ASML is a hidden tech gem

ASML (NL:ASML) is not a household name but it is a linchpin of modern technology, enabling the electronic devices we use every day. Dual-listed in Amsterdam and New York, the group describes itself as “the most important tech company you’ve never heard of” as it supplies the ‘lithography’ machines that are essential for manufacturing semiconductors. ‘Lithography’ is the use of light to print tiny circuit patterns onto silicon wafers. The group’s customer roster includes all of the major chipmakers such as Intel (US:INTC), Samsung (KR:005930) and Taiwan Semiconductor Manufacturing Corp. (TW:2230).

The semiconductor industry currently relies on ‘deep ultraviolet’ (DUV) lithography systems which, right now, are ASML’s biggest source of revenue. DUV systems accounted for almost 50 per cent of the €11.8bn (£10.7bn) of sales the group generated in 2019. While ASML is not the only maker of DUV equipment – its main competitors are Nikon (JP:7731) and Canon (JP:7751) – it has amassed a near 90 per cent market share.

While that’s an impressive feat, ASML’s next stage of growth could be even more so. It has spent two decades developing ‘extreme ultraviolet’ (EUV) lithography, which should form the basis for a new generation of semiconductors. Indeed, the 5 nanometre (nm) chip being used in Apple’s (US:AAPL) new iPhone 12 was produced using ASML’s EUV technology.

The evolution of the chip industry is underpinned by ‘Moore’s Law’, which states that the number of components that can be squeezed on to a chip should double every two years. Some are predicting that chips are now so small that this law – which was first formulated in 1965 – may finally have reached its end point. But EUV should allow manufacturers to continue along the general trajectory, producing smaller and more powerful chips, and to do so more quickly and efficiently. As a pioneer of this technology, ASML has a monopoly in EUV systems, granting it considerable pricing power. The average selling price of an EUV system was €108m in 2019, versus €58m for a typical DUV set-up. As prices are set to increase as more chipmakers transition to EUV, JPMorgan forecasts that sales of these systems will overtake DUVs from 2021.

Powering up

ASML’s dominant market position has made it a popular pick among UK funds, including the Ninety One Global Franchise Fund (GB00B7WN9P32) where it is a top 10 holding. “ASML operates in a critical stage of the semiconductor manufacturing process,” says portfolio manager Clyde Rossouw. “The firm is able to monopolise this critical position as there are significant barriers to entry due to the technological complexity and intellectual property involved in manufacturing lithography equipment to the high standards required.”

The group is also a top 10 holding of the Scottish Mortgage Investment Trust (GB00BLDYK618), which is similarly enthused by its monopoly position as well as its ability to tap into structural growth drivers. “Demand for semiconductor chips looks set to grow with the electrification of vehicles, 5G technology and the Internet of Things, meaning ASML has several rapidly expanding global markets to grow into,” says Stewart Heggie, investment specialist at Scottish Mortgage. Indeed, ASML should be both an enabler and beneficiary of the tech megatrends we are likely to see unfold over the coming decades.

ASML has built up its competitive advantage by investing in product innovation – Mr Heggie characterises chief executive Peter Wennink and chief technology officer Martin van Der Brink as being “unrelenting in their pursuit of continued improvement”. The group spent almost €2bn on research and development (R&D) in 2019, equivalent to around 17 per cent of net sales. ASML also uses a ‘customer co-investment program’, allowing chipmakers to purchase a minority equity stake and help fund R&D activities. Intel, Samsung and TSMC have all previously used this facility, cashing out once the technology has been developed.

The group’s technological edge has underpinned high margins. The gross margin came in at 47.5 per cent in the third quarter of 2020, with an operating profit margin of 30.7 per cent. ASML has guided that the gross margin will improve to 50 per cent in the fourth quarter. EUV systems are lower margin at present with a gross margin of around 40 per cent, but as production ramps up, ASML is guiding that the EUV margin will catch up to the DUV margin over the next two to three years. Bank of America predicts that the EUV and DUV gross margins will be level by 2025. As sales and margin increase, ASML’s earnings momentum is set to continue (see chart).

ASML was aiming to produce 35 EUV systems in 2020, but says it will fall just shy of its target. This is not down to pandemic-related issues; rather it stems from Intel experiencing delays with the production of its new 7nm chips due to a defect. Still, ASML is aiming to build 45 to 50 EUV systems this year and is guiding that EUV sales will grow by a fifth year on year to €5.4bn.

There could be a further Intel complication ahead, though, as it comes under pressure from activist investor Third Point to ditch its chipmaking business. But analysts at Liberum believe this could work out well for ASML if Intel outsources its chipmaking activities to TSMC. This is because ASML is the sole supplier to TSMC for lithography technology whereas it competes with Nikon for work at Intel.

Caught in the middle

Semiconductors have become a key battleground between the US and China under the trade war initiated by President Trump. China is not an insignificant part of ASML’s revenue picture, contributing to 12 per cent of net sales in 2019. The US recently placed China’s largest chipmaker, Semiconductor Manufacturing International Corp (CN:0981) (SMIC), on its ‘Entity List’, which means a government licence is required to export technology from US soil to the company. SMIC is an AMSL customer, but Liberum estimates that it accounts for less than 1 per cent of the group’s revenue.

ASML can circumvent US restrictions to a certain extent by shipping its DUV systems from the Netherlands to China. But as the US leans on its European allies, the Dutch government has held off on renewing a licence to allow the group to ship its EUV systems from the Netherlands to China. It is unclear when or if this will be granted. In the longer term, as China looks to become more self-sufficient, a domestic rival could conceivably develop its own EUV system. But it would have to start from scratch, competing with ASML’s heavy investment and decades of experience. In the meantime, the incoming Biden administration could ease trade war headwinds, although Mr Biden’s specific strategy vis-a-vis China as yet remains unclear.

Moore to come?

ASML was sitting on €219m of net debt at the end of September, but consensus estimates see it finishing 2020 with a little over €900m of net cash. The group has maintained a year-end net cash position for over a decade and it also has a good track record of annual free cash flow generation. This has enabled it to invest in acquisitions – such as the €2bn purchase of lithography light source supplier Cymer in 2013, which helped advance the group’s EUV technology – and reward shareholders through dividends and buybacks.

Having been weighed down by the semiconductor downturn of 2018/19, ASML’s shares have been gathering momentum over the past year, rising by over 50 per cent. Currently trading at 41 times consensus 2021 earnings with an enterprise value to operating profit ratio of 37, this is not a bargain-bucket stock. The question for new investors is whether this is an appropriate time to buy.  

The semiconductor industry has moved to an upswing, meaning that a cheap entry point could be hard to come by. Even in the event of another downturn, ASML should prove more resilient as capital expenditure on EUV lithography is likely to be maintained as chipmakers focus on the long-term picture. “ASML’s dominant market position and enhanced structural growth characteristics should arguably leave it more insulated than in the past,” says Sammy Dow, assistant fund manager at the Rathbone Global Opportunities Fund (GB00B7FQLN12), which holds the shares. Service revenue from a growing installed base and an order backlog should also prove defensive.

Just like fellow semiconductor player Nvidia (US:NVDA), we think ASML’s long-term growth story is worth paying up for as we are only at the cusp of the next era of technological progress. As Mr Heggie points out: “ASML may be the technology company that most people have never heard of, but its lithography machines are crucial to improvements we see in our daily lives, and should help to ensure that ASML grows handsomely for years to come.”