RealMoney Silver - TSM Is a Stable Buoy in a Rocky Sea

TSM Is a Stable Buoy in a Rocky Sea
By Bill Trent
RealMoney.com Contributor
1/16/2008 1:08 PM EST

In a volatile market, investors tend to gravitate toward companies and investments that provide stability. As crazy as this may sound, I think that stability can be found in a semiconductor company -- namely, Taiwan Semiconductor (TSM) . I think the table below shows just how stable.

Taiwan Semi operates in an unsexy part of the semiconductor industry known as "foundries." It sounds as exciting as a blacksmith shop, and that isn't far from the truth. Foundries don't design any of the products they manufacture. Instead, they make the chips that other companies design. Their expertise isn't in technology so much as process and efficiency.

Because they don't design the chips themselves, Taiwan Semiconductor and other foundries such as United Microelectronics (UMC) typically get lower gross margins. The design profits fall to their customers. TSM's expertise in manufacturing and economies, however, are much needed by its customers, which are often too small to absorb the enormous costs of building a chip fabrication plant.

Such customers include many fabless semiconductor companies and systems companies, such as Altera (ALTR) , Broadcom (BRCM) , Marvell (MRVL) , Nvidia (NVDA) , Qualcomm (QCOM) and VIA Technology, as well as integrated device manufacturing companies including Advanced Micro Devices (AMD) , Analog Devices (ADI) , Freescale (FSL) , and Philips (PHG) .

Having many small customers has given the company a balanced sales base. By end market, 40%-45% of sales are communications-related, about 30% go to the computer market, 15%-20% go to consumer electronics and the rest serve the memory and industrial markets. In 2006, the largest customer represented 10% of company sales, and the top 10 amounted to just over half of sales. The lack of concentrated exposure to any customer or end market is one of the reasons TSM can generate stable cash flows.

The largest customer-related risk factor may be that three-quarters of sales are to customers in North America; a U.S. recession may hurt the company. However, the global end markets for technology suggest that the true end customer is more widely dispersed geographically.

As the following cash flow table shows, it seems fairly safe to say TSM will generate about $2.5 billion in cash flow. In some years -- 2006, for example -- the cash flow may be unusually high. But even the industry downturns in 2004 and 2007 did relatively little harm. Given that the current enterprise value for Taiwan Semi is about $42 billion, it is offering a free cash flow yield of just under 6%.

Taiwan Semiconductor Cash Flow Generation ($ in U.S. Billions)
	2004	2005	2006	2007E
Cash flow from operations	$4.79	$4.77	$6.29	$4.85
Capital expenditures	2.54	2.43	2.41	2.6
Free cash flow	2.25	2.34	3.88	2.25
Source: Taiwan Semiconductor, Yahoo! Finance, William A. Trent estimates

If I had $42 billion that I wanted to invest safely, I might want to choose between buying TSM outright or investing it all in five-year U.S. Treasuries. The Treasuries are currently yielding about 3%, so I would get $1.25 billion in interest each year from my investment. If I had the choice, I think I would go with the $2.5 billion in cash flow offered by Taiwan Semi.

It's true that as a small investor owning a portion of TSM, I would not be able to access all of the free cash flow. There is some risk to the comparison, since I am hoping the company invests any cash they hold onto wisely. But the company does pay two-thirds of the cash flow as a dividend. Unless things change, that is still a 4% yield taxed at 15% compared to a 3% yield taxed at my marginal income tax rate.

How Bad Can it Get?

As stable as it may appear, I also have to acknowledge that TSM's cash flow is not guaranteed. All the same, I think 2007 probably marked a fundamental bottom for the semiconductor industry -- or at any rate, that things won't get much worse.

Year-Over-Year Change in
Semiconductor Prices

Click chart for larger image.

Source: Bureau of Labor Statistics

Consider, for example, the pricing environment. The Bureau of Labor Statistics reported that semiconductor prices declined 16.9% in December compared to the year earlier. That number was a modest improvement over November's decline, which was the worst on record. Even the depths of the Internet bust were better times for semiconductor pricing. The fact that the pricing environment is so extraordinarily bad suggests to me that it probably won't get too much worse.

Furthermore, as I have written in other columns, I think the turnaround in semiconductor fundamentals is within sight. Pricing is a function of supply and demand, and since March of 2007, demand (semiconductor revenues as reported by the Semiconductor Industry Association) has been growing at a faster rate than supply (bookings for new semiconductor equipment as reported by Semiconductor Equipment and Materials International).

I believe the industry's recent restraint in adding new capacity will soon become evident in stronger pricing, even if there is an economic slowdown. What already looks like a solid and stable cash flow level could soon look even better.