2023-07-06 12:27:46 ET
Summary
- TSMC is a compelling investment opportunity in the semiconductor industry due to its strong market position, commitment to innovation, and ability to navigate challenging market conditions.
- Despite a challenging operating environment, TSMC has shown resilience and adaptability, with signs of recovery and increasing demand for advanced technologies like 5nm, 3nm, and 2nm process nodes.
- With Q2 expected to be the bottom of the cycle for TSMC, a gradual improvement from Q3 onwards should boost the financial performance of the company.
- The company continues to invest in capacity expansion overseas with more significant investments expected in the US and Europe, which increases Western relations and decreases geopolitical risks.
- In my eyes, TSMC remains far ahead of its competitors in terms of scale and technological progress. Combining this with a stellar margin profile and mighty balance sheet, makes this an interesting investment.
Investment thesis
I initiate my coverage of Taiwan Semiconductor Manufacturing Company Limited ( TSM ) stock with a buy rating following my in-depth company analysis. TSMC has successfully been navigating the current challenging environment and sees a bottom in the cycle in Q2, followed by a gradual recovery from Q3 onwards which should bode well for the company’s financial performance over the next few years.
TSMC's position as a global force in the semiconductor industry is indisputable. The company's relentless focus on semiconductor manufacturing, combined with its commitment to innovation, operational excellence, and customer satisfaction, has propelled it to the forefront of the industry.
Despite a challenging operating environment, including weakened macroeconomic conditions and inventory corrections by customers, TSMC has demonstrated resilience and adaptability. While the company experienced a decline in revenue and margins in Q1, there are positive signs of recovery, with a deceleration in the revenue decline and increasing demand for advanced technologies like 5nm process nodes. TSMC's strong market position and dominance in semiconductor manufacturing, with a global market share of 60%, have further solidified its standing in the industry.
Looking ahead, TSMC's long-term growth potential remains promising. The company's exposure to advanced technologies such as AI and IoT, coupled with its ongoing investments in research and development, positions it well for future success. While challenges such as inventory corrections and rising energy prices may impact margins in the short term, TSMC's competitive positioning and focus on cost improvements are expected to mitigate these effects.
Overall, TSMC's track record of delivering industry-leading solutions, its technological prowess, and its ability to navigate challenging market conditions make it a compelling investment opportunity in the semiconductor industry. With its strong market position and commitment to innovation, TSMC is well-positioned to maintain its global leadership and continue driving advancements in the semiconductor industry.
In this article, I will take you through the company fundamentals, latest developments, and financial results to end up with a revenue and EPS forecast through 2026 to determine whether this company is an attractive buy today.
TSMC is a global force in the semiconductor industry
TSMC, also known as Taiwan Semiconductor Manufacturing Company, is a globally renowned semiconductor manufacturer and technology leader. Established in 1987, TSMC has emerged as the world's largest dedicated independent semiconductor foundry. The company plays a pivotal role in enabling innovation across various industries by providing cutting-edge semiconductor solutions and advanced manufacturing capabilities.
Using state-of-the-art fabrication processes and leading-edge technologies, TSMC enables its customers to design and manufacture highly complex, power-efficient semiconductor products. Just how broad the company’s offering is, is highlighted by the fact that the company manufactured 12,689 different products, using 288 different technologies, and servicing 532 different customers in 2022.
TSMC's commitment to innovation, operational excellence, and customer satisfaction has propelled the company to the forefront of the semiconductor industry. Its relentless pursuit of technological advancements and continuous investment in research and development have enabled TSMC to consistently deliver industry-leading solutions and maintain its competitive edge, allowing it to grow revenue at a CAGR of 18% since listing in 1994.
One of the primary strengths of TSMC compared to many of its competitors is its focus on just being good at a single thing – semiconductor manufacturing. This has allowed it to invest all sources in this one skill of providing the most technically advanced semiconductors for technology leaders at a massive scale. Meanwhile, competitors Intel ( INTC ) and Samsung ( SSNLF ) are forced to focus on many more business segments like electronics or chip design, forcing them to split resources and attention. As a result, analysts believe TSMC’s lead in semiconductor manufacturing today is so big that it will take at least four years for any competitor to come close to the technological prowess of TSMC, further solidifying the company’s long-term growth potential and moat.
In addition to the benefits of its foundry-only model discussed above, it also ensures that the company never competes with its customers on any front, which could be the case with either Intel or Samsung as these also design their own chips. This is part of why TSMC is a preferred choice among many technology companies worldwide.
TSMC is successfully navigating a challenging operating environment
In April, TSMC announced its Q1 results in which it reported a revenue decline of 4.8% YoY in US dollars to $16.72 billion while its growth in New Taiwanese Dollars (NT$) remained positive at 3.6%, which is a better indicator of financial performance as it takes out the FX headwind. The business was impacted by softened end-market demand as a result of weakening macroeconomic conditions, which did not come as a real surprise. In fact, if we look at the latest monthly revenue numbers in New Taiwan Dollars (taking out the FX change), we can see a positive trend as the decline in revenue is decelerating from a 16.2% YoY drop in January to just 4.9% in May. This shows that demand for TSMC’s products is slowly picking up again as customer inventory levels are starting to reach healthier levels.
TSMC did report a significant decrease in its gross margin in Q1 (56.3%) of 5.9 percentage points as Capex spending remains high despite the negative top-line growth. The operating margin also decreased by 6.5 percentage points to 45.5% while the net income margin remained somewhat more resilient at 40.7%, only down 0.6 percentage points. Despite some weakness in margins over recent quarters, TSMC maintains a very impressive margin profile that not many companies can match.
Looking at the revenue split between the different technologies, advanced technologies (including both 5nm and 7nm) accounted for 51% of wafer revenue, up slightly from 50% one year ago. Yet, under the hood, there is a clear shift happening with 5nm process technology seeing increasing demand as technology companies require smaller, faster, more powerful, and more energy-efficient semiconductors to satisfy their needs, and with TSMC being the leading player for these advanced nodes, the company is seeing strong demand. As a result, 5nm process technology increased its share of net revenue from just 20% one year ago to 31% last quarter, while 7nm nodes decreased from 30% to 20%. The increase in demand for highly advanced AI GPUs from Nvidia ( NVDA ) is expected to further boost this trend.
The revenue contribution by platform graph shows a similar pattern as high-end technologies start to account for a larger share of total revenue for TSMC, with the likes of High Performance Computing ((HPC)), IoT, and Automotive growing in importance, together accounting for 60% of revenue, up from 54% one year ago. With these technologies expected to see great growth over the next decade, this is not a bad development at all. Still, looking at the YoY growth rates by platform, we can see that almost all end markets drove the revenue decline with only Automotive recording positive growth as the automotive sector is still dealing with minor semiconductor shortages following the increased demand due to autonomous driving systems and EVs.
Moving to Q2 guidance , TSMC expects to report Q2 revenue of between $15.2 billion and $16 billion, which was below analyst estimates prior to the Q1 earnings release. Also, this is down 8% YoY at the midpoint, showing a further deceleration compared to Q1, while monthly data seemed to improve. Yet, the US dollar has also strengthened further, resulting in analysts currently projecting TSMC to report revenue of $15.37 billion in Q2. In addition, management projected the gross margin to come in between 52% and 54% and the operating margin between 39.5% and 41.5%, showing a further worsening of margins as revenue continues to decelerate while operating costs and Capex remain high. The reason for this decline is the continued expectation of inventory corrections by TSMC customers following the decline in electronics sales we have seen over the last year.
According to TSMC, inventory levels should reach a healthier level by Q3 which should then also boost growth for TSMC, meaning Q2 could be a bottom quarter with growth returning in Q3 or Q4. Still, management does believe that higher energy prices throughout the year, the ramp-up of its 3nm process technology, inventory corrections, overseas fab expansion, and inflationary costs will be a drag on margins. With internal cost improvements, the company does believe it should be able to keep its gross margin above 53%.
For the full year, TSMC expects the semiconductor industry to decline by mid-single digits and the foundry industry to decline by high-single digits. Still, TSMC believes its competitive positioning and exposure to advanced technologies like AI and IoT will ensure it will outperform both foundry and the semiconductor industry with a low to mid-single-digit decline in revenue in FY23.
It is also worth pointing out that despite a somewhat weak performance in Q1, TSMC still massively outperformed its largest competitor Samsung as this one saw revenue fall by 36.1%. This resulted in TSMC further solidifying its market position with it now holding a 60% global market share in semiconductor manufacturing. Counterpoint research shows a similar market share of 59% which has been steady over the last three quarters but is up from 55% one year ago as TSMC’s most advanced nodes continue to see relatively strong demand. In addition, the graph below once more highlights the mighty position of TSMC within the foundry industry.
If we look at the most advanced nodes and technologies, TSMC’s dominance gets even more pronounced as it holds a market share of over 90% in the most advanced 5nm and 3nm chips, used for technologies like supercomputers, IoT, and of course, AI. It's important to realize that the smaller the node becomes, the more processing power it holds while also decreasing energy usage and improving operating speeds.
As a result, TSMC should also be seen as one of the primary beneficiaries of the boom in AI demand. With the company holding a 90% market share in the most advanced nodes required for AI chips, TSMC is the go-to place for companies like Nvidia. This makes TSMC a prime beneficiary of the AI boom with currently almost all AI production most likely heading toward it. Therefore, AI will likely be a significant tailwind for the company. Illustrating the strength of this tailwind, Precedence Research predicts the AI semiconductor market to show massive growth with a CAGR of 30% through 2030 as demand booms.
TSMC is still an extraordinary capital allocator
Despite a weaker-than-expected quarter and outlook, TSMC does maintain its Capex plans of between $32 billion and $36 billion in 2023, despite some speculation of this being lowered by the company. Yet, management has stated that this will most likely come in at the low end of the range.
This shows that Capex levels remain incredibly high for TSMC. A decline in its Capex projections already was highly unlikely as the company can’t afford to cut back on technical development and capacity expansion plans, as these are key to maintaining its lead. This is also why the company consistently spends between 7-8% of net sales on R&D - it needs to stay on top of its game to maintain its impressive market share and industry dominance. The moment the company loses its technological edge or advantage, it will lose market share rapidly as companies like Nvidia or AMD ( AMD ) will always be looking for the most advanced available nodes and technology.
The graph below shows a decrease in R&D expense as a percentage of total revenue, which is caused by the rapid growth in the semiconductor industry over recent years. Yet, this percentage should increase this year as revenue growth falls back. To offset this, TSMC expects to further increase prices in 2024 in the range of 3-6% to offset higher energy prices and increased Capex.
TSMC has consistently achieved a 45% return on assets over the last several years, highlighting its excellent capital allocation abilities and removing any fear of the company overspending on Capex to stay ahead of the competition. Its R&D expenses as a percentage of net revenue are declining, showing that while TSMC is spending a lot of its cash on technological development, its revenue growth due to high Capex spending is even more impressive.
Meanwhile, it is safe to assume that Capex will remain high as the business requires significant investments for expansion and technological development as semiconductor manufacturing equipment is incredibly expensive. This is also part of the company's moat as there is a huge barrier to entry, causing today’s giants (Samsung and TSMC) to face very little competition. Just how hard it is to catch up is highlighted by Intel which is forced to spend many billions of dollars to compete with the likes of TSMC and it is still the question whether it will be able to catch up at all. As a result, smaller companies don’t stand a chance and so successes go to the biggest and most advanced players in my opinion. Simply put, none of its competitors have the balance sheet to spend over $30 billion in Capex a year to expand capacity and invest in more advanced chips.
As of the latest quarter, TSMC had a total cash position of $53 billion, up from around $44 billion in 1Q22 despite significant Capex spending, dividend payments, and slowing top-line growth. Meanwhile, its long-term debt stood at just $28 billion, giving the company a solid net cash position of around $25 billion, giving it plenty of room for further investments. This fortress balance sheet and excellent financial health have earned it an AA- rating from S&P Global.
This fortress balance sheet also allows the company to return significant numbers of cash to its shareholders. Shares currently yield a very solid 1.72% which, combined with a payout ratio of just 6%, offers decent value to investors. TSMC has been paying a dividend since 2004 without ever reducing the dividend. The company remains committed to growing its dividend in a sustainable way to reward shareholders. And despite this not being a financial priority of the company, I believe investors can expect TSMC to consistently increase its dividend through the cycles going forward.
Risks and business development
Now, a few final points are worth looking at when you are considering investing in TSMC or when you already hold a position. The one big elephant in the room here that has yet to be mentioned is, of course, the geopolitical risks that come with investing in a company located in Taiwan due to the threat of a Chinese invasion.
Cutting this part of the article relatively short, investors will need to accept this when investing in TSMC. An invasion of Taiwan seems highly unlikely for several reasons , but the threat will remain if the China-Taiwan-US relationship does not improve. Also, a potential invasion would have catastrophic consequences for the world economy and would impact many more companies besides TSMC. If you are genuinely scared of such an invasion, avoid any company that needs semiconductors manufactured by TSMC.
Overall, investors need to weigh this risk against the company’s worldwide importance and moat discussed before when considering investing in it. This will most likely largely depend on your own risk appetite. Nvidia CEO Jensen Huang recently stated that he feels perfectly safe relying on TSMC for its chip production. Personally, I believe investors can feel perfectly safe with their investment in TSMC as well.
Moreover, while 90% of production still takes place in Taiwan, TSMC has been diversifying its geographical exposure over recent years to increase Western relations and decrease its exposure to the Taiwan-China tensions. And while this does not resolve the geopolitical risks involved with investing in TSMC, it is a positive development. Also, TSMC has limited exposure to China of around 6% after the company stopped supplying Huawei a couple of years ago, which limits any other risks in relation to China.
In June 2021, TSMC started building its newest semiconductor manufacturing facility in Arizona which would require a total investment of $40 billion . In February, TSMC raised its expected investment in the Arizona facility further by $3.5 billion, bringing the total to $43.5 billion—a record investment for sure. Yet, through the Arizona plant, TSMC is poised to benefit from the last year's introduced US Chips Act designed to boost local semiconductor manufacturing. With about 75% of all semiconductors currently manufactured in Asia, it makes sense that both the US and Europe want more manufacturing to move to their respective regions to be less dependent on Asian countries. In the end, semiconductors are incredibly crucial in today’s society which is why they are referred to as the oil of the future.
The US chips act includes an investment tax credit for chip plants that could be worth an estimated $24 billion over the next decade, of which TSMC could be one of the primary beneficiaries as it would lower its required investments or increase its capacity potential. In fact, the February investment increase came after the passage of the legislation as TSMC believes it will receive anywhere between $7 billion and $8 billion in tax credits from the chips Act for its US activities, with an additional $6 billion to $7 billion in grants for its Arizona plants, bringing its potential government support to between $13 billion and $15 billion.
The Arizona plant will house one facility for the manufacturing of 5nm chips and this facility will become operational in 2024. By 2026, the company hopes to open a second facility producing the even more advanced 3nm node. The Arizona facility will be producing the highest-end nodes to satisfy the growing demand for these chips, driven by the integration of AI and IoT technologies. Once fully operational, the facility will be capable of producing 600,000 wafers annually, worth $10 billion in annual revenue.
Apple (AAPL) has already stated that it will be one of the first companies to source chips from the Arizona plant, highlighting the high demand for locally produced semiconductors to limit geopolitical risks. Also, with 65% of TSMC’s sales originating from the US, improving production capacity here makes even more sense. Obviously, by building the Arizona plant, TSMC wants to limit its reliance on Taiwan and diversify its geographical exposure, which will improve its relations with US and European technology companies. Therefore, besides significant investments in the US, TSMC also plans investments in new semiconductor plants in Japan and Germany .
On the note of the 3nm technology facility to be built in Arizona, TSMC plans to scale its 3nm technology in Q3 as it will start to have a meaningful contribution to total revenue. The company is the first to start producing 3nm chips at a large scale and is already seeing demand that outpaces its production capacity. N3, as TSMC calls the technology, will be fully utilized in 2023, supported by both HPC and smartphone applications, according to management commentary on the Q1 earnings call. Moreover, it is expected to contribute a mid-single-digit percentage to 2023 wafer revenue, which should rapidly increase in the following years as TSMC increases capacity for its newest technology. Through this, the company should be able to capture the current demand for 3nm technology well, as companies such as Nvidia and AMD are eager to leverage the new technology, resulting in a boom in 3nm adoption .
3nm is the most advanced semiconductor technology in both PPA and transistor technology, which is why TSMC expects to see strong demand as customers will be eager to make the next step in semiconductor technologies. The step is essential for TSMC as it solidifies its leading position in advanced semiconductor technology, positioning the company favorably for the expected growth in AI, IoT, and cloud computing. Also, as Samsung is the only company able to challenge TSMC in 3nm technology, competition is limited, further increasing the revenue potential for TSMC.
TSMC goes another step further in this as the company is already working with ASML ( ASML ) on realizing mass production of 2nm chips by 2025 , which will further improve power and energy efficiency. Most importantly, the company seems to remain ahead of competitors Samsung and Intel. Both are reportedly also working on 2nm technologies and Intel management even believes it will be able to produce these nodes by 2024. In all honesty, this is highly unlikely considering the current progress Intel is making. I find it hard to believe that the company could produce high-quality 2nm nodes on a massive scale by 2024 or even 2025.
Meanwhile, TSMC management stated that N2 technology development is progressing well and on track for volume production in 2025. If TSMC were to hit its 2025 target, it would meaningfully strengthen its technological edge even further over its competitors, limiting the risk of competition. TSMC is already observing high customer interest for the next step in semiconductor technologies and believes it will further extend its technological leadership. This should then bode well for the company financially over the following years as this could result in further market share gains in an already fast-growing industry. Putting this into perspective, the global semiconductor market is expected to grow at a CAGR of 12.2% through 2029, while the foundry market is projected to grow at a CAGR of 7.34% through 2028.
Outlook and TSM stock valuation
Following my in-depth analysis of TSMC, the company’s Q2 and FY23 guidance, the analysis of underlying growth expectations, and management’s aim to grow revenue at a CAGR of between 15% and 20% through 2026 (from 2021) and a gross margin of above 53%, I arrive at the following long-term expectations through FY26.
Long-term estimates (Daan Rijnberk)
(For Q2, I project TSMC to report revenue of $15.3 billion and EPS of $1.10)
Shortly explaining these estimates, I assume TSMC will report a 7% YoY decline in revenue for 2023, with a worse performance in EPS driven by declining margins due to high operating costs and investments. I expect Q2 to be a bottom, followed by a gradual improvement in demand for the company’s product in the following quarters. This means that the year's second half is expected to be meaningfully stronger than H1 as customer inventories normalize.
Following my expectation of TSMC further scaling the business, resulting in further scale advantages and possible market share gains, I am confident that TSMC should report solid growth over the remainder of the decade. Government incentives and improved relationships with Western companies will support this. 2023 and 2024 will most likely be recovery years for the company as the gradual economic improvement and growth in demand will support strong growth in both years, given an additional boost by explosive demand in AI semiconductors for which TSMC is the go-to manufacturer due to its expertise in advanced nodes. This will support the growth of the company. Furthermore, EPS should outpace revenue growth as margins bounce back from 2023 lows and the company should find more room for scale advantages to drive up margins.
Finally, I expect growth to normalize from 2026 onwards to the high-single digits, with EPS in a similar range. As long as the company is able to maintain its impressive competitive edge over its competitors and keep up its rate of innovation and international capacity expansion, which I believe it will, it should be able to maintain its growth in the high-single digits for a pronounced period of time.
Moving to the valuation, ADR shares are currently valued at a forward P/E of 19.5x, which is around 10% below its 5-year average P/E of 21.5x and 17% below the sector average. A similar undervaluation can be seen for other valuation metrics as well, showing that shares are not overly expensive despite a 36% price jump so far this year.
Considering the company’s incredible moat, growth potential, impressive margin profile, capital allocation ability, and global importance, a higher P/E seems more than justified. Yet, we should also consider the geopolitical risks involved which will most likely remain a drag on the company’s share price. Therefore, I am opting for a slightly discounted P/E of 21x, which seems to leave a sufficient margin of safety in my eyes.
Based on my FY24 EPS estimate and a 21x forward P/E, I calculate a target price of $135, leaving an upside of 34% from a current share price of around $100. (Please note, this target price is solely based on its forward P/E and is only for indicative purposes.)
Conclusion
The company's specialization in semiconductor production, unwavering commitment to innovation, and operational excellence have solidified its position in the industry over recent years. With a track record of delivering cutting-edge solutions, TSMC has maintained a significant lead over competitors, and it may take years for them to catch up. Moreover, TSMC's strong financial performance, including robust revenue growth and impressive margins, demonstrates its ability to navigate challenges. Also, despite short-term challenges such as inventory corrections and rising energy prices, TSMC's competitive positioning and cost improvements are expected to mitigate these effects.
TSMC's industry dominance, technological prowess, and strong financial performance make it an attractive investment. As the company continues to drive advancements in the semiconductor industry and capitalize on emerging technologies, investors looking for exposure to the sector should consider TSMC shares as these currently offer good value at a share price of around $100 per share. Based on my target price of $135, prices below $108 per share offer sufficient downside protection and long-term returns, even when taking into consideration the geopolitical risks the company is exposed to.
Therefore, I rate TSMC shares a buy.
For further details see:
Taiwan Semiconductor: Thriving Through Turbulence And Building A Bright Future