The Business Of
Semiconductors | TSMC | What Are Their Margins?
Morning All!
So, yesterday we dug into how TSMC makes money. And we saw that >50% of the company’s $69bn revenue comes from selling their most advanced chips - the 5nm and 7nm chips. We saw that Apple is their largest customer, making up ~26% of TSMC’s revenues. And we saw that for the most advanced chips, TSMC operates in a duopoly. As it’s only TSMC and Samsung who can even manufacture 5nm chips. With the huge market share, some would even say the company is a monopoly!
It’s pretty interesting that in the first two weeks of The Business Of Semiconductors, we’ve come across 2 different duopolies! But anyway, enough with revenues. Today, we’re going to switch gears and look at what costs are required for TSMC to run their operations. The chart below shows us that the huge majority of expenses are to do with cost of revenues and R&D.
As we’ll see further in this newsletter, the margin structure for TSMC is pretty phenomenal. But before we get there, let’s dive into cost of revenues. And see what this cost line is actually made up of!
EUV the MVP…
Okay so, to illustrate what TSMC’s cost of revenues are, let’s first remind ourselves of the value chain with an example. Let’s look at a PC gamer buying a Gigabyte graphics card, powered by a Nvidia Geoforce RTX GPU chip.
So, for the PC gamer, their cost is the graphics card. And they pay Gigabyte, the graphics card manufacturer.
For Gigabyte, their main cost is the GPU chip in the card. And they pay Nvidia, the GPU chip designer.
For Nvidia, their cost is the cost to manufacture the chip. And they pay TSMC, the chip manufacturer.
Now, for TSMC, what’s their cost? And who do they pay?
Well, one major cost for TSMC is the machines and equipment required. And the most expensive machine TSMC needs is the one they purchase from ASML. This machine is called the EUV lithography tool. And the screenshot below shows you what it looks like.
It might be tough to recognise from the photo, but these machines are the size of a bus. And cost an incredible $150 million… each! They’re so big that it requires 40 freight containers, 20 trucks and 3 cargo planes to transport one machine’s parts…
Now, you may be asking - why on Earth does one single machine cost $150m? And that’s a very fair question. But I hope you can wait a week, because we’ll be covering that and much more in The Business Of ASML next week! However, if you can’t wait, we suggest giving this article a browse.
But for now, I think the question to ask is - why do TSMC need these machines? If they cost so much, and are such effort to transport, are they really that necessary? And the answer is a resounding yes! These lithography machines are absolutely essential in creating semiconductor chips.
To understand why, let’s very briefly and simply touch on the process of lithography. So, lithography is the process of using light to create patterns on silicon wafers. And at a high level, that’s pretty much all you need to know! Told you it’d be simple! But how does this process fit into the whole chip-making process?
Well, remember, chip designers (e.g. Apple, Nvidia, AMD) work out how they want their chips to be patterned. Chip manufacturers (e.g. TSMC, Samsung) are the ones who carry out implementing those patterns. And these lithography machines are what manufacturers use to implement those patterns. So yes, every chip manufacturer in the world will need to purchase lithography machines!
But then the next question to ask is - are all lithography machines so expensive? And the answer to that is no. Machines from Nikon and Canon sell for about a third of the ASML machine prices. And these machines will be good enough for TSMC to manufacture the older chips (10nm and above) for customers. But to develop the most advanced (<10nm) chips for customers, the machines from ASML are needed!
Why is that? Well, the normal UV light used by Nikon and Canon’s machines are too big for chip manufacturers to work on the smallest chips. However, this issue was solved when ASML pioneered EUV lithography. The wavelength of the EUV light used by ASML’s machine is so small. Far smaller than the wavelength of visible light. That the machines are able to carve out the billions of circuit patterns found on the smallest chips. Remember, you absolutely need the wavelength of the light to be tiny. Because as we mentioned last week, these 5nm chips are 20,000x smaller than human hair!
Gross Margins On The Loose
So, it’s clear that lithography machines are crucial. But how many of these machines do TSMC actually own? Well, TSMC state that they have ~50% of all the EUV lithography machines in circulation. Given ASML had sent out ~70 of these machines to customers in 2020. It means that TSMC have spent at least $5.25bn (35 x $150m) on these machines!
The other major costs within TSMC’s cost of revenues are employees and the raw materials involved in the lithography process. We won’t go too deeply into these costs. But employees is fairly straightforward - it’s the salaries for the engineers required in the process. And raw materials include the raw silicon wafers and chemicals and gases needed in the process. Putting all these costs together, we can see how TSMC’s gross margins have trended over the last 2 decades in the chart below…
And the chart shows us that despite the high costs of the lithography machinery and the increasing employee counts. The company have been able to control their cost of revenues sensationally well. With TSMC’s gross margin growing from ~37% in 2003 all the way to ~60% last year!
As we mentioned yesterday, TSMC has operated in a near-monopoly when it comes to the manufacture of high-end chips. And this huge market power gives the Taiwanese firm significant pricing power. Strong cost control + increasing chip prices = growing gross margins!
Oh My Goodness - Are Those EBIT Margins Right?
Quite a dramatic heading for this section. But honestly, the EBIT margins for TSMC - which we’ll get to in a moment - deserve an over-reaction like that!
But first, outside of ‘cost of revenues’, the other significant cost line for TSMC is R&D. We saw this last week as well, with Nvidia’s 2022 R&D costs being a very sizeable 20% of revenues. For TSMC, it’s quite a bit less at 7% of revenues. But careful, because whilst that looks like Nvidia invests loads more into R&D than TSMC. That’s actually not the case.
In 2022, Nvidia’s R&D costs totalled $5.3bn whilst TSMC’s was actually higher at $5.4bn. TSMC’s R&D is just a lower % of sales because of the company’s sheer scale - with TSMC’s revenues ($69bn) more than 2x Nvidia’s ($29bn). For TSMC the majority of these R&D costs go towards trying to work out how to make smaller and smaller chips. Because smaller chips = happy customers! TSMC is actually in the process of ramping up R&D for a 1.4nm chip process!
Okay, now let’s put all these costs together. And see what I was saying about the EBIT margin! The chart below shows how TSMC’s EBIT margin has changed since 2003. And yes, you are seeing right. In 2022, the Taiwanese giant had an extraordinary EBIT margin of ~50%!
I’m not entirely sure what to say about this. Companies that command 50% EBIT margins don’t grow on trees. As this paper shows, the average operating margin for companies in the S&P500 index is ~12%. Even the tech industry has an average operating margin of ~20%. So 50% is just extraordinary.
But I suppose TSMC has all the ingredients you’d need for such margins.
A huge market. So potential revenues can be large.
A near monopoly position. So you can raise prices in most years.
And a strong control of costs. So you can raise margins as revenues rise.
I’m very tempted to bring up the TBO EBIT Margin Tracker now. But I’ll resist and save that for Thursday morning as usual. But look out… we may have a new #1 on the chart tomorrow!
10th May 2023
And that’s a wrap for today! I hope you enjoyed diving into TSMC’s margin profile. It really is a pretty special business model. And tomorrow we’ll look at where TSMC spends all their profits!
Have a fabulous day!
The Business Of Team