2023-03-21 04:15:36 ET
Summary
- ASML has been dominating the lithography market over the past decade thanks to the cutting-edge innovations of the company.
- The company's technological leadership is intact which enables the company to exercise substantial pricing power.
- My valuation suggests the stock is undervalued with a strong upside potential.
Investment thesis
ASML Holding N.V. ( ASML ) is a company that dominates the semiconductor equipment manufacturing business. This strong market position has enabled the company to deliver excellent financial performance over the past decade and to take advantage of favorable trends in the semiconductor industry. The world will continue its journey toward digitization, and the company's state-of-the-art lithography systems are essential to supporting this secular shift. My valuation is that the stock is currently undervalued, making it an attractive investment opportunity.
Company information
ASML is a Dutch semiconductor equipment manufacturer that provides advanced lithography systems to major chip manufacturers worldwide. The company employs over 39 thousand people and has manufacturing and research facilities around the world. ASML has a dominant market share of over 80% in the overall lithography equipment industry. The company claims that it has a 100% market share in Extreme Ultraviolet [EUV], according to the latest annual SEC filing . It is very important to mention, that according to Bank of America , there is no alternative equipment other than ASML EUV machines to make the advanced processors that train algos for Artificial Intelligence [AI] applications. Therefore, the company is well-positioned to benefit from a megatrend of AI.
Apart from good prospects linked to AI, ASML's lithography systems are critical to the production of advanced semiconductors used in smartphones, high-performance computers and other smart electronic devices.
The company disaggregates revenue sales by end-use into two broad categories: Logic, representing about 65% of company's revenues and Memory with approximately 35% of total.
Financials
First of all, I would like to analyze ASML's financial performance on long-term horizon, the last decade would be a good sample for this. 10 years ago, by the end of FY 2013, ASML recorded an annual revenue of $7.2 billion and about 24.5% operating margin. For the year ended December 31, 2022, ASML recorder a $22.7 billion revenue which means a 12.1% CAGR over the last decade. Operating margin also widened significantly to 30.7%. ASML's topline growth was very impressive if we compare to the broad semiconductor market, which grew at about 6.6% CAGR over the last decade from $306 billion in 2013 to $557 billion in 2022 .
Ability to increase revenue at a pace which over the last decade was almost 2 times faster than industry average, was mainly thanks to ASML's dominant position from the technological perspective. The company invests significant part of its expenses to research and development [R&D] with R&D to revenue ratio dancing on average around 16% during the last decade. This enabled the company to collect a strong patent portfolio to become a technological leader. This allows ASML to widen margins via strong pricing power with ability to charge premium prices.
If we narrow down to the latest reporting quarter, which was 4Q2022, which the company announced on January 25, 2023 , there was a beat in both revenue and EPS. The company's revenue increased 29% and EPS were up 5%, both YoY, if foreign exchange fluctuations ignored. The company sold 106 lithography units during the quarter, which is 29% higher than the same quarter year earlier.
For the full FY2022, the company reported a 14% increase in revenues with margins narrowing due to challenging macroenvironment. Operating margin narrowed from 35.12% to 30.70%. Logic segment demonstrated a 4% growth compared to FY 2021 and Memory system revenues rose 34% from year ago. The company's backlog as of FY 2022 year-end was 67% higher than at the beginning of the year.
Despite slowing demand from end markets such as personal computers and smartphones, management expects revenue growth of 25% in 2023 with a slight improvement in margins. According to the management , demand for FY in 2023 exceeds capacity with an order backlog of about € 40 billion, so it will focus on maximizing system performance. ASML has an undisputed leadership position in EUV technology and I expect the company to be able to absorb the increasing demand for its advanced products not only this year, but also in the long term.
The company's balance sheet is very strong with sound liquidity and leverage ratios. Cash and cash equivalents are substantially higher than the total debt amount. Therefore, I believe, the company will be able to sustain both generous investments into R&D together with returning funds to shareholders via both dividends and share repurchase.
Valuation
ASML's valuation has been historically on the higher side thanks to the company's dominant market position, which we can see from Seeking Alpha Quant valuation grades. As you can see from the below table, the company's 5 year average valuation ratios are multiple times higher than sector median multiples.
Therefore, we should compare current ASML multiples with ASML 5-year averages. From this point, we can see that variances across the board are mixed with TTM-based ratios looking fair and FWD-based ratios indicating undervaluation.
To challenge multiples analysis I use discounted dividends model [DDM] here since the company has been consistently paying dividends over last 9 years. For DDM I use WACC provided by Gurufocus , which is at 11.59% but I round it up to 12%. For current dividend I use FY 2024 consensus estimate of $8.13 per share. Dividend growth is always tricky, but from historical data available, to be on the safe side, I implement 5-year average dividend per share growth FY1-FY3 CAGR rounded down to 11%.
Incorporating all the above assumptions into DDM formula gives us stock fair value of $813 per share, indicating 28% undervaluation.
I also refer to third parties to cross-check my valuation. Morningstar Premium indicate ASML stock's fair value at $760 per share, which represents a 17% discount at current levels. Argus Research's 12-month target price is very close to their colleagues from Morningstar since they set it at $775 per share.
Risks to consider
As with any investment, there are risks associated with investing in ASML stock. In the following, I describe the risks that I consider to be material. First, the company's performance is tied to the semiconductor industry, which is cyclical and highly dependent on general economic conditions. A decline in semiconductor demand will have a negative impact on ASML's revenues and earnings. Second, ASML operates globally, exposing the company to geopolitical risks from regulatory changes or trade tensions. Unfavorable changes in the geopolitical environment will undermine the company's financial performance. Third, the company operates in a high-technology environment, which means that failure to keep pace with competitors or new market disruptors will lead to a deterioration in market share, which will affect the company's pricing power and its ability to achieve high margins. Fourth, ASML is dependent on a few large key customers such as Samsung, Taiwan Semiconductor ( TSM ) or Intel ( INTC ). Any churn of these customers to competitors will have a significant negative impact on the company's financial results. However, ASML is by far the market leader, so that this risk can be classified as low.
Bottom line
In summary, I believe ASML stock is a buy as the company has delivered excellent financial results over the past decade, is well positioned to benefit from secular growth in demand for semiconductors due to the ongoing trend toward digitization, and valuation metrics suggest the stock is substantially undervalued.
For further details see:
ASML: Dominating The Business