There are many ways to invest in the artificial intelligence (AI) sector, but one of the most popular is via chip companies. These businesses provide the nuts and bolts necessary to create the hardware that powers AI models. As a result, when you invest in one of these chipmakers, you're investing in the rising tide of artificial intelligence.
Among the AI chip companies, two that stand out are Broadcom (AVGO 3.84%) and Taiwan Semiconductor (TSM 1.26%). But which is the better investment? Read on to find out.
Both companies are highly profitable
These companies have very different business models.
Taiwan Semiconductor is a contract manufacturer that creates semiconductor chips for many customers, including Broadcom, Apple, and Nvidia. This makes it a fairly neutral player in the industry because it isn't competing with its customers.
Broadcom is a fabless chip manufacturer, meaning it only designs and markets the chips while outsourcing the actual manufacturing process to others (mostly to Taiwan Semiconductor). This asset-light approach makes for a stellar investment, as the margins are quite good.
But they aren't that much better than Taiwan Semiconductor's.
AVGO Gross Profit Margin data by YCharts
Although Broadcom's gross margin is higher (meaning its cost of goods sold is lower), Taiwan Semiconductor beats it on the bottom line due to its high efficiency. However, Broadcom's margins have rapidly risen and may overtake Taiwan Semiconductor's advantage someday.
Still, with both companies sporting around a 40% profit margin, these are two highly profitable businesses, and deciding a winner here would be splitting hairs.
The upside for Broadcom is higher, but so is the downside
Although the hype of artificial intelligence has excited investors about the prospects of both businesses, neither has been posting great results lately. In Q2, Taiwan Semiconductor's revenue declined 14% in U.S. dollars thanks to decreased demand for consumer electronics. Broadcom's third quarter (ending July 30) was much better, with revenue rising 5%. Still, 5% growth isn't the level of revenue expansion that AI investors expect to see.
But with Taiwan Semiconductor's 3-nanometer chip launching and Broadcom's AI chip revenue share expected to rise from 15% to 25% (within the company's chip division), strong growth catalysts are on the horizon for each business. Next year will be interesting for both companies, and once again, I cannot single out a winner based on their growth figures.
The picture is also muddled on the valuation front, as both stocks trade around the same forward earnings multiple.
AVGO PE Ratio (Forward) data by YCharts
As another interesting note, the S&P 500 trades at 19 times forward earnings, so neither company is trading at a massive premium to the broader market despite having strong AI-fueled potential upside.
So what is the deciding factor to help pick a winner? For me, it's customer concentration.
Because Taiwan Semiconductor is a neutral player, there isn't much of a replacement risk. Few can replicate what it has built, and the company has become an integral part of the digital economy.
Broadcom is also deeply integrated, but there is some replacement risk because its work can be moved in-house. Earlier this year, there were rumors that Apple could be looking to replace Broadcom as a supplier. Still, those were found to be unsubstantiated when the Mac maker announced a multibillion-dollar deal to develop 5G components. Likewise, Alphabet was rumored to be replacing Broadcom to save money on its AI chips but then publicly stated it sees no expected changes in its relationship with Broadcom.
While both of these stories turned out to be inaccurate, it shows that Broadcom's prices will always make cutting out the middleman an appealing option as companies look to reduce expenses. With Taiwan Semiconductor being a key supplier that cannot be replaced for many of these businesses, it's a much safer investment.
As a result, I think Taiwan Semiconductor is a much better AI chip investment than Broadcom, but its product line diversity will prevent it from having the same upside as Broadcom if products like the latter's Jericho3-AI chip take off. But that doesn't mean Broadcom is a bad investment; its products are still vital for building AI networks.
It all boils down to risk tolerance and what this stock is supposed to do for your portfolio. I'm already exposed to more risky AI investments, so Broadcom doesn't make as much sense to invest in as Taiwan Semiconductor. But buying both stocks in equal parts may be smart for investors who want a little of both.
Investing in Taiwan Semiconductor versus Broadcom comes down to personal preference, because both have the potential to be great stocks over the next few years.
