TSMC's Long-Term Outlook Backed by Ambitious Expansion in Multiple Sites; FVE Unchanged at TWD 850

Equity Analyst

Phelix Lee

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Taiwan Semiconductor Manufacturing Co. is the world’s largest dedicated contract chip manufacturer, or foundry. It makes integrated circuits for customers based on their proprietary IC designs. The firm has long benefited from semiconductor firms around the globe transitioning from integrated device manufacturers to fabless designers. TSMC, like all foundries, assumes the costs and capital expenditures of running factories amid a highly cyclical market for its customers. Such cyclicality stems from the fact that foundries tend to add excessive capacity during times of burgeoning demand, which can result in underutilization during downturns that hampers profitability.

The rise of fabless semiconductor firms has been maintaining the growth of foundries, which has in turn encouraged increased competition. However, most of these newer competitors are confined to low-end manufacturing due to prohibitive costs and engineering know-how associated with the leading-edge technology. To prolong the excess returns enabled by leading-edge process technology, or nodes, TSMC initially focuses on logic products, mostly used on central processing units and mobile chips, then focuses on more cost-conscious applications. This strategy has been successful, illustrated by the fact that the firm's one of the two foundries still possessing leading-edge nodes when dozens of peers lagged.

We note two long-term growth factors for TSMC. First, the consolidation of semiconductor firms is expected to create demand for integrated systems made with the most advanced nodes. Second, organic growth of artificial intelligence, Internet of Things, and high-performance computing applications may last for decades. AI and HPC play a central role in quickly processing human and machine inputs to solve complex problems like autonomous driving and language processing. Cheaper semiconductors have made integrating sensors, controllers, and motors to improve home, office, and factory efficiency possible.

Business Strategy & Outlook

We believe TSMC’s wide moat stems from its cost advantage and intangible assets, which are realized from its leading position in process technology, or nodes. TSMC’s long-standing leadership in node advancement comes from its ability to correctly and consistently prioritize the right areas in which to innovate for nodes, while maintain fiscal discipline. Process technology leadership not only enables TSMC to improve power, (faster) performance, and (smaller) area, or PPA, cost per chip and time to market, which are critical for the competitiveness of computing devices, but also justifies higher prices than peers. As such, we believe that TSMC's leading position in the advanced processes will contribute to attracting and retaining more customers, more stable utilization of ever-expanding production capacities and lower production costs, generating a higher return than its peers because of the cost advantage, and as a result, ensuring sufficient profits to fund research and development and capital expenditures on subsequent nodes. This virtuous cycle of intangible assets brought by heavy R&D and cost advantages brought by better PPA reinforce each other, preventing smaller peers catching up, in our view. In fact, TSMC has been leading nodes' advancement and maintaining over 50% market share since the early 2000s, and its gross and operating margins have been at least twice as high as those of its closest peers for years. 

We believe TSMC's wide moat is justified by a wider gap between itself and smaller peers. Because of technical hurdles, node advancement has been growing more costly, prompting some smaller players to give up catching up with the industry leaders and other firms to divest. While there were six companies with cutting-edge nodes when the industry introduced 16/14 nm fabs around 2015, there are currently only two, TSMC and Samsung Electronics, selling 5 nm chips, as smaller peers such as GlobalFoundries and UMC decided not to introduce sub-14 nm processes. TSMC’s historical and projected return on invested capital, stable market share, and superior margins all support our wide moat rating.

Multiple technical barriers and high capital requirements form TSMC’s wide moat. Semiconductor manufacturing is inherently capital-intensive. While for every foundry each successive node requires exponentially more R&D and capital expenditures; customers are only willing to pay a premium to first movers. Though node advancements are viewed as evolutionary, manufacturing methods may change drastically in every few generations of process technology. In CPUs and mobile systems on chips, where adoption of new nodes first occurs, planar processes are only used up to the 22/20 nm process. Fin field-effect transistor, or FinFET, is used from 16/14 nm onward. After FinFET comes Gate all-around, or GAA, that will be adopted on TSMC's 2 nm and Samsung's 3 nm nodes. Successive technologies improve electrical performance and miniaturization to fit as many transistors as possible onto chips; thus improving performance relative to costs. In a nutshell, breakthroughs in semiconductor manufacturing aim to improve PPA.

FinFET is the first major barrier that eliminated most foundries from advancing further. Only the largest foundries—TSMC, Samsung, GlobalFoundries, UMC, SMIC, and more recently Intel as a new entrant to the space—possess FinFET-related intangible assets. Yet only TSMC, Intel, Samsung and GlobalFoundries can meet customers’ stringent constraints in mass production. UMC has suspended expansion of 14 nm capacity while SMIC is still ramping up. Manufacturers that decide to halt FinFET R&D have little choice other than divesting, like Panasonic did in 2019, Fujitsu’s 12-inch operations in 2019 and IBM in 2014.

GAA is the new technology hurdle and major potential intangible asset that foundries must overcome to master 3 nm and later nodes. TSMC plans to implement GAA from 2 nm, with mass production projected in 2025. We do not expect foundries apart from Samsung to commercialize GAA-derived products owing to prohibitive costs, with R&D alone estimated to exceed USD 1 billion. The adoption of GAA should lead to better and more stable electrical performance even as circuitries become more intricate. Currently, only TSMC, Intel, and Samsung have unveiled timetables to introduce GAA-derived products. We think TSMC’s dominant market share and strategy to focus on high-end products put it in the best position to outspend competitors in terms of R&D to advance through GAA and beyond.

Close relationships with industry giants help justify investments in process advancement. One of TSMC’s intangible assets is its strong relationships with leaders in multiple subsectors, like Apple in mobile chips, Nvidia in graphic processors and Xilinx in reprogrammable chips. Combined with its leadership in process technology, TSMC can readily justify hefty investments in new process nodes by convincing customers to share detailed roadmaps, while smaller foundries have to build facilities first and wait for orders that TSMC cannot fill. Over the decades, TSMC has helped AMD to maintain competitiveness in PCs, Apple and Qualcomm to advance smartphone technology, and now also with Nvidia, Marvell, Xilinx among others to develop AI, HPC and automotive electronics for the next decade and beyond. TSMC’s technological independence ensures its R&D efforts are customer-agnostic and readily expanded to legacy applications as cost and reliability improve. An example would be Apple pays a premium for being the first in 5 nm chips in 2020, then the technology is projected to trickle down to AMD’s CPUs and NXP’s automotive platform in 2021, followed by data center-, server-, AI processors and so on. In contrast, without advance process technology, it is difficult for smaller foundries like SMIC and UMC to convince customers to risk their own roadmap.

Open Innovation Platform nudges customers closer to TSMC. TSMC’s OIP bridges intellectual property owners with potential licensees. These licensees are typically TSMC’s 500-plus customers outside the top 10, comprising of about 30% revenue. OIP becomes more valuable for all users when intellectual property owners join in search of potential licensees, and potential licensees look for solutions to optimize their products. In 2021 alone, we estimate more than 10,000 products are manufactured with intellectual property featured on the OIP. While other foundries have similar platforms, TSMC’s dominant market share and technical leadership would naturally gravitate users to its OIP. Even though TSMC offers OIP for free, it indirectly benefits from licensees eventually placing foundry orders. In order to keep licensees inside the ecosystem, the company releases some of its technical data—including FinFET and GAA data—to intellectual property owners to entice them to base their future designs on it. It also cooperates with top electronic design automation tool vendors like Cadence and Synopsys to manage intellectual property libraries and generic product modules. This way, licensees would not use other foundries as the latter have different production parameters.

Wide

Economic Moat

Taiwan Semiconductor Manufacturing

Taiwan Semiconductor Manufacturing Co., Ltd. engages in the manufacture and sale of integrated circuits and wafer semiconductor devices. Its chips are used in personal computers and peripheral products, information applications, wired and wireless communications systems products, and automotive and industrial equipment including consumer electronics such as digital video compact disc player, digital television, game consoles, and digital cameras. The company was founded by Chung Mou Chang on February 21, 1987 and is headquartered in Hsinchu, Taiwan.

Earnings data Q2 2023

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