UMC - Avoid TSMC In Favor Of United Microelectronics Due To The Elevated Threat Level

Summary

• This thesis assesses the risks to Taiwan's two main chip contract manufacturers by focusing on the location and impacts on their fabs in case of military action.
• First, U.S. sanctions restricting chip exports to China not only reduce China's ability to modernize its army but also reduce the competitiveness of its AI industry, which increases the probability of confrontation.
• While both Taiwan Semiconductor Manufacturing Company Limited and United Microelectronics Corporation would be impacted, UMC has a better chance of continuing operations in view of its expanding Singaporean operations.
• Also, looking beyond technological prowess and scale, it is factors like business continuity and the ability to expand operations more profitably that matter when investing.
• I start with the price action as from early August which shows that UMC is the preferred choice, amid the escalation in the threat level.

If investors wanted to convey to us a message about their perception of geopolitical risks, there would be no better place to view it than in the performance charts. Thus, after the ex-Democratic leader in the House of Representatives Nancy Pelosi visited Taiwan at the beginning of August last year, geopolitical tensions between the U.S. and China escalated to a new height.

In such a context, it is United Microelectronics Corporation ( UMC ) that has been outperforming Taiwan Semiconductor Manufacturing Company Limited ( TSM ) ("TSMC") by more than 3%. This relatively small chip contract manufacturer which operates in the shadow of TSMC has even outperformed the iShares Semiconductor ETF (NASDAQ: SOXX ), which holds some of the largest chip names in the world.

Now, in addition to geopolitics, there are other factors like financial results which were released for TSMC today that determine a stock’s price action, and taking these into account, the objective of this thesis is to assess whether investors' current preference for UMC is justified.

I start with the geopolitical importance of Taiwan's chip companies, best gauged through a comparison with the Ukrainian conflict.

Importance of Taiwan in the Global Supply Chain

The European war mostly deprived us of sunflower oil and wheat, not to forget the Russian gas which used to flow seamlessly to many countries including industrial Germany.

There were considerable effects on agricultural commodities and energy prices, somewhat mitigated by the ability of other wheat-producing countries and the U.S. to send LNG tankers to Europe. There were pains not only for developing countries but also for the American economy, namely with high inflation. This was largely unforeseen by central bankers on both sides of the Atlantic Ocean, which may have contributed to inflation being permanent and not transitory . As a result, the S&P 500 lost nearly 20% last year, and tech suffered even more.

Now, look past the Covid problem in China and think of the losses in case of a Taiwanese conflict.

This possibility came to the fore after Mrs. Pelosi’s visit to the island, but, another reason for it to happen is a chips war , as I will detail below. But, in case war happens, it would deprive us of all the appliances which have electronics embedded in them. As a matter of fact, the chips produced by TSMC and UMC are shipped to most countries of the world to manufacture everything from washing machines, televisions, and telecommunications to cars and planes. Some high-profile examples are Apple (NASDAQ: AAPL ) and Advanced Micro Devices (NASDAQ: AMD ) sourcing the chips they need for their devices ranging from iPhones to RYZEN PCs, as pictured below.

Dwarfed by its giant Taiwanese peer, UMC nonetheless remains the world's third-largest contract chipmaker behind South Korea's Samsung Electronics ( SSNLF ), and also, like TSMC, has prominent clients.

The above two lists of customers may not necessarily be comprehensive and up-to-date, but they still show the importance of Taiwan's champions in the supply chains of electronics manufacturers globally.

Risks of Sanctions Degenerating into a Military Conflict

Now, whereas previously Taiwan could export its chips to nearly all parts of the world, except to countries that were on America's blacklist, things started to change radically in 2020 when efforts to remove China's Huawei from the smartphone supply chain meant restrictions pertaining to specific chips exported to that country. A more recent example occurred in September 2022, when NVIDIA Corporation (NASDAQ: NVDA ) was barred from exporting the AI chips it designs and manufactured by TSMC to China. The same restriction applied to Lam Research (NASDAQ: LRCX ), which cannot ship its equipment-making gear to Chinese clients denying the country the domestic capability to produce advanced chips.

Now, since these sanctions put a break to Beijing's AI ambitions, it has taken the matter to the WTO , or World Trade Organization, whose priority remains trade. Viewed from a certain angle, this could be a step before a potential military action which could take several forms, but would certainly result in a disruption in the chips supply chain.

Now, by the time the organization gives its verdict, it is likely that TSMC would have started its operations in the U.S. scheduled for 2024 to manufacture 3 nm chips. However, the bulk of its operations remains in Taiwan, which is only 100 miles away from the Chinese coast. For this purpose, not only does the country's foundries produce 65% of the planet's semiconductors, but, TSMC produces the lion's share at 85% of the most advanced chips. In order to achieve such a feat, it has 12 Fabs and Gigafabs which exceeded 13 million 12-inch equivalent wafers capacity in 2020.

Looking at the less-sophisticated side of things, after having converted to a pure-play foundry play in 2021, UMC has 12 wafer fabs located throughout Asia as detailed in the table below. These have a combined capacity of over 800K wafers per month compared to 87K per month for its Fab 12A in Tainan, Taiwan.

The above table shows that, in the case of a conflict, Taiwan as pictured in red above would go out of production, while sanctions against China would bring uncertainty to Chinese foundry operations.

In such a scenario, and when viewed from a business continuity perspective, it is UMC, namely with its Singaporean and Japanese operations located about 3K miles and 2K miles away from Taiwan, respectively, that has a better chance to continue on unless the conflict also becomes contagious to neighboring countries, with heavy dependency of one country's operations on another. There is also the effect of human casualties to consider.

Scale, Profitability, Valuations, and Threat Level

Moreover, with trailing-edge (but still useful) process nodes, UMC is less valuable from the "technology sophistication" point of view, compared to TSMC's advanced 3nm production at Taiwan's Fab 18 to power leading-edge nodes.

Consequently, it is TSMC that the market has been rewarded with higher valuations, as evidenced by the P/E and P/S multiples (table below). The giant foundry operator also has a massive scale and higher revenues on which to spread its fixed costs, which partly explains its higher profitability.

However, TSMC's higher valuations are not justified in view of the threats.

For this matter, U.S. sanctions not only make it harder for the country to improve the sophistication of its military but also should have an impact on the very competitiveness of its public cloud giants, namely in AI as I detailed in a recent thesis. Therefore, unless the country develops alternative technology rapidly, which is impossible given the decades and tons of money it took the U.S. and its East Asian allies to develop the semi-system as we know it today, China has no other options, one of which is to use force.

Thinking aloud, whether China carries out an invasion or blockade of shipping lanes around Taiwan, we should expect some retaliation from the U.S. 7th Fleet. However, even if the attacks are pared, foundries are likely to form part of the collateral damages. Thus, with more greens than yellows or reds in the above fabs location table, UMC is the best option for exposure to Taiwanese pure-play foundry. It is also undervalued by more than 100% compared to TSMC, and, adjusting for a 50% gain, I obtain a target of $10.92 (7.28 x 1.5) based on a share price of $10.92.

Now, even in the case that there is no conflict, TSMC's profitability should suffer because of scaling up operations on American soil. In this regard, it must be mentioned that despite the company missing revenue estimates by $990 million in the fourth quarter of 2022, it delivered a 26.6% year-on-year growth, driven by more advanced 5-nanometer technology which accounted for 32% of total wafer sales. Profitability was up with GAAP EPS of $1.82 beating estimates by $0.05, but, things are likely to change in 2024.

In this case, despite billions of dollars of subsidies in the form of grants, loans, or tax breaks which should help the company in setting up operations in Arizona, one has to be realistic that in the longer term, running fabs in the U.S comes at a higher cost, about 50% more than in Taiwan. Thus, for investors, a better approach is to wait and see if its state-of-the-art technology Arizona fab is able to increase productivity and lower the cost structure when it begins commercial operations next year.

Conclusion

While unprecedented China's military activity in the Taiwan strait is associated with politics, the latest U.S. sanctions restricting its access to chips produced only 100 miles away from its coasts imply a setback for China's leading-edge chip industry and its AI ambitions. In retaliation, the country has filed a case with the WTO, but some form of military action is not excluded regarding Taiwan, which it already claims as its territory. Taking this view, this thesis has made the case for investment in UMC for someone looking to put some money at work in Taiwan's foundry operations.

In this case, the fabs location table shows that investing in TSMC is currently very risky, and as the world's leading contract chip maker with a $389 billion market cap, its operations currently lack the sort of country-level diversification which is required for such a scale. Its expansion to the U.S. in 1998 with its Camas factory did not work as expected. Moreover, the company indeed considers the construction of new fabs as part of operational perspectives for Business Continuity Planning purposes and certainly attaches importance to risks as per its corporate website, but these are more detailed for UMC. Also, UMC's decision to choose Singapore 20 years earlier was more reasonable as it has one R&D center and fab in that country and is planning a new one to become operational by next year. This should also be a more profitable path.

Finally, this thesis justifies United Microelectronics Corporation's stock outperformance since August, and I also chose to invest in UMC as it bears a higher risk premium, or provides a higher rate of return due to its lower valuations (by 100%) in view of the higher threat level surrounding foundry activities in Taiwan.

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