Things aren't looking so hot for the world's biggest chip maker, Taiwan Semiconductor Manufacturing (NYSE: TSM).

The contract fabricator posted a big drop in net profit in the third quarter while warning that global demand is drying up. Third-quarter revenue dipped by 5% to $3.7 billion. Net income got trounced by 35% -- falling to $1 billion, or $0.20 per American Depository Receipt. Gross margin wasn't spared either, falling from 50% in last year's quarter to 42%, with the drop being attributed to lower capacity utilization.

Going forward, fourth-quarter revenue is expected in the range of $3.4 billion to $3.5 billion, using current exchange rates, and gross margin is predicted to improve to between 43.5% and 45.5%.

Chips bound for smartphones were the only bright spot, as Taiwan Semi CFO Lora Ho said: "The outlook of the global economic condition continues to weaken, which has affected the demand for our wafers in the fourth quarter of 2011. Relative to the third quarter, all major segments are expected to decline, except for the communication segment, thanks to the strength in the demand for smartphones."

Demand was affected as the company's customers made inventory adjustments to accommodate the tough macroeconomic environment. Roughly 70% of the quarter's revenue came from North American customers, which include familiar names like NVIDIA (Nasdaq: NVDA), Qualcomm (Nasdaq: QCOM), and Texas Instruments (NYSE: TXN).

There have been rumblings that Taiwan Semi would displace Korean bigwig Samsung as the manufacturer for Apple's (Nasdaq: AAPL) next-generation quad core A6 chip, which would presumably power the iPad 3 and iPhone 5 next year. But recent reports have dashed those hopes, and Cupertino is expected to retain Sammy for the A6 because of capacity constraints. If there's one thing Apple needs to count on most, it's capacity. The generation after next, the A7, may still be on the table, though.

The company has been pouring money into its infrastructure lately, including $1.3 billion this quarter, although it plans on scaling back its capital expenditures to accommodate for tepid demand.

I've always liked Taiwan Semi as a key beneficiary of the industry's recent trend toward fab-less and fab-lite models, as most companies now prefer to outsource chip fabrication. Despite the somewhat soft quarter, I think the long-term story remains intact.

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