United Microelectronics Stock: Downturn Has Arrived (NYSE:UMC)

United Microelectronics (NYSE:UMC) has posted its Q3 results, and both the top and the bottom lines were better than expected. However, any positive momentum this might have generated was completely snuffed out by the outlook, which suggests UMC is heading for some lean, if not hard, times. Why will be covered next.

Sales and profits grew once again, but probably not for much longer

UMC added to a string of strong quarterly earnings with Q3 FY2022 numbers that surpassed expectations for the top and the bottom line. In Q3, revenue increased by 34.9% YoY to NTD75,392M, which is equal to $2,375M using an exchange rate of 1:31.74 for the U.S. dollar. EPS increased by 53.1% YoY to NTD2.19, which translates to $0.345 per ADS. Gross margin improved by 1050 basis points YoY to 47.3% and operating margin improved by 1290 basis points YoY to 40%.

Note that net income did not increase as much as operating income YoY. This was mostly due to a decline in non-operating income from NTD4,317M in Q3 FY2021 to NTD2,189M in Q3 FY2022. On the other hand, it was still better than the non-operating loss of NTD2,586M in Q2 FY2022, which helped boost the QoQ increase in net income and EPS. The table below shows the numbers for Q3 FY2022.

(Unit: NTD)	Q3 FY2022	Q2 FY2022	Q3 FY2021	QoQ	YoY
Revenue	75,392M	72,055M	55,907M	4.6%	34.9%
Gross margin	47.3%	46.5%	36.8%	80bps	1050bps
Operating margin	40.0%	39.1%	27.1%	90bps	1290bps
Operating income	30,157M	28,164M	15,135M	7.1%	99.3%
Net income	26,996M	21,327M	17,460M	26.6%	54.6%
EPS	2.19	1.74	1.43	25.9%	53.1%

Click to enlarge

Source: UMC

The utilization rate remained at 100%+ as it has been for quite some time. UMC is currently in the midst of a multi-year capacity expansion, with new fabs scheduled to come online in the next few years. Accordingly, fab capacity rose to 2,539K 8-inch equivalent wafers, up from 2,383K a year ago. Wafers shipped did decline by 1% QoQ to 2,597K wafers, but a better product mix, which boosted average selling prices or ASP, together with favorable foreign exchange rates, was able to compensate for the reduction in wafers shipped.

The balance sheet changed in Q3. Cash and cash equivalents totaled NTD180.6B in Q3 FY2022, less than the NTD183.7B in Q2 FY2022, mostly due to paying out the dividend, but more than the NTD113.1B in Q3 FY2021. Current liabilities totaled NTD108B and total liabilities totaled NTD204.2B in Q3, both better than in Q2. Debt-to-equity was 65%.

The Q3 report is pretty good up to this point, with UMC posting strong gains on a number of fronts, but the same cannot be said of the outlook. In fact, it was the outlook that stole the spotlight, overshadowing all else. For starters, the Q3 earnings release included the following statement:

“Moving into the fourth quarter, we expect to face headwinds amid demand weakness, impacted by factors including the inflationary environment and Ukraine war. While UMC will not be immune to the inventory correction affecting the industry, we will work closely with our customers as they adjust to current market conditions.”

Not only does UMC expect demand to weaken significantly, especially due to falling demand for PCs and smartphones, but it also cautioned not to expect a recovery in the near term. Guidance calls for wafer shipments to decline by a fairly hefty 10% QoQ. Capacity utilization will drop to 90%, making it the first time in a long time capacity is not fully utilized. ASP is expected to remain flat and gross margin is expected to fall to the low-40% range. Capex spending will be reduced, although UMC still expects to open two new fabs in the next two years as scheduled. From the Q3 earnings call:

“Now let’s move on to the fourth quarter 2022 guidance. Our wafer shipment will decrease by approximately 10%. ASP in U.S. dollar will remain flat. Gross profit margin will be in the low 40% range. Capacity utilization rate will be at 90%. Our 2022 cash-based CapEx will be revised to USD 3 billion.”

A transcript of the Q3 FY2022 earnings call can be found here.

In addition, UMC lowered its outlook for next year.

“Well, I mean, we — after the quarter from last quarter, given the rising macro uncertainties and ongoing inventory correction, like I said, in the PC and the smartphone space and as well as the high inflationary cost pressure and we do foresee the semi and foundry industry will decline in 2023 now.”

UMC had previously forecast growth, but in light of recent market developments, it now believes the semiconductor and foundry market will both contract in 2023.

The market response was fairly restrained probably for a couple of reasons

UMC is predicting a fairly large drop in demand in Q4, but the market took the news in stride. The stock only fell 5% after the release of the Q3 report, despite signaling the end of a multi-year expansion in sales and profits and heralding the start of a downturn. Part of it was probably because the stock has been in decline for most, if not all, of 2022. The chart below shows how UMC has lost 46% YTD. Note that the stock declined even though it posted strong earnings growth throughout the year.

The stock has been trending lower, but it’s worth noting how the stock has shown signs of life lately. The low of the year is $5.36, reached on October 11. However, the stock has rallied in the days since then. The stock even managed to move above the upper trendline as shown above. Note how the stock touched the upper trendline after it dropped in response to the Q3 report, only to bounce and stay above the trendline. The fact that the stock did not drop below the trendline could be interpreted as a sign of strength. It also managed to stay above the 20-day moving average with a timely bounce.

It appears there is some buying interest in UMC considering the recent price action. This is understandable since UMC does have a couple of attributes that a number of people may find appealing. For starters, UMC recently paid a dividend of $0.51, which translates to a dividend yield of 8.6%. It’s true interest rates have greatly increased in 2022, but a yield of 8.6% is still very respectable, especially for a tech stock. In comparison, UMC is projected to earn $1.22 in FY2022, which suggests UMC has some wiggle room to work with even if earnings decline.

Another trump card that is likely to draw interest is valuations. Many multiples for UMC are in the low-to-mid-single digits, which seems very low. For instance, UMC has an enterprise value of $11.4B, which is equal to 2.67 times EBITDA on a trailing basis and 2.53 times EBITDA on a forward basis. The table below shows some of the multiples for UMC.

	UMC
Market cap	$15.26B
Enterprise value	$11.37B
Trailing P/E	6.11
Forward P/E	5.32
PEG ratio	0.08
P/S	1.78
P/B	1.60
EV/sales	1.35
Trailing EV/EBITDA	2.67
Forward EV/EBITDA	2.53

Click to enlarge

Source: Seeking Alpha

However, it’s probably worth mentioning that the forward multiples are subject to revisions if or when earnings decline. UMC has posted strong earnings growth in the last few years, but UMC itself expects earnings to contract starting in Q4. UMC may not actually be as cheap as it appears to be, but that depends on how much or to what extent the upcoming industry downturn affects earnings at UMC going forward. While some may speculate on the extent or duration of the downturn, no one can be certain if they are right. The coming downturn may be your average one, but it could also be more severe than on previous occasions. To pretend to know for sure would be foolhardy.

Investor takeaways

UMC managed to keep it at bay for a while, but the industry downturn has officially arrived if the latest guidance is to be believed. UMC expects wafer shipments to decline by 10% sequentially and capacity utilization to fall to 90% in Q4 after seven consecutive quarters with a 100% or better utilization rate. The last time utilization was not higher than that was in Q2 FY2019 when the utilization rate was 88%. Historically, industry downturns have meant lower sales and profits for foundries like UMC, which suggests that is what is coming to UMC in the coming quarters.

This would be consistent with what other companies are reporting. It’s true some market segments like automotive chips continue to hold up, but the trend is clearly for chip demand to get weaker and not stronger. For instance, UMC released its latest guidance on the same day that industry heavyweights like Texas Instruments (TXN) and SK Hynix reported seeing weakening demand, while at the same time dismissing hopes for a quick recovery in the industry.

If anything, the deterioration in the semiconductor market seems to be spreading. Previously, it was assumed weakness was confined to just PCs and smartphones, but the latest updates from TXN suggest that is not necessarily justified. TXN and SK Hynix are just the latest in a growing list of companies reporting a downturn in the semiconductor industry. Other high-profile names like AMD (AMD) and Micron (MU) have earlier warned demand for semiconductor chips is going down. Basically, the prevailing industry trend is becoming clearer, and it is not one that bodes well for UMC.

I am neutral on UMC as stated in a previous article. It may be tempting to be a buyer with multiples where they are and the dividend, but that may not be such a prudent move with both facing an uncertain future. Earnings will start to decline in Q4 after increasing in the prior quarters. There is no way of knowing for sure how long the downturn will last and how far earnings could drop. Even UMC cannot really say for sure. Forward multiples are not set in stone. If earnings go down, the dividend is likely to follow as well, although it’s unlikely to be cut entirely.

With that said, the semiconductor industry is cyclical and downturns will end sooner or later. UMC is likely to have to deal with falling revenue and earnings in the near term, but it is also likely to emerge from the downturn when the next upturn is set to begin. Longs will have to wait for better times as the industry moves to fix what is ailing it, but those days are almost certain to come.