TSMC Telephone Conference Transcript: Inventory will be adjusted, and growth will wait until the second half of the year

TSM released its fourth quarter 2022 earnings report (as of December 2022) on the afternoon of January 12, 2023 Beijing time, with the following highlights:

Quarterly Report Core Data vs Market Expectations Quick Overview:

1) Revenue: $ TSMC. US Q19.93 billion, -1.5% sequentially, meeting the lower bound of guidance ($19.9-20.7 billion);

2) Gross margin: quarterly gross margin reached 62.2%, +1.8pct month-on-month, exceeding guidance expectations (59.5-61.5%);

3) Business: High performance computing is the largest source of revenue, with 5nm accounting for more than 30%;

4) Next Quarter Guidance: Q1 2023 revenue of $16.7-17.5 billion (below market expectations of $17.9 billion) and gross margin of 53.5-55.5% (in line with market expectations of 55.1%).

Detailed financial report information can refer to Longbridge Dolphin Jun's comment "TSMC's thunder, Buffett can't suppress it".

First, the telephone meeting incremental information collation:

1. Outlook for 2023:

1) Revenue: year-on-year high single-digit decline in the first half of the year, year-on-year growth in the second half;

2) Gross margin: the next quarter is affected by inventory adjustment and exchange rate decline;

3) R&D investment: next year year-on-year increase of 20%, accounting for 8-8.5%;

4) Capital expenditures: $32-36 billion planned, down from $36.3 billion this year, with a 30% increase in depreciation expense for the full year;

5) Industry view: The end market is weak, and the semiconductor market declines by single digits for the whole year of 2023. Inventory adjustments may not be until after the first half of '23;

2, 3nm situation: Originally expected to be mass production in 22Q4, it has been delayed. The Company expects related revenue contributions to begin primarily in 23Q3 with a single-digit contribution for the full year. The N3E will also be mass-produced in the second half of '23. For 2nm, trial production is expected in 2024 and mass production in 2025.

2. The original text of the telephone conference

2.1 Management Statement

1. Outlook for 2023:

(1) As a result of the government's recent amendments to the Industrial Innovation Regulations, the effective tax rate for 2023 and beyond will be approximately 15%.

(2) Gross profit margin:

Our stronger-than-expected gross margin growth in the fourth quarter was primarily driven by more favorable currency and cost-side improvement efforts;

Set the 1Q23 gross margin guidance at 54.5% primarily due to lower capacity utilization and lower exchange rates due to further adjustments to inventory levels by customers.

In 2023, our gross margin faced challenges posed by the cyclical nature of semiconductors. Excluding the impact of exchange rates, we continue to forecast a long-term gross margin of 53% and can achieve higher levels.

(3) R&D expenses:

In 2022, R&D expenses accounted for 7.2% of our net revenue. In 2023, as we increase our focus on technology development and add more resources, we expect R&D expenses to increase by approximately 20% year-over-year and represent 8%-8.5% of our net revenue.

(4) Capital expenditure and depreciation:

We will continue to manage our business prudently and, where appropriate, tighten our capital expenditures. In 2022, we spent $36.3 billion to meet structural needs and support our customers' growth.

By 2023, our capital budget is expected to be between $32 billion and $36 billion, of which approximately 70% will be spent on advanced process technology, approximately 20% on expertise, and about 10% on advanced packaging, mask manufacturing, and more.

Through 2023, our depreciation expense is expected to increase by approximately 30% year-over-year, primarily due to improvements in 3nm technology.

(5) Inventory:

The momentum of the semiconductor inventory correction began to wane in 22H2.

Heading into 2023, we continue to observe weakness in the consumer end market, while other end markets, such as those related to data centers, have also weakened.

We predict that inventories in the semiconductor supply chain will be significantly reduced and rebalanced to a healthier level at 1H23. During this period, we expect our revenue to decline by mid to high single digits compared to the same period last year.

(6) Industry

We expect the semiconductor cycle to bottom out at 1H23 and improve at 2H23. In 2H2023, we expect revenue in USD terms to grow compared to the same period last year.

We forecast that for the full year 2023, the semiconductor market, excluding storage, will decline by approximately 4%, while the foundry market is expected to decline by 3%.

We expect 2023 to be a year of modest sales growth in dollar terms.

2. N7/N6 demand outlook

Demand for 6nm and 7nm is lower than we expected 3 months ago. We expect this to continue in 1H23 and improve in 2H23.

3. N3/N3E progress

3nm has been mass-produced as planned in the fourth quarter of last year. Driven by the HPC and smartphone markets, the market is expected to grow smoothly in 2023.

Significant 3nm process revenue contribution is expected to begin in 3Q23. 3nm will contribute a single-digit percentage of our total wafer revenue in 2023, but 3nm revenue in 2023 is expected to be higher than 5nm revenue in 2012 (first year to market).

3nm Enhanced mass production will take place on 2H23.

4. Global expansion strategy

We are adding capabilities beyond Taiwan to continue to provide our customers with the best solutions they need to succeed.

In the U.S., we are building 2 state-of-the-art semiconductor plants in Arizona. The first plant will start producing 4nm process technology in 2024, and the second plant plans to start producing 3nm process technology in 2026.

In Japan, we are building a plant using 12/16nm, 22/28nm processes and achieving mass production by the end of 2024. If customer needs and government regulations permit, we may also choose to build a second factory in Japan.

In Europe, we plan to build factories to develop automotive-related specialized technologies, based on strong customer demand and government regulations permitting.

In Nanjing, China, we are expanding our 28nm production line to support the local market.

Locally in Taiwan, our 3nm is mass-produced in Tainan Science Park. We are also preparing to start mass production of 2nm in 2025, which will be located in Hsinchu and Taichung Science Parks.

Depending on customer needs and the level of government support, our overseas capacity for sub-28nm processes may reach 20% or more of our total sub-28nm process capacity in 5 years or more. Although the initial cost of overseas business is higher than that of Taiwan, we aim to minimize this cost gap through management.

Even with increased production outside of Taiwan, we still believe that gross margins above 53% and ROE of more than 25% are achievable in the long run.

2.2 Q&A:

Q1: Regarding investment costs, in terms of the 3nm process factories put into production in Taiwan and the United States, what is the main driving force for the gap in cost between the two?

A1: We plan to build two fabs – one to produce 5nm (actually 4nm) and the other to produce 3nm. We can't share with you the exact cost gap between Taiwan and the U.S., but we can share with you that the main cause of the cost gap is the cost of building and facility construction, and U.S. factories can be 4 to 5 times larger than Taiwanese factories. High construction costs include labor costs, permit costs, occupational safety and health costs, regulatory costs, inflation costs in recent years, and personnel and learning curve costs. Therefore, the initial cost of overseas fabs is higher than that of our fab in Taiwan.

Q2: What are the drivers of a 20% increase in R&D expenses?

A2: We are a leader in technology and we intend to continue to do so. Therefore, we invest more and more R&D resources, including personnel and other resources. That's why our R&D expenses will increase in 2023 and possibly even later.

Q3: In terms of tax rate, why has the comprehensive corporate tax rate increased from 11 to 15 without decreasing in the environment of the government's vigorous promotion of tax relief? Is the R&D tax rate likely to remain at current levels or continue to rise?

A3: The thing about taxes in 2023 is that some of Taiwan's tax exemptions or incentives have expired. Our true tax rate is between 18% and 19%. With this new amendment in Taiwan, our tax rate will be reduced to about 15%. From what we've seen so far, we expect the R&D expenses/revenue ratio to be between 8% and 8.5% over the next few years.

Q4: Regarding overseas pricing, given the higher unit cost overseas, will the company choose the overseas price to be higher, or the overall price is the same? What are the benchmarks used for pricing and returns when overseas?

A4: Our pricing is always strategic and consistent to reflect our value, which includes the value of geographic flexibility. In addition to selling our value, we will continue to reduce costs while also leveraging our competitive advantages in high volume, economies of scale and manufacturing technology leadership. With these actions, coupled with government support, we were able to absorb the high costs of our overseas factories and maintain our long-term financial goal of a gross margin of 53% or more.

Q5: What is the outlook for the 7nm process as weaker than expected? Can 5nm and 3nm avoid the cyclical impact of the semiconductor industry in 2023? Does the company have a countermeasure in place?

A5: Most of TSMC's 7nm business needs come from PCs and smartphones, and its inventory happens to be the worst, so the weakness in the end market is more severe than we thought. The cyclical nature of semiconductors is always there, but I think that in 2023 (the impact of cyclicality) is unlikely to repeat itself. Because our current weakness is actually fueled by the pandemic. Due to the pandemic, the process of digital transformation has been intensified, so the demand has increased significantly; But also because of the pandemic, supply chains have disrupted – people may have changed their lives during this time, and the visual manifestation is that people have changed their minds about inventory accumulation. As a result, inventories are accumulated quickly and significantly. This phenomenon is all caused by the pandemic, so we don't think this cyclical will happen again. In the next 5nm, 3nm, I believe that both the company and the customer will be more cautious.

In fact, between the technology nodes 5nm and 3nm, we have accumulated a lot of tools to use these two nodes. In order for the company to have sufficient production capacity, we look at 5nm, 3nm, and maybe 2nm in the future as a whole. We're going to be flexible and make timely adjustments, and that's all I can tell you.

Q6: What are the inventory adjustments in different end market segments in the first half of the year? What is the source of confidence in the rebound in the second half of the year?

A6: The inventory adjustment actually started last year. We think inventory peaked at 3Q22. And gradually decreased at 4Q. Recently, we have also seen some significant inventory reductions continue. That's why we say we're confident that business will rebound in the second half of the year. But is this a very strong V-shape? We don't know yet, but it's certainly not a U-shape for businesses that want to recover in the second half of the year.

As far as we see so far, some HPC customers will launch new products in the second half of the year, especially in the field of artificial intelligence or computing. This supports demand, so we are confident in the market performance in the second half of the year.

Q7: Has capital expenditure peaked today? Or is it likely to reach a higher capex intensity as the company expands overseas?

A7: As we've said before, we're using this year's capital expenditures for growth in the coming years. We also said earlier that we would tighten spending in due course, but we will continue to invest as long as we believe there are growth opportunities. From this year's guidance, capital expenditure growth will exceed 40% this year. From what we can see now, in about five years, we could see capital spending growth of between 35-40%.

Q8: How do you view the relationship between the value of semiconductors themselves and their costs and profits?

A8: Today, we're focusing on valuable technology. Not only the advanced level of the process, in fact, but also the energy efficiency. We also try to help our customers improve system performance with our advanced chiplets – that's where it's valuable. In the future, we want the world to be greener, safer and better. So energy consumption becomes very important. We're still improving system performance, but that's where our customers can get their value. This is how we see the future.

Q9: Are we seeing signs of slowing demand for smartphone SOCs to advanced processes? Are you seeing more companies designing ASICs? Can revenue contributions from these customers be properly disclosed?

A9: We haven't seen any slowdown in customer adoption of TSMC's leading-edge technology. In fact, they may have different product schedules, they may have different product plans, and so on. But in reality, technology adoption hasn't slowed down. This is my answer to your first follow-up question. And whether some hyperscale customers want to develop their own chips - yes, but I can't give you more information. What I can tell you is that they also calculate for their own business, position their opportunities, which is required. TSMC has leading technology, so we do have some hyperscale customers working with us to develop their own chips. And the growth of such a custom design business is unlikely to cannibalize the original business such as CPU and GPU.

Q10: Just mentioned that 3nm will have more than 5nm revenue in the first year, but the median income percentage contribution is smaller or lower, what is the reason behind this? What are our expectations for this growth?

A10: Revenue expectations for advanced processes are less important anymore because our base has become quite large. In fact, we continue to observe high customer engagement at 3nm and 3nm Enhanced. (N3, N3E) more than doubled the number of tapeouts compared to N5 in the first two years, so we expect our demand for 3nm technology, driven by HPCs and smartphones, to continue to be strong in 23, 24, 25 years and beyond. Advanced processes above 3nm will be a significant contributor to our 15%-20% CAGR in the coming years.

Q11: What are your assumptions for the growth of end markets in segments such as smartphones, PCs, and automobiles?

A11: Let's look at the smartphone and HPC space, and we think it's down in the total market and there are more product types. For the company, this actually increases our product portfolio. We are also expanding the segments we have available. That's why we expect the industry as a whole to decline and the company to still run smoothly.

Q12: What is your forecast for the automotive sector? Three months ago we said that car demand remained stable, what is the situation now?

A12: The demand for cars is still huge, and the demand actually continues to grow. Until now, we may not have 100% supplied them with enough wafers. But the situation is improving, and we expect the problem of car shortages to ease quickly. We expect car sales to increase this year.

Q13: As mentioned earlier, the proportion of overseas 28nm or less may reach 20% or more in a few years, will the company consider expanding advanced packaging overseas?

A13: We don't have actual plans today, but we don't rule it out because the backend is part of our customer's entire wafer service.

Q14: What is the company's progress regarding the structure of nanosheet transistors? When the process comes to 2nm, will the structure of the nanosheet transistor be affected?

A14: The development of our technology field is on track and is going more smoothly than we thought. We've been making good progress lately, expecting trial production in 2024 and volume production in 25 years.

Q15: Considering the company's capital expenditure this year and last year, what is the percentage of capital expenditure of infrastructure built by overseas production?

A15: We don't provide a percentage of facility construction and capital expenditure, but as I said, the cost of building and building facilities in the U.S. can be 5 times that of Taiwan, and that will continue for a few years.

Q16: Can you talk about the company's growth in advanced packaging in 2022 and its projected growth in 2023? Can you talk about the company's IC products and is customer interest in them accelerating?

A16: In 2022, our advanced packaging is growing at a rate similar to our company's estimates. It accounts for about 7% of our total revenue. In our view, growth this year will be similar, slightly below the overall growth rate and overall flat.

Q17: Regarding the approximately 20% year-on-year increase in R&D expenses mentioned earlier, what is the source of this growth driver?

A17: All your comments are correct. Because this is a newer technology, and a lot of new things are more expensive than before. The complexity of technology continues to grow exponentially. That's why we spend more on these budgets. We want to continue to be number one in the world, so we want to continue to invest – including advanced processes, including new transistor structures, including design support, including buying new equipment.

Q18: Do companies see a slowdown in the analog mixed-signal space in specific process development and expansion to more advanced nodes?

A18: Yes, there is little need to expand to 7nm or more advanced processes in this area. But as the needs evolve, computing capabilities need to be added to products, such as WiFi or RF, and their next-generation products require very fast and high-performance computing, while also meeting low-power performance requirements, which will require 7nm processes and even more advanced processes.

Q19: After the company has established factories overseas, what measures have been taken to continuously ensure the stability of the supply chain?

A19: TSMC's business model is service-oriented, not only simple production, service depends on the trust of customers. In the past, customer trust depended on TSMC's leading technology, manufacturing, low cost and quality, but the recent geopolitical evolution has made it impossible for us to meet the needs of our customers in a single factory, so the company began to build factories globally.

Although the cost of building a factory overseas will be higher, we have been focusing on maintaining the company's gross margin of 53% and above. Building a factory globally increases the value customers receive, because they also bear some of the added costs in terms of pricing. We are also trying to reduce costs, and the local government is helping us.

Q20: What is the company's plan for mature processes? Will mature processes be extended overseas? How are mature processes developing in China? How much of R&D spending will go to mature processes?

A20: The company does not produce "commercial" mature process technology, but will continue to develop special processes and differentiated mature process technologies that meet customer needs, and will also invest R&D expenses in this part of mature processes.

Q21:4Q22 How to understand the cost problem of the company's wafer shipment volume decreased month-on-month but gross margin increased month-on-month?

A21: As mentioned earlier, the gross margin in 4Q22 was 1.8% higher than in 22Q3, partly because the exchange rate movement was favorable to the company, giving the company about 1.4% gross margin improvement, and the rest was cost improvement, which was mostly offset by lower capacity utilization.