TSMC: Derisking China Invasion Threats

Summary:

• Taiwan Semiconductor Manufacturing Company is a strong buy for long-term investors due to its strong technological capabilities and central role in the semiconductor supply chain.
• TSMC dominates the industry with its advanced chips and strategic investments in international markets, mitigating risks associated with Taiwan-China tensions.
• Despite recent earnings report causing a drop in share price, TSMC’s leading position in the semiconductor industry and growth prospects make it a cheap and strong buy.

Investment Thesis

I believe that Taiwan Semiconductor Manufacturing Company’s (NYSE:TSM) strong technological capabilities, especially with expansions outside Taiwan, and central role in the semiconductor supply chain present a case for a strong buy recommendation for long-term investors. The potential risks from geopolitical tensions between Taiwan and China are critical for TSM’s future, but I think are being over-weighted by analysts. While any possibility of a Chinese invasion poses a threat to TSM and the global semiconductor supply chain, as previously emphasized by Mark Liu, TSM’s Chair, who warned that any conflict would render their advanced facilities inoperable due to their reliance on global supply chains, I really think this is a lower odds event and is being overpriced into the stock. These risks, in my opinion, are counterbalanced by the company’s positioning and growth prospects in the global semiconductor market.

TSM has become the world’s largest contract chipmaker through their most advanced chips, which include 2nm and 3nm nodes. They dominate the industry by securing a 54% market share and their capability to supply chips to Apple (AAPL), Qualcomm (QCOM), and Nvidia​ (NVDA). Despite the current geopolitical issues, TSM continues to exhibit strategic investments in international markets as part of a “Taiwan plus one” strategy to mitigate the risks associated with the Taiwan-China tensions. They have expanded outside Taiwan by setting up factories in the United States, Japan, and Germany to address the increasing market demand for AI-driven technologies. In fact, this demand was so high that TSM’s order book is sold out, with revenues up 59.6% in the month of April.

Recently, the company’s role as a strategic asset, not just for Taiwan but globally, was highlighted by the U.S. Secretary of Commerce Gina Raimondo, who warned that a possible control by China over the company would be “absolutely devastating.” The United States economy relies heavily on TSM for their advanced chips​​. As such, the Biden administration has offered financial support worth $11.6 billion to help TSM accelerate production of their Arizona plants.

However, despite a strong surge in their stock due to AI-driven demand, TSM’s recent earnings report caused shares to slide nearly 7% due to a revised outlook and unchanged capital expenditure plans​​. Despite this drop in share price, I still think this does not diminish the long-term value of the company’s technological and market position as demand for AI, Internet of Things (IoT), and cloud computing increases, especially with the company soon releasing their new two-nanometer chips.

TSM’s leading position in the semiconductor industry (although threatened by global tensions over chip access) will continue to help to sustain their technological superiority and supply chain security​​ leadership. With these, the stock appears cheap; therefore, I believe making them a strong buy.

Background On Tensions

Taiwan and China trace their tensions back to the aftermath of the Chinese Civil War in 1949. The democratization of Taiwan in the late 20th century helped develop the country’s separate identity. Cross-strait relations have also been exacerbated as Taiwan’s elected leaders have different political leanings than those of the Chinese Communist Party’s views. Periods of thawing relations have sea-sawed, particularly during the administrations favoring closer economic ties with China, have intensified, especially under leaders advocating for Taiwan’s sovereignty.

In response to these geopolitical pressures, TSM has initiated a diversification strategy by investing in the United States and other countries to lower the risks associated with geopolitical tensions with Taiwan. However, most of the company’s production remains in Taiwan, which remains a point of concern for global markets and security analysts.

Taiwan’s defense posture, often referred to as the “porcupine” strategy, is designed to deter aggression from China by making any potential invasion costly and challenging. This involves a combination of hard and soft power elements that focus on strengthening Taiwan’s military capabilities while ensuring economic and diplomatic resilience.

With recent arms sales authorized by the United States Congress, analysts expect that this move will fortify Taiwan’s defense capabilities (thus the nickname “porcupine” due to its ability to deter aggression through a robust defense posture​).

Taiwan is also advised to build up vast ammunition reserves and invest in defensive weapons like anti-satellite (ASAT) and anti-radiation missiles (ARMs) to redirect the economic burden of warfare to China.

TSM’s Geopolitical Mitigation Strategy

This long-standing political rift has become more intense when Taiwan’s growing importance in the global semiconductor industry, through which TSM​​​​ has become prominent. As the company became the largest contract manufacturer of semiconductor chips worldwide, their role has become a strategic point of contention because of global dependence on these chips for consumer electronics and infrastructure and military systems​.

With this, TSM’s capacity to meet demand for the most advanced chips, is caught between the intersection of the technological plans of both the United States and China. The company’s activities are closely watched by both superpowers​​​​.

The global semiconductor is also gearing up for the accelerated demand on top of their already key role. Companies such as Advanced Micro Devices’ (AMD) with their strong performance in the data center segment, which grew 80% year-over-year to $2.3 billion, highlight the rapid adoption of AI technologies. Nvidia’s strong last quarter revenue of $18.4 billion in their data center segment was powered predominantly by AI chips made by TSM. AI demand is hot and TSM is the current lead supplier.

To help bring new supply online, the United States has also bolstered their semiconductor capabilities through the CHIPS Act, which is partly motivated by the desire to reduce reliance on Taiwan’s chip production amid escalating tensions with China. Furthermore, the United States government’s commitment to reviving the local semiconductor manufacturing sector is definitely a good sign for TSM.

The Biden administration’s allocation of $6.6 billion (already) in federal grants to TSM for their Arizona expansion, along with plans for a third fabrication plant, also contribute to the importance of TSM in the U.S. semiconductor strategy.

I believe these diversification efforts are starting to bear fruit. With this, I think geopolitical concerns are going to be a much smaller part of the TSM story in the future. This is where I believe lies the upside opportunity.

Valuation

TSM’s P/E GAAP forward (FWD) is currently at 24.60, which is below the sector median of 30.04 or a -20.11% difference, suggesting TSM is seen as a less-than-average company even though I see them as an above-average company (the exact opposite). I am using GAAP P/E estimates here because the company has high capex spending, which GAAP accounting does a good job of recognizing.

I believe the market is severely undervaluing this company, as the demand for their semiconductor chips is very promising. Although I believe TSM deserves to be valued as an above-average company, if they were valued at the sector median, TSM has an upside potential of 22.11%. My calculation suggests an opportunity solely on valuation expansion (no growth in EPS, which also is a spot for immense growth).

Why I Don’t Think This Is Priced In

The PEG Non-GAAP forward (FWD) stands at 1.08, lower than the sector median of 1.99. This -45.39% deviation from the sector median indicates that the market is not fully pricing in TSM’s growth potential, even after strong revenue reports from April.

With a consensus EPS estimate growth rate of 21.77% for the fiscal years ending Dec 2024 and 24.76% for December 2025 respectively, I think the market is still assuming slower growth for the chipmaker.

My strong outlook is supported by high demand for AI chips, as seen in their partnerships with major companies like Apple, Nvidia, and Intel.

Risks To Thesis

Even though TSM announced their expansion in the United States, the Arizona plant will only be operational by 2025 due to a shortage of skilled workers and technicians who will install and operate the factory’s advanced semiconductor manufacturing equipment. TSM’s Chairman, Mark Liu, highlighted the necessity of importing experienced technicians from Taiwan to counterbalance the local skill gap and accelerate the project’s progress​. According to analysts, TSM is pressured to open the facility to prove that the United States’ efforts to advance chip manufacturing will not be wasted aside from recouping TSMs spending on labor, permits, regulatory compliance, and inflation, which is four times more than what they spent in Taiwan.

And there are other challenges as well. The chipmaker has embarked on cross-cultural training to develop their employees who will be moving to Arizona because they’re used to their local culture and work practices in Taiwan.

The company also admitted that they charge their customers higher prices for chips made in facilities outside Taiwan since the chipmaker will have to shoulder higher operational costs due to different regulatory environments, labor markets, and infrastructural needs. For instance, the U.S. expansion has been marked by higher power costs and a shortage of skilled labor, so the company has to hire Taiwanese engineers. Climate change is also blamed for adjusted prices in the future, since the chip-making process is highly water-intensive, as water is used to cool machinery and ensure wafer sheets are free from dust and debris. For the 16-nanometer process nodes, water consumption per unit is estimated to be over 35% since 2015 compared to other products.

Another potential risk is underestimating China’s capacity to accelerate their semiconductor capabilities faster than anticipated, or if the geopolitical tensions turn more favorably for their manufacturing sector, this could affect TSM’s market share and pricing power. If I am wrong, and the tensions with China are underpriced, the increase in TSM’s efforts for global production could help offset these risks. On top of this, TSM is expediting their A16 chips, which I believe is an effort to beat out competitors like Intel in order to capture a huge share of the market first.

With this, TSM’s advanced technology and manufacturing efficiency continue to give them a competitive edge. Intel, while currently lagging behind TSM in semiconductor manufacturing capabilities, is investing to revitalize their market position through developing 18A process technology.

However, I think that the demand surge in the semiconductor industry, from sectors like AI and data centers, means that there is enough market capacity to accommodate growth from multiple industry players (I am bullish as well on Intel)​​​​.

Bottom Line

The tensions with China remain a huge concern to TSM’s operations and the global semiconductor supply chain. However, I think TSM’s “Taiwan plus one” strategy and the setup of new facilities in geopolitically stable regions like the United States demonstrate a strong approach to managing the risks involved. The Biden administration’s $11.6 billion in grants for TSM’s Arizona plants are critical to this.

The chipmaker’s expansion outside Taiwan, however, has to resolve challenges such as labor shortages, cultural adjustments for Taiwanese migrant workers, and the need to replicate their Taiwanese supplier ecosystem. These factors lead to delays and increased operational costs. This also includes their adjustment to climate change impacts and the resultant price adjustments.

On the whole, I consider TSM’s initiatives, market leadership, and the ongoing global demand for their semiconductors as factors to support a strong buy opportunity.

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Analyst’s Disclosure: I/we have a beneficial long position in the shares of AMD 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.

Noah Cox (account author) is the managing partner of Noah’s Arc Capital Management. His views in this article are not necessarily reflective of the firms. Nothing contained in this note is intended as investment advice. It is solely for informational purposes. Invest at your own risk.

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