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Taiwan Semiconductor Manufacturing (TSM)

Equity Research, Technology

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Company Overview

Taiwan Semiconductor Manufacturing Company (TSMC) was founded in

1987. They manufacture and supply fabless semiconductor firms who do

not have vertical integration. Their focus is fulfilling outsourced

manufacturing contracts from companies such as Apple, NVidia, Marvell

and Broadcom. With around 440 customers and over 8,600 products

manufactured, their products are highly versatile and can be used in

many industries using electronics e.g. automotive, wireless, computing

and mass storage.1 In addition they also have subsidiaries specialising in

solar and lighting.

Market Dominant

TSMC is the world's largest dedicated semiconductor foundry. With the

main foundry in Taiwan, they also have two wholly owned manufacturing

subsidiaries: WaferTech in the United States and TSMC China Company

Limited; and a joint venture foundry called SSMC in Singapore. This

enables it to reach a maximum capacity of 30 million wafers annually.

Due to the low costs of production and labour, they have outcompeted

the likes of Intel (whose own fabrication facility stood empty in 2014).2

TSMC on the other hand have worked to capacity and continued to grow.

TSMC had 81.8% market share in 2013, up from 79% in 2012, and 54.2%

in 2010. This exponential growth shows just how fast the firm is

expanding.

Global Reach

TSMC serves the global semiconductor market through its network of

worldwide manufacturing facilities and offices. It distributes largely to

Western tech firms (with 70.9% sales to US and 6.9% to Europe).Account

management and engineering service offices in China, Europe, India,

Japan, North America and South Korea; has enabled TSMC to have a

global reach.

1 About TSMC. Available: http://www.tsmc.com/english/aboutTSMC/index.htm. Last accessed 20th Feb 2015.

2 Einhorn, B; King, I & Culpan, T. (2013). Intel Takes On Chip-Production King Taiwan Semiconductor. Available:

http://www.bloomberg.com/bw/articles/2013-03-14/intel-takes-on-chip-production-king-taiwan-semiconductor. Last accessed 20th Feb 2015.

Rating BUY (Overweight)

Price (07/02/15, US$) 24.2

Target price (US$) 26.2

¹Target price is for 12 months.

Market Cap. (US$ ) 123.01bn

Enterprise value (US$) 115.45bn

Outperform

P/E Ratio: 18.65

EPS: 8.8182

ROE: 23.11

ROA: 16.28

Beta: 0.88

Ticker: TSM

Research Analysts:

Will Skrebels, Paulo Prata,

Govind Nair, Ivan Tan

Email: wskrebels@gmail.com

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Future Plans

On the 13th November 2014 the Board of Directors approved capital appropriations of US$5,574.77

million for purposes including: 1) Installation and expansion of advanced technology capacity; 2)

Conversion of certain logic capacity to specialty technologies; 3) Construction of fab and office

buildings and installation of facilities systems; 4) Expansion of mainstream technology capacity; and

5) First quarter 2015 R&D capital appropriations and sustaining capital appropriations.

This shows the continued growth of the firm under high demand for their product.3 After a stronger

than expected 2014, TSMC announced plans at the start of 2015 to invest $16 billion in expanding

their existing Taiwan manufacturing facilities to produce advanced next generation chips and

creating an additional 5,000 jobs.4 This aims to boost production capacity and help win contracts,

amid increasing competition from Samsung Electronics. TSMC already has contracts from Apple,

however there is stiff competition between TSM and Samsung for the lucrative next generation

iPhone chip manufacturing contact.

Industry Overview

Semiconductor industry suppliers were a $113 billion market in 2011, growing 10% from 2010.

Front-end capital equipment manufacturers make up $51 billion and grew 10%, while back-end

manufacturers account for $11 billion and grew 20%. Assembly and test services providers

accounted for $15 billion, growing 4% yoy, while wafers, substrates and materials manufacturers

constituted $11 billion, up 5% from 2010. Foundry services providers, who manufacture and

assemble chips for non-integrated device manufacturers, account for $25 billion and 1% growth.

Role of firm in sector

TSMC is poised to take advantage of the emergence of the Internet of things (IoT) where it is

estimated that 4.5 billion devices will be connected to the Internet by 2017, and 15.5 billion devices

online by 2020. As the world’s largest semiconductor foundry, TSMC will have a guaranteed and

continuous stream of business and growth throughout this period by supplying a large portion of the

fabless semiconductor firms.

Most of the leading fabless semiconductor companies such as Qualcomm, NVIDIA, Advanced Micro

Devices, MediaTek, Marvell and Broadcom are customers of TSMC, as well emerging players such as

Spreadtrum, AppliedMicro, Allwinner Technology and HiSilicon and many smaller companies.

TSMC's largest customers are Qualcomm Inc. (Revs. 21.94%), MediaTek Inc. (Revs. 9.04%), Apple Inc.

34Traders, 2015 Taiwan Semiconductor Financials Available: http://www.4-traders.com/TAIWAN-SEMICONDUCTOR-MFG-

6492349/news/Taiwan-Semiconductor-Mfg--TSMC-Board-of-Directors-Meeting-Resolutions-19387156/. Last accessed 20th Feb 2015. 4 Robert Fenner. (2015). TSMC to Invest About $16 Billion Building Chip Plants in Taiwan. Available:

http://www.bloomberg.com/news/articles/2015-02-06/tsmc-to-invest-about-16-billion-building-chip-plants-in-taiwan. Last accessed 20th Feb 2015.

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(Revs. 8.2%). Leading programmable logic device companies Xilinx and Altera also make use of

TSMC's foundry services. Some Integrated Device Manufacturers that have their own fabrication

facilities like Intel and Texas Instruments outsource some of their production to TSMC. At least one

semiconductor company, LSI corporation, re-sell the product.

Affected by external factors?

A major external factor that can affect TSM operations is Chinas future plans to have more

dominance in the semiconductor industry. Chinese companies spent almost $5 billion in five major

chip-related takeovers in the past 18 months, data compiled by Bloomberg show, with most deals

getting state funding.

The Chinese government will provide as much as 1 trillion Yuan ($163 billion) in funding over the

next five to 10 years to boost the domestic market and help private companies make acquisitions at

home and abroad, McKinsey & Co. estimates.

Overall

The semiconductor market recorded $40 billion in revenues in 2013. Smartphones have been the

biggest driver for the semiconductor industry, with each smart phone containing approximately $7

of semiconductors. In 2014 global smartphone sales increased by 26%, however 2015 growth is

forecasted at 12%.5 Although there is a forecasted slowdown, there is still significant growth in the

market while analysts also anticipate fast growth in other tech sectors such as smart watches and

robotics. These would all bode well for the semiconductor industry as the tech industry continues to

grow.

China is a huge consumer of chips, accounting for about 45% of worldwide demand. Imports feed

more than 90% of that demand, with almost a quarter of processors bought from Taiwan, according

to a McKinsey report in August and Chinese customs statistics from 2012. Last year the value of

imported semiconductors amounted to $232 billion, up 35% from the year before and more than

China’s oil imports, according to customs authorities cited by the official Xinhua News Agency.

U.S. manufacturer Qualcomm Inc. (QCOM), for example, supplies high-end chips to Chinese

smartphone makers like Xiaomi Corp. Taiwan’s Mediatek Inc. (2454) provides the brains for cheaper

phones. The chips are also found in hardware stretching from computer servers to televisions.

In terms of barriers to entry, many companies would find it difficult to enter due to the high initial

capital requirements estimated at $3-4 billions.6 This has resulted in a long adhered to formula of

designing semiconductors at home and manufacture in Asia. The resultant is a split between the

designers and manufacturers of semiconductors. Before the recent string of deals, Chinese buyers

5 Aries Poon. (2014). Taiwan Semiconductor posts record profit.Available: http://www.marketwatch.com/story/taiwan-

semiconductor-posts-record-profit-2014-10-16. Last accessed 20th Feb 2015 6 Jim Handy, 2011, What's it like in a semiconductor-fab // Available:

http://www.forbes.com/sites/jimhandy/2011/12/19/whats-it-like-in-a-semiconductor-fab // Last assesssed: 15/12/2014

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had made just two semiconductor acquisitions that topped $500 million, according to data compiled

by Bloomberg going back to 1994.

Main competitors

Infineon Technologies (IFX)

Texas Instruments (TXN)

Intel Corporation (INTC)

NXP Semiconductors (NXPI)

Semiconductor Industry SWOT Analysis

Strength

Economies of scale – This is due to the initial capital requirements in the form of machinery and

technology, which once overcome enable the production of subsequent units at a much lower cost.

Technology – The increasing use of technology in people’s everyday life has meant the superior

technology of the semiconductor industry meets the needs of customers in ways competitors cannot.

Weakness

Cost structure – This weakness relates to the initial capital and technology requirements, which

subsequently creates a risk of investment in the semiconductor industry.

Opportunities

Innovation - To produce unique products and services.

New technology – This better meets customer’s needs with new and improved products and services,

while also building competitive barriers against rivals.

New products - Helps expand their business and diversity their customer base.

New markets - Expands their business and diversify their portfolio of products and services.

Threats

Mature market – A mature market is competitive with well established participants, making it harder

and more expensive to increase market share.

Intense competition – Competition is intense with rivalries between individual companies. The

resulting pressure on chip makers pushes them to redefine the state-of-the-art product every few

months. That pressure extends to chip makers, foundries, design labs and distributors. The result is

an industry that continually produces cutting-edge technology while riding volatile business

conditions.

The overall SWOT analysis concludes a highly competitive and fast paced industry that is dominated

by a number of large global participants. These participants have to deal with major multinationals

at all points on the product life line, resulting in a high grossing business if successful in a volatile

market.

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The analysis also identifies the difficulties for new or small participants to enter the market unless

backed by major investment and technological expertise.

For TSMC, they are one of the leaders and main participants in the semiconductor industry. Hence

they have the capital requirements, technology expertise and networks to excel in this industry.

Financial Status and Performance

Figure 17

7 Yahoo Finance, 2015. Key Statistics: Taiwan Semiconductor Manufacturing Co Ltd (TSM)// Available:

https://uk.finance.yahoo.com/q/ks?s=TSM // Last assessed: 15/02/2015

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Overview The above financial highlights for TSMC (shown in fig. 1) are extremely reassuring. When compared with its closest competitors (Sun Edison Semiconductor manufacturer (US), Texas Instruments (US), Qualcomm (US), Taiwan Mediatek Inc.) TSMC continues to far outstrip their rivals in a variety of aspects:

1. Profit Margins at 34.6% are vastly superior to those of Qualcomm (29.9%), Texas instruments (21.6%), Intel (20.9%), and SunEdison (14.5%) - just to name a few.

2. Total Cash at $13.84bn and Current Ratio of 3.12 is highly encouraging. While we may argue that its current ratio is almost too high, we should note that $15.9bn of investment (reported 6/2/2015) in a Taipei based factory was announced in order to boost output. This is to capitalise on large contracts garnered recently with the likes of Qualcomm and Apple.

3. Quarterly revenue growth (YoY) at 52.6% shows the lengths to which this company is still expanding and continues to beat out competition.

4. Dividend yield has increased from 3.0 in 2015, to 2.1 in 2014

Management Effectiveness

A comparison of various ratios shows TSMC is considerably outperforming the industry and sectors

in every aspect of management effectiveness.8 Not only is it currently outperforming, but estimates

also show that we can expect this performance gap between TSMC and the sector to widen over

time.

8Reuters, 2015. Financials: Taiwan Semiconductor Manufacturing Co Ltd (TSM)// Available:

http://www.reuters.com/finance/stocks/financialHighlights?symbol=TSM // Last assessed: 15/02/2015

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Return on Common Equity

The graph looks at return on

equity for TSMC, which displays

a positive return every year for

the past 10 years. Although

2010 was an exceptionally

strong year with ROE of over

30%, in 2011 research and

development expenditure was

increased by 39% to $1.5bn.

This has resulted in a strong ROE

for the past three years of over

22%, representing significant

and consistent growth.

Competitor Comparison

The table above illustrates the profit margins and cash flow of TSMC with respect to its main

competitors. With a profit margin of 38.36% and cash flow margin of 54.02%, TSMC clearly exceeds

all it other competitors and identifies itself as a health business with high efficiency in converting

sales into profit. With 8.83% in free cash flow, this represents a decent buffer for the company in

event of a sudden downturn or to raise capital internally for expansion.

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Share Price over One Year

The graph above showcases the share price and cumulative total return of TSMC over the course of

a year. From the share price there appears to be an approximate 6-month cycle of an upward trend

followed by a short trough. This is exemplified by the low of $16.46 in early February 2014 followed

by a peak of $22.95 in the middle of July. This trend was again repeated following a sharp fall to

$20.20 in the middle of July with a new high peak of $23.47 in late November.

Expert Consensus

According to industry consensus an overwhelming majority of analysts argue that to buy the stock or

that it will outperform. Of the analysts, 29% argued to buy the stock and 48% believed it would

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outperform. A further break down of reports from individual firms showed a buy recommendation

from HSBC and Goldman Sachs on with forecasted 1-year returns of 32.23% and 26.76% respectively.

Technical Analysis:

TSMC is a company with a strong history of aggressive growth, as previously demonstrated by their

fundamentals. Proof of this lies with the total stock price growth of 162% from September 2010

(9.48) to today (24.84). While a long term investment in TSMC may be most lucrative, even a time

horizon of a year will likely see significant return.

The indicators we have used demonstrate a sudden spike in the share price in the last few months.

The indicators all point to consolidation of this uptrend followed by steady growth in the future, as

the company has strong support from its fundamentals and plans for substantial investment.

We recommend a long position in TSM, but only under the following circumstances, which we

foresee occurring in the near future:

1. Moving Average Convergence Divergence (MACD): the crossover remains bullish

2. Average Directional Index (ADX): grows past the 25 mark

3. Relative Strength Indicator (RSI): currently seems to be overbought

To analyse the stock from a technical perspective, we’ve used MACD as a directional indicator, ADX

for momentum indicator, and general support and resistance lines. We believe that the strong

fundamentals enhanced by the technical analysis ensure a strong foreseeable movement in the

share price of TSM over the course of the next year.

Moving Average Convergence Divergence

MACD is an important momentum indicator, which illustrates the relationship between two moving

averages in price. Our technical analysis uses the customary 12 and 26-day periods, along with the 9-

day moving average to trigger buy and sell signals. The crossovers of the two directional movement

index (DMI) points show the entry and exit points on the MACD indicator. To gain a better

understanding of the volatility and momentum of our stock, we also have to use RSI

Relative Strength Indicator

RSI is a momentum tool that is used to signal whether a stock is overbought or oversold. Movements

above 70 are interpreted as indicating overbought conditions; conversely, movements under 30

reflect oversold conditions. So, the current RSI of 61.279 is extremely high, and close to being

overbought.

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Average Directional Index

ADX is another momentum indicator that measures the strength of a trend, regardless of its

direction, i.e. the same for positive and negative trends. Essentially, ADX gives an indication on

whether a stock price is trending. If the ADX value is above 25, it indicates a strong trend, while a

value below 20 is a weak trend. It is comprised of Directional movement (DM+) and Directional

movement (DM-), where positive DM indicates a bullish expectation, while a negative one is bearish.

Indicator analysis with respect to TSM

The yearly chart above, illustrates the TSM share price with respect to volume, MACD, RSI and ADX.

The volume traded (indicating how liquid TSM is) has recently dropped from 18 million shares to 8

million shares. This means that the share is more volatile due to less shares being traded. A more

liquid environment also ensures your trade being filled at the current level.

The MACD level is currently above the “zero level” indicating a bullish expectation, which is exactly

what we desire. Unfortunately, it seems that the two DMI lines are about to crossover again, which

would indicate a reversal into a bearish expectation. The RSI has clearly shown cycles for both buying

and selling, which means the volatility provides an opportunity to gain profit from a capital gains

perspective. The RSI reading for TSM is 61.2799, which is perilously close to being overbought. Both

the MACD and RSI figures would lead to one possible quandary- the stock is currently close to being

overbought. In contrast, the ADX figure of 23.4775 is extremely positive and is very close to clearly

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showing a strong trend. As ADX is unbiased regardless of the direction of the trend, it can be a

powerful scanning tool for stocks, and as TSM is currently up trending, it is clear that it is a strong up

trend. This is clearly observable in the trend analysis below.

Trend Analysis

Between March 2014 and January 2015, the stock was trading in fairly lateral movement with

support and resistance levels of 19.51 and 23.01. However, in January, TSM broke this resistance

level turning it into a support level for the future, further illustrating how impressive this stock has

been in recent months. However, taking a deeper look into the company reveals how impressive its

performance has been over the course of the last 5 years. The chart below shows TSM’s strong up

trend since late 2010.

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This chart further enhances our view of the company’s strong fundamentals and their steady

progress.

Conclusion

Considering the strong fundamentals, market dominance and continuing trend of aggressive growth

- coupled with support from industry analysts - we strongly recommend investing in TSMC. We

would argue that while a long term investment would be most lucrative, a one year time horizon will

still stand to provide significant returns.