ASMLF - ASML: Downgrading To Hold Expect An In-Line Performer Over Coming Months

2023-07-20 16:26:25 ET

Summary

• We’re downgrading ASML Holding N.V. to a hold post Q2 2023 earnings, but we remain confident that the company will outperform in the medium-to-longer term, driven by the strategic nature of lithography spend.
• We believe macro headwinds and a softer EUV growth outlook will weigh on the stock, and don’t expect higher demand for DUV tools by Chinese customers to offset near-term EUV weakness.
• While we expect macro headwinds to continue, we do see the end-market demand bottoming out in H2 2023. We, however, do not see many catalysts in the H1 2024 semicap spend.
• The stock is up roughly 20% since our April note, outperforming the S&P 500 by 7%. We expect the stock price to perform in line over the next 3–6 months.
• We expect ASML to outperform the market in the mid-to-long term and recommend investors explore entry points at lower levels, as we think lithography spending will reaccelerate by H2 2024.

We're downgrading ASML Holding N.V. ( ASML ) to a hold after Q2 2023 earnings results; while we continue to expect ASML to outperform in the medium to long term as lithography spending re-accelerates into 2H24, we see short-term uncertainties due to EUV (extreme ultraviolet) weakness. In the near term, we expect macro headwinds and softer EUV growth to weigh down the stock. Management guided lower for EUV growth this year; EUV growth is now projected to be 25% from the previous estimated 40%. We're seeing end-market demand bottoming out in 2H23, consistent with management's expectations on the Q2 earnings call .

We also extend our bearish sentiment of ASML to its semi-cap peers Lam Research Corporation ( LRCX ) and Applied Materials (AMAT). We're downgrading LRCX and AMAT to hold-ratings; both companies operate in the etching and deposition segments of the semi-cap market; LRCX is more exposed to memory markets, while AMAT is more exposed to logic/foundry markets. We see macro headwinds weighing on wafer output spending, negatively impacting LRCX and AMAT in H2 2023. Additionally, we don't see significant catalysts in 1H24 semi-cap spend.

LRCX is up 48% YTD, while AMAT is up nearly 40%, outperforming the S&P 500 (SP500) by 29% and 21%, respectively. ASML stock is up roughly 20% since our last note in late April, outperforming the S&P 500 by around 7%. YTD, the stock is up 29%, outperforming the S&P 500 by around 12%. We think the semi-cap stocks have captured the expectation of recovery and now recommend investors wait on the sidelines for attractive entry points at lower levels.

The following chart outlines ASML stock performance YTD against the S&P 500, as represented by SPDR® S&P 500 ETF Trust (SPY).

We see ASML being an in-line performer for the next 3 to 6 months. The company is an indispensable semi-cap player manufacturing and designing the lithography machines that are crucial for chip-making; ASML currently has an oligopoly over EUV tools that enable the most advanced higher-performance chip-making processes. Hence, we expect the company to outperform in the mid-to-long run, driven by the strategic nature of lithography spending. Our current downgrade is based on our belief that EUV growth will be lackluster in 2H23 and 1H24 due to weakening end-market demand.

Taiwan Semiconductor Manufacturing Company (TSM, "TSMC") reported 2Q23 early this morning, confirming just how bad the end-market demand is at current levels; revenue slipped 10% Y/Y and 5.5% sequentially. The company also cut capex to $32B from the previous $32 to $36B estimated. We don't see demand for EUV going up in 2H23 due to macro headwinds and customers dealing with higher inventory levels, which will negatively impact EUV utilization. Furthermore, PC and smartphone total addressable market ("TAM") are contracting Y/Y: 2023 PC TAM is estimated to -10% to 18% Y/Y to ~240-260M due to weakness in consumer spilling into enterprise client, and smartphone TAM revised down to -5% to 15% Y/Y to 1.10-1.23B versus the previous expectation of 0-5% Y/Y TAM due to the weakening macro environment. We don't see ASML, LRCX, or AMAT outperforming in 2H23, given the current macro backdrop.

Q2 2023: Higher DUV & Lower EUV

ASML beat top and bottom lines this quarter, reporting revenue of €6.9B, up 27.8% Y/Y, and net profit up 35% Y/Y to €1.9B. Yesterday's earning call can be more or less summed up in the following: ASML expects growth to be higher for DUV (deep ultraviolet), lower for EUV, and flat in the Installed base. Other than guiding for lower EUV growth this quarter, management also guided for higher DUV sales, forecasting more than the previously expected 375 units and anticipating DUV to grow 50% compared to the previous 30%. The uptick in DUV growth is largely attributed to increased demand for Chinese customers; while management is more optimistic that the higher DUV growth can help offset lower EUV demand, we disagree.

While we expect the higher demand for its DUV tools by Chinese customers will offset the near-term EUV weakness, we are somewhat concerned that these Chinese customers are buying ahead of true market demand. We think the DUV demand driven by Chinese customers is not sustainable and cannot support the next leg of growth for the company. We see short-term uncertainty due to weaker demand for EUV tech and a higher risk for wafer fab equipment spending in 2023.

Customers are facing higher inventory levels, causing them to lower EUV utilization and reduce wafer output to adjust to current macroeconomic realities. Advanced logic is weak; capex is driven by advanced logic nodes, and we currently see that advanced logic demand is weak from industry leaders like TSMC. Hence, if the industry leaders are under pressure from macro headwinds, we don't expect demand for the older DUV tools to sustain.

Still, we continue to expect industry orders for lithography EUV tools to reaccelerate in 2024, as DRAM manufacturers will be forced to adopt EUV, and the foundry and logic markets will demand higher-performance EUV tools to fabricate sub-3nm chips in coming years. EUV demand has to pick back up for ASML's outperformance to resume, which we don't see happening in 2H23. The company is guiding for net sales between €6.5B and €7B and a gross margin of 50% for the next quarter. We recommend investors wait for the stock to drop to lower levels to buy.

Additionally, while we understand investor concern over export regulations impacting ASML sales after the Dutch government published new regulations in June regarding export controls of semiconductor equipment, similar to the announcement in March, the controls target advanced chip manufacturing technology. The latest controls require ASML to apply for export licenses with the Dutch government for all shipments of the most advanced immersion DUV lithography systems, and will begin on September 1st.

We're not too worried, and expect the regulations will have minimal impact on ASML. Sales of ASML's EUV systems are already restricted, so the export controls focus on the most advanced DUV tech.

Valuation

ASML stock is trading well above the peer group; we don't believe the higher valuation is a reason to shy away from the stock, as the company maintains an oligopoly over lithography within the semi-cap space due to its EUV tools. On a P/E basis, the stock is trading 39.5x C2023 EPS $18.76 compared to the peer group average of 29.5x. The stock is trading at 11.3x EV/C2023 Sales versus the peer group average of 6.4x.

The following chart outlines ASML's valuation against the semi peer group.

Word On Wall Street

Wall Street is bullish on ASML stock. Of the nine analysts covering the stock, seven are buy-rated, one is hold-rated, and one is sell-rated. The stock is currently priced at $739 per share. The median sell-side price target is $775, while the mean is $735 with a potential -1% to 5% upside.

The following charts outline ASML's sell-side ratings and price targets.

What To Do With The Stock

ASML forecasted short-term uncertainties in 2H23 but raised its outlook for 2023 from prior estimates of 25% growth to 30%. We're constructive on the stock's outperformance in 2024, but don't see the stock working in the near term due to macro headwinds and lackluster EUV demand. We believe ASML and industry leaders (TSMC, Samsung (SSNLF), etc.) are leading indicators for semi-industry trends in 2H23, and hence we have negative views on the semi-space in the second half of the year. We recommend investors wait for more attractive entry points at lower ASML Holding N.V. levels to invest in 2024 growth driven by re-acceleration in lithography spending.

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