TSMC – What does Warren see?
Dec 2022 (Tw$470/$80)
In our recent research report on Amazon, we observed the following.
In sharing its efficiency with customers by reducing prices AWS has brought the Scale Economy Shared business model that has proven so powerful with consumers into the world of corporate buying. With perhaps TSMC as the only exception we cannot think of another company globally that is doing this. The implications of this could be very significant. Source: Holland Macro Views/Amazon – Raining Gold + Unpeeling Amazon, Sept 22
Like other investors we had noted TSMC’s semiconductor manufacturing supremacy. As the above quote observes we further spotted them doing an unusual thing amongst B2B suppliers and sharing some of their scale efficiencies with customers. We also knew a couple of investment managers we respected owned the shares. Up until now this was the extent of our TSMC knowledge. Berkshire’s recent purchase of $4bn worth of stock piqued our interest however. We have learnt a great deal from reverse engineering many of Berkshire’s past purchases. As such we thought we would take a look to try to answer the question as to what Warren/his team saw in TSMC? What follows is less of a research piece and more of a call to action/reference piece. Summarising such a company’s operations is not our game. Seeing how its operating, business and financial model fits against our investing approach is.
Semi-complexity or value in plain sight
In the last 10 days we have looked closer at TSMC including reading its annual report – all 200+ pages of it. Our annotated copy of it can be provided on request. We highly recommend looking at it. Also available is an annotated copy of the analyst conference call that accompanied those 2021-year end results. We think both are revealing as to the attraction of this company. We have read no stock market research on it at all, but have listened to quite a few podcasts that recount the story of the company’s history and its founder. Please look at these annotated documents. We also recommend a few books later on.
Summarising TSMC skills, market position/power and technological leadership in a note like this would be trite. There are thousands of people worldwide that can assess such technologies better than us. What we seek is proven business models with the outputs and inputs that suggest with high a high level of certainty that their current industry dominance will remain. We stopped being sector analysts many years ago. Instead, we have tried hard to be mental and business model finders. If we can ever have an edge in company like TSMC (or Meta/Apple/Amazon etc.) it will not be through sector specific knowledge or granular detail. Instead, it will be from spotting a familiar mental model that we have seen powerfully used in another sector or geography before.
Readers need to assure themselves of TSMC’s franchise strength and of its current and future position. The more we have read the more this outcome seems almost an inevitability, but we’re not semiconductor/FAB experts. Warren’s actions however made us wonder if maybe there was something for us in TSMC hidden in plain sight. We conclude from this work, we think there is. We find ourselves excited.
What we think Warren sees
What follows is the framework we found ourselves using as we read more about this company.
Process Power
Earlier in the year we recommended Hamilton Helmer’s book, 7 Powers. It highlighted the different business models that readers would know as giving some form of moat. Easily recognisable ones are Brands, Switching Costs and of course Scale Economics. One that gets less attention is: Process Power. We and the book can easily identify Toyota as a past success story using process power. Indeed, Toyota process system (TPS) is now a widely copied manufacturing efficiency process used by many successful organisations. The only company we have cited in this area in our research thus far has been Amazon (#ref the Amazonian approach).
However, if you have this mental model in your head when reading TSMC’s accounts it is impossible not to conclude that they possess process power in very powerful industry dominating scale. Years ago, we heard Munger talk about manufacturing at scale and the small incremental advantages that huge production volumes bring to such an operator over time (e.g. Ford early last century). This is the perfect model of what TSMC is, albeit with a little complexity! We conclude that numerous levers come together inside TSMC to re-enforce what have become now huge advantages. This includes patents, sunk assets and control of its suppliers. Also, a high level of customer trust and massive ‘share of mind’ in this sector. It controls the assets and IP required to produce cutting edge chips at scale. It also has an irreplaceable workforce and deep enough pockets to make the required massive investments that drive future scale efficiencies. Lollapalooza comes to mind.
Our limited discussion in this area should not undermine its crucial importance. Deciding or not that TSMC has, and will retain, franchise strength due to its excellence of Process Power is the most important conclusion readers/we need to make. The more we read on this company and the role it plays in its industry the clearer we see this conclusion. Others will need to make their own decisions as to their conviction on this point post their own research.
Culture and ethos
What you can’t measure often matters more – Munger
This is another area of intangible assessment that potential investors must also make. We think the TSMC Report and Accounts and a study of this company’s history give a wonderful insight into this important area. We would encourage readers to start by looking at the company’s Core Values and Business Philosophy https://www.tsmc.com/english/aboutTSMC/values
Extracts below give an essence of what you will find:
“Innovation is the wellspring of TSMC’s growth”
“At TSMC customers come first, their success is our success”
“Since the company was founded, we have treated our customers as partners and we have never competed against them”
Source: TSMC website Values and Philosophy
RONTA, ROE and reinvestment
For years now we have outlined our thinking on the above headings. Return on Net tangible Assets (Taxed EBIT/ PPE +/-WK) is our favourite measure of assessing a company*. Why? For four reasons:
- Firstly, it is the purist measure of what cash is being produced for each dollar of required physical capital in the business today
- Over years of study, it is the measure we know Buffett uses in assessing companies. We believe he does so because of point 1.
- Companies that make high returns on this measure for long periods must be doing something right, that others cannot copy
- Understanding this level of return also helps us to understand the true cost of future growth
In some companies the ROE calculation may be different to the RONTA calculation, but in more than a few, ROE acts as a good proxy for RONTA. TSMC’s historic ROEs are shown below. It’s RONTA as we calculate it was 24% for 2021 by comparison. As we highlight in the notated Annual report, TSMC’s high ROE’s are nearly all derived from strong ROA/RONTA. This is a company with no leverage (it is net cash) and has pretty much zero intangible assets. This high rate of sustained RONTA/ROE is a sign of a wonderful business. It is also evidence of the success of this business in the customers eyes. This company is in a super competitive, fast moving volume production field yet makes a gross margin of 53% and a net margin of 37%. Customers are clearly delighted with what TSMC provide to them, its profits are thus not a sign of any sort of customer gouging or branding. Instead, they are purely down to the scale efficiency its processes deliver to it.
Fig.1: Return on Equity
Source: Bloomberg
*NB: We do make other adjustments when necessary, such as maint. capex vs depreciation
Just a little theory
Read any good investment letter from a high-quality portfolio manager and they will use a phrase like. “We look to find companies that make high returns on capital, who can then allocate more future sums at that high ROIC rate.” We agree with that statement 100%. However, the reality of many businesses that make high returns (say Moodys or Visa) is that they have a limited ability to deploy more capital at these same rates. Hence good allocators running these businesses buy back their shares. The companies that can deploy more capital (our ‘Put up more to make more’ companies as we call them) often make returns that are a step lower than TSMC’s. Additionally, they may rely on some leverage to make their c.20-25% ROE, or experience some volatility in returns. (Examples might include Ashtead, Jet2 and Ryanair). We favour such companies not because they are better than Moodys or Visa. Instead, it is because they can sometimes offer us both future compounding and value at the point of purchase. This being due to uncertain outlooks or a lack of clear investor understanding as to how valuable future capital redeployment might be. By now readers will be bored of our Venn diagram, so instead we will let Buffett aptly express our approach:
“The best thing that happens to us is when a great company gets into temporary trouble – we want to buy them when they are on the operating table.” Warren Buffett
The reality is that the Visa/Moody’s of the world are rarely on the operating table.
Enter TSMC
Against these yardsticks of high returns and the potential to re-invest TSMC looks compelling. We hope the following quotes will be almost self-explanatory:
“We believe TSMC is entering a period of higher structural growth.”
“Looking ahead, as the world’s largest, reliable and effective capacity provider with our technology leadership, manufacturing excellence and customer trust, we are well positioned to capture the group from the favourable industry megatrend with our differentiated technologies. We expect our long-term revenue to be between 15% to 20% CAGR over the next several years in U.S dollar terms.
“We will also work diligently in our own fab operation and with our suppliers to deliver on cost improvement. By taking such actions, we believe a long-term gross margin of 53% and higher is achievable, and we can earn a sustainable and proper return of greater than 25% ROE through the cycle. Thus, even as we shoulder a greater burden of CapEx investment for the industry, we can continue to invest to support our customers’ growth and deliver long-term profitable growth for our shareholders.”
“Every year, our CapEx is spent in anticipation of the growth that will follow in the future years. We are witnessing a structural increase in underlying semiconductor demand underpinned by the industry megatrends of 5G-related and HPC applications.
“At the same time, we are committed to achieve a sustainable and proper return that enables us to invest to support our customers’ growth and deliver long-term profitable growth for our shareholders.”
Sources: TSMC annual report or Year-end Analyst call 2021
Price is what you pay – Value is what you get
The three legs of any great investment are high returns, good growth and a low starting valuation.
Exactly what has driven the valuation of TSMC lower in during 2022 any investor can never be sure of (see Fig.4). Of course, China/US relations have become more strained and unpredictable, particularly in reference to Taiwan. Equally the company is now set on a course of significantly increasing investment as the above quotes clearly show. This suggests short term investor sugar rushes of higher dividends may slow for a while (see pay-out ratio in Fig.3). With a clear history of excellent returns on capital being achieved we welcome this coming growth opportunity, but do all investors? Also do some investors see such expansions as risky offering chances of failure or low returns?
Allocate
We include a couple of charts below just to show the differing periods of growth TSMC has experienced in its past. This clearly shows that in its history there have been periods of time where revenues have grown at a very fast rate and periods when they were growing more slowly. With steady margins and capital intensity (turn/assets) both profit and asset growth has mirrored this growth seen in revenues.
What is also notable is the how the groups dividend pay-out ratio has inversely corelated with such growth. This is great to see. A company with high returns on tangible capital/ROE’s has two choices for future capital deployment. It can allocate annual profits to further reinvestment if it thinks it will make a good return on such capital. Absent such opportunities it can distribute excess capital to shareholders. The charts below and our wider study of the company suggests TSMC has been highly astute and nimble is this decision making in the past. This is highly unusual is such high growth industries. Often growth is far more linear. TSMC past investment can thus been seen as both selective and also broadly successful it its timing of deployment. The crucial test is that even as more and more capital is committed by the group over time returns on total capital are maintained at high levels. This is highly unusual (see Fig.1).
The quotes in the earlier section we hope outline what we have read with regard to how TSMC is only planning strong asset growth because it sees high demand from its customers in the coming years. That it spells out such growth but also makes clear this will still come will at high (i.e. current) margins and high (i.e. current) returns on equity is insightful and impressive. Very few companies ever do this. They will lay out a growth plan, but the likely returns from which are found out after the event!
Fig.2: TSMC revenue – Strong, but NOT LINEAR growth
Source: Bloomberg
Fig.3: Dividend payout ratio mirrors slower growth periods = TICK
Source: Bloomberg
Price is what you pay, Value….
Fig.4: TSMC EV/ EBIT ratio
Source: Bloomberg
A week or two studying TSMC’s business models’ inputs and the outputs it has produced, suggests past higher valuation multiples given by Mr Market were largely justified. This being due to the huge moat this business has and the rare combination of growth with sustained high returns it can produce consistently. Today’s lower valuation occurring just as strong re-investment opportunities are actively being developed by the company thus looks compelling to us. (Maybe to Warren too..?) The starting ROE (c.30%) gives credence to the companies 15 -20% growth outlook. Indeed, a look at the company’s recent growth in assets seems to suggest a growth rate closer to 20% is more likely than 15%. As such some very compelling compounding may lie in front of investors today. The company having been an astute deployer of capital for organic growth at high rates AND a disciplined payer of dividends when such opportunities were scarcer is a powerful combination. It gives us an outcome we best describe as “Heads we win loads & tails we still win quite a lot”. Some scenarios:
- At a 20% growth rate (sales + assets), investors expecting no change in share rating can reasonably expect Intrinsic Value Per Share (IVPS) to grow 22% (the extra 2% derived off of a 33% pay-out ratio and a current PE of 13x)
- At a 15% growth rate they can expect IVPS growth of 18-19% (50% pay-out ratio on PE 13x)
- Were post this period of strong growth revenues then slow to say an 8% pa rate of growth (implying a 75% pay-out ratio) IVPS would still grow by 13% pa
To some these might seem projections that can be met or missed. In fact, they are little more than mathematical extrapolations. Any assessment as to both the strength of TSMCs franchise and the competitive/political risks that may surround the company must not just be looked at in isolation, but against these probable outcomes.
Were any investor per-chance to decide todays 13x Multiple of both EV/EBIT and PE were too low, well then, they can add the chosen scale of the re-rating they expect to any returns assumed above!
The cost of growth
Whilst growth is regularly discussed and modelled, the true cost of growth is often not thought about hard enough. Whilst clearly for TSMC there is a high capital cost of growth which is understood. Are there others?
Yes. The company’s commentary of R+D makes it clear that the vast majority of today’s expensed spend is focused on specific future growth initiatives. R+D we note is c.8% of sales and therefore c.20% of EBIT. We make no suggestion that R+D levels should ever be cut thus revealing higher profitability. Instead, we assert that investors need to consider their degree of certainty that future profitable growth will be delivered upon due in part to today’s P+L expensed investment. When assessing the above three growth scenarios above did you take into account the scale of R+D expense already made on these growth initiates? The scale of the group and its leadership position means its R+D dollar absolute spend of course dwarfs any would be competitor. It is also growing very fast. In 2012 TSMC R+D expense was $1.3bn, by 2017 it had doubled to $2.6bn. It has now doubled again to $5.2bn. All these figures were c.8% Turnover
What about other costs of growth? A glance at TSMC’s high gross and EBIT margins suggests they must be maximising price. We think not. There is much focus on cost efficiencies and sharing those with customers. Customers in turn seem delighted with the service vs price offering that TSMC provides. There is zero claim of gouging. Yes, the company makes good margins and returns, but it only does so at points of massive scale. This is process power advantages. All of this implies TSMC is a serial scale economy re-investor in lower price/innovation. Again we make no claim that the company should ever change that strategy to produce higher margins in the future. Instead, we see this constant investment in customer pricing and relationships as a reason why future growth at good/great returns on capital has a higher probability of being achieved.
Were we to contrast TSMC with A.N other large manufacturer that did not invest similarly in R+D, customer relationships or pricing, surely we would conclude it to be less certain of its future dominance, even were its market share today strong. To think such a way is logical. As such we must also think logically in reverse. TSMC is making many investments for profitable growth that combine to imply a far greater probability of it occurring than Mr Market might realise.
Not all aspects of TSMC strengths we have discussed. We hope investors will find more of them in the R+A and other links we provide. One that talks to its process power and moat is that a high proportion of its COGS are either from the depreciation of assets (likely elevated as todays spend is for tomorrow’s production) or labour. Access to these hard and soft assets are crucial to TSMC’s continued dominance in this field. Reading about the scale of its highly specialised workforce and the supply contracts it has with the likes of ASML shed more light onto the size of its moat.
Just a word on politics
Clearly there is much that can be written on the political risks that exist for Taiwan and its incumbent companies. Most of it is idle and pointless speculation. We will observe only the following:
The China/US/Taiwan issue has existed for many decades. That a sort of war of words has recently occurred does not mean conflict is inevitable. Cleary risk is priced most highly when the noise is the greatest (ref hurricane insurance costs post storms).
A table on page 141 of the Annual Report shows TSMC’s importance to the US economy. 64% of its chips are sold to US end company users. This fact, the 2021 semi shortage (and the damaging effect it had on supply lines) and now significant political intervention in this sector leads to a simple conclusion. Microchips and their supply are today a crucial and critical infrastructure provider to the US and whole global economy Whilst this suggests risk/implies it could be leveraged if controlled, its pivotal importance might also result in politicians of any persuasion stepping back when the true knock-on economic consequences are explained to them of any hostile action…?
Despite trade wars and tariffs in recent years, global commerce is still hugely inter-linked, particularly so in the technology sector. We look for win-win outcomes in companies we like to own. By contrast aggressively interfering with TSMC and/or Taiwan looks like a lose-lose outcome for both China and the US. We suggest/hope that TSMC’s pivotal importance might make all think twice about their political actions.
On supplier politics we note the US is putting pressure on the main Dutch and Japanese companies that supply TSMC to stop supplying machines to China. Whilst we need to be careful that such actions don’t have a knock-on trade war type consequences it is notable that these actions make life far far harder for any TSMC would be competitor based in China to establish any sort of foothold. That TSMC tries so hard to retain its China/US neutrality is notable. That it benefits from any US/ASML export ban without being in any way connected to them is interesting. This we note is an industry where getting behind for a year or too almost risks extinction. Even were US advanced microchip sanctions to one day be reversed the damage to any possible TSMC competitor would already be done.
Chip Wars by Chris Miller gives great insight into this area. We thank client X for recommending it to us. The author has also discussed the book and the topics it covers in a few podcasts
Turning pages
When I started looking at TSMC a few weeks ago I was reminded that a Far East investment manager I respected a great deal owned the shares. I listened to Richard Lawrence present at a conference a few years ago and thought his thinking exceptional. When I heard he had a book out I made sure to order it. It arrived in the summer and I made a start. For whatever reason I put it down a third of the way though intending to return. Knowing he has been a long time TSMC fan I thought I should pick it up again. I did last week and found my reward in the last chapter. Not only did he lay out his view on TSMC. He also shows a letter he wrote to Buffett in 2007 outlining why he thought Buffett should invest in TSMC! If Warren has heeded this 15y year old advice we do hope he has written back. Sometimes as Warren says you just have to keep turning the pages and see what you find. The Model by Richard Lawrence is an excellent book which we highly recommend.
In short
It is not our intention to reduce one of the world’s most technologically advanced companies into a Ladybird guide. Accepting the complexity of what TSMC does is part and parcel of seeing just how strong their market position is. The two are inter-linked. That said whatever a company’s product or service complexity its financial model outputs are the same the world over: cashflow. Understanding how future cash will flow, be re-invested and with what confidence is the great skill Buffett has used across geographies, sectors and owned businesses or investments. That is all our job is too. We conclude from our work on TSMC so far that its future cashflows will be far stronger for far longer than Mr Market is today assessing. We gave estimates of potential intrinsic value growth rates earlier. If any of these are accompanied by a thawing of US/China/Taiwan relations Mr Market might change his view of this remarkable company by quite a jump.
Kind regards
Andrew Hollingworth
Disclaimer
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