UMC - United Microelectronics: Hold On But Putting New Money To Work May Be Risky

2023-10-30 23:16:05 ET

Summary

• The Q3 results were better than expected, but soft guidance caused the stock to drop by raising questions about where the industry is heading.
• United Microelectronics has a number of positive attributes worth mentioning, including a dividend yield that is likely to surpass 5% for FY2023.
• The slump in demand is showing persistence, which is cause for concern, especially with everyone adding capacity to cater to an expected growth in demand.
• UMC stock is worth holding onto for several reasons, but putting new money to work may not be such a wise move given the circumstances.

United Microelectronics ( UMC ), one of the leading providers of foundry services to the semiconductor industry, put in a mixed report on the 25 ^th . On the one hand, UMC beat estimates for the top and the bottom line in the Q3 report, but Q4 guidance was on the soft side. The stock fell as the overall impression of UMC is that while there are some positives, there are as many negatives, if not more. Why will be covered next.

Guidance negates the better-than-expected quarterly results

A previous article from early August rated UMC a hold after taking note of the repeated lowering of the FY2023 outlook by UMC due to weaker-than-expected demand in the foundry market. On top of that, UMC left open the possibility quarterly results may have further to drop before the worst has passed. The Q2 report, for instance, hinted at increasing signs of weakness in demand in some market segments that had up to then been fairly resilient during the current downturn.

Fast forward and UMC continues to feel the impact of a downturn in the semiconductor industry that has caused demand for foundry services to drop. This can be seen once more in the Q3 FY2023 report. Q3 revenue increased by 1.4% QoQ, but it also declined by 24.3% YoY to NTD57,069M, which converts to $1,769M using a USD:NTD exchange rate of 1:32.26. The table below shows the numbers for Q3 FY2023.

EPS declined by 41.1% YoY to NTD1.29, which translates to NTD6.45 or $0.20 per ADS. On the other hand, while the results entail a YoY drop, the results were better than expected with consensus estimates expecting EPADS of $0.16 on revenue of $1.76B. This can be attributed to a better product mix, higher prices and a favorable exchange rate, all of which were better than anticipated. Revenue from 28/22nm, for instance, reached a record share of 32%, up 300bps QoQ and 700bps YoY.

Source: UMC

The balance sheet changed along with the income statement, especially with UMC in the midst of an expansion of fab capacity. UMC finished with cash and cash equivalents of NTD140.64B in Q3 FY2023, down from NTD163.1B in Q2 FY2023 and NTD180.65B in Q3 FY2022. Total liabilities amounted to NTD197.26B in Q3 FY2023, down from NTD226.31B in Q2 FY2023 and NTD204.21B in Q3 FY2022. Of that amount, long-term credit/bonds rose to NTD49.38B.

Q3 guidance had called for wafer shipments to decline by 3-4% QoQ, but actual wafer shipments declined by a lower amount or 2.3% QoQ to 1,788K 8-inch equivalent in Q3. The Q3 utilization rate of 67% was also better than the mid-60% range guidance had called for. Still, it’s less than the 71% in the preceding quarter and the 100+% of a year ago, which shows the extent of the slump in demand for foundry services, although new capacity brought online played a role as well.

Furthermore, Q4 guidance calls for the utilization rate to drop further into the low-60% range. ASP are forecast to remain flat, but wafer shipments will decline by 5% QoQ. Gross margin will drop into the low-30% range. From the Q3 earnings call:

“Now let's move on the fourth quarter 2023 guidance. Our wafer shipment will decline by approximately 5%. ASP in US dollar will remain flat. Gross margin will be in the low 30% range. Capacity utilization rate will be in the low 60% range. Our 2023 cash base CapEx will be budgeted at US $3 billion.”

A transcript of the Q3 FY2023 earnings call can be found here .

The foundry market has yet to truly recover

Using these datapoints from UMC, EPADS is estimated to come in at about $0.15-0.16 in Q4. UMC is projected to earn $0.77-0.78 for the whole of FY2023 on revenue of $6.8-6.9B since UMC earned $0.62 in Q1-Q3. In comparison, UMC earned NTD7.09 on revenue of NTD278.7B in FY2022, which translates to NTD35.45 or $1.15-1.16 per ADS.

If UMC earns $0.77-0.78 in FY2023 and assuming that UMC sticks to a payout ratio of around 50%, then the dividend for next year is projected at $0.39. This is way less than the prior dividend of $0.58, but it still implies a dividend yield of about 5.5% with a stock price of $7.07, which is very respectable, especially for a tech stock.

Still, the trend looks concerning with UMC ending the year on a soft note. EPADS has steadily declined from $0.22 in Q1 to an estimated $0.15-0.16 in Q4. It’s also possible the slide in earnings could continue, especially since there are signs the weakness in demand is spreading to areas where it was not present before.

“For the Q4 outlooks, and currently, we see the PC and the Chinese smartphone segment will remain in line with the Q3. However, for the automotive market even that, the customer have been accumulating backlog from early last year till probably Q1 this year, we expect higher than expected inventory buildup already. As a result, our auto business is a projected to decline in Q4”

For example, the current downtrend started with a drop in demand for PCs and smartphones and while these seem to have stabilized, the automotive market, which had previously shown resilience, is regressing.

The stock drops

The market gave the Q3 report a thumbs down and the stock fell 4% on October 25 to bring YTD gains to 8.3% as shown below. Notice how there seems to be resistance in the vicinity of $9 or so. The stock hit a 2023 and 52-weeks high of $8.97 on June 16 before the stock turned south to hit a post-June low of $6.71 on August 16, which is just a penny away from the March 24 high of $8.96. Multiple tops months apart at around the same price point points to the presence of resistance.

If we assume the post-June decline is the result of the stock retracing the uptrend, starting from the October 2022 low of $5.36 and ending with the June 2023 high of $8.97, then the closely watched 61.8% Fibonacci retracement is at $6.74. This is $0.03 away from the post-June low of $6.71 set on August 16, following the decline in the stock after the June high. This could explain why the stock has proceeded to move higher after hitting what was likely support.

Why a case can be made for long UMC

While there are a few remaining months in 2023, UMC shareholders can look forward to a yield of 5.5% at the current stock price. In addition, an argument can be made that with a stock price of $7.07 UMC is trading below fair value. Granted, fair value is highly subjective, but if we assume UMC grows earnings by 15% on average per year in the next five years and with TTM EPADS of $0.87, then it can be argued that fair value is around $13.05. If using the discounted cashflow method, then fair value is a bit higher at $13.28. Either way, a fair value of $13+ is way above the current stock price of $7.07.

Source: SeekingAlpha

It’s also worth mentioning that UMC trades at significantly lower multiples than other foundries in the space. The table above shows how UMC compares to GlobalFoundries ( GFS ) and TSMC ( TSM ) in terms of multiples. Note that unlike TSM and UMC, GFS has yet to report for the third quarter.

How the foundry market could take longer to recover

Still, the latest guidance raises doubts about whether there will indeed be a rebound in semiconductor demand next year as many forecasts predict. Keep in mind that even though semiconductor demand has been weaker than expected this year, which has forced many, UMC included, to lower their 2023 outlook, many forecasts are nonetheless predicting a strong expansion in demand in 2024.

For instance, worldwide sales of semiconductors are predicted to grow by 11.8% YoY to $576B in 2024 according to WSTS, which would essentially offset the 10.3% contraction expected in 2023. If this happens and semiconductor demand returns to growth, the foundry market and relevant players like UMC should see a rebound in demand.

However, if the slump in demand persists at current levels or, worse, deteriorates further, then there could be a problem, especially with all the manufacturing capacity being added. Many semis, UMC included, have added additional fab capacity to cater to the expected increase in demand as predicted by many industry forecasts. If this demand does not arrive as anticipated, many stand to suffer losses due to these investments, especially when depreciation expense starts to weigh on earnings.

UMC itself has three fab expansions going on in Taiwan, China and Singapore. Other foundries like TSM, GFS and SMIC also have new fabs coming online, either now or in the near future. The latter, for instance, plans to add as much new 12-inch fab capacity as UMC currently has in total. In order to keep all these new fabs fully loaded, a lot more demand will be needed. Things can change, but at the moment, it does not look like there will be enough demand to balance out the supply.

Investor takeaways

There are a number of reasons why some may want to hold shares of UMC. Shareholders are likely to receive a yield of 5+% by mid-2024. The balance sheet is healthy with less long-term debt than cash. UMC has consistently been able to earn a profit with just one quarter in the last ten years finishing in the red and then only barely at just $0.01. UMC can be said to be trading below fair value, depending on the method used. Multiples are lower than most.

However, the persistent weakness in demand is a cause for concern. The industry forecast at the start of 2023 was that the market would bottom in H1 and that there would be a strong rebound in the semiconductor market in H2. There are two months left in 2023 and there is still no real evidence there is a rebound underway. On the contrary, some markets segments like automotive seem to be following in the footsteps of PCs and smartphones in terms of demand.

Yes, there are forecasts of better times ahead in areas like PCs, but the numbers do not really show it, at least not yet. In addition, there is a lot of new fab capacity being brought online, including by UMC. This is part of the reason why the utilization rate continues to drop, on top of demand already being weak. It is important that demand starts to strengthen soon to offset all the new supply because if it does not, the anticipated recovery in the semiconductor market that many predict will arrive in 2024 could take a lot longer to get here.

So while I continue to hold UMC, I would not be a buyer of UMC for now. It is not impossible for the downturn to continue, despite the general belief the semiconductor market will soon return to growth. And even if semiconductor demand does improve, it might not be by enough to offset all the new fab capacity coming online. This could hold down prices, revenue and thus earnings.

All in all, while there are reasons to hold on to UMC, there is not enough to warrant putting new money to work. There is a widely held expectation that the semiconductor market is close to taking off after the recent slump. This may turn out to be correct, but if it does not, UMC and many other semis may not have seen the bottom just yet.

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