Before investing in any company, it's important to have a solid understanding of how risky that investment is. This means understanding what factors could potentially drive the company's financial performance to come in worse than what the investment community at large might expect.
Although I am generally positive on Taiwan Semiconductor Manufacturing Company's (TSM +3.18%) long-term prospects, there's plenty that could go wrong for the chipmaker in the coming quarters or even years.
Let's dig deeper into those potential risks.
Image source: Getty Images.
A mobile slowdown
TSMC is the most popular contract chip manufacturer for mobile applications processors (APs), and many of the top mobile AP vendors rely on it to build their chips. The good news for TSMC is that it doesn't need to worry too much about share shifts among its customers; if its customers are winning business, it doesn't really matter to TSMC which one it is. The bad news is that, with 60% of its revenue coming from "communication" products (i.e., smartphones), it is extremely sensitive to the health of the broader smartphone market.
If the smartphone market slows down (perhaps due to macroeconomic factors, or simply due to a saturation of the market), there's real risk to TSMC's financial performance.
The impact of a significant, unplanned slowdown in smartphone sales would have two highly negative effects on TSMC's business. The first is that its revenue would simply be lower than planned, which naturally hurts profitability.
Just as bad, if not more so, a major smartphone slowdown would likely lead to lower factory utilization rates for the company. Lower factory utilization means that the depreciation expenses that TSMC incurs -- which are based on fixed equipment/building depreciation schedules -- would be spread out across fewer silicon wafers.
In effect, this would increase TSMC's cost structure per wafer, negatively impacting its gross profit margins.
Potential market-share loss
One risk that TSMC faces is that it could lose market segment share to competitors. TSMC doesn't operate alone in the world of contract chip manufacturing, and it will likely continue to face competition out in time.
Right now, its main competitor in leading-edge technologies is Samsung (NASDAQOTH: SSNLF) and it has several competitors in mature technologies, including Samsung, Global Foundries, United Microelectronics Corporation (UMC 1.03%), and Semiconductor Manufacturing International (SMI +0.00%).
Intel (INTC 2.48%) has also said that it's working to build out a contract chip business that offers leading-edge technologies as well.
TSMC has done a good job fending off that competition, though. The company's market share at the 14/16-nanometer generation is already quite high, and the company is projecting market share increases at the 10-nanometer and 7-nanometer technology generations.
In fact, there are now rumors that Samsung might spin-off its logic chip manufacturing business altogether, which could allow TSMC to further strengthen its position in higher-end technologies.
For more mature technologies, TSMC has been aggressive in rolling out enhanced versions of those technologies to keep customers around -- a strategy that appears to be working as TSMC recently reported that utilization of its 28-nanometer factories is currently maxed out.
An earthquake
Per Wikipedia, Taiwan is "located in the Ring of Fire, making it prone to intense earthquakes."
In Feb. 2016, Taiwan experienced a doozy of an earthquake, leading to the death of 117 individuals and the injury of 550 more.
TSMC reported that the earthquake affected about 1% of its wafer shipments in the first quarter of 2016. Luckily, not a lot of equipment was damaged as a result, with TSMC spokeswoman Elizabeth Sun telling Taipei Times that its "initial estimate is that more than 95% of the tools can be fully restored to normal in two to three days."
Nevertheless, because TSMC's 12-inch wafer fabs are located exclusively in Taiwan (and most of its eight-inch wafer fabs are in Taiwan as well), the company faces greater geological risks than some of its peers might.
If an earthquake were to cause extensive damage to its production facilities, this could lead to product shortages. In the near term, such shortages could hurt revenues. Longer term, it might encourage once-loyal customers to seek out dual-sourcing options to minimize risk.
