Business & History
ASML designs, assembles and sells machines used in the semiconductor (/chip) manufacturing process.
The core part of ASML’s business is selling lithography machines & other systems equipment. The remaining services part, c.20% of sales, relates to maintenance, customer support & upgrades.
The service’s business is subscription-like and given that 95% of lithography machines are still in service, maintenance & repair represents a 20+ year annuity.
[Source: ASML Investor Relations]
Key customers for ASML include TSMC, Samsung & Intel. They use ASML’s machines to manufacture chips which are subsequently assembled & packaged into smartphones, PCs, servers & other products.
In 1984, Philips and Advanced Semiconductor Materials International created a new company, ASM Lithography (‘ASML’). ASML would develop lithography systems for the semiconductor market.
In 1995, ASML listed on both the Amsterdam & New York stock exchanges. Since IPO, the equity has delivered a compound annual price return of 24%.
During the 90’s ASML was a small player, competing against the more established Japanese lithography companies, Nikon & Canon.
ASML improved its offering and at the turn of the century it was taking significant market share from its Japanese peers. In 2002 it was the clear market leader with 54% share.
ASML’s lithography market share is c.95% today.
ASML’s ultimate dominance was qualified in 2019 with the first use of an extreme ultraviolet (‘EUV’) lithography machine in high volume production.
EUV machines are advanced lithography machines. They are used to make the most advanced semiconductors for use in the latest smartphones, PCs and data centres.
ASML is the only company able to supply & maintain these machines globally, providing it with unique access to growth in leading edge semiconductors.
“The Dutch company ASML builds 100 percent of the world’s extreme ultraviolet lithography machines, without which cutting-edge chips are simply impossible to make. OPEC’s 40 percent share of world oil production looks unimpressive by comparison.” – Chip War by Chris Miller
LITHOGRAPHY
Semiconductors are manufactured by layering complex patterns of transistors on a silicon wafer.
[Source: ASML Investor Relations]
Lithography is one of the many steps required to manufacture semiconductors. It describes the process by which light is projected onto a wafer through a reticle or mask. Optics shrink and focus the reticle pattern. This pattern is then printed onto the wafer when a resist layer is exposed to light.
This creates a chip or die, a rectangular pattern on a wafer that contains circuitry for a specific function.
ASML’s technology is pivotal to chip production because lithography is the only stage where the wafer is processed die by die. Lithography therefore has a greater impact on performance (yield) than any other stage in the manufacturing process.
The lithography process is repeated to build up the layers of a chip. Modern chips can have more than 100 layers, all of which need to be aligned on top of each other with extreme precision.
The size of the features to be printed varies depending on the layer. Different types of lithography systems are used for different layers.
The latest-generation EUV (‘extreme ultraviolet’) systems are used for the most critical layers with the smallest features. DUV (‘deep ultraviolet’) systems are used for the less critical layers with larger features. EUV machines can cost over $150m.[1]
The next generation of lithography tool, high-NA EUV, is in the early stages of development. All major customers are placing initial orders for these tools. The timing of high-volume production for high-NA EUV is unclear, although early signs remain positive.
The risk of not investing at the leading edge is existential. For example, Intel’s decision to delay the adoption of EUV lithography severely impacted its competitive position in the industry.
WAFER FABRICATION EQUIPMENT
The Wafer Fabrication Equipment (‘WFE’) market has consolidated around a handful of companies with each one dominating a particular niche.
[Source: Compounding Capital]
The level of technological complexity required at each process step has created a concentrated WFE sector. The high level of innovation required has seen the sector cluster around a few firms in each vertical.
The overall ecosystem has attractive fundamentals.
Consolidation has allowed incumbent players to become more dominant within their niches, providing for attractive & durable return profiles.
GROWTH
The underlying market growth is driven by ever increasing demand for semiconductors globally.
Assuming the semiconductor market reaches $1 trillion by 2030-2032, this would represent annual growth of 7-10% from 2023-2030.
[Source: Applied Materialsl]
The lithography segment is expected to outpace the overall growth in the semiconductor market driven by higher complexity & lithography intensity.
Furthermore, increased focus on tech sovereignty is likely to boost capital intensity in the industry. This will lead to major investments in wafer capacity and higher spending on lithography equipment.
CYCLICALITY
The WFE players are susceptible to short-term cyclicality deriving from inventory-led corrections. This can lead to heightened equity price volatility. 20-30% plus drawdowns are commonplace.
That said, the long-term trajectory of the business is supported by the global shift towards a digitally connected society & economy. For the long-term investor, semi-cycle downturns have previously provided attractive opportunities to purchase ASML.
[Source: Bloomberg]
Over time, ASML has become more resilient[2]. The business model has improved to better deal with periodic semi downturns. An assembly-type business model provides cost flexibility during periods of lower demand.
COMPETITIVE ADVANTAGE
Technological disruption is a key risk for ASML. However, there are numerous factors which point to the possibility of disruption as low:
– Customer & supplier relationships are built upon a partnership model which confers a significant advantage to the incumbent players given that they are closely aligned in terms of product roadmaps.
EUV was only made possible through a customer co-investment programme. Intel, TSMC & Samsung jointly committed to provide ASML with the necessary capital for its development. There are not many industries where competitors invest together.
– Proprietary know-how, data & positive feedback loops create a virtuous circle that deepens ASML’s moat over time. The process to develop EUV took over 3 decades. ASML has 30 years of data & learning that it uses to continuously improve its product & service offering.
– The complexity involved in terms of the hardware, software and supply chain management sets a high bar for competitors & increases switching costs for the existing customer base. Here are a few examples:
EUV mirrors have a surface so flat that the imperfections are measured in picometers, or a trillionth of a meter. This is equivalent to keeping an area the size of California as flat as a human hair.
To create the highly specialised EUV light, a ball of tin, a few microns wide, is dropped into a vacuum at about 250 miles per hour. It is pulverized by two shots from a laser, generating plasma with a temperature of 220,000°C, 30 to 40 times hotter than temperatures on the surface of the sun. This plasma emits EUV light at exactly the right wavelength of 13.5 nanometre.[3]
An EUV system requires the assembly & integration of thousands of specialised parts from 5,100 suppliers. ASML acts as the integrator & assembler.
– Pricing power is strong. Customer willingness & ability to pay for equipment is high.
The high price for a machine is justified by the value-add to the customer in terms of a high ROI. ASML’s machines provide value to customers by lowering the cost per wafer through increased productivity.
PREDICTABILITY
An appealing characteristic of any business is its ability to provide some form of predictability. For ASML, near-term predictability comes from a backlog which provides 1.5x cover on system sales.
Lengthy customer roadmaps also provide for a level of predictability as customers think on a 5-year plus time horizon. Key customer TSMC guides to a revenue CAGR of 15-20% over the next several years with c.30% of sales to be spent on capex.
High quality companies & management often exceed expectations. ASML is known for under-promising & over-delivering, frequently upgrading its guidance.
At the 2022 analyst day ASML provided guidance implying a 10 to 14% sales CAGR from 2022 to 2030.
CONCLUSION
Picking long-term winners in attractive sectors will always be difficult because the characteristics that make a sector attractive tend to spur competition.
The attractive attributes are then eroded away over time as new competition enters a market and dilutes the benefits. However, in the case of ASML, significant barriers to entry protect the attractive returns & growth profile.
The digital transformation is a multi-faceted global trend that has a long runway for growth. Semiconductors represent the building blocks of that secular growth, and ASML represents a uniquely critical part of the value chain.
ASML is pivotal in enabling a number of major growth trends: Gen-AI, Edge Computing, Industrial Automation, Cloud, 5G, IoT & Energy Transition.
“Without ASML, the world would be a different place. Based in the quiet town of Veldhoven, this offshoot of Philips Electronics designs the gigantic and extremely complex machines that produce increasingly advanced computer chips. It’s Europe’s most valuable tech company: ninety percent of the world’s chips are manufactured using ASML machines, powering our phones, cars and the AI revolution.” – Focus: The ASML Way by Marc Hijink.
References:
[1] EUV machines weigh approximately 180 tons and require several Boeing 747s to deliver them to the end customer.
[2] The company operates with a conservative mindset, holding a net cash position on the balance sheet.
[3] https://www.trumpf.com/en_GB/newsroom/stories/euv-techology-beakthrough-thanks-to-master-laser-builder/
[4] This is an attractive feature given the material impact expectations can have on equity returns.
Written by Archie Tulloch, Senior Investment Analyst, Middleton Enterprises
Archie@middletonenterprises.com
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