I am a ginormous Chicago Bears fan, and the team is off to a rough start this season. Recently, the Bears traded two of its best defensive players. The Bears’ poor play devalued these players, and other teams saw an opportunity to capitalize. The other teams envisioned the players potential upside if they were put in a better situation. In the current equity landscape, tech is like the Bears, and the good players could be semiconductors.
Tech has performed poorly year to date. After a decade of inflated growth, harsh monetary policy and lackluster cash flows devalued many tech names.
I conduct screens on a regular basis for Warrior Stocks that have a smaller market cap, stable growth and margins, and solid balance sheets. Some tech equities that keep popping up reside in semiconductors. I never touched them because what the hell is a semiconductor.
I began to read semiconductor 10-Ks, industry overviews, and semiconductor definitions, and I became enamored with the importance of semiconductors. Meanwhile, there have been major political moves around the world that surround this sector. It has been very cool to learn about the new commodity that will shape the future economic and geopolitical landscape.
Building Blocks: What are semiconductors?
Semiconductors are the brains behind the phone in your hand, the respirator keeping someone alive, and the military drone conducting enemy reconnaissance. They are the building blocks of almost all modern electronic devices.
Semiconductors control the electric currents that give an electronic device its commands. For example, when you press the power button on your Xbox, you send a signal to a semiconductor to semi-conduct electric currents to the part of the Xbox that turns it on. In essence, semiconductors are necessary for any electronic device to do any of its intended functions.
Global Giants: How does the sausage get made?
The Design
There are only two softwares that semiconductor designers can use to make semiconductors: Cadence Design Systems (CDNS) and Synopsys (SNPS). Cadence and Synopsys are used to map billions of transistors onto a model of a new chip called a mask. Transistors are the elements in semiconductors that direct the flow of electric currents.
These are extremely complex and mathematically powerful programs, which is why there are only two global players. Imagine how long it would take to draw the Mona Lisa with billions of dots on a piece of paper the size of your thumb nail with a pen. These programs use a combination of matrix algebra, highly advanced calculus, and machine learning to reach the extreme level of precision necessary to design semiconductors.
The Production
Here is a quick two minute video that illustrates the production or you can skip to a quick summary below it.
Once a design is made, the mask (model of semiconductor) is printed onto a silicon wafer, which is a round piece of silicon that is about twelve inches in diameter. After the print, the silicon wafer is developed and etched with the intended semiconductor structure. Then, the semiconductors go through a testing process.
ASML Holding (ASML), a company based in the Netherlands, is the only company that can print masks onto silicon wafers through extreme ultraviolet lithography. Extreme ultraviolet lithography uses extreme ultraviolet light, lasers, and mirrors to print. Due to its novelty and effectiveness of ultraviolet lithography, ASML is an earned monopoly.
Lam Research Corporation (LRCX), Applied Materials, Inc. (AMAT), and Tokyo Electron (TOELY) are the only companies that can develop and etch semiconductors.
Terdayne, Inc. (TER), and Advantest Corporation, a private company, are the only semiconductor testers.
The Facility
The entire production process takes place at a single location called a foundry. Foundries are semiconductor factories, but they are unlike any other factory. Their foundations need to be as deep as bedrock to limit any unintended earthly vibrations. An etching that is a nanometer off could spell doom for a semiconductor. Foundries need to be void of dust to avoid contamination during production. Foundries are said to be ten times cleaner than an operating room.
As you might have already guessed, foundries have very few players. Notable foundries include the Taiwan Semiconductor Manufacturing Company (TSM), Samsung Electronics Co Ltd. (SSNLF), and Globalfoundries Inc. (GFS). Intel Corporation (INTC) is trying to emerge as a fourth player in the third party semiconductor manufacturing industry.
Another Story of Supply and Demand
During the COVID-19 pandemic, the United States was in a lockdown, and people could no longer go to the office. The demand for electronic devices at home such as docking stations, cameras, monitors, bluetooth mouses, and laptops grew, which all require semiconductors to function. People were buying more video games, consoles, and VR headsets. I’m sure you got just as annoyed as I did every time I heard somebody yell, “Alexa!” in the house and multiple Echos activated all at once.
Recently, the dozens of electric vehicle (EV) commercials during the Super Bowl displayed the shift towards EVs. Companies like Tesla, Ford, and Audi all require semiconductors for the production of their new EV lines.
Between the severely limited domestic semiconductor manufacturing locations and the pandemic, the United States supply could not match the sudden demand for the semiconductors.
Risks and Current Valuations
After the Russian invasion in late February, many people have drawn potential parallels to the relationship between China and Taiwan. After Nancy Pelosi’s visit to Taiwan, China has exuded more aggression. Any invasion of Taiwan, the central foundries hub, would be disastrous for semiconductor production.
Other headwinds include the shortage of noble gasses such as Neon and Argon that are pivotal to the production of chips, decreases in pandemic induced demand, and new regulations on semiconductor exports to China.
The United States viewed the chip shortage during the COVID-19 pandemic as a threat to the country’s national security. The Biden administration has made semiconductors a focus with the CHIPs and Science Act that subsidized $52 billion in domestic semiconductor manufacturing spending, backed Taiwan in a potential conflict with China, and imposed new regulations on companies that export chips to Chinese companies. Nvidia (NVDA) says that it could lose $400 million in revenue this quarter because of the new regulations.
Semiconductors are a new commodity. A commodity of great importance to national securities, healthcare, and everyday life. The industry has shaped legislation and created a global semiconductors arms race. Despite the necessity of semiconductors, the geopolitical risk and cyclical headwinds have caused extreme pessimism in the equity market.
Where There is Pessimism, There is Value
Most of the companies mentioned in the breakdown of the global semiconductor supply chain are in the above chart. Following the company name is the ticker, P/E, 52 Week High, Recent Price as of 10/30/22, 52 Week Low, the difference between the 52 Week High and Recent Price, the difference between the Recent Price and the 52 Week Low, and a ratio between the high difference and low difference.
Without looking at any financials, we already know that these companies are monopolies, duopolies, and very small oligopolies, the barriers of entry into the industry are absurdly high because of the immense capital spending and necessary expertise, and semiconductors are the lifeblood of all technological innovation and advancement. From the chart (which is a crude surface level analysis), we can see that every single company has positive net income, and every company (outside of GFS) is trading significantly lower than its 52 Week High.
This year the Nasdaq Composite is down 30% year to date because the combination of rising inflation and aggressive interest rate hikes devalued long duration tech securities. In other words, investors no longer have the ability to invest in growth without cash flows.
My argument is that semiconductor companies that produce stable cash flows, have long runways for growth, and provide extremely attractive investment opportunities exist. Especially, the companies listed in the chart above. In the event of geopolitical stability, I would bet most of these companies will thrive in the next five to ten years because of their importance to progress and the world economy.
Taiwan Semiconductor Manufacturing Co. (TSM)
Key Financials in USD (as of 10/30/2022)
- Market Cap: $318 B
- Enterprise Value: $298 B
- EV/NTM EBITDA: 6x
- Forward P/E: 10x
- Current Stock Price: $61
The Taiwan Semiconductor Manufacturing Company by itself represents 50% of the foundries industry market share, which means half of the world’s semiconductors are produced by a single company. Today, Taiwan Semiconductors might be the most important company in the world.
Even so, it is currently trading at a forward P/E multiple of 10x as of October 30th, 2022 because of the risk and uncertainty surrounding semiconductors and Taiwan in particular.
Taiwan Semiconductors’ 52 Week High was $145.00 and it is now $61 (down 58%), and year to date the Company is down 52% compared to the S&P 500 down 19%.
This is a chart of Taiwan Semiconductors’ forward P/E over the last five years. As recently as January 21st, 2022, TSM was trading at 30x. The swing in investor confidence is immense, and the historically low multiples could be an opportunity to enter with mitigated tail end risk. The question is “How much worse can investor sentiment get?”
Let’s look at the fundamentals
From 2019 to 2021, the Company grew despite the troubles with the pandemic (3.70%, 25.20%, and 18.50% year over year). Gross margins were large and stable at 46.50%, 53.10%, and 51.60%. The amount of capital expenditures necessary to maintain operations is evidenced by the EBITDA margin of 61.30%, 66.60%, and 67.20%. TSM plans to spend $40 B on capital expenditures this year. Net income at 33.10%, 38.10%, and 37.80% is impressive. Return on Assets and Equity are high and healthy. The final three ratios imply a healthy balance sheet.
Taiwan Semiconductors is an incredibly successful, highly profitable, and financially safe company. It is the center of the tech solar system right now, yet it is cheaper than the S&P 500.
Uncertainties regarding Chinese aggression, continued supply chain stressors, shortage of semiconductor inputs, United States industry subsidization, and new export regulations warrant the pessimism. But there is value in pessimism.
Continue the Research
This was a high level introduction to the inner workings of the semiconductor industry. There is a lot more to learn about the actual nuts and bolts of the crucial elements that go into the manufacturing process. Despite the very consolidated supply chain company environment, the semiconductor designer industry is highly competitive and full of many different products and players. In the future, I am going to search for Warrior Stocks in this sea of semiconductor pessimism.
Part of me wonders if securities exist that are inputs for semiconductor production and can benefit from a boom in the industry, but would be safe in the event of a geopolitical catastrophe.
The markets today are dynamic and investor sentiment swings wildly week-to-week, which is why when you spot superfluous optimism or overbearing pessimism, there is an investment idea to be had.
If you have more questions or want to talk all things markets, semiconductors, or TSM, do not hesitate to reach out on twitter, instagram, or shoot me a text.
Employ your curiosity.
-Maximus Beach
Learn more about Maximus Beach’s background here.
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