Should you follow Warren Buffett into semiconductors?

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  • TSMC valuation dropped to just 13 times forward earnings
  • It’s now one of Berkshire Hathaway’s top 10 holdings

Berkshire Hathaway (US:BRK) invested $4.1bn (£3.4bn) in TSMC (TW:2330) in the third quarter of this year suggesting that value may be starting to emerge in the global semiconductor industry after the recent sell-off. The high-profile chip shortage during the pandemic constrained supply in 2020 and 2021, but this year declining demand for consumer electronics and a consistent year of production from semiconductor foundries in Asia has started to change the picture. 

Berkshire Hathaway founder Warren Buffett famously doesn’t invest in businesses that he doesn’t understand. This has left him behind the curve of lots of technology trends. In 2017 he admitted regret at not buying into Google after failing to acknowledge the strength of its advertising business.

However, technology businesses now make up three of Berkshire’s 10 largest holdings. As of its third-quarter SEC filing, Apple (US:APPL) was by far the largest holding with a $123bn stake. It was followed by Bank of America (US:BAC), Chevron (US:CVX) and Coca-Cola (US:KO). Games developer Activision Blizzard (US:ATVI) ($4.47bn) and TSMC rounded off the top 10 holdings. But there are also smaller stakes in cloud computing companies Amazon (US:AMZN) and Snowflake (US:SNOW).

In the context of these other technology holdings, acquiring TSMC represents a doubling down. TSMC manufactures semiconductors that go into Apple products as well Amazon Azure’s cloud computing servers. If Apple and Amazon Azure increase sales, demand for TSMC’s semiconductors will rise.

TSMC’s wide moat 

TSMC is by far the world’s largest chip manufacturer with 53.4 per cent of the pure play foundry market, according to Statista. This is followed by Samsung (KR:005930) with 16.3 per cent and UMC (US:UMC) with 6.9 per cent. “When we first invested in this company there were over 10 players in the industry. But now, at the leading edge of technology, TSMC is virtually alone in its expertise. Samsung is the only comparable foundry at scale,” said Andrew Keiller, Baillie Gifford emerging market equity specialist.

Pure play foundry means these companies don’t design semiconductors themselves but instead make chips designed by other businesses. Qualcomm (US:QCOM) designs chips for the Apple iPhone and Nvidia (US:NVDA) makes them for the Amazon Azure cloud servers. Both are customers of TSMC.

The chip manufacturing industry has become so concentrated around a few companies because it requires a lot of capital investment and benefits from moving along the learning curve. These economies of scale are referred to as Wright’s Law, which suggests that for every cumulative doubling of units produced, costs will fall by a constant percentage. In short, the more chips TSMC make, the better it gets at it.

TSMC’s operating margin will have grown from 34.9 per cent in 2019 to 48.9 per cent in 2022, per the consensus analyst forecast. In the same period, its revenue is likely to have more than doubled from $34.6bn to $71.6bn. This rising profitability boosted return on equity which jumped from 20.9 per cent to an estimated 34.6 per cent for 2022.

This system works well for Qualcomm and Nvidia because they don’t need to invest in costly capital. It also means there are significant moats around TSMC’s business, a quality strongly valued by Buffett. At Coca-Cola, the moat is a worldwide brand built over a century. TSMC’s moat is decades of cumulative knowledge and capital investment, plus relationships with all the world’s leading chip designers.

Berkshire Hathaway Holdings Q3 2022
Company Amount invested ($bn)
APPLE INC 123.7
BANK AMER CORP 30.5
CHEVRON CORP NEW 23.8
COCA COLA CO 22.4
AMERICAN EXPRESS CO 20.5
OCCIDENTAL PETE CORP 11.9
KRAFT HEINZ CO 10.9
MOODYS CORP 6.0
ACTIVISION BLIZZARD INC 4.5
TAIWAN SEMICONDUCTOR MFG LTD 4.1

A value play

The other aspect of TSMC that will appeal to Berkshire Hathaway is that, although it is a technology business it is not valued like one. The company currently trades on a forward price earnings ratio of just 13.4. In the last 12 months, its share price has fallen over 22 per cent. “It trades on a remarkably low valuation for a business of this quality when compared with global leaders elsewhere in the semiconductor supply chain,” said Keiller. While its share price has come down, analysts have boosted earnings forecasts this year – 2023 EPS consensus is up a quarter year to date. 

The low valuation is in part due to the threat of an upcoming global recession. TSMC may have grown consistently over the past decade, but this was despite the fact it operates in a “notoriously cyclical industry”, according to Keiller. We are already seeing this cyclicality have an effect as last year’s shortage of chips is quickly switching to an oversupply.  In its recent fourth-quarter results, Qualcomm updated its guidance for 3G/4G/5G handset volumes and now expects “year-over-year low-double digit percentage decline”.

On a recent analyst call, TSMC chief executive CC Wei said there would be an overall decline in the industry next year. However, TSMC’s dominant position in the supply chain should help buffer it. “[Our] longer-term strategic relationship with customers will enable our business to be more resilient than the overall semiconductor industry,” he insisted. 

On top of the worsening macroeconomic conditions, TSMC is caught in a geopolitical tug of war between China and the USA. TSMC has 17 semiconductor fabrication plants: two are in China, one is in the US and the rest are in Taiwan. This brings complications.

Former Speaker of the US House of Representatives Nancy Pelosi’s trip to Taiwan on 2 August increased tensions between the US and China. The US stoked this further with the passing of its Chips and Science Act on 9 August. This Act provides subsidies to companies manufacturing chips in the US, but it also restricts US businesses from selling high end chips to the Chinese that could be used for military or AI capabilities.

TSMC could be forced to halt production on advanced AI or supercomputer chips designed by Chinese companies. Last year, 10 per cent of TSMC’s revenue came from China, while 65 per cent came from North America and 6 per cent from Europe. To comply with the US-imposed sanctions, Chinese chip designers Alibaba and Biren Technology, as well Nvidia in the US, are already designing chips with lower processing power. All these companies use TSMC to manufacture their chips. 

“The impact [of regulations] to TSMC is limited and manageable,” said CC Wei on a recent analyst call. However, he admitted “for the longer term, it’s too early to really assess all the true impact or influence”.

The upside of the US Chips Act is that there is nearly $40bn marked for chip manufacturing incentives. TSMC is currently constructing a $12bn plant in Arizona that will come online in 2023. The plant was originally slated to produce less advanced chips than those made in Taiwan, but this week reports emerged of a shift to production of the top-spec ‘3nm’ semiconductors. In any case, it will make TSMC less exposed to supply chain disruptions and entitle it to a portion of the US subsidies.

Despite the complexities of geopolitics and the physics of micro processing, Berkshire Hathaway is confident enough to plunge $4.1bn into TSMC. Buffett does have previous history in the semiconductor world. In both 2011 and 2012, Berkshire Hathaway bought large stakes in US business Intel (US:INTC) before selling again later that year. Intel used to be a leading semiconductor manufacturer before falling behind TSMC due to lack of capital investment.

Buffett is not an expert in geopolitics, but he can read an income statement, and currently TSMC looks undervalued. There are few companies available at this price with an operating margin of 50 per cent and return on equity above 30 per cent. In that regard it looks like a classic Buffett investment. Even if he can’t tell the difference between a 3nm or 7nm chip. 

 

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