Taiwan Semiconductor Still Dominates; Buying The Sell-Off

| About: Taiwan Semiconductor (TSM)


Taiwan Semiconductor sold off sharply after reporting a seemingly good quarter with good guidance for the rest of 2014.

Some current news regarding competition may have led to profit-taking following its strong stock performance the past several months.

This article reviews where I see TSM now and reiterates the bullish view of the stock I first propounded three months ago.

Background: Three months ago, following a strong beat-and-raise Q1, I wrote about Taiwan Semiconductor (NYSE:TSM) that Mega Cap Taiwan Semi Has A Beat And Raise Quarter; Why It's A Core Tech Holding.

On Wednesday, it reported another beat-and-raise quarter, and the stock plunged 7% to around $21. Should we respect Mr. Market here and sell or at least stand aside?

My answer is rather that long-term investors should thank Mr. Market and consider using cash reserves to buy in at the lower price. This is not a timing call, however. After all, the Fed is newly hawkish, and this is a classic time of year for profit-taking. August and September are the worst 2-month period in the U.S. stock market historically, and as we all know, stocks have had quite the epic run for what now seems like an eternity. So there are lots of reasons why I have no idea what traders will do with TSM in the short term.

Introduction: TSM (I'll avoid using the usual 'TSMC' abbreviation for simplicity since this is an article focusing on the stock) pioneered the semiconductor foundry industry in 1987. Founder "Morris" Chang is now Chairman of the Board. As the conference call transcript shows, he is still dominant in the company. The great majority of the company's business is for "fabless" chip design companies; about one-eighth is for companies that operate their own chip manufacturing facilities and may use TSM for overflow manufacturing. TSM has some competition, but has been gaining market share. It has an enviable growth rate of about 14% per year in sales and cash flow for the past 10 years, with EPS growing faster than that. It does not bother shrinking its float, and pays what currently amounts to a 2.4% dividend, once yearly.

TSM is known for high quality, reliable manufacturing. It is so huge that competition is limited. Sales this year may approach $24 B, with net profits around $7.5 B.

Because of ongoing investments in capital equipment, TSM is not a strong free cash flow generator; it is a growth engine. Whatever free cash is generated tends to go out the door in dividend payments; thus it tends not to retain net cash to shrink shares outstanding or make acquisitions. Even though it operates in a cyclical industry, it did not lose money even in the tech wreck following Y2K, and earnings merely softened pursuant to the recent Great Recession and then fairly quickly rebounded to all-time highs, which keep giving way to yet higher EPS highs. TSM is in the 80th percentile for price stability according to Value Line's universe of 1700 large stocks, and receives an 'A' for financial strength from them.

It is the combination of its leadership position in the great secular growth areas of our time - tech and telecom (which are merging/have merged) that makes me want to own this name. Note that TSM's dividends are subject to a 15% withholding tax for U.S. residents, which one effectively gets back unless the stock is held within an IRA.

Let's see what went wrong with Q2 results and associated newsflow. Hint: Not much.

TSM's Q2: Business was strong, and so was the outlook. EPS were $0.38, beating consensus by a penny. Sales were fine, and Q3 and Q4 look fine to management. The following table shows current, updated guidance ('NT' stands for New Taiwan dollar):

  2Q14 3Q14
Actual Guidance Guidance
Net Revenue
(NT billions)
183.02 180-183 206-209
Gross Margin 49.8% 47.5%-49.5% 48.5%-50.5%
Operating Margin 38.6% 36.5%-38.5% 38.5%-40.5%
Exchange Rate (USD/NTD) 30.12 30.10 29.81

Management explained its bullishness clearly. It is dominating its competitors in the 28 nm class ("node"), moving ahead rapidly with 20 nm chips, and readying the 16 nm and then 10 nm form factors in a timely manner. Analysts appeared bent out of shape because a competitor will dominate in one of these advanced dimensions for a while. TSM explained patiently that this is because it and not the competitor went from 28 nm to 20 nm before dropping to 16 nm. There are capital costs, learning curves, etc. in getting these extremely advanced technologies right, and making sure doing so is cost-effective. A transient leapfrog of TSM by a smaller competitor does not scare me.

I would urge anyone interested in this stock to read the Seeking Alpha transcript of TSM's prepared remarks and the following Q&A.

Newsflow: There was also some news to account for the sell-off from nearly $23 at the recent post-Y2K high to about $21. To wit, Qualcomm (NASDAQ:QCOM) is giving some 28 nm manufacturing to a Chinese foundry, and Samsung is getting some business. My view is that this is "noise," some of which relates to capacity constraints at TSM. In the conference call, Dr. Chang emphasized that in 2013 and this year, TSM has gained substantial market share within its industry. The news reports should be looked at in that context, in my opinion. Some news should be respected and other news faded; I am fading these bits of news and think this is what one sees in growing industries where suppliers such as TSM have little ability to handle extra business, and also where its customers do not want it to become a quasi-monopoly.

I am impressed by the speed with which TSM is moving from the advanced 28 nm designs all the way to, presumptively, 10 nm. This is 'wow' stuff and will fully support further advancements in the field. In turn, this rapid progress continues to drive the attractiveness of wireless communications as well as other electronics devices. So it's a classic virtuous cycle.

Valuation: I always like to look at independent analytic shops when evaluating a stock. I very much like what I see here. Here are summary views of TSM from different indices.

1. Standard & Poor's Capital IQ: Overall rating, 5 stars. 12-month price target: $27. Fair value: $24.20.

2. Value Line: Timeliness: 1 (highest). 3-5 year price target: $40. Annual projected total return (counting dividends): 20% (very high given VL's view that most stocks are fully priced).

3. Fidelity's Equity Summary Score: 8.2 (bullish). This approach weights different indices by historical accuracy. The most accurate rater for TSM was Jefferson Research. Jefferson rates stocks according to five criteria. Of those criteria, TSM rates highest for earnings quality, cash flow quality, and valuation; and next to the highest for operating efficiency and balance sheet.

Technicals: With the Wednesday sell-off, TSM is now more or less unchanged over the past one and three months, which I take as bullish. It has performed very strongly since some churning the first five weeks of this year, and therefore may be prone to more profit-taking.

TSM went public in the U.S. late in 1997 and has performed very well versus the S&P 500:

Splits: Aug 16, 1999 [123:100], Jun 19, 2002 [11:10], Jul 7, 2003 [108:100], Jun 14, 2004 [114:100], Jun 13, 2005 [105:100], Jun 20, 2006 [103:100]

TSM has also paid out over $4 per share in dividends, beginning with a small payout in 2004.

Risks: The eventual fading of Dr. Chang from this company is a risk. There are co-CEOs now, and that management structure could be problematic. Competition is a major risk, including from Intel (NASDAQ:INTC). Rapid technologic obsolescence is another risk. Failure of the industry to drive improved performance below, say 7-10 nm chips could harm the growth of the devices using these chips and do real harm to TSM's pricing structure. Macroeconomic and general stock market risks are clearly relevant to TSM.

Conclusion: Taiwan Semiconductor remains the dominant company in the field it pioneered. I see no serious reason to doubt that it will remain the leader in outsourced semiconductor manufacturing. Given my steadfast belief that this remains a growth area for years to come, I see TSM as a core tech holding. With a beta of 0.95, it is less volatile than many tech stocks, but if a recession hits important areas of the global economy, I would expect the stock to drop a good deal. Overall, though, with TSM trading just under 15X current year estimated EPS, I find the valuation reasonable. I believe that TSM is the sort of company that Warren Buffett was referring to when he recommended that we own great companies at fair prices rather than searching for fair companies at great prices.

Disclosure: The author is long TSM, QCOM. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Not investment advice. I am not an investment adviser.