Chantal Marx & Nick Crail
The semiconductor foundry market
A semiconductor fabrication plant (fab) is a factory where semiconductors are manufactured, and a business operating a fab for fabricating the designs is called a foundry. If a foundry also produces its own designs, it is called an integrated device manufacturer (IDM) such as Intel, but if it just manufactures based on customer designs then it is a pure-play foundry such as TSMC. A semiconductor company that designs and does not manufacture is a fabless semiconductor company, such as Advanced Micro Devices (AMD).
The semiconductor foundry industry was pioneered by TSMC in 1987. At the time, semiconductor companies both designed and manufactured their own chips. However, the amount of investment required to build fabs with the most up-to-date equipment was exceptionally high and many companies could not afford to invest. Therefore, the fabless model emerged with the idea of separating the design and manufacturing functions. The sheer amount of investment required to create semiconductor facilities with leading-edge technology creates a very high barrier to entry.
Most semiconductor companies these days do not own their own fabs and the foundry model has seen good growth as semiconductor companies have moved to fabless models, along with new technologies driving demand for semiconductors in general.
Looking forward, growth is expected to remain strong over the next few years, driven by high-performance computing (HPC), smartphones, Internet of Things (IoT), and automotive.
Market players
TSMC is the world's largest semiconductor foundry. According to Counterpoint Research, in 3Q24 TSMC had a 64% market share of the foundry segment of the global semiconductor industry.
Approximately 68% of its revenue comes from advanced manufacturing processes (geometries of 16 nanometres [nm] and smaller; a nanometre is a billionth of a metre). This is where the company has a major competitive advantage. It holds a commanding market share in the most advanced process nodes.
When it comes to leading-edge technology there are three main players: TSMC, Samsung and Intel. As mentioned above, TSMC is a pure-play foundry, Intel is an integrated device manufacturer and Samsung is a hybrid of the two as it has foundry customers but also produces its own silicon (the main input into chipmaking) to support its mobile business.
TSMC platforms
TSMC semiconductors are used in a variety of different products, but the principal platforms include smartphones, high-performance computing (HPC), Internet of Things (IoT), automotive and digital consumer electronics.
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High-Performance Computing is the biggest contributor to revenue. The growth drivers here are 5G base station deployment, rising data centre server demand (to enable AI applications), and next generation game consoles. These products require higher performance and power-efficient central processing units (CPUs), graphics processing units (GPUs) and artificial intelligence accelerators, which will drive the overall HPC platform towards richer silicon content and more advanced process technologies.
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Smartphone is the second largest contributor to revenue and is expected to be supported by 5G and new, longer battery life accelerating the new smartphone replacement cycle. On average 5G has 30% to 50% more silicon content than 4G.
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The Internet of Things, which makes up around 7% of TSMC's net revenue, is seen to be one of the big drivers of growth in semiconductors in the future as the demand for IoT, edge computing and wireless connectivity continues to increase.
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Automotive forms a small portion of revenue. Over the longer term, the trend towards safer, greener, and smarter vehicles will drive an increase in silicon content as well as demand for advanced and speciality technology.
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Digital Consumer Electronics includes digital TVs, set-top boxes, digitals cameras and wireless area networks. The proportion of production in this space has been shrinking over recent years.
Customers
TSMC's customer base is large and diverse, but its ten largest customers accounted for 69% of revenue in 2023, with its largest accounting for 25% of revenue (Apple) and second largest accounting for 10% of revenue (Nvidia). Other major customers include fabless semiconductor companies and integrated device manufacturers including AMD, Broadcom, Qualcomm, Intel, MediaTek, Nvidia, Sony and Intel.
Nvidia is expected to increase in importance for TSMC near term as it continues to see strong demand for its products as it relates to AI applications.
In terms of geographic exposure, TSMC classifies revenue according to where its customers are based, which may be different to where it sells or ships its products. The bulk of revenue comes from United States (US) companies.
Manufacturing facilities
TSMC operates 13 fab facilities, nine of which are in Taiwan, two in the US and two in China. The company has the world's largest capacity among the dedicated foundries.
TSMC is opened its Arizona, US fab and another fab in a JV with Japan Advanced Semiconductor Manufacturing Inc. in Kumamoto, Japan earlier this year, with further expansions in Taiwan, the US and Germany either in the planning or construction phase.
Geopolitical sensitivities between China and Taiwan, in addition to Taiwan being a seismically active zone, means it makes sense for TSMC to diversify its production base. However, management will continue to focus on Taiwan as a production location since its centre of research and development and most of its existing production fabs are located there.
Financial review
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TSMC has grown its revenue ~14% per annum on average over the past decade and it is expected that the company can continue to grow its top line at around 25% per annum medium term. In 3Q24, revenue rose 39% y/y (+12.8% q/q) supported by strong smartphone and AI-related demand for industry-leading 3nm and 5nm technologies.
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Margins came under some pressure in FY23 due to pressure on the top line, but an improvement has already been seen in the first three quarters of FY24. Moving forward, we expect gross margins to be well supported by the company's dominance in leading-edge technologies and coinciding revenue growth as well as improved capacity utilisation.
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As at 3Q24 TSMC was in a net cash position of $36.1 billion.
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The semiconductor industry is characterised by rapid changes in technology and therefore spending on research and development as well as capital expenditure to ensure sufficient capacity is of high importance to TSMC. The company spent 44% of net revenue on capital expenditure in FY23 to maintain its leading position within the industry but this is expected to come down near term because of the outsized revenue growth currently.
Investment case
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TSMC is the leading player in a growing industry with high barriers to entry. It is the dominant player in leading-edge semiconductor technology where it has a major competitive advantage and a majority market share in the most advanced process nodes.
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TSMC will continue to benefit from future growth in the semiconductor foundry industry, fuelled by increasing semiconductor content in new technologies and increases in integrated device manufacturer (IDM) outsourcing.
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The company has a strong balance sheet that will support further capacity roll-out.
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We believe its market dominance and advanced technologies will help it to achieve double-digit sales growth and stable operating margins over time.
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The company has a history of delivering strong returns, with its return on equity anticipated to remain stable at around 30%.
Risks
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A decrease in demand and/or prices for products that contain semiconductors. Overcapacity may also weigh on margins.
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Prolonged economic downturns will reduce demand for products that contain semiconductors.
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Loss of technological leadership.
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Loss of a major client - TSMC has major clients that account for a large part of its revenue.
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The timely attainment of supplies at reasonable prices; input price increases will have a negative impact on margins and delays in receiving raw materials could impact its own production process.
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Adverse fluctuations in exchange rates.
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Geopolitical tensions - particularly between China and the US as well as China and Taiwan, this has had an impact in the past. The company has responded to this risk by diversifying manufacturing outside of Taiwan and China.
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Seismic activity in Taiwan.
Outlook and consensus
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Consensus forecasts EPS growth of 38.5% y/y this year and 29.7% in FY25.
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The street is positive on TSMC stock, with 98% of sell-side analysts maintaining a "Buy" on the stock.
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Sales and earnings momentum is positive and bullish sentiment has risen over past 24 months.
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The consensus target price for the company is NT$1559.21, implying 45.7% upside from current levels.
Valuation
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TSMC trades on an 18.7 times 12-month forward PE - in-line with its average long-term rating.
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We are slightly more positive than consensus from a target price perspective - our exit multiple is 24 times, which is above the long-term average, but we believe that the company's fundamentals demand a higher-than-average PE multiple.