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Taiwan Semi Is a Fabulous Fab

08/22/2007 12:00 am EST


John Buckingham

Editor, The Prudent Speculator

John Buckingham of the Prudent Speculator Tech/Value Report says Taiwan Semiconductor, the world’s largest chip foundry, has good growth prospects at an attractive price.

We’ve mentioned myriad times the chip foundry group. They are large-scale manufacturers of semiconductors serving the needs of “fables” chip companies, which purposefully lack manufacturing facilities.

Taiwan Semiconductor Manufacturing Company (NYSE: TSM) is the largest of the foundries, reporting $8.97 billion in revenue over the past four quarters, generated in 11 “fabs” located around the globe.

TSM generated 43% of revenue in 2006 from communications chips and 32% from computing applications. Consumer devices, memory, and other applications filled in the rest.

Compared to fabless chip companies, and even most chip manufacturers, TSM shares maintain a relatively low valuation. That’s in part because the foundries must focus on careful capacity utilization, production, expansion, and margin management in order to maintain sufficient profitability to fund growth. And the group has a history of building too much too fast as the industry cycles up, only to suffer when the inevitable downturn comes.

But the foundry group has been slow to add capacity over the past few years. TSM says it’s just emerging from an oversupply-induced downturn that cost it a 25% drop in net income in the latest quarter.

But most of that excess has been worked off, while expectations of demand for PCs and mobile phones could well rise as we head further into the third quarter. In fact, capacity could be tight as demand ramps back up, particularly for chips produced at smaller, more advanced feature lengths.

That’s good in a way, as moderated capacity growth weakens cyclical pressures. It also presents a problem, though, in that high utilization increases the need to build fabs, which cost billions of dollars. For TSM, which maintains $6.3 billion in cash and short-term investments net of interest-bearing debt, while pulling in a billion dollars or more in cash each quarter from operations, capacity additions should come with little difficulty.

Yet, even as TSM adds capacity to meet increased demand, pricing pressure likely will remain. So, TSM is focusing not only on continued advancement of its production technology; it also is adding design skills to increase collaboration with customers.

The Semiconductor Industry Association looks for 1.8% global industry growth this year. TSM management thinks the industry might see 3% to 4% growth, while the foundry group grows [by a bit less] than that on account of the inventory correction. According to Reuters Estimates, analysts currently expect TSM’s revenue to decrease by about 1% this year to $9.68 billion. Earnings also are likely to drop this year, to 63 cents per share from 76 cents in 2006.

Growth should return next year, though, and should continue, albeit in typical cyclical fashion, over the long term. With so many marquee names in the industry using TSM—companies like Advanced Micro Devices, Altera, and Qualcomm—as they grow, so shall TSM. (Its stock closed below $10 Tuesday—Editor.)

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