Tokyo Electron: Last Word On Export Rules To China Yet To Come

Tokyo Electron (OTCPK:TOELY)(OTCPK:TOELF) suffered a couple of major setbacks recently. It took a while, but the Japanese government has decided to impose restrictions on the export of semiconductor manufacturing equipment, including to China, which is a major market for TOELY. In addition, it appears the recent outlook from TOELY was too optimistic in light of recent developments, which includes a change of heart at a major chipmaker. TOELY may have to revise its outlook as a result. However, it’s possible TOELY may yet avoid the worst-case scenario as the last word may not have been said regarding export controls. Why will be covered next.

How we got to this point

The U.S. and China are currently engaged in what can be described as a “tech war” with the former seeking to limit the flow of semiconductor manufacturing equipment to the latter, in particular for the production of advanced semiconductor chips. The U.S. has therefore imposed increasingly stringent export rules targeted at China, the latest round coming in October 2022.

In addition, the U.S. has sought to convince Europe, the Netherlands in particular, and Japan to join in with their own export controls. Japan was hesitant to do so for quite some time, but in late March, the Japanese government announced it would tighten restrictions on the export of semiconductor equipment, including to China.

Japan is home to a number of suppliers of semiconductor manufacturing equipment. For instance, Nikon, but also TOELY. The latter counts China as one of its most important markets. According to the most recent quarterly report, sales of semiconductor equipment in Q1-Q3 FY2023 totaled JPY1,611,886M and China was tops by accounting for JPY365,477M or 22.7%. Note that the USD:JPY exchange rate is currently about 1:132.

On paper, extensive export restrictions could have a major impact on TOELY. It would also come at an inopportune time with demand for semiconductor manufacturing equipment weakening. For instance, according to the latest outlook from TOELY, which predates the imposition of export rules by the Japanese government, the wafer fab equipment or WFE market is expected to decline by about 20% YoY to about $80B in 2023. From the Q3 FY2023 earnings call:

“Though the WFE market is currently under adjustment due to the impact of macro economy and geopolitical developments, such as inflation, interest rate, COVID-19, utility costs and sluggish final demand, we expect that the WFE market will start coming from the second half of this year and reach about $80 billion in the full year of 2023.”

A transcript of the Q3 FY2023 earnings call can be found here.

However, the outlook from TOELY also calls for a recovery in the WFE market that is not so far away. Note that this is in line with what others are saying. For instance, a recent forecast from SEMI predicts equipment spending will grow by 21% YoY in 2024 after shrinking by 22% YoY in 2023.

Semiconductor demand is expected to rebound, starting in H2 2023. The equipment market is thus expected to grow in 2024.

“So in the second half of this year, the memory market will start recovering and accordingly, the new trend of the investment will start from memory as well.”

For instance, while the memory market is currently in a deep slump, TOELY believes the memory market will start to rebound in H2 2023.

“In November 2022, we revised fiscal 2023 financial estimate. This time, we scrutinized the results of the third quarter and estimates of the fourth quarter again, and we are going to revise the financial estimate upward by JPY70 billion. On a full year basis, we expect net sales of JPY2,170 billion, gross profit of JPY946 billion, operating income of JPY580 billion and net income attributed to owners of parent of JPY433 billion.”

With this in mind, TOELY raised its guidance for FY2023. The updated guidance calls for FY2023 sales of JPY2,170B, or roughly US$16.4B using an exchange rate of 1:132, an increase of JPY70B compared to the old guidance.

“So the October 7 last year, the American Government announced their export control and customers -- American two vendors are not able to deliver to the China customers, and we incorporated the impact of first trade export controlled at maximum level.

Of course, the export control had some impact but compared to the worst scenario, there was not so much drastic change in the China customers, the CapEx plan. So that is the reason why we made the upward revised by JPY70 billion.”

This upgrade was primarily due to customers in China not making major changes to their capex plans, despite the recent export restrictions by the U.S. government.

Why TOELY may have to revise its outlook

The outlook from TOELY was upbeat, despite the current downturn, but keep in mind that all the above preceded the recent decision by the Japanese government to impose export controls. This could mean TOELY may have to revise its outlook, depending on to what extent the Japanese government restricts sales to China.

Furthermore, if that wasn’t enough, TOELY got more potentially bad news when Samsung (OTCPK:SSNLF) announced its decision to reduce memory chip production. Samsung had previously said it will maintain production levels despite the downturn in the memory market, but Samsung seems to have changed its mind after suffering a major loss based on recent quarterly guidance.

Keep in mind that Samsung had insisted there would be no production cuts, which is one of the factors TOELY cited as reason for its upbeat outlook. If Samsung cuts chip production and presumably capex spending as well, TOELY may have to factor this into its outlook, on top of a possible reduction in sales to China with new export controls in Japan on the horizon.

Why TOELY could still avoid a major hit

It's worth noting that the exact details regarding the new export controls have yet to be released. Still, the recent developments are not welcome as far as TOELY is concerned. However, the Japanese government may want to limit the damage from export controls to companies like TOELY for several reasons, which includes fading demand for semiconductor manufacturing equipment.

In addition, the Japanese government is likely to take into account China’s possible response to export controls when it releases the fine print for these controls. The Chinese government has reportedly urged the Japanese government not to follow the U.S. in order to block the development of its semiconductor industry.

Specifically, the Chinese government pointed out that export rules will only cause it to rely more on domestic alternatives, which seems to imply that Japanese companies like TOELY risk losing some, if not all, market share to competing suppliers. Furthermore, China seems to be suggesting it could retaliate.

While it may be a coincidence, China announced a few days later that it intends to impose export controls on rare earth technology. This could be seen as a signal to Japan that China has the means to retaliate. These rare earth products are essential in a range of high tech industries and their absence could result in serious disruptions.

While there are other suppliers of rare earth elements, China is the leading supplier of rare earth elements with the biggest reserves that are readily accessible. More importantly, China has a near monopoly on the processing required to turn these rare earth elements into finished products that can be used.

In practice, this means that, depending on the rare earth element involved, the raw elements need to be sent to China, even if they were extracted outside of it. The processing often includes proprietary knowledge or technology that China seems to want to ban from being shared with other countries with its latest initiative. In theory, a partial or complete ban on rare earths could be a potent factor.

It’s possible the Japanese government may water down the export controls for these reasons. Note that export controls do not necessarily imply the sale of affected equipment is banned. Companies need to ask permission before a sale can be concluded. It’s possible Japan may impose export controls, but at the same time allow the sale of most, if not all, equipment to go through, which would not be unprecedented since something similar has happened before. If this is what happens, TOELY may be able to avoid the worst-case scenario regarding export controls, which is a complete loss of the China market.

Investor takeaways

Up until a couple of weeks ago, things did not look all that bad for TOELY. Sure, the market for semiconductor manufacturing equipment is going through a downturn, but a rebound was also not far away. It’s not without reason that TOELY was upbeat in its outlook in the most recent earnings report.

However, the situation took a turn for the worse in late March/early April. First, the Japanese government announced it intends to introduce export controls that could have a negative impact on TOELY. Not long after that, Samsung released its latest guidance, which suggests that the downturn in the semiconductor industry is worse than expected. As a consequence, Samsung will reduce chip production and presumably capex spending.

Both should be considered bad news for TOELY as they could potentially lead to a downward revision of TOELY’s outlook. However, TOELY may still escape the fallout of export controls. It’s up to the Japanese government to decide how it chooses to implement export rules. Japan may decide to limit the impact of export controls for several reasons, which would come as a relief for TOELY, especially as it works its way through the current downturn.

I am therefore neutral on TOELY stock. Recent developments don’t help the bull case for TOELY, but their ultimate impact has yet to be determined. The export controls have the potential to be a negative for TOELY, but they don’t have to be. It’s possible there will be little to no impact on TOELY, but this is up to the Japanese government to decide. Similarly, Samsung has yet to announce by how much it will cut production and spending.

Bottom line, while recent developments are an ominous sign for TOELY, they need further clarification to determine what, if any impact, there will be on TOELY. It’s therefore best not to draw any premature conclusions when the last word, certainly as it relates to export controls, has yet to be said. Staying on hold is the way to go, at least for now.

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