Global Equity: ASML seeks to benefit from the world’s appetite for 175 Zettabytes

Introduction

The father of value investing, Benjamin Graham, once explained that in the short run the market is like a voting machine but in the long run it’s like a weighing machine. What this means is that over the short run, share prices can and will be affected by investor sentiment, the economy, monetary, fiscal policy, or the inflationary environment many investors are concerned with today. Yet in the long term, it’s all about the substance, the actual underlying business performance and not the speculators' fickle opinion.

Graham’s most famous student, Warren Buffet, once stated “Time is the friend of the wonderful company, the enemy of the mediocre”. This is because shareholder value is actually driven by those companies that are able to consistently generate returns above their cost of capital.

ASML Holdings

One company that certainly fits this bill is ASML Holdings. The firm is the global leader in photolithography, the technology that is vital to the mass production of microchips.

Deep Ultraviolet (commonly known as DUV) is the way most semiconductor nodes are produced today. ASML’s sheer scale leads to sustainable competitive advantages in this field. ASML is also the pioneer and only manufacturer of Extreme Ultraviolet systems. EUV lithography is the next generation technology that rejuvenates the pursuit of Moore’s law by the production of smaller chips.

The strong positioning of ASML within this secular growth industry together with its impressive shareholder-friendly management team have led ASML to generate consistent economic profits over time.

The table below is extracted from Canaccord Genuity’s Quest.

We were not the only ones to identify ASML as a great company and this led the share price to a higher valuation than we were comfortable to pay in order to establish a key position within the EPIC Global Equity Fund.

However, management’s recent upgraded growth targets, and the 20% drop in share price due to the market sell off, has finally provided the opportunity for us to build the position we’ve been were waiting patiently to do.

Investment Case

In 2018 the total amount of data created, captured, copied and consumed in the world was 33 zettabytes, or 33 trillion gigabytes. This grew to 59 zettabytes by 2020. It is projected that by 2025, 175 zettabytes of data will be created annually.

ASML sums it up pretty well, as per this extract taken from its investor relations website:

“This volume of data could not be realized without the relentless drive of the semiconductor industry to improve the performance of computer chips while reducing their cost.

While the world’s most advanced logic and memory chips are powering high-end trends in artificial intelligence, Big Data and automotive technology, the simpler, low-cost chips are integrating sensing capabilities in everyday technology to create a vast Internet of Things.

In short, the global semiconductor market will continue to grow exponentially for the coming years”

As the global leader in photolithography equipment for semiconductor manufacturers, the firm is enviably positioned in this global megatrend. The major players (i.e.TSMC, Intel and Samsung) all continue to invest heavily in order to enhance their capabilities and remain at the cutting edge. TSMC and Intel have committed to spending close to $70 billion combined in capex for 2022. ASML’s latest technological advancements are critical as it allows chipmakers to continually increase the number of transistors on the same area of silicon.

ASML Investor relations adds: “We’ve helped keep Moore’s Law alive for more than 30 years, with holistic lithography innovations that provide real value to our shareholders, supply chain partners, customers, employees and to society as a whole”.

Financial Results & Outlook

ASML reported decent fourth quarter results, top line grew 17% year on year despite being impacted by delayed system shipments resulting from materials shortages in the supply chain. Gross margins for the reporting period were up 244 basis points to 54.2%. We note however that whilst we do expect to see margin expansion from the business, the margin expansion has been aided by the 44% growth in the higher margin service revenues. Customers resorted to software upgrades to exert further output from existing capacity due to supply issues. Free cash flow exploded to Euro 9.906 billion from Euro 3.627 a year ago.

At first glance, next quarter’s guidance of between Euro 3.3 billion and Euro 3.5 billion is disappointing when compared to 2021 Q4 net sales of Euro 5 billion. However, this is due to timings of revenue recognition. As management explained “Lower guidance relative to Q4 is primarily due to a number of so-called fast shipments. These are shipments in the quarter, for both EUV and DUV, that will not complete factory acceptance testing. As we've discussed in prior quarters, fast shipments are in support of customers' desire to bring systems into production as quickly as possible. By skipping some of the testing in our factory, we can shorten the cycle time. Final testing and formal acceptance then takes place at the customer site, at which time we will recognize revenue”.

For the full year, management expected net sales to grow 20%; it was also disclosed that about six EUV systems will be fast shipped as management called it. If these are also taken into account, adding those delayed revenues on to the 20%, then the growth of the shipment value will be about 25% and not 20%.

Impressively, management also disclosed that in 2021, the company had total bookings of 26.2 billion Euros, more than a 2x increase year on year, reflecting customers' strong demand for EUV and DUV technology.

CEO Peter Wennink highlighted that “The biggest challenge that we currently see is that the demand significantly exceeds our capacity. I think it’s unprecedented. I have never seen this before. I think it has to do with a couple of things. It’s the secular growth trend. It’s the drive for more semiconductors to support the internet of things. It’s the disturbances as a result of Covid”.

Furthermore, when asked if he thought that the strong demand will continue beyond 2022 he stated “Absolutely. I said it before, we are looking at the secular growth trend and we talked about this extensively during our Capital Markets day at the end of last year. The growth profile of this industry is impressive. The semiconductor industry is planned to double in size to a trillion dollars by the end of this decade”.

Similar to the overwhelming majority of companies held by the EPIC Global Equity Fund, ASML has been winning market share over time. Back in 2008, ASML had a 62.3% market share in the lithography market; this has grown to 86.1% market share in 2020. Its main competitors (Nikon & Canon) have seen their market shares shrink from 23% to 8% and from 10.7% to 2.3% respectively over the same time frame. Over the 2014-2019 time frame, the industry, which according to Gartner was projected to grow at an annualised rate of approximately 7%, actually grew at an annualised rate of 10.84%. ASML grew at an annualised rate of 12.27%.

Depending on different market scenarios, management projects annual revenue in 2025 of between Euro 24 billion and Euro 30 billion with gross margins between 54% and 56%. Furthermore, significant growth opportunities have been identified beyond 2025. Management expects the systems (lithography, metrology and inspection) and installed base management (service and field upgrades) to provide an annual revenue growth rate of around 11% for the period 2020- 2030, based on third party research and internal assumptions.

At time of writing, we do not see this growth trajectory currently being priced in and think the shares are currently trading at a discount to our fair value estimate of around 20%.