OB Report
February 2023
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The Most Important Tech Company You’ve Never Heard Of

zicherman By Steven Zicherman, MBA, CFA, Director, Equity Analyst

Electronics permeate our everyday lives, from mobile phones and computing devices to automobiles and washing machines. Our dependence on electronics is fully entrenched, and our expectation that these machines become faster, more powerful and more energy-efficient relies heavily on microchips, otherwise known as semiconductors. These teeny tiny chips made of silicon materials manage the flow of electric current in digital equipment. Without chips, advancements in high technology areas such as cloud computing and artificial intelligence would not be possible. 

Semiconductor manufacturing is vitally important to the flowing of goods in the global economy. Even for less advanced chips, manufacturing interruptions like the ones we experienced during COVID can result in devastating losses. According to the American Automotive Policy Council, there are over a thousand chips used in the production of a single car. If chips are unavailable, the production process grinds to a halt. Anyone who wanted to buy a new car in 2021 knows this all too well. 

In the early days of COVID, auto manufacturers misjudged demand and cancelled chip orders, expecting sales to sink. At the same time, computer demand sky-rocketed due to lockdowns and a shift to remote work. By the time automakers realized the pandemic was actually stimulating demand, it was too late, and chip manufacturers were already at capacity. Consequently, experts estimate the auto industry produced 7.7 million fewer cars in 2021, implying a whopping $210 billion hit to overall revenues. Over time, chip content in electric vehicles will increase, possibly double, compared to internal combustion vehicles, making access to semiconductor supplies crucial to the wellness of the industry. 

There are only two companies in the world with the skills and scalability sophisticated enough to accommodate the production of advanced semiconductors: Taiwan Semiconductor Manufacturing Company (TSMC) and Samsung Electronics. 

Taiwan Semiconductor is the only “independent” chip fabricator in the world, meaning it only manufactures chips – no other products – using designs developed by clients like behemoths Apple and NVIDIA. This is a notable differentiator to Samsung who not only makes chips for others but also for its own branded cell phones and laptops that compete with companies like Apple. This creates a meaningful conflict of interest that simply does not apply to TSMC. 

Taiwan Semiconductor was founded in 1987 as a joint venture between the Taiwanese government and private investors. At the time, the decision to focus only on manufacturing chips was far from obvious. Most businesses were vertically integrated, meaning they designed and fabricated chips in house. But, as the industry matured and chips became smaller, faster and more efficient, production became increasingly complicated and expensive, pushing many to outsource fabrication entirely. This trend toward “fabless” flung the door wide open for TSMC thanks to its neutral position with respect to competing with customers.  

Today, TSMC enjoys a 55% share of the chip manufacturing market compared to Samsung at 9%. It has been said that data is the new oil, and if that is the case, then TSMC is the word’s largest and most important data refinery. 

This leadership position results in a positive feedback loop, as customers seek out the most advanced innovations. A high market share supports stable and strong cash generation, and the company’s margins are at least twice those of its closest peers. To stay at the forefront of technological developments, Taiwan Semiconductor leverages its scale and high-margin advantage to invest heavily in research and development. This makes it possible for the company to adopt new and more sophisticated techniques, and create more potent and effective semiconductors, such as radio frequency and 3D intelligent sensors targeting 5G and smart applications. 

The company’s continued growth is greatly enabled by its impressive financial performance. TSMC has produced an average return on equity of over 25% over the previous decade, which is exceptional compared to the general market. With a low leverage ratio and robust cash on hand, TSMC’s solid balance sheet allows it to take advantage of opportunities and changes in the market.

Of course, no company is without risk, and the main threat facing TSMC is cyclicality. Companies like TSMC and Samsung sell chips to manufacturers like Dell, who ship products to retailers like London Drugs. When demand is rising, retailers and distributors stock up. Manufacturers also stock up on raw materials. When demand is strong, semiconductor companies tend to sell more than is being consumed. When demand is weak, the cycle reverses, and profits can fall significantly. Investors need to be aware of how swings in product inventory may affect stock prices.

Geopolitical risk is also a consideration. The U.S. recently introduced restrictions on the sale of certain chips and semiconductor equipment to China. The goal is to slow China’s domestic semiconductor advancement, including efforts to modernize its military. These rules should make it harder for China to develop artificial intelligence and super-computing capabilities. A concern is whether, and to what degree, China will retaliate. We are not geopolitical experts, but we are optimistic that American and Chinese self-interests will result in a relationship that resembles the status quo. 

To prevent future supply bottlenecks, the U.S. and Europe are taking steps to support domestic semiconductor manufacturing. In August 2022, President Joe Biden signed the CHIPS and Science Act into law. The Act provides roughly $280 billion dollars in funding for domestic semiconductor research and manufacturing. TSMC will certainly be part of this effort, despite some cost challenges. TSMC founder Morris Chang noted that producing chips in the United States will cost 50% more than doing so in Taiwan. Still, the company is moving forward and actively constructing two cutting-edge factories in Arizona. TSMC is also looking at establishing a specialized facility in Europe with an emphasis on automotive technologies.

This geographic diversification of semiconductor manufacturing represents a shift away from where we are today. According to Chip War: The Fight for the World’s Most Critical Technology, by Chris Miller, “[The country of] Taiwan produces 11 percent of the world’s memory chips. More important, it fabricates 37 percent of the world’s logic chips. Computers, phones, data centers, and most other electronic devices simply can’t work without them, so if Taiwan’s fabs (fabrication plants) were knocked offline, we’d produce 37 percent less computing power the following year.” 

Numerous industries, including automotive, computing and telecommunications, depend on semiconductors. The viability of these sectors and the overall health of the global economy depend on companies like TSMC to produce high-performing semiconductors at scale. We expect TSMC’s role as a technology enabler will continue to increase as demand for semiconductors rises.

Contact your Odlum Brown Investment Advisor or Portfolio Manager for our Investment Case and latest research reports on TSMC.