Is Taiwan Semiconductor Manufacturing Stock a Buy Now?

Taiwan Semiconductor Manufacturing (TSM -5.75%), the contract chipmaking giant more commonly known as TSMC, posted its second-quarter earnings report on July 14. Its revenue rose 37% year over year to $18.16 billion, which beat analysts' estimates by $580 million.

Its diluted earnings rose 67% to $1.55 per American depositary share, which also exceeded analysts' expectations by a nickel. Those headline numbers were impressive, but is it the right time to buy TSMC's stock?

Image source: Getty Images.

Growing in all the right places

As the world's largest and most advanced contract chipmaker, TSMC produces the smallest, densest, and most power-efficient chips for fabless chipmakers like Advanced Micro Devices, Qualcomm, Nvidia, and Apple.

TSMC's growth decelerated in 2019 as consumers purchased fewer smartphones and consumer electronics. But in 2020, multiple catalysts -- including new 5G devices, robust sales of PCs during the pandemic, and a growing appetite for more powerful data center chips -- brought in a flood of new orders. That soaring demand, along with disruptions from trade restrictions, caused a global chip shortage, which further amplified TSMC's growth.

That momentum continued throughout 2021 and the first half of 2022, and TSMC started to generate a higher percentage of revenue from its smallest and most advanced 5-nanometer node. It also continued to manufacture a large number of chips with its second smallest 7nm node.

Data source: TSMC. FY = Fiscal year. YOY = Year over year. *Based on revenue expressed in U.S. dollars.

The stable expansion of its 5nm and 7nm nodes kept TSMC comfortably ahead of its two largest rivals, Samsung and Intel (INTC -1.16%), in the race to produce smaller and denser chips. 

Samsung also manufactures 5nm chips, but it hasn't been able to match TSMC's transistor density yet. Intel, which has fallen far behind TSMC and Samsung in that race over the past decade, completely abandoned nanometer-based measurements under CEO Pat Gelsinger -- who took the helm in early 2021 and tried to overhaul the chipmaker's manufacturing operations.

Its dominance of the 7nm and 5nm nodes has given TSMC the power to repeatedly raise its prices without losing customers. Its scale has also allowed it to expand its operating margins even as it increases its capital spending from $30 billion in 2021 to a historic high of about $40 billion throughout 2022 to produce even smaller 3nm and 2nm chips.

Data source: TSMC.

Can TSMC maintain that momentum?

Based on those two charts, TSMC looks like a rock-solid investment. However, TSMC's growth is cyclical, and the semiconductor market has been cooling off as people buy fewer PCs and as macroeconomic headwinds throttle the market's appetite for new chips.

As a result, there is a looming fear that the increasing production of chips to counter the chip shortage will create a sudden supply glut instead. TSMC's own guidance indicates that slowdown has already begun.

For the third quarter, it expects its revenue to rise 33%-38% year over year with a gross margin of 57.5%-59.5% and an operating margin of 47%-49%. Those metrics look healthy, but they also suggest its revenue growth will cool off slightly as its gross and operating margins dip sequentially.

Analysts expect TSMC's revenue to rise 31% for the full year, but to grow just 11% to $82.2 billion in 2023. They predict its operating margin will expand to 46.2% this year as some supply chain headwinds force it to postpone some of its planned upgrades (which recently caused it to reduce its full-year capex estimate from $40 billion-$44 billion to about $40 billion), then dip to 44.3% in 2023 as it ramps up that spending again. Its earnings per share are expected to increase 42% this year and grow 8% in 2023.

Even after increasing its capex this year, TSMC will still have plenty of cash left over for its dividends. During the second quarter, it spent 64% of its operating cash flow on capital expenditures, and 21% of that total on its dividends. It pays an attractive forward dividend yield of 2.3%.

It's a rock-solid buy at these prices

TSMC has endured plenty of cyclical slowdowns before, but it's still generated a total return of 1,520% over the past 20 years. It might not replicate those massive gains over the next two decades, but it will remain a linchpin of the growing semiconductor market for the foreseeable future.

TSMC's stock has declined about 30% this year along with the broader tech sector, but it now looks like a screaming bargain at 13 times forward earnings. The bears might fret over its near-term slowdown, but the bulls know it will inevitably recover as the cyclical tailwinds pick up again.