Taiwan Semiconductor: Not Immune To Industry Weakness, But Still A Great Value

Summary

• TSMC reported today positive 4Q financial figures, showing that its business remains resilient during a tough period for the semiconductor industry.
• Even though TSMC continues to invest aggressively in capex and R&D, free cash flow is improving and reaching new records.
• Its current valuation is quite low and is likely to increase over the medium to long term.
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Taiwan Semiconductor Manufacturing Company (NYSE:TSM) has reported another resilient quarter, even though its guidance for Q1 2023 was somewhat soft. Despite that, free cash flow is improving and valuation is clearly undemanding, making TSMC a great long-term investment in the semiconductor industry.

Q4 2022 Earnings Analysis

TSMC has announced today its Q4 2022 results that were positive considering the tough economic backdrop in recent months, with the company reporting quarterly revenue of $19.93 billion, an increase of 27% YoY, but being slightly below expectations. Its net income for the last quarter was $9.8 billion, up by 78% YoY, being above street estimates by more than 2%. As shown in the next graph, TSMC has a good history of beating market expectations, even though this quarter its revenue and earnings surprise were weaker than usual.

Earnings surprise (Bloomberg)

This financial performance is quite good considering that the semiconductor industry as experienced a setback in the past few months, but TSMC has been able to report strong growth during the past few quarters, showing that it has a leadership position in the foundry business. This leads to a business that is not much exposed to economic cycles, a profile that is quite attractive for long-term investors.

In Q4 2022, its revenue growth was in-line with its guidance and remained on a strong growth path despite headwinds from soft consumer electronic markets PC sales, while high-performance computing remained quite strong (+10% quarter-on-quarter).

Revenue by platform (TSMC)

This strong performance is also justified by TSMC’s technological leadership, which has been a strong support for revenue growth in recent quarters. Indeed, the weight of revenue generated by 7nm and lower technologies has increased significantly during 2022, which together accounted for 54% of total revenue in Q4. As the company is likely to start commercial production of its 3nm technology during 2023, the share of leading technologies is likely to increase even further in the coming quarters while older technologies lose importance, enhancing TSMC’s leadership position over its foundry competitors.

Revenue by technology (TSMC)

By platform, high-performance computing (HPC) and smartphones continue to represent the bulk of revenues (80% of total revenue in Q4), while other platforms have much smaller weight. However, the chip shortage that has affected particularly the automotive industry is still not fixed, and this platform showed strong growth in Q4 (+10% quarter-on quarter) and is expected to remain a growth driver in coming quarters.

While TSMC has increased the production of wafers for the automotive industry, demand is still increasing and the company is not yet able to supply all the chips the industry needs. TSMC expects this situation to relax in the coming months, but it is forecasting higher chip production for the automotive industry in 2023.

Due to strong customer demand, TSMC decided at the beginning of 2022 to reduce some price discounts to some customers, and favorable currency gains, its gross margin improved to 62.2% in Q4, the highest level in the company’s history. This level was above the company’s own guidance and much higher than its reported gross margin of 52.7% in Q4 2021, being another supportive factor for earnings growth in Q4.

While operating expenses also increased significantly (+34% YoY), its weight on revenue is only 10%, which means that most gross margin improvement led to higher operating margin. In Q4, TSMC’s operating margin stood at 52%, also above its own guidance, and a big improvement from 41.7% reported in the same quarter of last year. Its net income was $9.8 billion, and its return on equity ratio was 41.7%.

Regarding its cash flow generation, TSMC generated some $16.2 billion from operations during Q4 2022, while its capex amounted to $11.2 billion and distributed $2.36 billion in cash dividends. This means that TSMC continues to generate enough cash to finance its investments in capacity and return cash to shareholders, maintain a rock-solid balance sheet at the same time.

Indeed, TSMC has a very solid financial position, given that at the end of last quarter it had a net cash position, allowing it to invest significantly in business growth and distribute excess cash to shareholders at the same time. However, its current dividend yield is only 2.10%, which is better than most companies in the technology sector, but is not particularly attractive for income-oriented investors.

Guidance & Cash Flow

While its business has been quite resilient and TSMC reported strong financial figures in recent quarters, its business is not immune to weakness in some end-markets and revenue has declined considerably in December and the company’s guidance for the next quarter was quite soft. This is justified by a weak macroeconomic situation globally, which is leading to inventory adjustments from customers.

Due to this background, TSMC’s guidance for Q1 2023 was quite downbeat, as the company only expects to generate revenue between $16.7-17.5 billion, representing a sequential decline of 14.2% at the midpoint of its guidance. Its gross margin is expected to decline and be in the range of 53.5-55.5%, and its operating margin to be between 41.5-43.5%.

While this is obviously negative for its share price in the short term, compared to other companies in the semiconductor industry this is still a resilient performance, even though growth is clearly expected to decelerate in the coming quarters.

Regarding its capital expenditures, TSMC spent $36.3 billion during 2022 (47% of revenue), while at the beginning of the year was expecting to invest between $40-44 billion, which was later revised to $36 billion. For the next year, it expects capex to be between $32-36 billion, or about 43% of its revenue at the midpoint of its guidance.

While capex spending is usually more related to long-term growth prospects of the industry, this shows that TSMC is being prudent and is adjusting its supply expansion projects to expected slower demand in the short term, even though its investments are expected to be much higher than they've been historically.

As shown in the next graph, TSMC’s research & development plus capex spending was near $42 billion in 2022, and the company expects to increase R&D expense next year to 8-8.5% of revenue (vs. 7.2% in 2022), thus its total investments are not expected to decline much next year compared to 2022.

Capital intensity (TSMC)

This means that TSMC is still investing somewhat aggressively in business growth rather than prioritizing cash flow, as R&D plus capex is still projected to be above 50% of revenue in 2023. Going forward, while TSMC should continue to invest significantly in capacity and in technology, its capital intensity ratio (R&D+ capex to revenue) is expected to gradually decrease as the revenue pool increases in the coming years.

Another positive factor of reduced capex spending is that TSMC’s free cash flow (FCF) generation will improve compared to its recent past, as high investments in capacity led to very low levels of FCF in 2021. Indeed, while FCF was expected to remain depressed in 2022, it improved to $17.5 billion due to lower capex than expected and reached the highest level over the past seven years.

Over the following years, FCF should continue to grow to new record highs, given that TSMC’s investments in capex lead to higher revenue and capital intensity should return to more normal levels, leading FCF to double to about $30 billion by 2025.

Free cash flow (TSMC)

Conclusion

While TSMC reported a decent quarter during a tough period for the semiconductor industry, its business it not immune to weakness elsewhere and its guidance for the upcoming quarter was quite disappointing. Nevertheless, the company has strong fundamentals, supported by a leadership position in the foundry business, which means weakness should be a temporary factor.

As free cash flow improves in the coming years, this should lead to a higher valuation than in the past, making its shares undervalued right now. Indeed, as shown in the next graph, TSMC is trading at 13.4x forward earnings, at a discount to its historical average of 18.7x.

Valuation (Bloomberg)

This seems to be an undemanding valuation and has plenty of room to increase over the next few years, as the company increases its FCF generation, making TSMC a great play in the semiconductor secular growth investment theme right now.

Disclosure: I/we have a beneficial long position in the shares of TSM either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.