Top 3 Semiconductor Foundry Stocks To Buy

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Includes: SMI, SSNLF, TSM, UMC
by: Khaveen Jeyaratnam
Summary

After breaking down the semiconductor value chain, I identified the different types of companies operating in the industry.

I analysed the foundry business model and identified the top three companies operating in this space.

These companies each have large market shares and production capabilities that have cemented their positions in the foundry space.

Semiconductor Foundry

Source: Power Standards

Semiconductor Industry Value Chain

The companies operating in the semiconductor industry can be divided into 4 main types of business models. While each has different characteristics and functions, all remain important in the semiconductor value chain. The foundry model, in particular, makes for very attractive investments, given the monopolisation by some of these companies, high barriers to entry, and high growth rates of the semiconductor industry.

Semiconductor Industry Value Chain Source: Power System Design

Integrated device manufacturers ('IDM') are the oldest types of semiconductor companies, carrying out all the functions in designing, manufacturing, and sales of the integrated circuit ('IC') chips. Many of these companies have been operating successfully for years and specialise in certain types of semiconductor chips. Some of the prominent players include Intel (INTC), Micron (MU), and Samsung (OTC:SSNLF).

Fabless companies do not manufacture their own chips. They outsource production to foundries. These companies benefit from the lower capital costs and are able to focus on research and development of their products. These companies have some of the most innovative and extensive product portfolios. Among them are Qualcomm (QCOM), Broadcom (AVGO), Nvidia (NVDA), and Advanced Micro Devices (AMD).

Design houses have emerged recently and perform even less functions than fabless companies. They focus on designing the integrated circuits, which follow a certain set of structure and rules. They then license the intellectual property of the designs to other companies, which customise and fabricate the actual chips. Notable companies include Synopsys (SNPS), Cadence Design Systems (CDNS), and ARM Holdings (OTCPK:SFTBY).

Foundries are pure-play manufacturers. To meet the enormously high demand for semiconductor chips, which are used in most electronic devices, mass production of semiconductor chips is required. To take advantage of the economies of scale, foundries have large fabrication plants to mass manufacture semiconductor chips, which are then supplied to fabless semiconductor companies. As IC production facilities are expensive to build and maintain, foundries minimize these costs through careful scheduling, pricing, and contracting to keep their plants at full utilization. Due to the high cost of plants, which can reach up to $20 billion, the industry is concentrated with a few large foundries worldwide. The top 5 companies worldwide account for 87.3% of the market share.

Taiwan Semiconductor Manufacturing Company Limited (TSM)

TSMC is unquestionably the market leader of semiconductor foundries, with 2018 revenue of $33.49 billion USD, which accounts for an enormous 48.1% market share. Revenue has increased for the past 5 years consistently with revenue growth in 2018 of 5.52%. They have a net profit margin of 34.05%.

TSMC is miles ahead of the competition in process technology. Not only are they only foundry currently manufacturing 7nm chips, two of their closest competitors, GLOBALFOUNDRIES and United Microelectronics Corporation (UMC) have completely abandoned plans for 7nm development due to the high costs. This leaves free space for TSMC to further extend their market share, as they become the only option for companies interested in the most advanced process node.

TSMC is also set to start production of 5nm chips this April, with reports that a contract with Apple (NASDAQ:AAPL) is in place to feature 5nm chips in their 2020 iPhones. Looking to the future, TSMC is investing up to $20 billion for the newest 3nm fabrication plant. By the time competitors are able to offer a new process node, TSMC will have moved on to the next. Furthermore, the manufacturing capacity of TSMC is also unmatched by any other foundry, with manufacturing capacity of over 12 million 12-inch equivalent wafers annually as of 2018.

Price Target

TMSC carries a buy rating with a consensus price target of $42.67. Although their current price is just below the target price, now would still be a good time to pick up their shares, as they have a 3.29% dividend yield. Their revenue is also expected to get a further boost from growth drivers such as 5G, Artificial Intelligence, and Internet of Things. TSMC's combination of size, technology, and first-mover advantage is a formidable barrier to anyone trying to unseat the dominant position that TSMC currently occupies.

United Microelectronics Corporation

UMC also has consistent revenue growth over the past 5 years, albeit to a lesser extent than TSMC. Their revenue of $4.91 billion USD represents 7.2% of the market. They are the second largest public pure-play foundry in the world. Their net income margin, though, only stands at 4.68%. They do, however, have a high dividend yield of 6.08%.

UMC does not have a lack of demand. Instead, they have limited production capacity. The company recently bought Fujitsu's (OTCPK:FJTSF) 84.1% stake of their joint venture MIFS 300mm foundry, which has a production capacity of 36.8K wavers a month. In addition, UMC will list its Chinese subsidiary Hejian, on the mainland stock exchange. The proceeds from the IPO will be used to expand their eight-inch wafer production.

Despite taking the right steps to increase production, the company has stumbled into a few legal troubles with US regulators. In the past summer, UMC got caught up in the US-China trade war. The Chinese state-owned company filed an alleged patent infringement lawsuit against Micron, the second-largest US semiconductor company. In retaliation, the US Justice Department charged UMC with IP theft. To make matters worse, the Justice Department also charged Chinese chipmaker Fujian Jinhua and ordered a ban on supplies of equipment to the company. UMC had a major R&D project with Jinhua and, as a result, was forced to end the partnership.

Price Target

UMC carries a hold rating with a consensus price target of $1.79. This is slightly below their current share price. Despite a high dividend yield, their low profit margin and legal troubles do not justify purchasing the company shares at this time. One of the talking points in the US-China trade talks is an agreement to end the chipmaker spat as part of the trade deal. Should this be achieved, UMC's shares would be worth having another look at.

Semiconductor Manufacturing International Corporation (OTC:SMI)

SMIC had sales of $785 million USD in 2018, which represents 4.5% market share. Revenue has been flat over the past 5 years, and profit margin stands at 3.99%. They are the third largest public pure-play foundry in the world.

SMIC is based in China and is the preferred foundry for the country. Their sales in the region grew 40% Y/Y. As China is the largest IC market in the world, SMIC has signaled its focus on Chinese customers. In addition, the Chinese government themselves have made billions of dollars available to invest in the semiconductor industry. As a result, SMIC has received $10 billion in funding to expand its production capacity.

While 14nm production is in full swing, SMIC is already at work on its 10nm and 7nm processes as well, as previously confirmed by the company. Both processes are extremely costly to design, but since the semiconductor industry is growing in general and because of generous funding from the Chinese government, SMIC has enough money for the necessary R&D.

Price target

SMIC carries a hold rating with a consensus price target of $4.78. The company is fairly valued at current prices. With access to the largest IC market in the world and strong backing by the Chinese government, SMIC's future looks very optimistic. Any pullback below the price target would be an attractive opportunity to buy their shares.

Other Shortlisted Companies

Samsung (OTC:SSNLF)

Not only is Samsung the largest semiconductor company in the world, it is also the second largest foundry by revenue. Although Samsung has its own foundry business segment, which split off in 2017, it still operates under the same company. Hence, I classified them as an IDM and excluded them from the top three.

GLOBALFOUNDRIES

GLOBALFOUNDRIES is the third largest foundry in the world with 8.4% market share. They are the only major foundry in the US. The company was originally part of AMD and was divested in 2009. Despite major success in the US, the company has not been public-listed, the reason for their exclusion from the top three.

Verdict

The semiconductor industry is experiencing heavy growth in demand from the onset of the fourth wave of technology which includes robotics, artificial intelligence, nanotechnology, quantum computing, biotechnology, the Internet of Things, fifth-generation wireless technologies (5G), augmented/virtual reality, 3D printing, and autonomous vehicles. Semiconductor foundries are an attractive way to gain exposure to these markets, given the monopolisation from some of these companies. I identified the top three foundry companies as TSMC, UMC, and SMIC. They would make for attractive investments as each has large market shares and production capabilities that have cemented their positions in the foundry space.

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Disclosure: I am/we are long SSNLF, TSM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: No information in this publication is intended as investment, tax, accounting, or legal advice, or as an offer/solicitation to sell or buy. Material provided in this publication is for educational purposes only, and was prepared from sources and data believed to be reliable, but I do not guarantee its accuracy or completeness