Should Taiwan Semi Investors Be Worried About Huawei's Latest Smartphone?

It is no secret that China is investing heavily to build a homegrown semiconductor supply chain. Pouring billions of dollars into research and development (R&D) over the last few decades, the East Asian nation wants its homegrown technology giants to have computer chip manufacturing on par with that of Western nations and their allies. As a part of the simmering trade war, the United States has tried to slow down this progress by restricting computer chip exports to the nation.

Today it looks like China has inched forward in this technological tug-of-war despite these restrictions. Smartphone maker Huawei just released a new smartphone with a 7-nanometer computer chip made by Chinese chipmaker SMIC, with many other phone components coming from local suppliers instead of Western allies.

Shares of Western semiconductor companies have fallen in recent trading days on this news, with Taiwan Semiconductor Manufacturing (NYSE: TSM) stock off 16% from recent highs. Investors are likely worried that Chinese manufacturers are going to steal customers from them. But are these concerns warranted? Let’s investigate.

TSM Chart

TSM data by YCharts

A big step forward for China?

When it comes to semiconductors, the smaller the better. The leading manufacturers work tooth and nail to shrink the transistors they can make for customers, improving process speeds and other outcomes for the end consumer products.

Currently the most advanced semiconductor manufacturer is Taiwan Semiconductor, or just TSMC for short. The Taiwanese company started ramping up production on 5-nanometer chips in the second quarter of 2020, with plans to bring 3-nanometer chips to Apple later this year and to its wider customer base in 2024.

Without advanced equipment and manufacturing processes, the Chinese chipmaker SMIC has historically lagged behind competitors such as TSMC. This gives the Taiwanese manufacturer an advantage when trying to win customer contracts, and it’s why it has over 50% market share in the semiconductor foundry industry.

However, with SMIC proving it can manufacture 7-nanometer chips and get them to work in Huawei smartphones, it looks like this technological gap may be closing. This could spell competitive troubles for TSMC, which has dominated the advanced semiconductor market in recent years.

A headwind, but not the end of the world

China’s goal with its semiconductor supply chain is to make itself much less reliant on the United States and its allies. The political pressure between the two nations hasn’t reached a boiling point, but government leaders and company executives are making preparations in case things go south.

TSMC is allied with the United States, and therefore would likely lose access to any Chinese customers if they all switched to SMIC products. This presents a bit of a good news/bad news situation. The bad news is that TSMC would lose a decent chunk of its customer base (12% of its revenue came from China in the second quarter). However, the good news is that any customers outside of China will almost assuredly not use SMIC chips, especially if they are close allies of the United States. This should help TSMC keep a dominant share among the rest of its customer base, even if SMIC can sell technologically equivalent chips.

Management at TSMC has a goal of growing revenue by 15%-20% a year for the next few years as it rides the boom in semiconductor demand. If it loses all of its business in China, that would present a small headwind, but TSMC can overcome it with growth from its customers from other nations. This wouldn’t be the end of the world for the business.

Is now a buying opportunity?

With shares falling on this SMIC news, TSMC now trades at a price-to-earnings ratio (P/E) of just 15. This isn’t as cheap as when Warren Buffett bought last year, but this is a much cheaper multiple than when the stock traded at 20 to 30 times earnings in recent years.

TSM PE Ratio Chart

TSM PE Ratio data by YCharts

Even with the potential loss of the China business, today should present a strong buying opportunity for investors focused on the long haul. TSMC is poised to grow its revenue at a durable double-digit rate with strong profit generation. With the stock’s P/E below the market average, this is a recipe for long-term market outperformance.

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Brett Schafer has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Apple and Taiwan Semiconductor Manufacturing. The Motley Fool has a disclosure policy.

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