Taiwan Semiconductor Manufacturing Company (NYSE:TSM) recently talked about two big factors that the company expects will affect its gross profit margin percentage in 2018 relative to the levels that it saw during 2017. 

In this article, I will go over those factors and provide some additional explanation as to why they'll have the impact that TSMC expects them to. 

An Apple A10 Fusion chip inside of an iPhone 7.

Image source: Apple.

1. Wafer price increases

Chips are manufactured by etching patterns onto a silicon wafer using light. Much of the manufacturing cost of a finished wafer of chips is determined by the cost of the equipment that's used to perform all of the processing to transform a blank silicon wafer into a wafer full of chips, but the cost of that blank wafer is becoming an increasingly significant part of a chip's overall manufacturing cost. 

According to TSMC, the costs of those raw, unprocessed silicon wafers continues to grow as industrywide demand outstrips supply. The company says that wafer price increases negatively impacted its gross profit margin by 0.2% in 2017 and that it expects an additional impact of between a half a percentage point and a full percentage point in 2018. 

Although this might not seem like that big of a deal, the reality is that TSMC is expected to generate about $36 billion in revenue in 2018. The impact to the company's operating profit from the wafer price increases would be worth between $180 million and $360 million. 

That's not exactly the kind of thing that'll break TSMC's business, and it will likely affect all of TSMC's competitors (so TSMC won't be at a pricing disadvantage to the competition), but it's nonetheless an unfortunate development. 

On the bright side, TSMC CFO Lora Ho said that because it is such a large purchaser of silicon wafers (TSMC is the largest contract chip manufacturing company, after all), it has been able to negotiate long-term contracts with wafer suppliers that should allow TSMC to "be safe in terms of supply." 

2. 7-nanometer ramp

Whenever TSMC brings a new manufacturing technology into production, that new manufacturing technology usually serves to dilute the company's overall gross profit margins for between seven and eight quarters. 

Since Apple (NASDAQ:AAPL) is expected to manufacture its upcoming A12 processor exclusively using TSMC's 7-nanometer technology, and since Apple's order volumes are absolutely enormous (Apple ships more premium smartphones than any other company in the world), 7-nanometer shipments will quickly become a large part of TSMC's overall wafer shipments. 

Three Apple iPhones showing different portions of the Apple App Store.

Image source: Apple.

This is driven significantly by the fact that new production technologies tend to be more difficult to manufacture than older ones, resulting in lower yield rates (the proportion of manufactured chips that ultimately proves salable) and ultimately fewer salable chips.

As manufacturing yield rates improve over the life of the technology, the more valuable each processed wafer becomes to the buyer (since more of the chips on the wafer are usable). This ultimately means improved gross profit margins for TSMC for products built on that technology.

Fortunately for TSMC, while the ramp-up of 7-nanometer technology will dilute its overall margins, the increasing maturity of the company's currently-in-production technologies (e.g., 28-nanometer, 20/16-nanometer, and 10-nanometer) should serve to counterbalance the margin pressure.

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