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TSM stock or Taiwan semiconductor stock has become very popular lately. It's probably seen as an AI stock and everything nowadays is an AI stock which means nothing is an AI stock but it's a leading semiconductor Foundry. Today we're going to focus on key risks and we're going to start with a question.
So when you look at investing in TSM stock, what's the exposure you're looking for? Well, this article by the Mothley Fool talks about the Bull and Bear thesis for Taiwan Semiconductor and I like this first bullet point it says TSMC, it's a common acronym for Taiwan Semiconductor Company, has crushed the market over the past decade and they talk about how growth is cooling off.
This point here, "unpredictable geopolitical challenges," we're going to really focus on that. And they talk about investments that are going to help TSM maintain its technological lead. So let's start with this statement, "crushed the market," this is a classic example of somebody not choosing the appropriate Benchmark.
So sure, if you looked at the S&P 500 then you could make that claim about TSM but we need to Benchmark it against an appropriate Benchmark which would be, let's say, a semiconductor ETF. So we plugged in the top two semiconductor ETFs by AUM here, so you have SMH and SOXX. And look at this, it certainly doesn't trounce those, it underperforms both.
But the takeaway here is this, because you can always torture the data make it say whatever you want, right, the takeaway is that TSM is highly correlated to the semiconductor industry and the key question is, "do you think TSM will outperform the broader semiconductor industry going forward and is that potential upside worth the risk?" So when we look at what they do, this is a great chart here on the left that shows semiconductor foundries.
So these are places where they manufacture semiconductor devices and this statement here is quite telling it says, "unless foundries can be kept at nearly full use, they will become a drain on the finances of the company that owns them." That's because foundries are very expensive to build out and we look at where this production capability is located we could intuitively think that since they need to be nearly full use, we want them in stable geographies but that's not really the case you see that, what, 66% of foundries are in Taiwan, 17% are in South Korea.
So 75% of the semiconductor industry has always been at risk. So in the case of Samsung they reside in a country that has the most heavily guarded border in the world, this is the DMZ on the North Korean side, I took this picture. Then you have Taiwan, a hotly contested Island. They just had an earthquake that seemed to not have much impact on TSM.
They said some of their foundries were offline for a little bit but the USA here they're the big customer accounting for about somewhere around 60% of TSM's revenues and they need to remove these dependencies, these risks. And just remember that it's in nobody's interest to create problems. So this table here shows the various semiconductor foundries across the globe and their size and, of course, at the top is TSMC, then followed by Samsung as we saw before.
But the distinction I wanted to make here is the difference between Pure Play and IDM. So Pure Play does not offer a significant amount of their own products but instead focuses on producing products for other companies. This idea of fabulous, you've heard that term used before. So when we look at TSM stock they trade in the United States as an ADR which means it's a foreign company trading as an American depository receipt.
There's no refined Investor Decks that I could find. Instead, you're subjected to these short little monthly Revenue blurbs and this 325-page annual report that requires a great deal of scrutiny but they do summarize some of their key points. And they claim to, I didn't verify these numbers, it seems quite astonishing, they've delivered close to 18% Revenue compound annual growth and around 17% earnings compound annual growth since their listing in 1994.
That's pretty remarkable, over a 30-year time span. They started paying cash dividends from 2004 but, and this is important, they say "we have never reduced dividend per share." Well, that doesn't mean anything, it means they could have started paying in 2004 and never increased. We'd have to look at that.
And the way that we look at dividend stocks, we only invest in those that consistently increase every single year, and then we only invest if they've done that 25 years in a row, at least. They say here that "they've only relied on internally generated funds to finance organic growth." That means they generate a lot of cash.
And they've recently begun expanding outside of Taiwan to reduce geopolitical risk. And let's talk about the big 500 lb Panda in the corner, China's Xi says "outside interference can't stop reunion with Taiwan." I know that this is a sensitive topic for some of our viewers and I apologize for that in advance but we need to talk about these things.
So Taiwan cut off contact with mainland China and established its own government in 1949. Beijing views Taiwan as a province that must be reunited with the mainland. And I think this statement in this article says a lot here, it says, "both sides of The Straits absolutely have enough wisdom to handle all disputes peacefully and avoid heading into conflict." I believe that because it's in nobody's best interest to, you're going to see why, create problems in the semiconductor industry because it's so intertwined.
So let's talk about the geopolitical tensions that have increased and are prominently on display in the semiconductor industry. An example would be ASML. We've talked before about how their equipment is not allowed to be shipped to China and in response, China may take some action and they certainly have.
For example, here's a list of the leading countries based on production of silicon worldwide in 2023. So silicon is a popular component of raw material used by all these foundries. Look, China dominates, followed by Russia. So two places that the US doesn't have the best relationship with. But China's very clever, they're selling this product to lots of different countries and you'll see how Taiwan is clever as well.
But the point here is that China could certainly do something about that, right, say, well, we're not going to sell silicon, it kind of shoots them in the foot. But they're taking some steps. You see here this article by MIT Tech, "China just fought back in the semiconductor exports War, here's what you need to know" and they talk about how China restricted the supply of Gallium and Geranium, two materials used in computer chips and other products.
But experts say it won't have the desired impact. Why? Geranium and Gallium can be mined elsewhere, so it's not the only place that you can get that stuff. Export control is not as effective if the Technologies are available in other markets and we know ASML has, what, a monopoly, right? So that's very effective.
Now when we look at Silicon, what ASML calls digital gold, it's the material of choice in the chip industry. Silicon Wafers are made using a type of sand called Silica Sand which is made of silicon dioxide. And this great article from Wafer World breaks it down, you can use many substances to produce Wafers such as Gallium and Geranium, the substances that China was trying to not ship.
Silicon is the most popular though for making Wafers. It's also one of the most common elements found in the Earth's crust, second only to oxygen so it's accessible throughout most of the world often in open pits or via dredging. The Silicon used to create Electronics needs to be very pure, that's why the refinement process is very important.
And this is an interesting statement here, "one of the most important things that silicon-producing countries need is water, so when Taiwan had a bit of a drought that helped contribute to the semiconductor industry slowdown that you would have seen around the time of the Rona when there was problems with Supply.
So when we look at Taiwan semiconductor, this is a telling slide. Okay, so where are they getting their raw materials from? Their raw Wafers needed to do pretty much everything the company does. Well, they have five suppliers that they utilize that are responsible for 85% of the world's Wafer Supply, so if these guys don't work out you have a tough time finding anyone else that can supply.
Look at the countries here, so Taiwan, all right, they have their company in their own country, that's not a problem. Look at this, United States, Japan, Germany - these countries all have relationships with China and China's selling them the raw materials and then they're producing the Wafers and giving them to Taiwan semiconductors.
So you see how that works and they've done a great job of diversifying their suppliers so they don't run into problems. Now when it comes to where their foundries are at this is important. So you see here, what, they have nine foundries in Taiwan; one foundry in Nanjing, there, at least based on that name; two 8 in Wafer Labs; and one in Camas, Washington; and one again in China, and they're building three Fabs in Arizona and some Fabs in Japan, we're not going to talk about those.
But we want to focus on the ones in Arizona. So this was released, what, 3 days ago, Biden-Harris Administration announces preliminary terms and I like this, this is horrible really, something an over-the-counter company would say or a SPAC, "a non-binding preliminary memorandum of terms," okay, but since it's the US government, you can assume that it means more than just what it says on the tin.
They're going to provide up to $6.6 billion in direct funding under the Chips and Science Act to TSMC. TSMC is then going to invest more than $65 billion in three Green Field Leading Edge Fabs in Phoenix. Some points to make here. First of all, the Chips Act is said to, provided everything goes through, produce enough chips for the United States within the United States.
Now I talked to somebody that worked on this and specifically queried the coming elections and whether that posed a problem here and he didn't think at all that it would. In other words, this stuff is pretty set in stone. Now and it's certainly a good strategic move, it seems, by the United States to secure some very advanced technology.
You see here it says, "2-nanometer technology." So the world's leading semiconductor companies right now are racing to make the so-called 2-nanometer process chips that will power the next generation of chips. Now terms such as 2-nanometer or 3-nanometer are widely used as shorthand for each new generation of Chip rather than the actual physical dimensions.
That's important to note, that's according to RS Technica. But the smaller the transistors on a chip, the lower the energy consumption and the higher their speed. And when it refers to Green Field investment, that's just where you're creating a new operation in a foreign country from the ground up. So it remains to be seen how that works out but what we do know is that US companies account for a great deal of Taiwan Semiconductors' Revenue, so their biggest customers - this is interesting.
And NVIDIA became their second biggest customer, placing orders reportedly valued up to US $7.7 billion, 11% of the firm's total revenues. You can compare that to NVIDIA's 2023 COGS of 11 billion so what that's off by 4 billion. Well, there's other components that go into COGS but also NVIDIA has a second Foundry partner, Samsung, and as of December 2023, they were pondering a third partner.
The percentage of work that goes to TSMC versus anybody else is not quoted anywhere we could find, it's just said to be the majority. Now despite that rapid growth, Apple still remains TSMC's primary customer, accounting for 25% of TSMC's total revenue in 2023 around $17.5 billion and you have other firms like MediaTek, AMD, Qualcomm, Broadcom, Sony, and Marvel that were responsible for the rest of the growth and you might say, what growth, right?
So you see here that in 2023, they actually had a decline in Revenue growth though they saw 12% compound annual growth over the past 10 years in 2020 going forward you see that acceleration. And when we look at, this came from a page in that 325 page annual report, look at the breakdown between countries: 66% of their revenues come from the United States, therefore, when that's your key customer, you're certainly going to bend over backwards to do what you can to make them happy and thus the investment in the United States and what the US is throwing them, what, 10% of the investment and not a large amount but at least something.
And you can see also here the breakdown in smartphones versus high performance Computing their largest segment. So this is where we want to think about the build outs a bit. What happens to the Fabs that are producing chips for the US right now? Are those going to be filled by pent up demand? Is this expansion just part of continuing growth or something more than that?
Clearly, the Bulls would point to something more than that. Bulls and Bears would agree that this is going to reduce geopolitical risk though you're still operating out of Taiwan, you're still a Taiwanese company, there's a risk there. So when we look at profitability, just wanted to note this, as we said earlier, very profitable company with both gross and net margins moving in the right direction upwards.
When it comes to valuation, TSM isn't over valued relative to some other popular semi- names we've listed here. So you can see on the left forward priced earnings, that's more applicable. And the last time we used a price to sales, we were derided for that and perhaps that's that's the case. But we also put up SVR here, that's our own simple valuation ratio, a form of price to sales.
It's simply market cap divided by annualized revenues. We put that up because we use it in our community all the time. Why? Because most disruptive tech companies don't have positive earnings, right, they're burning lots of cash as they're trying to capture market shares. So we use that a lot. So that's a point of reference for a lot of people.
Regardless of which ratio you use, you can see here that TSM wouldn't be considered overvalued relative to others. So let's rehash: the US is poking the panda bear. You can't have certain NVIDIA chips, no advanced lithography for you. China sees Taiwan as its rightful possession and at some point in the future it's reasonable to assume that China is going to exert a great deal of influence over Taiwan.
So I'm a Hong Kong citizen. I've lived there for, coming up on over a decade, and I've watched the Frog get boiled very slowly. TSMC is a Taiwan company that's establishing locations in other places and you just need to remember it's still a Taiwanese company and this is a very complex intertwined situation.
So go look at NVIDIA's 10-K, you'll see sales to Taiwan, assets in Taiwan, and of course their major dependency on Taiwan Semiconductors. So are these risks priced in presently to TSM stock? You'd argue they are but, and they've always have been, but things seem to be getting more heated in terms of geopolitical risk.
So that's something to note. Here's the key question, "will the potential upside compensate these potential risks?" And if you want semiconductor exposure, why not just look elsewhere, so alternatives. What's the appeal of TSM? It's a company that benefits no matter which Semiconductor Company is ahead whether Apple selling more smartphones, whether NVIDIA is selling more chips, whatever.
That idea of a company that can benefit from the entire semiconductor industry is also the thesis behind Synopsys. Probably the better play here - software, not hardware. Now should Taiwan Semiconductor have downtime in foundries, for whatever reason, that's going to affect their profitability. Options we like as an alternative to TSM stock would be ASML, Synopsys, Arm.
You can search our website, we've written about all three of these companies and you can read our pieces as to why we like these firms. Just remember this, if TSM sneezes, the semiconductor industry is going to catch a cold. So the safer way probably to invest in semis rather than trying to pick a company would be to invest in an ETF and, fortunately, we've covered that for you.
So please make sure to subscribe to our channel for more work on the semiconductor industry we'll be putting out. Thanks so much for taking the time to watch this today.
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