A severe shortage of semiconductors has caused pain across the economy, but it’s also giving investors a new appreciation for the importance of semis—everything from simple chips costing a few dollars to the most advanced components that power high-end phones, computers, and data centers.
Taiwan Semiconductor Manufacturing (ticker: TSM) sits at the nexus of this global chip renaissance. The company is a critical supplier to U.S. technology giants like Apple (AAPL) and Qualcomm (QCOM) and Chinese companies like Huawei Technologies. TSMC’s stock is widely held across the globe, and for good reason. It has returned an annualized 29% over the past decade.
But TSMC shares are now caught up in a rare correction. The stock is down 15% since mid-February. Investors should avoid the temptation to buy on the dip, at least for now. A confluence of factors could make the next couple of quarters bumpy enough to give long-term investors a chance to scoop up shares of the tech juggernaut at an even cheaper price.
To be sure, the long-term opportunity hasn’t changed. If oil was the crucial commodity of the past, semiconductors are the critical commodity of the future—and TSMC is a leader in making the advanced chips needed for 5G, artificial intelligence, cloud computing, and electric vehicles.
“ This is an A-plus company with solid management. ”
Founded in 1987, the Taiwanese company accounts for roughly 60% of outsourced chip manufacturing and 90% of the profits. TSMC has made significant investment in its foundries, helping it manufacture ever-denser chips that generate more power while using less energy. Rival Intel (INTC) has struggled to match that success.
Even the lone analyst with a Sell rating on TSMC stock sings the company’s praises: “This is an A-plus company with solid management,” says Mehdi Hosseini, senior equity analyst at Susquehanna Financial Group, who has covered TSMC for more than 20 years. But Hosseini says he can’t ignore the near-term challenges and the pricey stock.
Despite the recent selloff, TSMC shares are still up 110% over the past 12 months, and they trade at 27 times earnings estimates for the next 12 months, well above the stock’s five-year average of 19.
That elevated multiple doesn’t offer much cushion if and when challenges arise. Some money managers caution that near-term demand may not live up to analysts’ rosy forecasts for the next couple of quarters. Also, increased spending by TSMC and its rivals to meet a surge in demand could dent profit margins.
Meanwhile, escalating geopolitical tensions put Taiwan, a self-ruled democracy that China considers a province, and its most important company in a fraught position.
Daiwa Capital Markets analyst Rick Hsu is concerned that the chip shortage—which has hobbled automotive plants and sent gamers scrambling to find new consoles—could create inventory-related issues in the first half of 2022.
Hsu told Barron’s in an email that TSMC’s stock needs to shed another 15%, to about $100, to adequately reflect the current risk profile. The stock recently closed at $118.
Lackluster demand related to smartphones, which accounts for 45% of revenue, could also lead to disappointment. With TSMC profit margins already near a peak, future growth will require a boost in sales. That could be challenging in the near term. Apple’s iPhone 13 is unlikely to offer a major catalyst, while Chinese smartphone vendors don’t currently have the killer app needed to drive upgrades, Hosseini says.
“You can’t just give it multiple expansion because it’s a great company. You need earnings power,” Hosseini says, noting that the company trades at a significant premium to the S&P 500 index. He has a price target of $85, putting him far outside the consensus. Wall Street’s average price target on TSMC is $141.
Analysts, on average, expect TSMC’s earnings to increase 14% to $4.06 a share this year, and 16% to $4.69 a share next year, with revenue growing 16% to $55.8 billion this year, and another 16% next year.
Chips on the Table
Shares of Taiwan Semiconductor Manufacturing have returned an annual average of 25% over the last decade.
In April, TSMC CEO C.C. Wei told investors of a structural increase in demand, with megatrends around 5G and high-performance computing applications fueling strong demand for several years to come.
Even so, Wall Street’s estimates may be too optimistic, says Laura Geritz, CEO of Rondure Global Advisors, which owns TSMC shares. She notes that growth at the company was boosted last year as quarantined families loaded up on PCs, gadgets, gaming consoles, and home appliances, all of which require more and more chips.
Those buying patterns could quickly change as the pandemic eases and central banks begin to taper their support of the economy.
“I think you will get a better shot,” Geritz says of buying TSMC stock. “It’s expensive when you strip away what could be fiscal and stay-at-home economics.”
One of the reasons that investors are drawn to TSMC is its deep and impressive list of customers. But that advantage is becoming increasingly costly to maintain as companies—and governments—push for more geographically diverse supply chains.
In the U.S., the Senate just passed a sweeping $250 billion China package that includes funding and incentives for producing more chips closer to home, along with calls for increased funding of research and development more broadly to help the U.S. maintain its technological edge against China.
The Biden administration just completed a supply-chain review of critical materials—such as chips—and is pushing to spur more production at home and make the U.S. less vulnerable to global supply-chain disruptions.
The industry is already reacting. Intel recently unveiled plans to spend $20 billion on two new manufacturing plants in Arizona, while Samsung Electronics (005930.Korea) plans to invest $116 billion over the next decade, which includes a new chip factory in the U.S. Meanwhile, TSMC has said it plans to invest $100 billion over the next three years—including building two new factories of its own in Arizona.
The companies’ increased spending is probably required to maintain a competitive edge, and the expenditure could address some of the Biden administration concerns by moving some production back to the U.S.
In the near term, though, the spending creates financial risk. Longtime TSMC investor Andrew Foster earlier this year sold the TSMC stake he held in his $2.1 billion Seafarer Overseas Growth and Income fund (SFGIX). He cites concerns about the company’s increased capital expenditure and its potential impact on free cash flow and the dividend, which has a yield of 1.8%.
Current valuations don’t account for those risks, according to Foster, who says he may reconsider if the stock gets cheaper.
In an email, TSMC representative Nina Kao said the company’s investment in Arizona is intended to support customers’ long-term capacity needs and isn’t related to political pressure. The company, Kao added, is confident that the Arizona factory will be profitable.
The biggest risk to TSMC shares is China. The country is intent on unification, and tensions have escalated with China increasing military activity in the South China Sea region. Friction is likely to intensify: The U.S. has said it will soon hold investment and trade talks with Taiwan, as the administration looks to strengthen Taipei.
While policy watchers don’t see an armed conflict on the horizon, the risk of an accident is rising as military activity mounts. How to quantify TSMC’s China risk keeps money managers up at night. They say that a military conflict between China and Taiwan is an all-bets-are-off event that would rattle entire markets, not just TSMC stock.
TSMC declined to comment on politics beyond stating that it was a “law-abiding company” focused on serving its customers.
The risks don’t change the fact that semiconductors have never been more important.
“Valuations in quality growth names such as TSMC have clearly gone up, in part because demand for semiconductors is elevated, while at the same time there is quite a serious shortage of them,” says Martin Lau, managing partner at $37 billion FSSA Investment Managers, which is focused on Asia-Pacific and emerging market strategies.
And yet, “cyclically, this is not the best time to buy TSMC, and the near-term margin of safety has fallen,” he adds. “We remain positive in the longer term.”
Investors just have to pick the right entry point.
Write to Reshma Kapadia at email@example.com