Equity Research Write-up

Michael Lin

Taiwan Semiconductor Manufacturing Co. Current Price (8/4/17): $36.03

(TSM.NYSE) Target Price: $39.74
Overweight Semiconductor Potential Upside: 10.29%

Market Profile (as of August 7, 2017) Brighter Outlook for 2H17 with Leading 7nm Solution
52-Week Range $28.20 - $36.92
Avg. Volume (3 month) 6.68M
Outpacing Samsung in 7nm development
Beta 0.91
Trailing P/E 16.23 We saw potential mass production in high-end chips using 7nm solution in 1Q18,
Forward P/E 15.74
as opposed to Samsungs in 2H18. TSM has a very smooth 7nm ramp-up in 2017,
Forward Dividend Yield 3.22%
Market Cap. $185.59B with yield learning even better than its 16nm. The 7nm process shares 90% of the
Shares Outstanding 25.93B equipment with 10nm; therefore, the margins for 7nm will be better than that of
Diluted EPS (ttm) $2.25 10nm.
ROA (ttm) 13.10%
ROE (ttm) 27.43% Potential Qualcomm Wins & Apple A12 Sole Producer
Given Samsungs 7mn timeline, we expect TSM to be the sole producer for
Apples A12 for next years iPhone. We believe TSM is also likely to grab share of
Qualcomms next generation Snapdragon 845 chips, due to the lead technology
development.

Well-Positioned to Capture HPC Growth through Advanced Technology

TSM is planning to debut the N7+ in mid-2018, which will have a better
throughput and yield compared to the N7 node, as opposed to Samsungs EUV
release in late-2018. TSMs advanced packaging technology in FOWLP-based InFO
also provides an edge over Samsung. The packaging technology will be crucial to
the HPC production.

Source: Company data Rebound from 1H17

Fabless clients are quickly digesting inventory in 2Q17, the inventory level is
expected to return to normal by the end of 3Q17. TSMs 1H17 top line was ~7%
negatively impacted by strong TWD, a rebound in operating metrics is anticipated
when the FX stabilized.

Market Leader with Under-Appreciated Stock

With over 50% market share, leading technology, lowest cost structure and
strong operation metrics, TSM is the undisputed leader in foundry business.
However, it has lower market multiples when comparing to group of pure-play
foundries, major chipmakers, or SOX index. We believe an expansion of forward
Source: Company data P/E to 16.9x is reasonable based on pure-play foundry competitors mean. We
arrived a target price of $39.74 based on our estimated FY18 EPS of $2.35.
 Equity Research Write-up
Michael Lin

Wafer Revenue by Technology Lead Player to Implement 7nm

2Q17 1Q17 2Q16
10nm 1% 0% 0% TSM is outpacing its chief competitor Samsung Electronics Co. (Samsung) in
16/20nm 26% 31% 23% implementing the 7nm technology and is likely to start mass production earlier than
28nm 27% 25% 28% expected in 1Q18 as opposed to Samsungs in 2H18. This lead can provide TSM with
40/45nm 13% 13% 15% a monopolistic position in early-stage 7nm implementation. The company mentioned
65nm 10% 11% 12%
that 30 tape-outs at 7nm in 2018 are currently in the pipeline (up from previous 15
90nm 5% 4% 5%
0.11/0.13um 3% 2% 2% tape-outs three months ago), with high-performance computing (HPC) customers
0.15/0.18um 11% 11% 11% accounting for over 50%.
0.25um/+ 4% 3% 4%
With Intels announcement to upgrade its Fab 42 by 2020/2021, utilizing the 7nm
Source: Company data manufacturing process, TSM may unseat Intel in the manufacturing technology with
its 5nm roll-out in 1Q19. Unlike the 10nm, TSM expects the 7-nanometer node, N7
and N7+ (EUV enabled), to be a major and long-life technology nodeto be used in
mobile, HPC and automotive markets. The 7nm process shares 90% of the same
Top Customers % Revenue
equipment with 10nm; therefore, the margins for 7nm will be better than that of
Apple Inc. 15.65%
10nm. In addition, the company is expected to have a very smooth 7nm ramp-up in
Qualcomm 14.44%
2017, with its yield learning better than 16nm.
MediaTek 9.02%
Huawei 4.36%
Nvidia 4.02%
Broadcom 3.77% Potential Major Customers Wins
Texas Instrument 2.17%
Apple - TSM has been the sole producer for Apples A10 Fusion and A11 processor.
NXP 1.72%
STMicroelectronics 1.66%
After Samsungs A9 were determined to have lower performance, Apple was forced
Sony 1.28% to require TSM to level its processing power to match that of Samsungs chips. The
AMD 1.13% processors from Samsung consumed ~20% more power as a result. Rumor has it that
Total 59.22% Samsung will once again share the contract to produce Apples A12 for the next
Source: Bloomberg, as of 7/20/17 generation of iPhones. Given Samsungs late 2018 timeline to launch its 7nm with
extreme ultra violet (EUV) lithography and the lead time required for the
manufacturing process, we believe it is unlikely for Samsung to catch up production-
wise to meet iPhones September release date of next year. The 7nm is estimated to
have a power, performance and area (PPA) boost of 20% to 30% compared to
Samsungs 10nm and 8nm technologies. Our view is that TSM will receive most, if not
all, of the A12 contract.

Qualcomm After switching to Samsung for its Snapdragon 820, 830 and 835 chip
production, we believe TSM is likely to grab share of Qualcomms next generation
Snapdragon 845 chips, due to the lead in 7nm development.
 Equity Research Write-up
Michael Lin

Advanced Packaging Technology Secured High-End Clients

TSMs advanced packaging technology in FOWLP-based InFO provides an edge over

Samsung by reducing both heat and power consumption. Samsungs answer involves
integrating the FoPLP packaging technology with its chip, but the process will take
one to two years. InFO, along with another high-end packaging technology CoWoS, is
used on high-performance computing products and the revenue doubles yearly. TSM
spends 10% of capex to invest in the deployment of back-end packaging.

Extreme Ultraviolet Lithography Utilization

TSM has finished the initial test run of the long-awaited EUV technology on the 7nm
and testing is expected to be completed by the end of the year with the transfer to
fab production afterward. TSM is planning to debut the N7+ mid-2018 as opposed to
Samsungs EUV release late-2018. TSMC has an edge over Samsung as it has climbed
the learning curve early in its progress in EUV technology.

The EUV enabled N7+ node requires minimal adjustments to existing N7

manufacturing processes, yet it can significantly reduce the number of masks and
shorten the lithography process. On the whole, yield and performance are expected
to be better post-EUV implementation.

Expanding the Lead in Existing Processing Technology with Higher Utilization

FY17 capex is guided at $10 billion, which is in-line with that of FY16. TSM is expecting
an overall 10% year-over-year capacity increase. The company will expand its 28nm
capacity by 15%, with 5% of that increase to be contributed from the newly added
capacity for this year and the remaining from the productivity improvement gain. TSM is
also improving the technology from 28nm to 22nm, which is based on high-K metal
gate. The company is seeing a strong third quarter and fourth quarter, which will
result in a higher utilization rate and a subsequent impact on gross margin.

10nm Ramp-up and 12nm Roll-out in Second Half

The company anticipates a significant ramp-up in 10nm production in the third

quarter, which will contribute 10% of the wafer revenue this year and negatively
impact the 2H17 gross margin by about 2% to 3%. TSM will also produce chips using
its 12nm, which will boast a 10% better performance and 25% drop in power
assumption as compared to its 16nm FinFET Compact (FFC). The initial 12nm
products are expected to be NVIDIAs new Volta GPU - Xavier SoC in 3Q17 and
MediaTeks new P-series chipset in 1Q18. Hisilicon and Silicon Motion are also likely
to adopt the 12nm process in producing high-end mobile chipsets.
 Equity Research Write-up
Michael Lin

Emerging Demand for High-Performance Computing Chips on the Horizon

The rapid development in cutting-edge technology such as Artificial Intelligence,

Internet of Things, cloud computing, deep learning accelerators, virtual
reality/augmented reality, etc., increase the demand of HPC chips. The HPC chips
market is estimated to be $10 billion to $11 billion in 2017 and is expected to grow at
a 5% to 10% annual clip going forward. Growth is still within an early stage but will
likely gain traction and fuel future growth after 2020.

The HPC chips highly depend on advanced processing technology, among the 30 tape-
outs for N7, more than half are from HPC products. The company believes that most
customers will transition to N7+ after the technology is made available. Furthermore,
the InFO and CoWoS packaging will be increasingly important in the HPC market,
placing TSM at the forefront to capture and benefit from the future growth in HPC.

Potential Upside Risks: earlier than expected adoption of HPC applications from
auto/industrial/mobile industry; market share gain from competitors; sharper
learning curve enables faster implementation of new technology.

Potential Downside Risks: unfavorable FX movement (stronger TWD) - 1% change of

FX will result in 0.4% change in gross margin; longer than expected inventory
adjustment; slowdown in mobile growth or overall economy growth; potential
customer loss to main competitor due to the competitors negotiating position.

Lower Valuation Compared to Peers

We issued a target price of $39.74, based on FY18 estimated EPS and a forward P/E
of 16.9x from competitors mean. Although TSM is trading at a higher end of its
historical P/E range, it is still relatively inexpensive compared to other public listed
peers. TSM and SOX have both enjoyed continuous but slow multiple expansion since
August 2015. TSM is trading at a discount in terms of P/E compared to the SOX index.
TSM is also trading at a discount compared to its pure play foundry competitors. A
comparison with UMC, SMIC and Vanguard International Semiconductor shows that
TSM is trading at a 15% discount when comparing its forward P/E to that of peers.
 Equity Research Write-up
Michael Lin

Given TSMs market leading position, we see no reason why it should trade below
competitors market multiple.

Pro forma income statement key assumptions:

FY17: 3Q17 revenue is estimated at $8.2 billion; 48.5% to 50.5% for gross margin and
37% to 39.5% for operating margin; 17% depreciation increase from last year; 10% to
11% corporate tax rate for 2H17 and 13% to 14% for the full year; 5% to 10% top line
growth in US Dollar in 2017; 2H17 USD revenue guided more than 5% higher
compared to 2H16.

FY18: revenue is estimated to grow in sub-double-digit range, COGS as percentage of

revenue decrease slightly from 2H17 due to higher margin from 7nm; R&D expenses
remain at the same percentage of revenue as FY17, which is 8.63%; SG&A and non-
operating items are projected to increase modestly; the tax rate will remain at 13%
to 14% given the companys history of higher income tax in second quarter due to the
10% retain earning tax presumably from cash hoarded for dividend payment.

The share count are projected to stay intact and the USD/TWD rate are assumed to
be $30.3, as the company guided.

Based on a forward P/E of 16.9x and the estimated FY18 EPS of 2.35, we arrived a
target price of $39.74, which represents 10.29% upside from the closing price of
$36.03 on August 4, 2017.

($NT mn) 1Q17 2Q17 3Q17e 4Q17e 2016 2017e 2018e

Net Revenue 233,914 $213,856 $248,230 $272,158 $947,938 $968,158 $1,060,133
Cost of Revenue (112,424) (105,148) (122,874) (136,079) (473,106) (476,525) (521,585)
Gross Profit 121,490 108,708 125,356 136,079 474,832 491,633 538,548
Operating Expenses
R&D Expenses (19,413) (19,057) (21,100) (23,950) (71,208) (83,519) (91,489)
SG&A & Others (6,725) (6,395) (6,950) (7,076) (25,666) (27,147) (28,624)
Total Operating Expenses (26,138) (25,452) (28,050) (31,026) (96,874) (110,666) (120,113)
Income from Operations 95,352 83,256 97,306 105,053 377,958 380,967 418,434
Depreciation 60,172 57,993 68,300 70,195 223,828 256,660 277,193
EBITDA 155,524 141,249 165,606 175,248 601,786 637,627 695,627
Non-operating Income and Expenses 2,470 2,862 1,000 1,500 8,001 7,832 8,000
Income Before Income Tax 97,822 86,118 98,306 106,553 385,959 388,799 426,434
Income Tax Expenses (10,201) (19,847) (10,814) (11,721) (51,621) (52,583) (57,569)
Net Income 87,621 66,271 87,492 94,832 334,338 336,217 368,866
Earnings per Share - Diluted 3.38 2.56 3.38 3.66 12.89 12.98 14.25
Earnings per ADR - Diluted 16.90 12.78 16.90 18.32 64.45 64.90 71.25
Earnings per ADR - Diluted in USD 0.54 0.42 0.56 0.60 2.01 2.14 2.35