BING-JHEN HONG/iStock Editorial via Getty Images
Taiwan Semiconductor Manufacturing Company (NYSE:TSM) is perhaps the world’s most important company.
TSMC is a pure-play semiconductor foundry with the majority of global foundry revenue share, and over 3 times the share of its closest competitor, Samsung (OTCPK:SSNLF) (SSNNF).
Counterpoint
But market share alone understates the dominance of the TSMC. The firm has a massive advantage in process technology that allows it to manufacture chips at highest level of transistor density, cost-efficiently, and with the highest quality/yields in the industry. At the high-end, there is no competition. This is why all the major firms that sell/market high-end processors—Apple (AAPL), AMD (AMD), Nvidia (NVDA), Intel (INTC), Amazon (AMZN), Google (GOOG) (GOOGL), etc.—have lined up at TSMC’s door and made billions of dollars in advance payments to guarantee space in TSMC’s fabs.
And the moat is deep. Process technology development is expensive. TSMC has announced they will spend over $100 billion in capex in 3 years. As Samsung and Intel desperately try to catch up, they have announced tens of billions of dollars in expenditure of their own.
If TSMC went away today, trillions of dollars in economic activity around the world would stop. Global production of cars, phones, computers, and other devices would drop enormously or stop altogether for a time. Software and services related to all those products would similarly plummet. For example, all Apple iPhones, Watches, and computers rely on TSMC chips. This article doesn’t have the space to detail just how big a disaster that would be for the entire world.
TSMC’s strength is shown by its ability to keep growing revenues 44% even during the semiconductor industry slowdown that is in progress as the COVID demand boost subsides and Ethereum mining demand is eliminated.
Normally in this current market a firm with a technological monopoly, strong balance sheet, and strong earnings growth of 76% YoY in the most recent quarter, would be trading at a PE of at least 30+. For example, Nvidia is trading at around TTM PE 50 despite earnings about to fall off a cliff (due to the Ethereum GPU demand elimination) and only growing revenues 3% YoY in Q2. Instead, TSM trades at a stupidly cheap 13x likely 2022 earnings!
Q2 comparison
TSMC | Nvidia | |
Revenues | $18.16 billion | $6.7 billion (estimated) |
Non-GAAP Gross Margins | 59.1% | 46% (estimated) |
YoY rev growth | 43.5% | 3% (estimated) |
YoY EPS growth | 76% | TBD, but will be down |
Market Capitalization | $440 billion | $450 billion |
The reason for the shockingly low market capitalization is irrational fear of a Chinese takeover of Taiwan, and a misunderstanding of what would ensue.
TSM Discounting on China Fear is Irrational
The media and financial pundits have been hyping up fear over China invading Taiwan for years now. It reached a fever pitch in recent weeks with Speaker Pelosi’s visit to the island. But let’s get beyond the narrative and examine the 4 possible scenarios in this situation:
- Status quo
- Peaceful reunification
- Chinese non-peaceful takeover, but in a manner that is acceptable to the rest of the world.
- Chinese invasion unacceptable to the rest of the world (almost certainly resulting in World War 3)
Scenario 1: Status quo
In the status quo scenario, TSMC continues to dominate the semiconductor industry and grow earnings rapidly. Eventually the market capitalization will rise to a reasonable valuation given the dominant position in the industry and the strong earnings growth.
This is by far the most likely scenario over the near/medium term.
Scenario 2: Peaceful reunification
In the peaceful reunification scenario, TSMC continues to dominate the semiconductor industry and grow earnings rapidly. Presumably TSM equity would be treated like other US ADRs of Chinese equities. Eventually the market capitalization will rise to a reasonable valuation given the dominant position in the industry and the strong earnings growth.
This scenario is somewhat likely to happen in the coming decades, if the people of Taiwan decide it is preferable to be officially part of China.
Scenario 3: Chinese non-peaceful takeover, but acceptable to the rest of the world
It is hard to imagine a non-peaceful takeover that is acceptable to the rest of the world. Nevertheless, any acceptable takeover would necessarily mean that Taiwan’s technology companies, and TSMC in particular, are unharmed. It would also mean that TSM equity stays in place and would be treated like other US ADRs of Chinese equities. There is no scenario where TSMC fabs are impaired and the world accepts that outcome. Eventually the market capitalization will rise to a reasonable valuation given the dominant position in the industry and the strong earnings growth.
This scenario is unlikely.
Scenario 4: Chinese invasion, unacceptable to the rest of the world
In a Chinese invasion scenario, TSMC and the Taiwanese technology industry would largely cease to operate. As TSMC Chairman Dr. Mark Liu has stated, TSMC is dependent on the cooperation of the United States, Europe, and nations in order to operate. These nations would definitely cease cooperation if the Chinese invaded. The international sanctions and other actions (likely including direct military action) against China would be much more profound than those taken against Russia over the recent invasion of Ukraine.
Sanctions would result in much of China’s economy being devastated. China has an export driven economy, and trade would shut down. China also depends on other nations for important resources like coal and foods like pork and soybeans.
The international economy would be devastated as well. Firms like Apple would have no products to sell. Walmart shelves would be largely bare. Car manufacturers around the world may not be able to make any cars. Even chip makers with fabs outside of Taiwan would be disrupted since finished products would not able to be assembled without a diversity of components (many of which come from Taiwan). And many devices are assembled in China, which would be another supply chain that would shut down. The economic calamity is hard to quantify.
The world needs TSMC’s fabs and Taiwan’s technology industry to keep operating. A Chinese invasion almost certainly means World War 3.
All of this devastation would certainly wreck stock prices for thousands of firms worldwide. The performance of TSM equity may not differ that meaningfully from that of other firms like AAPL and NVDA which are dependent on TSMC and China for their products.
And this all assumes that the hypothetical Chinese invasion would be successful—a very dubious claim. An invasion of that scale is hard to pull off, and the Chinese are not practiced at military operations. The Chinese have seen what happened with Russia invading Ukraine. Both with the international response and Russia's struggles on the battlefield. Russia has a much more experienced military. And it’s much easier to conduct a war where you share a long land border than one across ocean waters.
This is an unlikely scenario.
Key Takeaways
The Chinese people have a culture of patience. They know that aggressive action against Taiwan in the short term is economic suicide and will bring World War 3. The prudent strategy is to angle for peaceful reunification in the coming decades. China’s bellicose rhetoric is not inconsistent with a long-term strategy of bullying Taiwan into reunification—peacefully if also coerced.
It is nonsensical to discount TSM to such a degree when the entire worldwide economy would crater, and revenues for firms like AAPL and NVDA would be decimated, in any scenario where TSM’s equity is impaired. It makes far more sense to buy stupidly cheap TSM and hedge with short positions or puts on indexes or high multiple firms like NVDA or AAPL that would get stomped in a Chinese invasion scenario. Owning TSM provides strong growth at a deep discount, with a relatively small risk of downside greater than other popular equities in a World War 3 scenario.
