ASML Stock: The Best Pick-and-Shovel Semiconductor Stock?
Last year, we did a series of articles to find the best semiconductor stocks not named NVIDIA (NVDA). Our search led us to five interesting semiconductors stocks, though we did not feel compelled to invest in any of them, especially since our Nanalyze Disruptive Tech Portfolio is already overweight in that category. That’s largely because generative AI hype has propelled NVIDIA into one of the handful of $1 trillion companies by market cap. Speaking of artificial intelligence: We also looked at ways last year to invest in AI with semiconductor stocks. Two companies, Synopsis and Cadence, are among the leaders that develop software for designing chips. We favored the former as an intriguing pick-and-shovel play on the semiconductor theme, while also scratching the AI itch to boot.
Yet our paying subscribers want more coverage on semiconductor stocks and have been urging us to cover ASML (ASML), a Dutch company that manufactures lithography machines, which are used to produce advanced computer chips at scale. A pick-and-shovel semiconductor stock, ASML has been posting significant revenue growth and solid gross margins – despite being a massive hardware company with a market cap of nearly $280 billion. It’s a complex business that comes with some regulatory risk, particularly thanks to a U.S. export ban on certain chip technologies to China (more on that later). But as one subscriber told us (by quoting us on gold-standard investing): “‘A stock we would be willing to go into a coma for ten years and be confident it would be green when we wake up,”’ I think of ASML.” So, let’s go all Rip Van Winkle on ASML stock.
About ASML Stock
Founded in 1984, ASML used to go by the name Advanced Semiconductor Materials Lithography. That’s obviously way too long for a text message, so the company eventually shortened it to ASML. It pioneered the use of photolithography to manufacture computer chips. The technique involves projecting light through a sort of blueprint of transistor circuitry. Using high-tech optics, the light is shrunk down and focused to etch the pattern onto photosensitive silicon wafer.
ASML is reputedly the only company with machines capable of extreme ultraviolet (EUV) lithography for working at extraordinarily fine scales – just 13.5 nanometers (nm) or about five times the width of a DNA strand. The ability to manufacture chips at those nano dimensions enables manufacturers to build chips with ever more processing power and memory. The company also manufactures deep ultraviolet (DUV) machines that use light with wavelengths between 193 and 248 nm. EUV is a key manufacturing technology for stuff like laptops and smartphones that need to jam and cram as much computing power as possible into these kinds of devices. Decades of R&D in this highly specialized technology has helped turn what was once dubbed a “relatively obscure” Dutch company into Europe’s most valuable tech firm.
Strong Revenue Growth for ASML Stock
As noted earlier, this is incredibly complex and expensive technology. For instance, the machines must operate in vacuum chambers to ensure nothing interferes with the delicate lithography process, while the mirrors used are the flattest surfaces known to man. You certainly won’t find one in your local Costco: In the first half of 2023, ASML sold just 29 machines from its high-end EUV line for $5.4 billion. In other words, each instrument retails for nearly $200 million and they collectively accounted for 45% of revenues so far this year.
Sales of lithography machines and related products make up the majority of revenues, including about 80% through the first three quarters of 2023. ASML refers to its other main source of income as installed base management, which is money made from maintenance, upgrades, and other types of service revenue (96% of their machines ever sold are still in service). The company further breaks down its machine revenue between logic and memory based on the end-use of the lithography systems. The former refers broadly to processing semiconductors, while the latter for chips designed for data storage purposes.
Investors have to love the revenue trajectory here. Management is projecting 2023 total revenue will end about 30% higher than the previous year, despite the semiconductor industry being at the bottom of what they characterized in the Q3-2023 earnings call as a down-cycle. It certainly helps that ASML has a nearly $40 billion backlog (more on that later) to keep the Keebler elves busy. In the near term, the company believes it will hit annual revenue of between $33 billion and $44 billion by 2025, with a midpoint gross margin of 55%. Production of new chip designs is expected to account for more than 50% of lithography machine shipments next year, particularly for DUV systems thanks to strong demand from China.
China: Risks and Opportunities
While sales to China have been increasing over time, it’s important to view them as a percentage of total sales to see their decline in significance:
- 2020: 17%
- 2021: 15%
- 2022: 14%
Despite geopolitical tensions, these numbers remain strong. China accounted for 46% of machine systems sales in Q3-2023, nearly double from a year ago. The increase is partly a function of timing: We know that demand for semiconductors has been exceeding supply for years now, and adding chip manufacturing capacity is a slow and expensive process.
Other customers apparently took priority but ASML is finally catching up on the Chinese backlog, which has become more complicated of late due to geopolitics. The United States has been actively blocking imports into China of advanced computing chips, especially any AI hardware. Countries in Europe have predictably followed the U.S. lead, including the Netherlands, which is restricting ASML from exporting its advanced EUV machines into the PRC. That means somewhere between 10% and 15% of planned 2023 shipments from ASML to Chinese customers were banned.
Management tried to put a positive spin on these developments by noting that demand for DUV machines in China is showing no signs of slowing down. These less advanced chips power everything from renewable energy technologies to IoT and electric vehicles in a country of 1.4 billion people. Consider that China imported $350 billion worth of semiconductors in 2020 alone – more than crude oil imports. In fact, semiconductors account for the country’s biggest trade deficit of more than $230 million. However, the regulatory risks remain high for companies like AMSL while the Chip War rages on.
A Competitive Landscape?
When people talk about ASML’s “monopoly,” they’re referring to this statement taken from ASML’s website about their superior technology debuted in 2019.
EUV lithography is currently a technology entirely unique to ASML. Other companies also produce lithography systems, but ASML’s EUV platform is leading the semiconductor game and enabling cutting-edge technology.
ASML
EUV equipment is used to produce the highest performing chips, so based on Moore’s Law, that’s where the market will eventually move towards. When it comes to “less sophisticated” equipment the market is strikingly diverse and fierce between companies that manufacture machines for semiconductor fabrication. Based on this Statista market map, AMSL is vying with Applied Materials, Lam Research, and Tokyo Electron, among others.
However, without diving too deeply into each competitor’s tech, it appears that the major players manufacture different types of fabrication equipment, so some markets may not overlap. For example, Applied Materials manufactures equipment used for semiconductor fabrication following EUV or DUV processing, such as etching and deposition, which create the layers and structures of the hardware. Another kind of machine implants ions onto the wafer surface to modify electrical properties, a process called doping (insert your own joke here). Lam Research specializes in deposition and etching using plasma technology.
Thanks to those decades of R&D, ASML has built a pretty big moat around its business that would require a serious contender to spend billions of dollars to catch up. Both Canon and Nikon produce photolithography systems but are obviously more focused on photography systems. However, we have come across some internet chatter where Canon claims its nanoimprint lithography (NIL) tech is comparable to and cheaper than EUV, but we have yet to see any significant results (i.e., sales) on those claims except for marketing around better energy efficiency.
Moat or Monopoly?
Sometimes if a company’s competitive moat is wide enough – the business is so dominant that it becomes a monopoly – regulators could lay siege. We’ve seen regulators become more aggressive against big tech in recent years. Think NVIDIA’s failed acquisition of ARM or the ongoing fallout from Illumina’s acquisition of GRAIL. There is even a remote possibility that Google could be broken up at some point. While there is no reason to believe ASML is in the crosshairs of regulators, it is no longer a relatively obscure little Dutch company either. Regulators will likely more closely scrutinize future mergers, particularly in an industry with such high-profile international attention as semiconductors. Retail investors can never really snooze on any stock for too long, no matter how bulletproof it seems.
And ASML is certainly not bulletproof. Aside from regulatory risks associated with China, the company is heavily reliant on just two or three customers for most of its revenues. In 2022, just two customers accounted for more than 55% of revenues. In 2021, the percentage was about 67% and the year before that, three companies made up more than 71%. So the customer concentration is going in the right direction, but it’s still massive. Taiwan Semiconductor Manufacturing Co (TSMC) is undoubtedly the biggest customer, reportedly accounting for 40% of ASML revenues in 2021 alone. That makes sense: Only a small handful of companies can afford to buy $200 million EUV machines with any regularity.
Today, ASML sells the machines to only five chipmakers. The biggest three — Taiwan Semiconductor Manufacturing Co., Samsung and Intel — made up nearly 84% of its business in 2021. TSMC says that in 2019 it was the first to deliver high-volume chips made with EUV and that it has stayed in front ever since, with chip technology at least one node ahead of Samsung’s and Intel’s.
Credit: CNBC
As we said at the outset, our portfolio is already maxed out in terms of exposure to semiconductors with NVIDIA. If we decided to trim our position in NVDA or exit completely, we would probably sniff around a company like Synopsis first, because we generally favor software over hardware companies. Retail investors who believe in ASML stock should note the company currently trades at a simple valuation ratio ($284 billion market cap/$29 billion in annualized revenue) of less than 10. That’s about half the SVR of NVDA ($1.3 trillion market cap/$76 billion) at 18, but above our catalog average of 6.
Conclusion
It’s not an understatement to say that ASML is one of the most important companies serving the semiconductor industry today. Its breakthrough photolithography technology has helped keep Moore’s Law alive while making it the most valuable tech company in Europe. The world’s hunger for semiconductor chips to digitize everything will feed the company’s bottom line for the foreseeable future. But as we’ve seen time and again in tech, that future is not without inherent disruptions, whether from regulators or competitors. The company’s complicated relationship with China, and reliance on just a handful of deep-pocketed customers, are enduring risks that investors need to accept.