DeepSeek Panic: Here's Why I'm Doubling Down on TSMC

Seeking Alpha01-29

SummaryThe DeepSeek news sparked unfounded fears of reduced AI hardware spending, ignoring TSMC's critical role in AI infrastructure.3nm technology accounted for 26% of Q4-24 wafer revenue, reflecting...

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Since then, TSM has delivered outstanding returns, up 125%, outperforming the market by nearly 3X. The last coverage on TSMC focused on Q3-24 performance based on AI and HPC market demand. Now, the focus of current coverage is on Q4-24 performance and forward revenue growth in Q1-25 through AI accelerators, HPC demand, and expanded adoption of 3nm tech lead. There are margin improvements and strategic CapEx allocation with downsides in overseas expansion. Finally, the recent overreaction to DeepSeek-related fears has created a compelling opportunity for long-term investors, and I’m taking full advantage of this dip with confidence and conviction.DeepSeek Hype: Why TSMC’s Dominance Remains UnshakenThe recent selloff in TSMC’s stock, driven by fears that AI spending may shift away from hardware toward operational tools like DeepSeek, presents a clear overreaction. TSMC remains indispensable to the AI ecosystem, manufacturing the advanced semiconductors powering Nvidia (NVDA) and AMD (AMD) and other industry leaders. While DeepSeek’s innovations highlight efficiency gains, they do not replace the growing demand for cutting-edge chips needed for AI training and inference workloads. The market’s response misprices TSMC’s robust fundamentals and its pivotal role in AI hardware.That spending on AI would, therefore, be dampened as DeepSeek continues its upward trajectory does not stand up to a critical mind that really knows what happens around the simple investment motives into AI. DeepSeek aims to improve supply chain efficiencies with its AI-enabled toolsets. However, all such incremental benefits that these provide will in fact, supplement the sizeable investments that need to go into hardware and other infrastructures in AI growth. Advanced hardware consists of GPUs, TPUs, and accelerators used in training and inference that form the backbone of AI, which is manufactured by leaders such as TSMC. As workloads for AI grow increasingly complex, demand will only increase for high-performance semiconductors. Meanwhile, hyperscalers like Amazon (AMZN) AWS, Microsoft (MSFT) Azure, and Google (GOOG) Cloud are building out their data centers and cloud infrastructure to meet surging demand for AI services, further solidifying the need for large capital expenditures on foundational hardware.www.visualcapitalist.comAlthough DeepSeek’s tools may optimize manufacturing and supply chain processes, they will not reduce infrastructure spending. In fact, its technology could contribute to the faster deployment of more AI projects, smoothing resource allocation and reducing inefficiencies that drive higher spending. Also, from autonomous vehicles, health care to finally generative AI, the depth of AI’s penetration in industries keeps increasing the use cases and is hence in strong demand for AI hardware, software, and services. DeepSeek speaks to a very specific niche within supply chain optimization and doesn’t change any of the structural drivers underpinning AI investment. In the end, the efficiencies unlocked by DeepSeek are likely only to augment and magnify existing spending trends in AI, underlining long-term growth and resilience in this industry.35% YoY Revenue Growth for Q1-25, Driven by Advanced Tech and AI ExpansionIn Q4-24, TSMC had a sequential revenue growth of 14.3% in New Taiwan Dollars (NT). This growth was based on the increasing demand for the company’s advanced 3-nanometer (N3) and 5-nanometer (N5) tech. Notably, N3 tech alone accounted for 26% of wafer revenue in Q4-24, marking a significant adoption relative to 6% in Q3-23. On an annual basis, revenue from advanced technologies, defined as processes at 7-nanometer (N7) and below, represented 74% of wafer revenue in Q4 and 69% for CY-24, up from 58% in CY23. This Q4 growth reflects a 15%-point YoY increase in advanced tech contributions. It underscores TSM’s stronghold in leading-edge semiconductor processes.Q4 Earnings DeckGross margin improved by 1.2%-points sequentially to 59% in Q4-24 due to higher capacity utilization and productivity gains. Operating margin increased by 1.5%-points to 49%. Whereas, full-year gross margin rose 1.7%-points to 56.1%, while operating margin grew by 3.1%-points to 45.7%. These improvements mark TSM’s capability to optimize production and control costs sharply. The consistent revenue contributions from N3 and N5, along with their growing share of total revenue, reinforce TSM’s sequential margin improvements even amidst the dilution effects from ramping new techs. In Q4-24, the High-Performance Computing (HPC) platform is the largest revenue contributor, increasing 19% sequentially to account for 53% of top-line. Smartphone platform revenue grew 17% sequentially and brought in 35% to the consolidated top line.Conversely, IoT revenue declined by 15% and accounted for 5% of revenue, while Automotive revenue increased by 6% to reach 4% of revenue. On an annual basis, HPC revenue grew by 58% YoY in CY24 based on strong demand for advanced computing applications. Smartphone revenue increased by 23%, while IoT and Automotive platforms grew by 2% and 4%. Overall, HPC and smartphone platforms led to 51% and 35% of CY24 revenue. The strong growth in HPC revenue reflects TSM’s lead in capitalizing on the increasing demand for AI accelerators, GPUs, and ASICs vital for advanced computing and AI applications. This increasing demand led to inventory days being reduced by seven days to 80 days in Q4. There were increased shipments of N3 and N5 wafers and with that, accounts receivable turnover improved to 27 days, which points to sharp management of working capital.Q4 Earnings DeckFor Q1-25, TSM projects the top-line to be between $25B and $25.8B with a 34.7% YoY jump at the midpoint. With that, the gross margin may range between 57% and 59%, and the operating margin can be between 46.5% and 48.5%. The company also forecasts a 2% to 3% margin dilution impact from the ramp-up of overseas fabs in 2025 under its global expansion strategy. Moreover, TSMC plans to allocate $38B to $42B for CapEx in 2025, with ~70% dedicated to advanced process technologies (7nm and below), 10% to 20% for specialty technologies, and 10% to 20% for advanced packaging and related capabilities. This represents a strategic focus on high-growth areas like 5G, AI, and HPC. Also, the high top-line guidance and massive CapEx investment point to TSMC’s confidence in stable demand for its technologies. In short, the strategic allocation of resources towards advanced processes and packaging targeting industry megatrends may continue to benefit the stock’s upside potential.In CY24, revenue from AI accelerators accounted for a mid-teens percentage of total revenue that may be double in CY25. TSMC forecasts a mid-40% compound annual growth for AI-related revenues over the next five years, with AI as a core driver of HPC platform growth. TSM’s global expansion includes new fabs in Arizona, Kumamoto, and Dresden, which are supported by strong governmental and client partnerships. These initiatives may boost geographic flexibility and address the growing demand for specialty and advanced tech. TSMC’s development of 2-nanometer (N2) and A16 tech reflects its lead in semiconductor advancement. The company expects volume production for N2 to begin in H2 2025, which will offer high performance and power efficiency improvements.DeepSeek Panic Triggers Undervaluation in TSM StockTSM’s forward P/E TTM stands at 25, below the sector median and close to its five-year average of 22.4. Its 0.63 PEG ratio stands well below the sector average, underlining attractive growth-adjusted valuation, as does a Non-GAAP Peg of 0.75. Overall, the revenue factors discussed in the previous section will boost TSMC’s top-line moving forward, and any drop in the stock price provide another buying opportunity. Thus, the current PS ratio (11) is near the long-term average and any aggressive top-line growth might bring the ratio down toward the average.Data by YChartsPossible Annual Gross Margin Erosion Over Five Years Due to Overseas OperationsOn the downside, a fundamental weakness for TSM is the financial strain created by its overseas operations (particularly the US fabs). The factors contributing to this issue are smaller-scale operations, higher supply chain prices, and an immature ecosystem in the US fabs. These elements lead to a 2%-3% annual gross margin dilution that may persist over the next five years. Considering TSMC’s quarterly gross margin was approaching ~60%, a 2%-3% dilution translates to a potential erosion of ~$1.7 billion (2.5% of gross margin) annually based on TSMC’s CY24 projected revenue of ~$113B. This loss is significant and can lead to a drop in stock as these overseas operations are not yet yielding margins comparable to Taiwan. The CFO’s acknowledgment that overseas fabs are operating with substantially lower gross margins, which may be potentially as low as 5%-10%, marks this issue. This disparity suggests that TSMC’s US operations may take several years to reach profitability and will create a drag on TSM’s overall bottom-line in the interim.Data by YChartsFurther, TSMC’s strategy to prioritize Taiwan for its most advanced tech nodes is another structural issue. Ramping up new nodes requires proximity to research that is concentrated in Taiwan. This logistical challenge sharply prevents TSMC from deploying its latest tech in overseas fabs like those in Arizona. This limitation may delay the adoption of advanced nodes in critical markets like the US and lead to a strategic vulnerability. If geopolitical tensions surrounding Taiwan escalate, TSMC’s dependence on its local R&D infrastructure may hinder its ability to expand advanced manufacturing globally. In short, this gap could limit TSMC’s market share growth and weaken its long-term competitive lead.Despite approaching a gross margin of ~60% in its last cycle, TSMC’s financials face headwinds that may cap margin expansion in the current upcycle. These headwinds include utilization rates, depreciation costs, and overseas fab operations. Although high utilization rates in Taiwan fabs historically boosted margins, the financial drag from overseas fabs offsets these gains. Additionally, depreciation costs for new fabs, which are head-to-head with top-line growth and consistent across regions, do not compensate for the inefficiencies in overseas operations. This parity in depreciation further highlights the structural cost disadvantages TSMC faces overseas.Data by YChartsEven if utilization improves in overseas fabs, the inherent cost structure differences make it unlikely that these facilities will contribute meaningfully to margin expansion in the upcoming quarters. Therefore, this limitation puts a ceiling on TSMC’s bottom-line growth while it competes with integrated device manufacturers (IDMs) and other foundries.TakeawayTSMC remains a compelling investment with robust top-line growth driven by AI, HPC, and advanced technology adoption, particularly its 3nm and 5nm nodes. While the company projects a 35% YoY revenue growth for Q1-25, supported by strong demand and strategic CapEx allocation, challenges persist with margin dilution from overseas expansion and geopolitical risks tied to Taiwan. Despite near-term headwinds, TSMC’s leadership in cutting-edge semiconductor processes and long-term AI-driven growth trajectory make it a buy on any significant pullbacks.Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. 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