December 5, 2020

Taiwan Semiconductor Manufacturing Company: Dominant Player In A Growing Business (NYSE:TSM)

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Overview

Taiwan Semiconductor Manufacturing Company (NYSE:TSM) is the undisputed industry leader in semiconductor fabrication. They are ahead of the competition in mass-producing 5 nanometer chips and are investing heavily to be the first to have 3 nm chips. The industry has experienced strong growth this year and should continue to do so for years to come. Based on my evaluation, I believe TSM still has a 10.9% upside from its current value.

TSM is a pure play semiconductor foundry (fabrication plant/fab). This means that it does not produce its own designs but manufactures microchips designed by its customers. In contrast, integrated device manufacturers (IDMs) are a type of foundry that designs and manufactures microchips. Examples would be Intel (NASDAQ:INTC) or Samsung (OTC:SSNLF).

Fabless semiconductor companies design their own microchips but rely on a foundry such as TSM to manufacture them. This is due to the capital-intensive nature of manufacturing microchips. For example, TSM spent $9.3 billion USD on their last Taiwan factory, and their new fab could cost around $20 billion. New EUV technology is also very expensive, with EUV lithography machines costing a reported $120 million each. These machines are also on backorder for years. High costs are one of the reasons TSM counts firms such as Apple (OTC:APPL), Qualcomm (NASDAQ:QCOM), Advanced Micro Devices (NASDAQ:AMD) and Nvidia (NASDAQ:NVDA) as a few of their close to 500 customers.

Technology and Competition

TSM currently enjoys greater than 50% market share of the $42 billion semiconductor foundry business, with Samsung coming in at about 18%. No other firm holds greater than 8%. According to Technavio, the global semiconductor foundry market was at $65.27 billion in 2019 and is projected to reach $91.74 billion by 2024. TSM is well positioned to benefit most from this growing market.

At the heart of the semiconductor foundry battle is the race for smaller, more advanced microchips. Currently, TSM is mass-producing 5 nm chips using EUV lithography to be used in the new iPhone 12. While Samsung has developed 5 nm tech, it has been reported that they are facing yield issues (defects). If these issues cannot be resolved quickly, it will lead to Samsung losing business to TSM. While its closest competitor struggles with 5 nm, TSM is aiming to mass-produce 3 nm by 2023.

Other competitors would include Intel and Semiconductor Manufacturing International Corporation (OTCQX:SMICY). However, both are years behind TSM at best. Intel recently announced issues with their 7 nm chips, delaying their release to 2022 or 2023. SMIC is only at 14 nm chips and is facing US sanctions which could severely harm its future prospects and add to TSM’s orders.

Risks

The biggest risk facing TSM is competition from Samsung. Although they are ahead technologically, Samsung has the will and resources to try and play catch up. They announced plans to invest about $116 billion over the next decade in 2 different areas, one being the foundry business. They charge less for their chips, so if they can close the technological gap, it could be a problem for TSM. They could also increase price competition, putting pressure on TSM’s margins.

There is also the political risk from China-Taiwan relations, which could have a major impact on TSM. If Taiwan’s independence was ever under jeopardy, the effects on TSM could be severe.

Lastly, there is always a possibility of flattening demand for TSM’s chips, especially if/when we find a vaccine for COVID-19. If the shift to work from home and cloud computing is less than expected, it could affect future growth.

I believe all of these risks are outweighed by the possible benefits. Samsung is spending a lot, but so is TSM, with full year 2020 CAPEX projected to be $16-17 billion. This will be used to help expand its already industry-leading capacity and fund preliminary risk production of 3 nm chips during 2021 and the development of a 2 nm process by 2024. They are positioned well to continue their technological superiority and, thus, will benefit from steady, strong margins.

Although the threat of war from China cannot be dismissed, it seems very unlikely, considering the world response would be devastating for China. They will continue with their rhetoric, but in the end, I think they know it is in their best interest to leave Taiwan as effectively independent.

Semiconductor demand can be cyclical, but with the rollout of 5G and the further shift to the cloud and data warehouses, TSM should have continued demand for their products for years to come. Add to that the further advancements and needs of artificial intelligence and the Internet of Things, and you see why they continue to spend tens of billions of dollars to increase capacity.

Valuation

I performed a discounted cash flow analysis based on historical numbers and future prospects. I used a combination of the first 2 quarters of data and company guidance to estimate values for the current year. Revenue is estimated to be 22.78% for 2020, with operating margins at 40.28%. I made some other key assumptions that led to my valuation. After the surge in 2020 revenues, the growth rate moderates in future years, to a more conservative level. With the growth rates used and estimates of market size, TSM will grow their market share to 65.6% by 2024. Operating margins stay steady, which I believe is fair due to strong demand as discussed above. The effective tax rate increases incrementally towards the marginal rate, which is also a conservative estimate on my part. TSM will need to continue to invest heavily to maintain its industry dominance and grow revenues. I linked revenue growth with reinvestment needs using the sales to capital ratio, which helps me estimate how much TSM has to invest in future years to generate my projected growth. This reinvestment is subtracted from after tax operating income to arrive at free cash flow to the firm (FCFF), which is discounted by the weighted average cost of capital (WACC) to get present value of cash flows. I assume the terminal cost of capital to remain the same as the WACC.

I have a price target of $89.29 for TSM, which gives it a 10.9% upside from the $80.51 price at the time of writing this article.

DCF

Source: Myself using TSM financial reports from their website, tsmc.com.

I have added an image of TSM’s operating results from their latest quarterly report for reference:

TSM operating results

Source: tsmc.com

TSM has a strong balance sheet. As of their last quarterly statement, they have a current ratio of 1.4. Their cash position of $15.89 billion is more than enough to cover all interest-bearing liabilities of $9.5 billion. I project a return on invested capital of 32% for 2020.

Conclusion

TSM is a high quality, best in class semiconductor foundry. Although no business is without risks, I believe its technological advantages and dominant position as industry leader make it a good long-term investment. You will currently get a 2.10% dividend yield as the 10-year Treasury pays 0.65%. While many firms, especially tech-related ones, are experiencing stretched valuations, TSM still has upside and strong long-term prospects.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in TSM over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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