Taiwan Semiconductor: Nvidia's Dirt-Cheap Proxy

Taiwan Semiconductor Manufacturing Company Limited (NYSE:TSM) is the main supplier to most big chip companies, including Nvidia Corporation (NVDA). It is Nvidia's sole supplier and is also the main supplier to Apple (AAPL), Qualcomm (QCOM), Advanced Micro Devices, Inc. (AMD), and others. The vast majority of big tech relies on TSM in one way or another, and the company manufactures about 59% of all computer chips used worldwide.

Lately, investors have been getting excited about Nvidia, another semiconductor company that's getting a second wind because of generative artificial intelligence ("AI"). The company's stock fell in 2022, along with the rest of the tech sector, as its revenue and earnings declined. This year, the company's stock began rising when it revealed in an earnings release that it would make money off the rising generative AI phenomenon. Later, it rallied even further when it upped its Q2 guidance to $11 billion from $7 billion, which would represent 68% growth from last year's $6.5 billion.

It looks like NVIDIA will resume its strong growth next quarter, after several quarters of declining revenue and earnings. There's just one problem:

Nvidia stock is extremely expensive.

According to Seeking Alpha Quant, it currently trades at:

• 143 times adjusted earnings.

• 228 times GAAP earnings.

• 42 times sales.

• 44 times book value.

• 158 times operating cash flow.

That's a nosebleed valuation, no matter which way you put it. It is true that Nvidia expects enormous growth in Q2, however, as I wrote in a recent Tweet, that growth would only bring the price/sales ratio down to 25. Sustained, above-average growth would be needed to justify NVDA's current valuation.

This is a big part of what makes Taiwan Semiconductor so enticing (among many other things). As Nvidia's main contractor, it participates in any growth that NVDA enjoys. But unlike NVDA, TSM trades at a modest valuation.

When I last touched on TSM, Nvidia still hadn't released its second quarter earnings release featuring the massive guidance raise to $11 billion. Even without that catalyst in the picture, I considered TSM stock a good value. Today, I like the stock even better. While TSM has gotten more expensive since I last wrote about it, it has also gotten a new growth driver in the form of Nvidia's AI chips. For this reason, my expectations for TSM stock have increased significantly, and I'm upgrading my rating to 'strong buy.'

The Nvidia Catalyst

By far, the biggest reason for my increased optimism toward TSM is Nvidia's expected Q2 sales growth. Even if NVDA fails to hit the target, doing say $10 billion in sales, its growth would be substantial. Were NVDA to earn $10 billion in sales in Q2, that would be a $1 billion miss, but nevertheless a growth rate of 53.8% year-over-year. As Nvidia's manufacturer, Taiwan Semiconductor would share in that growth. As of its most recent earnings release, TSM was expecting more or less flat revenue growth for the second quarter. Even flat growth is above average for a semi in 2023, but TSM's topline growth could be better than that. The company's last earnings release came out several months ago, more than a month before Nvidia's most recent release. Possibly, management did not know about Nvidia's expected sales jump before it released its guidance. If so, there is a decent chance that TSM will beat on earnings when its next release comes out. That will be happening next month, so make sure to keep your eyes peeled.

Competitive Position

By far the single most impressive thing that Taiwan Semiconductor has going for it is its competitive position. TSM has a 59% market share in chip manufacturing, and there are reasons to think that it will maintain its lead over its competitors. Semiconductor manufacturing is a very capital-intensive business. To make modern computer chips, you need access to ASML Holding N.V. (ASML) EUV machines, which cost hundreds of millions of dollars. This results in the industry's margins being slim, but on the other hand, prevents new competitors from entering the industry. Not just anybody can afford $300 million for a state-of-the-art ASML lithography machine, which limits the number of competitors that can enter the industry.

In fact, TSM's only real competitors are Samsung (OTCPK:SSNLF) and Intel (INTC), and of those two, only Samsung is comparable in size. Intel is still a fairly small player, though it aims to surpass Samsung as the #2 next year. The big takeaway is that Taiwan Semiconductor is the biggest player in its industry, and the cost of scaling up foundry businesses makes it unlikely that other businesses will gain share on it rapidly.

Valuation

So far, I've shown that Taiwan Semiconductor is a chip foundry with a strong competitive position that will likely gain revenue as a result of Nvidia's increase in AI chip orders. These are all fair points. However, they leave open the question, "why not just buy NVDA stock and participate in the increase in AI chip sales directly?"

The answer comes down to valuation, a factor that is much more favorable for TSM than NVDA stock. As mentioned at the beginning of the article, Nvidia is an extremely expensive stock. Trading at 42 times sales, it is valued similarly to many "hype stocks" at the height of the 2021 tech bubble.

Taiwan Semiconductor is a different story. Owing to its more "low key" presence in the media, and its being caught in between the U.S. and China, it trades much more cheaply than Nvidia does. According to Seeking Alpha Quant, it trades at:

• 15.94 times earnings.

• 6.5 times sales.

• 4.8 times book value.

• 9.2 times operating cash flow.

• 33.5 times free cash flow.

This isn't an across-the-board "cheap" valuation. The sales, book value, and free cash flow multiples are all fairly high, but they're much lower than the same multiples for Nvidia. Now, of course, there's a reason for this. Nvidia's AI chips are but a small portion of TSM's business, but a large portion of Nvidia's business. We wouldn't expect TSM's revenue to grow by the 68% that Nvidia is expecting its own revenue to grow. However, analysts are expecting TSM's revenue to come in at just $15.53 billion for Q2. That's a significant decline from the same quarter a year before. So, it is quite possible that Nvidia's AI chip orders will drive a revenue beat for TSM in its upcoming release. Even if Nvidia was only 10% of TSM's business last year, it will likely be a much larger percentage this year.

Risks and Challenges

As I've shown so far, TSM is a very strong semiconductor company with a modest valuation. It looks like a great bet for value investors who can't quite take the leap of faith in Nvidia. Nevertheless, the long thesis on this stock faces many risks and challenges, including:

• A potential invasion of Taiwan. If China ever were to invade Taiwan, the consequences to Taiwan Semiconductor Manufacturing could be serious. Facilities could be damaged. China could cut off sea trade with the rest of the world. Other countries would almost certainly scramble to ramp up their own chip manufacturing capabilities, eating into TSM's competitive advantage. It's impossible to say for sure what would happen if China invaded Taiwan, but it could potentially impact Taiwan Semiconductor Manufacturing. On the other hand, TSM's importance to China's own tech industry is arguably a "defense" asset to Taiwan, as it raises the cost of a failed invasion to the Chinese military. Were China to invade Taiwan and fail, it might face trade restrictions from Taiwan in the aftermath, so TSM's vital economic importance to both countries is a deterrent to invasion.

• Competition. TSM's 59% market share in chip manufacturing is extremely high. However, it's not guaranteed to last forever. Intel has been eying TSM's foundry business and aims to build one of its own. So far, it's not going all that well. Intel Foundry services did $118 million in revenue last quarter, which was down 24% year-over-year. In the same period, TSM saw positive growth in constant currency terms. TSM still seems to be winning, but you never know what will happen with the U.S. trying to incentivize homegrown semiconductor production. Potentially, a special subsidy or tax credit could be all that Intel needs to build its own Taiwan Semiconductor 2.0.

As you can see, there are several major risks and challenges to the long thesis on Taiwan Semiconductor Manufacturing. Nevertheless, the stock is one of the best ways to play the AI phenomenon today. In a world where both NVIDIA and AI software companies are becoming extremely expensive, TSM enjoys a positively modest valuation. It was one of the few chip companies that enjoyed positive revenue growth last quarter (in constant currency terms), and it could ramp up its growth in Q2. Overall, I'm content with being long Taiwan Semiconductor Manufacturing Company Limited stock.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.