Taiwan Semiconductor Manufacturing (TSM 1.86%), better know as TSMC, is the world's largest contract chipmaker. It posted its third-quarter earnings report on Oct. 13. Its revenue rose 36% year over year to $20.23 billion, beating analysts' estimates by $1.14 billion, as its earnings grew 66% to $1.79 per ADR and topped the consensus forecast by $0.11.

TSMC's stock price rose slightly after that earnings beat, but it still remains down about 45% this year. So is this the right time for patient investors to accumulate some shares of this linchpin of the semiconductor industry?

An engineer inspects a silicon wafer.

Image source: Getty Images.

Understanding TSMC's business

TSMC produces the world's smallest, densest, and most power-efficient chips for fabless chipmakers like Apple, Advanced Micro Devices (AMD 1.93%), and Qualcomm. It manufactures its most advanced chips with its 5nm and 7nm nodes. TSMC's closest competitor, Samsung, also produces 5nm chips. But TSMC's 5nm chips have a significantly higher transistor density than Samsung's, which makes them faster and more power-efficient.

TSMC generated 41% of its revenue from the smartphone market in the third quarter. Another 39% came from the HPC (high-performance computing) market, 10% came from the Internet of Things (IoT) market, 5% came from the auto market, and 2% came from the DCE (digital consumer electronics) market. The remaining 3% came from other industries.

TSMC is still growing like a weed

If you track TSMC's growth over the past four years, you'll see that its growth is cyclical. It experienced a slowdown in 2019 as smartphone sales stalled out and a supply glut sank the memory market. But its growth accelerated again over the following three years as new 5G devices hit the market, data centers upgraded their infrastructure, and the pandemic forced more people to buy new PCs to work from home. New gaming consoles, connected cars, and IoT devices amplified that demand.

Metric

Q3 2022

Q2 2022

Q1 2022

FY 2021

FY 2020

FY 2019

Revenue Growth* (YOY)

36%

37%

36%

25%

31%

1%

Percentage of Revenue (5nm)

28%

21%

20%

19%

8%

0%

Percentage of Revenue (7nm)

26%

30%

30%

31%

33%

27%

Data source: TSMC. YOY = Year over year. *USD terms.

TSMC also ramped up the production of its 5nm chips over the past three years. In the third quarter of 2022, its 5nm revenue eclipsed its 7nm revenue for the first time. Even as it ramped up its production of those top-tier chips, its gross and operating margins consistently expanded.

Metric

Q3 2022

Q2 2022

Q1 2022

FY 2021

FY 2020

FY 2019

Gross Margin

60.4%

59.1%

55.6%

51.6%

53.1%

46%

Operating Margin

50.6%

49.1%

45.6%

40.9%

42.3%

34.8%

Data source: TSMC.

TSMC's gross margins are supported by its unmatched pricing power, since it's the only contract chipmaker that can mass produce the world's smallest and densest chips. The unmatched scale of its business -- which spans 17 fabs in Taiwan, China, and the United States -- also enables it to consistently expand its operating margins even as it plows tens of billions of dollars into the development of smaller chips to maintain its technological lead.

Why TSMC's stock tumbled this year

TSMC's revenue is rising and its margins are expanding, so it might seem odd that its stock was cut in half this year. However, investors are worried that TSMC's next cyclical downturn has already begun.

The post-pandemic slowdown of the PC market has already prompted major chipmakers like AMD and Micron to dramatically reduce their near-term forecasts. IDC expects global shipments of personal computing devices (PCs and tablets) to decline 10.8% this year and dip 2.3% in 2023. IDC also expects global shipments of smartphones to fall 6.5% this year as inflation and other macro headwinds disrupt the market and only slightly recover with 5.2% growth in 2023.

That's worrisome because many chipmakers previously ramped up their production to address the chip shortage during the pandemic. Therefore, the chip shortage could quickly become a surplus as the global economy cools off and companies curb their orders for new chips. The Biden administration also recently issued new export restrictions for advanced semiconductors to China, which could cause the supply of higher-end chips to skyrocket in the United States and other countries.

That's why TSMC is now allocating just $36 billion to its annual capex this year, compared to its previous target of $40 billion. That's still a lot of spending, but it clearly indicates the market's demand for new chips is waning.

TSMC is still a solid long-term investment

Analysts expect TSMC's revenue and earnings to grow 29% and 30%, respectively, this year. But in 2023, they expect its revenue to only rise 5% and for its earnings to drop 5% as it ramps up its production of its newer 3nm and 2nm chips. That imminent slowdown is keeping investors away from TSMC, even though it trades at just eleven times forward earnings.

TSMC might remain stuck in neutral for a few more quarters. But over the long term, I believe it will head higher as chipmakers ramp up their production again to address the ever-growing need for faster chips. That secular expansion makes TSMC a great semiconductor stock to buy at a steep discount right now.