Taiwan Semiconductor Manufacturing Co Ltd Q1 FY2024 Earnings Call

Good afternoon, everyone, and welcome to TSMC's First Quarter 2024 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 shortly. The format for today's event will be as follows: first, TSMC's Senior Vice President and CFO, Mr. Wendell Huang, will summarize our operations in the first quarter 2024, followed by our guidance for the second quarter 2024. Afterwards, Mr. Huang and TSMC's CEO, Dr. C. C. Wei, will jointly provide the company's key messages. Then we will open the lines for the 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 on our press release. And now I would like to turn the call over to TSMC's CFO, Mr. Wendell Huang, for the summary of operations and the current quarter guidance.

Thank you, Jeff. Good afternoon, everyone. Thank you for joining us today. My presentation will start with the financial highlights for the first quarter 2024. After that, I will provide the guidance for the second quarter 2024. First quarter revenue decreased 5.3% sequentially in NT dollars or 3.8% in U.S. dollars as our business was impacted by smartphone seasonality, partially offset by continued HPC-related demand. Gross margin increased 0.1 percentage point sequentially to 53.1%, mainly reflecting product mix changes due to smartphone seasonality, partially offset by a less favorable foreign exchange rate. Total operating expenses accounted for 11.1% of net revenue, which is lower than the 12% implied in our first quarter guidance, mainly due to tighter expense controls. Thus, operating margin increased 0.4 percentage points sequentially to 42%. Overall, our first quarter EPS was TWD8.7 and ROE was 25.4%. Now let's move on to revenue by technology. 3-nanometer process technology contributed 9% of wafer revenue in the first quarter, whilst 5-nanometer and 7-nanometer accounted for 37% and 19%, respectively. Advanced technologies, defined as 7-nanometer and below, accounted for 65% of wafer revenue. Moving on to revenue contribution by platform. HPC increased 3% quarter-over-quarter to account for 46% of our first quarter revenue. Smartphone decreased 16% to account for 38%. IoT increased 5% to account for 6%. Automotive remained flat and accounted for 6%, and DCE increased 33% to account for 2%. Moving on to the balance sheet. We ended the first quarter with cash and marketable securities of TWD1.9 trillion or USD 60 billion. On the liability side, current liabilities increased by TWD113 billion, mainly due to the increase of TWD140 billion in accrued liabilities and others, partially offset by the decrease of TWD44 billion in accounts payable. The increase in accrued liabilities and others was mainly due to the reclassification of the temporary receipt from customers from long-term liabilities. Our financial ratios, accounts receivable turnover days remained at 31 days, while days of inventory increased 5 days to 90 days, primarily due to ramp of 3-nanometer technologies. Regarding cash flow and CapEx. During the first quarter, we generated about TWD436 billion in cash from operations, spent TWD181 billion in CapEx and distributed TWD78 billion for second quarter 2023 cash dividend. In addition, we raised TWD23 billion in cash from bond issuances. Overall, our cash balance increased TWD233 billion to TWD1.7 trillion at the end of the quarter. In U.S. dollar terms, our first quarter capital expenditures totaled $5.77 billion. I have finished my financial summary. Now let's turn to our current quarter guidance. We expect our business to be supported by strong demand for our industry-leading 3-nanometer and 5-nanometer technologies, partially offset by continued smartphone seasonality. Based on the current business outlook, we expect our second quarter revenue to be between USD 19.6 billion and USD 20.4 billion, which represents a 6% sequential increase and 27.6% year-over-year increase at the midpoint. Based on the exchange rate assumption of USD 1 to TWD32.3, gross margin is expected to be between 51% and 53%, operating margin between 40% and 42%. Also, in the second quarter, we will need to accrue the tax on the undistributed retained earnings. As a result, our second quarter tax rate will be slightly above 19%. The tax rate will then fall back to 13% to 14% level in the third and fourth quarter, and the full year tax rate will be between 15% to 16% compared to 14.5% in 2023. This concludes my financial presentation. Now let me turn to our key messages. I will start by making some comments on the impact from the April 3 earthquake. On April 3, an earthquake of 7.2 magnitude struck Taiwan, and the maximum magnitude at our fabs was 5. Safety systems and protocols at our fabs were initiated immediately, and all TSMC personnel are safe. Based on TSMC's deep experience and capabilities in earthquake response and damage prevention as well as regular disaster drills, the overall tool recovery in our fabs reached more than 70% within the first 10 hours and were fully recovered by the end of the third day. There were no power outages, no structural damage to our fabs, and there's no damage to our critical tools, including all of our EUV lithography tools. That being said, a certain number of wafers in process were impacted and had to be scrapped, but we expect most of the lost production to be recovered in the second quarter and, thus, minimal impact to our second quarter revenue. We expect the total impact from the earthquake to reduce our second quarter gross margin by about 50 basis points, mainly due to the losses associated with wafer scraps and material loss. Next, let me talk about our first quarter '24 and second quarter '24 profitability. Compared to fourth quarter 2023, our first quarter gross margin slightly increased by 10 basis points sequentially to 53.1%, primarily driven by product mix changes due to smartphone seasonality. We have just guided our second quarter gross margin to decline by 1.1 percentage points to 52% at the midpoint, primarily due to the impact from the earthquake on April 3, as just discussed, and higher electricity cost in Taiwan. After last year's 17% electricity price increase from April 1, TSMC's electricity price in Taiwan has increased by another 25% starting April 1 this year. This is expected to take out 70 to 80 basis points from our second quarter gross margin. Looking ahead to the second half of the year, we expect the impact from higher electricity cost to continue and dilute our gross margin by 60 to 70 basis points. We also expect the higher electricity cost to indirectly lead to higher materials, chemicals and gases and other variable costs. In addition, we expect our overall business in the second quarter of the year to be stronger than the first half. And the revenue contribution from 3-nanometer technologies is expected to increase as well, which will dilute our gross margin by 3 to 4 percentage points in second half of '24 as compared to 2 to 3 percentage points in first half of '24. Finally, as we have said before, we have a strategy to convert some 5-nanometer tools to support 3-nanometer capacity given the strong multiyear demand. We expect this conversion to dilute our gross margin by about 1 to 2 percentage points in the second half of 2024. To manage our profitability in second half 2024, we will work diligently on internal cost improvement efforts while continuing to sell our value. Longer term, excluding the impact of foreign exchange rate and considering our global manufacturing footprint expansion plans, we continue to forecast a long-term gross margin of 53% and higher is achievable.

We apologize for the interruption, Wendell. We've learned that some participants are experiencing issues accessing the call through the website. Let's take a few minutes to address this IT problem. We appreciate your patience. There is a technical difficulty with the phone line as well, but we aim to resolve this shortly. Please bear with us for a few more minutes. Thank you again for your understanding. We believe that if you’re accessing the webcast through the TSMC website, you should be able to log back in and continue listening. For those on the phone line experiencing issues, I recommend trying the webcast first, as the phone line will be available soon. We apologize for any inconvenience this has caused. Considering these technical issues, we will proceed with Wendell Huang, our CFO, for our guidance followed by our prepared remarks. Thank you.

Thank you, Jeff. I would like to reiterate the guidance for the second quarter. For Q2 2024, we anticipate strong demand for our leading 3-nanometer and 5-nanometer technologies, although this will be partially offset by ongoing smartphone seasonality. Based on our current outlook, we expect our second quarter revenue to be between USD 19.6 billion and USD 20.4 billion, which indicates a 6% sequential increase or a 27.6% year-over-year increase at the midpoint. Assuming an exchange rate of USD 1 to TWD32.3, we expect the gross margin to fall between 51% and 53%, and the operating margin between 40% and 42%. Additionally, in Q2, we will need to account for tax on undistributed retained earnings, leading to a tax rate slightly above 19% for the quarter. This rate is expected to decrease to between 13% and 14% in the third and fourth quarters, with the full-year tax rate projected to be between 15% and 16%, up from 14.5% in 2023. Now, I will address the impact of the April 3 earthquake. A 7.2 magnitude earthquake struck Taiwan, resulting in a maximum magnitude of 5 at our fabs. Safety protocols were immediately activated, and all TSMC personnel are safe. Thanks to our experience and established earthquake response measures, over 70% of our tools were operational within the first 10 hours, and we were fully recovered by the end of the third day. There were no power shortages or structural damage to our fabs, and all critical tools, including EUV lithography equipment, remain unaffected. However, some wafers in process were impacted and had to be scrapped, but we anticipate recovering most of this lost production in Q2, leading to minimal impact on our revenue for the quarter. The total impact of the earthquake is expected to reduce our gross margin by about 50 basis points due to wafer scrap and material loss. In terms of profitability for Q1 and Q2 2024, our Q1 gross margin saw a slight increase of 10 basis points to 53.1% compared to Q4 2023, attributed mainly to changes in product mix resulting from smartphone seasonality. We have recently projected a decline in our Q2 gross margin by 1.1 percentage points to 52% at the midpoint, primarily due to the earthquake impact and higher electricity costs in Taiwan. Following a 17% increase in electricity prices last April, there has been an additional 25% increase beginning this April, which is expected to reduce our Q2 gross margin by 70 to 80 basis points. Looking forward to the second half of the year, we expect higher electricity costs to persist, further affecting our gross margin by 60 to 70 basis points. Additionally, these increased electricity costs may indirectly contribute to rising material, chemical, gas, and other variable costs. We anticipate that business performance in the second half of the year will surpass that of the first half, with increased revenue contributions from 3-nanometer technologies, which will reduce our gross margin by 3 to 4 percentage points in the latter half compared to 2 to 3 percentage points in the first half. As previously mentioned, we aim to convert some 5-nanometer tools to support 3-nanometer capacity due to the robust multiyear demand, which is expected to further dilute our gross margin by 1 to 2 percentage points in the second half of 2024. To maintain profitability during this period, we will focus on internal cost improvement efforts while continuing to emphasize our value proposition. In the long term, excluding foreign exchange impacts and considering our manufacturing expansion plans, we continue to forecast achieving a gross margin of 53% and above.

Thank you, Wendell. Good afternoon, everyone. Before I start, I would like to take a moment to make a few remarks. On April 3, TSMC experienced a significant earthquake with a magnitude of 7.2. Our deepest sympathies go out to everyone affected by this tragedy. I also want to express my gratitude to all our employees and suppliers for their hard work during this time. Despite being the largest earthquake in Taiwan in the last 25 years, we collaborated diligently and managed to resume operations at all our fabs within 3 days with minimal disruptions, showcasing the resilience of our operations in Taiwan. Lastly, I would like to extend our appreciation to our customers for their understanding and support as we work to recover lost production during the second quarter. Now, I will begin my prepared remarks with our near-term demand outlook. We concluded our first quarter with revenue of USD 18.9 billion, slightly above our guidance in U.S. dollar terms. Our business in the first quarter was affected by smartphone seasonality, which was somewhat balanced by ongoing demand related to high-performance computing. Moving into the second quarter of 2024, we anticipate strong support for our industry-leading 3-nanometer and 5-nanometer technologies, though smartphone seasonality will still have an impact. For the full year 2024, macroeconomic and geopolitical uncertainties continue, which could further affect consumer sentiment and end-market demand. Consequently, we now expect the overall semiconductor market, excluding memory, to recover at a more moderate and gradual pace in 2024. We lowered our forecast for the overall semiconductor market, excluding memory, to a growth rate of around 10% year-over-year, while we now project foundry industry growth to be in the mid- to high-teens percentage range, both coming off a steep inventory correction and/or base from 2023. That said, we expect 2024 to be a year of healthy growth for TSMC. Given our technology leadership and broad customer base, we expect our business to grow quarter-over-quarter throughout 2024 and reaffirm our full-year revenue increase to be in the low to mid-20% range in U.S. dollar terms. Next, I will discuss the strong outlook for demand related to AI. The ongoing surge in AI-related demand reinforces our belief that the structural demand for energy-efficient computing is accelerating in an intelligent and connected world. TSMC plays a vital role in enabling AI applications. AI technology is evolving to utilize increasingly complex models, which necessitate more powerful semiconductor hardware. Regardless of the approach taken, it requires the most advanced semiconductor process technologies. Therefore, our technological position is becoming increasingly valuable as customers depend on TSMC to deliver advanced process and packaging technology at scale with a reliable and predictable cadence. In summary, our technology leadership enables TSMC to secure business and allows our customers to thrive in their respective markets. Almost all AI innovators are collaborating with TSMC to meet the growing demand for energy-efficient computing power. We expect the revenue contribution from several AI processors to more than double this year, accounting for low-teens percentage of our total revenue in 2024. Over the next 5 years, we anticipate this revenue to grow at a 50% compound annual growth rate, increasing to over 20% of our revenue by 2028. Several AI processors are specifically defined as GPUs, AI accelerators, and CPUs performing training and inference functions, excluding networking edge or on-device AI. We believe several AI processors will be the key drivers of our high-performance computing platform growth and the largest contributor to our overall incremental revenue growth in the coming years. Now, let me update you on our global manufacturing footprint. TSMC's mission is to be the trusted technology and capacity provider for the global logic IC industry for many years to come. Given the strong demand for high-performance computing and AI, it's strategically important for TSMC to expand our global manufacturing footprint to continue supporting our U.S. customers' growth, enhance customer trust, and expand our future growth potential. In Arizona, we have received strong commitments and support from our U.S. customers and plan to build 3 fabs to create greater economies of scale. Each fab in Arizona will feature a cleanroom area approximately double the size of a typical logic fab. We have made significant progress on our first fab, which commenced engineering wafer production in April using the N4 process technology. We are on track for volume production in the first half of 2025. Our second fab has been upgraded to utilize 2-nanometer technologies to meet strong AI-related demand, in addition to the previously announced 3-nanometer technology. We have recently completed structural work, with volume production set to start in 2028. We also announced plans for a third fab in Arizona utilizing 2-nanometer or more advanced technologies, with production slated to begin by the end of the decade. We are confident that once we commence volume production, we will maintain the same level of manufacturing quality and reliability in our Arizona fabs as we do in Taiwan. In Japan, we held an opening ceremony in February for our first specialty technology fab in Kumamoto. This fab will employ 12/16 and 22/28-nanometer processes and is on target for volume production in the fourth quarter of this year. Alongside our JV partners, we also announced plans for a second specialty fab in Japan, focusing on 40, 12/16, and 6/7-nanometer technologies to support a strategic customer in consumer, automotive, industrial, and HPC-related applications. Construction is expected to begin in the second half of 2024, aiming for production by the end of 2027. In Europe, we plan to establish a specialty technology fab in Dresden, Germany, concentrating on automotive and industrial applications, with construction set to commence in the fourth quarter of this year. Our overseas decisions are guided by our customers' needs and the requisite level of government support, aimed at maximizing value for our shareholders. In today's fragmented globalization landscape, costs are rising for all, including TSMC, our customers, our competitors, and the entire semiconductor industry. We intend to manage and minimize the cost gap overseas by strategically pricing to reflect the value of geographic flexibility, collaborating closely with governments for support, and leveraging our manufacturing technology leadership and large-scale base, which no other manufacturer in this industry can match. Therefore, even after accounting for the increased costs of overseas fabs, we are confident in delivering a long-term gross margin of 53% or higher and a sustainable return on equity exceeding 25%, as we have committed to our shareholders. At the same time, TSMC aims to be the most efficient and cost-effective manufacturer in the regions where we operate. We are dedicated to providing our customers with the most advanced technology at scale to aid their growth. Lastly, I will discuss our N2 status. Our N2 technology leads the industry in addressing the growing need for energy-efficient computing, and nearly all AI innovators are partnering with TSMC. We are seeing a high level of customer interest and engagement with N2 and anticipate that the number of new tape-outs from 2-nanometer technology in its initial 2 years will surpass both 3-nanometer and 5-nanometer in their first 2 years. Our 2-nanometer technology will adopt the nanosheet transistor structure and will be the most advanced semiconductor technology in terms of density and energy efficiency. Development of N2 technology is progressing smoothly, with device performance and yield on schedule or ahead of plan. N2 is on track for volume production in 2025, with a ramp profile similar to N3. With our commitment to continuous improvement, N2 and its derivatives will further strengthen our technology leadership and enable TSMC to seize AI-related growth opportunities well into the future. This concludes my key messages, and I appreciate your attention.

Okay. Thank you, C. C. This concludes our prepared remarks. Again, thank you, everyone, for your patience. If you would like to ask your question in Chinese, I will translate it to English before our management answers. Now let's begin the Q&A session. Operator, can we please proceed with the first caller on the line? Thank you.

The first one to ask questions is Gokul Hariharan from JPMorgan.

My first questions are on demand. So C. C., you kind of reduced the expectation for the overall semiconductor industry growth. Could you talk a little bit about where is the area where you have seen that slower pickup in demand? I think you talked about smartphone a couple of times in the call. Is it primarily the smartphone area where you've seen a slower pickup in terms of demand? And previously, a couple of quarters back, you talked about cannibalization or decline in regular data center demand due to the crowding out of AI and being a drag for TSMC. Do you see that the regular compute, regular data center networking kind of demand is coming back? Or is it still remaining muted and most of the demand uptick is still focused on AI?

Okay. So Gokul, thank you. So Gokul's first question is a little bit 2 parts. So he notes that we have lowered our overall semiconductor ex memory growth forecast for this year to approximately 10% and foundry now to mid to high teens. So Gokul wants to understand, in what segments or applications or areas are we seeing a slower pickup in demand? And then also, in terms of specifically AI versus traditional servers, how are you seeing that demand shape out? And what is the impact to TSMC? Is that generally correct, Gokul?

Yes. And I think maybe since you called out smartphone, just maybe mention how you see the smartphone demand compared to maybe 3 months back as well.

Well, Gokul, this is C. C. Wei. Let me answer your questions and some of your comments also. Yes, smartphone end-market demand is seeing a gradual recovery and not a steep recovery, of course. PC has been bottomed out and the recovery is slower. However, AI-related data center demand is very, very strong. And the traditional server demand is slow, lukewarm. IoT and consumer remain sluggish. Automotive inventory continues to correct, okay? What does that mean to TSMC? The budget for a hyperscale player, their wallet share shifted from traditional server to AI server is favorable for TSMC. And we are able to capture most of the semiconductor content in an AI server's area as we define the GPU, networking processor, etc. Well, we have a lower presence in those CPU-only, CPU-centric traditional servers. So we expect our growth will be very healthy. Do I answer your question, Gokul?

Okay. So yes, I just wanted to ask, is it smartphone the main change compared to, let's say, back in January when you had more than 10% growth for semi? Or is it across the board you're seeing a slower recovery?

Yes, Gokul, three months ago, we projected that the automotive platform would increase this year, but now we're expecting it to decrease. So I think that is the one area where we noticed a difference.

Okay. My second question, just wanted to understand gross margin trends. We talked about 3 to 4 percentage point gross margin dilution from N3 ramp in the second half of the year. Should we think that the N3-related gross margin drag is more severe than usual for what we have seen for leading-edge nodes in the past? Or is it largely similar to what we have seen in N5 or N7? And when we go to N2, do you think that the gross margin dilution will be lower when we go to future process nodes given that N3 seems to be, at least compared to the previous cycle, seems to be dragging a little bit more compared to like N5 or N7 in the past few years?

Okay. Thank you, Gokul. So let me summarize your second question, basically, it is on gross margin. Gokul notes that N3, as Wendell said, will dilute our margin by 3 to 4 points, percentage points in the second half. So his question is, it seems that N3, the gross margin dilution or drag is more severe than past nodes such as N5 and N7. Is that the case? And also, of course, with N2 upcoming, will we face a similar pattern? Or what is the margin profile for N2? Which I think Wendell can address, yes.

Yes, Gokul, it is true that N3 is taking a longer time to reach the corporate margin than the other nodes like N5 or N7. N5 or N7 before, it was like 8 to 10 quarters to reach the corporate. But for N3, we think it will take about 10 to 12 quarters. And this is probably because N3 process complexity has increased, and also our corporate average gross margin also increased during the period. But another reason is that we set the pricing of N3 very early, several years ahead of production. However, we experienced a lot of cost inflation pressures in the following years. So as a result, N3 will take a longer time than N5 and N7 to reach the corporate average gross margin. For N2, based on what we can see so far is that we are doing a better job in cost and selling our value, and we expect N2 to have a better margin profile than N3.

The next one to ask a question, Brett Simpson, Arete.

I had a question on the AI returns at TSMC. So I think it's clear that AI is producing a large profit pool at your customers. And the HBM is also driving super-normal returns for memory players. So my question is, does TSMC believe they're getting their fair share of the returns in the AI value chain today? And is there scope for TSMC to raise pricing for AI chips in the future?

Okay. Thank you, Brett. So Brett's first question is looking at the AI-related demand. He notes that AI customers are earning very good returns, HBM and other components as well. So his question is that whether TSMC, do we feel we are earning or capturing our fair value or right value of the returns? And I think on pricing, how would we price for AI basically, I think. Brett, sorry, that's your question, right?

That's it.

Well, let me answer the questions. We always say that we want to sell our value, but it is a continuous process for TSMC. And let me tell you that we are working on it. We are happy that our customers are doing well. And if customers do well, TSMC does well. So let me summarize it. We are working on it, and we hopefully that we can sell our value.

For my follow-up question, I wanted to ask about the lighting edge nodes at TSMC. Looking at Q1 sales for 12-nanometer and above, the overall revenues for these nodes collectively dropped by 20% year-on-year, and they make up only 35% of your total sales. Can you share whether you anticipate any recovery this year at these nodes? Additionally, there seems to be significant government support for building new fabs in the U.S. and China related to lighting edge nodes. Are you at all worried about structural overcapacity for the older nodes as we move through the cycle?

Okay. Thank you, Brett. So Brett's second question is more on the mature nodes. He notes that the demand for our mature nodes, 12-nanometer and older, are down year-over-year. So he wonders sort of what is the outlook for the recovery of mature nodes in the second half of the year. I think that's the first part of his question.

Okay. Brett, let me address your question. First, the demand for mature nodes remains weak at this time. While the semiconductor industry is gradually recovering, the pace is slow. We expect improvements in the latter half of 2024. Regarding your concern about overcapacity, some companies continue to build a significant amount of mature node capacity. Our approach is to collaborate closely with our strategic customers to create specialty technology solutions that fulfill their needs, which helps us maintain long-term value for them. This strategy reduces our exposure to potential overcapacity issues. We believe that our utilization and profitability in mature nodes can be effectively safeguarded.

Does that answer your second question, Brett?

That's clear.

Next one, we have Randy Abrams, UBS.

I wanted to ask a question, following up on C. C.'s comment about a ramp profile similar to 3-nanometer for 2-nanometer. Could you clarify for the timing of the meaningful revenue ramp for that node? Is the expectation that would be starting early 2026 and ramping up steep through 2026? Or any potential to pull that in? And then just a second question on that is you noted that tape-outs are higher. Would there be potential with higher tape-outs in 3 and 5 for either steeper or it ramps to be larger than the prior nodes once underway or looking out a couple of years?

Okay. So Randy's first question is around 2-nanometer. So his first question is to C. C. with that we said that the N2 ramp profile will be similar to N3. We also said, of course, the production begins in 2025. So his question partly is, when do we expect to see the revenue contribution, meaningful revenue contribution from N2? And then also that with N2, the tape-outs being higher, what is the multiyear opportunity or contribution from N2 maybe in terms of the revenue as compared to N3 or other nodes?

The ramp profile for N2 is expected to be quite similar to N3. We plan to start N2 production in the latter half of 2025, specifically in the last quarter. Given the cycle time and the backend processes involved, we anticipate that significant revenue will begin to materialize by the end of the first quarter or the beginning of the second quarter of 2026. Regarding your second question, we do foresee a high level of engagement and an increase in tape-outs, which may lead to a steep production ramp. However, I must emphasize that N2 is a complex technology node, and customers will need additional time to prepare for tape-out. This is why they have been collaborating with TSMC early on. Each customer will have their unique product roadmap and business considerations for ramping up their products. Nevertheless, we firmly believe that N2 will represent a substantial node for TSMC. I hope that answers your question.

Okay. Great. No, that's helpful color. Yes. Yes, it does. No, helpful color. My second question is just relating to the upward expectations you gave for the AI accelerators. Curious how that ties to how you're looking at the CapEx, if you say that we're entering either higher growth or investment cycle, where capital intensity could need to rise up above that mid-30s range that you set or at least in absolute dollars from the $30 billion this year, we should start growing or thinking about CapEx at least growing with revenue.

Yes. Randy, for TSMC, a higher level of capital expenditure is always correlated with higher growth opportunity in the following years. We work with our customers closely, and our CapEx and capacity planning are always based on the long-term structural market demand profile that is underpinned by the multiyear megatrends. We always review our CapEx plan on an ongoing basis. And as a key enabler of AI, we will work with our customers closely to plan the appropriate level of capacity to support their needs.

And then in terms of the capital intensity and CapEx dollar outlook.

The capital intensity has been high in recent years due to our significant investments to satisfy strong customer demand. Currently, the rate of increase in capital expenditures is stabilizing. We anticipate that the capital intensity will be around the mid-30s level for this year and the next few years. However, as I mentioned, if opportunities arise in the future, we will invest accordingly.

I have a quick follow-up question. Does this indicate a digestion year since you increased 3-nanometer spending significantly over the past couple of years? Should we anticipate a lower outlook, or is this more of a return to a normal trend?

Yes, Randy, I wouldn't describe it as a digestion year. We invest every year based on future business opportunities, and we continually reassess that. This reflects our outlook for the future, which is why we are investing the funds we are. So no, I wouldn't categorize it as a digestion year.

And next one to ask questions, Charlie Chan from Morgan Stanley.

So my first question is about selling the value. I think another caller also addressed this topic, but I want to go a little bit deeper. Because given all the efforts you made, right, and also ongoing cost challenge made at the coming U.S. fab, electricity cost hike, I'm not sure if you can give investors kind of a range about a potential price adjustment or kind of the value you're going to sell to your customers. Based on our back testing, I think based on your revenue and shipments in 2022 and 2023, we calculate your price hike could be around 10% in 2022 and the price hike of 5% in 2023. So C. C., I'm not sure whether you are planning to hike price in this kind of a range or magnitude for 2025, so we can be comfortable you can achieve the 53% gross margin in 2025.

Okay. So Charlie's first question is about TSMC's pricing strategy. He notes that TSMC, of course, makes a lot of efforts to deliver technology leadership and manufacturing excellence to our customers, but we also face a lot of cost challenges, whether from electricity price hikes or the higher cost of overseas fabs. So his question is, number one, I guess, what is our intention about pricing strategy to sell our value; and then, number two, he would like to know what percentage range, if any?

Okay, Charlie, this is C. C. Wei. First, I would like to emphasize again this kind of a pricing strategy is very confidential and totally between TSMC and the customer. However, let me expand a little bit, we do encounter some kind of higher cost in the overseas or even recently, the inflation and the electricity. We expect our customers to share some of the higher costs with us, and we already started our discussion with our customers. And as I said, for the overseas fab, we want to share our value, which also includes the flexibility of location or something like that. If my customer requests to be in some certain area, then definitely, TSMC and the customer had to share the incremental cost. Charlie, did I answer your question?

Yes, I believe that addresses my question. I think it makes sense to pass on some or all of the incremental costs to customers, especially since you are delivering significant value to them. My second question is regarding AI. Although your capacity has been very limited and strategic, I'm curious about how you intend to assess demand and allocate capacity among the various AI semiconductor customers. We've heard that your major customer is asking for twice the capacity next year, so how do you plan to manage that? Will you still reserve a portion for smaller or strategically important customers, regardless of whether they are ASIC or smaller GPU vendors? What criteria will you use to allocate capacity to customers? Are you prepared to accept that you may not meet all of your major customers' demands? Are you willing to lose some market share to industry competitors?

Okay. So Charlie's second question is around, I guess, basically, our advanced packaging and more specifically, CoWoS. And he, of course, notes that the CoWoS capacity, the demand is very strong today and also into 2025. So the capacity is very tight. So his question is, how does TSMC decide on how to allocate the capacity to customers, where we have large customers, but will we reserve capacity to support smaller customers as well? And then lastly, would we be okay if customers want to use somebody else, so to speak? So several parts to this question.

Charlie, let me say it again, the demand is very, very strong, and we have done our best where we put all the effort to increase the capacity. It's probably more than double this year compared with last year. However, it's still not enough to meet the customers' demand, and we leverage our OSAT partners to complement TSMC's capacity to fulfill our customers' need. Still not enough, of course. But in my mind, my first priority is to make our customer successful, no matter which one. And of course, the long-term partners will have a better cooperation with TSMC in terms of technology and processing complexity, so it will be much easier to be ramped up. However, no matter what, let me say again, the demand is very high, extremely high. And we do our best to increase the capacity to alleviate the shortage. We also leverage the OSAT partners. We want to make sure that all our customers get supported, probably not enough this year; but for next year, we try, we try very hard. And you mentioned about giving up some market share, that's not my consideration. My consideration is to help our customers to be successful in their market.

I see. So since your major customers said there's no room for other type of AI computing chips, but it seems like TSMC is happy to see some similar customers, right? So is that the right interpretation of your comments?

Yes.

Yes. C. C. said all customers, yes. Thank you, Charlie.

Next one to ask questions, Bruce Lu from Goldman Sachs.

I think, again, the question is coming back to AI still. I think currently, most of the AI accelerators are mostly in 5-nanometers, which is N minus 1 comparing to a smartphone for now. So when do we expect them to catch up or surplus in terms of technology node? Do we see them to be the technology driver in 2-nanometers or above?

Okay. So Bruce's first question is about, again, looking at AI accelerators. He notes that in his view, they're currently at 5-nanometer now. His question is, do we expect them to catch up? How do we see AI accelerators and also maybe HPC as a whole being the driver or adopter of TSMC's most leading-edge or advanced technology node? Is that correct, Bruce?

Yes, your observation is right. Today, all the AI accelerators, most of them are in the 5- or 4-nanometer technology. But my customers are working with TSMC for the next node. Even for the next-next node, they have to move fast because, as I said, the power consumption has to be considered in the AI data center. So the energy-efficient is fairly important. So our 3-nanometer is much better than the 5-nanometer. And again, it will be improved in the 2-nanometer. So all I can say is all my customers are working on this kind of a trend from 4-nanometer to 3 to 2. Bruce?

If that’s the case, do we anticipate higher revenue in the first two years of the 2-nanometer technology? In the past, the revenue was primarily from smartphones, but the 2-nanometer technology would serve both smartphone and HPC customers.

Yes, Bruce, as we mentioned, we believe that our advanced technologies will focus on long-lasting and larger nodes, such as N2, followed by N3 or N5. Therefore, the dollar value will definitely be higher.

I think, Bruce, we're locating at these opportunities in a multiyear period. So as Wendell and C. C. just said, certainly, with the demand that we're seeing, we do expect N2 revenue contribution to be even larger than N3, just like 3 has a larger contribution or larger node than 5, etc.

I see. So my second question is about dividends. We observed strong free cash flow in the first quarter, and, as Wendell mentioned, capital intensity is stabilizing. We have also started paying a significant amount in taxes. So can we adopt a more aggressive approach to dividends? The current dividend level is much lower than 70% of free cash flow based on rough calculations. Can we anticipate an increase in dividends in the upcoming quarters?

Okay. So Bruce's second question is on the cash dividend policy. He notes that in the first quarter, we're generating very, very strong free cash flow. As we have said, the capital intensity is beginning to stabilize and also that we are paying a very high retained earnings tax. So his question, I think, is, what is the outlook? Can we pay more dividends in the coming quarters? Or what should investors expect?

Yes. Bruce, our dividend policy is, in principle, to pay 70% of our free cash flow in a year as cash dividends. So I would not just look at quarterly cash, free cash flow to make a judgment. But indeed, as we said before, now that we're harvesting the heavy investment that we did in the past few years, we expect our dividend policy to switch to steadily increasing from the sustainable in the past few years.

Next one, we have Laura Chen from Citi.

My question is about the edge AI. We know that C. C. mentioned that the smartphone and the PC recovery is still probably prolonged, yet we are also seeing that the AI PC or AI smartphone is getting quite topical. So I'm just wondering, what's TSMC's view on this kind of edge AI device take off maybe later or 2025? And what's the implication to TSMC? That's my first question.

Okay. So Laura's first question is on AI, but more specifically edge or what we call on-device AI. She notes that there's AI being added to smartphones and also AI for PCs. It's quite topical. So she wants to know how do we see this trend, more importantly, what is the implication to TSMC. Is that correct, Laura?

Okay, Laura. Let me address your question. Edge AI, or on-device AI, primarily impacts the die size. We have observed that with the AI neuroprocessor included, the die size will indeed increase. That's the initial observation. Additionally, I believe the replacement cycle for smartphones and similar PCs will slightly accelerate in the future. Although this has not occurred yet, we anticipate that it will happen soon. Overall, I believe on-device AI will greatly benefit TSMC as we will capture a larger share of the market. Did I answer your question, Laura?

Yes, very helpful. In that case, can we anticipate that our demand, which is still primarily focused on smartphones or mobile, will lead to a greater revenue contribution from N3 in the second half of this year or next year, perhaps around 20% or more in the second half of this year?

Okay. So well, Laura's follow-on to the first question is then should we expect that N3 demand in the second half or into 2025. Sorry, I didn't catch the exact percentage, but a large percentage or significantly larger than it is today. Is that correct, Laura?

Yes. Certainly, as I said, we expect it to happen at a larger die size. As I said, we already observed that. And for the replacement cycle to be accelerated, it will happen, but I cannot give you a definite number because it's too early to predict in 2025. But it's an upward trend, no doubt about it, and we expect to have a good business.

Just to follow up on C. C.'s comments. Last time, we also said that this year, N3 revenue will be more than triple than the revenue in 2023.

Okay. That's very clear. My second question is about, again, advanced packaging. We know that TSMC is working on the 3DIC for many years. So I'm just wondering what's the current progress? Will we expect to see more meaningful take-off with our N2 ramp-up for like a high-computing PC? And between different kinds of technology, like hybrid bonding or TSV, what's TSMC's major consideration?

Okay. So Laura's, I guess, second question, although yes, fine. Second question is about our advanced packaging solutions and 3DIC solutions. She is wondering, what is the outlook or take-up for the demand for the next several years? And she also would like us to comment on the consideration of TSV versus hybrid bonding and such.

Wow, you asked a very technical question about the TSV and the hybrid bonding. It's all together. The 3DIC's packaging technology is very complicated, and our customers start to adopt it. Not a big volume yet, but we expect it to start to grow from this year. How big will it be? It's hard to say, but I think it is a trend. Whether it is a micro-bumping or a hybrid connection, it depends on the customer's product requirements.

Okay, Laura?

So starting from later this year, we will see 3DIC products from our customers, that's the current progress?

Now. I'm sorry, I just said that the customers start to adopt it from now, and you would expect that product in the market soon. All right?

Thank you, Laura. Okay. In the interest of time, maybe we'll take questions from the last two participants on the call. Thank you. Operator?

Next one, we have Rolf Bulk from New Street Research.

Earlier on the call, you mentioned the possibility of converting so much of your N5 capacity to N3. But what I was wondering, considering the strong demand for AI chips and a recovery in smartphones, is there a scenario in which you would consider similar conversions from some of your older nodes such as N7 given that utilization and revenues there are still well below peak levels?

Rolf's first question concerns our tool commonality and conversion. He points out that we have mentioned converting some of the capacity to support the strong multiyear demand for N3 related to AI. He asks if we would also consider converting 7-nanometer tools to meet the stronger leading-edge demand, given that our 7-nanometer is still underutilized.

Well, let me answer this question. We can convert one technology node capacity to the next one is because of our GI's physical advantage, meaning, let me give you one example, our 3-nanometer and 5-nanometer are adjacent to each other, the fabs, and they are all connected. So it's much easier for TSMC to convert from 5 to 3. And that doesn't mean that every node can do the same. That's one. And your question about the N7 converted to N5, presumably. No, because we expect the N7 in the next couple of years, it will pick up, the demand will pick up again. And you want to repeat the same kind of experience we have in 28-nanometer. So today, no, we don't have any solid plan to convert the N7 into N5.

Okay. Rolf, does that answer your first question?

Yes. An unrelated follow-up?

Sure.

Yes, it does. And unrelated follow-up, it's a follow-up to Laura's question, actually. On SoIC, given that the technology is now being adopted more broadly, do you see beginning of interest of your smartphone customer base to also adopt the technology? Could you comment on the likely timeline of adoption of SoIC in smartphones?

Well, let me answer the question. Just HPC product is the first one. HPC customer is the first one to adopt, that is a 3DIC or SoIC's advanced packaging technology. And the other area, let's wait and see. I cannot make any comment. We are working on it. Okay?

Okay. Rolf?

Yes.

The last one to ask question, Mehdi Hosseini from SIG.

Two from my end. You had a very nice upside to revenue expectation for the first half of '24, but has kept the year-end unchanged. Is that a reflection of that slow recovery that you were highlighting? Or would you prefer to wait to have more visibility before updating 2024 target?

Mehdi's first question is about our revenue outlook and guidance. He noted that we have a promising increase in revenue for the first half of this year, but we have maintained our full-year guidance for low to mid-20s growth. Is this due to a more cautious view for the second half, or are we waiting to see how things develop? I'm not entirely clear on your mention of the upside for the first half, Mehdi. You pointed out that our first quarter, as C.C. mentioned, exceeded our guidance slightly in U.S. dollar terms, but just barely.

Yes. Mehdi, our guidance for the quarterly profile did not change. We always said that quarter-over-quarter, there will be growth. And also, the full year guidance will stay the same. So I don't think there is a so-called upside, as you just said.

Okay. And regarding the investment in U.S., especially for 2-nanometer, does that include advanced packaging? Or would advanced packaging be mostly concentrated in the Taiwan region?

Okay. So Mehdi's second question is that, of course, that we have announced to build 3 fabs in the U.S., including 2-nanometer, given the strong AI-related demand. So his question is then what about the advanced packaging side, will we also build advanced packaging in Arizona? Or yes, what is our plan?

Well, let me answer this question. It is always the customer's decision for where the back-end service is done for their product. So in Arizona, we are happy to see that Amkor's recent announcement to build an advanced packaging facility that's very close to our AZ fab. Actually, we are working with Amkor and trying to support all our customers in AZ and for their demand, for their needs.

Okay, Mehdi, does that address your second question?

Yes.

Okay. Great. All right. Everyone, this concludes our question-and-answer session. Again, we do apologize for the technical difficulties. If you have anything unclear or need to follow up, please contact TSMC's IR, and we'll be more than happy to help. Before we conclude today's conference, please be advised that the replay of the conference will be accessible within 30 minutes from now, and the transcript will become available 24 hours from now, both of which are going to be available through TSMC's website at www.tsmc.com. So thank you again for joining us today. We hope everyone continues to stay safe and healthy, and we hope to see you again next quarter. Goodbye, and have a good day.