological capability using AI to accelerate innovation in science, and that is our part. We have been working on that for many years already. So, of course, it's a fair competition and a solid endeavor.

Do you have another question about one?

Yes. Indeed. I will retire in June, and from now until then is a long time. In the company, a lot can happen. I hope we can definitely execute to C.C.'s forecast for this year. By the middle of this year, I think we can be quite sure we will accomplish that. Of course, C.C. just mentioned that our technology development is on the slew of success. By June this year, we will know what we are to expect in 2025. I set a milestone for our executives. I don't want to share with you, but it's going to be very exciting for TSMC. Of course, from now on, I simply want to encourage our people in TSMC that the world has changed. Just like you mentioned, we must use artificial intelligence for future technologies. So, we will go global, trying to enhance our global footprint and strive for digital excellence. By digital excellence, I mean that we cannot rely exclusively on the hard work of Taiwan engineers; we must recreate our role to tap their talents and bring semiconductor technology engineering to a different level, based on what we already have. Of course, corporate governance is one thing that will always be in my heart. During this transition, I want every executive and our board to adhere to sound corporate governance so that we ensure all process steps abide by our ethical governance rules.

Thank you, Chairman. Let's take the next two questions from the floor. I think there is one here first: Laura Chen from Citibank.

I think we got a lot of discussion about the leading position in the most advanced node. So, I just have a question about your view on the mature node dynamic. In particular, we are seeing that globally, considering geopolitical tension, we are witnessing many fabs being set up around the world. Do you see that, in the longer term, any concerns regarding an industry-wide oversupply? So, what's TSMC's strategy? And also, what's your view on your mature node profitability as well? That's my first part.

I think your observation is right. There might be too much capacity being built right now for mature nodes. So, the concern about overcapacity is valid. Now let's talk about TSMC. As I said, TSMC increased the mature node capacity for specialty technology differentiated from others. We work with customers, and that capacity, which we call 'effective capacity', is backed by commitments from customers and future business because we offer value for our customers to design their products. So, we believe that as long as our customers are doing well, TSMC is doing well. And regarding profitability, as I mentioned in my statement, it will hover around the corporate average, so we don't have concerns.

That's very helpful. Thank you. Also, my second question is focused on AI-related aspects. As we know, a lot of investors care about your advanced packaging progress. We also know that TSMC has made excellent progress on 3D IC SoIC. So, can you share with us your progress in development beyond CoWoS? What's your plan on the 3D IC and what capacity are you aiming for in the next two to three years?

The demand is actually very strong. Today's situation is that we cannot offer enough capacity to support our customers. This condition will likely continue all the way to next year. We are working very hard to increase our capacity; for example, this year we are doubling our output, and still not enough, so we will continue to increase for next year. The progress so far is good because we have invested in advanced packaging technology for more than 10 years already. Hence, we expect the growth rate for CoWoS for 3D IC or for SoIC, per se, to be more than 50% CAGR in the next few years, at least. And we are confident that the demand is there. It's TSMC's capability to offer enough capacity to support our customers.

Thank you for taking my question. My question will still revolve around N3 and the IDM. As we understand, the demand is uncertain, but we can increase our business certainty by gaining market share. Do we expect some more contribution or market share gain, especially from the IDM side or any more contribution from the PC side, maybe by the end of the year or anytime soon?

That is too specific. You refer to the IDM outsourcing, and I know whom you're talking about, so I better not make any comments. I have stated what I said: we take everything into consideration; we welcome the business, but we're prepared for our capacity expansion.

Your second question?

Yes. It’s on advanced packaging. We know that CoWoS is the mainstream right now—have the management seen clients converting to either CoWoS R, CoWoS L? And then what's the implication for revenue and margin profile?

Well, let’s make a joke, I even didn’t know what is called CoWoS R, CoWoS L. But anyway, we are working with customers to support them with adequate capacity, although it's not 100% now, but we do our best. And we're developing that next generation, CoWoS A or something like that for our customer, and it's overwhelming that it is welcomed by all my customers, so we are preparing the capacity for you.

Yes, I just want to confirm, C.C., you mentioned that we have a very narrow definition. You call server AI processor contribution and that you said it can be high teens in five years' time because the last time we said low teens.

The demand has suddenly increased since last year, I believe around Q1, up to March or April when ChatGPT became popular. So, customers responded quickly and asked TSMC to prepare capacity both in front-end and the back-end, which is why we have confidence that this AI's revenue will increase. We only narrow it down to the AI application processors, by the way. So, we view ourselves as preparing technology and capacity in both our front-end and also our back-end. And it's still in the early stage so far. We already see the growing momentum and we expect, if you guys continue tracking this one, the number will increase. I have confidence to say that, although I don't know how much.

So high teens, you confirm?

Or higher.

Thank you so much. The second is about gross margin. In the downturn, we are forming up at much higher utilization than before. Can you talk a little bit about what happens when we get back to close to full utilization? I think we are still running at well below full utilization in 2023. And could you also explain the gross margin dilution that you're expecting in the second half of 2023 because of this capacity conversion. What exactly leads to that gross margin dilution? And is that like a one-time kind of dilution that lasts for a little bit of time and levels off in 2025?

Right. In the second half, as I said, there are two negative factors affecting our gross margin this year. The first one is the N3 dilution. N3 volume will be much bigger in the second half than in the first half. So the second half impact from N3 dilution will be between 3 percentage points to 4 percentage points. Additionally, the N5 capacity converted to N3 will mostly occur in the second half as well. That will result in 1 to 2 percentage points. That's for this year. For the longer term, if you look at these two factors, our N3 dilution will gradually reduce because the profitability will continue to improve in the next several years. The N5 converted to N3 is a one-time short-term impact on profitability, which will bring capital efficiency to us in the medium to long term. The benefits together would be much greater than the one-time hit in the short term. If you're talking about the longer-term profitability, including these two factors plus we are selling our value, our technology value, as C.C. mentioned, we continue to drive down the cost. We build our capacity based on the long-term market profile and not the short-term cyclicality, enabling us to have a good utilization.

So, just to clarify, given we are at much lower utilization than normal, what you suggest, Wendell, is that gross margin should get back to the mid to high 50s once the upcycle starts to gain more momentum, just like what we saw in 2022. Is that a reasonable expectation?

We are working on it. Certainly, we prepare our capacity according to customers' demand. Last year was very challenging because everybody missed their forecast, and so did TSMC, leading to poor utilization rate. I believe everyone will gain more experience in the next few years, and TSMC's utilization rate will continue to increase; I can guarantee that.

Okay. Yes. And good luck to both Mark and C.C. as you go through the upcoming transition. I wanted to ask, going back to the question on the IDM, I think earlier you conceded that your competitors’ process is actually pretty good for optimizing to their products. Could you talk about your view on the sustainability of the ramp of that IDM outsourcing with your own products in HPC? If you look out over the next two to three years, do you see that continuing to grow or reversing where there could be a bit of a cooling off from some of the opportunities you have right in front of you now?

Randy, that's a good question. Actually, we have taken into account all the considerations, including the IDM capabilities. We have incorporated that into our capacity planning. We implemented a very conservative approach to ramp up our capacity in this kind of situation. I cannot speak more about our strategies.

Okay. If I can ask a follow-up on CapEx, earlier you stated the rate of increase will slow down, but I think spending should increase over time as you grow. If you could discuss the CapEx that you guided was flat, should we think of it as a pause where as you start to move into 2-nanometer, there should be another wave of increase? The second part is somewhat related but curious about geographic expansion. There's been a lot of press about new fabs in Japan, the second fab, and potential third advanced fab. And it feels like the first fab went smoothly. Are you starting to redirect or think more expansion to Japan rather than U.S. or potentially both?

Okay, Randy. The CapEx dollar amount every year may vary based on different situations. The rate of increase is definitely slower than the past three years. If you look at that differently, the capital intensity in the past three years peaked in 2021 at over 50%, followed by 47%, and 43%. This year, if you do the math, it will average around mid-30s. We expect in the next several years, it will remain in the mid-thirty percentage capital intensity.

Then, the other part of Randy's question is on geographic expansion. He notes a lot of reports saying we may build a second fab in Japan and we may even build a third. He wants to know if we are redirecting our overseas expansion focus to Japan, or if there indeed is a significant change?

No, no. I think the second fab in Japan is in a serious evaluation stage. We haven't announced it to the public yet, and we're still discussing it with the Japanese government. They have been very cooperative, so you may have to wait for that. However, that technology will still be either 7 or 16, 12 technologies. Remember our Kaohsiung fab, the first fab, used to be 28-nanometer or 7-nanometer. Now it's becoming 2-nanometer. If there is a second fab in Japan, that will be our current plan.

That's helpful. Quickly on 3-nanometer because 5-nanometer was slightly delayed. Will the 3-nanometers still come two years after the new plan for 5-nanometer in Arizona?

Yes. The second fab is under construction. But what technology will be set in that shell is still in negotiation. I think this also depends on how much incentives the U.S. government can provide. Yes, there will be a gap. At least, the current planning has it being set for 2027 or 2028. To be honest, most of the fabs overseas and the technologies being set up are really customer demand decisions at that area at that time. So, nothing is definitive, but we are trying to optimize value for the overseas fabs for TSMC.

Thank you, Chairman. In the interest of time, we will take the next two from the floor. I think there is one here first: Laura Chen from Citibank.

I think we've had a lot of discussion about the leading position in the most advanced node. So, I just have a question about your view on the mature node dynamic. In particular, given the geopolitical tensions around the world, do you see any potential oversupply issue with mature nodes? What is TSMC's strategy? And also, what's your view on your mature node profitability?

Your observation is correct; there might be too much capacity being built now for mature nodes. Therefore, concerns regarding overcapacity are legitimate. For TSMC, as I mentioned, we've increased mature node capacity for differentiated specialty technologies as opposed to others. We coordinate closely with customers, and that capacity represents a commitment to future business because we provide real value that enables our customers to design their products. Thus, we remain confident that, as long as our customers thrive, TSMC will as well.

Thank you, everyone, for your questions and participation. This concludes the Q&A session. We look forward to speaking with you in the next quarter. Goodbye and have a great day.