Bull vs. Bear: Is Taiwan Semiconductor Manufacturing Stock a Buy or Sell?

Continuing my series of "bull vs. bear" articles looking at the bull and bear theses of popular stocks, we come to Taiwan Semiconductor Manufacturing (NYSE: TSM). The stock has been a strong performer, up around 140% over the past year and 30% year to date, as of this writing.

Let's dive into why the stock could keep hitting all-time highs, and why investors may want to take some profits.

Image source: The Motley Fool.

The bull case

Taiwan Semiconductor Manufacturing, or TSMC for short, is the world's leading chip manufacturer. Today, most semiconductor companies that design logic chips outsource their manufacturing to third-party foundries, like TSMC. Notably, this is much different than the memory market, where most manufacturing is done in-house.

There are a few reasons why most companies outsource their logic chip manufacturing to third parties. First, chipmaking is a capital-intensive business that involves building fabs and using very expensive extreme ultraviolet lithography (EUV) machines. By outsourcing manufacturing, chipmakers can avoid these high up-front costs. Second, semiconductor manufacturing is a scale business. Fabs (chip manufacturing facilities) need to be running near full capacity to be profitable, and that is easier with multiple customers compared to a company that is vertically integrated. And most importantly, chip manufacturing is a complex task that involves a completely different type of technological expertise that few companies have.

Foundries need to consistently shrink chip density for chips to continue to advance. At the same time, they need to maintain high yields. This means that most of the chips on a wafer need to be defect-free. This is what has set TSMC apart. While competitors have pushed down node sizes (chip density), they have run into problems maintaining adequate yields. Meanwhile, TSMC has also become the leader in advanced packaging (integrating chips and memory components into a single unit), further cementing its technological lead.

This has all led TSMC to become a virtual monopoly in the manufacturing of advanced logic chips at scale. As a result, the company has become one of the most important parts of the semiconductor value chain and a vital partner to chip designers, who must work closely with TSMC on their development roadmaps. This has also, in turn, given it strong pricing power, which has helped drive gross margin expansion.

As demand for artificial intelligence (AI) accelerators, like graphics processing units (GPUs), continues to boom, TSMC is a huge beneficiary. Meanwhile, the sudden surge in demand for high-performance central processing units (CPUs) will become another growth driver for the company. Best of all, it generally doesn't matter which company's chips win or take share, as almost of them are TSMC customers.

The bear case

As noted above, chip manufacturing is a highly capital-intensive business, and fabs need to be running near full utilization to be profitable. A partially utilized fab is a money-losing endeavor. As such, no company is as exposed to a potential AI infrastructure downturn as TSMC.

The company is planning to spend a massive $52 billion to $56 billion on capital expenditures (capex) this year to build more fabs and increase capacity. That's a big bet. While a pullback in demand for AI chips would hurt chip designers, it would absolutely be devastating for TSMC if it had a bunch of underutilized fabs.

And while TSMC currently has a virtual monopoly on making advanced chips, that doesn't mean there isn't competition. Samsung is a big player, and its ability to manufacture both logic and memory chips and package them together could eventually be a differentiator. Meanwhile, Intel has poured money into its foundry business and is strong in advanced packaging. Both competitors have also been more open to using ASML's newer High-NA EUV machines, which could catapult them ahead of TSMC if it continues to balk at the new tech due to its price tag.

Lastly, the company does face geopolitical risk, with the majority of its fabs in Taiwan. While it is expanding geographically, its new fabs in the U.S. generally have lower margins.

The verdict

While not without risks, I see TSMC as one of the biggest winners of the continued AI infrastructure build-out. With no sign of spending slowing down and now an added catalyst with CPUs, this is an AI stock to own for the long term. Meanwhile, it is still attractively valued, trading at a forward P/E of 25.5 times for a company growing its revenue at a 30% to 40% clip.

You can find past "bull vs. bear" articles on Apple, Meta Platforms, Palantir Technologies, Micron Technology, Tesla, and Nvidia by following the links.

Geoffrey Seiler has positions in Meta Platforms. The Motley Fool has positions in and recommends ASML, Apple, Intel, Meta Platforms, Micron Technology, Nvidia, Palantir Technologies, Taiwan Semiconductor Manufacturing, and Tesla. The Motley Fool has a disclosure policy.