Taiwan Semiconductor: Underrated King of Semiconductors (NYSE:TSM)

Investment thesis

After a quick look at TSMC (NYSE:TSM), you immediately see that it is no ordinary company. With a market share of 57%, TSMC is the market leader in the semiconductor foundry, accounting for 30% of the world production of integrated circuits, chips for short.

But this is not just market dominance.

TSMC is the epicenter of geopolitical tensions between the US and China over control of critical semiconductor technologies, and the presence of TSMC’s precious manufacturing plants on Taiwanese soil has avoided the threat of a potential Chinese invasion, earning the gentle giant the title of “silicon shield” .

While many semiconductor stocks have skyrocketed recently as AI technologies turn out to require tons of chips to run, TSMC stocks have remained fairly calm.

The low rating must be imputed However, given the geopolitical risks surrounding the company, it seems foolish not to dig a little deeper into the business given the technology moat TSMC has established in the foundry sector and the long-term growth momentum of the semiconductor industry.

Business model

As a pure-play foundry, or Fabs, TSMC does not design a single chip, but focuses its resources solely on developing new manufacturing processes, offering its fabrication facilities to chip designers who rely on the Taiwanese company to manufacture their cutting-edge chips.

Semiconductors generated a whopping $672 billion in revenue in 2022, with the Fabs segment accounting for 19%, with $128 billion.

TSMC alone accounted for $73 billion by 2022, the largest semiconductor company by revenue, with a total market share of 11% or 57% in the Fabs segment.

In my recent analysis of the industry, I projected semiconductor revenues to reach $2.7 trillion by 2032, growing at a CAGR of 12.27%, based on my assumption about how much and how well semiconductor companies have collectively reinvested for future growth.

Assuming the percentage of Fabs segment revenue remains constant, pure-play foundry businesses are expected to generate $409 billion by 2032.

According to my TSMC story, the chips giant remains the undisputed king of the market, but I couldn’t ignore Intel’s (INTC) promise to become the second largest foundry by 2030.

Currently second place is Samsung Foundries with an estimated revenue of $20 billion and a market share of 15.5%. In 2022, Intel Foundry Services (IFS) – Intel’s newly established business unit – generated just $895 million in outsourced manufacturing, and even factoring in the acquisition of Tower Semiconductor – generating $1.68 billion in revenue – the total market share of IFS is only 2%, putting Intel ninth in the foundry segment.

Assuming the US chipmaker stays true to its promise, going from ninth to second is a long way. To make that happen, Intel will have to steal market share from its competitors, and while the majority can be expected to come from smaller foundries, Samsung and TSMC will also have to give up some of their shares.

That’s why I assumed TSMC’s leadership would drop from 57% to 53%, which would translate into revenue of about $217 billion by 2032.

TSMC is currently leading the foundry market with its 3 nanometer nodes along with Samsung, and both companies are working on 2 nanometer nodes, which are said to begin production by 2025. According to Intel’s management, they expect their 20A and 18A nodes – similar to those of TSMC 2 and less nanometer nodes – to enter production by 2024, giving a temporary lead in the Asian market, implying a decline in future would justify TSMC’s market shares.

Efficiency and profitability

On the road to efficiency and profitability, this is where TSMC’s moat shines best. Over the past five years, the Taiwanese chipmaker has achieved a median operating margin of 41% and a median return on invested capital (ROIC) of 27%, far exceeding industry median values ​​of 16.9% for both ratios.

Continuing my TSMC story, since I assumed the company would maintain its moat and significant market dominance, it is highly likely that both operating margin and ROIC will remain around their historic levels going forward.

As reported in my semiconductor analysis, a common thread for any company operating in the industry is the need for continued reinvestment to support future growth.

TSMC’s median reinvestment margin for the past decade was 16.4%, and while I expected it to stay in the double digits, I assumed it would drop to 13% of total revenue as TSMC achieves even greater economies of scale .

As nodes continue to shrink – while the use of advanced chips expands into new sectors such as the automotive industry – only a handful of foundries, including TSMC, will be able to meet this demand, enabling them to improve their economies of scale and become more efficient could be.

Cash flow projection

Despite the massive reinvestment required by its business model, TSMC has historically been able to deliver solid Free Cash Flows to the Company (FCFF) equivalent to $15 billion by 2022.

With the assumptions made so far, TSMC’s FCFF is expected to be around $46 billion by 2032, with a CAGR of 11.9%.

valuation

Applying a discount rate of 8.44%, calculated using the WACC, we obtain that the present value of these cash flows equals $654 billion or $126 per share.

Compared to current prices, TSMC’s stock appears 22.3% undervalued.

Risks

The low valuation must be attributed to the geopolitical risks surrounding the company.

Aside from the ongoing trade war between the US and China – with the recent news that the latter issued a series of export restrictions on its rare earths used in semiconductor manufacturing – the company’s biggest threat is a possible invasion of Taiwan.

Since China seems to consider Taiwan part of its domain, speculation abounds about the island being invaded by Chinese forces.

Given that 90% of semiconductors are made on Taiwanese soil, a direct military strike to take control of the country would likely damage delicate and costly manufacturing plants, not just hurt Western economies – which rely heavily on of Taiwanese Fabs for a continuous flow of chips – but China itself would also suffer catastrophic harm from the destruction of such critical technologies.

If an invasion were ever to occur, it would be more reasonable to take the form of some sort of political treaty to preserve the island’s production capabilities. If this option allows for TSMC’s continued existence as a company, it does not eliminate the risk of potential policy changes – made by an eventual takeover by the Chinese government – that would structurally alter and likely harm TSMC’s business model.

Conclusion

It’s difficult to factor in geopolitical risk in a valuation, as the result may well be the complete destruction of TSMC’s factory, the survival of TSMC but the end of the company as we know it, or altogether nothing.

If the geopolitical risks make you feel uncomfortable about owning TSMC, you should probably avoid investing in the company and look for other opportunities, on the other hand, for those who believe TSMC can continue to deliver solid performance for years to come , at current prices, it represents a good investment opportunity.