Shares of Taiwan Semiconductor Manufacturing (NYSE:TSM) recently jumped after the company posted its second quarter earnings on July 19. However, the rally was surprising since TSMC's numbers weren't that impressive.

TSMC's revenue rose 9% annually to $233.28 billion NT dollars ($7.85 billion), which matched analyst estimates. That represented 11% growth in U.S. dollars due to year-over-year shifts in exchange rates. Its EPS rose 9% to $2.79 NTD, or $0.47 per ADR share, which beat expectations by a penny.

Chips being printed on a wafer.

Image source: Getty Images.

But for the current quarter, TSMC only expects 1.6% to 2.8% annual sales growth (in U.S. dollars), compared to the consensus forecast for 2.9% growth. It also slashed its full year sales guidance to 7% to 9%, compared to its forecast for 10% growth back in April -- which was already a reduction from its prior forecast for 10% to 15% growth.

However, a key difference was that this time TSMC only attributed its guidance cut to slower demand for cryptocurrency mining chips, which could be partly offset by stronger demand for chips for new premium smartphones. Back in April, TSMC blamed its guidance cut on slower demand in both the crypto mining and smartphone markets.

That might seem like a minor difference, but it convinced some analysts and investors that TSMC's sales could rebound in 2019. However, TSMC's recovery still depends heavily on new premium phones reviving the stagnant smartphone market and chipmakers launching new 7nm chipsets.

Understanding the challenges

TSMC is the world's largest semiconductor foundry. It produces nearly 10,000 types of products for almost 500 active customers -- including NVIDIA (NASDAQ:NVDA), AMD (NASDAQ:AMD), and Apple (NASDAQ:AAPL). So when TSMC sneezes, everyone assumes that the semiconductor sector has caught a cold.

Furthermore, TSMC cut its full-year sales forecast for the entire semiconductor industry (excluding memory chips) from 5%-7% to just 5% back in April, which seemed to indicate that the semiconductor market was approaching a cyclical peak. Escalating trade tensions between the U.S. and China could also throttle chip sales into China and raise prices on a wide range of electronics.

TSMC mostly attributed its slowdown to a gradual shift toward newer 7nm chip designs, which are expected to account for over 20% of its revenues during the fourth quarter and subsequently grow more than 10% per year. But revenues from 10nm chips (which generated over a fifth of its revenues last year) and other older chips are still declining.

A chip on a circuit board.

Image source: Getty Images.

What does this mean for chipmakers?

TSMC's shift toward newer 7nm designs tells us a lot about its top customers. For NVIDIA, this means that demand for its current-gen 14nm and 16nm Pascal GPUs is peaking. The same can be said about AMD's current-gen 14nm Vega GPUs and Zen CPUs. Moreover, soft crypto prices are causing prices for used GPUs to decline, which could cause a global glut of cheap GPUs. The ongoing price war between NVIDIA and AMD in low-end GPUs could exacerbate that pain.

NVIDIA's high-end Volta GPUs are 12nm chips, but its next-gen GPUs are widely expected to be 7nm chips. Recent reports suggest that those chips could arrive by the end of the year. AMD also plans to make the leap to 7nm with its next-gen Vega GPUs and Zen 2 CPUs, which should arrive in 2019.

Apple, which jumped from 16nm to 10mm chips with the A10X and A11 chips last year, recently started production on its 7nm A12 chips. Those chips should debut in its trio of new iPhones this fall. Other major TSMC customers like Qualcomm, the top mobile chipmaker in the world, are performing similar upgrades.

Getting ready for the next cycle

On their own, TSMC's second quarter earnings and guidance look bleak for semiconductor stocks. However, new 7nm chips should lead the charge next year -- not only in smartphones, but in an increasing number of Internet of Things (IoT) devices, connected cars, and GPUs for gaming and AI.

Therefore, TSMC's slowdown shouldn't be considered a red flag for semiconductor stocks yet. Instead, it should be considered a temporary dip that might precede bigger gains next year.