The bullish case for TSMC
Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
As Nvidia stock hits new record highs, it is not a stretch to say the US chip designer has been one of the main driving forces of the artificial intelligence sector rally in Asia. AI-related stocks in the region, especially chipmakers, have seen dramatic gains that have closely tracked share price moves of Nvidia in the past year.
Yet among them, the company that makes all Nvidia’s advanced chips has been treated a little more cautiously by investors. Shares of Taiwan Semiconductor Manufacturing Company, the world’s biggest contract chipmaker, are hardly a laggard, rising 60 per cent over the past year. But still its share price gains have trailed behind regional peers in the past year. It also trades at less than half that of Nvidia on a forward earnings basis.
That is surprising given TSMC has just broken two records — the stock has hit a historic high following a more than 30 per cent increase in May net revenue to $7.1bn, giving the company a market value of $738bn, and its share of the global contract chip manufacturing market surpassed 60 per cent in the first quarter.
The latter is most significant. Global tech groups all want their own homegrown chip. They may have the resources to design their own, but they must outsource manufacturing. That means the business of chip foundry — making the physical chips for other companies on a contract basis — now offers growth opportunities.
Until now, a handful of top customers had a disproportionate impact on TSMC’s business. Before the global race to develop AI services, business from clients such as Apple was lucrative, but that also meant dealing with cyclical sales that tracked new iPhone launches.
But that is changing. The number of cash-rich clients that need a steady supply of chips is growing rapidly as companies upgrade data centres and update chips to run AI functions.
Apple, for example, has been integrating AI capabilities using advanced chips for its latest laptops. Mobile chipmaker Qualcomm recently announced a chip for laptops with features that run Microsoft AI services. TSMC also makes chips for Nvidia’s closest competitor Advanced Micro Devices. Companies including Google, Microsoft and Amazon are all building custom processors.
Regardless of whether these chips are intended for sale or for internal use, that all means more orders for TSMC. These are high-margin products, with advanced chips that use 7 nanometre and below technology accounting for two-thirds of TSMC’s total sales. Its high-performance computing business in particular, which includes chips for AI applications, makes up nearly half its total.
There are, of course, risks. Despite building out more plants overseas, 80-90 per cent of TSMC’s production capacity remains concentrated in Taiwan. China, which sees the self-ruled island as a part of its territory, has been increasing threats and military exercises around the island. That would explain part of the reason TSMC trades at a discount to global peers.
But for now, the stakes are just as high for Beijing. An invasion of Taiwan would severely disrupt global chip supply and also have an impact on China, which like the rest of the world relies heavily on TSMC for its supply of advanced chips. The country is TSMC’s third-largest revenue contributor by geography, accounting for nearly a tenth of TSMC’s sales.
A good measure of foreign investor anxiety — the premium that TSMC’s US-listed American depositary receipts trade at compared with the stock listed in Taiwan — suggests investors are becoming increasingly sanguine about geopolitical risks. These trade at more than a 20 per cent premium to local shares for the current quarter, the widest gap in more than a decade.
That sentiment is mirrored in Taiwan, where locally listed TSMC is the most bought stock by overseas investors. Nvidia has also added support by announcing plans to increase its investments in the island.
Growing demand from its cash-rich clients means it can increase chip prices, which would boost already high margins. Gross margins have long surpassed 50 per cent. Free cash flow more than quadrupled in the past year to $7.9bn, which means ample cash to invest in building capacity for the next generation 2nm chips which would widen the gap with rivals yet further.
Meanwhile, global smartphone sales grew in the first quarter, showing signs of a reversal in a years-long slump in the industry. Just five years ago, mobile chips accounted for over half of TSMC’s group revenue. Coupled with new demand from AI, that could provide outsized growth in the coming quarters.
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