Taiwan Semiconductor Manufacturing Company ( TSMC)

Q4 Results

We have looked at TSMC before. The reports can be found here and here.

The first one is comprehensive and is worth reading if you want to get a good understanding of the company.

In our earlier report we noted the following:

TSM is the world’s largest contract chipmaker with a particular strength in the most advanced chips. As the main producer of advanced chips used in artificial intelligence applications, it has seen very strong demand. It manufactures for key “fabless” companies such as Nvidia, AMD, Apple, Qualcomm and Broadcom.

The AI investing boom, which currently accounts for 40% of the growth in US GDP, has created unbelievably good demand conditions for TSMC.

Chips have become strategically critical and TSMC is perhaps the most important company in the world. It is based in Taiwan which is claimed by China. If China invaded Taiwan, they would accomplish their stated political objectives and become a key supplier in global technology.

The Biden-era Chips Act recognised the vulnerability and subsidised investment in chip plants in the US. TSMC, among others, has responded by building chip manufacturing plants. There were reports TSMC were finding it difficult to replicate their domestic engineering eco-system in the USA and cost there were likely to prove to be higher than in Taiwan.

However, the company made no reference to this in the conference call and was optimistic on its US expansion. One Fab in Arizona started production in Q4 2024 and three others are in varying stages of establishment. TSMC has also built a Fab in Japan and is in advanced negotiations with the German government for establishing one in Dresden.

Quarterly Results

The CNBC summary of the results was as follows:

Taiwan Semiconductor Manufacturing Company on Thursday reported a 35% increase in fourth-quarter profit, beating estimates and hitting a fresh record as demand for artificial intelligence chips remained strong.

There was strong double- digit growth in revenues, operating profit and net profit due to very strong demand for the most advanced chips.

Thanks to the strong demand for our leading-edge process technologies, we continue to outperform the foundry industry.

There was an impressive growth in already high margins. Gross margins at 62.3% were 330 bps higher (y/y). The chart below shows the strong ten-year trend in margins. This looks like a secular rise in a industry which is cyclical.

TSMC: the only game in town

The company is the undisputed leader outed leader in making the most advanced chips where the transistor packed closest together. This means the lowest nanometer (nm) chips. According to the company press release:

“In the fourth quarter, shipments of 3-nanometer accounted for 28% of total wafer revenue; 5- nanometer accounted for 35%; 7-nanometer accounted for 14%. Advanced technologies, defined as 7-nanometer and more advanced technologies, accounted for 77% of total wafer revenue.”

This 77% compares with 64% in Q1 2024. A higher percentage of the company’s output is composed of advanced chips. The latter are also more profitable

The company is optimistic on the outlook for Q1.

“Moving into first quarter 2026, we expect our business to be supported by continued strong demand for our leading-edge process technologies.”

Based on the Company’s current business outlook, management expects the overall performance for first quarter 2026 to be as follows:

Revenue is expected to be between US$34.6bn and US$35.8bn;

This is 4% higher than Q4, Q1 usually sees a decline after the Christmas consumer rush. This is an important indicator of the strength of demand. Margins are expected to increase further again.

Gross profit margin is expected to be between 63% and 65%;

Operating profit margin is expected to be between 54% and 56%.

The management further expects the 2026 capital budget to be between US$ 52bn and US$56 bn

Manufacturing the most advanced chips with a low rate of faults is an extremely difficult process. It takes huge amounts of capital, a complex ecosystem of suppliers and a huge bench of engineering talent and deep experience.

As chips developed rapidly, the number of players able to manufacture the most advanced chips began to decline as shown in the 2023 chart below. If we were to update , as we are about to see the rollout of 2nm chips, TSMC is the only player in town.

TSMC is in a monopoly supplier position at a time when demand is exploding thanks to the huge investments being made by the cloud hyperscalers such as Microsoft and Amazon as well as other large tech companies such as Meta and Oracle. The scale of the investment in AI datacentres is so large that it accounted for 40% of the growth in US GDP in H2 2025.

The lines of racks of high-performance computers need more and more powerful chips, including GPUs in ever increasing numbers. These GPUs may be designed by Nvidia and AMD but they are mainly manufactured by TSMC. In addition, TSMC also sees demand for chips from companies such as Apple and Qualcomm, driven by consumer demand for things such as mobile phones, tablets and desktop computers.

We can look at the source of demand seen by TSMC.

• High Performance Computing (HPC) increased 4% quarter over quarter to account for 55% of Q4 revenue.

• Smartphone increased 11% to account for 32%,

• IoT increased 3% to account for 5%,

The real growth came from HPC. HPC is becoming more important for TSMC. 18 months ago, it only accounted for 34%. This is an important and positive change. Consumer demand is cyclical: it peaks in Q4 due to Christmas but troughs in Q1. Hyperscaler driven HPC demands for chips is not cyclical, it is spread out throughout the year.

TSMC is in a sweet spot – a monopoly supplier with increasingly secular and fast-growing demand. It is like the proverbial only toll booth on the only highway in the city.

This explains the strong growth in revenues as shown below

Revenue has grown at a CAGR of 17.1% in the last decade. In addition, as noted above, margins have also increased, significantly giving a double boost to TSMC. The impact of this can be seen in Net Profit and Operating Cash Flow growth. They have grown at a CAGR of 20.5% and 17.8% respectively.

Expansion of this kind in capital intensive industry required capital expenditure. This is shown below. It is shown as a negative bar as it represents a cash outflow.

Capex has increased from $10bn in 2026 to $40bn in 2025. It is forecast to accelerate significantly to nearly $60bn in December 2028.

Despite the high capital expenditure, free cash flow growth has been impressive. The chart below is has grown at a CAGR of 21.9% over the last decade.

The free cash flow has been used to pay dividends, buy back of debt and cash retention. The company has not bought back its own shares.

In the last few years, the company has diversified manufacturing away from Taiwan, though it continues to invest in Taiwan too.

Geographical diversification

US

Our first (US) fab has already successfully entered high volume production in 4Q 2024.

Construction of our second fab is already complete and tool moving and installation is planned in 2026.

Due to the strong demand from our customers, we are also pulling forward the production schedule and now expect to enter high volume manufacturing in the second half of 2027.

Construction of our third fab has already started and we are in the process of applying for permits to begin the construction of our fourth fab and fourth advanced packaging fab.

Our plan will enable TSMC to scale up an independent GIGAFAB cluster in Arizona to support the needs of our leading-edge customers in smartphone, AI and HPC applications.

Japan

Next in Japan, thanks to the strong support from the Japanese central government and the local government, our first specialty fab in Kumamoto has already started volume production in late 2024 with very good yield. The construction of our second fab has started and the technologies and ramp schedule will be based on our customers need and market conditions in Europe.

Germany

We have received strong commitment from the European Commission and the German federal, state and city government. Construction of our specialty fab in Dresden, Germany is progressing in our plan.

The company has consistently warned that overseas expansion will lead to lower margins.

This is for two reasons

First despite the subsidies offered by the foreign governments, TSMC does not have the advantage of the Taiwan ecosystem which has been built up over decades. As a result overseas costs should be higher.

Second it takes a few years for a new plat to reach maximum productive efficiency. In the early years the yield is lower and this reduces margins and profitability.

However, as we noted above, the margins continued to rise in 2025. A decline in margins was likely offset by a combination of higher capacity utilisation in existing plants and an increase in pricing power which would be expected of a quasi-monopolist.

The company continues to warn of margin pressures due to overseas expansion.

As the scale of our overseas expansion grows, we continue to forecast the gross margin dilution from the ramp up of overseas fabs in the next several years to be between 2%-3% in the early stages and widen to 3%-4% in the latter stages.

The introduction of the most advanced 2nm technology is further expected to dilute margins as initial yields are lower but improve greatly by year three.

One key issue with regard to TSMC. How sustainable is the strong demand from the hyperscalers and Meta and Oracle? The analysts asked about this in the earnings call.

You essentially try to ask whether the AI demand is real or not. I’m also very nervous about it. You bet. Because we have to invest about $52 billion-$56 billion for the Capex, right? If we didn’t do it carefully and that would be a big disaster to TSMC for sure.

Can the semiconductor industry to be good for three, four, five years in a row? I’ll tell you the truth, I don’t know. But I look at the AI looks like it is going to be like endless. I mean that’s for many years to come.

They said they have gone out and spoken to the relatively small number of customers and asked them

I want to make sure that my customers demand are real. I talk to those cloud service providers, all of them. Actually, they show me the evidence that the AI really help their business. So they grow their business successfully and this is in their financial returns. So I also double check their financial status. They are very rich.

They asked customers for evidence that AI is generating attractive returns .

I mean that’s for one of the hyperscalers. They told me that that helped their social media software and so the customer continue to increase. I believe that and with our own experience in the AI application, we also help to our own fab to improve the productivity. As I mentioned one time say that 1% or 2% productivity improvement that is free to TSMC. We call it AI Megatrend.

They are convinced that demand will continue to be strong and this means the company is going to see strong profit and operating cash flow growth over the next few years.

Underpinned by our technology differentiation and broader customer base, we now expect our overall long-term revenue growth to approach 25% CAGR in U.S. dollar terms for the five-year period starting from 2024.

This strong revenue growth will be driven by very strong growth in AI accelerators

We raise our forecast for the revenue growth from AI accelerator to approach a mid to high 50%s CAGR for the five years period from 2024 to 2029.

With our strong technology, leadership and differentiation, we are well positioned to capture the multi-year structure demand from the industry megatrends of 5G, AI and HPC.

This growth will require strong increase in capital expenditure as noted above. Higher capex will lead to higher depreciation.

Our depreciation expense is expected to increase by high-teens percentage year over year in 2026 mainly as we ramp our 2nm technologies. As complexity increases, it requires more capex to produce the same amount of units.

The Capex dollar required to build 1K wafers per month capacity of N2 is substantially higher than 1,000 wafers per month capacity. For N3, the Capex per 1,000 cost for A14 will be even higher.

As the chart above shows, deprecation is expected to double to $41bn by 2028.

A fast-growing company in a capital-intensive industry will have rising depreciation. Depreciation is a deduction on the income statement and reduces reported net profit. It is described a non-cash cost.

However, as investors such as Warren Buffet have noted, depreciation is a real cost because it means future cash flows will have to be used to replace the depreciated capital stock. This means there will be less free cash flow left over for investors.

In a capital-intensive industry with poor economics, all the operating cash flows may be used to counter the effects of deprecation and shareholders will see no increase in free cash flows despite high revenue and profit growth. TSMC has excellent economics but nevertheless faces pressures on free cash flow due to high levels of capex and depreciation.

Summary

TSMC is in a very strong position as the dominant producer of leading-edge chips in a world of high demand growth and capacity shortages.

The short to medium outlook looks strong.

Valuation

TSMC trades at roughly 26x 1-year forward earnings. This looks attractive for a high growth company which has an ROE in the range 32% to 35% and impressive ability to grow margins. The structure of demand is improving as it is becoming less cyclical.

Conclusion

We had originally invested 1.3% of over portfolio to TSMC and this has grown to about 2.4%. We are happy to add 1% to make it 3.4%. This is a smaller allocation than in other AI plays such as Google and Nvidia which are at about 5.0%. We prefer to have a larger position in the latter,as it benefits from TSMC manufacturing excellence while it maintains a capital light model.