With consumer spending at a low and supply chain disruptions in technology, many investors are naturally worried about semiconductors. While these fears are well founded, they are slightly exaggerated in my view and will ultimately result in considerable risk-adjusted returns. I am particularly bullish about Taiwan Semiconductor Manufacturing Co. (TSM) due to an anticipated rise in utilization rates and margins. United Microelectronics (UMC) is riskier and vulnerable to end market demand, as evidenced by reserved customer order booking.
From a multiples perspective, both firms appear fairly valued. TSMC trades at 13.9x past and forward earnings while offering a dividend yield of 4.1%; UM trades at a respective 10.5x and 23.2x past and forward earnings while offering a dividend yield of 9.2%. TSMC's gross margins were 49.4% in 2010, a staggering 2,020 basis points higher than that of its competitor. Accordingly, I believe that the latter has a major catalyst in cutting SG&A and other expenses.
At the third quarter, TSMC's management noted challenges:
In the third quarter our revenue was higher than the guidance provided on July 28 thanks to some rush orders in August and some and more favorably change rate. Third quarter revenue decreased 3.6% sequentially to NT$106.5 billion and the wafer shipments decreased 3% with 3.2 million inch equivalent wafer.
Our wafer demand was expected by a weakened slow growth economy conditions in customer’s inventory adjustment.
Computer and consumer related revenue was more of packet and decreased by 16% and 18% respectively whereas communication and industrial increase by a 3% and 9% from the second quarter. Overall, communication accounted for 48% of our total wafer revenue in this quarter, while computer, consumer and industrial accounted for 21%, 10% and 41% of wafer sales respectively.
Even still, I believe that the firm will fare well in a weak 2012 environment and am attracted to its top position in 40 and 28 nm. Management is particularly ramping up production in the latter and will benefit enormously from the rise of Ultrabooks. By the end of 2012, Ultrabooks may have a plurality of the notebook market, as I illustrated earlier here.
In November, sales declined by 5% m-o-m, which was actually a modest amount compared to expectations. Going forward, I anticipate that wireless/wireline cuts will result in around a 8% q-o-q decline in the first quarter of 2012.
Consensus estimates for TSMC's EPS are that it will grow by 72.7% to $1.71 in 2011, 8.2% in 2012, and then decline by 40% in 2013. Assuming the multiple drops to 12x and a conservative 2012 EPS of $1.76, the rough intrinsic value of the stock is $21.12, implying 65.5% upside. Even if the multiple were to decline to 8x and 2012 EPS turns out to be an egregious 65.5% below the consensus, the stock would be fairly valued. Accordingly, the Street rates shares near a "strong buy".
My opinion on UM - which is rated a "hold" - is more reserved for right now. October monthly sales were down 29% y-o-y, but gained 1% m-o-m. November sales of NT$8.1B represented a 2% m-o-m decline, but more or less anticipated. In the fourth quarter, orders for power management and LCD drivers have been weak. I expect that orders will be flattish in the start of the new year due to concerns about end markets. A possible bright spot for the firm might be 12'' wafers due to rising demand for low-end Chinese smartphones. My main concern for the valuation is that the level of stock decline has not been commensurate with the long-term sales decline.
Consensus estimates for UM's EPS are that it will decline by -81.8% in 2011, hold flat in 2012, and then decline by 50% more in 2013. Accordingly, I recommend holding out.