Summary
- QCOM's outlook is optimistic due to the stabilizing smartphone market and China's market recovery due to the easing of COVID-related restrictions.
- Qualcomm will likely ultimately eliminate vestiges of its once top US legal risk, the FTC's failed antitrust challenge to its IP licensing policies.
- The EUV adoption remains on a rising trajectory, and ASML is on track to achieve a remarkable EUV 4-Year CAGR of 23.3%, strongly supporting its growth prospects.
- Both stocks earn a buy rating, but if I had to choose an overweight position, that would be on QCOM due to its more favorable risk/reward profile.
Investment Thesis
The analysis below explores ASML Holding N.V.'s (ASML) (ASMLF) outlook, growth prospects, and a key risk management has managed to hedge effectively, proving ASML's leadership superiority and deep ties in the semiconductor sphere. Secondly, the analysis reviews Qualcomm Incorporated's (QCOM) market outlook, inventory cycle, China's reopening effect, and why 2023 could be a good year for the fabless firm.
Without a doubt, ASML deserves a premium valuation, but from a risk/reward profile perspective, it might not be a perfect entry point. However, ASML operates a monopoly, being far ahead of its competitors, which justifies the buy rating, but I would not overweight a position yet. Similarly, QCOM is a buy in light of the improving market outlook and its historically low valuation levels.
ASML-QCOM Relationship
ASML does not compete head-to-head with QCOM; both companies are part of the semiconductor supply chain. However, ASML is at the top of the supply chain (upstream), running a near-monopoly of its extreme ultraviolet (EUV) systems. ASML's clients consist of Taiwan Semiconductor ( TSM ), Samsung Electronics (SSNLF), and Intel Corporation ( INTC ), and it supplies them with advanced EUV machines that cost $200 million each.
On the contrary, QCOM, a fabless manufacturer (design and sale), does not transact with ASML but relies on ASML's clients to fabricate its chips. Even though both companies are located on the far ends of the supply chain, examining their outlook provides exciting findings for the sector's direction.
ASML's Solid Demand Despite The Downturn
A large portion of the semiconductor industry is experiencing high inventories and weaker demand, which has led to a pullback in demand for memory and lagging-edge foundry/logic equipment. This has a greater impact on ASML's competitors, such as Applied Materials and Lam Research.
ASML's order intake reached €6.3 billion in the last quarter. While this is lower than the extreme booking levels seen in the two quarters before, orders in the final quarter remained robust and in line with recent trends. More than half are concerned with EUV systems, reflecting the prospective demand expectation of the leading chip manufacturers for high-end chips.
As orders again exceeded system sales by a wide margin, the backlog expanded to over €40.4 billion. This level equals more than 2.5 times 2022 system sales, significantly higher than in earlier periods with favorable market conditions. As such, ASML can be optimistic and confident about sales growth this year and projects an increase of more than 25%.
25% growth In 2023? How?
In 2023, ASML projects an increase in revenue of at least 25%, driven by the " fast shipments " of €3.1 billion ($3.4 billion) until 2023, which have not yet been recognized. More specifically, these "fast shipments" are used to expedite the installation of its EUV systems; ASML delays the recognition of its fees and avoids several factory inspections during a short shipment. During the chip shortages of 2020 and 2021, that practice spread widely, although it is now less prevalent as the semiconductor market slows.
Lastly, management considers that similar amounts will occur in 2024. In addition to the €3.1 billion, management expects non-EUV revenue to grow by about 30% , while EUV revenue will be the key growth driver pushing the top line by about 40%. According to ASML, "fast shipments" worth €3.1 billion ($3.4 billion) through 2023 will increase revenue by at least 25% in 2023.
However, based on ASML's shipments, the EUV adoption rate is still increasing. In particular, ASML shipped 26, 31, 42, and 54 EUV tools from 2019 to 2022, respectively. The company remains on track to deliver at least 60 EUV instruments in 2023. Assuming the prediction for 2023, ASML may achieve a remarkable 4-Year CAGR of 23.3%, strongly supporting its growth prospects.
The company further expects underlying demand trends to remain favorable. In response to economic conditions that currently soften chip demand, ASML foresees that the chip production industry will curtail output in the first half of 2023, after which recovery should pick up in the second. TSMC's $32-$36 billion CapEx plan in 2023 compared to $36.3 billion in 2022 implies ASML can still expect solid sales growth this year. TSMC's shipment growth for advanced 3 nanometers (nm) chips and ASML's hefty backlog could contribute to the growth. In addition, the development of 2nm chips at TSMC is on track, which could also support solid demand for ASML's tools.
High-NA Lithography Gear Is Expected Soon
ASML could soon launch its new EUV lithography model . The new model will improve processing speed (throughput) and patterning precision by about 20% over the current model, according to ASML. It is likely to be used to produce 2nm generation chips which may begin in about 2025.
ASML has a dominant market position in leading-edge photolithography and a dominant position in trailing edge. The technology roadmap shows continued demand for its machines that should drive ASP growth and, in turn, gross margin expansion. The company's foundry customers, such as TSMC and Samsung, are aggressively investing in 3nm and 2nm technology and may require more of ASML's EUV lithography gear, which no one else provides. In addition, sales of deep ultraviolet (DUV) tools with higher gross margins might remain strong due to the rising demand for power semiconductors for electric vehicles.
When first introduced, EUV lithography machines processed about 1,000-1,500 wafers daily but can now process about 3,000. Throughput may improve further as customers gain photoresist experience and mask technology advances. ASML is also conducting R&D on its next-generation model "NXE4000F", which has a numerical aperture ((NA)) of 0.33. The ASML lithography machine that is now available is outfitted with a 0.33NA exposure optical system, and work has been ongoing for the past four to five years to develop the 0.55NA exposure optical system, which will be the machine's replacement.
ASML Effectively Owns & Relies On Zeiss SMT
ASML expects to gain significantly from selling its EUV lithography tools for Intel's "Intel 4" and 3-nm process nodes used by its foundry clients. However, the number of lithography systems that ASML can produce may be constrained by the fact that one of the company's primary suppliers, Carl Zeiss SMT GmbH , ((SMT)) is ASML's exclusive source for lenses, mirrors, illuminators, collectors, and other essential optical components. As a result, ASML's revenues and orders would suffer if SMT cannot sustain and increase production levels. In the latest Annual Report 2022 , ASML's management noted:
If Carl Zeiss SMT GmbH were to terminate its supply relationship with us or if Carl Zeiss SMT GmbH is unable to maintain production of optics over a prolonged period, we would effectively cease to be able to conduct our business.
There have been strong ties between ASML and Zeiss for around three decades. In 2016, the company made a strategic move and purchased a minority stake of 24.9% in Carl Zeiss SMT Holding GmbH & Co. K.G., which owns 100% of the shares in SMT to secure the development of EUV imaging technology and enhance its offerings. As a result, in the fiscal year 2021/2022, ASML's total purchases from SMT and its affiliates climbed by 27% in 2021 and 30% in 2022, reaching €2.7 billion and representing close to 31% of Zeiss Group's overall revenues of €8.8 , and ?100% of SMT's 2022 revenue.
The SMT segment led the Zeiss group's overall revenues for 2021-2022, increasing by over 19% YoY, or about twice as much as the next fastest-growing segment. In light of the fact that the Zeiss group's orders have grown by 40% in 2021/22 and that 31% of the group's total revenues come from the SMT segment, we can assume that ASML's orders will continue to expand by high double digits for the foreseeable future, everything else being equal.
Furthermore, ASML's overall exposure to SMT grew in 2022; for instance, advance payments for orders from SMT were €982.8 million and €1.10 billion in 2021 and 2022, respectively, while the loan receivable climbed by nearly three times to €364.4 million. For context, the €2.078 billion ASML's net exposure in 2022 represents around 29% of the consolidated equity of the Zeiss group, which is a sizeable amount, and around 90%-95% of the equity of SMT assuming proportional equity based on sales contribution (31%*€7.17b). Theoretically, ASML can control SMT, as it generates nearly all of SMT's revenue, making the ASML-Zeiss relationship practically hard to end.
QCOM's Market Stabilization & China Growth
The positive outlook for Qualcomm is largely based on its leadership in 5G technology, and the recent agreement with Apple Inc. ( AAPL ) further validates its technological superiority. Thus, it is reasonable to expect significant gains for Qualcomm's QCT division through selling 5G modems and radio frequency front-end components to mobile device manufacturers and a strong push into non-mobile markets. As a result, QCT's fiscal 2022 revenues saw a 39% increase compared to the previous year, driven by higher selling prices, a shift towards more high-end 5G products, and an increase in integrated circuit shipments for mobile devices and higher revenues from IoT.
However, in the short term, Qualcomm will likely face challenges such as high inventory levels and weak demand in Handsets and IoT in the first half of the year, compounding the typical seasonal challenges in the second and third quarters. Nevertheless, Qualcomm could potentially offset these challenges to some extent through new product launches, recent market share gains, and a disciplined approach to operating expenses until the second half of the year, when recovery is expected to begin due to seasonal factors and restocking of depleted inventory.
The headwinds for the smartphone supply chain have been more pronounced than the decline in the industry's sell-through, which has also been admittedly challenged. The double-digit decrease in full-year 2022 smartphone sales was not expected at the beginning of the year. As a result, manufacturers overstocked their inventory due to concerns about being able to procure supplies in case demand improved beyond expectations. This overstocking exacerbated the challenges at the end of the year as suppliers and manufacturers had to deal with the large amounts of inventory built up, despite the slight improvement in actual sales throughout the year.
Looking ahead to 2023, there are several reasons to be optimistic about the prospects of QCOM. Firstly, the smartphone market is expected to stabilize following an 11% decline in 2022, with a recovery in the China market expected due to the easing of COVID-related restrictions. Secondly, they will cycle past the peak inventory digestion in Q4 2022. Lastly, there is the potential for restocking in 2023, led by a return to normal seasonal growth trends. These three drivers will likely improve investor sentiment on Qualcomm's shares and bring attention back to content growth-led outperformance in underlying markets.
The stabilization of the smartphone market is the first step towards a recovery for the smartphone component supply chain. The reopening of China is expected to lead to a return to normal seasonal sales trends. This should translate to a return to sequential growth in 2H 2023 and restocking in anticipation of that growth. While there may be some uncertainty around the return of inventory levels to previous levels, component companies are expected to benefit more and be positioned for growth, given the expected restocking.
The market stabilization should refocus growth drivers on content growth and reassure investors regarding limited downside to consensus estimates. While restocking of component inventory in the channel is likely to be a driver of upside for volumes relative to a flat smartphone market, the primary driver of sentiment on Qualcomm's shares should be the stabilization of the market. This should allow for a return in the Handset revenue boost due to content growth opportunities, as demonstrated by the robust growth in Handset revenue in 2022 despite a declining market. In addition, this stabilization should also reassure investors regarding the limited downside to consensus estimates.
Long-term Trends Remain Positive
Investors are comparing the decline of the P.C. market and the smartphone market. The P.C. market peaked in 2011 and then declined between 2011 and 2019 before experiencing a rebound in 2020 and 2021 due to the pandemic. Despite the volatility in the P.C. market, it is expected to continue to decline at a CAGR of -7% and moderate to a new level of 267 million units in 2023. This consistent decline over a long period suggests that replacement cycles have not improved and are unlikely to change significantly from the long-term run-rate of decline. In comparison, the smartphone market peaked in 2017 and declined in 2018 and 2019 due to extended replacement cycles .
The outlook for consumer spending in China in 2023 is more favorable than in 2022 despite some disruptions in November. During a Communist Party of China meeting on February 16, the government announced a victory over COVID-19. The statement claimed that China has effectively defeated the virus, providing medical care to 200 million individuals infected with COVID-19 since November 2022, including nearly 800,000 patients in critical condition.
Chinese scientist George Gao has stated that the likelihood of new COVID-19 variants emerging in China is low. This is supported by the statement of China's CDC that their ongoing surveillance has not detected any new strains of COVID-19 during the recent outbreak. Gao has reassured the world that there is no need to worry about the emergence of new or unusual variants in China and that the fear around this issue should be alleviated.
QCOM Overhang In The US May Soon Be Over
Qualcomm will likely ultimately eliminate vestiges of its once top US legal risk, the FTC's failed antitrust challenge to its IP licensing policies. Unfortunately, a consumer class action that followed the FTC's suit partially survived dismissal in Q1, prolonging the remaining litigation. Still, the potency of that matter faded with an appellate court order reversing class certification in Q3 2021.
Qualcomm will likely rebuff a consumer antitrust lawsuit over allegedly anticompetitive IP licensing practices. However, the January 6 partial denial of its motion to dismiss means the process will take longer than expected . Moreover, given its strong position in the suit, success in vanquishing the FTC's suit, and tendency to litigate, Qualcomm is unlikely to settle soon. Still, the judge's January 6 decision, which drags out an already protracted case, inches the suit closer to the possibility of a pact just to put the matter to rest. This is especially true if plaintiffs succeed in again winning class certification at the trial court.
Valuation Review
QCOM's P/E multiple of around 12x is lower than the sector median and significantly below long-term multiples for more diversified semiconductor companies. As shown below, QCOM trades substantially below its long-term average multiples, despite limited earnings downside in the near term. On the contrary, ASML trades higher than its 5-year P/E multiple averages of 40x, signaling its resiliency and valuation premium due to its near-monopoly business.
Undoubtedly, growth is the most important factor of a company's valuation, and considering the fact that both stocks share a similar 3-year CAGR of around 21%, QCOM appears undervalued compared to ASML. Moreover, even though ASML enjoys higher long-term growth, QCOM's headwinds might be over in the second half of 2023, returning to double-digit growth in 2024.
Concluding Thoughts
Accounting for ASML's 90% market share in EUV and the expected growth of 40% in this segment for 2023, the company is well-positioned to protect its cash flows for the foreseeable future, justifying the valuation premium and making the firm recession-resilient.
Even though ASML's stock isn't particularly cheap, its monopoly and unique economic moat supported by patents, deep technological ties in the industry, dependency from other semiconductor firms, key chipmaking technology, and its unrivaled pricing power more than justify its premium. ASML is among the finest semiconductor stocks for long-term investors to hold for the long term.
Investors have been concerned about the potential downside to estimates from further consumer spending pullback in relation to the smartphone market. However, the stabilization in the smartphone market and the limited downside to Qualcomm's current consensus estimates, offer an attractive point to QCOM.
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ASML Vs. QCOM: One Has A More Favorable Risk/Reward Profile