Taiwan Semiconductor (TSMC) Stock – Investing in the world´s largest hardware manufacturer

Taiwan Semiconductor (TSMC) is by far the world’s largest supplier in the semiconductor industry. A business that is both demanding and profitable. Within one year, the stock price of TSMC has doubled. And anyone who bought the stock at the end of 2008 is now enjoying a yield of over 1,100 percent, with around a tenth of this yield coming from steadily rising dividends. This is something that many people do not know: TSMC is also a reliable dividend payer.

With a market capitalization of 405 billion USD, TSMC is one of the most valuable companies in the world and yet it is rather unknown among shareholders. The somewhat exotic location of the company’s headquarter north of the South China Sea in Taiwan is probably one reason for this. This stock-analysis will show you whether the appeal of the exotic still promises a lucrative return.

How TSMC makes billions of dollars in cash

TSMC was founded in 1987 and is a pure foundry, this means it produces exclusively for customers and not for its own sales. Of its 17 fabs, 14 are located in Taiwan and three in China, which are operated through subsidiaries or as joint ventures.

Production-line of TSMC (source:Taiwan Semiconductor Manufacturing Co., Ltd.)

In the course of the digitalization of our lives, TSMC hardware can be found almost everywhere. Not only in computers and smartphones, but also in cars, maybe your fridge in the kitchen or the alarm clock on the nightstand.

TSMC stock
Logo
Country	Taiwan
Industry	Hardware
Isin	US8740391003
Market cap.	398,9 billion $
Dividend yield	1,9%
Dividend stability	0,90 of max. 1.0
Earnings stability	0,96 of max. 1.0

TSMC´s business segments

Customers include both hardware manufacturers with and without their own factories. Important customers who have outsourced their hardware production entirely are, for example, Advanced Micro Devices (AMD), Apple, Nvidia or Qualcomm, for whom we have already published free stock analyses. Other customers such as Intel or Texas Instruments outsource only part of their production to TSMC.

On the other hand, TSMC manufactures exclusively for its 500 customers. This is the only way TSMC can avoid being both a supplier and a competitor to its own customers, which would inevitably lead to conflicts. However, not producing in-house also means that TSMC can only be successful if its customers are successful, regardless of the capabilities of its own production technology. And that in turn depends crucially on the markets in which the customers sell their products. I will now briefly introduce the five most important sales areas of TSMC’s customers.

Smartphones

After years of rapid growth, the smartphone boom has reached its peak in 2016. Since then, the number of units sold has been declining. A trend that is being reinforced by the Corona crisis and the associated reluctance to replace the old smarthone due to a deterioration of the economic situation in many countries.

Source: https://www.statista.com/statistics/271490/quarterly-global-smartphone-shipments-by-vendor/

All hopes for a trend reversal rest on 5G. With the latest network technology, data on the Internet should flow even faster and more efficiently. Cell phone owners will benefit from this, for example, when high-resolution YouTube videos load faster. The improved user experience will encourage the switch to new 5G smartphones and could thus boost their sales again after several weak quarters.

Internet of things (IoT)

In contrast to smartphones and high performance computing, the Internet of Things is growing rapidly, most recently by 25 percent in a single year. The increasing availability of devices connected to the Internet, such as smart speakers, smart watches and surveillance systems, is likely to continue in this manner in the coming years.

Car manufacturing

However, demand in the automotive industry is declining, with a 5 percent drop in sales in 2019, a trend that will be further reinforced by Corona. But here, too, it is foreseeable that megatrends such as electrification, autonomous driving and the car as an entertainment center will lead to a growing demand for built-in hardware.

Consumer electronics

This includes TV and peripheral equipment such as receivers. Again, sales in this segment were down 7 percent in 2019. Innovations such as 8K resolution or voice control should lead to higher sales in this segment in the near future.

In summary, I believe that while some segments are weakening in the short term, TSMC will clearly benefit from the megatrend of digitization in the long term.

TSMC is the absolut market leader

TSMC estimates that the market for “foundries” in 2019 was worth USD 67 billion in sales. TSMC accounts for 52 percent of this (source: Business Overview, p. 11), making the Taiwanese company the clear market leader among contract manufacturers. TSMC’s competitors include not only pure foundries, but also giants such as Samsung, which produce both for itself and on demand.

source: https://www.design-reuse.com/news/48137/2q20-total-foundry-revenue.html

It is impressive that TSMC generates more revenue than all competing foundries combined. According to my research, the two main reasons for TSMC’s success are firstly, a strict customer focus and secondly, outstanding manufacturing technology.

The close customer focus is made possible by the previously mentioned renunciation of self-production and is expressed in initiatives such as the “Open Innovation Platform“, in which TSMC designers work together with customers on the technical fine-tuning to bring the customer’s product to market as fast and cost-effectively as possible.

TSMC’s outstanding manufacturing technology is already attracting customers such as Apple, Advanced Micro Devices and Nvidia, who are placing orders for the latest generation of high tech. TSMC spent almost 3 billion USD on research in 2019. TSMC´s research budget exceeds the annual sales of competing foundries such as TowerJazz or PSMC.

TSMC -Technology Overview; (source: Business Overview 2019)

In general, the structures built into the hardware are becoming increasingly tiny. The advantage of smaller structures is a lower power consumption with simultaneously increasing computing power, which is the essential prerequisite for even more powerful hardware. Currently, TSMC already produces structures in the size of 5 nanometers (abbreviation nm). 1 nanometer corresponds to 0.001 micrometer. 1 micrometer in turn corresponds to 0.001 millimeters. The research of ever smaller hardware structures is a costly step without certainty as to which step is the right one and where the researcher is merely wasting time and money. Thus Globalfoundries as the second largest foundry behind TSMC researched until 2018 on an own 7 nanometer process, but gave up in the course of a strategic change of direction. And Intel announced just a few days ago that its own 7 nanometer process would be delayed until 2022 due to a “defect”. At the same time, Intel must remain competitive against the strengthened opponent AMD and is now considering contract manufacturing of its latest processors. TSMC is at the forefront as a potential beneficiary of Intel’s setback. In this case, TSMC’s sales in the United States, which have recently fallen slightly, should rise again to over 60 percent:

Revenue exposure by country (source: FactSet)

TSMC is highly profitable

Even in the Middle Ages, blacksmithing was a respected profession that ensured a decent living. TSMC as a kind of new age high-tech blacksmith can also make a good living off foundry. Sales increase by an annual average of about 10 percent and the high operating margins fluctuate in a range between 33 and 40 percent.

TSMC – Revenue and Margins

Although margins have recently fallen due to the corona pandemic (see above), TSMC is still operating very profitably with an operating margin of almost 30 percent. Only during the bursting of the dotcom bubble margins fell to 10 percent. During the financial crisis in 2009, margins remained stable, but revenues fell by 15 percent.

Are TSMC’s dividends safe?

TSMC shines with a steadily increasing dividend of around 10 percent annually and has never reduced the dividend since the beginning of the dividend payments in 2004. The supposed dividend reduction as of June 30, 2020 is due to a change in the dividend rhythm. Since autumn 2019, TSMC has been paying the dividend on a quarterly basis instead of once a year. Further slight declines in dividends on the chart are due to exchange rate bias. This is because TSMC pays out in Taiwan dollars, but the dividend is shown in USD.

The free cash flow has been significantly below profit in recent years, indicating the high investments TSMC has to make to expand its production facilities.

TSMC´s long-term development of earnings, cash-flow and dividends

Currently, the dividend is no longer covered by free cash flow, i.e. the dividend is paid from the company’s reserves. Thus, dividends of USD 10.5 billion have been paid out within the last four quarters, representing a shortfall of USD 7.3 billion with free cash flow of only USD 3.2 billion. This fact can be seen in the screenshot below by looking at the negative amortization power:

TSMC is currently paying dividends from its balance sheet

Nevertheless, I do not see the dividends at risk. This is because the drop in free cash flow is due to exceptionally high investments in the first quarter of 2020 and the quarter before. In the second quarter of 2020, capital expenditure returned to normal and, in return, free cash flow quadrupled:

TSMC´s Free cash flow development for the last 4 quarters

The analysts also expect a significant increase in free cash flow, which should cover the continuing increase in dividends. In addition, TSMC’s liquidity currently amounts to almost USD 20 billion, which corresponds to dividend payments of almost two years.

Is TSMC’s stock undervalued ?

The Dynamic Fair Value calculator determines whether a quality stock is over- or undervalued. And not only for today, but in a kind of backtest additionally for any period of time including the projected future. The logarithmic illustration shows that there have always been long phases of over- and undervaluation of the TSMC’s stock.

Over- and Undervaluation of TSMC’s stock over time (logarithmic view)

In 2015 and 2016, for example, the stock was significantly undervalued when, at a fair value between USD 28 and USD 30, the stock price temporarily dropped below USD 20.

The TSMC stock was significantly undervalued between 2015-2016

Today, however, the situation looks completely different. Business is booming for customers such as Apple, AMD or Nvidia, as well as for TSMC, and at the same time corporate profits and stock prices have risen. Because of the mentioned failure of Intel to convert to 7 nanometers, the stock price of TSMC has risen again. Currently the stock costs 77 USD and is thus significantly above the fair value of almost 50 USD. As a reminder: during the corona crash TSMC’s stock was available for 44 USD. The high valuation can also be seen from various multiples such as the P/E ratio, which in 2015 was still a modest 12, but today is almost 27, and has thus more than doubled in just under 5 years. Although earnings per share are expected to rise significantly from USD 2.15 in fiscal year 2019 to USD 3.07 in the current fiscal year and this positive development is expected to continue, there is still a short-term potential for a setback of just under 40 percent (red dotted line) in relation to the current fair value of the stock.

The stock seems to be clearly overvalued

Which TSMC stock to buy ?

Like recently at Alibaba, an investment in TSMC can be done by either buying the original share or as ADR (American depository receipt). The ADR is a so-called “sponsored ADR“, i.e. TSMC itself has mandated the ADR and guarantees the right to exchange one ADR for five original stocks. From my point of view you should buy the version that is available from your broker with the lowest fees. In general, this usually boils down to the ADR, whose main stock exchange is the New York Stock Exchange.

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Conclusion: TSMC stock looks overvalued

It’s like a curse. A lot of tech stocks seem way too expensive and still keep rising. TSMC’s stock is no exception. Despite current headwinds in the form of declining demand in some segments due to the corona pandemic, the stock price is rushing from one all-time high to the next. Investors are looking beyond Corona and praising a golden future for TSMC, which even seems plausible to me due to the technological lead in production engineering. Overall, I consider TSMC to be an excellently managed company whose market leadership in the long-term growing hardware segment is undisputed. And yet, TSMC’s stock seems to be too expensive to buy right now.