Good afternoon, everyone. Welcome to Realtek 2022 third quarter earnings call. This call will be chaired by Realtek spokesperson, Yee-Wei Huang. The presentation will be available on the company website before 6 P.M. today. At the beginning, our spokesperson will report our third quarter results and give a management's remarks. After that, we will have a Q&A session. You are welcome to type your questions in the box at the lower right corner on the screen. We will answer the questions accordingly. During the call, you can browse through the pages of the presentation any time. Note that portion of what presented in this call contain forward-looking statements. Investors are cautioned that forward-looking statements involve risk and uncertainty. Actual results may differ materially from the results forecasted or implied in such statements. Investors should not place undue reliance on such statements.
Now, I'll pass this call to our spokesperson, Yee-Wei Huang.
Thank you. Good afternoon, ladies and gentlemen on the line. This is Yee-Wei Huang. You are currently participating in the third quarter 2022 webcast earnings release hosted by Realtek Semiconductor Corporation. Now, let's go through the third quarter 2022 operational results. Q3 revenue was TWD 29.8 billion, a small 2.4% QoQ drop, and a 2.4% increase compared to the same period last year. The weak PC market is the main reason leading to a QoQ drop. Q3 gross margin was 48.0%, a 2.2 percentage point drop compared to the previous quarter. Two main reasons for the drop in gross margin in Q3 are, first, change in product mix caused by market downturn. Second, average cost increase. However, Realtek continues to cooperate with customers to develop a high-value product portfolio.
We are confident that the mid-to-long term growth profit margin will be at a level higher than what was seen before the shortage. Q3 operating expense was TWD 10.27 billion, or 34.5% of revenue. 0.5 percentage point drop compared to the previous quarter. We remain confident to leverage our economy of scale to lower our OpEx ratio as the company grows in the long term. Q3 operating profit was TWD 4.04 billion or 13.6% of revenue. Lower growth margin was the main reason for a lower operating profit. Q3 non-op income was TWD 354 million. Higher interest income from a higher interest rate gave rise to a higher non-op income compared to the last quarter.
As a result, Q3 net profit was TWD 4.24 billion or 14.1% of revenue. This leads to Q3 EPS to be TWD 8.20, a slight drop from TWD 9.12 in second quarter. Regarding inventory, Q3 inventory turnover days were at 137 days, a 17-day increase from 120 days last quarter. Consistent with what we share in second quarter earnings call, we do not expect the inventory turnover days to drop in Q4 at Realtek. While we put a priority on supporting the distributors and customers to manage their inventories. However, we are confident that most of these inventories are effective, excuse me, are effective ones, and will be gradually digested. There's no need to worry. This concludes Realtek's third quarter 2022 financial report.
In summary, the end market demand weakened in the third quarter under the influence of multiple factors, including inflation and geopolitics. In response, the supply chain is adjusting itself to cope with the challenges. This is expected to continue into the fourth quarter, and the operating outlook is cautiously conservative. Next, we will review the top product lines at Realtek. First, we observe that PC versus non-PC revenue to be approximately at 32%-38% in the third quarter. This is a visible drop in PC percentage. On Ethernet, in response to the demand for PC notebook falling sharply in the third quarter, while the demand for consumer products remained tepid, customers aggressively adjusted their inventory and their stocking principles. For these reasons, single port Ethernet controller sales visibly declined in the third quarter. This phenomenon is expected to continue into the fourth quarter.
However, we expect the growth momentum of Ethernet chips to recover in 2023, driven by specification upgrades in the PC peripheral, and network communication markets. The market readiness manifests itself in the recent announcement of Realtek 2.5 Gb Ethernet controller with network bandwidth optimization software as a winner of the Taiwan Excellence Award. On switch, it performed very well in third quarter, partly to make up the supply shortage in first half this year. Forward-looking, the market seems to start feeling the pinch of the strong US dollar and inflation in the fourth quarter. Customer orders may turn conservative in coming quarters. In spite of the short-term pressure, the mid and long-term prospect of infrastructure build up remains very positive, with strong growth potential in managed switches. On Wi-Fi, the spec upgrade to Wi-Fi 6 was strong in the third quarter.
The Wi-Fi 6 penetration is on track to reach 50%-60% in PCs and about 50% for routers in 2022. Other than PCs and routers, Realtek Wi-Fi solutions are widely deployed in consumer, broadband, retail, IoT applications. Overall, Realtek Wi-Fi 6 now accounts for roughly 20% of our Wi-Fi business. It is expected to grow strongly in 2023 as Wi-Fi 6 finds its way into many targeted applications served by Realtek. We expect Wi-Fi 4, Wi-Fi 5, and Wi-Fi 6 will co-exist in the foreseeable future, and with Wi-Fi 7 adding to the mix in 2024. On audio codec, started around April, the PC notebook shipment dropped aggregate in the third quarter. We expect the PC notebook market to drop 15%-20% this year compared to 2021, with most of the drop arriving in the second half.
Such a drop has a very direct impact on Realtek audio codec and PC related lines. Forward looking, we expect PC market to maintain flattish or drop slightly in 2023. Nevertheless, we expect spec upgrades and growing business beyond PC for Realtek audio codec solution. On TV, the overall TV market in 2022 may drop close to 10% compared to last year. Realtek's TV business, nonetheless, is still holding steadily as we still have headroom for growth.
Thank you, Yee-Wei. Now we are entering the Q&A session. Please type your questions in the box at the lower right corner on the screen. We will reply accordingly. Now the first question is from Randy, Credit Suisse. How do you see sales trending for fourth quarter? How is the relative performance by application? Do you see a softer area and potential sales decline, inventory correction continuing to the first quarter 2023?
Okay. With high inventory, low demand, and very limited visibility, the PC related market is not expected to perform well in the fourth quarter. The consumer market has been wobbling for over a year and may remain the same in the fourth quarter due to inflation. Although the network communication and automotive markets perform relatively well compared to PC and consumer at the present time, we are observing customers behaving conservatively towards the year end given the uncertainty in global economy. We hope the situation may improve next year as the market rebounds.
Thank you, Yee-Wei. Next question is from Daniel, Morgan Stanley. Any potential impact from the U.S. BIS chip restriction on your China business?
Okay. We see no immediate impact to Realtek business at this time. You know, as this October 7th, BIS rules seems to target at certain very high performance ICs, super computer products containing such ICs, and certain advanced semiconductor manufacturing items, all beyond the scope of Realtek business. We will continue to monitor the situation as more information becomes available to ensure compliance by the company.
Thank you, Yee-Wei. The third question is from Daniel, Morgan Stanley. He would like to ask our initial view about 2023. Do we still expect a growth year? What are the growth driver in 2023?
Yes. Despite the short-term headwind, Realtek still expects 2023 to be another growth year in terms of revenue. We see the market continues to demand more connectivity solutions that are faster, lower power, more manageability, and easier to use. We expect the growth to come from both spec upgrades and expanded applications, especially in the network communication segment such as Wi-Fi 6, 2.5G Ethernet, multi-gig Ethernet managed switch, and 10G-PON. Moving forward, we see audio/video-based man-machine interfaces being the most natural connectivity solution for the connected world that will further fuel the growth of the company.
Thank you, Yee-Wei. Next question is from Nick, Daiwa. His question is about pricing. What's your customers' attitude on pricing right now, and Realtek's expectation on the product pricing in 2023?
Yes, customers are requesting price down as we speak, or for that matter, as always. At the same time, we have not yet received cost relief from our suppliers. To this end, we are working closely with our customer to manage the price challenge together. For 2023, we still expect the overall ASP to trend upward from new products and spec upgrade.
Next question is from Kevin, Mizuho, on question related to the gross margin. Kevin would like to ask the gross margin trend in fourth quarter and next year.
Fourth quarter gross margin is expected to drop some compared to the third quarter level, mainly due to the product mix change. For 2023, we expect the gross margin to fluctuate at a level that is higher than pre-COVID historic range.
Next question is from Terrence, KGI. Can management give us some hints about the OpEx or the OpEx ratio in 2023? Will there be chance of headcount freeze due to the market demand slowness?
Regarding Terrence, we do not have a headcount freeze, but are always prudent in hiring. We do not expect OpEx ratio to change much in 2023 compared to this year. Nevertheless, lowering the OpEx ratio remains our goal, which we believe to be achievable through leveraging the economies of scale as Realtek grows.
Next question is from Randy, Credit Suisse. How do you view Realtek's own inventory versus your target and timing to bring it down? How is the customer and channel inventory?
The inventory now is high within Realtek, as well as with our distributors and customers. This may be attributed to at least two factors up to second quarter. First is an oversight on the amount of products held en route due to port congestion and container shortage. Second was overbooking during supply shortage. In Q4, we will be focusing on working with our distributors and customers to support their aggressive goal in inventory management. The high in-house inventory is expected to last at least until the end of this year, and then start subsiding in 2023. It may take up the first half of 2023 before the inventory returns to a normal level.
Okay. Next question is from Bruce, Goldman Sachs. He would like to know for our PC market in 2023, we are expecting PC shipment to be flat to slightly down. Any update view on this? If so, what has changed over the past few months?
Well, barring factors that no one may expect, we still believe that PC market will stay flattish or decline slightly in 2023. Longer term, we expect the PC market to return to a normal refresh cycle with expanded applications.
The next question is from Sunny, UBS. She would like to ask, have you seen any foundry begin to reduce foundry pricing? During the chip shortage, you qualified new foundry and fab sources, allegedly some in China. Now, given the end demand moderation, will you consider moving back the production to Taiwan, the primary foundry supplier?
Well, at this point, we have not seen foundries offering price reduction in spite of the expectation of the market and customers. With an expanded supplier base now, Realtek will choose the best qualified fabs for new product introduction and wafer allocations based on their specialty area, quality, reliability, yield, and of course, price.
Okay. Thank you, Yi Wei. The next question is from Aaron, Nomura. What's the supply and demand gap for networking products? And for what percentage could this segment compensate the loss and downside from the PC space?
The PC market made a dramatic turn from supply shortage to oversupply when entering the third quarter. We have seen PC customers lowering their 12-month rolling forecast in each of their twice-a-month updates since late second quarter. At the present time, it may be still premature to ascertain if the PC forecast reduction has bottomed out. To this end, suffice it to say, the drop in the PC market in the second half of 2022 has outstripped the strength of the communication network business. It is worth noting that we are observing many customers behaving conservatively towards the year end, given the uncertainty in global economy.
Next question is from Terrence, KGI. He would like to know the Wi-Fi 4, 5, 6 ASP, and the Wi-Fi 7 development progress. Does the Wi-Fi penetration rate forecast for router and PC is negatively impacted by the weakening demand?
Okay. The relative ASPs among Wi-Fi 4, 5 and 6 in the third quarter are around 1 to 2.5 to 4, signifying a shrinking gap between Wi-Fi 4 and Wi-Fi 5. Still, roughly a 60% premium for Wi-Fi 6 over Wi-Fi 5. The ASP differences among different technologies imply that they may coexist for some time. Regardless of the ASP gap, the upgrade to Wi-Fi 6 is unstoppable as far as we can see. Case in point, Realtek just launched its 5th-Generation Ameba E-series IoT solution, featuring Wi-Fi 6 and smart voice. That will allow smart devices to have the ability to perceive, interact, and determine actions to take. Regarding Wi-Fi 7, the PlugFest is ongoing and may last until mid-2023. Realtek is among the first batch of Wi-Fi 7 providers in the PlugFest.
We will timely release our Wi-Fi 7 products to meet the market needs.
Thank you, Yee-Wei. The next question is still Wi-Fi related. Jason from CLSA would like to ask, seeing other players are aggressively migrating to Wi-Fi 6, can we expect that Realtek get market share in Wi-Fi 5 market?
Sure. Adding to Wi-Fi 4, Wi-Fi 5 is expected to have a long tail. During the downturn, the demand for Wi-Fi 5 tends to pick up because of its cost advantage. As Realtek strives for maintaining a complete Wi-Fi portfolio, including Wi-Fi 5, we will continue to win customers with Wi-Fi 5 solutions with unparalleled cost performance.
Next question is from Sunny, UBS, and she would like to ask that on our Ethernet and switch business, what are the drivers to manage switches in 2.5 gig Ethernet?
Well, with 5G driving anytime, anywhere wireless connectivity, delivering up to 20 Gb per second peak data rates, it has become a clear requirement for the Ethernet LAN-based connectivity, including single port Ethernet controllers, PHYs, and multi-port Ethernet switches to go beyond gigabit per second per port. This way, the LAN-based wired connectivity solutions do not become the bottleneck in the connected world. Furthermore, the network traffic with increasing complexity and throughput is demanding switches to provide more in manageability and intelligence, thereby fueling the growth of both 2.5G Ethernet and managed switches.
Thank you, Yi-Wei. The next question is from Sunny, UBS. She would like to ask about the competition in China. Do you see the competition emerging for Wi-Fi 4 and 5, Bluetooth and Ethernet, et cetera, in China? How about Wi-Fi 6?
Well, as a provider of connectivity solutions that support international standards, Realtek always faces competition from many directions, including those from China. Up to now, nevertheless, we have not seen a competitor from China or elsewhere, that has a Wi-Fi, Bluetooth, or Ethernet solution portfolio that is as complete as what Realtek offers. We acknowledge the incessant rise, and other times falls, of competitors from China, but there's nothing we cannot manage.
Thank you, Yee-Wei Huang. The next question is from William, JP Morgan. He would like to know about the auto market and business. Could you update the current auto Ethernet penetration rate, number of Ethernet port adoption per vehicle, and competition landscape change? For Realtek, please comment on your revenue contribution targets, order backlog, and customers, as well as the market share.
Automotive Ethernet is growing steadily among car makers and their tier ones. We estimate for 2025, 2026 new car models, well over 50% of them will adopt automotive Ethernet to a varying degree. An entry-level model may have only one Ethernet switch and less than 10 Ethernet ports. A high-end, often electric vehicle may have multiple Ethernet switches and over 50 Ethernet ports. In addition to Realtek, the major suppliers of automotive Ethernet solutions include the familiar names of Broadcom and Marvell. The competitions will focus on full range of speed, ranging from 10 Mbps to 10 Gbps. High speed XFI interface, time-sensitive network features, safety, and security. Suffice it to say that Realtek is as competitive as other major suppliers. We expect continuing growth in our auto Ethernet product lines in the coming years.
Thank you, Yee-Wei. Next question is from Daniel, Morgan Stanley. Could you share your view on the bidding market in China? For example, the set-top box and PON. Do you think that it's sustainable into 2023?
China new telco tender projects slowed down for the time period leading to the 20th Party Congress in China. One reason was the difficulty for the broadband infrastructure deployment under the zero-COVID policy. Nevertheless, people are expecting that the tender projects will pick up the pace again after the Party Congress ends. We shall pay close attention to the development. Overall, we believe the telco tender projects in China will maintain its strength at roughly the same level between 2022 and 2023, namely set-top box annual TAM will be TWD 50 million-TWD 60 million, PON will be TWD 70 million-TWD 80 million, and routers TWD 60-TWD 70 million.
Okay, thank you, Yee-Wei. Next question is from Sunny, UBS. We understand that the TWS market is still weak, but would you be able to share with us the strategy and the focus of the Bluetooth? How should we think about Bluetooth and the wearable market growth outside China versus within China?
Yes. Realtek remains committed to the Bluetooth TWS solutions. Nevertheless, we are staying away from the basic TWS market, competing solely on price. We are focusing on global brand customers, gaming applications, and the new BLE Audio applications. We are also combining wearable and TWS into a two-in-one solution to provide a double dual-mode wearable solution, namely BLE data plus Bluetooth Classic audio, and also BLE classic audio plus BLE Audio. As BLE Audio becomes commonplace in the near future, Realtek will help customers enjoy time-to-market benefits for BLE Audio watch, TWS, and various related applications.
Thank you, Yee-Wei Huang. The next question is from Terence, KGI. He would like to know what's our focus application for the USB4 and the PCIe 5.0. Could Realtek give us your initial sales contribution target in 2023 and 2024 for those products?
Okay. USB4 is markedly different from the early version of USB in that it can share a single high speed link with multiple data types used in PC-oriented applications, including USB 3.2, Thunderbolt 3.0, DisplayPort 1.4, and PCIe 3.0. It is worth noting that USB-IF just announced on October 18, the latest specification for USB4 version 2.0, doubling the bandwidth to 80 Gbps. Almost in lockstep, VESA announced DisplayPort 2.1, and Intel shared the first teaser of next generation Thunderbolt, both supporting 80 Gbps USB version 2.0. As noted, USB4, DisplayPort, Thunderbolt, and for that matter, PCIe, are all PC-oriented high speed connectivity solutions. To this end, it is not hard to expect the first wave of applications for USB4 and PCIe 5.0 may include PC peripherals such as high-end displays, storage devices, and USB hubs.
Realtek USB4 and PCIe 5.0 solutions are under development. The first full feature USB4 hub featuring Realtek solution will be ready in the second half of 2023. Realtek PCIe 5.0 will be ready in 2023. We prefer not discussing the revenue goals for individual products.
Thank you, Yee-Wei Huang. The next question is from Michael Wong, Polymer. He would like to know about the fourth quarter and the first quarter gross profit margin outlook. Will inventory write-off hurt the gross margin more than the company expected for the inventory every three months we need to write off them? What mix of inventory and networking versus the PC?
Three months, that's pretty short. We do not write off inventory that fast. We expect full Q gross margin, gross margin. We say we expect that to be lower than third quarter, mainly due to product mix change. The impact on gross margin is the impact of inventory write-off on gross margin. We said it may come later, but it wouldn't be a significant impact. In terms of the mix of inventory, at the present time, we do observe higher percentage in PC as opposed to networking.
Okay. Thank you, Yee-Wei. Next question is from Laura Chen, Citigroup. Can you also talk about the ASP declining trend for the networking? Do you see acceleration of the ASP declines?
Yes. Well, there's definitely ASP pressure in the market today. Short term, we do expect short-term ASP decline. Longer term, as we explained, the spec upgrade is unstoppable. Longer term, for example, next year, we actually still believe Realtek ASP will trend upward because of the spec upgrade and product mix.
Thank you, Yee-Wei. There's no further questions, and we will conclude the meeting now. Thank you for your participation today. Please feel free to con-