TSMC: Potential for 60% Upside?
TSMC is one of the most important companies in the world and it's a great play for investors. Why? No matter who comes up with the best chip, TSMC will be the one who will manufacture it.
I only buy companies with a wide moat.
I advise other people to follow this if they are not a hedge fund manager.
Why?
It’s not that you have to keep track of each one of the companies, this is the easy part. If you buy a company with a great many competitors you also have to keep track of the competitors to see whether your business is losing or winning.
This is nearly impossible to do if you don’t have a research & analysis division with many bright brains working in it and most of us don’t have this.
However, you don’t need to worry about this for the companies with wide moat. They are by definition competition proof.
So what are the exceptional businesses with wide moats?
Exceptional businesses are providers of unique products or services, or low cost suppliers of high demand consumer products.
- Warren Buffett
As you can see the definition obviously excludes manufacturers. Indeed, it is well known among investors that manufacturers have no durable competitive advantage. Today’s lowest cost manufacturers are rarely tomorrow’s lowest cost manufacturers., same goes for the quality. TSMC is an exception.
It’s the most fairly valued semiconductor stock
It receives vast grants from governments
It has the widest moat in the industry
Compounding for decades
It’s my third largest position after UNH 0.00%↑ and AXP 0.00%↑. I believe it makes an amazing investment and every intelligent investor should own it.
Let’s cut the bullshit and dive deep into the mechanics that set TSMC apart from other manufacturing companies!
What you are going to read:
Business description
Moat Analysis
Fundamental Analysis
Valuation
Conclusion
🔑🔑 Key Takeaways
🎯 TSMC is one of the most important companies in the world. It manufactures all of the most advanced chips in the world.
🎯 Chip manufacturing is capital intensive and requires long years of accumulated expertise. TSMC is the first dedicated chip manufacturing company in the world and there is no one who can match its capabilities.
🎯 Despite its behemoth status, revenue is growing at 13% and earnings are growing at 18% annually.
🎯 It has no debt and just one year of EBIT is enough to pay down all the debt.
🎯 Despite its capabilities, the company stays undervalued in the overvalued semiconductor industry and offers around 60-70% upside potential for investors.
🏭Business Description
Let’s make it plain and simple: TSMC manufactures chips designed by other companies like Nvidia, Intel, AMD, Apple, Qualcomm…
You now know 50% of what you need to know to understand the business.
Now let’s get into some details.
Chip companies have distinct business models. They don’t sell the chips they manufacture, they design the chips and outsource the manufacturing, they are called fabless chip companies.
This wasn’t always like this. First chip companies had factories to manufacture chips they designed. Prime example of this is Intel. For long, it has been the largest integrated chip company in the world, designing and manufacturing its own chips. Its founders had invented the integrated circuit and created the first commercially viable chips.
First fabless chip company was Chips and Technologies. The reasoning was simple: Semiconductor business was extremely competitive and companies needed to compete in two segments in order to stay competitive: Chip design and manufacturing. It wasn’t enough to design cutting edge chips, they also needed the capability to manufacture them. This required heavy R&D investment in both of these areas which made it impossible for newcomers to compete with the incumbents like Intel.
Solution was separating design and manufacturing.
From this solution born the world’s first dedicated semiconductor manufacturing company: Taiwan Semiconductor Manufacturing.
You are probably asking: Why Taiwan? The USA was where the show was going on, all big chip companies were American so how come the world’s first dedicated and most advanced manufacturing facility was created in Taiwan?
It was a genius political move.
After the Chinese Civil War was lost to communists, the Government of the Republic of China fled to Taiwan. They separated themselves from mainland China and started to operate independently. However, their military might was nowhere near China and thus they were dependent on the US support.
How could they secure everlasting protection of the US?
Simple: By making the US dependent on Taiwan.
They turned to Morris Chang for this.
Chang was born in Mainland China in 1931 and he was committed to the Republic of China which fled to Taiwan. At the time, he was a senior executive in Texas Instruments and he was passed for the third time for the CEO role.
It was then Taiwanese government approached to Chang and said “We want semiconductor industry in the island.”
Chang commercialized the foundry model and founded Taiwan Semiconductor Manufacturing Company, first dedicated foundry in the world.
American chip companies started outsource manufacturing from TSMC for the low cost in the first place. However, over time, as chip design has become insanely complicated and so has the skills required to manufacture them, TSMC appeared as one of the two companies that have needed expertise, the other was Samsung.
However, Samsung was a few steps behind the game for two reasons: It was also a chip designer itself therefore most advanced chip designers hesitated to trust it with their designs. Secondly, though it was able to manufacture those advanced chips, its yields were nowhere near TSMC and the customers were only paying for working chips.
This made TSMC the sole option in manufacturing the most advanced chips.
Today, TSMC has over 91% market share in advanced chip manufacturing. It manufactures all the chips for Apple and Nvidia. Even Intel, which has its own foundry arm, trusts TSMC to manufacture its most advanced chips.
Now you understand why there is a chip manufacturing business.
🏰Moat Analysis
Chip manufacturing is not an easy job.
Look at the machine below:
This is an Extreme Ultraviolet Lithography machine that is needed to place extremely small transistors into the silicon. It has 100,000 parts and shipping requires 30 freight containers.
I am going to explain to you why TSMC moat is extremely wide in the context of this machine.
1. Owning This Machine
Owning this machine is extremely costly. One of these machines costs $150 million to produce for ASML and god knows what price they charge to the companies who want to buy it because there is a premium attached to the price if you want to own one of these machines before the competitors.
Even if you are able to own it after the competitors, you may have just wasted your $200 million because most contracts have probably already been awarded to the competitors and you will not gain a significant market share unless there comes a significant demand boom.
So, the first layer of the moat: This is an insanely capital intensive business.
2. Operating This Machine
It’s not over when you get this machine.
You have to operate it. It takes immense time and resources to train people to successfully operate this machine.
Its malfunction costs millions to repair.
3. Establishing a Manufacturing Process
This machine only does one part of the job: Lithography.
Semiconductor manufacturing has several steps: wafer preparation, photolithography, etching, doping, metallization, passivation, packaging, and testing.
Even if you outsource some of these steps like packaging and testing, you still have to coordinate each one of them.
This is an insanely hard job.
4. Other Competitive Advantages
There are few other industry related competitive advantages.
First of all, think about the customers. There not that many companies in the world that design the most advanced chips. They wouldn’t want to replace their manufacturer for small advantages because replacing your long trusted foundry means additional risk.
Moreover, also consider that TSMC is a dedicated foundry. It has a market cap of over $600 billion. We said that the only other company that is able to manufacture the most advanced chips is Samsung, which has a $400 billion market cap.
On the one hand, you have $600 billion dedicated to chip manufacturing, on the other hand you have a $400 billion conglomerate. Who would you trust with your chip designs?
Considering all these factors, one can easily understand that TSMC has no real competition in the market.
📊Fundamental Analysis
➡️ Business Performance
TSMC is a continuous compounder.
The 10 year revenue compound annual growth rate is 13.72%.
This is an exceptional record for a manufacturing company and clearly sets out why TSM is not your ordinary manufacturing company. It’s a beast in its own league.
In the last ten years, the company more than tripled the earnings. It earned $1.52 per share in 2013 vs $4.98 in 2023, giving it 18.2% 10 year EPS compound annual growth rate. This means that the company didn’t just increase revenue, also enhanced efficiency.
What comes next will stun you, at least it stuns me every time I see.
You are looking at a manufacturing company that expanded its margins in the last 10 years!
Look at this:
Its gross margin expanded from 49.5% in 2014 to 54.36% in 2024.
This documents the company’s wide moat. This margin expansion documents that no competitor was able to even threaten it in the last 10 years. For this reason, it was able to charge more to its customers and customers had no chance but to pay.
To illustrate how striking this is I will let you know Apple’s margins. Apple had a gross margin of 44% and operating margin of 30% in 2023. For comparison, TSMC’s operating margin in 2023 was 42%.
This is a manufacturing company that charges a larger premium than perhaps the most recognized brand in the world.
➡️ Financial Conditions
TSMC has a rock-solid balance sheet as other wide moat companies.
To start with, it has more cash than debt, meaning the company effectively has no debt.
Moreover, its shareholder equity is also more than three times of its total debt, giving the company a Debt/Equity ratio below 0.3, which is absolutely amazing.
Moreover, also consider that the company has more than tripled the shareholder equity in the last 10 years.
The company’s 1 year of EBIT also pays all the debt on the balance sheet, this is the definition of a rock-solid balance sheet.
Just look at this company overall:
10 Year Revenue CAGR: 13.72%
10 Year Earnings Per Share CAGR: 18.2%
Debt/Equity: 0.3
EBIT/Debt: 0.95
Gross Margin: 54%
Operating Margin: 42%
This is like the dream company!
➡️ Efficiency
When it comes to manufacturing business my favorite efficiency metric is Return on Equity, meaning how much more the company makes on every dollar of equity.
Why not use Return on Investment (ROI)?
You can. But it doesn’t tell you as much in an asset intensive business as ROE.
From this aspect, TSMC is a challenging company.
Why?
Because it’s asset intensive indeed, but it’s also one of the most tech heavy businesses in the world.
So, let’s look at both: How much TSMC is making shareholder money and on its total investments?
During the past 5 years, Taiwan Semiconductor Manufacturing Co's average ROE was 29%. Meaning, most of the time the company is able to make 29% on its shareholders’ money.
In the last 5 years the company’s average ROI was 23%, meaning the company was able to make around 23% on its own invested capital.
These are amazing numbers.
Why?
This means that you are also justified to expect above average results from your investment in the company!
📈Valuation
Now the most important part: Valuation. This is the most important part.
Why?
Because investment operations are characterized by price. Even the best company in the world can be a bad investment at the wrong price.
By now, we understand the company and thus we can choose the right method to value the company.
Here, two factors make our work easy in TSMS.
First, despite the complexity of the operation, the key performance metric is obvious. The company either needs to sell more of the same items or sell them at higher prices and it ideally does both.
Second, the fact that TSMC has no real competitor in manufacturing of the most advanced chips makes it easier for us to rely on the past data for business performance in the future.
So, let’s not make it complicated.
TSMC earned $4.98 in 2023 and it grew earnings 18% in the last 10 years.
Let’s be a bit conservative here and apply a 20% margin of safety and assume that it will grow earnings 14% in the next 6 years. In this case it will produce $10.90 per share earnings at the end of 2030.
In the last 5 years, TSMC traded between 10 and 40 times of earnings, median being 22.
If we attach the same median PE to the end year 2030 EPS, you have $239 per share in stock price, indicating 68% upside potential from today’s $142 per share.
You may see this as a very rough valuation. It is. But this is how you should value companies. If you engage into complicated formulas or start assuming positive things about the future, you are essentially speculating.
Be careful, we are first measuring the company’s ability to maintain previous performance, this is why we are so obsessed with moat. Only after we decide that there is a moat, we rely on the historical performance and simply value the company based on this.
🏁Conclusion
TSMC is one of the most important companies in the world.
If something happens and it is completely wiped out tomorrow, the whole global semiconductor supply chain will be disrupted and it won’t recover for a very long time. Such an incident would cause $10 trillion of loss in the world economy and push many countries into an economic crisis.
This is how critical TSMC is.
It doesn’t have any real competitor in advanced chip manufacturing and it has one of the strongest balance sheets I have ever seen.
The company is also a bargain now in the inflated semiconductor industry because of its ability to maintain previous performance.
I wouldn’t trade TSMC, I would own TSMC.
That was great.
I’d recommend the podcast Acquired’s 3hr history of TSMC. Really gives you a sense for how entrenched they are.
https://open.spotify.com/episode/2sUyRjx5GaDYXVWnhWjsRv?si=-WDuCFmXTtac0BHowi75ig
I linked to your post in my Monday web links post - Emerging Market Links + The Week Ahead (April 15, 2024) https://emergingmarketskeptic.substack.com/p/emerging-markets-week-april-15-2024