When you’ve got something special and the market knows it, sometimes it knows it all too well. And this presents a CFO with a unique set of challenges.
ASML Holding N.V. [NASDAQ: ASML]
Advanced Semiconductor Materials Lithography, a.k.a., ASML Holding N.V., is a Dutch corporation with a very special technology. It produces machines called Extreme Ultraviolet Lithography scanners (EUV or EUVL) used in the manufacture of semiconductors, the chips which form the brains of computers used in all sorts of applications which run the world today. These EUVs are no ordinary machines. They are essentially lasers, which use extremely sophisticated materials and mechanical processes involving high-energy plasmas and complex arrays of mirrors and lenses to produce a precise streams of ultra-high frequency radiation. They are really hard to make. And they don’t come cheap. EUVs tools now sell for USD 120 million apiece.
The reason these EUVs are necessary is that in order to extend Moore’s Law and continue to make computers more powerful—an ongoing trend since the invention of the transistor in 1947, predicted by electrical engineer Gordon Moore of Intel—the semiconductors which contain the logic on which they operate need to pack more of these working units, or transistors (0 or 1 switches) onto an extremely small microchip a few square inches in area. Typical densities now for integrated circuits are in the vicinity of tens of millions of transistor per square millimetre, even up to 100 million MT/mm^2, and a typical microprocessor for a personal computer can have as many as 50 billion transistors, on a die size of 10 square centimetres (1 1/2 square inches), packaged into a chipset which will fit comfortably into the palm of your hand.
Semiconductors are etched at an microscopic scale with precision lasers. When the minimum metal pitch, the distance between two interconnected lines, got as small as 40 nanometres—about a thousandth the thickness of a human hair—for sufficient precision in the etching process it was necessary to use light beams with a commensurably short wavelength, and therefore a very high frequency. For this the etching process required a new technique, so the foundries moved from immersion lithography to EUV lithography.
Below is a brief video about EUVs:
It took a lot of research and development to get this right. ASML was able to develop this technology. Japanese competitors Nikon and Cannon, semiconductor capital equipment (semicap) suppliers which were key players in the immersion lithography tool business, did not make it to this next level of technological advancement. Today ASML has annual net profit exceeding the entire market capitalisation of Nikon.
In 2012, while the EUV technology was in the development stage, ASML bought US semicap firm Cymer, Inc. for $2.5 billion. The surviving company became a lucrative monopoly on EUV machines, currently earning in excess of $4 billion dollars in annual profit selling these fancy lasers to leading foundries such as Taiwan Semiconductor Company (TSMC) and Samsung Electronics, who currently employ these tools to make some of the densest microprocessors manufactured today.
Anyway, as far as business is concerned ASML—in the American parlance—is in the catbird seat. They are growing fast with the computer hardware industry, remain highly profitable, and have no visible competition on the horizon, as they continue to advance to the next level of magical microsopic manufacturing. Or, more properly, nano-manufacturing, but that would destroy the alliteration. This next phase is called High-NA (numerical aperture) EUV, which is currently under development. The growing monopoly market position is not exactly lost on Wall Street. In fact, at the corner of Wall & Broad, where word of profit or loss travels at the speed of light, ASML is pretty well the cat’s pyjamas, as it crosses the tape today with a market valuation of roughly $230 billion. The value of the company is not exactly lost on regulators either, as last year the White House had been lobbying the Dutch government to cancel ASML’s export licence to China, in fears that the technology could be poached, and help to accelerate the Middle Kingdom’s rise to technological, military, and economic hegemony. Western concerns over legal protections for intellectual property in China are certainly relevant to ASML. One can see this by observing that the market capitalisation of the company is roughly 30 times its tangible book value. The difference? Intagibles such as IP (patents), customer relationships, etc. In short, the savoir faire in constructing these wonderful and mysterious machines.
ASML’s net income for 2020 was $4.3 billion. Since they’re growing, cash conversion was 80%, and resulting free cash flow was $3.5 billion. They have roughly zero net debt, and so trade at a (levered or unlevered) P/E of 54, and a P/FCF of 67. This is no modest valuation, in absolute terms. However, it could be justified, given the growth potential and strong competitive position of the company.
ASML’s best customer, TSMC, forecasts 10-15% annual growth in sales for the next five years. In the past 15 years, TSMC has grown at a 14% rate. ASML, along with TSMC, should benefit from expected growth in demand for electronic devices from continued PC and mobile penetration in the developing world, more complex automobiles, 5G internet, internet of things, artificial intelligence, and the general trend towards there being more and more sensors and computers installed in everything. TSMC has taken the lead in process technology from competitor Intel Corporation, and will produce most of the most advanced and expensive chips for several years’ time. So this forecast made on the Q4 2020 conference call by Taiwan Semi’s management may prove to have been conservative. On the other hand, foundry TSMC’s competitors Samsung and Intel, both Integrated Designers and Manufacturer’s (IDMs) of microprocessors, are not standing idly by to watch TSMC monopolise chip fabrication at the most advanced node. All three will be using EUV technology in their foundries in the coming years, and ASML should find other customers for EUVs as well. In this arms race, ASML should be a winner.
Semiconductor manufacture has transitioned years ago from a vertically integrated industry where players like International Business Machines Corporation (IBM) designed and manufactured microchips from scratch, and built mainframes and personal computers for consumer end markets, to a more horizontal industry where firms specialised mostly at one stage of the production cycle. Consequently, today the industry has a tightly integrated global supply chain. But not every echelon of the vertical supply chain is equally competitive. For example, there are three leading foundries for advanced logic: TSMC, Samsung, and Intel. Meanwhile, only one company makes EUVs: ASML. In theory, the monopoly which makes key equipment required for the growth and continued competitiveness of each these oligarchic industrial behemoths should have even more pricing power than they do. It is not implausible that as the cost structure of the three foundries expands with their revenue, a disproportionate share of the expense growth goes into ASML’s pockets. And as competition intensifies among the foundries with the entry of Samsung and Intel into the EUV market, ASML’s pricing power rises. So it is conceivable that revenue growth could be as much as 20% for ASML, over their and TSMC’s forecasting horizon of 5 years, yielding a roughly 2 1/2-fold increase in net revenue. In addition, provided that suppliers are held in check by competition, and ASML’s costs rise more slowly than revenues, as well as a little help from operating leverage to a more modestly rising general and administrative expenses—an accomplishment trumpetted by ASML’s CFO in the company’s last conference call—and consequently net margins rise from the low-30s to perhaps 40%., net income could increase by 230%, to over $14 billion. Discounting this at an equity rate of 9% to the present, and applying a terminal multiple of 30x, which would be typical of today’s equity market for an business with average growth, one could arrive at an appraisal of $280 billion, indicating that the stock is undervalued. Given that in 2025 the growth outlook for the industry is entirely likely to be higher than in the average industry, the stock may prove to be a considerable bargain, as gains continue to outpace the market.
We should here emphasise that this is really no more than a shot in the dark. Nobody knows what these industry demand growth rates will be, how competitive the sector will become, how the technological landscape will evolve, or whether an entirely new process will displace EUV, and whether ASML will own it or not. Semiconductor analysts and investors attempting to assess ASML’s equity are faced with such questions, and even an electrical engineer who is a specialist in advanced semiconductor technologies and commerce may find it hard to arrive at a appraisal within a margin of error not containing the current stock price.
Not only do analysts and investors need to make a judgement about ASML’s valuation; so too must the company’s board of directors and chief financial officer, Roger Dassen.
With all that lucre, what can they do?
Hoard cash
Pay down debt
Invest more in R&D
Make an acquisition
Pay a dividend
Buy back stock
Conservatively repaying debt and hoarding cash is sensible, to a point, as it derisks the company and protects it from a downturn in the industry capital cycle. The company’s balance sheet is already strong, with positive net cash and securities, and positive working capital. Since interest rates are virtually zero, and credit ample, there is a limit to how much of this should be done.
Dividends are a neutral way of returning profits to shareholders. One ought to do this if the potential returns of reinvesting in the business are low. But in theory, as long as the company grows profitably, with a high return on capital, it ought to retain earnings and reinvest them.
According to Modigliani-Miller (MM) Dividend Irrelevance Theory, buybacks are equally good. Shareholders’ interests are automatically concentrated, and those who prefer a dividend can simply sell a few shares as they wish, creating a synthetic dividend of their own. One advantage of buybacks is that they are not taxable, and those who harvest by selling concentrated shares have their synthetic dividend taxed at a capital gains rate, which is often lower than that of dividend taxation, and not subject to withholding tax in tax-deferred accounts, as cash dividends generally are.
At a certain valuation, buybacks destroy value. If the stock is overpriced, management creates more value by issuing equity to fund investment via acquisitions. But what should they buy?
A competitor? Yes. It is always in a firm’s financial interest to buy a competitor at a fair, or equal, valuation, as it reduces competition and gives them pricing power over customers (revenue synergies), and reduces corporate overhead, as expenses are amortised over a larger operation, and they attain a stronger negotiating position with their suppliers (cost synergies). For purposes of return maximisation, firms should always buy competitors and integrate horizontally, provided they can get it past competition regulators.
A customer or supplier? Customers would be too big in this case, but suppliers, whose business management understands, if available at a lower valuation, could make for an accretive acquisition candidate. For example, German optical equipment maker Carl Zeiss AG, long-time supplier of lenses to ASML, which is privately held, may be a sensible target, provided shareholders are willing to sell at worthwhile price. In fact, ASML already acquired a 25% stake in 2016. On the other hand, the history of vertical mergers suggests that most destroy value, given that acquirers are often forced to overpay, integrations can be costly and distracting to management, and cultural differences can wreak havoc.
In this case the answer is probably that the company should buy any company with IP which threatens to break their monopoly, or has a technology which could help them develop the next generation of equipment which could help their customers advance to the next process node, and thereby add value to them.
ASML makes EUV exposure machines. Many of the semicap companies contributing to the EUVL process are Japanese. But while often described as competitors, they are more properly thought of as complements or suppliers: Gigaphoton (light source), AGC and Hoya (mask blanks), NuFlare (mask writers), and Tokyo electron (photoresist) specialise in other equipment and consumables used in the wafer etching process which uses ASML’s EUV exposure machines. In fact, each one has high market share in its speciality line(s). In theory, each one could commit R&D resources to adjacent businesses and compete with their complements, but in practice they mostly stay in their high-margin niches where they enjoy the benefits of economic concentration. Being in an oligopoly or monopoly business is a lot better than being in a competitive one, but pricing power is not infinite; rather, it depends on the relative competitiveness of adjacent horizontal markets (customers and suppliers) and the value add to the overall process for the end user. They can only earn as much as their value add and whatever portion of competing customers’ and suppliers’ margins they can chip away with their dominant market position. Whether an acquisition of a supplier or complement would make sense for ASML is a judgement for management to make.
Japanese corporations have a somewhat different culture to Western companies, and tend to have less profit and return on capital relative to their value add, and this seems to have held true for decades. Many Japanese exporters specialise in advanced engineering process technologies, and have very high market share; yet, their profit margins and returns on capital remain anaemically low. There are many reasons for this. One is that they are not financially optimised. They tend to be underlevered, by Western—and certainly, American—standards, and even hoard cash. So returns on equity are lower. But there are operational reasons as well, and theories involving more subtle cultural explanations.
Japan could be described as a more egalitarian conformist society, which does not tolerate the levels of inequality that other developed nations do, except for perhaps a few in Northern Europe. A few years ago it had the lowest Genie coefficient—a measure of income inequality—in the world, at 25. This has been ticking up, along with most other developed countries, to about 30. But still, there seems to be more concern for taking care of less productive or older employees, which limits mobility for more productive workers. Japan has never had the aggressive hiring and firing culture of America; quite the opposite. There are humorous accounts of Western investors sitting in on boardroom meetings with Japanese multinationals where they discuss the interests of customers, employees, suppliers, creditors, regulators, etc., without a single mentions of shareholders. Furthermore, corporate governance is somewhat less shareholder friendly than in America. The Japanese Keiretsu model of horizontally- and vertically-integrated conglomerates with cross-shareholdings in other corporations, which is common throughout the Far East, partly allows directors to maintain control of enterprises with a fraction of the economic interest which would otherwise be required. So Japan hasn’t the M&A culture of America, either. All this is a broad generalisation, and some say that governance is starting to become more Western and shareholder friendly, but change is slow.
The German economist Richard Werner, who worked in Japan as chief economist of Jardine Fleming, wrote a book called Princes of the Yen. There was a wonderful documentary made about it, which I shall link below. The basic idea is that after World War II, during the Japanese reconstruction, at the behest of US occupying forces, many of the wartime senior bureaucrats, who were implicated as war criminals, were reintroduced to build an advanced industrial economy. This economy, although ostensibly capitalist and market-driven, was, in actuality, largely centrally planned; not in the sense of the Soviet Union or Mao’s China, but more like post-Deng Xiaoping modern China, often dubbed “capitalism with Chinese characteristics”, for which post-war Japan could be considered a model. This capitalism with Japanese characteristics was more akin to the pre-war industrial economy of Dai Nippon Tei Koku, the Great Empire of Japan, dominated by Zaibatsu, horizontally-, and vertically-integrated financialised industrial conglomerates.
As such, this new economy was actually largely centrally planned by the Bank of Japan (BoJ)—Japan’s central bank—and the Ministry of Finance (MoF) via a mechanism known as madoguchi-shido, or window guidance. This was a sort of credit guidance, whereby the MoF would periodically advise the BoJ on recommended instructions to the commercial banks on how to allocate credit to various sectors of the economy; whether to expand or contract their loan books, and in which areas. The result was a business climate which incentivised competition for market share, and tended towards productivity and full employment, at the expense of shareholder returns. This worked quite well, as Japan became a threat to American global industrial dominance in the 1970s and 1980s. Indeed, it worked perhaps all too well. And this comes to the conspiracy theory. Werner points out that the MoF tried for many years to reform the system to one of Western-style shareholder capitalism, but was unable to persuade bureaucrats and the Japanese people that its planned “structural reforms” were needed. Whey would they, when the nation was so prosperous, and all citizens were sharing well in that prosperity?
Failing at persuasion, the BoJ turned to coercion, by issuing extremely aggressive window guidance, which caused the commercial banks to blow up a huge credit bubble in the late 1980s. The result was Japanese corporations engaging in a great deal of corporate mergers and acquisitions, buying up trophy assets in America, the almost incredible phenomenon of the land under the emperor’s palace in Tokyo being worth more than the entire state of California, and a stock bubble whereby the NIKKEI traded at 60x earnings. Credit was misallocated to speculative asset-based lending, such as in real estate and in the stock market, rather than productive lending, in manufacturing and the real economy. Then, in 1989, the MoF pulled the rug out from under the Japanese economy. Window guidance advised a contraction of loan books. The subsequent long deflationary recession, accompanied by severe unemployment and bankruptcies of Japan’s Lost Decade paved the way for US vulture funds to buy up assets cheaply. Apparently, it didn’t work very well for these Western moneyed interests, but similar tactics employed by the same cast of characters against weaker, less developed and diverse economies in the Far East, including Malaysia, Indonesia, the Philippines, and, to a lesser extent, South Korea, were apparently quite effective in the late 1990s during the regional recession which followed in the wake of the Asian Tigers’ currency crisis following the Russian sovereign default in 1997 and the implosion of Long Term Capital Management in 1998.
The unspoken implication here was that some influential people in the United States somehow infiltrated, or at least influenced, the MoF—either directly or through the economic theories promoted by the Western academic establishment—with a view to collapsing America’s greatest competitor at the time, as well as creating an opportunity for private investors, with the help of US investment banks, to poach Japanese assets. The World Bank and IMF are characterised as facilitating, through predatory lending, the transfer of assets from countries in crisis to established Western nations, and, in particular, into the hands of the latter’s capitalist elites. Chinese mercantilist policy apparently uses many tactics in the developing world not dissimilar to this American economic imperialism, which, in turn, may be compared to the methods of economic control of European colonial territories.
Returning to the point at hand, it appears that the MoF has implemented its plan and completed the intended structural reforms, transitioning the Japanese economy towards a more Western-style shareholder capitalism. But the ultimate degree of change appears modest in some respects, at least insofar as listed companies’ economic value added translating into shareholder returns. This, together with the cultural differences, may make ASML’s peers less than a good fit for mergers and acquisitions, when considering industry consolidation opportunities as an accretive use for their valuable currency of 60-PE stock.
As to what ASML should do with its ballooning profits from selling plasma laser guns, I really have no idea. They are currently choosing dividends and buybacks. Last year they paid $1.3 billion in dividends, and repurchased $1.5 billion in shares. They spent $2.7 billion on research and development, and have transacted the occasional tuck-in acquisition. Based on the above assumptions on growth and operating margin for the next 5 years, nearly 75% of ASML’s market cap resides in its terminal value. And, technically, with share buybacks, a lot of that free cash flow gets ploughed back into terminal value anyway, so the terminal value ratio is effectively much higher than that. Terminal value, here, is just a fancy way of saying how much you’re willing to pay for a company’s future well beyond the horizon of the foreseeable future.
It’s pretty obvious that ASML’s EUV is the bee’s knees. But that’s the problem. It’s obvious to analysts and to the market. ASML is nearly the most valuable listed company in all of Europe, just a shade less valuable than luxury goods maker LVMH, and about the size of oil majors Royal Dutch Shell Plc and Total SA combined. So, while the esoteric capital goods supplier headquartered in Veldhoven, North Brabant of the Netherlands is not exactly a household name, its mission critical space-age computer hardware monopoly and the exorbitant lucre flowing into its coffers are not exactly a well kept secret in the global capital markets. Does their growing monopoly justify such a high asking price? It is neither obvious to me that it does, nor that it doesn’t. Given the lack of diversity in the company’s business lines (they essentially make 40 units of one type of machine per year) there is a high variance of outcomes, depending on if, when, and how the company’s technological advantages are competed away, disrupted, or otherwise obsoleted. An industry specialist may have a strong view on how long ASML can retain its dominance, and may be able to build a discounted cash flow model to value it. I, for one, cannot.
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Below is a link to the documentary Princes of the Yen, published 2014.