Taiwan Semiconductor Manufacturing (TSM -2.40%), the world's largest and most advanced contract chipmaker, posted its first-quarter earnings report on April 20. Its revenue rose 3.6% year over year to 508.63 billion New Taiwan Dollars (NTD) ($16.72 billion) but missed analysts' estimates by $170 million. Its net income rose 2.1% to 206.95 billion NTD ($6.8 billion), or $1.31 per American Depository Receipt (ADR) -- which cleared the consensus forecast by 11 cents.

TSMC's growth cooled from its 43% revenue growth in 2022, mainly due to the post-pandemic drop in PC sales, the cooling upgrade cycle for 5G smartphones, the pandemic shutdowns in China, the Ukrainian war, and other macro headwinds. However, TSMC's stock has also declined nearly 40% from its all-time high in January 2022 -- so a lot of those concerns could have been priced into its shares.

Could TSMC's stock bounce back over the next 12 months? Let's review its near-term challenges, long-term expansion plans, and its current valuations to decide.

A TSMC fab in Nanjing, China.

Image source: TSMC.

Most of TSMC's end markets are struggling

TSMC's year-over-year growth rates aren't as significant as its sequential growth rates, which paint a clearer picture of the chip market's recent slowdown. On a sequential basis, TSMC's revenue fell 19% in Q1 (and 16% in USD terms) compared to its 2% growth in the fourth quarter.

TSMC generated 44% of its Q1 revenue from the high-performance computing (HPC) market, which includes CPUs and GPUs, and 34% from the smartphone market. Its major HPC customers include Advanced Micro Devices and Nvidia, while its top smartphone customers include Apple and Qualcomm. All those tech giants rely on TSMC to produce their smallest, densest, and most power-efficient chips.

Yet both of those markets struggled in Q1. On a sequential basis, its HPC revenue dropped 17% as its smartphone revenue plunged 27%. Those declines aren't too surprising. In Q1 2023, Gartner estimated that global PC shipments plunged a whopping 30% year over year, while Canalys claimed that global smartphone sales dropped 12%.

The Internet of Things (IoT) and digital consumer electronics (DCE) segments collectively generated another 11% of TSMC's first-quarter sales. Its IoT revenue declined 19% sequentially as its DCE revenue dipped 5%. Both segments faced tough headwinds from inflation, sluggish enterprise and consumer spending, and other macroeconomic challenges.

The only bright spot was the auto market, which accounted for 7% of TSMC's top line and grew its revenue by 5% sequentially. That growth was driven by the persistent automotive chip shortages, which forced chipmakers to ramp up their production of new chips for electric, connected, and driverless cars.

TSMC expects that broad-based slowdown to continue with a 4% to 9% sequential decline in revenue (in USD terms) in the second quarter. Nevertheless, that milder sequential drop supports TSMC's belief that the semiconductor market will bottom out in the second half of 2023.

But its margins are still contracting

TSMC is reining in its spending, but its margins are still declining. Its gross margin fell from 62.2% in Q4 2022 to 56.3% in Q1 2023, and it expects that figure to contract to 53.5% to 55.5% in Q2.

TSMC's operating margin also fell from 52% in Q4 to 45.5% in Q1, and it anticipates another decline to between 41.5% and 43.5% in Q2. In other words, TSMC still hasn't reached the trough of the semiconductor slowdown yet.

As for its capex, TSMC maintained its prior outlook of $32 billion to $36 billion for the full year. This shoots down the recent rumors that claimed it would slash its capex to about $28 billion to $32 billion while reducing its orders of high-end lithography systems from ASML.

It remains ahead of Intel and Samsung

On the bright side, TSMC's percentage of sales from its top-tier 5nm node reached 31% in Q1, up from just 20% a year earlier. That ongoing expansion will pave the way for the rollout of its 3nm process this year and 2nm chips in 2025. In other words, investors can still count on TSMC to remain at least one to two generations ahead of its closest competitors, Samsung and Intel, in the "process race" to manufacture the world's most advanced chips.

TSMC remains exposed to the persistent military and trade tensions between Taiwan, China, and the United States, but the world's top fabless chipmakers still don't have any option but to rely on TSMC's most advanced Taiwanese plants for the foreseeable future. Unless that status quo changes, I believe TSMC will remain a linchpin and bellwether of the global semiconductor market.

For now, analysts expect TSMC's revenue and earnings to dip 3% and 17%, respectively, in 2023 before growing again in 2024. It still looks cheap at 17 times forward earnings, and I believe it will rise over the next 12 months as investors look past its near-term slowdown and the macro headwinds.