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Taiwan Semiconductor Manufacturing Company, "TSMC," (TSM), the world's first dedicated semiconductor foundry, reported solid 2013 results. The revenue guidance seems a bit weak, but the reports coming out suggest solid first quarter growth.

Absent the near-term oversupply in the market, TSMC should continue to report growth above global GDP growth as global consumers and businesses allocate larger portions of their budgets to staying on the cutting edge of technology. Additionally, TSMC gains a tailwind in the second half of the year from the ramping of 20-nanometer chips.

Right now, the market is pricing in the slowing rate of earnings growth. Consequently, the ADR price is consolidating. But the market may be too pessimistic as the base case intrinsic value is 28% above the current ADR price. Potential upside catalysts could come from earnings releases.

Recent Developments

  1. TSMC reported revenues that rose 8.4% Y/Y, in January, to $1.7B. In December, sales increased 33.7%.
  2. Production of the 20-nanometer chip is expected to begin in the second quarter.
  3. The Board of Directors may authorize a NT$3.0 ($0.40) cash dividend per common share; the proposal will be discussed on the morning of June 24, 2014.
  4. Apple (AAPL) may shift the production of A8 processors from Samsung to TSMC. But Samsung and TSMC will handle the production of the A9 processor. The A8 processor is expected to debut alongside the iPhone 6 in late 2014.

Business Summary

Taiwan Semiconductor Manufacturing Co Ltd manufactures integrated circuits for computers, communications and consumer electronics market segments. It also provides wafer manufacturing, wafer probing, assembly and testing, mask production and design services.

The reader should note that in order to make an already complex situation simpler, all conversions from Taiwan dollars to U.S. dollars were done at the exchange rate of NT$30 to US$1.

For the first quarter of 2014, TSMC is forecasting revenue between $4.53B and $4.6B. The gross profit margin is expected to be between 44.5% and 46.5%, and the operating margin is expected to be between 32% and 34%. TSMC's forecast suggests revenue growth of just over 3% Y/Y. My net income forecast is $1.35B, which would be about 2% growth. The results of operations are likely to be adversely impacted by the weaker U.S. dollar and near-term oversupply, which was forecasted in the previous report.

The liquidity appears to be ample with the cash ratio at 1.29 at the end of 2013. Further, the defensive interval increased from 235 days at the end of 2012 to 299 days at the end of 2013. TSMC increased the proportion of debt in the capital structure to 21% at the end of 2013 from 14% at the end of 2012. There is ample room to increase the proportion of debt in the capital structure should the need or desire arise as the financial leverage ratio stood at 1.42 at the end of the year.

There was a decline in efficiency, which could be partly attributable to the growth of the organization. Receivables turnover declined during fiscal 2013 relative to the prior year. Also, total asset turnover declined from 0.59 to 0.54. Declining efficiency could turn into lost customers in the coming years.

The quality of earnings improved in 2013, which is a trend that hopefully will continue in 2014. But cash collected from customers increased 17.7% while the core operating margin declined slightly.

Since 2011, the book value per ADR increased at a CAGR of 16% from NT$121.43 ($4.05) to NT$163.42 ($5.45). TSMC earned its cost of equity capital during 2012 and 2013. So, the growth number and the return on equity numbers are satisfactory. Growth may slow, but the returns appear to be persistent.

Given the capital intensive nature of the organization, a substantial amount of capital is spent on PP&E. Free cash flow-to-equity is significantly larger than free cash flow-to-the firm. Both cash flow measures grew at an unsustainable pace during fiscal 2013. The free cash flow-to-equity numbers incorporate the increasing contractual financial obligations associated with the changing capital structure. FCFE was $5.81B for fiscal 2013.

Risks

  1. The ADR price is likely to remain volatile and investors could lose a portion or all of their investment.
  2. Investors should judge the suitability of an investment in TSMC in light of their own unique circumstances.
  3. A decline in the global economic growth rate and/or a decline in the pace of economic growth in the United States could adversely impact the results of operations and the ADR price.
  4. The technology industry is characterized by rapid technological change, which could materially adversely impact the results of operations.
  5. Competition in product development and pricing could adversely impact performance.
  6. Incorrect forecasts of customer demand could adversely impact the results of operations.
  7. Higher interest rates may reduce demand for TSMC's offerings and negatively impact the results of operations and the ADR price.
  8. A stronger Taiwan dollar relative to the U.S. dollar is likely to adversely impact the results of operations.

This section does not discuss all risks related to an investment in TSMC.

Portfolio And Valuation

(click to enlarge)

TSMC is in a bear market of primary and intermediate degree which is showing latent signs of bullishness. But it is possible that the period of consolidation could last for an extended period, most of 2014. Simply said, the trend is sideways, and the ADR price could react in either direction, which depends on the supply-demand for ADRs. Additionally, the accumulation/distribution line suggests investors are distributing ADRs.

Since 2009, TSMC's ADR price has been strongly correlated with the broader market (SPY). But more recently, the correlation has broken down. TSMC is a "trader's market" while SPY continues to be an investment story. It could be worth watching how the correlation plays out in the near term.

In terms of price targets, the 3-months, 6-months and 9-months price targets are $18.89, $19.47 and $20.64. But the S&P 500 appears set to outperform TSMC in the coming months.

Under the base case scenario, TSMC is undervalued by 28%, which implies an intrinsic value of $22.71. The valuation under the pessimistic scenario is $12.71 per ADR. Given the relatively clean balance sheet and the growth rate, TSMC is deserving of its premium valuation relative to the S&P 500. Theoretically, the valuation model suggests the downside should be limited at this share price.

Source: Taiwan Semiconductor: Solid Financials And Undervalued