- ‘Defacto monopoly’ in leading-edge chip manufacture.
- Huge competitive moat built on spending power, know-how and ability to attract talent.
- ‘There are very few companies in the world that deliver [these] sorts of returns at that magnitude of investment.’ – Andrew Keiller, Baillie Gifford
Of all the stocks in the Fix the Future database, Taiwan Semiconductor Manufacturing (TSMC) currently boasts the most holders among the funds run by elite managers – the best 5%-or-so of fund managers in the world.
Some of its popularity with the investment cognoscenti comes down to the fact that TSMC is very big. It’s the world’s biggest semiconductor foundry business with a 53% revenue share of the $108bn market. It therefore has a large weighting in some important Asian and global indices.
But many of the world’s best managers also show extremely high levels of conviction in the stock. We measure conviction based on how overweight an elite manager is in a stock compared with their other portfolio holdings. So, whichever way we look at it, TSMC is a massive favourite.
Source: Citywire / Morningstar, latest portfolio disclosure
It’s no secret why it’s so popular. As the chart below shows, the growth record is phenomenal and operating margins are generally fantastic. Looking further back into the past, since its IPO in the early 1990s, the company has achieved a staggering compound annual sales growth rate of 17.5% and 17.1% for earnings.
‘The number of devices into which TSMC’s chips go, we think, will grow almost exponentially into the future,’ says Andrew Keiller, who works with elite manager Roderick Snell, an investor in TSMC through his Baillie Gifford Worldwide Asia ex-Japan fund.
You hardly need to pay up for the shares either. They’re priced at just 13 times forecast earnings for the next 12 months. We’ll come on to the reasons for this in a bit.
Behind the amazing track record, and forecasts that it is set to continue, is the fact that TSMC taps into some of the most dominant megatrends of our day. It is central to many of the most important changes in our world, driven by exponential growth in computing power and demand for more chips in everything from cars to coffee machines. The company only manufactures for third parties and counts most big tech names as customers, working with chip pioneers such as AMD, Apple, Nvidia and ARM.
TSMC’s sustainability claim
TSMC is one of a few global technology leaders that is making the exponential growth in computing power possible. The accompanying chart, which uses a logarithmic scale to prevent it being flat before quickly going vertical, illustrates just how tremendous progress is in just one field of computing.
The rapid improvement in our ability to process and crunch data is powering several megatrends. Two key areas TSMC is a leader in are high performance computers and 5G. Aside from its traditional expertise in smartphones, its chips are fuelling the rapid growth in applied artificial intelligence (AI), the internet of things and automation, including autonomous vehicles.
These technological developments benefit areas such as health, green energy, safety and resource efficiency. There’s enough Fix the Future potential in TSMC’s activities that no less than 16 funds run by elite managers with a sustainability focus hold the shares.
The company also has its own internal green pledges, which include plans to run off 40% renewable power by 2030 and 100% by 2050. That’s no small commitment given the company has been estimated to use almost as much energy in its operations as Taipei City.
And TSMC’s relentless push to advance chip technology also means it is playing a vital role in keeping the energy use from computing down even as computing power moves in lockstep with Moore’s law (a doubling every two years).
Playing the advantage
|Year-end 31 Dec||Sales (NT$bn)||Pre-tax profit (NT$bn)||Free cashflow (NT$bn)||EPS (NTc)||DPS (NTc)|
Source: FactSet, adjusted earnings figures, data as of 20 Jul 2022
Semiconductor manufacturing is renowned for being hugely competitive. However, as the industry has grown, matured and consolidated, scale has become an increasingly important competitive edge. That’s because it costs eye-watering sums to build state-of-the-art fabrication plants – or ‘fabs’ – and billions of dollars a year are needed to fund the research and development (R&D) necessary to stay at the cutting edge.
Over the past five years, TSMC has splashed a gargantuan $101bn on capital expenditure (capex) and R&D. Forecasts are for capex to be around $40bn in each of the next two calendar years. This includes building a $12bn facility in Arizona, which is expected to gain TSMC political favour in the US, partly through addressing risks associated with having China as a covetous neighbour.
The sums of money and specialism involved in running TSMC leave little scope for new entrants to muscle in.
‘If you depreciate that [spending] over years, you end up with capacity that is much lower cost than anyone who is trying to put it in now,’ says Richard Clode, who works at Janus Henderson with elite manager Hamish Chamberlayne and co-manages the Sustainable Future Technologies fund.
‘A lot of the cashflow TSMC generates is because it depreciates that equipment over five years but runs it for many more. One of the reasons they can spend so much and still make these very good margins is because they have all of this legacy business too.’
The downside to a competitive moat built on the ability to spend ever larger amounts is that the business is very capital intensive. Last year, it produced just 49 cents of sales for every dollar of assets recorded on the balance sheet. But the high margins mean it is still worth investing every dollar. The average return on equity over the past five years has been 25%, including 33% last year.
The company also keeps what it describes as a ‘fortress balance sheet’ to help it cope with any downturn. It has the highest credit rating among its peers, with an AA- from S&P and an Aa3 from Moody’s.
Such strong standing with the rating agencies is also a comfort given the massive investments TSMC makes in growth means cash generation at the free cashflow level normally looks poor and profits can fluctuate.
‘There’s the demand story, the business characteristics but importantly, the financial characteristics are what we really like about the company,’ says Keiller. ‘We’ve identified over time that some of the best companies in the world are those that reinvest back into their business and do that often countercyclically to raise barriers to competition.
‘So, it is very striking that TSMC plans to spend $40bn a year on capex yet it is still doing that on a return on equity of close to 30%. There are very few companies in the world that deliver those sorts of returns at that magnitude of investment.’
TSMC’s business model is another source of competitive edge. It only does work for other companies and does not produce any of its own chips. This reduces conflicts of interest and has helped it to work closely with customers. It has deep expertise in all aspects of precision manufacturing and has developed open innovation platforms to help ensure customers’ products are successful and relationships are ‘sticky’.
Meanwhile, the company’s deep ties with universities and reputation for technological excellence means it can attract and retain the industry’s top talent – what Keiller calls a ‘talent advantage’.
First bite of the Apple
A pivotal moment in TSMC’s development occurred in 2005. Rival Intel, having just won the contract to supply chips for Apple’s Mac computers, turned down the offer to make them for the company’s new iPhone too.
TSMC won the contract, and with the success of the iPhone it won both new customers and the cashflows to help bring it prominence in the foundry spending arms race.
‘Increasingly the guardian of Moore’s law sits in Hsinchu science park in Taiwan because of the infamous decision of Intel to turn down taking the Apple’s [iPhone] chip business,’ says Clode. ‘It’s meant TSMC has ended up with this 200 million-plus-volume leading-edge order from the largest tech company in the world.
‘That’s meant they’ve ended up leapfrogging Intel and bringing out every year that leading-edge, Moore’s-law chip in for the iPhone that everyone buys. They are now the complete defacto monopoly in leading-edge manufacturing.’
The Apple order also meant TSMC started working with the ARM chip designs favoured by smartphone manufacturers due to their lower power consumption compared with the x86 standard that Intel had developed for the PC market.
The connection with ARM may once again be set to serve TSMC well as its designs are expected by many to become the dominant standard for use in data centres and AI, which are viewed as two huge growth areas in the decades ahead.
Winter is coming!
A major downside with high levels of long-term investments is it puts a lot on the line should markets weaken – and semiconductor markets are highly cyclical. Part of the reason for the seemingly low valuation of the shares is that there are fears of pain ahead following mammoth recent spending commitments by chip makers coupled with signs of slowing demand as the world appears to move towards a recession.
This follows investment decisions made against a backdrop of long-running supply constraints caused first by the US-China trade war followed by the disruption sparked by the pandemic.
But for fans of TSMC, the bigger story is one based on structural changes related to increased use of data. The longer-term issue could prove one of undersupply, not oversupply. TSMC is confident of 15% to 20% annual sales growth for several years to come.
‘If you are not willing to be a patient investor, I’m not sure TSMC is the right company to invest in,’ says Keiller. ‘If you look at its earnings stream over the last decade, quite frankly, it has been all over the place. If we were to question our investment staff every time an estimate was missed or every time there was weak guidance, then we would inevitably get this very wrong by trying to time it.
‘We’ve taken the approach not to worry too much about the cycle but to think about how sustainable the long-term competitive advantage is and what the company is doing to improve it, and that gives us a great deal of comfort.’
But upbeat, and expectation-smashing second-quarter results in mid-July, which reported a 44% leap in sales, could nevertheless prove the last days of summer. The company itself said at its quarterly results that it thinks the next down cycle, probably in 2023, will be modest rather than a gnarly one of the type it faced in 2008.
The share price is off 16% since its January high. In the context of the performance of other growth stocks, this is not too bad. However, the valuation based on the next 12-month earnings is near a five-year low. That’s a problems-on-the-horizon valuation.
‘We know the market and fund managers are ahead of where sell-side consensus forecasts are, and the consensus, which is for low-teens revenue growth next year, is way too high,’ says Clode.
‘This is a company that will probably see earnings come down next year because it is still a cyclical business. But even if you look at what that downcycle would be, the stock is still on 16 or 17 times earnings. Even in a downcycle, people can justify owning it.’
The smart money seems to be looking through the bumps in the road.