How can it be that a product smaller than a human fingernail, with billions of transistors jammed onto it, can be the most important product of our time? Semiconductor chips are the brains powering our digital world today and will be the basis for all future mankind advances.
Just how important are semiconductors today? Consider how the current global chip shortage has impacted a staggering 169 industries, according to Goldman Sachs, from steel and ready-mix concrete to air-conditioning units and breweries. Automakers in America, Japan and Europe were forced to slow and even halt production, resulting in 3.9 million fewer cars rolling into dealer showrooms this year as compared to last year. It is mind blowing how an industry that is running at a rate of one trillion manufactured units per year (128 per person on the planet) is experiencing a shortage. It speaks to the insatiable demand for semiconductor chips around the world.
Simply put, semiconductors are the mother of all cutting edge technologies.
The semiconductor industry will continue to grow with no end in sight as new technologies like Artificial Intelligence (AI), high performance computing, 5G and 6G, autonomous driving, the Internet of Things, and now the metaverse emerge. The complexity of these new technologies are pushing semiconductor chip manufacturers across previously imagined physics boundaries and into new frontiers.
My stock idea this month is one of those the company's, the world's most important chipmaker Taiwan Semiconductor Manufacturing (TSMC).
TSMC, is the ninth most valuable company in the world and the largest dedicated contract chip manufacturer, or foundry. A semiconductor foundry (also known as a fab) is a factory where integrated circuits are manufactured. In the past, most chipmakers (the companies that design the chip) manufactured using in-house manufacturing plants. But as computer chips became smaller and more difficult and capital intensive to manufacture, many chipmakers either closed or spun off their capital-intensive foundries and outsourced their production to contract foundries like TSMC.
Today, technology companies such as Apple, Nvidia, AMD, Qualcomm, Amazon, Microsoft, Facebook, and yes even Intel, all rely on TSMC for their most advanced chips. Every major customer wants TSMC to do their most advanced, custom chips, because they are the best in the world at it.
The story of TSMC is fascinating, combining elements of redemption, revolution, and geopolitics. And it starts with its founding CEO. Rising through the ranks of Texas Instrument (TI) quickly, future TSMC CEO and founder, Morris Chang ran the entire TI semiconductor business for much of the 1970s. Chang achieved multiple important industry milestones while at the company, including increasing production yield to unheard of levels and pioneering the idea of pricing semiconductors ahead on the cost curve to grab market share and realize economies of scale. Despite these successes he was hung out to dry by TI senior management and had to leave the company.
After a couple career setbacks it would have been hard to foresee Morris Chang would ascend his TI accomplishments after being recruited by the Taiwanese government in 1987 to help the burgeoning island state start a semiconductor company. But, that's exactly what happened thanks to a revolutionary idea Chang had to create a "pure play" foundry model. The idea to build a pure play foundry was born out of necessity. At the time Taiwan was not the economic powerhouse it is today. When Chang considered his options he recognized Taiwan was weak in both chip design and marketing, and therefore focused the company on manufacturing alone.
Chang served two terms with the company. In addition to leading the company from its startup days to a profitable chip manufacturer, he returned in 2009 after retiring in 2005, serving as CEO for another 9 years. It was during that second stint Mr. Chang won the Apple iphone business after Intel famously declined, putting TSMC on its current trajectory.
The comeback story of Morris Chang and Taiwan is rooted in geopolitical intrigue, stemming from China's long standing policy that Taiwan belongs to China and will be re-unified, by force if necessary. After being abandoned by the world at the behest of China, Taiwan based their national survival on semiconductor technology with the mandate given to Chang to start TSMC. Known in geopolitical circles as the silicon shield, it is the idea that Taiwan's strength in semiconductor chips protect the country against Chinese aggression. Any military action taken against Taiwan by China, due to their longstanding belief that Taiwan is part of China, would be as harmful to China as it is to Taiwan, the United States and the rest of the world.
"Economic disruption in the Taiwan Strait is the computing equivalent of mutually assured destruction" - Andy Grove, Intel Corporation
This silicon, supply chain and economic integration between China, Taiwan and the west is protecting the physical security of the Taiwan Strait. With the recent provocations on its Taiwan policy including the use of force if necessary, the risk in TSMC as an investment has grown. In my further analysis below I dive deeper into the seriousness of this risk and why I ultimately believe it is a manageable risk.
The story of TSMC is fascinating and I encourage you to learn more, starting with this incredibly informative and entertaining Acquired podcast episode. Let's move on to evaluating TSMC as an investment.
My investing thesis for TSMC is that they are a near monopoly in the world's most important industry. The are best in class at the world's most complicated manufacturing process. They have a wide moat that even if competitors were able to clear the capital hurdle to just been on par spending wise with TSMC, would still be unable to match TSMC's IP and engineering know-how built up over decades. They are a dividend grower, with a 17 year track record of paying a dividend, growing it at an 12% annualized rate over the last 5 yrs.
Let's look at each element of the investing thesis for TMSC.
Near monopoly
The semiconductor industry utilizes the most complicated manufacturing methods and technologies in the world today. It's an incredibly capital intensive industry. It costs $15 - $20 billion to build just one semiconductor manufacturing factory and that factory will be obsolete in 5 years. These demands have led to a Darwinian effect within the semiconductor industry with the the number of manufacturers competing at the absolute cutting edge of semiconductor chips drop from over 25 in 2000 to an oligopoly of three today - Taiwan Semiconductor Manufacturing (TSMC), Samsung and Intel.
In the most important sector of the industry, TSMC manufactures over 90% of the world's most advanced chips (the ones used in iPhones, Artificial Intelligence scenarios, supercomputers, autonomous driving). For completeness sake, TSMC manufactures 24% of all computer chips in the world.
“TSMC is just absolutely critical,” says Peter Hanbury, a semiconductor specialist at the Bain & Co. consulting firm. “They basically control the most complicated part of the semiconductor ecosystem, and they’re a near monopoly at the bleeding edge.”
The company's near monopoly position is reflected in their improving fundamentals:
Operating margins have expanded from 35% in 2013 to 41% in the TTM
Profit margins have expanded from 30.8% in 2013 to 38.7% as of 2020 EOY
P/E has grown from 14.7 in 2013 to current levels of 30.12 as of November 24, 2021
Best in class manufacturing processes
It is not an exaggeration to say manufacturing semiconductor chips involve the most advanced process in human history. It brings the disciplines of chemistry, physics, and mathematics together into a never ending cycle of manufacturing process innovation.
TSMC is the unquestioned leader in process technology for the most advanced chips in the industry. When technology companies want to build something at the bleeding edge of technology, their first phone call is to TSMC. Increasingly, those customers are having to get in line as much of their 2022 capacity has now been fully booked.
Over the decades, TSMC has helped AMD maintain competitiveness in PCs, enabled Apple and Qualcomm to advance smartphone technology, and now with Nvidia and Marvell, to develop the metaverse, AI, and High Performance Computing.
TSMC is not only at the leading edge of today's technology, 5-nanometer processes (only TSMC and Samsung can do this today), but they are well on track to be one year ahead of both Intel and Samsung as the only manufacturers in the world capable of delivering the next gen 3 nanometers processes.
Wide moat
TMSC's moat is sizable. It has built a virtuous cycle that will be very hard for competitors to break:
TSMC manufacturers the most advanced processors due to their technology advantage
Because TSMC has been able to deliver at the cutting edge they are able to attract and retain more customers
More loyal customers has led to optimal utilization of their production capacity and economy of scale cost advantages
Cost advantages have led to higher profit margins than their peers
More profit allows TSMC to invest more in R&D and modern facilities that keep them technically ahead of their peers
TMSC customers have high switching costs. With 90% market share, if you decide to move off of TSMC you are in effect giving up being on the leading edge. Also, customers and TSMC are deeply integrated process wise. It would take years to switch to another foundry, and why would their customers who are trying to deliver the most advanced software and experiences downgrade the brains of their products.
TMSC's moat is about to get even wider, with a planned capital expenditure of $100 billion over the next three years, exceeding their competitors Samsung and Intel over a similar period.
Growing dividend
I am always on the lookout for growth stocks that offer a material, growing dividend. TSMC definitely fits the bill of a dividend grower backed up by steady and growing earnings. As compared to their peers, TSMC's earnings are stable. Their earnings volatility is lower with no EPS decline greater than 20% in the past 10 years. EPS has grown at an annualized rate of 14.2% over the last 5 years.
TSMC’s stable earnings lead to a more consistent dividend. The company has paid a dividend each year from its first distribution in 2004. Their annual dividend per share has increased for six consecutive years, growing at an annualized rate of 13% over the last five years. This is a pretty amazing accomplishment given the industry’s cyclicality and high capital expenditure requirements. The yield is currently 1.59% with a payout ratio of 47%, so lots of room to comfortably grow their dividend over the coming years. The company has two main shareholder return policies. The first is to at least maintain, if not increase, their annual dividend. The second is to prioritize dividends over share repurchases.
Risk
No stock analysis of TSMC would be complete without acknowledging the most notable risk. That is, the threat of war between China, Taiwan and potentially the U.S. This is not a geopolitical article so while we won't analyze this risk in depth there are a couple things to keep in mind when assessing this stock as a suitable investment for your portfolio:
Tensions could continue to rise with real impact on TSMC, including increased U.S government subsidies given to Intel or China relying more heavily on SMIC, China's largest contract chipmaker - though SMIC is currently several generations behind TSMC. While consequential, the impact would likely be manageable by TSMC given the massive demand for their chips. Also, more money for Intel does not guarantee they will catch up to TSMC technology, it takes a lot more than money to make the sort of advancements TSMC has.
While there is a risk that China could invade Taiwan, it is quite low. This goes back to the idea of the silicon shield. In addition to China's economy coming to a halt as a result of any disruption to Taiwan's semiconductor production, the world would not tolerate China’s use of force to control TSMC. The world’s superpowers view TSMC as a key driver of future technological advancements and economic growth.
While I am personally comfortable with the risk/reward quotient for TSMC, you must be as well. Consider this carefully as we are likely to hear more saber rattling as part of the normal diplomatic discourse between China and the U.S. I would recommend monitoring this risk and acting accordingly if this risk rises considerably.
Bottom line
TSMC provides investors with a rare combination of growth and dividend income that itself should grow over the years. There are lots of tailwinds as the world's insatiable appetite for chips will only grow as our world becomes more and more digital. There is no company better positioned to ride this wave than TSMC, their process power, wide moat and deep relationships with the world's most important technology companies solidifies their number one position in this market oligopoly.
I have a position in TSMC and recommend it as a buy at its current price of $120.71 (as of November 26th, 2021) for investors looking for growth and dividend income. While its current valuation is high I am comfortable with the price given the growing demand for semiconductor chips. TSMC has earned its multiple expansion over the years.
Taiwan Semiconductor trades as American Depositary Receipts under the ticker “TSM” on the NYSE.
As with any investment decision you make it’s important to complete your own due diligence and assess if the investment matches your risk profile. Like any individual stock there is risk. You are entirely responsible for your own investment decisions.
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