2023-11-28 17:45:12 ET
Summary
- ASML's sales performance stands out in the industry downturn, with a strong order book and a 25% YoY increase in sales.
- ASML's hold on EUV technology and long-term capital investment decisions give it a unique edge in the market.
- ASML's fundamental shift in market position is evident in its increased adoption of EUV and surpassing sales of AMAT for the first time.
Investment Thesis
ASML Holding N.V.'s ( ASML ) dominance in the lithography market places it in a unique position to capitalize on the growing demand for semiconductors, driven by advancements in areas like Artificial Intelligence, the Internet of Things, and electric vehicles. This advantage is solidified by high barriers to entry in this field, which include extensive capital requirements and sophisticated R&D operations in close collaboration with chip manufacturers.
However, while these factors contribute to a bullish outlook for ASML, one can't ignore its high valuation and its comparatively modest shareholder return policy, particularly in terms of its share repurchase program.
Exemplary Performance Amid Industry Slowdown
ASML's sales performance in the September quarter was notably robust, especially given the current industry slowdown. The company achieved an earnings per share ((EPS)) of $5.07, surpassing expectations by $0.20. Sales grew by 24.5%, slightly missing the market by $92 million. The company sold 11 EUV systems, one unit less than last year. EUVs are ASML's latest lithography tools used to build the semiconductor's blueprint on a resolution as small as 3nm. These systems are expensive, ranging from $100 to $300 million per unit. So, even minor delays in delivering a single unit can substantially impact ASML's quarterly sales. The market quickly overlooked the company's minor quarterly sales shortfall, recognizing the broader upward trend in Extreme ultraviolet 'EUV' lithography systems, as shown below.
ASML's exemplary performance shines brighter when compared to peer companies like Lam Research Corporation ( LRCX ), Tokyo Electron Limited ( OTCPK:TOELF ), KLA Corporation ( KLAC ), and Applied Materials, Inc. ( AMAT ), all reporting sales decline in the same period. So, while the 24.5% YoY growth is softer than in prior quarters, ASML's performance stands out in light of a broader market decline.
Graph created by the author. Data sourced from Seeking Alpha
ASML's market moat extends beyond its monopoly over the EUV market. It's also about the significant commitment customers have to make. Each of these EUV machines is a major investment that takes years to build. Since ASML is the only manufacturer, customers can't afford to cancel orders. If they do, they're back at the end of a long line. This kind of long-term capital investment decision transcends regular industry cycles, underpinning ASML's exemplary performance this year. Backlog orders stood at $35 billion as of October 2023.
What we see right now is the increased adoption of EUV for mass production in logic applications. ASML continues to push the envelope with the development of High NA EUV, with the company expecting mass production orders starting in 2025. This year, ASML sales exceeded that of AMAT for the first time in history, another sign of a fundamental shift in its position.
We also expect further tailwinds from the advent of gate-all-around 'GAA' architecture. GAA represents a significant advancement in transistor design, offering superior electric current flow control compared to traditional FinFET structures. This complexity necessitates using advanced lithography techniques such as EUV for high resolution chips, which ASML provides.
Another tailwind is the expanding margins, as ASML sells more high-end, high-margin EUV products, as shown in the chart below.
This margin expansion, coupled with an increase in the average selling price of EUV equipment, lends confidence in our bullish outlook despite ASML's above-average valuation.
Valuation Risk
Buying ASML at current prices is a bet on long-term semiconductor demand forecast. I believe we are entering a new era of digitalization, accelerated by the advent of Generative AI, secular tailwinds in the auto industry, and increased Internet of Things IoT penetration.
Although the progress path of these technologies is not linear, ASML derives nearly a quarter of its sales from services whose revenue drivers depend on the installed base's level rather than its customers' cyclical capex decisions. This creates a buffer against cyclicality.
Moreover, ASML relies primarily on third-party manufacturers and limits its manufacturing to assembly and testing operations, lowering their risk and fixed cost and allowing flexibility in responding to downturns. This is why, in the past two decades, it only reported a net loss once in 2010 due to non-cash impairment charges after the great recession.
Still, when looking at a valuation of 32x Forward PE, this high valuation is a bit concerning for a cyclical enterprise, regardless of its market position. Our buy rating is predicated on a strong demand starting in 2025. The graph below shows new fab projects in different regions. New fabs translate to higher demand for ASML's lithography units. Many of these projects will come online in 2024 - 2025. Management's confidence is reassuring, with the company expanding its production capacity in preparation for the next wave of demand. This sentiment is shared across ASML and its peers, offering confidence in our hypothesis.
Share Buyback and Dividend
ASML has been successful in managing the cyclical challenges of its industry by constantly innovating and launching new products to mitigate industry downturns. The company has implemented a share buyback program to reduce this cyclicality's effects on investors. However, compared to its peers, the scale of ASML's share buybacks seems relatively modest.
Company | YoY % Change Outstanding Shares 2013 - 2023 |
Tokyo Electron Limited ((TOELF)) | -13% |
Applied Materials, Inc. ((AMAT)) | -31% |
ASM International NV (ASMIY) | -22% |
KLA Corporation ((KLAC)) | -18% |
LAM Research Corporation ((LRCX)) | -19% |
ASML | -10% |
Similar to its repurchase program, ASML's dividend policy is also opportunistic, characterized by a variable distribution policy that fluctuates based on economic conditions. This contrasts AMAT's stable distribution approach and LRCX's dividend growth policy. What is common among all WFE companies is a prudent payout ratio designed to withstand economic fluctuations.
Company | Cash Dividend Payout Ratio (5-year average) |
ASML | 39% |
KLA | 30% |
AMAT | 21% |
ASMIY | 39% |
LRCX | 26% |
Summary
ASML, a leading Wafer Fabrication Equipment company, plays a crucial role in the semiconductor industry, comparable to selling shovels in a gold rush. With a leading position in the lithography market, it stands to benefit from rising demand for advanced semiconductors, supported by long-term secular trends such as AI, sustainable energy, and IoT.
The company is the sole provider of EUV lithography machines essential for advanced chip manufacturing. This monopoly creates a significant moat. The development of High NA EUV technology and its anticipated adoption by 2025 not only demonstrates its commitment to technological advancements but also creates a medium-term catalyst for growth. Its financial performance, especially considering the current downturn, is encouraging. Increasing ASP, margins, and sales assuage some valuation-related concerns. We also see room to further enhance the share repurchase program and dividend as the company continues to benefit from rising demand for WFE.
For further details see:
ASML: 3 Key Elements Mitigating Valuation Concerns