The more worried the U.S. government becomes about China’s ambitions in the chip industry, the more equipment China appears to be buying to make chips. When Dutch company ASML reports fourth-quarter results next week, one of the most eye-catching numbers will be its share of sales in China. This number reached a staggering 46% in the third quarter, up from 8% in the first three months of last year.
One reason for the growth is slowing demand in the West, which has given ASML a chance to catch up on orders from China. But the other one is export controls. While the company has never been allowed to ship its most advanced "extreme ultraviolet" machines to China, the Netherlands and Japan agreed last year to join the United States in banning the sale of some less advanced equipment to China. Chinese chipmakers may be rushing to purchase equipment before restrictions take effect this month.
Even with the ban in place, ASML's sales to China are likely to be strong this year. The company said only 10% to 15% of shipments will be affected. Most of its business with Chinese chipmakers is for mature technologies that are still in scope. For more advanced applications, China may be able to use a few older-generation machines to achieve similar results to newer machines it cannot purchase, which could further drive orders.
China is investing aggressively in emerging industries such as electric vehicles and wind turbines that require large amounts of semiconductors. The country still buys most of its chips from Western chipmakers: today it imports more microchips than oil. But China is hell-bent on becoming self-sufficient, and U.S. concerns about China catching up with Western chip technology will only accelerate that effort.
Companies that sell chips to China are increasingly being replaced by local counterparts. When UBS dismantled a popular electric car made by BYD, it showed that 36% of the semiconductor content in the powertrain came from domestic suppliers. The current global leaders in powertrain chips, Germany's Infineon, Switzerland's STMicroelectronics and the United States' ON Semiconductor, will be affected by the rise of China's electric vehicles.
But China cannot easily replace the machines that make chips, leaving it dependent on ASML and competitors such as Applied Materials. This is why export controls are so sensitive.
Although these measures show few signs of harming ASML, investors cannot relax. First, the level of potential demand in China has become difficult to measure. Even though the country's industrial strategy will require a large number of lithography machines, everyone agrees that it has been over-ordered, perhaps in case restrictions tighten further. This increases the risk of a sudden plunge.
In the long term, export controls will force China to develop its own semiconductor ecosystem. This is very challenging, especially without access to established supply chains in Europe, Japan and the United States. But even if China only succeeds in reverse-engineering older lithography machines, it would shut down an important revenue stream for Western suppliers.
Even ASML's most advanced competitors have been unable to replicate its extreme ultraviolet equipment, giving the Dutch company a monopoly on one of the foundations of artificial intelligence. This is one of the reasons why its stock trades at a higher forward price-to-earnings ratio of 33 times than its peers, helping it become Europe's most valuable technology company.
But the market dominance that makes it so attractive to investors also puts ASML squarely in the middle of the U.S.-China chip war. It's an unwelcome development, even if it has boosted the company's financials so far.
At the top of the semiconductor "food chain", ASML is alone in seeking defeat.
ASML (NASDAQ:ASML) is one of the leading companies in the semiconductor space and plays a vital role in the industry. Its stock performance history is exceptional, with a remarkable 380% growth over the past five years. Despite these successes, there are signs of uncertainty about its long-term potential.
Some recent news has raised doubts about the sustainability of ASMLEUV technology, especially in the face of competition from Japanese companies such as Canon. Additionally, the release of less optimistic guidance for 2024 raised more concerns about the company.
In my opinion, competition from Japanese companies does not appear to significantly threaten ASML's market dominance. On the other hand, while this year's guidance may look poor, I still firmly believe that the company's future remains promising over the long term.
A key feature of the ASMLEUV machine is its ability to project patterns at much shorter wavelengths than previous technologies. This allows for higher resolution and precision in chip manufacturing, allowing the creation of smaller, denser circuits. This capability is critical to continuing to advance Moore's Law, which states that the number of transistors on a chip will double approximately every two years.
In addition to high-resolution pattern projection capabilities, ASML's EUV machines offer greater energy efficiency compared to previous technologies. This is partly due to the use of extreme ultraviolet light, which improves the accuracy of pattern projection and reduces the need for additional processing stages.
It is almost impossible for any global competitor to copy ASML's supply chain. In fact, in the words of Frits Van Hoyts, who took over the EUV project in 2013, the key to developing EUV machines is not any specific breakthrough, but ASML's ability to manage its supply chain.
In the early stages of machine development, ASML manufactured only 15% of EUV machine components; the rest had to be sourced from thousands of external suppliers. One might think this is a weakness of ASML. If several suppliers go out of business, it will completely lose the ability to produce new equipment. However, I believe this is not the case.
Most companies, especially those critical to the supply chain, have exclusive contracts with ASML. This means that even if someone outside these companies wishes to obtain their products to try to replicate their technology, they will not be able to do so and will be forced to find alternative suppliers. Obviously, this proved to be quite a challenging task, especially given the type of product we're talking about.
Furthermore, ASML has such a strong dominant position in this supply chain that if it finds any suppliers falling short of expectations, it can simply acquire them. ASML acquired Cymer in 2013, HMI in 2016, or BerlinerGlasGroup in 2020, among other companies involved in its supply chain. These companies are typically much smaller than ASML, allowing ASML to acquire them with relative ease if it believes its supply chain is at risk or if it thinks it can do a better job leading these companies.
Building the world's most complex machines requires one of the most complex supply chains, and ASML, through its exclusive contracts and ability to acquire key players in the supply chain, has almost complete control over what happens within it. For any competitor trying to copy its technology, in addition to the extremely difficult task of replicating its intellectual property, they must also have the ability to build and control an equally challenging supply chain. Given the current position of its closest competitors (in my opinion, Canon and Nikon), this seems virtually impossible to me, at least in the short term.
While we have established that ASML’s technology will be difficult to replicate due to its complexity and convoluted supply chain, there is an additional reason why I believe ASML will dominate the EUV space. Let's consider the worst-case scenario: one of its competitors manages to copy its technology and bring to the market a machine with the same functionality. How will they replace ASML given the limited number of customers in the market?
Currently, the world's most important semiconductor foundries have backlogs of orders based on ASML technology. ASML is their reliable supplier, providing cutting-edge technology and proven to be highly profitable. Considering all the potential problems this could cause, I highly doubt they would want to switch suppliers. Essentially, this means abandoning one production standard that has been in use for decades in favor of another that provides similar results at best but carries the significant risk that the transition to a new supplier may not be successful.
So in order to incentivize a big customer like Samsung or TSMC to switch to a major supplier, you not only need to match ASML on performance and price, but exceed it. Considering it seems impossible for them to match ASML's technology, the idea of someone significantly surpassing it seems almost impossible. Especially when we consider that ASML is a leading investor in next-generation technology research. Last year alone, they invested 4 billion euros in research and development, and the investment is expected to exceed 6 billion euros by 2030. If anyone is to surpass ASML technology, it seems to be ASML itself.
Three of ASML's main customers and chipmakers - Samsung, Intel and TSMC - have invested heavily in ASML during the development of EUV technology. Therefore, it is reasonable to assume that they would prefer to use the technology they invested money in developing.
In the latest financial report, ASML mentioned that they expect sales to be basically flat in 2024. This shocked many investors, because ASML has always been classified as a "growth" company, and how could a growth company not grow?
The clear answer to this question is that the semiconductor market is a cyclical industry. When demand increases, so does manufacturing capacity, as will be the case in 2020 and 2021. The current drop in demand has led chipmakers to postpone investments in some capacity expansions. However, demand will rise again, just as it has been happening since the industry's inception, and will continue to be so for many years as long as the industry's tailwinds (cloud, digital, 5G, IoT, etc.) persist.
So I don't think the lower guidance for next year reflects a deterioration in their business or a lack of interest in their technology. Instead, it more accurately reflects the cyclical nature of the industry. In fact, some TSMC and ASML executives themselves said in recent earnings reports that they believe the bottom of the cycle is very close, or that we may already be in it. In fact, 2025 is expected to be a year of significant growth for the industry as a whole, and ASML in particular. ASML CEO himself said:
"As a result, we expect 2024 to be a transition year. Based on our current view, we take a more conservative view and expect revenue numbers to be similar to 2023. But we also view 2024 as an important year to prepare for the substantial growth we expect in 2025." - ASML President and CEO Peter Wennink.
In my opinion, we should not view 2024 as a weak year for ASML, but as a strong year. If your sales remain flat during the trough of the cycle, that's a huge success in my book. Considering that companies like Intel, AMD, Texas Instruments or Analog Devices have seen sales decline in recent quarters, ASML maintaining the same revenue level shows that its moat is still very strong.
I understand that some investors would rather see 10% growth two years in a row than 0% growth one year and 22% the next. However, the semiconductor industry has been operating this way for decades and will likely continue to do so. Our best approach as investors is to be aware of this and take advantage of the potential market volatility that comes with sudden changes in expectations that often occur.
2024 will be a transition year, so revenue is not expected to grow and margins are expected to decline slightly. However, as management said, growth is expected to return to 24% by 2025, with margins expanding significantly. From there, I believe growth will slow to more sustainable double digits, while margins continue to expand slightly.
On the other hand, stock buybacks will continue due to the large amount of cash flowing into the company. ASML expects annual R&D investment to be around 6 billion euros, and capital expenditures according to their own estimates will be around 1.5 billion euros. So the amount of excess cash will be significant, and I believe they will choose to return it to shareholders in the form of stock buybacks. I expect shares outstanding to decrease by 1% per year. Additionally, in order to calculate our total investment return, we have to consider that ASML pays a small dividend yielding approximately 1%. Extremely conservatively, I assume this will not grow over the next few years, although the likelihood of this happening is very low.
Although the prospects for 2024 are not the best; however, if we look further out, we will find that ASML's long-term potential is still huge.