UMC - United Microelectronics: The Downturn Might Last Longer Than Expected

2023-08-08 17:49:06 ET

Summary

• UMC beat estimates for Q2, but the latest report contained a number of troubling developments in several areas.
• UMC lowered its outlook once again due to demand coming in weaker than expected, in addition to hinting demand could fall even further.
• UMC is not alone in being confronted with stronger headwinds than anticipated, including in markets that had previously been unaffected.
• An article from late last year urged caution in light of what might happen to UMC and the developments this year have shown this to be prescient.

United Microelectronics ( UMC ), one of the leading providers of foundry services to the semiconductor industry, had some good news to share in its latest report. Earnings, for instance, were significantly higher than expected. However, the good was overshadowed by the bad. The outlook was revised downwards with UMC hinting at a downturn that could be a lot more severe than originally expected. Why will be covered next.

UMC surpassed Q2 expectations

The market was expecting worse, but UMC managed to surprise by beating expectations for both the top and the bottom line. Q2 revenue increased by 3.8% QoQ, although it still declined by 21.9% YoY to NTD56,296M, which converts to $1,808M using a USD:NTD exchange rate of 1:31.13. EPS declined by 27.1% YoY to NTD1.27, which translates to $0.204 per ADS or $0.05 more than the consensus estimate.

The balance sheet saw changes as well, especially with UMC in the process of expanding by adding capacity. UMC finished with cash and cash equivalents of NTD163.1B in Q2 FY2023, down from NTD171.83B in Q1 FY2023 and NTD183.72B in Q2 FY2022. Total liabilities reached NTD226.31B in Q2 FY2023, up from NTD194.08B in Q1 FY2023 and NTD216.51B in Q2 FY2022. The table below shows the numbers for Q2 FY2023.

Source: UMC

The better-than-expected results were primarily the result of a better product mix with 28 nm revenue reaching a record 29% of total revenue in Q2, up from 26% in Q1. Wafers shipped increased by just 5 wafers QoQ to 1,831K and fab capacity increased from 2,522K to 2,626K QoQ. Utilization rate improved by one point QoQ to 71%, which is still way below the 100% of a year ago and a reflection of how much demand has fallen off in the foundry market.

Furthermore, guidance calls for the utilization rate to drop to the mid-60% range. While ASP are expected to increase by 2% QoQ, wafer shipments are expected to decline by 3-4% and gross margin is expected to drop in the low single digits. UMC is also facing inflationary pressure, which is raising the cost of goods.

UMC is estimated to earn about $0.16 per ADS on revenue of $1.78B in Q3 using these data points from UMC. This would be the fifth consecutive sequential decline in earnings. From the Q2 earnings call:

"Now let's move on to third quarter 2023 guidance. Our wafer shipments will decline by approximately 3% to 4%. ASP in US dollar will increase by 2%. Rising costs will erode gross margin by low-single digit percentage point. Capacity utilization rate will be in the mid-60% range."

A transcript of the Q2 FY2023 earnings call can be found here .

This sequential decline in the top and the bottom line was a letdown. Keep in mind that there were many who earlier in the year called for the downturn to hit bottom in the first half of 2023, followed by a recovery in the second half. The latest guidance from UMC implies the downturn will last longer than expected.

UMC pointed to weak demand, which actually got worse in Q2. Worse, the weakness appears to have spread to market segments like industrial and automotive that had previously remained fairly resilient. All this contributed to a continued glut of inventories. This situation is expected to linger into Q4. From the Q2 earnings call:

"given the overall softer end market demand while the post-lockdown, the recovery in China has being slower than expected and weakened macro conditions, where our customers are cautiously managing their inventory. And we expect the situation will likely linger into Q4. So mainly is inventory concerns.

So about inventory, while the end market demand has worsened compared to a quarter ago across a segment in smartphones, PC and server, the inventory will be slower -- slowly work off now. The pace of digestion is slower than we previously expected. At auto and industrial segment the demand of year-over-year projection at this time our projection shows remains unchanged from the previous quarter. However, the inventory level has picked up in Q2 for these two segments now. So therefore we will kind of cautiously observe the demand-supply situation now to determine when the semi-cycle was will start to improve or come back."

It's worth mentioning that UMC is not alone in noticing a rather worrisome development in the semiconductor space. For instance, Microchip ( MCHP ) recently took note of weakening demand in the automotive and industrial segments in its latest earnings call . TSMC ( TSM ), the market leader in the foundry market, cited weaker-than-expected demand for its decision to lower its outlook. TSM stated the following in its latest earnings call with regard to the current state of the foundry market:

"Yes, we did see something different. The first, the market is weaker than what we thought. Three months ago, we probably - probably more optimistic, but now it's not. Also that is - for example, China economy's recovery is actually also weaker than what we thought. And so the end market demand actually did not grow as we expected.

So put all together, even we have a very good AIs processor demand is still not enough to offset all those kinds of macro impact. So now we expect that the whole year will become minus 10%. That's what we thought."

As a result of the growing weakness in demand, UMC decided to lower its FY2023 outlook after Q2. The latest outlook sees a decline in the mid-teens for the foundry market instead of the high single-digit decline previously expected. In addition, it's possible UMC might underperform with a bigger decline than the overall market. From the Q2 earnings call:

"Of the semi outlook, we expect the 2023 semiconductor market, exclude the memory will declined by mid-single digit year-over-year. For the foundry we now expect the industry will decline by mid-teens year-over-year. With the weaker macro condition we'll need to be very conservative as our customer continue to manage their business, and inventory now. For our addressable market I think we'll be higher than the mid-teens, actually the decline will be higher."

Keep in mind that UMC had earlier forecast a mid-single digit decline early in the year. A previous article goes deeper into why UMC lowered its outlook after Q1.

FY2024 is not expected to bring much relief for UMC

There was a fairly widespread belief at the start of 2023 that 2024 would be a strong year of expansion for the semiconductor industry, something that would benefit a foundry like UMC. However, the latest outlook with back-to-back downward revisions to growth has put further doubt into that belief. Consensus estimates predict UMC will end FY2023 by earning $0.75 per ADS on revenue of $7.03B and that is not expected to get much better in FY2024 with $0.74 on revenue of $8.03B. So flat all the way to the end of next year.

On the other hand, earnings of $0.75 with the stock priced at $7.26 as of August 4 means UMC comes with a P/E ratio in the single digits. The table below shows some of the most commonly used multiples for UMC in comparison to GlobalFoundries ( GFS ), which is arguably the foundry closest to UMC, and TSM, the market leader. UMC is the less pricey option. Keep in mind UMC also pays a dividend, unlike GFS. UMC paid a dividend of $0.58 for the year in late July, which, with the stock priced at $7.26, means a generous yield of 7.9%.

Source: Seeking Alpha

UMC has gradually lowered its outlook as 2023 has progressed and this can be seen in how the stock has faded after a fairly strong start in 2023. Notice how in the chart below the lows are going lower after January. If they are connected, a descending trendline appears. Trends do not last forever, but as of right now, they are unlikely to convince buyers the time has come to step in.

Investor takeaways

An earlier article from October 2022 urged caution, especially against the backdrop of all the optimistic forecasts, with the following statement:

"There is no way of knowing for sure how long the downturn will last and how far earnings could drop and even UMC cannot really say for sure."

This turned out to be prescient in light of recent developments, which includes UMC repeatedly lowering the outlook this year. Forecasts that called for the downturn in semiconductor demand to bottom in H1 have turned out to be incorrect.

The latest FY2023 revenue outlook from UMC now sees an even bigger decline of at least the mid-teens, up from the previous high single digits, which was itself a downward revision. Furthermore, UMC noted early signs of demand faltering in markets segments like automotive and industrial that had stayed resilient up to now, suggesting further downward revisions to the outlook cannot be ruled out.

It's true downturns in the semiconductor industry eventually pass and UMC is not expensive with multiples where they are, but there is no hard cap that says a downturn cannot last longer than it has in the past. The general expectation was that the current downturn would be a relatively shallow and short one, but it is increasingly becoming clearer this forecast was too optimistic.

The expectation was for the market to recover in the second half, followed by a strong expansion in 2024, but not only did that turn out to be overly optimistic, but semiconductor demand could stay depressed for much longer as there is scope for it to fall further. Keep in mind that while the overall semiconductor market has been in a downturn, particularly the memory segment, not all segments have experienced one.

The automotive market in particular, and the industrial market to a lesser extent, have been resilient, but the latest statements from UMC and others like MCHP indicate they are starting to show cracks with demand waning. If the downturn spreads to other markets, it will take the industry longer to get back on its feet. The fact that UMC and others like TSM have revised their FY2023 outlook downwards after each quarter is concerning. At the very least, it will cause someone to think twice before committing new capital when UMC itself seems to suggest the bottom is yet to arrive.

UMC does pay a dividend, the latest coming in late July. While the yield may seem high at close to 8%, it's worth mentioning that UMC is very likely to cut its dividend next year. UMC earned NTD7.09 or NTD35.45 per ADS in FY2022, which converts to $1.155 per ADS. Roughly half of it was used to pay a dividend of $0.58 in 2023.

Assuming UMC sticks to a payout ratio of about 50% and UMC earns $0.75 as consensus estimates predict it will, then the 2024 dividend is projected to be around $0.38, a reduction of $0.20 YoY. That still implies a yield of 5+% with the stock priced at $7+, which is nothing to sneeze at and better than most tech stocks, but it's also down from where it is right now.

In light of the above, I continue to hold UMC, but I would not be a buyer for the time being. The latest data points suggest the downturn has ways to go before it is over. At the same time, it is worth reminding that all downturns eventually come to an end. Those long UMC should probably keep their head down and their powder dry while they wait for the cycle to turn. It may require patience, which is where the dividend from UMC helps, but that day should come, provided one has the time and wherewithal to stick it out.

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