2023-04-20 13:48:55 ET
Summary
- We reckon the likely recession may be more of a pressing matter for TSM, given the notable impact on its top and bottom line, worsened by the tougher YoY comparison.
- The global demand for electronics may be further moderated ahead as corporate capital expenditures are tightened, with layoffs likely still occurring through FQ2'23.
- While MU has been optimistic about a memory demand recovery by H2'23, it remains to be seen how things may develop ahead, with South Korea still reporting record-high inventory levels.
- Therefore, we believe the TSM stock may underperform from current levels over the next few quarters, especially given the unpromising FQ1'23 performance thus far.
The Recession Bottom Investment Thesis
Some of my readers had asked us for our opinion, on why Berkshire Hathaway ( BRK.A ) ( BRK.B ) sold almost all of its stake in Taiwan Semiconductor Manufacturing Company Limited ( TSM ) by the end of 2022.
Well now, the question was answered by Warren Buffett himself, in an interview with Nikkei Asia, which might also similarly explain why BRK's stake in BYD (BYDDF) was trimmed:
Question: You dramatically reduced your holding of Taiwan Semiconductor Manufacturing Co. just after making an investment. Why? Is it due to the geopolitical tensions [over Taiwan]?
Answer: That is certainly a consideration. But Taiwan Semiconductor is the greatest business in the field by a huge margin. The management is good. But is there a difference between that being located in Omaha, Nebraska, and in Taiwan? Yes.
Fueling our pessimism, it appeared that the geopolitical situation between the US and China had further worsened over the past few months, signaling a great change in investors' sentiments towards Chinese-based stocks. The same had been observed with Alibaba Group Holding Limited ( BABA ), with the stock now a third of its original value and trading sideways for the past year, despite the recent move to break up the company.
However, here is where we reckon the similarities end. TSM has definitely made significant efforts to diversify its location to the US and Japan, which we have closely covered in our previous article here . Once its new plants start production by 2024, we reckon much of the geopolitical concerns may be dispelled, potentially lifting its stock valuations and prices then.
However, the point that we are more concerned about is the possibility of a mild recession , as highlighted by the Fed in the recent meeting minutes. It appears that the regulator is already predicting an economic slowdown through 2025, suggesting further headwinds to TSM's execution.
TSM already reported a weaker FQ1'23 performance , with revenues of 508.63B TWD, declining by -18.7% QoQ and only expanding by +3.4% YoY, notably worse for February and March 2023. Given that it historically recorded a cadence of +12.1% QoQ/ +35.6% YoY in top-line growth during FQ1'22, it was apparent that the demand destruction and inventory adjustment had impacted its performance, normalizing from the hyper-pandemic era levels.
Perhaps this was why the foundry had dramatically adjusted its 2023 capital expenditure from the previous midpoint of $42B to $34B instead , with market analysts also already projecting a further reduction ahead, against the $36.3B recorded in 2022 .
Recent reports suggested that TSM might also cut EUV orders from ASML ( ASML ), suggesting that the impact of the demand destruction and potential recession might be worse than expected. The same was observed with memory chip makers , such as Micron Technology ( MU ) and Samsung (SSNLF), where capex and production cuts had been announced, spurring rumors of recovery from H2'23 onwards.
Unfortunately, we are less optimistic. While we reckon the inventory correction may be at its tail end, the possibility of a mild recession may potentially push back the recovery of consumer demand.
With many tech companies, including Amazon ( AMZN ), Meta ( META ), Alphabet ( GOOG ) ( GOOGL ) still announcing drastic headcount reductions over the past few months, especially in the former's cloud segment, we reckon the demand correction may not be over yet.
The cost reductions naturally came with smaller office spaces and reduced discretionary spending on hardware, on top of increased operating efficiency. Even META had decided to cut its data center spending by $4B, one that might impact TSM since the former relies on Nvidia's ( NVDA ) GPUs for AI training .
Even Apple ( AAPL ) was not spared in the PC demand destruction , with Mac sales declining by over -40% YoY in FQ1'23, compared to the Windows PC ranging between -24% to over -30%. The Cupertino giant's iPhone sales had also declined by -5% in FQ4'22 compared to FQ4'21 levels, suggesting a notable moderation in discretionary spending from the elevated interest rate environment and rising inflation.
With NVDA and AAPL comprising nearly 30% of TSM's revenues , we have turned cautious, especially with market analysts expecting the Fed to further raise the interest rate by another 25 basis points in the upcoming May meeting. With the March CPI still indicating elevated inflation, albeit decelerating MoM, it remained to be seen how the global outlook for electronics/ automotive demand might turn out.
Based on the historical cadence of the 2008 recession, both TSM and AAPL recorded minimal top-line growth in 2009, with demand only rebounding by 2010. Assuming a similar cadence, we might see the foundry similarly impacted in 2023, with things only improving from 2024 onwards.
This sentiment was highlighted by MU and market analysts alike , which had projected that demand for memory chips might recover from H2'23 onwards, with logic chips slightly lagging behind. However, we reckon the recovery may be later than expected, with South Korea still reporting eye-watering inventory levels of $52B for memory chips by the end of 2022.
Therefore, we are more inclined to concur with the Fed that recovery for memory chips may only occur from H1'24 onwards, with logic chips likely from H2'24. That conjuncture may point to TSM's further underperformance, especially burdened by the elevated capital expenditure in Arizona and Japan through 2024.
In addition, TSM faces hurdles in securing part of the $52B Chips Act, due to the unexpected regulations imposed on the foundry. For one, there are rumors about profit-sharing with the US government, which may impact its profit margins, on top of the elevated operating costs in Arizona.
On top of that, the regulators have also added strict restrictions on capital expenditure and investments in China for the next ten years, potentially impacting the foundry's operations in Nanjing, where it manufactured 28-nm and 16-nm chips.
While TSM has obtained a one-year exemption for its expansion in China, its prospects still appear uncertain, in our view, due to its 10.9% exposure to China, based on the FY2022 revenues.
So, Is TSM Stock A Buy , Sell, or Hold?
TSM 3Y Stock Price
For now, TSM has successfully rebounded from the previous October 2022 bottom and maintained its momentum nearing the August 2022 and February 2023 resistance levels. The same cadence is visible in ASML's performance thus far, suggesting that the recession and geopolitical bottom likely have been found, assuming that nothing drastic occurs over the next few quarters.
However, we must also highlight that ASML's geopolitical headwind is naturally less severe than TSM, despite the export restriction on the former's technology to China . While we believe that the foundry may still hold a war deterrent silicon shield , the foundry needs to face the impending recession first, due to the notable impact on its top and bottom-line performance ahead.
Therefore, we prefer to prudently rate TSM as a Hold here, since we reckon that the stock may eventually retrace to the December 2022 support, giving investors an improved margin of safety there at those levels.
For further details see:
Taiwan Semiconductor: Overweighted Geopolitical Concerns - Recession May Be A Bigger Issue