2023-03-21 10:49:57 ET
Summary
- TSMC management had earlier cautioned about continued weakness into the first half of 2023, with early recovery expected in the back half of the year.
- But with piling macroeconomic challenges, the industry's optimism for a back-half recovery has yet to sufficiently de-risk for what is to come.
- Although the stock continues to trade at a discount relative to its historical levels and peers, the broader industry remains susceptible to another correction that risks fizzling the recent rally.
Taiwan Semiconductor's ( TSM ) stock has been on a steady uptrend in recent weeks alongside the broader semiconductor sector, buoyed by both optimism in growing AI momentum as well as market speculation of impending rate cuts, which growth stock valuations would thrive on. But near-term risks of fundamental weakness remain acute, and TSMC's modest growth guidance for the year disclosed in January may not have sufficiently de-risked for worsening macroeconomic conditions ahead, while geopolitical tensions continue on an intensifying trajectory.
We believe our thesis discussed earlier this year for the stock has been reinforced by growing uncertainties to the near-term global economic outlook, as central banks grapple with the diverging needs of taming inflation and maintaining stability in the financial system. While TSMC's moat in chip manufacturing continues to be bolstered by its dual advantage of technology leadership and scale amid longer-term secular growth trends buoyed by digitization demands, we remain incrementally cautious of near-term pullbacks as both economic and industry data point to more pains ahead before the emergence of any sustainable recovery.
Incremental Headwinds Upstream
As discussed in our latest coverage on the stock, TSMC's relative resilience amid the semiconductor industry's cyclical downturn through 2022 has been showing signs of weakness, especially after the company sought to temper expectations for the year ahead. After reporting its "first quarterly miss in two years", the company is warning of further weakness in the first half of the year, accompanied by an anticipated y/y sales decline in the current quarter.
While management echoed peers' optimism for recovery in the second half of 2023, macroeconomic conditions look to be taking a turn for the worse with inflation still at 6%, alongside a still-tight labour market that needs to be reined in further. Although the recent banking crisis has put pressure on the Fed to slow the pace of rate hikes - or even consider a pause altogether - persistent price pressures mean tightening will remain the theme in the long run. It is looking more likely by the day that a recession will be inevitable, while the recent banking turmoil is likely to elongate those pains, putting the potential for a soft landing further out of reach. On one hand, if the Fed loosens its monetary policy to appease the liquidity needs within the banking system, it risks a resurgence of inflationary pressures that could run wild and put further stress on the economy. Meanwhile, on the other hand, keeping rates higher for longer with no intermediary pause while the banking crisis erupts simultaneously is also bound to bring about detrimental impacts on the economy - differing from previous market optimism that any impending recession resulting from the latest tightening cycle would likely be mild and swift .
Although the chorus of speculation is growing louder that rate hikes are nearing an end with a potential cut in the books before the end of the year - which is sparking momentum for growth stocks like TSMC - we view the resulting rally in recent weeks as premature, if not superficial on over optimism. Even if long-end yield comes down in the latter half of the year as a result of potentially loosening policy, the earnings component that dictates valuations is very likely to weaken further from stiffening recession headwinds, overcoming industry optimism for a stronger back half that is currently being priced into shares, and offsetting hopes for an ensuing uptrend.
These concerns are further corroborated by recent data on Taiwan and Korean exports - a key barometer for global spending. Specifically, Taiwan exports fell for the sixth consecutive month by 17.1% y/y in February, while Korean exports are also likely headed towards its sixth consecutive month of declines with daily shipments down 23.1% y/y through the first 20 days of March. Semiconductor exports from the two key global production hubs also "showed a deepening slump", indicating continued demand erosion. Taiwan's integrated chip exports fell by 17.2% y/y in February, while Korea's fell by 17.4% y/y in the first three weeks of March. This continues to underscore demand risks from the industry's cyclical downturn observed through 2022 now flowing upstream to foundries like TSMC, which have previously stayed resilient relative to fabless chipmakers.
Taken together, it appears the pervasive industry slowdown in chip demand has only just started to worsen for upper stream constituents across the supply chain - like foundries - which is in line with TSMC management's caution for further weakness in the first half of 2023. But instead of a pivot to recovery mode in the second half, we think more pain lies ahead for TSMC until at least the next year, based on recent economic data and observations downstream. While both TSMC and its key customers like Nvidia ( NVDA ) and AMD ( AMD ) have recently sowed optimism for an industry-wide recovery in the back half of the year, we think the looming recession will likely slow the pace of ongoing efforts in reversing the current inventory glut across end-users like PC makers, and thus cause a back-up of products at fabless chipmakers and stall demand for foundries. Specifically, inventories at some of TSMC's largest clients like Nvidia and AMD have almost doubled in the past year, accelerating from historical trends. With leading PC makers like Dell ( DELL ) and HP ( HPQ ) still cautioning a contracting PC market unit TAM in the current year, alongside macroeconomic conditions that have just gotten all-the-more messier with the latest banking crisis, TSMC's target for "slight growth" on a net basis by the end of the year is likely to have become an increasingly difficult endeavour to maneuver.
Intensifying geopolitical tensions between Beijing and Washington and its allies have likely played a role in the industry's deterioration as well. Taiwan's chip exports to China and Hong Kong during February fell by almost a third y/y, while Korea's fell by more than 36% so far this month. While TSMC has taken active mitigation efforts against said risks by diversifying its supply chain to the U.S. and potentially in Japan , related efforts will remain an extreme burden on its profit margins within the foreseeable future considering the intensive capital outlay, despite generous government subsidies, as well as ensuing ramp-up costs (previously discussed in detail here ). Meanwhile, new production capacity that will be coming online outside of Taiwan in the coming years is likely to be based on technology that is still years behind, which leaves the incremental geopolitical risks still a lingering downward-adjusting factor to TSMC's valuation.
Also keep an eye out for upgrades to the technology that will be deployed. Much was made of news that TSMC would manufacture at the 4 nanometre node (dubbed N4) in Arizona. At that time, 7nm was the most advanced available…The company's timeline meant N4 would be available in Taiwan this year, two years before it would reach the U.S. This week TSMC is lauding the fact that 3nm will hit Arizona in 2026, whereas that same technology is scheduled to be unveiled in Taiwan next year. In other words, the U.S. will still be behind by two to three years, or one to two generations of chip technology.
Source: Bloomberg News
Final Thoughts
While TSMC is the critical backbone to enabling key next-generation technologies - including AI which is being implemented pervasively at a rapid pace in recent months - and improving costs of said developments with industry-leading scale, we expect further weakness to its fundamentals in the near term, which will inevitably lead to incremental tempering to current optimism priced into the stock's valuation. With the pathway to a sustained recovery not yet clear, and in fact, headed towards bumpier times, we remain hold-rated on the stock despite recent confidence observed across the broader sector's valuations.
For further details see:
Taiwan Semiconductor: A Bumpy Recovery Ahead