LRCX - ASML: Don't Chase It To The Sky

Summary

• ASML is a leading wafer fab equipment player with a monopoly in EUV lithography systems, which are necessary for making the world's most advanced chips.
• The US-Netherlands-Japan alliance's chip export restrictions to China threaten to impede its immediate growth prospects.
• Despite the negative sentiment, investors remain unwavering, zeroing in on the company's long-term growth potential.
• But, ASML's expensive valuation demands caution.

When a company has a monopoly in the most advanced lithography machines in the world, like ASML Holding N.V. ( ASML ), it's hard to be so bearish.

Japan and the Netherlands recently joined hands with the US in its chip export curbs to delay and cripple China's semiconductor ambitions. However, ASML has emerged from its momentary pullback toward its December lows and surged higher in 2023.

Lifted by the revival in growth and tech stocks , the market continues to afford ASML a premium valuation against its wafer fab equipment (WFE) peers.

Management highlighted that 18% of its backlog comprised orders from its Chinese customers, not an insignificant metric. With the company's DUV tech making up €7.7B of net revenue in 2022 (relative to EUV's €7B), geopolitical risks remain challenging.

Moreover, management accentuated that non-EUV systems growth is expected to reach 30% in 2023, suggesting investors need to keep the developments of the restrictions in mind.

Despite that, the market has seemed to shrug off the near-term headwinds, focusing on ASML's ability to leverage the secular growth drivers dependent on its technology, including automotive and industrial.

The remarkable recovery in Applied Materials ( AMAT ) and Lam Research ( LRCX ) have likely given investors an impetus to brush off negative headwinds against ASML. Both WFE suppliers were impacted in the earlier stages of Biden's chip export restrictions.

Hence, we believe investors need to focus on whether they have confidence in riding the recovery in ASML as the industry moves further into High-NA EUV lithography systems.

However, the company's growth cadence is expected to slow from 2023, even though management telegraphed a 25% YoY revenue upside this year. Delayed revenue recognition from 2022's fast shipments and deferrals have helped lift its forecasts. Moreover, its robust €40B order backlog proffers investors' revenue visibility through 2024, helping de-risk its FY25 revenue target.

ASML guided for 2025 revenue of between €30B to €40B, with the EUV and DUV capacity increasing to 90 and 600 units, respectively. Based on its 2023 target to ship 60 EUV and 375 DUV systems, there are significant opportunities for growth.

Notably, management articulated that investors should continue to expect gross margin evolution as its systems become more complex. As such, its EUV average selling prices ((ASP)) of €165M to €170M should continue to see upside potential, even though costs should rise as well.

However, we believe it demonstrates the significant market leadership of ASML, as leading logic and memory fab makers require its most advanced tools. Coupled with the attendant effect of lifting DUV revenue, ASML also leverages the drivers in mature nodes. CEO Peter Wennink highlighted:

On top of that, if you have more EUV sales, well, you don't make a chip for a semiconductor device with only EUV. I mean so if you grow the EUV base, we need a lot of deep UV layers. So this is also an extra driver against the background of the fact that we can't ship enough. So this is what is happening. (ASML FQ4'22 earnings call)

As such, there should be no surprise that ASML is not cheap, priced at an NTM EBITDA of 27.1x (Vs. a 10Y average of 21.8x). Therefore, investors who dared to pick up the pieces from the market pessimism in mid-October have been duly rewarded.

ASML had a brief pullback toward its late December lows but has recovered remarkably well.

It's heading closer to re-test its March 2022 highs, with its downtrend bias likely reversed.

Despite that, we are not keen to add at these levels, as its valuation seems aggressive, while growth could slow further post-FY23.

A deeper pullback will likely create a more rewarding reward/risk opportunity to enter or add to positions.

Rating: Hold (Reiterated).

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