Taiwan is once again at the center of attention, as Beijing has signaled publicly and privately that the ‘reunification’ of the island with the mainland is only a matter of time. While no one knows for sure what’s going to happen with Taiwan in the foreseeable future, the rise of tensions in the Taiwan Strait along with the worsening of Sino-American relations will certainly put additional pressure on TSMC’s (NYSE:TSM) stock in the following years.
The good news though is that the rising demand for AI chips was able to mitigate the geopolitical risks so far. That’s why TSMC has been able to outperform the broader market since the publication of my latest article on the company back in May. While supply constraints are expected to remain for a while and help the company improve its performance next year, there are questions about whether it makes sense to cash out and realize the profits given the fact that geopolitical risks could start to outweigh growth opportunities in the long run.
All Eyes On AI
TSMC’s latest earnings report for Q3 showed that its revenues declined by 14.6% Y/Y to $17.28 billion, while 69% of revenues were generated in North America. Despite such a decline, there’s a chance that the upcoming earnings report for Q4 that’s expected to be released next month will be much better thanks to the fact that the demand for AI chips continues to increase. To this day, the backlog for Nvidia’s (NVDA) H100 GPUs continues to increase while the release of H200 and AMD’s (AMD) MI300X GPUs next year will make it possible for TSMC to greatly improve its performance given the current supply constraints.
What’s more is that Apple (AAPL) is currently under pressure to revive growth after several quarters of sales decreases and to improve its own performance it has already committed to ordering the production of 3nm chips from TSMC for next year. It is also currently testing TSMC’s 2nm chips, which are expected to enter the volume production stage in 2025 and give the Taiwanese-based foundry an additional edge against its foundry competitors.
In addition to all of that, it’s important to understand that the current geopolitical landscape presents not only risks but also opportunities for a company like TSMC. As capital is leaving China and governments across the globe are trying to secure their own supply chains, TSMC is expected to receive billions of dollars in government funding to build its fabs across the globe and minimize its own geopolitical risks as well.
Next year, TSMC is expected to start the construction of its first fab in Europe in the German city of Dresden where the government will cover half of the expenses to build the facility. The same is expected to happen in the United States, where TSMC is expected to receive funds under the CHIPS and Science Act to finish the construction of its fab in Arizona in 2025. What’s more, is that Japan is also ready to finance a significant portion of the plant that TSMC builds there to revive the Japanese chipmaking industry.
The construction of all of those new fabs will help TSMC expand its footprint at a reduced cost thanks to the additional funding and subsidies from the governments, and minimize its own geopolitical risks at the same time.
Major Risks To Consider
As expected, the potential invasion of Taiwan is the biggest risk to TSMC’s growth story. Even though the demand for chips is expected to increase in the following years, most of TSMC’s fabs along with those that produce the most advanced chips will remain in Taiwan. That’s why the risk premium for investing in TSMC will likely remain relatively high indefinitely.
However, the potential invasion is not the only risk at this stage. The ongoing Sino-American trade war could also have a direct impact on TSMC’s performance in the future. Currently, China is the second biggest market for TSMC after North America. In Q3, the revenues from China accounted for 12% of the overall revenues, an increase from 8% a year ago. While sales there are on the rise, the potential implementation of stricter chip export controls by the United States in the future could make it harder for TSMC to expand its presence and grow its revenues further on the mainland.
One of its major clients Nvidia is already prohibited from selling its advanced chips like A100 and H100 that TSMC produces in China. Even though Nvidia so far managed to offset the downside caused by those restrictions by offering a less advanced version of its flagship chips, there’s a risk that that’s not going to be the case in the future. In my latest article on Nvidia, I’ve noted that the company is likely going to continue to generate aggressive returns thanks to the high demand for its chips across the globe, but once the demand subsides, it could become much harder to offset the Chinese-related losses. This is likely going to have a direct impact on TSMC in the future, especially as China itself tries to become more self-reliant in the chipmaking industry.
What’s The Fair Value of TSMC?
Considering all of those developments, I’ve made a DCF model to figure out what is TSMC’s fair value in the current environment. Revenue in the model below is expected to decline Y/Y in FY23, but later grow in the following years at a double-digit rate mostly due to the rising demand for AI chips. Most of the other assumptions in the model are closely aligned with the company’s historical performance. The WACC in the model stands at 9%, while the terminal growth rate is 3%.
The model shows that TSMC’s fair value is $98.31 per share, which is slightly below the current market price of ~$104 per share.
The Bottom Line
While the rising demand for AI chips is certainly going to help TSMC improve its performance next year, the rising geopolitical risks could start to outweigh growth opportunities in the foreseeable future. That’s why now might be a good time to cash out and look for other opportunities, especially since it appears that TSMC is fairly valued at the current price.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.