Taiwan's reform-minded president, Ma Ying-jeou, is making good on his promise to normalize relations with mainland China. The two countries, which have been engaged in a 60-year cross-strait staring contest, have begun to inch toward friendlier ties. China has agreed to let "Chinese Taipei" join international organizations. Chinese tourists have been welcomed to the island -- and even allowed to exchanged their money, something heretofore impossible.

The result of improved diplomatic relations will be an increase in trade. China is already the top destination for Taiwanese goods: Taiwan's exports to China have surged nearly five-fold since 2002 alone. China's fast-growing economy means rising disposable income for mainland consumers, and you can bet they'll spend some of that cash on Taiwanese goods such as flat-panel TVs, computers and networking equipment.

Taiwan Semiconductor Manufacturing (NYSE: TSM, $8.45) is a semiconductor foundry that is bound to benefit from increased Taiwanese exports. The company designs, manufactures, tests, packages and sells semiconductor chips -- also known as "integrated circuits." Chips are the building blocks of all sorts of technologies, including personal computers, cell phones and some household appliances.

Catalysts: The primary catalyst for the company is a growing trend among semiconductor firms to outsource the actual manufacture of chips. Factories for chip production, known as fabrication plants or simply "fabs," are extremely expensive to build, costing billions of dollars.

Even worse, semiconductor technology is constantly evolving and becoming more complex. As any consumer that has ever purchased a new electronic device knows, the prices of products like televisions, PCs and phones tend to drop rapidly the longer that product is on the market. The same situation is true of integrated circuits -- that means operations need to be upgraded on a regular basis to handle the newest, most expensive chips with the highest profit margins.

As a result of all these expenses, a number of major semiconductor producers have decided to change their business model. Instead of building fabs for all the chips they produce, many have decided to design chips in-house and outsource the actual manufacturing. Texas Instruments (NYSE: TXN), a leader in cellular telephone components, is just one of the companies to recently announce plans to outsource chip manufacturing to foundries like Taiwan Semiconductor.

Competitive Advantages: TSM's main advantage is size and scale. The company is the largest chip foundry in the world and, according to the company, controls more than half the global market.

As noted earlier, building and updating fabs is important, yet expensive. Most of these costs are fixed -- up-front construction costs are a perfect example. The trick to squeezing higher margins out of high fixed-cost businesses is volume. Because the TSM accepts orders from dozens of chip companies, it can spread the cost of building new fabs over a huge number of orders. In short, the company garners significant economies of scale in manufacturing.

But size and scale benefit far more than manufacturing. Designing and building more advanced chips requires considerable spending on research and development (R&D). TSM's huge size makes it far easier for them to fund the massive R&D budgets required to innovate new chip designs.

Valuation and Outlook: The stock trades at 12 times estimated 2008 earnings and has a long-term estimated growth rate approaching +18%. That gives the company a price-to-earning-to-growth (PEG) ratio of less than 0.7, cheap by any measure, particularly for a global market leader.

The foundry business is highly competitive, and you might expect these firms to have thin profit margins. But TSM's larger size and more sophisticated R&D operations give it an edge; it's +34% profit margin is roughly double the industry average.

A weakening U.S. economy has cut demand for consumer electronic products and related chips. Nonetheless, sales of electronics in emerging markets, including China, remain strong, offsetting that weakness. And Taiwan's warming relationship with Beijing should open up new markets and allow the firm to invest more heavily in mainland semiconductor foundries -- such plants offer the advantage of extremely low labor costs.

Action to Take --> TSM is a world leader in the foundry industry. While the business is cyclical, strong growth in emerging market demand has offset some of the normal cyclicality over the past few years. TSM looks like a solid long-term "Buy" candidate for more aggressive investors.

-- Paul Tracy
Editor
StreetAuthority Market Advisor

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