Taiwan Semiconductor Manufacturing Company

Q4 22’ SUMMARY

TSMC delivered revenue that slightly missed management’s guidance and consensus estimates as industry wide inventory rebalancing and conservatism suppressed growth. The business delivered earnings that exceeded guidance and estimates as a result of management’s efficient leadership. This performance is in stark contrast to many other players in the semi industry as TSMC has a unique position in the foundry segment of the massive industry, which insulates the company from shocks across the industry.

In Q4, TSMC continued to demonstrate that the business model of driving growth from launching nextgen products is still as power as ever. TSMC is one of the few businesses that actually plan to make its own products obsolete. The business can do this by developing and launching products with unrivaled technology, which makes customers migrate to these products at the expense of older technologies. This is lucrative as it keeps customers on a steady upgrade cycle at higher price points.

While the semi industry is experiencing volatility driven by imbalanced supply & demand, the overall TAM remains massive. This is not going to change as the global economy literally depends on the semi industry, which we witnessed during the pandemic. In TSMC’s case, the business will win as the semi industry wins as TSMC has no real competition at the higher end of the technology spectrum. As a result, TSMC continues to expand capacity through massive CapEx investments, which positions the business to maintain product leadership and rapid release of nextgen products.

Key Takeaways from Q34 22’

Key Takeaway 1- balanced technology growth

• TSMC continues to ramp the 5nm products at a rapid rate.

• Demand for the 7nm products moderated due to industry headwinds and 5nm ramping.

• Demand for 28nm products continued to demonstrate strength.

• Demand for legacy technologies (larger than 28nm) continues to demonstrate strength.

Key Takeaway 2- end market cross currents

• The High Performance Computing end market demonstrate material strength despite end consumption volatility.

• The Smartphone end market was strong; however, trends are not as strong as the average market served.

• The Automotive and “Other” end markets demonstrated immense strength as supply availability has materially improved.

KEY TAKEAWAY 3- MASSIVE SEMICONDUCTOR TAM

• Data center CapEx, gaming spend, and embedded devices are projected to expand in 23’ and beyond.

• PC shipments are projected to pullback in 23’ followed by a return to growth in 24’.

• Market research firms expect cross-currents to persist into 23’, which is expected to be characterized by high variability in growth between end-markets.

GROWTH TRENDS

growth Factor 1- technology portfolio strength

In Q3, TSMC drove material growth from both advanced technologies as well as legacy technologies. The advanced technologies are the products with smaller chip sizes while the legacy technologies are products with larger chip sizes. The advanced technologies are designed to optimize power, performance, and efficiency in smaller devices such as computers and smartphones. The legacy technologies are designed to optimize power, performance, and efficiency as well; however, the legacy technologies are used in applications that do not require the size constraints of smaller products. These larger chips are in a range of devices from cars to microwaves.

TSMC’s growth in advanced technologies comes at higher sales prices as these products are at the cutting edge of technology on a global basis. The growth in legacy technologies is driven by the specialty nature of these products combined with recoveries in the end markets served as much capacity went to the smaller form factor products used in smartphone and computers. TSMC’s position in the semi industry is firmly held due to the business innovative design and manufacturing capabilities, which are supported by continuous R&D and CapEx spending.

• Advanced technologies (5nm and 7nm) represented 54% of revenues in Q4.

• In Q4, 5nm continued to ramp as HPC and smartphone end markets ramped integration of this leading technology to make their own products more competitive.

• In Q4, 7nm products experienced moderate growth as these products were most affected by inventory adjustments and conservatism.

• TSMC is preparing to launch 2nm and 3nm products that have much greater performance, power, and yield than the current offerings.

• 3nm products have already been used by early adopter and the business is expecting scaling to occur in 2H 23’.

• Inventory adjustments are expected to occur through 1H 23’, which will be followed by a return to strong growth.

• Specialty products were also affected by inventory adjustments and conservatism.

growth Factor 2- balanced end market demand

TSMC’s business model of monetizing megatrends across many end markets continued to position the business to take share in Q4. While there are noted headwinds in the smartphone and HPC end markets, TSMC continued to drive growth in every market except the DCE market. This outperformance is driven by the unique utility that TSMC’s customers capture through the business’ products. TSMC’s high performance products help their customers win business over their respective competitors. Additionally, tech companies need to continuously release improved products, which drives business for TSMC as the business is the supplier of chips needed in the improved products. In reality, these customers are only able to make improvements because TSMC has made advances in chip technology. While the business is not fully insulated from activity in the aggregate end markets, playing in the cutting edge of the market provides optimal insulation.

growth Factor 3- geographic cross currents

TSMC is a massive global business with customers that span the globe. This comes with material advantages beyond expansion of TAM. An additional advantage is diversification from market-specific volatility, which was the case in Q4. In the quarter, growth was driven by material strength in the North America, Japan, EMEA, and China markets. Unlike previous periods, trends were weak in the APAC region, which was not touched upon by management. Interestingly, the Japan and EMEA markets generated immense demand after several periods of moderate demand. Also, the business saw strong performance in the China market after several periods of contraction. Given that the data creation, sharing, and storage megatrends are a global phenomenon, TSMC is well position to continue capturing share from customers across the globe.

OPERATIONAL EFFICIENCIES

TSMC generated immense operating leverage in Q4 driven by continued efficiencies and economies of scale. The business drove significant margin expansion, which caused earnings to grow much faster than revenue. This has become a trend for TSMC as the business model is based on driving growth from higher value products while keeping expenses in check, which leads to material earnings growth. In Q4, the business continued to driver higher average selling prices, which caused gross margins to materially expand. These gains were strong enough to offset the headwinds from reduced utilization resulting from slightly lower wafer shipments.

In the quarter, gross margins expanded 1,000bps as the business realized higher product margins on 5nm products along with efficiencies in the manufacturing process. TSMC’s management is a great example of driving efficiencies from executing on compelling strategies designed many years ago. Additionally, the unique market positioning of the business creates a need for the business’ products, which gives pricing power to TSMC. While the business does not price gouge customers, it does “hold the line” on pricing in deflationary environments. This is especially the case as the business’ products enable customer to gain market share at higher price points.

INDUSTRY TAILWINDS

The semi-conductor industry experienced a massive boom in 20’ and 21’ that has continued in 22’. This abnormal activity created massive forecasting problems for end-market purchasers, which led to supply build-ups that now exceed the level needed to meet present demand. As a result, inventory corrective actions are being taken in many end-markets such as PC’s, gaming, and even within the data center.

Even still, the semi-conductor CAGR remains well above pre-pandemic levels. Importantly, near-term headwinds are unable to outlast the megatrends that underpin the semi-conductor industry’s critical role in the global economy. These megatrends are all shaped in some way by the massive explosion in data creation, storing, sharing, and consumption. Semi-conductors are needed to facilitate these activities, which creates a powerful flywheel that drives semi-conductors long-term growth. Lastly, leading players are positioned to continue taking share from lagging players as the business that delivers innovation will win much more share than those that fall behind.

• Frost and Sullivan is forecasting data center spend (CapEx) to increase 17% in 22’ followed by compounding growth of ~10% through 26’.

• Frost and Sullivan is forecasting hyperscale growth to drive most of the data center spend.

• Statista is forecasting that network and online gaming users will decrease in the low single digits in 22’ followed by a material return to growth in 23’.

• Statista is forecasting that gaming spend will decrease less than usage followed by a much stronger return to growth in 23’.

• Gartner is forecasting that PC shipments have decreased -15% in Q3 22’. The market research firm is forecasting shipments to fall -1% in 23’ followed by a 4% increase in 24’.

• Gartner is forecasting all of the end-market demand to translate to a 7% increase in 22’ followed by a modest pullback in 23’, which is forecasted to increase over 7% each year from 24’ to 26’.

FORECAST AND VALUATION

TSMC is arguably the best positioned business in the semiconductor industry as a result of the company’s powerful business model. TSMC is essentially the manufacturing arm of the world’s best performing semiconductor businesses, which is the result of many billions in CapEx investments over many decades. TSMC is uniquely positioned to drive their own revenue growth by delivering continuous innovation in the form of chips designed at the cutting edge of performance. While the industry is dealing with an inventory rebalancing driven by massive demand during the pandemic and widespread spending conservatism, TSMC is positioned to continue driving growth from the business’ broad end market placement along with launching nextgen chips, such as 2nm, 3nm, and 5nm.

While many end customers are rebalancing inventory, these customers do not have products that incorporate TSMC’s nextgen chips. As a result, the inventory that needs to be reduced does not consist of products with the nextgen chips. Electronics business still have to compete with each other and performance enabled by high power chips enable these businesses to take share. This dynamic is even more important in a lower growth environment as there are fewer dollars of incremental growth to win. While 23’ is likely to be a year of continued contraction across the industry, TSMC is positioned to outperform the industry as the business maintains its 15%-20% CAGR target over the next several years. This is likely to translate into moderate growth in 23’ as the cross currents of 1H 23 and 2H 23 net a growth rate of ~6%; however, momentum is likely to continue into 24’ thus leading to reacceleration of growth.

Overall, the business is well positioned in the foundry segment of the semiconductor industry, which means the business is supported by customer who need to plan well in advance of actually utilizing the products. While there is significant conservatism and rebalancing taking place, these dynamics are expected to shift in 2H 23 as the contraction peaked in 2H 22. Additionally, TSMC is working to make specialty products out of the 7nm advanced technology chips, which can create an additional wave of demand for these products. TSMC is also well positioned from the continued ramping of the 5nm product type, which still has material scale before reaching maturity.

TSMC is one of the most profitable companies on the entire stock market driven by the business’ high value products combined with immense operational efficiencies. The cost structure is highly unlikely to change any time soon as the business has worked hard to design and implement strong economies of scale. While there will be some contraction in 1H 23 driven by the net effect of inventory rebalancing, profitability is expected to return to record levels in 2H 23 as revenue growth returns. This supports a material valuation reset as the stock market negativity continues shifting in 23’. The stocks recent sharp increase is early evidence that the valuation reset is already underway. Overall, the stock is trading at a steep discount from historical averages despite the business’ material revenue growth and margin expansion over the last several years.