Semiconductor FCF Conversion: Why TSM Beats ARM Despite Lower Margins

Last Updated: January 2, 2026 Data Currency: ARM FY2025 20-F, TSM FY2024 20-F, Intel Q3 2025 10-Q. ARM, TSM, INTC

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The FCF Conversion Paradox

Most investors screen for high gross margins, assuming profitability flows to cash. Semiconductor business models reveal why this assumption fails.

Company	Gross Margin	FCF Margin	Conversion Gap	ROIC
ARM	97.0%	4.4%	-93 points	13.3%
TSM	56.1%	63.1%	+7 points	87.2%
INTC	56.2%	-23.7%	-80 points	Negative

ARM's 93-point margin leak and TSM's 7-point margin gain from gross to FCF demand explanation. These aren't rounding errors—they represent fundamentally different capital allocation outcomes that determine long-term shareholder returns.

Understanding Free Cash Flow Margin

Free Cash Flow (FCF) measures the cash a company generates after accounting for capital expenditures:

FCF = Operating Cash Flow - Capital Expenditures

FCF Margin expresses this as a percentage of revenue, showing how efficiently a company converts sales to distributable cash:

FCF Margin = Free Cash Flow / Revenue

Unlike gross margin (which excludes operating costs) or net margin (which includes non-cash items), FCF margin reveals actual cash generation available for dividends, buybacks, or reinvestment. This makes it the ultimate test of business model quality.

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ARM: Where 93 Points of Margin Disappear

ARM Holdings operates the semiconductor industry's purest IP licensing model. With no manufacturing assets, the company should theoretically convert gross profit directly to cash. The FY2025 20-F tells a different story.

The Margin Waterfall

ARM's FY2025 financials show systematic margin erosion:

Metric	Value	Gap from Prior
Gross Margin	97.0%	—
Operating Margin	20.7%	-76 points
Net Margin	19.8%	-1 point
FCF Margin	4.4%	-15 points

The 76-point drop from gross to operating margin reflects ARM's R&D intensity. Maintaining architectural leadership against RISC-V and custom silicon requires continuous investment. This is expected for an IP company.

The 15-point drop from net income to FCF is more concerning.

Cash Conversion Red Flag

ARM's 20-F discloses several factors explaining this gap:

1. Revenue Recognition Timing (ASC 606)

ARM recognizes license revenue at contract signing but collects cash over multi-year terms. The filing notes:

"Significant judgment required in ASC 606 application, including determination of distinct performance obligations, standalone selling price estimation using residual approach when direct observable prices are unavailable, and assessment of contract combination criteria."

This front-loads revenue relative to cash collection—earnings appear before cash arrives.

2. Growth-Phase Capex

ARM's capex increased 138% year-over-year ($219M vs $92M) as the company builds out cloud infrastructure and data center capabilities. The 20-F discloses $912 million in non-cancelable purchase commitments for cloud services, data centers, software, and licenses extending through 2035.

3. Stock-Based Compensation

As a recently-public company (IPO September 2023), ARM carries significant SBC that reduces reported expenses but doesn't generate cash.

Investment Implication

ARM's 13.3% ROIC is mediocre for a company claiming monopoly-like market position in mobile processors. The 97% gross margin creates an illusion of profitability that doesn't translate to capital returns.

The analytical insight: ARM's valuation (currently ~40x sales) prices in the gross margin without discounting for the FCF conversion gap. Investors comparing ARM to other "asset-light" tech companies may miss that ARM's cash generation resembles a growth-stage company, not a mature IP licensor.

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TSM: The Counterintuitive FCF Machine

Taiwan Semiconductor's 63% FCF margin from a 56% gross margin appears mathematically impossible. FCF margin should always trail gross margin because operating expenses, taxes, and capex consume cash between the two metrics.

TSM's FY2024 20-F explains this anomaly.

Why FCF Exceeds Gross Margin

1. Depreciation Exceeds Capex

TSM's mature fab assets generate massive depreciation expense (non-cash) that reduces reported operating income but doesn't consume cash. In mature capital-intensive businesses, depreciation on installed base exceeds maintenance capex, creating cash flow that exceeds earnings.

2. Customer Prepayments

TSM's leading-edge capacity is so scarce that customers (Apple, NVIDIA, AMD) prepay for wafer allocation. These prepayments generate cash before revenue recognition. The 20-F shows substantial deferred revenue and customer deposits.

3. Scale Economics

At TSM's scale, incremental wafer production has near-zero marginal cost once fab capacity exists. The company runs at high utilization, converting fixed-cost depreciation into variable cash generation.

The 87% ROIC Explained

TSM's exceptional ROIC stems from a virtuous cycle:

1. Technology leadership → Pricing power on leading-edge nodes
2. Scale → Lower per-wafer costs than competitors
3. Customer prepayments → Negative working capital
4. High utilization → Depreciation becomes "free" cash flow

Intel and Samsung have tried to replicate this model for decades. Neither achieves TSM's capital efficiency because scale advantages compound—the leader's cost advantage widens with each technology node.

The Risk Disclosure

TSM's hidden liabilities analysis shows significant debt financing fab expansion:

Debt Component	Amount (TWD)	USD Equivalent
Domestic unsecured bonds	NT$478.5B	~$14.5B
Overseas unsecured bonds	NT$507.9B	~$15.4B
Total Debt	NT$926.6B	~$28B
Nearest Maturity	March 2025	—

USD converted at approximately 33 TWD/USD.

This debt funds fab construction for 2nm and advanced packaging. Unlike Intel's debt (discussed below), TSM's borrowing finances capacity that customers have already committed to purchase.

The analytical insight: TSM's FCF margin exceeding gross margin signals a mature, optimized capital base. Investors who see 56% gross margin and assume TSM is "less profitable" than ARM miss that TSM generates 14x more FCF per revenue dollar (63% / 4.4% = 14.3x).

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Intel: The $44 Billion Debt Trap

Intel's Q3 2025 10-Q reveals a company where one-time gains mask fundamental cash burn.

The Headline Numbers Mislead

Intel reported several positive developments in 2025:

• $5.5 billion gain from Altera divestiture
• $5.7 billion in accelerated CHIPS Act disbursements
• Revenue stabilization in client computing

Yet FCF margin remains deeply negative (-23.7%), and ROIC is negative for the fourth consecutive quarter.

Where the Cash Goes

Intel's hidden liabilities analysis from the 10-Q explains the cash drain:

Cash Drain	Amount	Context
Total Debt	$44,057M	$5B credit facility due Jan 2026
Restructuring YTD	$1.8B	Three consecutive quarters
VLSI Litigation	$1.0B	Accrued charge
EC Antitrust Fine	$401M	2009 finding, still accrued
Derivative Liabilities	$5.6B	Altera escrowed shares

The CHIPS Act Illusion

Intel received $5.7 billion in accelerated CHIPS Act funding during 2025. This sounds transformative until you net it against ongoing cash drains:

One-Time Benefits	Ongoing Cash Drains
Altera gain: $5.5B	Restructuring: $1.8B
CHIPS Act: $5.7B	Litigation: $1.4B
Total: $11.2B	Negative operating cash flow

The government funding offsets cash burn rather than funding growth.

Investment Implication

Intel's executive summary from the filing states directly:

"Significant one-time gains from the Altera divestiture ($5.5 billion) and accelerated CHIPS Act disbursements ($5.7 billion) are impacting current financial results."

Translation: Strip out asset sales and government subsidies, and Intel's underlying business still destroys capital.

The analytical insight: Intel bulls point to CHIPS Act funding and foundry aspirations. The 10-Q shows that $11.2 billion in one-time benefits haven't moved Intel to positive FCF. The turnaround thesis requires operational improvement that hasn't materialized in the financial statements.

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Framework: When Each Model Works

ARM: Buy When FCF Conversion Improves

ARM's model becomes attractive when:

• Cash conversion ratio exceeds 0.8x (currently 0.5x)
• Capex intensity normalizes post-growth phase
• Royalty revenue (higher margin) grows faster than license revenue

Current valuation assumes this transition happens. The 20-F doesn't yet show evidence.

TSM: Buy on Capex Cycle Concerns

TSM's best entry points occur when:

• Market fears capex cycle (2nm investment spooking investors)
• Geopolitical risk creates discount (Taiwan Strait concerns)
• Smartphone demand weakness pressures near-term revenue

These concerns are typically transient. TSM's structural advantage—leading-edge monopoly with customer prepayments—persists through cycles.

Intel: Avoid Until FCF Turns Positive

Intel becomes investable when:

• Quarterly FCF turns positive without one-time gains
• Foundry business wins external customers (currently minimal)
• Debt/EBITDA falls below 3x (currently elevated)

None of these conditions exist in the Q3 2025 filing. The turnaround remains a thesis, not a reality.

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The Counterintuitive Conclusion

Surface metrics mislead in semiconductor investing:

Metric	Apparent Winner	Actual Best Performer
Gross Margin	ARM (97%)	TSM (FCF generation)
Government Support	Intel ($5.7B)	TSM (self-funding)
Asset-Light Model	ARM	TSM (scale economics)

The lesson: FCF conversion, not gross margin, determines shareholder returns. TSM's "lower margin" foundry business generates 14x more cash per revenue dollar than ARM's "higher margin" IP licensing.

The Actionable Screen

For retail investors screening semiconductors, invert the typical margin-first approach:

FCF/Gross Ratio	Interpretation	Example
>0.5x	Strong cash conversion	TSM (1.13x)
0.2-0.5x	Acceptable	Industry average
Less than 0.1x	Cash flow concerns	ARM (0.05x)
Negative	Avoid	Intel

Companies where FCF margin exceeds half of gross margin convert profitability to cash. Companies below 0.1x leak value between income statement and cash flow statement.

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Key Takeaways

1. High gross margin ≠ high cash generation. ARM's 97% gross margin produces only 4% FCF margin due to R&D intensity and 0.5x cash conversion ratio.

2. TSM's FCF margin exceeds gross margin because depreciation on mature fabs exceeds maintenance capex, and customer prepayments generate cash before revenue recognition.

3. Intel's $11.2B in one-time gains (Altera + CHIPS Act) mask ongoing negative FCF. The turnaround hasn't materialized in financial statements.

4. Screen using FCF/Gross ratio. Companies above 0.5x convert profitability to cash; below 0.1x signal structural issues.

5. TSM generates 14x more FCF per revenue dollar than ARM despite having 41 percentage points lower gross margin.

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Related Analysis

• Semiconductor Equipment ROIC: Why KLA's 43% Returns Have a Catch — ASML, KLAC, LRCX, AMAT comparison
• Semiconductor ROIC Rankings: QCOM's Licensing Moat — Fabless peer comparison

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Next Update: After ARM Q4 FY2026 earnings (February 2026) and Intel Q4 2025 10-K filing.

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This analysis is for informational purposes only and does not constitute investment advice. Past performance does not guarantee future results. Always conduct your own due diligence before making investment decisions. Data sourced from SEC EDGAR filings using standardized financial metric calculations.