Taiwan Semiconductor: One Of The Best (And Cheapest) AI Plays

Summary:

• TSM is the cheapest generative AI play as one of the trifecta of AI godfathers along with NVDA and ASML, attributed to the FWD PEG non-GAAP ratio of 1.06x.
• With the foundry already reporting robust preliminary FQ3’24 sales results, we believe that it is well positioned to report a double beat and raise performance in October 17, 2024.
• With SSNLF already losing market share and INTC unable to produce viable 18A chips, it goes without saying that TSM is likely to remain the clear market leader moving forward.
• Combined with the extremely rich balance sheet and geographically diversified production capability from 2025 onwards, it may undoubtedly remain a core holding in most discerning investors’ portfolio.

TSM Is Inherently Undervalued As One Of The Trifecta AI Godfathers

We previously covered Taiwan Semiconductor Manufacturing Company Limited (NYSE:TSM) in August 2024, discussing why we had reiterated our Buy rating after the great market rotation in July 2024, attributed to its double beat FQ2’24 earnings call, raised FY2024 guidance, and the accelerated 2nm monetization compared to 3nm and 5nm through 2026.

Combined with the robust long-term market trends surrounding generative AI, we had believed that the stock remained a great Buy at every dip.

TSM YTD Stock Price

Since then, TSM has rallied by +24.8%, well outperforming the wider market at +8.3%.

Much of the optimism is naturally attributed to the robust generative AI/ data center capex trends, as observed in the foundry’s robust July and August 2024 sales – with it reaching “68% of JPM’s estimates for the third quarter of 2024.”

This is on top of the recently released September 2024 sales, which triggered the Q3’24 sales of NT$759.68B (+12.7% QoQ/ +38.9% YoY), exceeding the consensus estimates of NT$748B (+11% QoQ/ +36.8% YoY) – with it underscoring why the recent market fears on “overhyped AI bubble” has been overly done.

If readers have forgotten, TSM has also hiked the prices for 3nm chips by over +5% and advanced packaging/ CoWoS by up to +20% in 2025, with it occurring across the board to other clients, including Apple (AAPL), Advanced Micro Devices (AMD), and Nvidia (NVDA) – with it likely to be top/ bottom-line accretive.

Given that 3nm comprises 15% of its FQ2’24 revenues with the management looking to “more than double” its CoWoS capacity in 2025, we believe that the foundry’s prospects remain bright given the highly sticky consumer base and minimal market competition.

If anything, readers may want to note that the second largest global foundry with an 11% in market share (-0.3 points QoQ/ +1.1 YoY/ -8.1 from Q1’19 levels), Samsung (OTCPK:SSNLF), has already “issued a rare apology after warning of weaker-than-expected third-quarter profit, as the South Korean tech giant struggles to keep up with rivals in the artificial-intelligence chip race amid delays.”

With SSNLF also largely operating in the memory end-market, it is unsurprising that it has admitted defeat in the logic segment for now, especially since the Korean foundry has struggled “to win big orders from customers to fill up the new (contract chip manufacturing) capacity.”

At the same time, the new foundry contender, Intel (INTC), has supposedly failed to produce a viable test result on the 18A advanced manufacturing process, attributed to the high defects on each wafer – otherwise, also known as, low manufacturing yields.

With the low yields typically resulting in profitability issues, it is unsurprising that the market is increasingly pessimistic about INTC’s prospects, worsened by the ongoing headcount reduction and potential restructuring to turn around the stuttering legacy business.

TSM’s Weightage In SMH ETF

This is also why we believe that TSM deserves the second largest weightage at 12.47% in VanEck’s flagship Semiconductor ETF (NASDAQ:SMH), second only to NVDA at 20.7% – with it partly contributing to the ETF’s robust YTD outperformance at +51% compared to the wider market at +22.1%.

With the Taiwan foundry proving itself to be irreplaceable in the intermediate term, we believe that it remains a compelling play for opportunistic investors seeking to partake in the ongoing generative AI boom, with it forming the trifecta of AI godfathers along with NVDA and ASML Holding (ASML).

The Consensus Forward Estimates

As a result of the robust FQ3’24 results and growing global foundry market share to 61.7% by Q1’24 (+0.5 points QoQ/ +1.5 YoY/ +13.6 from Q1’19 levels), it is unsurprising that the consensus have upgraded their forward estimates, with TSM expected to generate an accelerated top/ bottom-line growth at a CAGR of +24.1%/ +26.5% through FY2026.

This is compared to the original estimates of +13.5%/ +16% and the normalized top/ bottom line growth at a CAGR of +12.5%/ +14% between FY2016 and FY2023, respectively – with generative AI driving the foundry’s next growth opportunity.

TSM Valuations

And this is also why we believe that TSM is not expensive at FWD P/E non-GAAP valuations of 28.14x, compared to the 5Y mean of 22.21x, 10Y mean of 17.19x, and the sector median of 23.92x.

This is attributed to its extremely cheap at FWD PEG non-GAAP ratio of 1.06x, compared to its 5Y mean of 1.16x, 10Y mean of 1.06x, and the sector median of 1.90x.

Even when comparing to its foundry peers, including INTC at FWD PEG non-GAAP ratio of 10.70x and SSNLF at 0.32x, it is undeniable that TSM is reasonably valued at current levels.

This is especially when comparing the Taiwanese foundry to the two other AI godfathers, including ASML at 1.85x and NVDA at 1.28x – with it triggering an improved margin of safety for those looking to add.

Lastly, TSM has already reported an extremely rich balance sheet with a net cash position of $32.62B in the last earnings call (+11% QoQ/ +82.7% YoY), despite the elevated capex in Japan and the US – with it underscoring the sustainability of its high growth prospects.

So, Is TSM Stock A Buy, Sell, or Hold?

TSM 5Y Stock Price

For now, TSM has already fully recovered from the painful July/ August 2024 market rotation, while recording an impressive +26.4% rally to retest the all-time heights of $190s and running away from its 50/ 100/ 200 day moving averages.

For context, we had offered a fair value estimate of $143.90 in our last article, based on the raised FY2024 growth guidance of “slightly above mid-20s percent in US dollar terms” to approximately FY2024 adj EPS of $6.54 (+26.25% YoY) and the 5Y P/E mean valuations of 22x.

Based on TSM’s robust YTD sales growth by +31.9% YoY and H1’24 adj EPS growth by +21.7% YoY at constant currency, we believe that the management may potentially report another beat and raise performance in the FQ3’24 earnings call scheduled on October 17, 2024 – as hinted by the management’s higher gross profit guidance in the last earnings call.

Based on the consensus raised FY2026 adj EPS estimates from $9.34 to $10.35, there remains an excellent upside potential of +21.6% to our updated long-term price target of $227.70 as well, despite the recent recovery.

As a result of the promising preliminary FQ3’24 revenue results, cheap PEG non-GAAP ratio, robust AI trends as reported by numerous market players, and the excellent capital appreciation prospects, we continue to rate the TSM stock as a Buy.

Risk Warning

Market sentiments appear to be rather exuberant after the Fed pivots in the September 2024 FOMC meeting, as observed in the elevated McClellan Volume Summation Index at 1,715.76x compared to the neutral point at 1,000x, and the rising CBOE Volatility Index to 20.99x compared to the start of the year at 13.20x.

With the stock market entering the Q3’24 earnings season in October 2024, readers may want to brace for near-term volatility, since it remains to be seen how long the AI hype may last, with Palantir’s (PLTR) over exuberant run up directly contrasting against Super Micro Computer‘s (SMCI) stock price underperformance in Q3’24.

While TSM’s market leading foundry position and bright long-term prospects are undeniable, it goes without saying that readers may want to observe the market sentiments a little longer before adding, preferably at its previous trading ranges of between $160s and $170s for an improved margin of safety.

At the same time, readers must note that the management has warned that “the overseas fabs will dilute our gross margins by between 2 to 3 percentage point next year and in the next several years,” contributing to the guidance of a long-term gross margins of 53% – well below the peak of 59.6% observed in FY2022.

Combined with the higher labor and operating expenses in overseas fabs, we believe that TSM is likely to report impacted profit margins and adj EPS performance over the next few years – with it triggering tougher YoY comparison from FY2024 levels.

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Analyst’s Disclosure: I/we have a beneficial long position in the shares of TSM, NVDA, AVGO, ASML either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

The analysis is provided exclusively for informational purposes and should not be considered professional investment advice. Before investing, please conduct personal in-depth research and utmost due diligence, as there are many risks associated with the trade, including capital loss.

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