TSMC Stock: Why Buffett Is Buying Big (NYSE:TSM)

Industry – Appearance

I’ve been following the semiconductor industry since 2020, but I’ve missed both the boom and the bust. In 2020, companies like Intel (INTC) looked pretty cheap, but I hated the performance from their chips. Advanced Micro Devices (AMD), on the other hand, appears to be a growth machine, but turns out to be more of a bubble.

In a way, semiconductors are a commodity in their own right, driven by the forces of supply and demand. The difference here is that the technological edge differentiates competing companies. Still, in a competitive and cyclical industry, margins for these companies fluctuate wildly. Strategy? As Baron Rothschild once said,

“Buy it when there’s blood in the streets.”

So far, almost no one in the industry is losing money. But we saw it happen in 2002, 2009 and 2013:

Taiwan Semiconductor (NYSE: TSM), on the other hand, has maintained its profitability through thick and thin. And now, as profit margins in the industry begin to shrink, TSMC’s profit margins have only increased, demonstrating the full force of its competitive advantage, the moat.

To understand where we are, we must understand where we are. 2020 and 2021 were exceptional years for semiconductors. Revenues rose as the stay-at-home trend boosted sales of PCs, smartphones and tablets. At the same time, consumers were spending like crazy as rock-bottom interest rates and stimulus money boosted consumer confidence. With increasing demand for the automotive industry’s hottest technology, automakers simply didn’t have enough chips to meet their needs. All this has boosted sales and margins in the semiconductor industry.

It should come as no surprise that these stocks are now correcting as the market anticipates the next major recession. The question is “what has a price and what doesn’t?” Let’s take a look.

Thesis

I think it was a big buy by Buffett’s Berkshire Hathaway (BRK.B). Over the next decade, I project 12% annualized returns for TSMC.

Why did Buffett buy TSMC?

TSMC manufactures more than 90% of the world’s most advanced chips. I believe that the Sino-American conflict involving Taiwan is really a war over TSMC. Yes, this company is so important to our modern lives that the most powerful nations on earth risk war over it.

Now we begin to see why Warren Buffett’s Berkshire Hathaway recently bought a stake in the company. Apple (AAPL), in which Buffett owns a $100 billion-plus stake, relies heavily on TSMC to make its chips. While Apple gets all the credit for its outstanding iPhones and Macs, it’s TSMC’s chips that drive these devices’ outstanding performance. Hint: TSMC has pricing power.

Given Apple’s huge profit margins, TSMC has plenty of room to charge Apple a bit more for its chips and take advantage of Apple’s profitability. Buffett can hedge against this outcome. If Apple relies too heavily on TSMC, it risks losing profits.

I have one more point about this purchase and it is related to fund flow. You see, market-cap-weighted index funds have become very popular over the past five years. Stocks in these indexes benefit from passive income. After buying Apple in 2016, Buffett saw the power of inflows from the S&P 500. They caused Apple’s stock to soar. Now, emerging markets seem poised for better returns. I covered this thesis in the article “Emerging Markets: For the Next 50 Years”. Maybe Charlie Munger and Warren Buffett see potential here too. TSMC is the largest stock in emerging market indices and thus has benefited from inflows since 2016, as has Apple.

Plants of Arizona

TSMC is expanding its production in the United States, building two chip manufacturing plants on American soil. Are the Arizona plants a good investment by TSMC? I see several glaring problems with this investment.

Saltwire reported:

“Taiwanese chipmaker TSMC plans to build a second chip plant in Arizona, more than tripling its initial investment to $40 billion. It will generate $10 billion in annual revenue when the plants start operating on Tuesday.”

Assuming a 35% profit margin on this expected return, we have a total profit of $3.5 billion from the two plants. On an initial investment of $40 billion, that’s a pretty poor return on investment, or just a 9% ROA. Not great. To put this yield into perspective, TSMC currently has a return on assets (ROA) of 19%.

Saltwire also reported:

“The foreign investment of Taiwan Semiconductor Manufacturing Co., the world’s largest chip contract manufacturer, is one of the largest in U.S. history.

The first chip manufacturing facility, or fab, will be operational by 2024, while a second facility nearby will produce the most advanced so-called “3-nanometer” chips by 2026.

So one of the largest foreign investments in US history? Yes, semiconductor manufacturing is capital intensive. However, since the construction of these plants is very expensive, there is also a huge barrier to entry for new competition. This only adds to TSMC’s moat.

The other issue I see now is whether this poses a threat to TSMC’s trade secrets. Until this point, TSMC had only operated outside of Taiwan. The company is known for its secrecy, denying US media access to its Taiwanese sites. Asked by CNBC, TSMC employee Tony Chen said, “IP [Intellectual Property] protection is critical to this industry, not only for TSMC, but for other companies in the industry.”

Now here’s also “Why expand production to the US in the first place?” the question arises. Last year, 60% of TSMC’s customers were US companies. TSMC’s long-term customers, such as Apple, want the company to manufacture on US soil. This avoids supply chain disruptions and reduces shipping costs. But at the same time, TSMC will have to pay higher wages and see increased production costs.

Overall, this seems like a better deal for consumers than TSMC’s shareholders. TSMC’s pricing power may be partially offset by increased supply from these new US plants. After all, Samsung (OTCPK:SSNLF) also plans to build a $17 billion plant in Texas.

Long Term Returns

To determine TSMC’s future growth, let’s first look at the growth of the semiconductor industry. Globally, the industry has grown at an annual rate of 7.5% over the past 10 years. Meanwhile, TSMC beat the industry at 14.8%. This is revenue growth, by the way. Over the next decade, research groups estimate the market to grow by 6% to 12% per year. When you think of all the chips we now need for vehicles, smartphones, computers, military equipment, and artificial intelligence, the growth is obvious. Factor in price growth and I can see the industry growing at 9% per year through 2033.

Now, TSMC’s market share seems limited. Below is an illustration. These are actually the corporations that own the manufacturing plants and make the chips, while the “flawless” companies like NVIDIA (NVDA) mainly make the chips:

TSMC has a dominant 53% market share. How did TSMC do it? He had a special focus: Manufacturing excellence. Everything follows when you make the best bare chips the world has ever seen.

Assuming TSMC shines through the moat, the company can maintain its market share. However, the Arizona plants could lead to lower profit margins. Also, keep in mind that TSMC currently pays a very low corporate tax rate.

My 2033 target for TSM stock is $185 per share, which implies a 12% annual return with dividends reinvested.

• I believe TSMC can grow its EPS at a 7% annual rate from $5.89 today to $11.60 by 2033. I have applied terminal 16 times. Since TSMC is not buying back shares, the company should be able to grow its dividend by 11% annually.

In the end

TSMC is one of the world’s first dividend growth stocks. Tailwinds and ditches are undeniable. However, I would caution that TSMC’s Arizona plants could hurt the company’s profitability and that the semiconductor industry can be quite cyclical. Buffett could be hedging his Apple position with this purchase, and the purchase is also a bullish sign for emerging market indices. I rate TSMC a “buy” here and would upgrade it to a “strong buy” if it falls further. Will you follow Buffett at TSMC?

Until next time, happy investing.

Editor’s note: This article discusses one or more securities that do not trade on a major U.S. exchange. Be aware of the risks associated with these stocks.