In many respects Taiwan Semiconductor, also known as TSMC, (NYSE:TSM) acts as a proxy investment for the semiconductor industry at large. Boasting a who's who client list and the most capacity in the business, Taiwan Semiconductor rises and falls with the fortunes of the sector, but manages to do reasonably well even in the worst of times. While Taiwan Semiconductor is a well-run company, the valuation on the stock today suggests that investors willing to take on additional risk could do better with individual chip stocks.
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Will There be a Second Half Rebound in Expectations?
Like the semiconductor sector as a whole, investors went into 2012 with fairly strong expectations for a rebound in chip demand and revenue. So far, though, those expectations seem like they may have been a bit hasty. Once again, both Texas Instruments (NYSE:TXN) and Altera (Nasdaq:ALTR) revised guidance lower for the first quarter of 2012 and TSMC has also modestly trimmed its expectations for logic chip sales growth in 2012.
Bulls will argue that a lot of these revisions stem from the last vestiges of the Thai flooding disruptions and slower carrier spending to close out 2011. Moreover, demand in markets like automobiles and industrial has been picking up as expected. That's all well and good and it may be true, but investors should be cautious about paying premiums to invest in "don't worry, it'll get better" stories.
The Challenge of Right-Sizing Capacity
Taiwan Semiconductor is always a fixture on the top spender lists for companies like Applied Materials (Nasdaq:AMAT) and ASML (Nasdaq:ASML) and it's no wonder, given how much of the chip industry relies on TSMC for its production. So what should the industry make of the company's plans to grow capacity by about 10% in 2012, towards the bottom of the prior growth range?
On one hand, Taiwan Semiconductor has posted excellent long-term free cash flow margins, despite such high ongoing capex needs, because it understands it markets and fine tunes its needs. On the other hand, there is a risk that under-investing in 28nm capacity will drive customers to rivals and shore up competitors like UMC (NYSE:UMC). Consider the case of GlobalFoundries - did AMD (NYSE:AMD) recently shed its stake in this foundry because of its 28nm yield issues and the need for a second source?
A Future a Lot Like the Past
There has been a fair bit of talk lately about the challenges and costs that will go with ongoing migration to smaller dies and more complex chips. Certainly this is true to a point; companies like Nvidia (Nasdaq:NVDA), Qualcomm (Nasdaq:QCOM) and Broadcom (Nasdaq:BRCM) are all staking a lot of their system-on-a-chip products and these are indeed more complicated to manufacture, but this is a familiar refrain. TSMC has always been challenged by the migration to the next generation of chip manufacturing, and they've always managed to find a way. After all, facilitating these migrations is a lot of what supports the growth theses at the equipment manufacturers.
While there is some risk that rivals like Samsung or Intel (Nasdaq:INTC) could get a leg up, those advantages are likely to be fairly temporary; while Intel is not a rival in the foundry space, it is a rival in respect to TSMC's capabilities and the market shares of its customers.
The Bottom Line
TSMC was, is, and likely will remain, a fine option to play the broader trends in semiconductors. The problem with TSMC is that it's not especially cheap today. Companies like Broadcom and Qualcomm do offer more potential returns at current prices, though they also carry more individual execution risk.
It boils down to a risk-return trade-off, then. For pure capital appreciation potential, investors would likely do better with individual chip stories. For investors who do not feel that they can reliably separate winners from losers, or don't want the risk of being wrong, Taiwan Semiconductor is a fairly-valued play that will largely track the fortunes of the chip sector. (For related reading, see The Semiconductor Industry.)
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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.