Inventory will continue to adjust for the next six months, with growth expected in the second half of the year (TSMC 22Q4 conference call).

TSMC announced its Q4 2022 earnings report (as of December 2022, UTC+8) before the Dolphin US stock market on January 12, 2023. The highlights are as follows:

Quick look at Quarterly Core Data vs Market Expectations:

1. Revenue: TSMC.US achieved 19.93 billion US dollars during the quarter, a QoQ decrease of 1.5%, reaching the lower limit of the guided expectation (19.9-20.7 billion US dollars);

2. Gross margin: The quarterly gross margin reached 62.2%, a QoQ increase of 1.8pct, exceeding the guided expectation (59.5-61.5%);

3. Business situation: High-performance computing became the largest source of income, with 5nm chips accounting for more than 30%;

4. Guidance for next quarter: Q1 2023 revenue is expected to be between 16.7-17.5 billion US dollars (lower than the market expectation of 17.9 billion US dollars) and gross margin is expected to be between 53.5-55.5% (consistent with the market expectation of 55.1%).

For detailed financial information, please refer to the Dolphin Analyst's review: "TSMC's Thunder, Buffett's increase cannot suppress it".

I. Summary of Phone Conference Incremental Information:

1. 2023 outlook:

i) Revenue aspect: YoY slight decline in the first half of the year and YoY growth in the second half of the year;

ii) Gross margin: Affected by inventory adjustments and currency depreciation in the next quarter;

iii) R&D investment: YoY growth of 20% next year, accounting for 8-8.5%;

iv) Capital expenditure: Planned at 32-36 billion US dollars, lower than this year's 36.3 billion US dollars. Depreciation expenses will increase by 30% for the year;

v) Industry view: Terminal market weakness, the semiconductor market will decline by a single digit in 2023. Inventory adjustments may happen after the first half of 2023.

1. Situation of 3nm:

N3 has delay in volume production which was expected to start from 22Q4. The company expects that related income contribution will start mainly from 23Q3, with a single-digit contribution for the full year. N3E will also start volume production in the second half of 2023. For 2nm chips, it is expected to start trial production in 2024 and mass production in 2025.

II. Phone Conference Transcript:

2.1 Management's comments

I. 2023 outlook:

i) Affected by the recent passage of the amendment to the Industrial Innovation Act by the government, the actual tax rate from 2023 onwards will be approximately 15%.

ii) Gross margin:

The higher-than-expected growth in gross margin in Q4 was mainly due to more favorable exchange rates and improvement efforts on the cost side;

The reason for setting the Q1 23 gross margin guidance at 54.5% is mainly due to lower capacity utilization and currency depreciation caused by further customer inventory adjustment. 2023, our gross margin is facing challenges from the cyclical nature of the semiconductor industry. Excluding the impact of exchange rates, we continue to forecast a long-term gross margin of 53% that can be achieved at even higher levels.

(3) Research and development expenses:

In 2022, our R&D expenses accounted for 7.2% of our net income. By 2023, with increased focus on technological development and allocation of more resources, we expect our R&D expenses to increase by about 20% YoY and account for 8-8.5% of our net income.

(4) Capital expenditure and depreciation:

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

By 2023, we estimate our capital budget to be between $32 billion and $36 billion, of which about 70% will be allocated to advanced process technology, about 20% will be allocated to professional technology, and about 10% will be allocated to advanced packaging, mask manufacturing, etc.

By 2023, we expect our depreciation expenses to increase by about 30% YoY primarily due to the improvement in 3nm technology.

(5) Inventory:

The correction in semiconductor inventory began to weaken in 22H2.

Entering 2023, we continue to observe weakness in the consumer terminal market, while other terminal markets such as data center-related markets have also weakened.

We predict that the inventory of the semiconductor supply chain will decrease significantly in 1H23 and rebalance to a healthier level. During this period, we expect our revenue to decline by mid-to-high single digits YoY.

(6) Industry:

We expect the semiconductor industry cycle to bottom out in 1H23 and improve in 2H23. In 2H2023, we expect dollar-denominated revenue to increase compared to the same period last year.

We predict that in 2023, the semiconductor market, excluding storage, will decline by about 4%, and the foundry market is expected to decline by 3%.

We expect 2023 to be a year of slight growth in dollar-denominated sales.

2. N7/N6 Demand Outlook

Demand for 6nm and 7nm is lower than our forecast from three months ago. We expect this situation to continue in 1H23 and improve in 2H23.

3. N3/N3E Progress

3nm production was completed as planned in Q4 of last year. With the promotion of the HPC and smartphone markets, the market is expected to grow smoothly in 2023.

Significant revenue contribution from the 3nm process is expected to begin in 3Q23. 3nm is expected to contribute a single-digit percentage of our total wafer revenue in 2023, but 2023 revenue is expected to be higher than 2012 revenue for 5nm (its first year in the market). 3nm Enhanced mass production will take place in 2H23.

4. Global expansion strategy

We are increasing our capabilities beyond Taiwan to continue providing our customers with the best solutions for their success.

In the United States, we are building two advanced semiconductor factories in Arizona. The first factory is slated to produce 4nm process technology in 2024, while the second factory is planned to produce 3nm process technology starting in 2026.

In Japan, we are establishing a factory using 12/16nm and 22/28nm processes, with mass production set to begin at the end of 2024. If customer demand and government regulatory supervision permit, we may also choose to build a second factory in Japan.

In Europe, we plan to build factories to develop specialized technology for the automotive industry based on strong customer demand and government regulatory supervision.

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

Locally in Taiwan, we have achieved mass production of 3nm in Tainan Science Park. We are also preparing to start mass production of 2nm in 2025, located in the Hsinchu and Taichung Science Parks.

Depending on customer demand and government support levels, our overseas production capacity of processes below 28nm may achieve 20% or more of our total production capacity of processes below 28nm in five years or more. Although the initial cost of overseas business is higher than that of Taiwan, our goal is to minimize this cost differential through management.

Even with increasing production beyond Taiwan, we still believe that a gross profit margin of over 53% and a net asset return of over 25% are achievable in the long term.

2.2 Q&A:

Q1: Regarding investment costs, what drives the cost difference between the factories producing 3nm process technology in Taiwan and in the US?

A1: We plan to build two fabs—one to produce 5nm (actually 4nm) and the other to produce 3nm. We cannot share with you the exact cost differential between Taiwan and the US, but what we can share with you is that the main reason for the cost differential is the construction and facility construction costs, with the US factory possibly being 4 to 5 times the cost of the Taiwan factory. High construction costs include labor costs, license costs, occupational safety and health costs, regulatory costs, recent inflation costs, and personnel and learning curve costs. Therefore, the initial cost of overseas fabs is higher than that of our fabs in Taiwan.

Q2: What are the driving factors of the 20% increase in R&D expenses?

A2: We are leaders in technology and intend to continue to maintain our leadership position. Therefore, we are investing more and more resources in R&D, including personnel and other resources. That's why our R&D expenses will increase in 2023 and may continue to increase in the future. Q3: On tax rates, why has the company's comprehensive tax rate risen from 11 to 15 despite the government's push for tax reduction? Will the tax rate during the R&D period remain at the current level or continue to rise?

A3: Regarding the issue of tax in 2023, some of Taiwan's tax exemptions or incentives have expired. Our actual tax rate is between 18% and 19%. With this new amendment in Taiwan, our tax rate will be reduced to around 15%. Based on what we currently see, we expect the R&D expense to income ratio over the next few years to be between 8% and 8.5%.

Q4: Regarding the issue of overseas pricing, given that there are higher unit costs overseas, will the company choose higher overseas prices or a uniform price for the whole product? What is the benchmark and return situation for pricing overseas?

A4: Our pricing always has strategic and consistent values that reflect our value, including the value of geographical flexibility. In addition to selling our value, we will continue to reduce costs while also using our competitive advantages of large volume, economies of scale, and leading manufacturing technology. With these actions and government support, we can absorb the high cost of overseas factories and maintain our long-term financial goal, a gross margin of 53% or even higher.

Q5: Demand for the 7nm process is weaker than expected. How do you view its prospects? Can the 5nm and 3nm processes avoid the cyclic impact of the semiconductor industry in 2023? Does the company have corresponding countermeasures?

A5: Most of TSMC's 7nm business demand comes from personal computers and smartphones, and its inventory happens to be the most severe. Therefore, the weakness in the terminal market is worse than we imagined. The cyclical nature of semiconductors always exists, but I think it is unlikely to replay the cyclic impact in 2023. The current weakness is actually exacerbated by the epidemic. Due to the COVID-19 pandemic, the process of digital transformation has been strengthened, resulting in a significant increase in demand. However, at the same time, the supply chain was interrupted, and people may have changed their thoughts on inventory accumulation during this time. Therefore, inventory has accumulated rapidly and significantly. This phenomenon is caused by the epidemic, so we believe that this cyclic effect is unlikely to happen again. In the next 5nm and 3nm processes, I believe that the company and customers will be more cautious.

In fact, we have accumulated a lot of tools that can be used between the 5nm and 3nm processes. In order for the company to have sufficient production capacity, we will treat 5nm, 3nm, and perhaps 2nm in the future as a whole. We will remain flexible and make timely adjustments, that's all I can tell you.

Q6: What is the inventory adjustment situation for different segmented terminal markets in the first half of the year? What is the source of confidence in the rebound in the second half of the year?

A6: Inventory adjustments actually started last year. We believe that inventory peaked in 3Q22. And gradually declined in 4Q. Recently, we have also seen trends of significant inventory reduction that are continuing. This is 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 definitely not a U-shape for businesses that want to recover in the second half of the year.

From what we've seen so far, some of HPC's customers will launch new products in the second half of the year, especially in the field of Artificial Intelligence or computing. This provides support for demand, so we're confident in the market's performance in the second half of the year.

Q7: Have capital expenditures peaked already? Or will they reach even higher levels with the expansion of overseas business?

A7: As we've said before, we've used this year's capital spending for future growth over the next few years. We've also said earlier that we will tighten spending at the appropriate time, but as long as we believe there are growth opportunities, we will continue to invest. Based on this year's guidance, the growth rate of capital expenditures will exceed 40%. From what we can see now, after about five years, we may see capital expenditure growth rate between 35-40%.

Q8: How do you view the value of semiconductors and their relationship with cost and profit?

A8: Today, we focus on valuable technology. Not only on process advancement, but actually, more importantly, on energy consumption efficiency. We're also trying to help our customers improve system performance with our advanced chiplets - that's where it's valuable. In the future, we hope for a more environmentally friendly, safer, and better world. So energy consumption has become very important. We're still improving system performance, but that's where our customers can obtain value. That's our view of the future.

Q9: Are we seeing signs of a slowdown in demand for advanced processes for smartphone SOCs? Are we seeing more companies designing ASIC? Can we accurately disclose revenue contributions from these customers?

A9: We haven't seen any deceleration in customer adoption of TSMC's cutting-edge technology. In fact, they may have different product schedules, they may have different product plans, and so on. But in fact, the adoption of technology has not slowed down. This is the answer to your first follow-up question. And whether some of the super-large-scale 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 themselves for their opportunities, and it's necessary to do so. TSMC has leading technology, so we do have some super-large-scale customers working with us to develop their own chips. And the growth of such customized design business is unlikely to eat into existing businesses such as CPU, GPU.

Q10: It was just mentioned that revenue in the first year of 3nm would exceed 5nm, but the median percentage contribution of revenue is smaller or lower. What is the reason behind this? What are our expectations for this growth?

A10: The percentage of revenue from advanced processes is less important now because our base is quite large. In fact, we continue to observe high participation from customers in N3 and N3E and the number of wafers produced in the first two years of N3 and N3E has more than doubled compared to N5. Therefore, we expect in 23, 24, 25 and beyond Our demand for 3nm technology, driven by HPC and smartphones, will continue to be strong. Advanced processes above 3nm will be an important contributor to our 15%-20% CAGR over the next few years.

Q11: What assumptions do you have about the growth of end markets in sectors such as smart phones, personal computers, and cars?

A11: Let’s look at the smartphone and HPC markets. We believe that there is a decline in the overall market size and more types of products available. For the company, this actually increases our product portfolio. We are also expanding the available submarkets. This is why we expect the entire industry to decline, but the company still operates smoothly.

Q12: What is your forecast for the automotive sector? We said three months ago that demand for automobiles remains stable, how is the situation now?

A12: There is still a large demand for cars, and demand is actually continuing to grow. So far, we may not have provided them with enough wafers. But the situation is improving, and we expect the problem of car shortages to be quickly resolved. We expect car sales to increase this year.

Q13: It was previously mentioned that the proportion of overseas 28nm and below may reach 20% or more within a few years. Will the company consider expanding advanced packaging overseas?

A13: We don't have any actual plans right now, but we don't rule out the possibility because the backend is part of our customers’ entire wafer services.

Q14: How is the company progressing with the structure of nano-sheet transistors? When the process comes to 2nm, will the structure of nano-sheet transistors be affected?

A14: The development of our technology field is on track and smoother than we imagined. We have recently made good progress and are expected to start production trials in 2024 and mass production in 2025.

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

A15: We do not provide the percentage of facility and capital expenditures, but as I mentioned before, the cost of building and facility construction in the United States may be five times that of Taiwan, and this situation will continue for several years.

Q16: Can you talk about the growth the company achieved in advanced packaging in 2022 and the expected growth in 2023? Can you talk about the company's IC products, and whether the interest of customers in these products is accelerating?

A16: In 2022, our advanced packaging grew at a pace similar to our company's estimates. It accounts for about 7% of our total revenue. We believe that this year's growth will also be similar, with an overall flat trend slightly lower than the overall growth rate.

Q17: About the previously mentioned YoY growth of approximately 20% in R&D expenses, what is driving this growth?

A17: All of your comments are correct. Because this is a newer technology, and many new things are more expensive than before. The complexity of the technology continues to grow exponentially. That's why we spend more on these budgets. We hope to continue to be the world's number one, so we need to continue to invest – including advanced processes, including new transistor structures, including design support, and including purchasing new equipment. Q18: Does the company see a slowdown in the development of simulation mixed-signal field in specific processes and expansion to more advanced nodes?

A18: Yes, this field basically doesn't need to be expanded to the 7nm or more advanced process. However, with the development of demand, computational functions need to be added to products, such as WiFi or RF, and their next-generation products require very fast speed and high-performance computing, while also meeting low-power performance requirements, which will require the 7nm process or even more advanced processes.

Q19: After the company established factories overseas, what measures were taken to ensure the stability of the supply chain?

A19: TSMC's business model is service-oriented, which is not just simple production. Services rely on customer trust. In the past, customer trust depended on TSMC's leading technology, manufacturing, low cost, and quality. However, recent geopolitical developments have made our single factory location unable to meet customer needs. Therefore, the company has started global factory-building.

Although the cost of overseas factory-building will be higher, we have always focused on keeping the company's gross margin at 53% or above. Global factory-building increases the value customers receive, as they also bear some of the cost increases in pricing. We are also working hard to reduce costs, and local governments are helping us.

Q20: What is the company's plan for mature processes? Will mature processes be expanded overseas? How is the development of mature processes in China? How much of R&D expenses will be invested in mature processes?

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

Q21: In 4Q22, the wafer shipments of the company decreased on a month-on-month basis, but gross margin increased on a month-on-month basis. How should the cost issue be understood?

A21: As mentioned earlier, the gross margin of 4Q22 was 1.8% higher than 22Q3, partly because changes in exchange rates were favorable to the company, giving the company about 1.4% gross margin improvement, and the rest was cost improvement, but this part was mostly offset by lower capacity utilization.

Dolphin Analyst's Research on TSMC and Wafer Manufacturing Industry

TSMC

January 12, 2023, financial report review: "TSMC's Thunder, even Buffett's enlarged position can't suppress it"

October 13, 2022, TSMC conference call: "Even with an impressive financial report, TSMC cannot avoid industry decline (third quarter conference call)"

October 13, 2022, financial report review: "TSMC: How long can the 'lone hero' survive in the dark?" 2022 July 14 TSMC Telephone Conference "How can TSMC continue to grow when the semiconductor cycle is down? (TSMC Telephone Conference)"

2022 July 14 TSMC financial report review "TSMC: A "different" backbone in the midst of a wave of order cuts"

2022 April 14 TSMC Telephone Conference "2nm is on schedule (TSMC Telephone Conference)"

2022 April 14 TSMC financial report review "TSMC: Strong "faith," independent of the cycle"

2022 April 8 TSMC stock in-depth report "TSMC (2): Price discounts, no compromise in faith"

2022 March 16 TSMC stock in-depth report "After the market crash, let's talk about the bone-ash grade foundry king TSMC again"

2022 January 13 TSMC Telephone Conference "After providing strong guidance for the quarter, what did the TSMC management discuss?"

2022 January 13 TSMC financial report review "TSMC is too strong in the face of "cycles," opting for a detour"

2021 October 14 TSMC financial report review "TSMC: The leader takes the lead, the limelight still shines"

Semiconductor/Wafer Manufacturing Industry

2022 December 29 Semiconductor industry overview "Semiconductor avalanche? Only after the most severe downturn can true resilience be achieved"

2022 June 24 Semiconductor industry overview "Order cuts, order cuts, order cuts, is the semiconductor industry really going to "change"?" On September 3, 2021, the Semiconductor Manufacturing Industry Overview: "Performance Upward vs. Stock Price Downward: Are SMICs 'To Be Killed' or 'Wrongly Killed'?" was released.

On July 16, 2021, a detailed analysis of the SMIC individual stock was conducted: "SMIC (Part II): The Undervalued Chinese 'Core'."

On July 9, 2021, a detailed analysis of the SMIC individual stock was conducted: "SMIC (Part I): On the Leading Attack Strategy for 'Core'."

Risk Disclosure and Statement in this article: Dolphin analysts' Disclaimer and General Disclosure