Taiwan Semiconductor Manufacturing Company

Analysts:

JeBang Ahn, Michael Chen, Brian Chung, Eric Sanchez, Sapan Shah

Agenda

• Case Overview

• Country Risk Analysis

• Company and Industry Overview

• Market Analysis

• Financial Analyses

– Ratios– Discounted Cash Flows– Comparable Companies– Black-Scholes Options Pricing

• Conclusions

• Questions & Answers

Case Overview

“Things are not always as they seem”

Managed Funds Performance

• Mutual funds investing in technology and science stocks have plummeted 43% in 2002

Source: Lipper

2002Fund ReturnsMarketocracy Tech Plus -10.20%Jacob Internet Fund -13.00%Franklin Cust Dyna A -19.90%Fidelity Select Software -23.40%Kinetics Internet A -24.30%Kinetics Inet Emerg NL -24.70%Matthews Asian A Tech -24.90%Turner Energy&P Tech II -26.60%W&R Adv Science & Tech A -26.80%Wasatch Gl Science & Tech -27.80%

Avg. science & tech fund -43.00%

Case Overview

• Assist investment manager in determining whether to invest in Taiwan Semiconductor Manufacturing Company– Is the current stock price an attractive entry level for

investors? If so,

– Decisions to make – invest in equity (Taiwan or ADR), or wait and purchase call options

– Does the Shanghai foreign direct investment add to the Company’s intrinsic value?

Agenda

• Case Overview Country Risk Analysis

• Company and Industry Overview

• Market Analysis

• Financial Analyses

– Ratios– Discounted Cash Flows– Comparable Companies– Black-Scholes Options Pricing

• Conclusions

• Questions & Answers

Taiwan

Country Overview

• Taiwan, Republic of China– Governmental System

• Multiparty democratic regime headed by popularly-elected president (Chen Shui-bian)

• Major Political parties are the Democratic Progressive Party (DPP), Kuomintang (KMT), and People First Party (PFP)

– GDP: US$ 281,300 Million

– Current Account Balance: US$ 18,861 Million

– Foreign Reserves (excl. gold): US$ 122,211 Million

– External Debt: US$ 18,900 Million

– Inflation Rate: 0.5%

- Figures for 2001

GDP Growth

Export Partners

Hong Kong, 22.00%

US, 22.50%Others, 38.10%

Germany, 3.60%

Netherlands, 3.40%

Japan, 10.40%

Country Risk Analysis

• Political– Alleviated political tension with Mainland China– Government (DPP) strongly advocates for foreign investment– Alliance between Kuomintang and People First Party looks

promising in next Presidential election in 2004

• Economic– Strong Current Account Balance and Foreign Reserves– Free and liquid capital market with high trading volume– To stabilize market, daily price fluctuation is limited:

• Stocks and convertible bonds: 7%

• Bonds: 5%

…of the closing price of the preceding business day

Country Risk Analysis

• Intangibles

– Chairman/CEO Morris Chang • Advice is highly regarded and valued by the government as

well as business sphere– In 1985, Taiwanese government recruited him to head its Industrial

Technology Research Institute (ITRI)

• Ph.D in Electrical Engineering from Stanford University• Masters in Mechanical Engineering from M.I.T.• Board of Directors of Goldman Sachs• Cognizant of corporate governance issues

China

Country Overview

• China– Population: 1,273 Million

– Governmental System • Communist State• President and vice president elected by the National

People’s Congress for five-year terms (President Hu Jintao)

– GDP: US$ 1,159,000 Million

– Current Account Balance: US$ 17,400 Million

– Foreign Reserves (excl. gold): US$ 215,600 Million

– External Debt: US$ 147,700 Million

– Inflation Rate: -0.8% (2002 E)

- Figures for 2001

GDP Growth

Export Partners

Germany, 3.70%

UK, 2.60%

Netherlands, 2.70%

Singapore, 2.20%

South Korea, 4.70%

Japan, 16.90%

Hong Kong, 17.50%

Others, 29.30%US, 20.40%

Country Risk Analysis

• Political– Admittance to WTO has led to further liberalization of rules

and statutes– Current President Hu Jintao and his predecessor Jiang

Zhemin have embraced western ideals (i.e. FDI)– “Roach Motel” – strict capital controls has created difficulty

in ceasing operations if deemed unprofitable

• Economic– Utilized considerable foreign reserves in maintaining a

constant currency exchange rate– Focus on infrastructure development (soft-budget policy)– Currently improving Mergers & Acquisitions regulations

Exchange Rate Stability

Exchange Rate Fluctuation(RMB Per Unit Of Currency)

99.25

99.50

99.75

100.00

100.25

1997 1998 1999 2000 2001

US Dollar HK Dollar

Agenda

• Case Overview

• Country Risk Analysis Company and Industry Overview

• Market Analysis

• Financial Analyses

– Ratios– Discounted Cash Flows– Comparable Companies– Black-Scholes Options Pricing

• Conclusions

• Questions & Answers

Company Overview

• Leading dedicated Integrated Circuit (IC) foundry– IC used for microprocessors, graphics chips, wireless

communications platforms and programmable logic devices

– Currently operates 7 wafer fabrication plants and 3 joint ventures

• Major customers include:– Altera, Nvidia, Motorola, Texas Instruments, and others

• Listed on:– Taiwan Stock Exchange (TW 2330)

– New York Stock Exchange (NYSE: TSM ADR)

Company Overview

Company Overview

• Sales – FY 2001 = 125,885– FY 2002(E) = 158,645– FY 2003(E) = 192,817

• Net Income– FY 2001 = 14,483– FY 2002(E) = 22,755– FY 2003(E) = 33,189

- Figures in New Taiwanese Dollars (Millions)

Regional Sales

USA67.4%

Asia26.6%

Europe6.0%

Industry Overview

• Integrated circuits are semiconductor wafers containing resistors, capacitors, and transistors– Used for a variety of devices, including microprocessors,

audio and video equipment, and automobiles

• TSMC has grasped approx. 60% of IC market

• Pure-play competitors’ market share:

Industry Overview

• Current state– Slow growth due to excess production in the late 1990’s,

leading to high inventory levels

– Scaled back capital expenditures

– Pricing pressure due to market over-saturation

– A leading source of growth is the wireless communications sector, which is a significant portion of the Company’s revenues

Agenda

• Case Overview

• Country Risk Analysis

• Company and Industry Overview Market Analysis

• Financial Analyses

– Ratios– Discounted Cash Flows– Comparable Companies– Black-Scholes Options Pricing

• Conclusions

• Questions & Answers

5-Year Stock Chart

Earnings Per Share

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

1998 1999 2000 2001 2002 (E) 2003 (E) 2004 (E)

Price/Earnings

0.00x

10.00x

20.00x

30.00x

40.00x

50.00x

60.00x

70.00x

80.00x

90.00x

100.00x

1998 1999 2000 2001 2002 (E) 2003 (E) 2004 (E)

Market Analysis

• Book-to-Bill Ratio has been below one over the past year– Measures the orders shipped to new orders received

– However, there are signs of life

• Investor Sentiment– Suspicious in regards to high-technology stocks

– Poor performance of competitors in the industry

• Should the investment manager invest in the Company’s Common Stock or ADR?

Taiwan Trading Volume

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Analyst Recommendations

Broker Recommendations:

This Month Last Month 2 Months Ago 3 Months Ago

Strong Buy Buy Hold Sell Strong Sell Mean*

3 4 0 1 0

1.85

2 3 3 0 0

2.1

1 3 3 0 0

2.3

1 4 2 0 0

2.1

* (Buy) 1.00 - 5.00 (Sell)

Agenda

• Case Overview

• Country Risk Analysis

• Company and Industry Overview

• Market Analysis Financial Analyses

– Ratios– Discounted Cash Flows– Comparable Companies– Black-Scholes Options Pricing

• Conclusions

• Questions & Answers

RatiosRisk Ratios 1999 2000 2001 Current Ratio 2.261

0.893 1.965 2.298

2.124 2.919

Quick Ratio 1.623 0.734

1.389 1.955

1.620 2.522

Accounts Receivable Turnover 7.603 8.135

8.232 9.147

5.787 4.857

Inventory Turnover 9.342 8.037

9.018 8.291

8.157 7.338

Debt/Equity Ratio 0.363 0.301

0.216 0.183

0.190 0.259

Interest Coverage Ratio 9.535 0.599

24.519 21.757

4.431 -0.104

Profitability Ratio 1999 2000 2001 Profit Margin 0.339

0.659 0.404 0.469

0.133 -0.023

Return on Assets 0.159 0.179

0.222 0.237

0.046 -0.005

Return on Common Equity 0.230 0.120

0.314 0.243

0.054 -0.011

Industry Sales Growth

1999 2000 2001 CAGR

Taiwan Semiconductor Manufacturing 2,195.2 4,781.3 3,621.5 18.16%Winbond Electronics 930.6 1,414.2 694.2 -9.30%United Microelectronics 970.5 3,325.9 2,008.5 27.44%Advanced Micro Devices 2,857.6 4,644.2 3,891.8 10.84%Tower Seminconductor 69.8 104.8 52.4 -9.14%ASE Test 270.3 440.3 298.5 3.37%Chartered Semiconductor 694.3 1,134.1 462.7 -12.65%ON Semiconductor 798.7 2,073.9 1,214.6 15.00%Advanced Semiconductor Engineering 938.1 1,464.1 1,103.8 5.57%

Average 5.48%

(In $US Millions)

Sales Growth Determination

• Used a 4.70% growth rate for 2005-2007– 2002-2004 I/B/E/S estimates relatively high, as Company

benefits:• Status as industry leader• Continued trend towards outsourcing

– Businesses expected to replace information technology components

– High growth rate is not expected to continue:• Company already possesses a sizable portion of IC market• Industry consolidation is expected, increasing competition for

a currently stagnant industry

Pro Forma Cash Flows2000 2001 2002 2003 2004 2005 2006 2007

Revenues 166,198 125,885 158,645 192,817 248,116 259,777 271,987 284,770

Cost Of Goods Sold (89,682) (92,228) (116,229) (141,265) (181,779) (187,299) (193,111) (197,915) Cost Of Goods Sold Margin 54.0% 73.3% 73.3% 73.3% 73.3% 72.1% 71.0% 69.5%

Operating Expenses:Research and development (5,132) (10,649) (13,420) (16,311) (20,989) (21,975) (23,008) (24,090) General and administrative (7,408) (7,940) (8,599) (9,313) (10,086) (10,923) (11,829) (12,811) Marketing (2,682) (2,290) (2,886) (3,508) (4,514) (4,726) (4,948) (5,181) Total Operating Expenses (15,221) (20,879) (24,905) (29,131) (35,588) (37,624) (39,785) (42,081)

EBIT 61,295 12,778 17,510 22,421 30,748 34,854 39,091 44,774 Depreciation & Amortization (41,446) (55,323) (66,941) (76,045) (86,387) (98,135) (111,138) (122,586) EBITDA 102,741 68,101 84,451 98,465 117,135 132,989 150,229 167,359 Tax Benefit (Provision) 1,168 3,741 4,714 5,730 7,373 7,719 8,082 8,462 Tax Shield On Facility Loan - - - - 2 2 2 2

Operating Cash Flow 103,909 71,842 89,165 104,195 124,510 140,711 158,313 175,823 NetWorking Capital (12,502) 8,297 (4,149) (5,601) (19,004) (7,537) (8,072) (8,758) Capital Expenditures (2,107) (5,121) (6,196) (7,039) (39,210) (9,083) (10,287) (11,346)

Free Cash Flow 89,299 75,018 78,821 91,556 66,296 124,090 139,954 155,719

Note: Chinese Manufacturing Facility Assumed To Be Fully Operational By 2005.

Shanghai Mfg. Facility

• Will be used to manufacture 8-inch wafers– Cost of Goods Sold Implications – lower direct labor costs,

tariff reductions and tax breaks

• Cost of Factory = NT$ 31,214 Million• Sources of Funds:

– Cash = NT$ 12,896 Million– Leverage = NT$ 14,530 Million– Retained Earnings = NT$ 3,789 Million

• Exchange Ratio = 34.8 NT$/US$• Assumptions:

– Interest rate = Company’s Cost of Debt– Tax Rate = 15%

International Cost of Capital

• Goldman Integrated Model for Cost of Equity– US Risk-Free + Sovereign Yield Spread + Beta (World

Historical Risk Premium)

– Beta (ADR relative to S&P 500) = 0.9

– US Treasury 10-Yr Bond Yield = 3.96%

– Taiwanese Government 10-Yr Bond = 2.16%

– S&P 500 Historical Returns = 8.00%

– Cost of Equity = 5.80%

International Cost of Capital

• Cost of Debt calculated through Altman Z-Score– Altman Z-Score: 3.25+6.56*X1+3.26*X2+6.72*X3+1.05*X4

– X1 = Working Capital / Total Assets = 0.10

– X2 = Retained Earnings / Total Assets = 0.10

– X3 = EBIT / Total Assets = 0.03

– X4 = Book Value / Total Liabilities = 3.11

• Comparable Bond Rating = AA+

Adjustment of Altman Score

• No adjustment for foreign currency fluctuation– Low vulnerability of revenues (73.3% of revenues outside

Asia)

• No adjustment for industry risk– Very low leverage industry

• No adjustment for competitive position – Leading player, but not considered dominant due to

competition

• +2 adjustment for Market vs. Book Value– Market Cap (NT$ 875,275 Million), Book Value (NT$

295,853 Million)

Adjustment of Altman Score

• No bond specific adjustment– Some unsecured debt outstanding, but unsure about

contingencies (collateral, guarantees)

• No sovereign risk spread adjustment– Taiwanese yield slightly lower than comparable US Bond

yield

Debt Rating Conclusion

• EM Adjustment suggests AAA

• Company Rating on Taiwan Ratings Agency (Affiliate of Standard & Poor’s) = AA+

• We, conservatively, used AA+ as the credit rating for the Company

• Cost of Debt = 3.06%– Taiwan Government 10-Yr Bond Yield = 2.16%

– Bridge spread for AA+ Bond = .90%

WACC Assumption

• Weighted Average Cost of Capital = 5.28%

• Assumptions:– Constant Debt/Equity Ratio of .19

– BV of Equity (from Company) = NT$ 295,853 Million

– Projected Debt = NT$ 56,343 Million

Discounted Cash Flows

• Three cases:– Case 1: Precedent Transactions Multiple

– Case 2: Technology Industry Multiple

– Case 3: Gordon Growth Model

Case 1 DCF

• Used 3 mergers & acquisitions transactions to determine EBITDA Multiple to be applied– Target companies integrated circuits manufacturers– Min PP/EBITDA Multiple of 12.19x– Implied value per share = NT$ 112.06– Implied value per share (ADR) = US$ 16.12

Target Acquirer Purchase Price / EBITDA Dallas Semiconductor Maxim Integrated Products 12.19x Telcom Semiconductor Microchip Technology 17.94x Jumptec Industrielle Computer Kontron AG 34.96x

Case 2 DCF

• Technology industry multiple used to calculated terminal value– Typical PP/EBITDA Multiple = 7.00x

– Implied value per share = NT$ 75.95

– Implied value per share (ADR) = US$ 10.93

Case 3 DCF

• Gordon Growth Model to calculate terminal value– TV = FCF /(WACC – LT Growth)

– LT Growth Rate = 2%

– Implied value per share = NT$ 223.43

– Implied value per share (ADR) = US$ 32.24

DCF Conclusion

• DCF Range of Values: – Based on Taiwanese Stock: NT$ 75.95 – 223.43

– Based on US ADR: $10.93 – 32.24

• Current Price Per Share:– Taiwanese Exchange = NT$ 47.00

– New York Stock Exchange = $ 8.18

“The Force is strong with this one” - Star Wars

Sensitivity Analyses

112.06 3.28% 4.28% 5.28% 6.28% 7.28%6.19x 76.41 73.32 70.39 67.62 64.98 9.19x 99.35 95.18 91.24 87.50 83.96 12.19x 122.30 117.05 112.08 107.38 102.93 15.19x 145.24 138.91 132.92 127.26 121.90 18.19x 168.18 160.77 153.77 147.14 140.88 21.19x 191.13 182.64 174.61 167.03 159.85 24.19x 214.07 204.50 195.46 186.91 178.82

Case 1: Discount Rate vs. Terminal Value Multiple

Case 2: Discount Rate vs. Terminal Value Multiple

76.00 3.28% 4.28% 5.28% 6.28% 7.28%6.00x 74.96 71.93 69.07 66.36 63.78 6.50x 78.78 75.58 72.54 69.67 66.95 7.00x 82.61 79.22 76.02 72.98 70.11 7.50x 86.43 82.87 79.49 76.30 73.27 8.00x 90.25 86.51 82.97 79.61 76.43 8.50x 94.08 90.15 86.44 82.92 79.59

Sensitivity AnalysesCase 3: Discount Rate vs. LT Growth

224.14 3.28% 4.28% 5.28% 6.28% 7.28%0.50% 285.03 207.60 162.63 133.28 112.63 1.00% 341.16 234.94 178.43 143.38 119.54 1.50% 428.83 272.13 198.41 155.60 127.64 2.00% 584.98 325.62 224.48 170.67 137.28 2.50% 941.33 409.16 259.93 189.73 148.94

Comparable CompaniesPrice/Earnings Price/Book Price/Sales EV/EBITDA

Taiwan Semiconductor Manufacturing 60.43x 3.16x 6.95x 13.06xWinbond Electronics NM 0.94x 2.59x NMUnited Microelectronics NM 0.05x 0.15x 0.46xAdvanced Micro Devices NM 0.63x 0.57x 3.01xTower Seminconductor NM 0.48x 2.31x NMASE Test NM 0.49x 0.98x 3.78xChartered Semiconductor NM 0.59x 2.03x 16.56xON Semiconductor NM NM 0.20x 19.07xAdvanced Semiconductor Engineering NM 0.21x 0.23x 4.25x

Max NM 3.16x 6.95x 19.07xMean NM 0.73x 1.78x 6.69xMedian NM 0.54x 0.98x 4.25xMin NM 0.05x 0.15x 0.46x

Conclusion

Multiple Range of Values Price / Book 0.05x – 3.16x

Price range: NT$ 0.73 – 47.00 Mean: 10.83

Price / Sales 0.15x – 6.95x Price range: 1.01 – 47.00 Mean: 12.03

Enterprise Value / EBITDA 0.46x – 19.07x EV range: 1.68 – 69.73 Mean: 24.45

• Multiples serve as a testament to the relative strength of the Company– TSMC at the higher end of each respective multiple– Market price may be high, relative to competitors, as investors

recognize:• Robust Cash Flows, Revenues and Balance Sheet

• Company as industry leader

Black-Scholes Pricing

Assumptions: Intinsic Value of Call:Current Stock Price (S) 7.75$ Call Price 0.35$ Exercise Price (E) 7.50

Yrs. Till Exp. (t) 0.33 d1 1.81

d2 1.78

10-Yr Treasury 3.96% NormDist(d1) 0.965

Variance 0.20% NormDist(d2) 0.963

Prevailing Market Call Price 0.95$

Formulas:a. Call Price = [S * NormDist(d1)] - [E * e(-rt) * NormDist(d2)]

b. d1 = [ln(S/E) + t * (r + .5(Var))] / (Var * t).5

c. d2 = d1 - (Var * t).5

Agenda

• Case Overview

• Country Risk Analysis

• Company and Industry Overview

• Market Analysis

• Financial Analyses

– Ratios– Discounted Cash Flows– Comparable Companies– Black-Scholes Options Pricing

Conclusions

• Questions & Answers

Insight / Take Home Points

• Investors should not be averse towards investing in a particular sector/industry– Due Diligence

– Use of various methodologies to evaluate equity

• Ride the wave– Investment in technology companies could be a profitable

venture in the long run

• If there is the potential to make “a killing,” pull the trigger

Insight / Take Home Points

• “ … 從過去的財報數字中，我們從巴菲特 (Warren Buffet) 選股邏輯的複式篩選，選出了下列完全符合條件的八檔公司，其中前五名包括有億豐、中華、台積電、裕隆、寶成…”

• “…By using Warren Buffet’s highly-regarded

methodology, TSMC will be selected as one of the eight companies to invest in Taiwan.”

- Taiwan Economic Information Co.

Insight / Take Home Points

Taiwan Semiconductor Manufacturing Company

“Will Be Back!!!”

Q & A Session