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Is Taiwan Semiconductor Under Threat From a Chinese Chipmaker?

A semiconductor wafer being processed.

Reports have surfaced that China-based contract chip manufacturer Semiconductor Manufacturing International Corporation (NYSE: SMI) plans to go into production on its 14-nanometer (nm) technology at some point in the first half of 2019. Manufacturing technologies designated by smaller nanometer numbers tend to be more area- and power-efficient than technologies designated by larger numbers.

SMIC is by no means a chip manufacturer on the cutting edge of technology. The industry's largest contract chip manufacturer by revenue, Taiwan Semiconductor Manufacturing Company (NYSE: TSM) , began mass production of its comparable 16nm technology in 2015 and has refined that technology multiple times. The latest iteration of TSMC's 16nm technology is referred to as 12nm. (TSMC also has more advanced 10nm and 7nm technologies in production, too.)

A semiconductor wafer being processed.

Processing a semiconductor wafer. Image source: Getty Images.

With SMIC now set to go into production on its 14nm technology, TSMC investors might be worried that additional competition at 14/16nm-class technologies could be a significant negative for TSMC, which generated 23% of its revenue from 16nm/20nm technologies (this includes 12nm, too) in 2018.

Here's why this isn't as big a deal as some might think.

Understanding the competitive landscape

Both TSMC and SMIC are contract chip manufacturers that need to compete to win manufacturing contracts from companies that design -- but don't manufacture -- their own chips, also known as "fabless" semiconductor companies.

There are a number of factors involved when a fabless company chooses a contract manufacturer, but ultimately fabless companies are going to want the best product performance at the lowest cost.

In this case, TSMC has two crucial advantages over SMIC. The first is that because TSMC has been manufacturing 16nm-class technologies for about four years, the company should be a master of building those chips. What that means is that TSMC's yield rates -- that is, the percentage of the chips manufactured that are salable -- should be extremely high. For SMIC, 14nm is a brand-new technology, and it's very likely that the company still isn't enjoying yield rates anywhere close to what TSMC does.

A much higher yield rate for TSMC could mean that it can match SMIC on cost while maintaining substantially higher gross margin, or TSMC could match SMIC on gross margin while dramatically undercutting it on wafer price. Now, SMIC's trailing 12-month gross margin percentage -- at 22% -- is substantially lower than TSMC's -- at 49% -- so TSMC is going to want to price its 16nm/12nm wafers in a way that allows it to maintain high market share while also preserving its gross margin profile.

The second advantage for TSMC is that it has had years to improve and tune the performance of its competing technology. Although I don't have access to detailed performance information for TSMC's 16nm/12nm technologies or SMIC's upcoming 14nm technology, I'd be willing to bet that TSMC's technology offers better power and performance characteristics, which should make TSMC's technology more attractive to customers whose products value power and performance.

TSMC has successfully defended itself in the past

TSMC investors should also keep in mind that the contract chip-manufacturing giant has successfully defended its business against the likes of SMIC at older technology generations. For example, although SMIC is currently mass-producing chips on its 28nm technology, TSMC's business at 28nm is still robust, making up 20% of the company's revenue in 2018.

For some perspective, TSMC generated $34.2 billion in revenue in 2018, meaning that the company's 28nm revenue alone was $6.84 billion -- more than twice SMIC's 2018 revenue of $3.36 billion. And, to provide some additional color, 28nm revenue as a percentage of SMIC's total ranged from 3.2% to 8.6% over the course of 2018, exiting the year at 5.4%.

SMIC's 28nm revenue in 2018 was, at best, a rounding error compared with TSMC's. My guess is that the situation will be no different for TSMC's 16nm-class technologies even once SMIC's 14nm technology is in full production.

Put simply, TSMC shareholders don't have much to fear from the latest news around SMIC's 14nm technology.

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Ashraf Eassa has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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