TSMC Responds To Intel (NYSE:TSM)

Investment Thesis

Due to the rise in revenue and even stronger rise in EPS in 2022, combined with the stock pullback, Taiwan Semiconductor Manufacturing Company Limited’s (NYSE:TSM) (“TSMC”) valuation has declined to more investible levels.

However, in the near term, this will be offset by a decline in profitability in 2023, driven by a ramp in depreciation and R&D spending. Although the valuation is still manageable at around 16x forward P/E, given these dynamics and the strong rally in the last few months, there is no need to rush into the stock. Nevertheless, it is definitely still a sound investment for the medium term, as it seems investors are being perhaps a bit overly conservative about the long-term semiconductor outlook due to the current downturn. However, the long-term outlook remains more cloudy given the ongoing changes in competitive environment.

Background

I have covered TSMC a few times in the last year. Although it is the majority market share leader in the foundry business (outsourced semiconductor manufacturing), it is facing increased competition from newcomer Intel Corporation (INTC), which is also vying to reclaim the technology leadership TSMC took from it in 2018.

• In December, I noted how TSMC’s U.S. (trailing edge) fab strategy was uncompetitive: TSMC: Taking A Page From The Intel Playbook.
• In October, I noted that TSMC had vindicated my 2020-21 thesis of its N3 node being delayed, resulting in a 2.75-year cadence. As confirmation of this, TSMC announced N3 production in the very last few days of 2022, despite comments in 2021 that it had actually intended to go into production in July or August: Taiwan Semiconductor: No 3nm Soon.
• Nevertheless, after declining from its 2021 ~$120 level in 2021 to ~80, in July I called TSMC a buy on both near- to mid-term growth, although the stock seems to have bottomed around ~$60: Buy Taiwan Semiconductor Stock: Too Oversold.
• Earlier in 2022, I provided an update on my expectations with regards to process technology leadership, as by that time TSMC had provided information about its N2 timeline (going into production in Q4 2025) as well as density target (“>1.1x”). The conclusion was that TSMC was moving about as slow as Intel during its 3-year 10nm delay: TSMC Stock’s Process Leadership Under Threat Vs. Intel.

Despite weak H2 results by many major semiconductor companies such as Intel, Advanced Micro Devices (AMD) and Nvidia (NVDA), it seems there are still pockets of strength, as TSMC delivered 27% revenue growth to $20B. Advanced process technologies, which are 7nm and 5nm (and their derivatives) accounted for 54% of revenue in Q4.

Nevertheless, it marked a deceleration from prior quarters, as revenue declined by 1.5% QoQ. Full-year revenue was 33.5% in U.S. dollars, while EPS increased by 70% due to higher leverage.

Despite the strong results, TSMC has adjusted its expectations downwards during the year. Initially, capex of up to $44B was expected, but instead TSMC ended the year with $36B capex (although still up by up to 3x from pre-pandemic capex levels). For 2023, there will be another reduction, with guidance for $32-36B.

Guidance

Q1 revenue of up to $17.5B is expected, marking a 14% QoQ decline at the midpoint, and resulting in low single-digit growth at best (and a small decline at worst). It would also end TSMC’s double-digit growth streak since Q3’19.

Gross and operating margins are still expected to be robust in the mid 50s and low 40s respectively. This would still be above pre-pandemic levels, but down from the recent highs, including the all-time high gross margin of 62% and operating margin of 52% in Q4.

For 2023, TSMC expects to slightly outperform the semiconductor industry, which is expected to decline 4%, and expects low growth. However, profitability is likely to decline as depreciation is expected to increase by 30% due to the ramp of N3.

Responding to Intel

One of the most notable items from the Q4 earnings report was the announcement that TSMC would step up its hiring and R&D investments. In 2022, R&D accounted for 7% of revenue or $5.5B. For 2023, TSMC expects a 20% increase, which implies $6.6B spending. Since TSMC is not expecting much growth in 2023, spending would increase to up to 8.5% of revenue.

I mean that is because of a newer technology like N2, N1.4 and also a lot of new teams are more expensive than before. And actually, the technology complexity continued to increase exponentially. So, that’s why we spend much more R&D budget. We want to continue to be number one in the world. So, we continue to invest including the geometric shrinkage, including the new transistor architecture, including the design enablement and including buying the new equipment that all is.

With this action, TSMC is following in the footsteps of Intel, which has hired over 20k net new employees across the full business and has increased its R&D spending by over $4B. Although Intel is taking actions to reduce its spending in the wake of the downturn that started mid-Q2’22, Intel said it would not reduce its investments in process technology, which it said it has increased by over $1.5B.

Overall, Intel has maintained it would reclaim process leadership (at least in terms of performance per watt, but most likely also density) with 18A in 2025, whereas TSMC’s N2 (which likely will be behind 18A in terms of technology) is not expected to reach the market until 2026. So clearly, TSMC has seen that it is necessary to not just invest in fabs (given the enormous capex spending in the last few years), but also technology.

Investor Takeaway

Due to the rising depreciation in 2023 in combination with low to no growth, EPS is expected to decline from 2022. Nevertheless, TSMC still expects to continue its 15 to 20% growth target in the long-term.

In terms of valuation, TSMC had been valued at around 30x TTM P/E during 2021, but due to the growth in 2022 and the declining share price, the valuation has compressed to a low double-digit P/E. However, given the expected EPS decline in 2023, the forward valuation is a bit higher at around 16x.

Overall, this TSMC valuation is reasonable and investible given the expected long-term growth in semiconductors, which will benefit TSMC as the prime foundry. For example, the valuation is over 2x cheaper than ASML Holding N.V. (ASML). Still, the investment is not risk-free, given previously discussed ongoing changes in the competitive environment given the resurgence of Intel in technology competitiveness, which it is using to build its own foundry business. On the other hand, it takes time build a foundry business, so as has been my thesis, these developments are going to play out in the back half of the decade at best.

More subjectively, given the strong rally since early November and the small growth expected for the next few quarters, there could be a pullback in TSMC shares, although it is not necessarily guaranteed that the stock will go back to its recent lows given that its valuation had been approaching bargain basement levels at those prices. This was likely driven by pessimism regarding the semiconductor downturn, which may improve as a recovery is expected in the second half of the year (although the reverse may also happen if this recovery does not, or does not fully, materialize).