Even with impressive financial reports, TSMC cannot avoid industry downturn (Q3 earnings call)

TSM announced its Q3 2022 earnings report on the Dolphin Analyst before the US stock market opened on Oct. 13 (as of September 30, 2022). The quarterly financial highlights are as follows:

1) Revenue: TSM earned $20.23 billion this quarter, up 11.4% QoQ, meeting expectations of between $19.8 billion and $20.6 billion.

2) Gross profit margin: This quarter's gross profit margin was 60.4%, up 1.3% QoQ and higher than the expected 57.5%-59.5%.

3) Business status: Smartphone revenue rose slightly, and the proportion of 7nm and below hit 54%.

4) Q4 guidance: TSM expects Q4 2022 revenue to be between $19.9 billion and $20.7 billion (higher than market expectations of $19.3 billion) and gross margin to be between 59.5% to 61.5% (higher than the expected 57.9%).

For more detailed information, please refer to Dolphin's comments on TSM's earnings report in the article titled "TSMC: How long can the "lone warrior" last in the dark night?".

I. Conference call summary:

1) Annual guidance: TSM's full-year revenue guidance is still around 30%, and its full-year capital expenditure has been reduced to $36 billion from $40-44 billion.

2) Long-term gross profit margin: TSM continues to maintain a gross profit margin of 53% or higher. With Q3 gross margin already reaching 60.4%, there will be downward pressure on gross margin in the medium to long term as the semiconductor cycle declines.

3) Company business outlook: ① As customers adjust inventory levels, TSM will gradually shift its focus on smartphones and HPC to the 5nm platform. ② It is expected that the semiconductor supply chain inventory will peak in 22Q3 and decrease from 22Q4, and will return to a healthy level in the first half of 23. ③ Starting from 22Q4, the utilization rate of the 6/7nm process will decrease and rebound in the second half of 23. ④ The company expects long-term revenue growth of 15-20% in US dollars over the next few years and a gross profit margin of 53% or higher.

4) Progress of 3nm/new process: ①3nm: TSM plans to produce 3nm by the end of 2022, and there are equipment delivery issues, with current 3nm demand exceeding supply. N3E will start production in the second half of 2023, and TSM estimates that 3nm will dilute gross margin by approximately 2-3%. ②2nm: The current progress is very good and slightly ahead of schedule. The company still plans to start mass production in 2025.

5) Company's production capacity expansion plan: ① Arizona Factory in the US: along the 5nm direction. ② Nanjing Factory: has obtained a one-year 28nm expansion authorization. ③ Kaohsiung Factory: The 28nm expansion plan is progressing as planned, and the 7nm plan has been adjusted. ④ The Kumamoto plant is also fulfilling customer demand as planned;

6) Semiconductor industry cycle: The company expects the industry to decline by 2023, which the company cannot avoid, but it will still achieve growth.

II. Telephone Conference Transcript

2.1 Management Report:

1. Capital Expenditure Plan: Of the approximately US$36 billion in capital expenditures in 2022, 70%-80% will be allocated to advanced process technology. 10% will be used for advanced packaging and mask plates, and 10%-20% will be used for specialized technology.
2. Outlook for Next Quarter: Business is expected to stabilize in 2022Q4 as customers are conducting inventory adjustments. This will be balanced by the continued improvement of 5-nanometer technology supported by smartphones and HPC applications.
3. Full-Year Outlook: It is expected that in US dollars, the full-year growth rate for 2022 will reach around 30%.
4. Market Demand: Continued observation of weakness in the consumer terminal market, while other terminal markets such as data centers and automobiles remain stable, but we are beginning to see the possibility of future adjustments
5. Inventory Outlook: Customers and the supply chain continue to take action to adjust inventory. It is expected that semiconductor supply chain inventory will peak in 22Q3 and begin to decrease in 22Q4. It is expected to take several quarters until 23H1 to rebalance to a healthier level.
6. N7 and N6: Due to the ultimate market weakness of smartphones and PCs, N7 and N6 utilization rates will not be as high as they have been in the past three years starting in 22Q4. Demand for N7 and N6 is expected to recover in the second half of 2023.
7. N3 and N3E: N3 is expected to begin mass production later this quarter, and a smooth climb driven by HPC and smartphone applications is expected in 2023. Due to continued equipment delivery issues, demand for N3 from customers exceeds our supply capability, and the development of N3E is advancing ahead of schedule, with mass production planned for the second half of 2023.
8. Long-Term Revenue Outlook: Strong demand for leading node technology driven by smartphones and HPC applications will drive our long-term revenue growth of 15% to 20% in US dollars over the next several years.

2.2 Analyst Q&A

Q: Regarding N7 and N6. Why will utilization rates decline? Why do you think N7 and N6 demand will recover in the second half of the year? In which areas will future demand fill in as smartphone high-end chips and HPC shift to N5 and N3?

A: The demand decline is due to market weakness, especially in smartphones and PCs. Another important factor is the delay in the progress of our customers' products. The impact on utilization rates will continue from 2022Q4 to 2023H1.

In the long run, this is a cyclical problem. So it will recover anyway. We believe that the recovery will occur in H2 2023. We will continue to work closely with our customers over the next several years to develop specialized and differentiated technologies to drive additional structural demand from consumers, RF, connectivity, etc. to supplement our N7 and N6 capacity utilization rate and future years.

Q: In 2022, the capital expenditure was tightened. What changes will there be in capital expenditure in 2023?

A: For capital expenditure in 2023, it is too early to comment now. We will provide specific guidance in January. Looking forward to 2023, considering the recent uncertainty, we will continue to manage our business carefully and prudently. We will adjust and tighten our capital expenditures at the appropriate time and invest in long-term structural market demand to support their growth.

Q: What is the latest situation with the expansion plans in Kaohsiung, Nanjing, Arizona, and Kumamoto?

A:

1. The work at the Arizona factory will continue as planned because it belongs to the N5 family and still has a very strong demand.
2. In Nanjing, we have just obtained a one-year 28nm production expansion authorization. So it is also proceeding as planned.
3. For Kaohsiung, we originally planned for two wafer fabs and N7 at the beginning of the 28nm expansion. N7 has been adjusted now, but the 28nm expansion is still proceeding as planned.
4. The Kumamoto factory is also on track to meet customer demand.

Q: Regarding HPC, it is the main growth driver for TSMC in the coming years. But considering the recent US bill's restrictions on China, what kind of impact does this have on TSMC and the overall demand for the HPC industry?

A: The restrictions set by the new regulations mainly apply to very high-end specifications, which are mainly used for artificial intelligence or supercomputing applications. Therefore, our preliminary assessment is that the impact on TSMC is limited and controllable. We will continue to closely monitor the situation and ensure that everyone fully complies with the regulations. In the long run, it is still too early to assess all the true impacts now, but we will provide you with the latest news in the upcoming earnings conference call.

Q: Why does the utilization rate of other nodes still seem to be good, but N7 is more cyclical and its utilization rate is not as high as before?

A: Most smartphone and PC customers are using N7 and N6 nodes, but the weakness of the smartphone and PC market has emerged simultaneously, and there are also plan delays for other customers or products. That is why its utilization rate is lower than other nodes. However, compared with N5 or 28nm, our orders are still in high demand.

Q: If we work closely with customers and plan well, why can't the utilization rate of 7nm be as high as other nodes?

A: We do work closely with customers, but they are struggling with inventory adjustments and market slumps. They may not have anticipated these unexpected situations two quarters ago, so at the beginning of this year, they still gave us a very high forecast number. But we believe this is a cyclical problem that will recover and may take several quarters. Q: TSMC issues guidance on Q1, 2023 and other issues

Q: TSMC's data center and auto businesses have remained stable. What is the outlook for inventory levels and development prospects in the future? Can you provide some more granular data on the 1Q23 outlook and seasonality? Will 1Q23 be the industry bottom?

A: Our customers have given demand forecasts and demand for data centers and automotive applications remains stable. However, the market is now soft and our 2023 planning will also be conservative. They may also have some adjustments, but we do not see them now.

As for inventory adjustments in 2023, we expect that the semiconductor industry may decline in 2023 and TSMC will not be immune, but we believe that our technological position, strong high-performance computing business portfolio, and long-term strategic relationships with customers will enable our business to be more resilient than the entire semiconductor industry. That's why we say 2023 is still a year of growth for TSMC, while the whole industry may decline.

Q: What is the depreciation expectation for next year? How dilutive is 3nm technology expected to be to gross margin in 2023?

A: It is still too early to talk about depreciation for the whole of next year. However, the year-on-year growth rate this year is around a single digit percentage. But we expect this number to increase significantly next year. We will give you guidance in January. As for the dilutive effect of N3, it will be 2 to 3 percentage points on our full-year gross margin.

Q: Even in the inventory adjustment in the first half of next year, do you still expect gross margin to remain at a high level of 53% or higher?

A: It is still too early to talk about 2023 gross margin (including quarter-on-quarter), but even in the face of all these cost challenges, we believe that our structural profitability can be maintained, and we are confident of achieving a long-term gross margin of 53% or even higher.

Q: Will the company consider share buybacks?

A: We have been evaluating various ways to return cash to shareholders. For share buybacks, we have not considered them yet. We believe that our cash on hand will be better used for investment in capital expenditures to bring better returns to our shareholders.

Q: Under the influence of the U.S. bill, how does TSMC view the Chinese market?

A: Every region is important to TSMC. However, what I want to say is that TSMC will continue to serve customers around the world under the premise of complying with all regulations. This is our position.

Q: With the tense geopolitical situation, how do we evaluate the long-term impact and risk to customers using other foundries?

A: We still believe that the most important thing is to be in a leading technological position. This is our strategy, and we keep it simple, with technology, manufacturing, and customer trust.

Q: In the future, if overseas expansion is accelerated or to diversify production bases, can a wafer factory be established in Europe?

A: We will continue to increase our manufacturing share overseas based on customer needs, business opportunities, operational efficiency and economic conditions. So whether we will go to Europe, we are conducting preliminary evaluations and do not exclude any possibilities. Q: With the increase in the usage of high-performance computing chips, if there are production problems with other companies or places, how does TSMC manage the risk that impacts them?

A: We certainly hope that our customers manufacture every chip within TSMC. However, if they have to use products from other companies, we will work closely with our customers to minimize the risk of certain products.

Q: Does increasing production in 16nm in Nanjing also require authorization? What are our long-term expansion plans in China?

A: We have obtained a one-year authorization that covers the Nanjing factory, so 28nm and 16nm are included.

Q: Are costs higher for overseas wafer factories? Can you provide specific data on the cost differences between Japan, the United States, and Taiwan? If costs increase with overseas expansion, how will this affect our long-term profitability and profit margins?

A: The initial costs for overseas wafer factories are indeed higher than those in TSMC's Taiwanese wafer factories. This is mainly because labor costs at different levels of the supply chain are higher. We continue to work closely with the US government, our customers, and our supply chain partners to manage and reduce cost differences.

Q: Can you provide more information about the equipment shortage you mentioned regarding the 3nm devices? Is it related to lithography, EUV, or other equipment shortages?

A: In fact, its scope is broader because our demand is high, and lithography equipment is included and is one of the most important equipment.

Q: What is the timeline for N2? And compared to N3 and N5, is there more information on the production volume during similar stages?

A: N2 is progressing very well and is slightly ahead of schedule. We plan to start mass production in 2025. So far, our customer engagement is very good and can be compared to N3 and N5. The current situation is very similar to N5 and N3.

Q: TSMC previously mentioned that long-term growth would be between 5% and 10%, and during this period, announced spending of $10 billion to $12 billion. TSMC now mentions that the compound growth rate for the next few years will be between 15% and 20%, which means what kind of range for capital expenditures?

A: When we invest heavily to seize future growth, capital intensity will be high, as it was last year and this year. However, if growth slows down, capital intensity may decrease. In the long run, we believe that a normal and reasonable capital intensity may be around 30%.

Q: The current guidance is about 36 billion, while last time it was close to 40 billion. Half of it is related to equipment delivery, and the other half is production optimization for medium-term demand prospects. Is production optimization mainly reducing equipment, or are there other issues?

A: Half the difference is due to transportation issues. The other half is production optimization, which is due to the uncertainty in the current market environment. Therefore, we are tightening our capital budget. It is related to the entire capacity. It includes equipment, as well as other things in capital expenditures. Yes, and primarily N7, we have made some adjustments to the capacity and capital expenditures for N7 and N6 for the above reasons. Q: The new US regulations are quite lengthy. Are they difficult to interpret? Will they bring larger management costs to TSMC?

A: Although the rules consist of more than 100 pages, based on our initial assessment and feedback from our customers, they are actually quite easy to understand. We will continue to work with our customers to ensure full compliance. As for the second question, I don't think it will have any indirect financial costs.

Q: There may be specific high-end restrictions in supercomputing, but there will also be supporting chips that use other chips. Will this have any negative impact?

A: The company has made efforts to ensure that there are no restrictions or regulations. So we once again ask our customers to work with their own customers to develop those products.

Q: Many countries hope to have domestic semiconductor manufacturing industries. We are increasing and expanding the scope of our global manufacturing. Does higher cost mean higher prices?

A: In fact, TSMC's pricing is strategic and consistent. We will continue to see our own value, which comes from our technology manufacturing and from our relationships with customers, regardless of whether they are in different countries or places.

Q: Customer inventory levels are very high. And demand in the consumer sector is observed to be weak from an industry perspective. What is the future outlook? Will wafer shipments see their first year-over-year decline in many years in the second quarter?

A: Our current forecast is that the supply chain inventory will peak in the third quarter of this year. We observe that inventory will begin to decline in the fourth quarter- the last quarter of this year. We expect to see the greatest impact in the first half of 2023. As for details on the first or second quarter, or similar situations, we are not ready to share because we will continue to work with our customers to understand their needs.

Q: Why did depreciation decline on a quarterly and yearly basis? Would you consider converting N7 capacity to N3 or N5?

A: As for depreciation, for this year, we expect year-over-year growth to be in the single digits, and it will be significantly higher next year. Every year, there is depreciation that enters the depreciation table and there is also depreciation that is deducted from the table. What you see is the end result.

As for converting N7 capacity to N5, as we mentioned earlier, the N7 demand issue is cyclical, not structural. So currently, I don't think we have such a plan.

Q: In terms of inventory adjustments, are there any leading indicators we can refer to?

A: Internally, we have been doing analysis, and at the moment we are taking a very conservative approach to our plans. That's all I can tell you.

Q: Are the production ramp-ups for N3 and N3E at the same time?

A: No, we have added N3, and N3E should be one year apart, but because progress has been smooth, we may delay it by 2 to 3 months, that's all.

Q: During the inventory adjustment period, will there be any changes in pricing strategy? #Keeps The output the same number of newlines as the input text.

Dolphin Analyst's Research on TSMC and the Wafer Manufacturing Industry

TSMC

October 13, 2022 Financial Report Commentaries "TSMC: How Long Can the "Lone Warrior" Last in the Dark?"

July 14, 2022 Telephone Meeting "How can TSMC Continue to Grow in the Semiconductor Downturn? (TSMC Telephone Meeting)"

July 14, 2022 Financial Report Commentary "TSMC: The "Alternative" Backbone in the Cut-down Wave"

April 14, 2022 TSMC Telephone Meeting "2nm on Schedule (TSMC Telephone Meeting)"

April 14, 2022 TSMC Financial Report Commentaries "TSMC: Strong "Belief", Unrelated to Cycles"

April 8, 2022 TSMC Individual Stock Depth "TSMC (Part 2): Faith Not Discounted with Price"

March 16, 2022 TSMC Individual Stock Depth "After the Market Plunge, Let's Talk about the Ashes-level Wafer King TSMC Again"

January 13, 2022 TSMC Telephone Meeting "After Giving Strong Quarterly Guidance, What did the TSMC Management Team Talk About?"

January 13, 2022 TSMC Financial Report Commentaries "TSMC is So Strong, Cycles Take A Detour"

October 14, 2021 TSMC Financial Report Commentaries "TSMC: The Top Dog Leads the Way, Still Dominant"

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June 24, 2022 Semiconductor Industry Overview: "Cutting orders, cutting orders, chopping orders, is the semiconductor industry really going to change?"

September 3, 2021 Wafer Manufacturing Industry Overview: "Performance up, stock price down: should SMIC be "killed" or "mistakenly killed"?"

July 16, 2021 SMIC individual stock in-depth: "SMIC (Part 2): The Undervalued Chinese "Core""

July 9, 2021 SMIC individual stock in-depth: "SMIC (Part 1): On the "Core" Technology of the Leading Company"

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