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ASML Has A Wonderful Future With EUV

Summary EUV tools have changed the world and ASML is the only company making them. The unit price of EUV tools has climbed to $150 million and it will continue rising with high NA. ASML management has been buying back shares prodigiously. Introduction Lithography systems are key as the semiconductor industry keeps shrinking transistors on microchips. The shorter the wavelength of the light, the better. This is the same way that a finer brush is better than a thick brush for detailed painting. ASML (NASDAQ:ASML) is the world's only manufacturer of Extreme Ultraviolet ("EUV") lithography systems. The 13.5 nm EUV product offering is used for 7nm and 5nm chips. ASML sold 42 EUV systems to customers like Taiwan Semiconductor (TSM) and Samsung (OTC:SSNLF) in 2021. The 193 nm Deep Ultraviolet (DUV) system is still widely used but it is 14 times wider than the 13.5nm EUV. My thesis is that ASML's EUV business will continue to do well for many years but it is less clear how the stock will perform. At the time of this writing, $1 = €0.96. ASML - The Only Maker Of EUV Tools The $150 million EUV tools are complex machines and ASML is the only company making them. Chairman of the Supervisory Board Gerard Kleisterlee makes it clear in the 2021 annual report that EUV customers "have no alternative" to ASML: Particularly in EUV, it is important for ASML to be totally transparent toward its customers, because they have no alternative. It wasn't easy for ASML to become the world's only EUV manufacturer. The 2021 annual report talks about the billions in R&D and the Cymer acquisition as required groundwork: We succeeded by innovating in close cooperation with our customers and suppliers. This partially explains why ASML is the world's only manufacturer of EUV lithography systems. Since its introduction, our EUV installed based produced more than 59 million wafers by the end of 2021, compared to 26 million wafers produced by the end of 2020. The 2021 annual report explains that 96,566,077 shares were issued in 2012 as part of the customer co investment program ("CCIP") to speed up the development of EUV. A November 2012 F-4 filing says ASML issued 62,977,877 shares to Intel, 20,992,625 shares to TSMC and 12,595,575 shares to Samsung. 13G filings show that all of TSMC's shares were sold by the end of 2015 and Intel's shares were partially sold over the years such that they had just 6,936,055 shares remaining by the end of 2019. The 2018 annual report shows that we started seeing double digits of EUV system sales in 2017: The 2021 annual report shows that EUV sales passed ArFi or Argon Fluoride Immersion sales in 2020: We see that the average unit price of EUV tools has gone up over the years such that they are now close to €150 million each. This will continue to rise in future years as High NA ("numerical aperture") tools become part of the EUV sales mix: Year EUV Units (in millions €) EUV Average (in millions €) EUV % of system sales Logic % of end-use 2016 4 €331 €83 7% 68% 2017 11 €1,084 €99 17% 54% 2018 18 €1,880 €104 23% 45% 2019 26 €2,800 €108 31% 73% 2020 31 €4,464 €144 43% 72% 2021 42 €6,284 €150 46% 70% One part of the above spreadsheet that stands out is the increase of logic as a % of end-use from 45% in 2018 to 73% in 2019. This shift from memory to logic was explained in the 2019 annual report where it was said that innovation drivers such as AI, 5G, high-performance computing, self-driving and big data require performance logic: Logic customers are accelerating the ramp-up of their leading-edge nodes, while the Memory market continued to digest inventory in the supply chain and operate with reduced wafer output as they worked to reach a more normalized supply-demand balance. This led to a decrease in Memory demand while we experienced an increase in Logic demand. Major innovation drivers such as artificial intelligence, 5G, high-performance computing, autonomous driving and big data are enabling new end-user applications. These applications require increasingly more high-performance Logic, fueling increased demand for leading edge nodes. CTO Martin van den Brink talks about continued growth for EUV in the 2021 annual report: We expect that adoption of EUV will continue to grow, with all advanced node chipmakers expected to use EUV in production by 2024. The Business Model portion of ASML's September 2021 Investor Day presentation shows that they will continue having 100% of EUV market share in 2025: The same Investor Day presentation shows that EUV growth is continuing. The larger 2025 pie size reflects expected revenue growth: Viewed through the buyback lens, ASML is intriguing at today's levels. The 2021 annual report shows that 14,358,838 shares were repurchased in 2021 at an average price of €596.17 for a total consideration of €8,560.3 million. In other words, management thought it was smart to buy back a large amount of stock at prices higher than today's level. Putting the €8,560.3 million in perspective, the cash flow statement shows that they only spent €410 million and €1,207.5 million on buybacks in 2019 and 2020, respectively. Apart from synthetic buybacks, their share buyback page shows that there was only 1 other time going back to 2006 when they spent €1 billion or more in a single year and that was in 2018 when they spent €1,146 million. In terms of the number of shares purchased in a single year ignoring synthetic buybacks, they only beat the 2021 number of 14.4 million shares 3 times and that was when they bought 40.4 million shares in 2006, 17 million in 2007 and 25.7 million in 2011: Their 2021-2023 share buyback program spreadsheet shows that strong buybacks continued beyond 2021 and into 2022 such that 4,477,345 shares were purchased for a total consideration of €2,626,128,434 between January 1st and May 6th at an average price of €586.54: Viewed through a lens of traditional yardsticks in an environment where interest rates are going up, ASML's valuation is less intriguing. The presentation in the 1Q22 results section breaks down the latest quarter. 9 EUV units were shipped during the quarter but only 3 were recorded as sold such that we get a good view of EUV end-use by comparing this to the previous quarter where 11 EUV units were sold. EUV was almost half of system sales in 4Q21 and logic was nearly 3/4ths of end-use. In 1Q22, EUV fell closer to 1/4th of system sales and logic end-use fell to about half. This implies that relative to older technology like ArFi, EUV skews more towards logic end-use. This is consistent with what we saw in the spreadsheet earlier when logic went from 45% of end-use in 2018 to 73% in 2019 such that the 2019 annual report cited innovation drivers like AI, 5G, high-performance computing, self-driving and big data: I'm not overly worried about the quarterly fluctuation above. Sales growth expectations for 2022 are unchanged; strong demand drives expected net sales growth of around 20%. Also, CEO Peter Wennink said the following at the latest Investor Day: This is not about the next quarter. It's about the next decade. The April 2022 annual meeting presentation shows that net income in millions of € has been climbing rapidly but the 2021 net income of €5,883 million is relatively small compared to the company's market cap: The 2021 annual report shows that free cash flow ("FCF") was €3,626.8 million and €9,905.5 million for 2020 and 2021, respectively. I like to think of share-based compensation as a cash expense and lower these amounts by €53.9 million and €117.5 million, respectively. Much of the 2021 FCF came from changes in assets and liabilities that are not sustainable. These changes came to €531.6 million in 2020 and €4,892.4 million in 2021 such that future earning power is better reflected by the 2021 net income number than the 2021 FCF number. Some investors might be concerned that the 2021 annual report shows that 2 customers [TSMC and Samsung] are responsible for 2/3rds of sales totaling €12,505.4 million. Furthermore, ASML's 3 largest customers based on net sales accounted for €3,855.2 million, or 83.7%, of accounts receivable and finance receivables as of December 31st. EUV sales have propelled growth in Taiwan due to TSMC and in South Korea due to Samsung. South Korea sales jumped from €2,202.1 million in 2019 to €4,151.6 million in 2020. China has large sales despite the fact that exogenous political considerations prevent EUV sales in that geography. The U.S. has large sales as well despite the fact that Intel has not been participating in major investments in EUV tools like TSMC and Samsung. Optimists may point out that the potential for future EUV sales beyond Taiwan and South Korea is extremely high: The Business Model portion of ASML's September 2021 Investor Day presentation is helpful for a valuation framework. Systems revenue grew at a 10% CAGR between 2010 and 2020 while Installed Based Management revenue grew at a 20% CAGR. EPS grew at a 14% CAGR with some help from buybacks. We see a revenue inflection point in 2017 as EUV started becoming meaningful: The Investor Day presentation goes on to show that shareholders have been extremely well rewarded relative to the S&P 500 over the years: Looking ahead at the future economics, we have to start with end market growth on a general level and hone in on the wafer level. The total semiconductor end market CAGR from 2020 to 2025 is expected to be 7.4%. Management believes High NA should be a big factor in 2025 and 2026. Management notes that the revenue CAGR for the installed base from 2015 to 2020 was 13% and they say it should be 12% from 2020 to 2025. In 2018, management thought ASML's 2025 Dry market share would be 60% but now they believe it will be higher at 65%. Management is being conservative in saying there will only be 5 High NA units in 2025 revenue as it is expected that shipments will be well above 5. They are building more capacity than what is shown for sales. The 2025 low and high market numbers from the annual report match the numbers in the Investor Day presentation: By 2025, it is expected that capex will only be 3% of sales. Here is their updated model for 2025: Given the capacity plans and other considerations, I'm optimistic that the actual 2025 numbers will be close to management's high market assumptions. This means gross profit of €16.8 billion given a 56% gross margin on sales of €30 billion. Subtracting R&D of €3.7 billion along with €1 billion of SG&A gives us operating income of €12.1 billion. Our job is to figure out what a business with these types of future numbers is worth today. It looks like Yahoo Finance uses a share count similar to what we see in the annual report for their market cap. The 2021 annual report says there were 402,601,613 shares outstanding as of December 31st and the May 16th ADR price was $534.95 indicating a market cap of $215.4 billion. We know that 4,477,345 shares were repurchased from January 1st to May 6th so the real market cap is lower than this. The enterprise value is fairly close to the market cap as the 1Q22 balance sheet shows €4,324.1 million in cash and equivalents which is largely offset by €3,951.7 million in long-term debt. It's hard to say if Mr. Market is correct such that ASML is worth more than $200 billion. The business is wonderful but investors are willing to pay less of a premium as interest rates go up. Disclaimer: Any material in this article should not be relied on as a formal investment recommendation. Never buy a stock without doing your own thorough research. This article was written by I'm an individual investor heavily influenced by Warren Buffett and Charlie Munger. Munger's 1994 USC Business School Speech is something I think about a lot: ### Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result. ... Another very simple effect I very seldom see discussed either by investment managers or anybody else is the effect of taxes. If you're going to buy something which compounds for 30 years at 15% per annum and you pay one 35% tax at the very end, the way that works out is that after taxes, you keep 13.3% per annum. In contrast, if you bought the same investment, but had to pay taxes every year of 35% out of the 15% that you earned, then your return would be 15% minus 35% of 15%—or only 9.75% per year compounded. So the difference there is over 3.5%. And what 3.5% does to the numbers over long holding periods like 30 years is truly eye-opening. If you sit back for long, long stretches in great companies, you can get a huge edge from nothing but the way that income taxes work. ### Feel free to follow me on twitter: Disclosure: I/we have a beneficial long position in the shares of ASML, VOO either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Comment

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