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Taiwan Semiconductor Outshines the Competition

The semiconductor industry is notoriously cyclical. That cycle is currently at a low point; according to the Semiconductor Industry Association, semiconductor sales worldwide dropped 16% in July from the previous year.

However, there are signs of a rebound. Even though sales may be momentarily depressed, the sector has still outperformed this year. As of late September, the iShares PHLX Semiconductor exchange-traded fund has gained 34%, beating the 18% increase in the S&P 500 over the same period.


There is one company that has relative immunity from the declining chip demand, which has been exacerbated by the trade war and slowing growth in the worldwide smartphone market. Taiwan Semiconductor Manufacturing (NYSE:TSM) is well poised not only for increased revenue growth in China but also for worldwide growth because of its critical role in the entire tech supply chain.

TSM is in a good position to not only rebound along with other chip makers but also to surpass the competition in a number of areas and maintain continued growth, irrespective of the whether the industry is in a trough or crest of the demand cycle. The company presents an excellent way for intelligent investors to benefit from its continued innovation thanks to aggressive R&D and capital spending on cutting edge products and processes.

TSM's advantage

TSM's customer roster includes some of the world's leading tech companies, such as Apple (AAPL), Qualcomm (QCOM), Huawei Technologies, Nvidia (NVDA) and Advanced Micro Devices (AMD.) All of these tech companies rely on TSM to manufacture the most in-demand, high-performance chips for use in smartphones, cloud servers, AI applications and networking switching devices.

No other chip maker has such a built-in demand advantage. The numbers support this proposition. According to JP Morgan (JPM), TSM accounts for approximately 50% of global foundry revenues and 80% to 90% of the sector's profits.

In addition, TSM has increased its market dominance in recent years. Due to its R&D investments, the company was the first to offer the market the first 7 nanometer chip production at significant capacity. Lower nanometer ratings translate into greater performance and improved power efficiency, which helps address the always-present heat-dissipation issue.

By comparison, no other chip maker in the industry has the capabilities for making 7nm processors; Intel, which makes its own chips, isn't slated to have 7nm products until 2021.

Even though it far surpasses the competition in its processor offerings, the company is not resting on its laurels. TSM has recently announced that it intends to begin volume production of 5nm processing products in the first half of next year. The 5nm engineered chips will offer 15% enhanced performance and/or a 30% power reduction than its existing 7nm semiconductors. An additional benefit is that due to their increased density, the new 5nm processors will require less material, leading to cost savings.

As the cloud computing services sector continues to expand exponentially, cloud database companies will need chips that can deliver bone-crunching power in order to handle the massive increase in end-users. Indeed, although there was a slight decrease in capital outlays for cloud computing firms, the demand for new chips in the cloud computing sector is accelerating and TSM is the only company at present that can supply the most technically advanced processors in the volume the burgeoning cloud services market will need.

How favorably situated is TSM relative to the overall market?

TSM has effectively taken away the leadership role from Intel, which had been at the top of the hill for decades. TSM's shares have increased 28% this year, giving it a current market value of $244.66 billion, which tops Intel's $228.32billion.

Because of its lead in innovation and its crucial position in the semiconductor supply chain, not only is TSM shielded somewhat from the vicissitudes of the industry, it also benefits when overall demand in the sector increases. No other company has TSM's chip foundry capabilities or enjoys its sway within the marketplace.

TSM announced its third quarter financial results for fiscal 2019 on Thursday morning, which evidence its ability to continue consolidating its commanding market lead.

The company reported a 13.5% increase in net profit for the third quarter to $3.30 billion, which represents its strongest growth since 2017. Revenue rose 10.7% to $9.4 billion, which exceeded the company's own revenue estimate of $9.1 billion to $9.2 billion. The increase was largely due to strong sales to smartphone makers, which accounted for 49% of total revenue compared to 45% a year ago.

TSM offeres an estimate for upcoming fourth-quarter revenue of between $10.2 billion and $10.3 billion, up from $9.4 billion a year ago, and it anticipates gross margins between 48%-50% versus 47.7% for the same period in the previous year.

Lastly, TSM announced a $5 billion increase in 2019 capital spending plans, bringing the total amount to a record $14-15 billion.

Though some securities analysts seem to have discounted the built-in advantages TSM enjoys over its competitors in both innovation and production capacity, others can see the potential. TSM's shares are up approximately 10% since late September compared to the 3% rise of the iShares PHLX Semiconductor ETF (SOXX).

Even though TSM is selling at 19 times forward earnings, which hits the upper range of the stock's five-year average, the valuation is warranted in light of the company's robust 3.2% dividend yield, which makes its shares alluring in a low-interest world. As icing on the cake, TSM has pledged to payout 70% of its annual free cash flow, which approached $9 billion last year.

Given its enviable lead in innovation, foundry capacity, and its dominant market position, the company could prove to be on the cusp of a growth cycle, which makes it a worthy semiconductor candidate for investors' portfolios.

I have no position in any of the securities referenced in this article.

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This article first appeared on GuruFocus.