Taiwan Semiconductor Manufacturing has attracted a lot of attention lately after Berkshire Hathaway invested $4.1 billion in the company. This is surprising since Warren Buffet avoids technology stocks. Yet, given TSM’s expanding margins and strong bottom line, it makes sense a value investor would be attracted to the stock.
Our thesis is that the company has developed market leadership in the foundry industry particularly with advanced nodes, which are nodes defined as 7nm and below. The advanced nodes have strong demand by top design companies, such as Apple and Nvidia, particularly in high-performance computing and smartphones. The company has started the production of 3nm process technology and currently this is the most advanced chip production technology. Samsung is a competitor that has begun production using 3nm technology. However, in the past TSMC has been able to win the business from Samsung due to better yields and economies of scale.
The company’s fundamentals are also strong and that makes it an ideal bet in the current market environment. Along with the top-line growth the company’s bottom line has sharply improved. For example, the company’s net profit margin has improved from 37.7% in Q3 2021 to 45.8% in Q3 2022. This is on a large net profit base of $20 billion and is headed toward $30 billion. Many companies have struggled with rising costs while TSM has successfully navigated these challenges with cost controls and negotiating better prices with its customers.
Notably, part of the company’s success has been in developing a niche as a pure-play foundry. Its focus has been manufacturing for its customers, and its success has been built on the principle of not designing or manufacturing semiconductor products under its own name. It counts leading companies like Apple, AMD, Nvidia, Qualcomm, and Intel as its customers. Samsung lost much of its business from Apple as Samsung is a direct competitor to Apple on smartphones. The growing use of smartphones, PCs, Internet of Things, Artificial Intelligence, automotive, and 5G are tailwinds for the company in the long term as TSM has mastered advanced node output.
Market Opportunity
According to Fortune Business Insights, the semiconductor market size was $528 billion in 2021. The market is expected to grow at a compound annual growth rate of 12%, from $573 billion in 2022 to $1.4 trillion in 2029. According to Verified Market Research, the semiconductor foundry market was valued at $102 billion in 2022 and is expected to reach $183 billion by 2030, growing at a compound annual growth rate of 6.5% from the year 2023 to 2030.
TSMC is expected to grow faster than its industry. C.C. Wei, said in the Q3 earnings call, “We expect strong demand for our leading node technologies, driven by both smartphone and HPC applications to fuel our long-term revenue growth of 15% to 20% CAGR over the next several years in U.S. dollar terms.”to fuel our long-term revenue growth of 15% to 20% CAGR over the next several years in U.S. dollar terms.”
Similarly, McKinsey predicts that the semiconductor industry will be a trillion-dollar industry by the end of this decade. The article highlights the impact of the chip industry in our daily lives and how this industry is critical to the functioning of the modern economy. It predicts that the market could grow at an average of 6-8% from 2021 to 2030, growing from $590 billion to $1.07 trillion in 2030. About 70% of the growth is expected to be driven by automotive electronics, computation and data storage, and wireless communication.
Market leadership
According to TrendForce research, TSMC is the leading global foundry in terms of revenue. It has a market share of 56.1% in Q3 2022, up from 53.4% in Q2 2022. Samsung ranks a distant second with 15.5%, followed by UMC with 6.9%, and GlobalFoundries with 5.8%. The report suggests that TSMC was able to withstand the slowdown in the global economy and the impact from the China Covid-19 outbreak. The report states the company benefitted from strong demand from the new iPhone models.
Product and business model
Fabless semiconductor companies benefit from outsourcing their fabrication of chips to companies like TSMC. They hereby save the high costs of building and maintaining facilities for chip manufacturing. The fabless companies instead spend their resources on R&D for designing chips. There is a third category of semiconductor companies which are called integrated device manufacturers (IDMs), who design and manufacture chips like Samsung and Intel.
TSMC was founded by Morris Chang in 1987. He is known as the father of Taiwan’s chip industry and is credited to the concept of the foundry business. The company successfully developed a business model that ensures it will not compete with its customers as it does not manufacture under its own name. The company was able to win Apple’s business from Samsung since the latter is a direct competitor of Apple. . The company’s chips are mainly used in five platforms: smartphones, high-performance computing, Internet of Things, Automotive, and Digital Consumer Electronics.
TSMC’s Advanced Nodes
Smaller nanometer technology nodes refer to a smaller size for each transistor, allowing more transistors to be squeezed in a given die area, and thereby providing better power efficiency and performance.
Source: Company website
TSMC’s 5nm (N5) technology process follows the 7-nanometer process node. The company began volume production in Q2 2020 and experienced a strong ramp in the 2H 2020. TSMC’s 5-nanometer technology is the company’s second available EUV process technology, which enabled the company to win orders for smartphones and high-performance applications. 5-nanometer process technology provides about 20% faster speed than N7 technology or about 40% power reduction. The company also launched an enhanced version of the 5nm called 4nm technology. Apple’s A16 chip is made using 4nm technology.
TSMC’s 3nm technology (N3) will be the next die size following 5nm technology (N5). The company claims that the 3 nm will offer up to 70% logic density, gain up to 15% speed improvement at the same power and up to 30% power reduction at the same speed as compared with the 5nm technology. 3nm technology will be used for the production of chips for mobile and high-performance computing applications. The company also plans to make N3 chip production in the Arizona plant. Currently, the 3nm chips are made in Taiwan.
The company’s CEO, C.C. Wei, said in the Q3 earnings call, “Our N3 is on track for volume production later this quarter with good year. We expect a smooth ramp in 2023, driven by both HPC and smartphone applications. Our customers' demand for N3 exceeds our ability to supply partially due to the ongoing tool delivery issues, and we expect N3 to be fully utilized in 2023.
We expect N3 revenue in 2023 to be higher than N5 revenue in its first year in 2020 and for N3E to contribute mid-single-digit percentage of our wafer revenue in 2023, as our overall revenue base is much larger today than in 2020. N3E will further extend our N3 family with the enhanced performance, power and yield, and offer complete platform support for both smartphone and HPC applications. N3E development is progressing ahead of plan, and volume production is now scheduled for second half 2023.”We expect N3 revenue in 2023 to be higher than N5 revenue in its first year in 2020 and for N3E to contribute mid-single-digit percentage of our wafer revenue in 2023, as our overall revenue base is much larger today than in 2020. N3E will further extend our N3 family with the enhanced performance, power and yield, and offer complete platform support for both smartphone and HPC applications. N3E development is progressing ahead of plan, and volume production is now scheduled for second half 2023.”
Financials
The company’s revenue growth has been strong. Along with the top-line growth the margins have also improved. The October and November monthly figures suggests that the revenue might accelerate in the Q4 2022.The company’s Q3 2022 revenue grew by 36% YoY and 11% QoQ to $20.23 billion. Wendell Huang, CFO of the company, said, “Our third quarter business was supported by strong demand for our industry-leading 5nm technologies.” The company’s revenue grew 37% in Q2 2022 and 36% in Q1 2022.
The company releases monthly revenue figures in the local currency. The U.S dollar figures for the quarter and full year results will be released in mid-January.
For October 2022, revenue was approximately NT$210.27 billion, an increase of 1% MoM and 56.3% YoY. For November 2022, revenue was approximately NT$222.71 billion, an increase of 5.9% sequentially from October 2022 and a YoY increase of 50.2%. Revenue from January to November 2022 was NT$2,071 billion, a YoY growth of 44.6% compared to the same period in 2021. This marks an acceleration in revenue from the previous quarter when we look at the October & November monthly figures and helps to substantiate TSM’s comments that they will withstand a semiconductor slowdown better than competitors.
The advanced technologies, which are defined as 7-nanometer and below, accounted for 54% of Q3 wafer revenue with 5nm process technology contributing 28% and 7nm process technology contributing 26%. In Q2, 5nm contributed to 21% of wafer revenue, and 7nm contributed to 30%. This means 5nm is gaining market share sequentially.
Smartphone revenue accounted for 41% of Q3 revenue, high-performance computing accounted for 39%, Internet of Things accounted for 10%, automotive accounted for 5%, Digital Consumer Electronics accounted for 2%, and others accounted for 3%. The management has reiterated in the earnings call that HPC and Smartphone will be the growth drivers for the company in the long-term.
Source: Investor Presentation
Another reason for the strong revenue is that the HPC and automotive business is still steady. The company’s CEO, C.C. Wei said in the earnings call. “Okay, let me answer this one. Of course, we say that so far, our customers give us their demand forecast — so the data center and automotive related are still steady. But now the market becomes solved and will take a more conservative way in our planning for 2023. And that's why we say that we don't rule out the possibility. They might have some correction also, but we did not see it right now, to be frank with you.”so the data center and automotive related are still steady. But now the market becomes solved and will take a more conservative way in our planning for 2023. And that's why we say that we don't rule out the possibility. They might have some correction also, but we did not see it right now, to be frank with you.”
The company’s gross profit was $12.2 billion, with a gross margin of 60.4%, up from 51.3% in the same period last year and 59.1% in Q2 2022. This was higher than the management guidance of 57.5% to 59.5% as the company benefited from favorable foreign exchange and cost improvements. The margin improvement is very good in spite of the inflationary pressures.
The company’s operating income was $10.2 billion compared to $6.1 billion in the same period last year. The operating margin improved to 50.6% from 41.2% in Q3 2021 and 49.1% in Q2 2022. It was higher than the management guidance of 47% to 49%.
Pictured above: TSM’s expanding operating margin Source: YCharts
The net profit was $9.3 billion compared to $5.6 billion in the same period last year. The net profit margin was 45.8% compared to 37.7% in Q3 2021 and 44.4% in Q2 2022. The EPADR (Earnings per American Depository Receipt) was $1.79 compared to $1.08 for Q3 2021 and $1.55 for Q2 2022.
The return on equity was 42.9%, up from 39.4% in Q2 2022 and 30.7% in the same period last year. The strong margins also highlight that the company has been able to negotiate better prices with its customers and also grow its revenues.
The free cash flow in Q3 was $4.8 billion, with a free cash flow margin of 24%, compared to a free cash flow of $4.7 billion (31% of revenue) in Q3 2021 and $4.1 billion (23% of revenue) in Q2 2022. The company generated a total of $18 billion in free cash flow in the last four quarters.
TSM has a stable balance sheet. The company had cash and marketable securities of $47.2 billion and debt of $27.3 billion at the end of Q3 2022.
Guidance
Management Q4 guidance given during Q3 results is $20.3B at the mid-point, representing a YoY growth of 29% and QoQ growth of 0.4%. The gross margin guidance is 59.5% to 61.5% and operating margin is 49% to 51%.
Below is the analyst consensus revenue estimates as per Seeking Alpha. Notably, the company discussed in detail that the first half of 2023 is likely to be weaker than the second half
C.C. Wei, CEO of the company, said in the Q3 earnings call that 2023 will be a growth year for the company, “Looking ahead to 2023 with the successful ramp up of N5, N4P, N4X and the upcoming ramp of N3, we're continue to expand our customer product portfolio and increase our addressable market. While the ongoing semiconductor inventory correction will affect the first half 2023 utilization rate we expect our business to be supported by stronger demand for our differentiated and leading advanced and specialty technologies, and for 2023 to be a growth year for TSMC.”While the ongoing semiconductor inventory correction will affect the first half 2023 utilization rate we expect our business to be supported by stronger demand for our differentiated and leading advanced and specialty technologies, and for 2023 to be a growth year for TSMC.”
The inventory correction that has impacted the entire semiconductor industry will result in a tough 1H 2023. However, the company’s technological leadership, strong relationship with the customers, and also a strong portfolio of HPC business will help the company fare better than the overall industry. The CEO said in the earnings call, “And for the inventory correction in 2023, all we want to say is like that. We expect probably 2023, the semiconductor industry were likely to decline. But TSMC also is not immune, we believe our technology position, strong portfolio in HPC and longer-term strategic relationship with customers will enable our business to be more resilient than the overall semiconductor industry. And that's why we say in 2023 still a growth year for TSMC and the overall industry probably will decline.”But TSMC also is not immune, we believe our technology position, strong portfolio in HPC and longer-term strategic relationship with customers will enable our business to be more resilient than the overall semiconductor industry. And that's why we say in 2023 still a growth year for TSMC and the overall industry probably will decline.”
Note: The revenue numbers will not match since we used company IR's revenue figures. The above figures differ, probably due to the currency conversion. However, we use the above estimates to understand the growth rate estimates.
The company reduced Capex for the full year 2022. The CFO said in the earnings call, “Three months ago, we said our 2022 CapEx will be closer to the lower end of our $40 billion to $44 billion range. Now, we are further tightening up this year's capital spending and expect our 2022 CapEx to be around $36 billion. About half of the change is due to capacity optimization based on the current medium term outlook. And the other half is still to continue to delivery challenges.”
The management continues to be optimistic about the long-term outlook. C.C. Wei, said in the Q3 earnings call, “We expect strong demand for our leading node technologies, driven by both smartphone and HPC applications to fuel our long-term revenue growth of 15% to 20% CAGR over the next several years in U.S. dollar terms.”
Valuation
The company is currently trading at a P/E ratio of 13.2 and fwd P/E ratio of 12. It has a P/S ratio of 5.6 and a fwd P/S ratio of 5.4. It is trading lower than the 5-year P/E ratio of 23.3 and a 5-year P/S ratio of 8.5.
Source: YCharts
The company has a better free cash flow margin when compared to its peers.
Source: YCharts
Risks
The geopolitical tensions related to China might negatively impact the stock. The company has been reducing this risk by setting up fabs outside of Taiwan. However, this could also lead to lower profits. For example, manufacturing in the US will be expensive compared to Taiwan. Some of the cost burden could be reduced by the benefits of the CHIPS Act of 2022.
The global economy's overall slowdown and delays caused by Covid-19 might negatively impact the company's 2023 revenues and the other semiconductor companies. The analysts expect revenue to grow single digits in 2023. However, the company has managed the slowdown better in the past and its results in the past few quarters have proved it. The analysts expect full year revenue to grow 30% in 2022, 7% in 2023, and 19% in 2024. Similarly, full-year EPS is expected to grow 57% in 2022, decline 9% in 2023, and grow by 27% in 2024.
Conclusion
The company has good long-term revenue growth potential due to its leadership in advanced technology nodes. Advanced nodes and a strong HPC presence will drive outsized market share of 15% to 20% — or nearly 3X more than the overall semi-market is expected to grow. The company has been able to negotiate prices with its customers, make cost improvements, and improve the profit margins, along with generating industry-leading free cash flow. We expect H1 to be weaker than normal, but the market will reward any incremental strength from TSM compared to peers.