September 23, 2021
ASML: The Monopoly Semiconductor Business Few Have Heard of

In an earlier post, I talked about how semiconductors are now in fact the fourth largest commodity traded globally. They are mission critical in almost every sector and represent the lifeblood of the modern, electronics-driven economy. What’s more, they’re in serious short supply at the moment. Today I would like to tell you about my holding in a company with a virtual monopoly in this space that many people still don’t know about!

Dutch company ASML is a defacto semiconductor monopoly but they are hardly ever in the news! All semiconductor companies are booming right now given the chip shortages but ASML is uniquely  poised to benefit from the global chip shortage a bit longer than its chipmaker customers because only ASML can supply EUV and DUV tools. And, at least for the next three years, ASML can singularly benefit from the semi equipment technology transition to EUV in logic and in DRAM. Read below why I believe as EUV’s growing contribution becomes incorporated in estimates, there is a good chance that ASML’s share price still has significant upside.

Pynk Community - ASML Market Cap

Pynk Community - ASML Share Price Performance

Source: Stockopedia
Past performance is not indicative of future performance.
The price may increase or decrease as a result of currency fluctuations.

Business Description

ASML is the leading producer of a lithography system that is used by every major semiconductor company in printing integrated circuit patterns on a silicon wafer. ASML makes extreme-ultraviolet lithography (“EUV”) machines, considered one of the most advanced chip making tools, which can give chipmakers an edge in the next generation of production. ASML is in a “sweet spot” with the main semi equipment technology transition to EUV in logic, followed by shift to EUV in DRAM. Lithography demand will see a secular increase as an integral part of front-end semi equipment spending till this transition is completed. For the next two to three years, there will be strong foundry demand from the two sector leaders TSMC and Samsung, which are aggressively investing in (smaller) 5-, 3- and 2-nanometer technology for advanced chips for high performance computing and 5G communication.

The semiconductor basics

In order to understand ASML’s business, it is helpful to review the process of semiconductor manufacturing and the role of Lithography. To turn a blank sheet of silicon wafer to a completed wafer that contains meticulous pattern, which eventually powers up every electronic device, there are 5 major steps to go through, namely, 1) oxidation and coating, 2) lithography, 3) Etching, 4) doping, 5) metal deposition & etching. Semiconductor Industry Associate has created a concise summary of the wafer (i.e. chips) fabrication (i.e. manufacturing) process.

Pynk Community - ASML Semiconductor Manufacturing Process

Source: Semiconductor Industry Association (SIA)/Boston Consulting Group (BCG)

Lithography is one of the most technically challenging steps. It involves printing an integrated circuit pattern design onto the silicon wafer through systems of ultraviolet light, which are supplied by ASML’s core systems. One can think of lithography as printing images on A4 paper, but of much smaller size (one-millionth of a millimeter). The smaller the features on a chip can be printed, the more transistors can be packed in one chip, the more powerful is the chip. In fact, Moore’s Law states the number of transistors in a dense integrated circuit doubles about every two years.

ASML has Rock Solid Market position in a booming industry

Conditions in the semiconductor sector could hardly be better. The semiconductor industry is booming, and chipmakers have been increasing capacity utilization over the past two years and are anticipated to further increase utilization in 2021 to meet demand.

Pynk Community - ASML Semiconductors Growth Market

Source: Semiconductors.org
Past performance is not indicative of future rewards.

Apple chipmaker TSMC’s CEO said in a letter to customers that the company’s fabs have been running at over 100% utilization over the past year, but demand still exceeds supply. While chipmakers have turned to immediate solutions such as increasing capacity utilization and software upgrades to boost short term output, over the long run, global fab capacity will have to be increased to meet demand growth for chips which cannot be met through higher utilization alone.

Emerging technologies such as AI, IoT, 5G, electric vehicles (EVs) are expected to drive long term demand for larger quantities of diverse semiconductors with better performance. Semiconductor manufacturers are building capacity in response to what IC Insights described as a “golden opportunity”. TSMC, the world’s largest foundry, is spending a record USD 100 billion in capital expenditure over three years to grow capacity. TSMC has said this capex is not in response to the current chip shortage, rather this is a long term investment to capitalise on anticipated demand growth for advanced chips in the coming years with TSMC reportedly seeing stronger engagement with more customers on 5nm and 3nm.

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Semiconductor Equipment Companies Poised to Capture Much of that spending

A big chunk of that spending will go towards semiconductor manufacturing equipment which gets more expensive with every new generation of chip. Beneficiaries in this favourable climate are chip equipment players, notably ASML. Semiconductors are typically characterised by the distance between each transistor on the chip, measured in nanometers (NMs). The smaller the gap, the more complex the chip manufacturing process and as smartphones and devices are becoming increasingly demanding in terms of performance to handle new technologies such as AI capabilities, the way forward is to cram increasingly greater numbers of transistors into these chips. This in turn demands greater investment into new leading edge manufacturing processes. TSMC for instance has committed USD 28 billion in capex this year, a nearly USD 10 billion increase from last year. About 80% of that will be spent on the company’s most advanced chip making processes – 7nm, 5nm, and 3nm. TSMC didn’t disclose what sort of equipment will be purchased. However, given that beyond 7nm, chipmakers heavily rely on EUV, the next generation lithography technology, it is safe to say that a big chunk of that spending will be on EUV machines. TSMC’s N7+ was the company’s first node to make use of EUV lithography and the company’s N5 process will likely depend heavily on EUV.

Major chip makers began full use of EUV technology a few years ago and ASML is the sole producer of EUV machines, commanding a monopoly position with close to 100% market share. Over the coming years, ASML stands out as a prime beneficiary of the semiconductor upcycle as demand for high-end chips increase (such as chips for 5G smartphones) leading to increasing penetration of EUV machines. EUV penetration has been growing over the past few years and is gathering momentum. TSMC, which was the first company to use ASML’s EUV lithography machines for high-volume production, claims to have more than 50% of the world’s EUV installed base and 60% of the industry’s cumulative EUV wafer production.

Pynk Community - ASML TSMC in EUV Production

Source: Anandtech

TSMC plans to stay ahead, having placed orders for ‘at least’ 13 machines with ASML due to be delivered this year. With the company continuing its aggressive capex plans, it looks set to continue maintaining that capacity lead while other chip makers are trying hard to play catch up. One of those feverishly working to catch up is Samsung, which currently lags TSMC in EUV installations (according to industry officials Samsung has about half the quantity owned by its bigger rival TSMC). Samsung uses EUV to make some DRAMs and 7LPP, but as Samsung expands its usage of EUV for logic and EUV-based DRAM, EUV purchases look set to increase in the coming years. Intel too is reportedly planning on deploying EUV systems to make chips using its 7nm node adding further to ASML’s order book in the coming years. Meanwhile DRAM giant SK Hynix plans to use EUV in volume production. Meanwhile, even Micron expects to deploy EUV in a few years.

Thus demand for EUV tools is anticipated to increase in the coming years. However with ASML having a production capacity of just about 50+ EUV systems per year, ASML appears to be in the rather enviable position of demand potentially outstripping production and installation capacity. Last year alone, Samsung is understood to have ordered 20 new machines from ASML as part of the Korean giant’s effort to match TSMC’s ambition to volume produce 3nm chips by 2022 and Samsung’s urgency was reflected when vice-chairman Lee flew to ASML headquarters to press ASML for faster delivery. In a world where pricing power is a rare commodity, being the only game in town is an extremely fortunate position for ASML.

It took decades and billions of dollars to develop current EUV technologies and there are no viable competitors to threaten ASML’s near monopoly position in the foreseeable future. As chips become increasingly advanced, the chip making landscape is becoming increasingly concentrated among the fittest few who can maintain the necessary capital expenditures to remain competitive amid rapidly advancing semiconductor technologies.

EUV Machine Monopoly

ASML is the leading producer of a lithography system that is used by every major semiconductor company in printing integrated circuit patterns on a silicon wafer. To be precise, ASML has over 90% market share in the semiconductor lithography market (the remaining players are Canon and Nikon) and is the monopoly in Extreme Ultraviolet (EUV) light lithography market. As of 2Q21, 45% of revenue came from selling EUV systems and 55% of revenue came from selling DUV systems (and metrology & inspection systems). 72% of its customers are logic players (TSMC, Samsung, Intel, etc.) and 28% of its customers are memory players (Samsung, SK Hynix, Micron, etc.). In terms of geographical shipment mix, 39% of its sales are shipped to South Korea (majority is Samsung), 36% are shipped to Taiwan (majority is TSMC), 17% are shipped to China while the rest are shipped to USA, Japan and EMEA. ASML has maintained this de facto monopoly position in the lithography market for the last decade and it is difficult to see who can unthrone them in the near future.

EUV adoption set to rise

EUV is critical in driving cost improvement in advanced process nodes……
Due to the dramatically lower wavelength used in EUV (13nm vs DUV immersion 193 nm), multi-patterning DUV steps could be replaced with single exposure EUV ones, enabling cost improvement. If this sounds too complicated, think of it as wearing one N95 mask being better than wearing multiple basic masks in terms of cost and effectiveness.

…Adoption to rise across foundry / logic players…followed by DRAM makers
EUV is also used by DRAM makers. Leveraging its experience with EUV on foundry, Samsung was the first to adopt EUV for DRAM production on 1z node in Aug 2020. SK Hynix started mass production in July of 8-gigabit LPDDR4 mobile DRAM based on 1a node. In July, Micron increased its FY21 capex guidance from US$9 billion to US$9.5billion due to EUV facility investment pre-payment.

Structurally Higher DUV demand driven by Automotive

While EUV adoption will rise along with leading edge node capacity expansion, the key upside surprise in my opinion will be if DUV demand is not cannibalised due to proliferation of auto semi, which is underpinned by rising adoption of EV and ADAS (Advanced driver-assistance systems). This will in turn drive surging demand in semiconductor devices in vehicles, including sensors, microcontrollers (MCUs), and power semi. Gartner estimates the average semiconductor content per vehicle will rise from US$489 in 2020 to US$719 in 2025 and auto semi revenue demand will grow 14% CAGR across 2020-2025 from US$38.7bn to US$75.5bn, outgrowing other key demand segments in the total semiconductor market such as smartphone (7% CAGR), consumer electronics (7% CAGR), PCs (0% CAGR), and the total semiconductor industry (7% CAGR) as a whole.

Pynk Community - ASML Global Semiconductor Revenue
Pynk Community - ASML Global Semiconductor Research Data

…reflected by Foundries’ expanding mature node capacity plan
Among the US$37bn incremental demand, Gartner estimates mature nodes will account for 67% of the incremental auto semi demand, i.e. US$25bn. In response to the rising auto demand (and of course other applications), foundries are expanding their mature node capacity in the upcoming years. UMC, the leading second tier foundry, has announced NT$100bn (US$3.6bn) capex in expanding 28nn fab in the Tainan Science Park across FY22-FY24 in the Tainan Science Park, representing 57.2% increase in total capex across 2018-2020. Gartner estimates that a total of 1,575,000 wpm (wafer per month) for 28nm+ nodes will be added across FY21-FY25. Note that 2024 worldwide foundry capacity at 7,275k wpm is 26% higher than the capacity pre-pandemic in 2019. It is likely that DUV sales will follow this growing trend.

Chip Shortage Produces DUV’s Upside

While EUV lithography tools are used for both logic chips and DRAM, technical and financial entry barriers are high with next-generation machines costing about $250 million or more. The persistent chip shortages also spur demand for deep ultraviolet (“DUV”) tools, which have a higher operating margin. Just in Q1, ASML beat analysts’ estimates for operating profit of 1.244 billion euros due to strong demand for DUV tools amid the global chip shortage.

TSMC has recently indicated that it will spend $100 billion in capex in the next three years. Mizuho estimated that TSMC’s capex may reach $30 billion in 2021 and $35 billion in both 2022 and 2023. Samsung is unlikely to under-spend between $11-$12 billion. Intel announced '21 capex of $19.5 billion at the midpoint and committed $20 billion to building two new fabs.

Mizuho also claimed that large increases in capex at foundry customers will likely be seen in ASML orders through '21 translating to '22 and beyond sales. TSMC, Samsung and even Intel are expected to purchase more EUV tools. This is due to their more aggressive 5nm/3nm capacity increase and higher EUV spending with rising EUV layer adoption for 5nm/3m/2nm. In short, the EUV portion of the capex for major logic players will rise to 13% and 15% in 2022 and 2023.

Valuation Upside

ASML is a business with a monopoly in one of the fastest growing and vital product areas and hence trades at a premium multiple (currently trading at 50x FY21 P/E). While it appears that the valuation is fairly rich, such a premium multiple is comfortably justified given the monopoly status of ASML in the structurally growing semi market with multiple tailwinds ahead. ASML is one of the very few companies that provide highly certain revenue growth into the next decade. Having said that, to cushion the risk of market correction as we look into next year, even if I apply a lower 45x PR to FY22 EPS forecast of EUR 18.3, I derive a target price of US$970, representing 23% upside. Note that the consistent EPS growth story alone (FY22 EPS growth 34%; FY21-FY25 EPS CAGR 20.5%) reflects the quality of the business. In terms of a catalyst for the share price, ASML’s upcoming investor day event on 29 September 2021 is set to re-calibrate market expectations for FY25 sales, and likely to create material upside surprise to the market.

In its 2018 Investor Day, ASML guided 2025 revenue to be EUR 15 - 24 bn. However, FY21 revenue guidance is already EUR 19bn, 4 years ahead of meeting the midpoint of 2025 guidance. This makes the original high end of 2025 guidance EUR 24 bn looks like a bear case scenario assuming EUV growth is broadly in line with analyst estimates and DUV is significantly above market (for reasons detailed above). Both of these feed through to higher Installed Base Management revenues. Overall, this would lead to  revenue growth of  15.2% CAGR across FY21-25, hitting EUR 33bn by 2025, 39% higher than the EUR 24bn 2018 guidance, and 27.5% above analyst estimates.

As a cross-check, note that TSMC’s 15% revenue CAGR guidance across 2020-2025 implies 14.3% revenue CAGR across FY21-25. Given that TSMC is the largest foundry in the world (also ASML’s largest customer) and historical revenue growth trajectory of TSMC and ASML looks similar, I believe ASML  revenue forecast at CAGR 15.2% looks closer to reality than the 8.6% revenue CAGR currently implied by market consensus. There is obviously a knock on effect on margin expansion: with gross margins expanding due to increased sales towards 55% level, EPS is likely to grow 20.5% CAGR across FY21-25, materially higher than 13.3% CAGR estimated by the market.

Earnings Analysis

In Q1 2021, ASML’s revenues amounted to €4.4 billion, while analysts were on average expecting only €4 billion being a revenue beat of 10%. The company justified this beat due to the market situation in the semiconductor industry, namely the chip shortage that is boosting demand for ASML’s systems and services. Other positive factors are the rollout of 5G, artificial intelligence, and high-performance computing that is also boosting demand, especially for its EUV systems.

During the first quarter, ASML has shipped nine EUV systems but only recognised revenue for seven, amounting to EUV revenue of €1.1 billion (average sale price of €157 million for each unit). In 2020 as a whole, the company sold 31 units and should deliver some 38 units this year, which leads to revenue growth of about 30% YoY on EUV systems.

In 2022, ASML has said that it expects to deliver some 55 units, which is slightly above the 53 units in consensus estimates, which means that EUV revenue growth should be about 38% YoY in 2022. Given that EUV systems are needed to make chips that are smaller and faster, there should be strong demand for many years as the industry moves to more advanced technologies (7 nm nodes and smaller) while previous technologies become less relevant.

Beyond EUV revenue growth, ASML’s service revenue also increased strongly to €1.2 billion (+44% YoY) as customers upgraded software. Its gross margin was 53.9%, above its own guidance and the 45% margin achieved in Q1 2020, due to the software upgrades and also due to the average selling price of EUV systems increasing 8.2% compared to the average price achieved in 2020.

Regarding net bookings, ASML received new orders at €4.7 billion, of which €2.3 billion were EUV systems, an increase of 12% from the previous quarter.

Pynk Community - ASML Net Bookings

Source: ASML

Its operating costs increased at a smaller rate than revenue growth, leading to income from operations of €1.5 billion (+265% YoY) and operating margin of 35.8% (vs. 17.5% a year ago). Its net income amounted to €1.3 billion and its EPS was €3.20 (+244% YoY), which is quite impressive.

In the second quarter, ASML expects the good operating momentum to continue and has guided for revenues between €4 billion and €4.1 billion and gross margin of around 49%, while sell-side analysts were forecasting €3.95 billion in revenues and a gross margin of 50%.

But most  impressive was its revised guidance for the full year, given that ASML is now expecting revenue growth of about 30% YoY, while previously it was only expecting double-digit growth. This is a much higher revenue growth than in 2020 (it reported 18% YoY), but it is not completely surprising considering that its largest customer, Taiwan Semiconductor, has raised last week its capex spending to $30 billion this year, with ASML being obviously one of the companies that would benefit from this increased spending.

Regarding gross margin, its outlook for the full year is between 51% to 52% compared to 48.6% reported in 2020. Given that costs are expected to grow moderately, this improvement in gross margin is an important driver of earnings growth in the coming quarters.

During the last quarter, ASML has repurchased shares in the amount of €1.6 billion and expects an earlier completion of its current $6 billion share buyback program, even though it continues to aim to return significant amounts of cash to shareholders in the future, thus a new share buyback program should be approved in the coming months.

Pynk Community - ASML Capital Return

Source: ASML

Indeed, at ASML’s  upcoming investor day, it is not only likely to revise its medium-term revenue targets higher but also possibly announce a new share buyback programme to be completed in the next 2-3 years. Both these factors should be an important driver for a higher share price in the next 6-9 months.

Risks

ASML has faced some recent difficulty getting the Dutch government to renew a license to export its EUV systems to China due to ongoing trade sanctions, which would be a strong boost for EUV sales, even though it has recently renewed a contract with SMIC to supply more DUV systems this year. However, it’s still unclear if ASML will be able to supply EUV systems to China in the coming years. Should they manage to find a solution, this would be another important EUV growth driver in the medium term.

A key risk is if a DUV ban extends to China should geo-political tension intensify. With the potential loss up to 17% of 2020’s revenue, ASML is significantly affected by any new US sanctions against China. Though, one silver lining is that Semiconductor Manufacturing International Corporation has secured supply of DUV lithography systems from ASML in an amended purchase agreement worth $1.2 billion. Both Lam Research and Applied Materials may have more China exposure if the U.S. alters its stance toward technology exports to Chinese chipmakers. Among major semi tool suppliers, ASML has the lowest China risk (see table below). In my personal view, while currently China accounts for 17% of ASML’s sales, I believe the real impact of the DUV ban extended to China on ASML is less than 17% of ASML’s sales. This is because EUV demand will simply shift to other geographies (Taiwan, Korea). If the shortage worsens significantly, DUV price will be increased to offset the impact partially.

Pynk Community - ASML Sales Contribution from China

ASML is capacity limited in EUV with slightly above 40 tools in 2021. However, it has no capacity limitations in lagging edge tools, the company may see upside to 2021 sales estimates from lagging edge tools. There should be upside to margin as well due to lagging edge tools being more profitable. Given ASML’s dominant position in the EUV lithography tool market, Nikon and Canon are ASML’s far distant competitors in the DUV and UV lithography market. We cannot entirely discount the possibility of more severe competition emerging, sparking market share loss or ASP erosion for ASML’s DUV and UV lithography products.

The longer term risks from China however are potentially significant. China is not sitting still and the country’s domestic players, while generations behind their Western counterparts, have tremendous support from the Chinese government which is pouring billions of dollars into building domestic semiconductor technology in an effort to reduce reliance on U.S. technology. And all that investment is giving rise to shoots which could potentially grow into future challengers; Shanghai Micro Electronic Equipment (SMEE) for instance is reportedly on track to deliver its second-gen deep ultraviolet (DUV) lithography scanner by the end of this year. The tool can produce 28nm chips and uses components from China and Japan which means China could potentially produce 28nm chips with zero U.S. technology. While these 28nm chips can hardly be used for smartphones and PCs that use leading-edge chips, they could however be used for IoT devices which are expected to proliferate along with the rise of 5G and edge computing.It may be years before Chinese players catch up to ASML if at all; however, the wheel is in motion and the possibility of a Chinese challenger cannot be ruled out. This scenario however is likely to be years away and by then ASML may have progressed to more advanced technologies (ASML’s next generation EUV technology called high-NA is targeting 3nm in 2023). Chinese players have a lot of catching up to do and until then, ASML looks poised to retain its dominant position in the lithography market.

Other risks include supply constraint, timing of EUV adoption and High NA EUV adoption.

Conclusion

  • As a result of cyclical, structural, and geopolitical forces, semi fab equipment capex will be elevated in the next few years, auguring well for ASML’s lithography system sales.
  • ASML can singularly benefit from the semi-equipment technology transition to extreme ultraviolet lithography, or EUV, in logic and in DRAM.
  • ASML may be helped by the global chip shortage a bit longer than its chipmaker customers because only ASML can supply EUV and deep ultraviolet lithography, or DUV, tools.
  • AI, IoT, and 5G are driving a new wave for semiconductors.
  • Chipmakers are spending billions to increase fab capacity in response to this structural uptrend in chip demand.
  • EUV adoption is set to rise across foundry and DRAM players while DUV sales will be structurally higher driven by automotive end-market demand.
  • Higher systems sales will in turn drive higher installed base management revenue, which is a higher margin business than system sales.
  • Modelling these growth stats gives ASML revenue growth of 15.2% CAGR across FY21-25, hitting EUR 33bn by 2025, 27.5% above analyst estimates.

As the de-facto monopoly provider of Lithography systems, ASML is one of the very few semiconductor companies that is poised to fully benefit from the cyclical, structural and geo-political tailwind in the semiconductor market. EUV adoption is set to rise across foundry and DRAM players while DUV sales will be structurally higher driven by automotive end market demand. Higher systems sales will in turn drive higher installed base management revenue, which is a higher margin business then system sales. I expect the company to confirm guidance and grow above analyst estimates, giving upside potential to the shares.

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Written by
Pouneh Bligaard
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