Stock of the week - Taiwan Semiconductor Manufacturing Company (09.03.2023)

Taiwan Semiconductor Manufacturing Company (TSM.US) which is a top chip manufacturer, has been moving sideways in recent weeks, taking a breath after a dynamic upward move launched in mid-October. The question remains whether the recent rally was just the result of euphoria caused by falling inflation, or does the company have a long-term, fundamental potential?

Impressive financial results

Net revenue increased from NT$1,031.47 billion in 2018 to NT$2,263.89 billion in 2020, with a 5-year average annual growth rate (CAGR) of 17.03%. According to information published in "The Base Rate Book" by Crédit Suisse, only 6% of companies enjoyed a similar growth rate over the period of 5 years.

TSMC's revenues are not only impressive in absolute terms, but also stand out from competitors like Samsung, UMC, GLOBALFOUNDRIES, SMIC, TowerJazz, PSMC, VIS, Hua Hong and DB HiTek.

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The largest source of revenue is 5 nanometer (NM) chips, which accounted for 32% of revenue in Q4 of 2022, followed by 7nm chips with 22% of revenue, 16nm with 12% of revenue and 28nm with 11% of revenue. Forecasts indicate that 5nm chips will gain in importance over time and become the largest source of revenue as their use becomes more widespread.

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Profitability is approaching an attractive level

Gross profitability, which according to research by Robert Nova-Marx becomes attractive at 0.33 and above, has increased from 0.23 in 2018 to 0.27, approaching this threshold.

Operating profits jumped from NT$383.74 billion in 2018 to NT$1,121.27 billion in 2022, with a 5-year average operating profit CAGR of 23.92%. Operating profit margins increased from 37.2% in 2018 to 49.53% in 2022. Meanwhile other companies from the industrial sector, recorded average operating profit margin of 8.1%, and the median operating margin 8.5%. TSMC's operating profit margins are in the top quintile for the sector. In the first quarter of 2023, management expects the operating profit margin in the region between 41.5% to 43.5%.

Net profit increased from NT$363 million in 2018 to over NT$1 billion in 2022, with a 5-year earnings CAGR of 22.87%. Only 8.8% of companies in the sector reported a similar growth rate over the period of 5 years.

Market entry barriers

While the production of the chips themselves is quite cheap considering the low cost margins, building the manufacturing facilities is an extremely costly endeavor with huge fixed costs. Therefore manufacturers are trying to keep the factory running as long as possible. Of the company's 26 production facilities, seven have been operating for 20 years or more. These factories are now fully depreciated, thanks to which they achieved a high level of profitability

China threat 

Perhaps the greatest threat to TSMC's growing advantage comes not from the aforementioned competitors but from China. Again, the importance of technologically advanced chips should be emphasized. Taiwan is an attractive target for China for two reasons: an invasion of Taiwan would give China access to the leading-edge IC production capacity it desperately needs, and it would remove an important competitor in the production of low-adhesive ICs. Although a lot of speculation regarding China's invasion of Taiwan emerged recently, so far there is no reason to believe that an invasion is imminent.

Conclusions

Over the decades, TSMC has become the most important semiconductor company around the world. The market entry barriers for this company are significant, and its competitive advantage is constantly increasing. With the growing demand for leading and less advanced chips, there is a good chance that TSMC's position will strengthen in the long term. The biggest threat to the company comes not directly from the competition, but from potential China invasion. However the probability that this scenario will fulfill is relatively low at the moment.