Taiwan Semiconductor Stock: I’m Buying And Here Is Why (NYSE:TSM)

The island of Taiwan is marked with a red pen on the map.

Yevhenii Orlov

Introduction

Taiwan Semiconductor (NYSE:TSM) is the one that always managed to get away from my portfolio. For many years, but especially in the wake of the pandemic, Taiwan Semiconductor has been trading at high levels seen across multiple valuation metrics. As a consequence of the strong pull back, I do conclude that Taiwan Semiconductor has reached levels that make it investable, having caused me to initiate a position at $60.5 per share.

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Data by YCharts

I’ve inserted the development within the price to sales ratio over the past five years, coupled with the mean levels across both 3Y, 5Y and the 10Y horizon, showing how the company consistently has been an appreciated asset by the market, but especially in more recent times, with a 3Y mean PS ratio of 9.9. That is not common for any type of company heavily reliant on physical assets such as property, plant and equipment, but has been the case for Taiwan Semiconductor and many of its peers due to the promising outlook for their industry, in a world going ever more digital and therefore reliant on semiconductors to smarten up every household appliance ranging from your coffee maker to your TV extending further to your car, and also a critical input in the coming decades of focus on renewables, such as offshore wind farms.

I’ve for long refused to partake in the bonanza that characterised the applied valuation levels, but with the stock price having come down more than 55% since the most recent high, I’m finally content with initiating a position.

Taiwan Semiconductor’s market cap went all the way into the stratosphere, but the market cap is still significant at $321 billion, resembling the peak just prior to the pandemic, meaning that despite having come down 55%, it’s still a massive mega cap company.

The natural question is why I’ve decided to initiate a position at this level and not when the stock was trading at $80 which would have represented a significant trade-off as well. First of all, I’m invested within the industry already in the form of Texas Instruments (TXN) and Broadcom (AVGO), but also because the valuation assigned to the industry participants had begun to detach itself from common sense for what, after all, are cyclical and asset dependent companies with substantial CAPEX costs in order to expand capacity.

There Are However Also Many Positives – With An Emphasis On Three Anchor Points

From an industry perspective, what attracts is the fact that the industry is enjoying robust growth in both the short- and long-term. Supply and labour shortages as well as inflation is also causing pain within this industry, as with everything else, but the demand outlook remains strong seen over a multiyear horizon. According to this industry report, the sector is expected to grow 10% during 2022 in order to exceed $600 billion as a whole, while McKinsey expects the sector to have grown beyond $1 trillion by 2030. Forecasting growth on an industry level more than half a decade into the future inevitably means the estimate will be off the mark, but whether the industry value reaches a combined $950 billion or $1.1 trillion by 2030, doesn’t take away from the fact that this is an industry offering products in demand.

Semiconductor Sector Outlook 2030

Semiconductor Sector Outlook 2030 (McKinsey “The semiconductor decade: A trillion-dollar industry”)

Almost anything requiring electric power to operate these days requires semiconductors. This means, that across almost all end markets, the absence of the relevant chip may prevent the sale of a device worth a lot more than the individual chip in question. Just think about the iPhone, easily costing upwards of $1000 dollars, but still dependent on chips representing a fraction of that cost. We could just as easily think of a $25.000 car. Who doesn’t know a friend, cousin, neighbour or colleague who has experienced several months of delay on their car with the salesperson quoting the lack of semiconductors.

Why is this relevant? It is so, as it creates strong downstream dependency, allowing for a favourable position of leverage for foundry companies, such as Taiwan Semiconductor. This inevitably translates into strong economics, with semiconductor companies in general churning out strong returns on invested capital.

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Data by YCharts

That brings me to my second point, which concerns technological leadership. If we turn back the clock to the 1980’s, there was an array of companies who produced the semiconductors of the day, but as Moore’s law has consistently driven ever more efficient and innovative solutions, the herd has been reduced. Of the top ten manufacturers of 1990, only two remain in the list of today’s ten largest producers, being Intel (INTC) and Texas Industries, with the rest having fallen to the sword of technology. Semiconductor manufacturing is a game of milestones, you can’t manufacture a smaller node before you have mastered the one just prior to it. In other words, if you want to be able to produce 3nm nodes, you must first learn to manufacture 5nm nodes, and that has caused many companies to lose their ability to compete throughout the decades. That’s maybe putting it a bit on edge, but technological and process know-how matters greatly in this industry, in fact its key, meaning those that can, run away from those that can’t, or take longer to acquire the same technological skill.

Semiconductor Industry Earnings Distribution

Semiconductor Industry Earnings Distribution (McKinsey “It pays to be a technology leader in the semiconductor industry”)

As can be seen in the illustration above, this is a game of “winner takes it all”, as a result of the ever-fiercer competition fuelled by companies managing to move the anchor point for what defines technological leadership. A great example of Taiwan Semiconductor being a technological leader, is the fact that they were the firsts to adopt extreme ultraviolet lithography (EUV) technology in high volume production, as well as the first to adopt 7nm production, ahead of Samsung Electronics (OTCPK:SSNLF) and also the fact that only Taiwan Semiconductor, Samsung and Intel stand to be able to master the 5nm technology in its early days, with 3nm already knocking on the door.

This has also resulted in the emergence of a new strategic prioritisation amongst semiconductor companies, the fabless model, where companies rely upon companies with foundries (the actual manufacturer as opposed to the fabless model where the company only handles the design). This creates a concentration around those who have the foundries, such as Taiwan Semiconductor, who is servicing many of the larger fabless companies, such as Broadcom, Nvidia (NVDA) and Advanced Micro Devices (AMD).

Taiwan Semiconductor History Of Manufacturing

Taiwan Semiconductor History Of Manufacturing (Taiwan Semiconductor Investors Portal)

With the world becoming ever more dependent on only a few companies that master the edge of technology, the semiconductor business has also increasingly become national security policy of the world’s leading nations. This topic requires a separate talk when it comes to risk, but more on that later. Effectively, this means, that companies may be offered favourable taxation schemes when choosing where to allocate future investments. There is still debate whether this is actually the case, but for those following the horrors ongoing in Eastern Europe this year in form of the war, it’s evident that modern defence systems are heavily reliant on semiconductors, making national defence vulnerable to lack of access to supply of relevant semiconductors. The US in particular is leading this agenda, as decades of underinvestment in the industry, has meant that majority of semiconductor production is taking place in Southeast Asia, putting the US in a vulnerable state. This is where the favourable taxation- and support schemes come into play. As such, these companies have become too big to fail, if I were to put it into a slogan that we as investors have seen elsewhere over the past decade.

Summarising, and Taiwan Semiconductor is a very interesting company as it’s a technology leader causing strong profits due to strong customer dependency, while also benefitting from an open-door policy across the world’s leading nations, while riding the waves of strong secular growth for as long as the eye can see.

If Everything Is So Great, Why Is The Stock Down 55% From Its Recent High?

Valuation aside, we are starring down a recessionary environment, with consumer sentiment dropping globally. The sector has enjoyed strong growth for many consecutive years, but there is a substantial likelihood the sector as a whole will experience a setback during 2023. During the most recent earnings call which took place on October 13th, management highlighted its belief in being able to provide a growing topline in 2023 compared to 2022, while also having tightened up the CAPEX budget for 2022 expecting it to land close to $36 billion as opposed to the previously communicated range of $40 to $44 billion. Currently, management isn’t able to provide a more specific CAPEX guidance for 2023 until January. However, management was very clear that they’ll manage their budgets prudently to avoid overexerting the financial muscle in the coming year.

This industry uncertainty acts like gravity on stock prices, and Taiwan Semiconductor is no exception.

In addition, major customers, such as AMD and Nvidia have presented downwards revised guidance outlooks. The smartphone market is also starting to show cracks, despite Apple being able to hold its’ own up until this point. It doesn’t change the fact, that other players have begun to communicate weaker guidance in general, all impacting Taiwan Semiconductor.

Taiwan Semiconductor Revenue Consensus Estimates

Taiwan Semiconductor Revenue Consensus Estimates (Seeking Alpha)

Right now, consensus estimates show an expected revenue growth of 8% for Taiwan Semiconductor in FY2023, but as we don’t yet know the depth of a potential global recession, it’s of course difficult to assess whether that outlook can withstand whatever economic chock is coming the way of the global consumer. A new car, a new smartphone, any such item will be the first to disappear on the consumers shopping list if they start to see colleagues losing their job.

Uncertainty is what creates opportunities in the stock market, and here I remain focused on the sectors long-term possibilities and the fact that Taiwan Semiconductor has belonged to the upper echelons of semiconductor manufacturing for decades, with no reason to expect that to change.

The Wall Street consensus price estimates for the coming year show an average price tag of $110.9 per share, with the lowest estimates coming in at $60 per share. There is no popularity in being the first Wall Street analyst to really hammer a stock with a hard rating, and I find that’s part of the picture here, but I also believe this is a company with a broken stock, and not a broken company.

This dilemma does however paint the picture of investors having to approach this story with an extended timeline as the stock could very well trade lower once we know how the macro situation will develop.

If we zoom in on the quarterly performance for just a second, then Taiwan Semiconductor easily managed to beat expectations.

Taiwan Semiconductor Summarised Q3 Results

Taiwan Semiconductor Summarised Q3 Results (Seeking Alpha)

The quarter resulted in strong growth and expanding margins allowing for an expansion in income, all good, but of course the market is more interested in what’s to come than what has been.

Taiwan Semiconductor Q3 2022 Income Statement

Taiwan Semiconductor Q3 2022 Income Statement (Taiwan Semiconductor Investors Portal)

The numbers really do speak for themselves, with not a single negative to report from the income statement. Expanding margins on both a sequential and YoY level. However, income levels can warry, and we could just as well see margins depress over the coming years, especially in a situation where we have to go through a deep recession. As such, I’m more interested in having a look at the balance sheet, as a weak balance sheet can force the management team into making short-term decisions at the expense of what drives long-term value for the company.

Taiwan Semiconductor Q3 2022 Balance Sheet

Taiwan Semiconductor Q3 2022 Balance Sheet (Taiwan Semiconductor Investors Portal)

As can be observed, the company currently holds more cash and short-term investments on its balance sheet, than it does interest bearing debt. It’s hard to ask for much more as an investor, as it leaves management with all the flexibility as one could have hoped for. Additionally, the company also continues to produce a positive free cash flow measured in billions of dollars.

For the last quarter of the year, management currently expects operating margins to land in the 49% to 51% range, which could be slightly down on a sequential basis if they strike the midpoint, as this quarter showed an operating margin of 50.6%.

On a product basis, Taiwan Semiconductor experienced growth across all major segments, showing that this company remains the partner of choice amongst its customers. The Internet of Things segment grew by a very strong 33% and while this segment remains but a small chunk of overall revenue, it indicates what this segment may become over time. Similarly, Automotive also grew 15%, expected to grow substantially over the coming years.

From an operational performance standpoint, I find that Taiwan Semiconductor is in great shape with strong business growth and a solid industry foothold. While the expanding margins will be partly due to the supply and demand unbalance, meaning that margins may be artificially high these years, there is no way around the fact, that Taiwan Semiconductor is a cornerstone of what makes everything electronic, work.

As the company has a continuously high CAPEX budget, due to a need to investment in new fabs with all the machinery that goes with it, it’s pleasing for shareholders to know, that economically, the company is in great shape.

The Very Important Considerations On Risk

Taiwan Semiconductor is in a unique position seen from the vantage point of an international investor. The company does come with a unique set of risks, that must be taken into consideration. More generally speaking, the company is also characterised by substantial execution risk. As mentioned earlier on, the company runs a CAPEX budget of roughly $36 billion this year, and that of course requires a balance concerning the financial position of the company as well as the forward-looking earnings associated to such an investment.

The more interesting risk is the geographical- and geopolitical one. The company is located in Taiwan, one of the hot regions of the world, not only today but for the foreseeable future. Reason being, that China has a goal of unifying Taiwan with China. That can be done peacefully or aggressively, and this is a matter of hoping for the best but preparing for the worst. Before Xi Jinping’s rise to power, China had Hu Jintao as leader of the communist party, and at one time, he advocated for the use of soft power. What has been translated into ‘China’s peaceful rise’. This was official policy and a slogan in China back then, in order to assure the international community and regional neighbours of China’s intentions. The underlying reason was constructed around the idea of soft power, that strong and close relations do more for China, than the use of real power.

The ‘peaceful rise’ principle was constructed at a time where China wasn’t the same superpower it is today, and there was a different leader of the Chinese communist party. Furthermore, the principle was communicated prior to the later, and now official policy concerning Taiwan, labelled the Anti-Secession law, voted into effect back in 2005. This states, that China is authorised to use force if peaceful means are not able to unify the two, or if a situation should arise where Taiwan declares its independence. International response at the time was as could be expected, with the western countries in opposition.

So far, China has in fact managed to climb the ladder of economic development without having resorted to warfare, but the question is of course if the same shall be the outcome for this particular question. We are all allowed to speculate, but at the end of the day, I’ll be taking my precautions as an investor, when it comes to an event that could have a detrimental effect on the company operations. Why could it have such an effect, quite simply because all existing foundries are located in either Taiwan or mainland China, with a single expansion on the way, located in Arizona. More could follow, but how the existing assets would end up being controlled in such a scenario is impossible to predict, not least because of the national security status of this particular industry. In a time of “tech war”, it’s not unlikely, that the output of the assets in Taiwan would be restricted or perhaps nationalised. This is a known risk, and not an unknown unknown as phrased by then United States Secretary of Defense, Donald Rumsfeld. On a company specific level however, this almost qualifies as a black swan event, a term originally coined by Nassim Taleb back in 2005, describing events that come as a surprise but qualify as major event with a substantial or detrimental consequence.

How I Approach Taiwan Semiconductor As An Investment

While Nazeem’s theory may not be spot on in terms of the risk and case in question here, it does present the thought of how to benefit from positive events (the sector outlook and dominant position of Taiwan Semiconductor), while building robustness towards negative events (The unknown unification approach and timeline). Here, there is a fair likelihood of a negative event somewhere in the horizon, be it five years or fifty years from here. The impact being small, or major is also a question, but I can’t take away the fact that Taiwan Semiconductor is leading its industry from a technological standpoint and benefitting from it greatly from an economic standpoint.

How I build robustness in my own portfolio, is that I diversify across different holdings, only assigning a weight of 2-3% on a cost basis for any individual company I invest in. If it outgrows the portfolio and eventually grows to e.g., 8% of the portfolio or more, so be it, then I let it grow. As my portfolio is highly diversified already, that path of action has secured my portfolio remains robust in terms of specific company risk. in addition, I’ll not allow myself to build a maximum position within Taiwan Semiconductor, instead I’ll keep it closer to the 2% as opposed to 3% from a cost perspective, to lower the risk further.

I don’t find that Taiwan Semiconductor belongs in the high-risk basket along with the high-growth no-income segment of the stock market, and here I’m referring to the basket of companies favoured by ARKK investment. However, there is no denying that this company comes with an elevated risk level compared to its peers who don’t suffer from the same geographical risk.

The positive I find in this, is that the management team is beginning to invest outside Taiwan, as exemplified by the ongoing construction of its foundry in Arizona, expected to become operational some time in 2024, but there is a long way from here to a truly diversified asset allocation within the company as that particular foundry only makes up an incredibly small fraction of the full picture. It is a step in the right direction, but it’s also a question whether that course of action could accelerate China’s unification policy as to avoid too large a shift of manufacturing footprint within what is arguable one of the world’s key industries, especially in a time where the two superpowers of the world are flexing their muscles in the tech sphere.

Valuation

The only question remaining is whether the company is trading at a valuation appealing enough to add it to one’s portfolio.

No matter the valuation metric, be it price to sales or EV to EBITDA, the stock comes in on the low end of its historical valuation over the past decade. with a forward EV/EBITDA metric of 6.2, it’s the lowest it’s been since back in 2016, with the same being the case when observing the price to earnings ratio, coming in at 10.4 on a forward basis for next year.

Chart
Data by YCharts

Even in situations where companies appear cheap on a historical basis, we have to keep there are no observations in the past decade that allows for a comparison towards a potentially steep recession, and we have to keep in mind that this industry remains cyclical. As such, the valuation could easily have further to contract before reaching its bottom for this cycle, but on a relative basis, I find the stock has reached a level where it’s worth picking up.

Volatility remains the name of the game, and I believe the best an individual investor can do, is to maintain discipline and establish a position in tranches via the concept of dollar cost averaging, that’s at least what I’ve personally decided is the best path forward.

Wrapping Up

Taiwan Semiconductor has been hammered during 2022, down 48.5% YTD in comparison to 38.5% for its peer ETF, the iShares Semiconductor ETF (SOXX). The company is an industry leader operating at the edge of technology, with most leading companies offering electronics highly dependent on its offerings. This creates an environment of strong growth in both the short- and long-term for the company and has also resulted in expanding margins. Furthermore, Taiwan Semiconductor operates with a very clean balance sheet, maintaining more cash on hand, than what it carries in total debt.

The company is exposed to a unique set of risks, that also weighs like gravity on the stock, but it doesn’t change the fact the company remains a leader, and given its current valuation, the lowest it’s been since 2016 on a number of valuation metrics, I find it’s now reasonable to establish a position. We are potentially approaching a prolonged global recession, something that hasn’t happened in more than a decade, meaning the valuation comparison doesn’t allow for that very relevant observation. This is also why, despite appearing cheap, the stock could have further to fall, as the industry remains cyclical. However, even for cyclical companies, there comes a point where the downside vs. upside balance becomes attractive.

As I’ve laid out in the risk section, portfolio robustness is important, and therefore I personally take extra precautions here, in order to protect my portfolio, while at the same time obtaining exposure to what I consider a very strong company, operating in an industry with a very interesting outlook.

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