Every Nanometer Counts

As we stand on the precipice of the fourth industrial revolution, it is impossible to overlook the pivotal role of semiconductor chips in every facet of our lives. From the omnipresent smartphones in our pockets to the colossal data centers that power our internet, at the heart of all these marvels lies a tiny, intricate chip.

Be it healthcare, finance, entertainment, transportation, or the cutting-edge areas of Artificial Intelligence (AI), machine learning, or quantum computing – every domain relies on the advancements brought forth by companies forging chips that serve as the neurons and synapses of the global economy’s digital brain, enabling machines to think, learn, and evolve at unprecedented scales.

Today, chip producers are what oil producers were in the 20th century. In addition to their vast economic importance, they serve as a strategic linchpin in the global supply chain, often holding the balance in geopolitical and trade standoffs. As countries vie for technological dominance, having unfettered access to cutting-edge chips has become as important as having a potent military or a robust economy.

Particularly noteworthy is the burgeoning realm of Artificial Intelligence (AI). Its rapid advancements, encompassing deep learning and neural networks, hinge critically on the power and efficiency of chips.

The pinnacle of the AI rally is Nvidia (NVDA), which designs and manufactures computer graphics processors tailored for artificial intelligence. The tech giant’s stock has risen more than 175% in the past 12 months alone; as a result of this surge, NVDA is now trading at a forbidding valuation of over 250 price-to-earnings. Investors who missed the opportunity to buy the stock at its lows are now afraid, and justifiably so, to enter at these high levels, as despite the company’s AI moat, the stock is overbought and might be prone to a correction.

But not all is lost for aspiring AI investors: those who missed a chance with NVDA can enter the race using its best proxy – which also happens to be the very basis of the chip world. If not for the company we are writing about in this letter, Nvidia couldn’t have been able to become the AI-chip champion; moreover, the whole AI revolution may have stalled.

But first, let us delve into a short update on the economy, markets, and Smart Investor calendar.

 

Economy and Markets: Looking Forward

There are several important reports scheduled to be published in the next few days:

  • Later today, we will receive August’s S&P Global Manufacturing and Services PMIs, which are used by policymakers and analysts as forward-looking indicators reflecting trends in the overall economy.
  • On Thursday, we will see published a report on July’s Durable Goods Orders, providing an important leading indicator of manufacturing activity, as well as an insight into the overall economy.
  • On Friday, we will see the reports on August’s Michigan Consumer Sentiment Index, which reveals the level of trust consumers have in the strength of the economy, and University of Michigan (UoM) 5-year Inflation Expectations. UoM’s survey shows consumers’ views of long-term inflation and is used as a component in the Fed’s calculations of its Index of Inflation Expectations.

As for the stock calendar, the Q2 2023 earnings season for Smart Investor Portfolio companies is drawing to a close, with no earnings reports scheduled until August 31, when Broadcom (AVGO) is expected to publish its quarterly results.

The ex-dividend dates for Applied Materials (AMAT) and CDW (CDW) are today and tomorrow, respectively.

 

Today, we are adding one of the world’s most economically important companies, which happens to be an AI-chip monopolist, and whose stock is now trading at a discount due to the short-term difficulties in its industry.

To make room for this valuable addition, we are letting go of a stock, which engages in an overall stable and profitable business, but has been stuck in a negative performance/sentiment loop for the best part of the last three years.

 

New Addition: Taiwan Semiconductor (TSM)

Taiwan Semiconductor Manufacturing Co., Ltd., also known as TCMC, is the global leader in contract chip manufacturing. TSMC is the source of cutting-edge chips for all the world’s leading tech companies, including Nvidia (NVDA), Apple (AAPL), AMD (AMD), Qualcomm (QCOM), Tesla (TSLA), and about 530 other names, making the IT industry – and the world economy at large – highly dependent on the company.

Notably, one of the world’s most indispensable companies has mostly eluded headlines, staying out of the spotlight. That is because Taiwan Semi works backstage, producing its chips to meet the specific needs of its client companies, which are at the forefront of end-customer sales. Despite its relative anonymity, at least compared to its corporate clients, TSMC is responsible for over a third of the global annual production of chips that power electronics.

Taiwan Semi commands a 59% share of the global chip foundry market, and the second runner-up, Samsung, holds a market share of just 13%. TSMC is not only the world’s largest contract chipmaker, but the most technologically advanced one. The company produces about 90% of all the world’s semiconductors used for AI and quantum computing applications. In this sphere, Taiwan Semi faces no competition, as at least for the foreseeable future, the barriers to entry to produce the most sophisticated chips at scale are impassable.

As the global economy becomes ever more digital, chips have become one of the most crucial enablers of its functioning. In 2022, global sales of chips accounted for more than $0.5 trillion. Semiconductors are irreplaceable in the functioning of data centers, computers, and mobile phones, and ubiquitous in most other economic industries, from electrical grids and missile systems to automobiles and home appliances.

The foundry market is the cornerstone of the global semiconductor supply chain. This chain is a world-spanning, complex inter-coordinated network of companies involved in all stages of chip manufacturing, from sourcing materials, through design and development, to end-user sales.

As we have seen during Covid-19 chip shortages, global supply chains are easily disrupted. That is why governments and companies in the U.S., Europe, Japan, and other countries, are investing heavily in research and development in the field, as well as in the promotion of local production of chips. The Biden administration’s $208 billion Chips and Science Act, enacted last year, is one of the efforts to secure supply chains as well as cement technological leadership over China, the West’s technological and economic rival.

As a leader in the chip foundry business, TSMC stands to benefit from these initiatives. Taiwan Semiconductor has announced plans to invest tens of billions of dollars in plant construction in the U.S., Japan, and Germany. These plans will not only lead to the welcome expansion of chip-building capacity but also alleviate the company investors’ fears about its production concentration in close proximity to China.

Taiwan Semiconductor was incorporated in 1987; it pioneered the model of dedicated semiconductor foundry production. Today, TSMC commands a market capitalization of $436 billion – making it the world’s 12th largest company – and has over 73,000 employees. It is headquartered in Taiwan, with offices, subsidiaries, and production facilities in the U.S., Japan, South Korea, Singapore, Europe, India, and China.

Taiwan Semi is a financially healthy company with a low debt-to-equity ratio of 29%; its debt is extremely well-covered by operating cash flow, while the cash and cash equivalents it holds are a multiple of its debt. As for capital efficiency and profitability metrics, the company also checks all the boxes. It takes pride in an outstanding Return on Equity (ROE) of 33.7% and Return on Assets (ROA) of 18%, leaving its industry far behind on these metrics. Its operating margin of 48% and net profit margin of 43.3% are superb, indicating outstanding operational efficiency. The company’s revenues have been growing at an average annual rate of 23% in the past three years, while EPS has increased by 28% annually. Despite the recent slowdown, we believe that the company will display even higher rates of growth in the medium to long term.

TSMC shares have been publicly traded on the Taiwan Stock Exchange (TWSE) since 1994 and on the New York Stock Exchange (NYSE) since 1997. The company’s stock, TSM, has risen by 125% in the past five years. Its more recent gains have been more modest, as it suffered a downturn together with the rest of the semiconductor industry in 2022. TSM has rebounded from its recent low in November, rising almost 80% to June 2023.

Since June, it has been under pressure as several factors weigh on the stock, with the most prominent of them being an accelerating weakness in the Chinese economy, expected to depress demand for mobile phones, laptops, and other electronics built with TSMC’s chips. The whole semiconductor industry is expected to be impacted by Chinese economic troubles this year and probably next year as well. For now, the world’s ten largest chip producers – TSMC, Intel (INTC), Micron Technology (MU), Samsung Electronics, Infineon Technologies (DE:IFX), and others – are reducing their investment in capacity expansion, in the first cut after four years of strong investment growth. Another reason for the slowdown in the chip industry this year is a supply glut that appeared on the back of the increased production following the post-pandemic shortage scare.

Despite the short-term difficulties, in the medium to long term, the semiconductor market will most definitely flourish. According to McKinsey’s research, the global chip market will reach over $1 trillion by 2030 (from $580 in 2022). All end-use applications, from the Internet of Things (IoT), through electric vehicles (EVs), to artificial intelligence, are expected to add to the surge in demand for semiconductors. However, the main driving force will be the acceleration in AI implementation; the demand for the most advanced chips, tailored for AI, is expected to triple from 2022 to 2025 and soar 13-fold by 2030.

Naturally, Taiwan Semiconductor will be the main benefactor of this demand as the main link in the AI-chip supply chain. Since Nvidia controls over 80% of the market for graphics processing units (GPUs) needed to run AI models, and since TSMC is Nvidia’s sole chip supplier, it will share the gains – if not the fame – brought by AI to its perpetrators.

That’s why we view the recent weakness in the company’s share performance as an opportunity to gain exposure to this AI-chip stalwart at a low price. The foundry giant’s stock is currently trading at a TTM P/E of 16.3 and a Forward P/E of 19.0, representing a significant discount to the IT sector, its peers in the chip industry, and its own historical valuations.

The belief in Taiwan Semi’s bright outlook is shared by TipRanks-scored top analysts, who foresee an upside of 46% for the stock in the next 12 months. TSMC carries a “Perfect 10Smart Score rating on TipRanks with a “Strong Buy” recommendation:

Hedge and mutual funds have recognized the appeal of this undervalued gem and have been loading up on the stock. Leading funds, such as Maverick Capital, Appaloosa Management, ARK Investment Management, and others, have added tens or even thousands of percent to their holdings of the stock.

An additional reason to buy into Taiwan Semi is that the company pays a generous quarterly dividend, with its current yield standing at 1.5%, well above the IT industry’s average. While in the past the payouts haven’t been stable (albeit never falling below 1.1%), the recently announced company shareholder compensation strategy states that TSMC intends “to maintain a sustainable quarterly cash dividend, and to distribute the cash dividend each year at a level not lower than the year before.”

To conclude, we believe that Taiwan Semiconductor will be an extremely valuable addition to the Smart Investor portfolio.

 

New Deletion: Euronet Worldwide (EEFT)

Euronet Worldwide, Inc. provides payment and transaction processing and distribution solutions to financial institutions, retailers, service providers, and individual consumers. It operates through three segments: Electronic Fund Transfer Processing, E-pay, and Money Transfer.

The Electronic Fund Transfer Processing segment provides electronic payment solutions, including ATM cash withdrawal and deposit services and point-of-sale (POS) management solutions, credit and debit card outsourcing, card issuing, and merchant acquiring services. The E-pay segment distributes and processes prepaid mobile airtime and other electronic payment products; and provides payment processing services for various prepaid products, cards, and services. The Money Transfer segment offers consumer-to-consumer and account-to-account money transfer, customers bill payment, check cashing, foreign currency exchange, mobile top-up, and cash management services.

Euronet Worldwide, Inc. was founded in 1994 and has been publicly traded on NASDAQ since 1997. It is a mid-cap company belonging to the Financial sector (Industry: Financial Services).

EEFT’s financials demonstrate robust health, apart from its high debt-to-equity ratio of 127%. Still, the company’s debt is well-covered by operating cash flow, while interest coverage is more than satisfactory. It also has a very solid cash position. However, Euronet’s efficiency and profitability ratios are not as strong, with a mediocre Return on Equity (ROE) and Return on Assets (ROA), standing at 13% and 4.8%, respectively. The company’s margins are also nothing to write home about, with a net profit margin of 7% and the operating margin of 11.5%.

On the front of revenue and earnings growth, EEFT hasn’t done as well as could have been expected from a successful FinTech company. Revenues grew at an average rate of 7% in the past three years, while the EPS growth rate for the same period was negative, although it must be said that the metric is skewed by the pandemic’s outsized hit on the industry. The last quarterly report delivered a beat on EPS, as it did in the four quarters prior to that. However, in the past 12 months the company has suffered from numerous earnings estimate downgrades, depressing sentiment towards the stock.

All in all, Euronet is not a star in its sphere, but it is a healthy and profitable company. Unfortunately, its stock has been stuck in a negative performance/sentiment loop for quite a while. It suffered during the pandemic along with the rest of its industry but has rebounded nicely from its low in April 2020, almost reaching its pre-pandemic high in March 2021. However, it has been on a very volatile path downward since that date, declining by almost 50%, and losing 13.5% in the past 12 months. Heavy insider selling and hedge fund holdings reduction, coupled with institutional investors’ cutbacks on exposure, added additional pressure to the negative sentiment towards the stock.

In conclusion, we may reevaluate EEFT in the future, but for now, we believe it is best to cut the losses and sell the stock.

 

Charter Members of the 30% Winners Club

*The 30% Winners Club includes stocks from the Smart Investor Portfolio that have risen at least 30% since their purchase dates.

Our prestigious club’s ranks have remained unchanged this week, still containing five stocks: GE, ORCL, TECK, AVGO, and ALV.

The closest runner-up is now CDW  with a gain of 28.3% since we included it in the Portfolio. Will it join the ranks next week, or will someone else outpace it to the finish line?

 

What’s Next?

Our next commentary will come out on Wednesday, August 30, before the market opens.

Until then – we wish you a world of investment success!

Access the full Smart Investor Archive, including all historical stock picks and original newsletters.

 


Disclaimer

The information contained in this article represents the views and opinions of the writer only, and not the views or opinions of TipRanks or its affiliates and should be considered for informational purposes only. TipRanks makes no warranties about the completeness, accuracy, or reliability of such information. Nothing in this article should be taken as a recommendation or solicitation to purchase or sell securities. Nothing in the article constitutes legal, professional, investment and/or financial advice and/or takes into account the specific needs and/or requirements of an individual, nor does any information in the article constitute a comprehensive or complete statement of the matters or subject discussed therein. TipRanks and its affiliates disclaim all liability or responsibility with respect to the content of the article, and any action taken upon the information in the article is at your own and sole risk. The link to this article does not constitute an endorsement or recommendation by TipRanks or its affiliates. Past performance is not indicative of future results, prices, or performance.