Taiwan Semiconductor Manufacturing Company (NYSE:TSM) is the biggest semiconductor foundry in the globe. The company has experienced substantial volatility over the past two years reaching its market capitalization peak at $730 billion, subsequently plummeting by 55% to $320 billion within 12 months. Despite this volatility, TSM has a huge market opportunity in semiconductor industry due to its technological and production advantages against its rivals. To provide context, the company's two closest competitors are not able to manufacture the most advanced semiconductor chips to the scale TSM can. In addition to this dominant market position, TSM has also improved its financial performance, increasing its gross and operating margin during FYE 2022. More on this at a later stage. To top it all off, TSM has a long runway ahead in an industry set to grow to $1.1 trillion by the end of the decade.
In essence, TSM is the leading semiconductor company in the world with solid fundamentals and the potential to continue growing along with the industry. However, the company faces risks such as geopolitical risks, customer concentration, trade controls, market valuation volatility, etc. These risks should not be taken lightly when analyzing TSM. I believe the company's mitigants offset this risk and consider it a sound long-term investment opportunity.
TSM could possibly be the most important player in the semiconductor industry. If it is not the most important, it is clearly the most dominant, operating as a foundry and manufacturing over 90% of the most advanced semiconductor chips available worldwide. The company's competitive advantage against its main competitors Samsung (OTCPK:SSNLF) and Intel (INTC), is the fact that TSM focuses specifically on manufacturing. In contrast Samsung and INTL are considered Integrated Device Manufacturers, meaning that these companies both design and build semiconductors. TSM specialization has two important impacts. Firstly, by specializing solely in manufacturing it has been able to efficiently allocate its resources and reach a leading technology position in the industry. Secondly, by taking itself out of the competition with its customers such as Apple (AAPL) the company has been able to achieve more customer loyalty. This is no surprise, as companies are at a clear disadvantage when they rely on their competitors to manufacture the semiconductors needed for their products. For example, Samsung and Intel compete with Apple in smartphones, tablets, laptops, etc.
TSM serves a global customer base that is large and diverse with a wide range of applications. These products are used in a variety of end markets including smartphones, high performance computing, the Internet of Things, automotive, and digital consumer electronics. The company's focus on manufacturing has enabled it to achieve technological advantage as well as gain customer loyalty.
The semiconductor industry plays a crucial role in the technology sector. To think about the role of semiconductors and the players in the industry let's deconstruct the value chain from the end use of the product, for example a smartphone and work backwards. A smartphone has many chips inside of it, these chips are design by companies such as Nvidia (NVDA), Qualcomm (QCOM), and even OEMs in the industry such as Apple (AAPL) and Alphabet (GOOG) (GOOGL). The semiconductor chips are manufactured at fabrication plants from companies such as TSM, Intel or Samsung. The semiconductors are made using the equipment sold by ASML (ASML). TSM essentially provides manufacturing services to chip designers that have no fabrication plants. Let’s take a look at the financials!
TSM recently shared its FYE 2022 results and reported great numbers increasing revenues by 29% to $73.6 billion. The company's revenue per technology is an important factor to note. During FYE 2022 TSMC reported that 26% of total revenue was generated by 5nm semiconductor chips. This is important to note because it is here where TSM has a competitive advantage against its rivals. Neither Samsung nor Intel are able to manufacture these advanced chips at the scale TSM can. Further to this, 27% of the total revenue came from its 7nm semiconductor chips. By platform, smartphones and high-performance computing accounted for the bulk of revenues contributing to 80% of total sales. Here it is important to understand the growth rates the company is experiencing in the different revenue platforms. Smartphones had a y-o-y growth of 39% while high-performance computing had an explosive growth of 59% compared to the previous year.
The company also achieved an outstanding gross margin at approx. 60%, this is nice improvement compared to the previous year at 51.6%. Let's be clear that this is an important improvement! The gross margin improvement translates into the company being able to retain $6 billion compared to if gross margin would have remained at the 51% level. TSM continues to invest in research and development, with total R&D expenditures amounting to 7.2% of revenue or $5.3 billion. These R&D investments help TSM continue to pursue developments in 2nm semiconductor chips, the leading-edge technology in the semiconductor industry. The company's bottom line saw a spectacular improvement with increased net profits by $12 billion to $33 billion. Net profit margin also saw an important increase from ~37% to ~45%.
TSM has paid cash dividends since 2004 and since then it has never reduced dividend per share. The company returns capital to shareholders specifically through dividends. These attractive shareholder returns are possible thanks to the company's ability to generate a substantial free cash flow, with FYE 2022 FCF standing at $17.1 billion. Further to this, TSM has a balance sheet fortress with $50.8 billion in cash and cash equivalents and net cash position.
This gives the company the flexibility it needs to continue paying dividends to its shareholders while pursuing growth initiatives.
TSM growth opportunity is highly correlated with the growth of the semiconductor industry as a whole. In the end TSM is the largest chip maker worldwide. With the industry forecasted to grow to $1.1 trillion by 2030, it puts the industry at a potential to almost double within the end of the decade. It is evident that as the semiconductor industry grows, TSM grows with it. For reference, TSM has experienced double digit growth rates for the past three years. As more smart digital devices are needed and set to keep growing during the next years, TSM is in a prime position to manufacture the chips that will power these devices.
From the graph below, provided by McKinsey & Company we can see that many markets are set to grow at high single digits or even double digits through 2030. With TSM markets being largely focused on consumer electronics, computing and data storage, and industrial electronics, it is in a great position to take advantage of this growth.
As many other companies in the semiconductor industry, the market valuation of TSM has experienced substantial volatility over the past two years. To summarize, at the beginning of 2022, the company reached its market capitalization peak at $730 billion, later that year its market valuation plummeted by 56% to $320 billion. Fast forward to today and we can see a significant appreciation in its market valuation. These fluctuations are significant and pose a risk to investors.
For the valuation of the company, I have used the market multiple method, using future forecasted earnings to a 15x multiple. This is below the multiple the company usually trades at. I have obtained the analysts' revenues forecast from Seeking Alpha data and have applied a conservative net profit margin of 35%. As a result, I arrive at a market valuation of $623 billion by FYE 2027.
Customer Concentration: The semiconductor industry major players tend to have a relatively high customer concentration. In this regard TSM is no different to its peers with the company having 2 customers which account for approx. 35% of revenues and. Further to this, its top ten customers account for more than 70% of total sales. The biggest customer is reported to be Apple, this provides some risk mitigation to TMS as Apple continues to be the most valuable company in the world for a reason. Management will need to find ways to diversify revenues from customers are much as possible, as the loss of one customer could have serious financial impacts for the company.
Trade Controls: TSM has already been a victim of trade controls after it was banned to sell semiconductor chips to Huawei. At the time Huawei corresponded to an important share of TSM total revenues. The global chip war is clearly getting worse with more trade control being imposed by the US. It should not be a surprise to see more TSM customers being in a blacklist essentially not allowing TSM to sell its chips to relevant players in China. TSM has shown resilience with revenues increasing by double digits even with the loss of an important customer. Nonetheless, this does not mean the company can continue shedding customers.
In conclusion, TSM is well-positioned to maintain its position as the largest chip manufacturer in the world. With the industry projected to grow to $1.1 trillion, it provides the company with a nice runway to grow. Despite this, it is important to note that the company's stock has shown significant volatility in short periods of time. Additionally, risks such as the imposition of stricter export controls on its most advanced semiconductors to China presents a risk to the company's revenue growth. Taking this into consideration, I believe TSM is primed to remain the industry's leader and an attractive long term investment opportunity.
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