ASML: A Monopoly In A Critical, Future-Forward Industry

The modern world runs on integrated circuits like never before.

Consider all of the devices, old and new, in which electronic chips are a critical component. Smartphones, a device which barely existed 20 years ago, is now one of the most important possessions most people own. Your washing machine, refrigerator, oven, heck, even your coffee maker likely relies on electronics to function in a way that was unfathomable a decade ago! A shortage in chips due to the COVID pandemic led to shortages in everything from automobiles to video game consoles (the PS5 is *still* hard to find) to industrial components.

There is little doubt that semiconductor chips have become, and will continue to be, extremely important in our everyday lives.

What if I told you that there is a Green Screen stock set to continue reaping the benefits of this trend?

Would you be interested? Likely so. But what if I then told you that it owns a true monopoly in one of the key future technologies for this massive, $1 trillion dollar industry?

Sound too good to be true? It isn't. What I've just outlined is the investment case in a nutshell for ASML Holding (ASML).

Let's dig a little deeper into this intriguing company...

A One-of-a-Kind Company

ASML makes photolithography systems. Lithography is a key step in how microchips are produced. We could go into a explanation of the chip making process here, but it turns out that ASML itself has an excellent overview of the process, so check that out instead (it's way better than I could do)!

ASML can be thought of as a "picks and shovels" play for the semiconductor gold rush. It doesn't make the chips, it simply sells others the equipment to do so. No matter who succeeds and who fails, ASML benefits.

Where this firm really stands out is in its extreme ultraviolet (EUV) lithography technology. At very small process sizes (7 nanometers and under), the width of a beam of light becomes a problem in producing such small circuits.

Why is this important? Because continuing to reduce circuit size is critical to achieving ever smaller and more energy efficient electronics. Want more powerful smartphones that remain small and have longer battery life? Smaller process sizes are critical. Want less bulky, more realistic VR and AR headsets? Smaller process sizes are critical. Need network hardware that can handle massive bandwidth while reducing data center footprint and energy usage? You got it... smaller process sizes are needed.

It is clear to see where demand for 7nm and below chips will come from. But here's the exciting part. ASML is the ONLY photolithography machine manufacturer in the world that can etch chips this size!

It took the company nearly 15 years to perfect its EUV technology, and no competitor is even pursuing it. What's more, ASML is nearing rollout of its "EXE High-NA" technology which will be able to produce chips at an amazing 3nm!

These factors lead to a compelling investment case. Let's take a look at some of the key points...

Pricing Power Galore

ASML's revenue model is pretty easy to comprehend.

About 73% of revenue comes from sales of its photolithography equipment. It sells this equipment to chip fabrication suppliers - the firms that actually build chip designs from companies like Apple, Nvidia, network hardware providers, auto makers, etc.

The remaining 27% are from service and field option sales, which include consulting fees, installation, and upgrades on previously installed equipment.

These are not inexpensive products. Deep ultraviolet (DUV) machines, a mature technology which is used to produce the majority of chips, cost in the $20 million range. ASML's high end EUV machines have over 100,000 components and run about $150 million each. And its emerging EXE High-NA machines are forecast to cost an incredible $340 million apiece! Both of these are a testament to ASML's pricing power in advanced lithography, where it has no competitors.

The semiconductor equipment market is large and growing. It was worth an estimated $88 billion in 2021, and is forecast to grow at a 9% annual rate to reach $210 billion by 2030. The EUV market is expected to grow at rates exceeding 25% annually. Chip demand, particularly on the high end for the most cutting edge devices, has always gravitated towards smaller process nodes and that is almost certain to continue.

Another trend in ASML's favor is the strategic migration of chip fabrication activities from outside of concentrated locales in Taiwan and South Korea. The U.S. recently passed the CHIPS and Science Act, which sets aside $52 billion for building out domestic production. Intel (INTC), Taiwan Semi (TSM), and Micron (MU) are all in the process of building multi-billion dollar fabs onshore. All of these will require equipment from ASML.

All of these factors bode well for continued growth. The firm has a 3-year CAGR of 21.5%, and more recent figures are even more impressive, exceeding 25%. I believe the firm can generate at least 15% annualized sales growth over the next 5 years.

One thing to note is that ASML fails the "recurring revenue" test. These are product-based, big dollar equipment sales for machines that last decades.

Judging the Moat

I don't want to sound redundant but once again: ASML is the ONLY company in the world producing EUV lithography machines that can create microchips at 7nm and below processes.

It is a true monopoly in this segment. We already mentioned the pricing power this gives the company, allowing it to generate free cash flows exceeding 35% of revenue, in an industry where most players are happy with 20%.

Currently, about 1/3rd of ASML's sales are from EUV. The rest of sales come from more mature DUV equipment, as well as metrology and inspection (methods for testing completed wafers).

In these two categories, ASML faces some competition from Nikon and Canon. But consider this... in addition to its 100% share in EUV, ASML also has a commanding 90% market share in DUV! The company is simply a powerhouse when it comes to microchip lithography machines.

All of this attests to multiple moats. The UNIQUE ASSET of EUV and High NA technologies. Unavoidable SWITCHING COSTS, as there is nobody to switch to. And ECONOMIES OF SCALE, as ASML has solidified its position by signing suppliers to exclusive deals and even acquiring some of them.

The key moat question in any high technology firm is: can competitors catch up or even bypass them altogether?

It seems unlikely. Most analysts in the industry believe it would take anybody at least 10 years to catch up, and by then ASML could be two technologies ahead. Even if a competitor somehow managed to surmount the cost, technical expertise, and supplier challenges to create an EUV alternative, there's still the matter of actually selling them to the big chip fabs, who are notoriously conservative (for good reason).

In short, ASML looks to have an extremely strong moat and very limited competition. That would take decades to change.

Management and Financial Health

ASML is led by CEO Peter Wennink, who has been in the role since 2013. There is still a sense of founder-led spirit here, as CTO Martin van den Brink is "employee #1", dating back to the company's roots as a subsidiary of Philips Electronics. The bulk of the executive team has been with the company for 10 years or more.

It's hard to argue with management's success. The company completely dominates the most important step in semi manufacture. It has next-generation technology nobody can match. Operating and free cash flow margins are the best in the industry. R&D continues to keep the company far ahead of everyone else.

ASML is also shareholder friendly. It uses some of its cash flow to pay a reasonable dividend (1.2% yield), and buy back shares (6.25% decline in shares over the past 5 years).

Risks

Despite all of the positives here, ASML is not a company without risks. I would characterize it as a "moderate" risk firm within our universe of picks.

Let's start with customer concentration. There are only a handful of companies in the world that can afford multiple $150 million dollar machines. Over 80% of ASML's sales are to just 3 customers: Intel, Samsung, and TSMC. TSMC alone accounts for 65% of sales. Any disruption there (geopolitical or otherwise) would be felt keenly by ASML shareholders.

Geopolitical risk extends farther than just TSMC. There is currently a "chip war" going on worldwide, as major governments in the U.S., Europe, and Japan attempt to domesticate their own chip production for national security reasons. ASML has still not sold an EUV machine to China in order to maintain good relations (and subsidies) with western governments. Ultimately, this limits the revenue potential for the firm.

Finally, ASML's lack of structurally recurring revenues opens investors up to volatility. Semiconductors are a notoriously cyclical business, and ASML only ships a few hundred machines a year. This is a firm that could easily suffer 30-40% revenue drops in a bad recession, with accompanying stock price drops. While this should not be a major concern for long-term focused investors, that's easier to say now than it is to experience later.

Conclusion

A monopoly in a future-forward and critically important industry is something you just don't come across much nowadays. ASML is a remarkable firm, with strong growth potential and one of the most impressive economic moats I've ever seen. It is an exciting new add to the Watch List, and we will keep a close watch for a good buying price soon.