Key upstream components of the broader semiconductor value chain, such as equipment makers like ASML (NASDAQ:ASML) and fabs like TSMC (TSM), have yet to benefit as much from the emergence of AI momentum in the market. And this is largely due to the slimmer margins and ensuing cash flows that result from the capital-intensive, yet mission-critical, business models. This also explains why these stocks are typically more prone to adverse headlines concerning the broader semiconductor industry, such as cyclical challenges, geopolitical headwinds, and regulatory constraints.
But ASML remains the leader in critical chipmaking equipment and is an essential enabler of key next-generation technologies such as AI. Its proprietary extreme ultraviolet, or “EUV” system is the backbone to propelling scale in the pursuit of high performance and high complexity advancements in microchip technology. Between ASML, EUV, and AI, the common thread is that they represent some of the most expensive abbreviations in the world, as they entail long-term growth opportunities for industries beyond tech.
Despite recent concerns that demand for ASML’s EUV systems might come in weaker than expected next year – which has triggered a brief immediate pullback in the stock, consistent with the name’s sensitivity to any and all fundamental-impacting semiconductor headlines – the company’s long-term moat remains intact. With the stock still largely trading below its semiconductor peer group average – and reasonably so given the sector’s massive premium attributable to lofty AI profit margins that ASML only benefits partially from due to its capital-intensive business model – we believe there is room for more durable upside realization over the longer-term, sustained by the company’s advantage in being the sole provider of some of the most mission-critical equipment in the industry.
What is EUV?
ASML credits EUV as the technology that enables the mass production of increasingly advanced microchips. EUV lithography uses a “wavelength of just 13.5nm”, enabling the production of increasingly advanced and complex chips fitted with billions of tiny transistors at scale. EUV lithography is behind the highly competitive race in introducing finer process nodes, including TSMC’s most advanced 7nm, 4nm and 3nm process nodes used in manufacturing Nvidia’s (NVDA) existing H100 and A100 GPUs optimized for AI workloads, as well as the next-generation B100 GPUs shipping in late 2024. ASML’s EUV lithography system is also used in Intel’s (INTC) “Intel 4” process node, which the next-generation Meteor Lake CPUs shipping later this year are manufactured on.
As previously discussed, increasingly fine process nodes are becoming critical in supporting the development of higher performance and more power efficient semiconductor technologies – hence ASML’s allusion to EUV as the system that “drives Moore’s Law forward”. Specifically, Moore’s Law stipulates that the number of transistors fitted in a chip will double every two years. However, the limitations are increasing as technologies become more advanced and complex, making it increasingly difficult to uphold the performance improvement timeline stipulated in Moore’s Law. This has accordingly unleashed a series of complementary innovations and theories in recent years to extend the relevance of Moore’s Law, including the introduction of new processes like “3D Chip Stacking”; innovations like Intel’s transition from the nanometer to Intel puts TSMC on notice with step towards Angstrom era chips era with “Intel 18A” and “Intel 20A”; chipmaking equipment enhancements like ASML’s EUV lithography systems; as well as the extension beyond hardware improvements to complementary features of a full stack process inclusive of software and AI capabilities, as preached by Nvidia CEO Jensen Huang.
Circling back to EUV – by using a 13.5nm wavelength (for perspective, a human red blood cell is 7,000nm in diameter), ASML’s EUV lithography systems allow packing more performance into microchip architectures at scale, which is critical for chipmakers and only practical for facilitating the continued development and deployment of advanced semiconductor technologies. Think of the recent innovations by chipmakers like Nvidia, Intel and AMD (AMD). Each new generation of their GPU, CPU, and accelerator architectures require packing more transistors to make the hardware “more powerful, faster and energy efficient”, hence the never-ending competition on refining process nodes among chip foundries, all of which are dependent on ASML’s EUV system.
By being the only maker of EUV technology in the world, ASML benefits from a tremendous first-mover advantage in the digital era heavily reliant on microchip advancements. As mentioned in the earlier section, increasingly complex chips required for massive AI and other high-performance computing workloads rely on EUV lithography. This underscores a significant market opportunity for ASML and reinforces its role as the backbone of next-generation growth technologies. And this moat is reflected in its pricing power and sustained demand.
Specifically, on the demand front, ASML’s monopoly in EUV lithography capitalizes on next-generation manufacturing requirements from key chipmaking fabs like TSMC and benefits from the recent slew of investments into new chip production capacities beyond Asia. Meanwhile, on the pricing front, the small volume of EUV systems deployed to date due to the consolidated fabrication industry footprint and complex manufacturing process of the lithography system itself also commands a hefty price tag. For context, since the inaugural shipment of ASML’s first-generation “EUV lithography demo tool” in 2006, the company didn’t celebrate the shipment of the machine’s 100th unit until 2020. The system goes for hundreds of millions of dollars for one unit, highlighting the capital-intensity to making the machine, as well as the premium that ASML’s proprietary system commands – the MSRP from early 2022 was around $150 million per unit on the standard 0.33 numerical aperture, or “NA”, system, and could go as high as $321 million a pop for the upcoming 0.55 “High-NA EXE” variant.
We spent 20 years developing EUV with our partners and suppliers, resulting in a machine that contains around 100,000 parts. To ship just one of these huge machines to customers requires 40 freight containers, three cargo planes and 20 trucks.
Source: Busting ASML myths, asml.com
Drilling a little further into ASML’s next-generation High-NA EUV lithography system. The company is not without its competitors. Key competitor Applied Materials (AMAT) has recently introduced a new technology dubbed “Centura Sculpta”, which effectively reduces the costs of chip manufacturing by addressing the redundancies in some of the previously required EUV lithography processes. Instead of a substitute for EUV technology, Applied Materials credits Centura Sculpta as a complement effective in helping chipmakers realize greater cost-savings in the manufacturing process while also reducing waste and improving output efficiency.
To ensure it is not falling behind in matching said improvements, ASML has relentlessly worked on next-generation variants of its proprietary EUV lithography technology, including the High-NA platform “EXE” that has recently shipped its “first pilot”. The High-NA EXE platform is designed to facilitate scale in chip manufacturing advancements “well into the next decade”, including support for the “2nm logic node and followed by memory nodes at similar density”. High volume chip production utilizing the High-NA EXE platform is expected to start in 2025.
A Potential Cut in 2024 Volumes
The latest news on the street is that ASML could potentially be in the position to cut its EUV delivery volumes for 2024. The dire expectations come from observations of weaker than expected end-market demand for advanced semiconductors, such as Apple’s (AAPL) 3nm-based A17 silicon currently used in the iPhone 15 Pro line-up, as well as its upcoming M3 chip that will be used in powering the next-generation line-up of Macs and iPads. This is in line with the lingering aftermath of the chip inventory glut that has led to the cyclical downturn experienced over the past 12 months, which has been exacerbated by a weak consumer spending environment that has impacted shipments of PCs and smartphones.
There are also concerns that the slow phase-out of a location-agnostic work environment implemented during the pandemic could impact demand for portable computing devices such as laptops and iPads, which will reduce the need for “Apple silicon and Mini-led features” reliant on fine process nodes enabled by EUV lithography. Limited exposure to demand for advanced chips from China – the largest semiconductor market – due to ongoing geopolitical tensions and restrictive national security policies implemented by Beijing and Washington has also been cited in the report as a potential limitation on the near-term need for EUV systems from fabs.
Near-Term Implications for the Stock
However, we see these concerns as a short-sighted view and unlikely to materially alter the prospects of ASML’s cash flows, or its stock’s upside potential. Much of ASML’s volumes are locked-in by long-term supply contracts, providing a high level of visibility into its growth and profit trajectory.
For instance, Intel had placed orders for ASML’s EUV systems in early 2022 in anticipation of the start of production of its Intel 4-based Meteor Lake this year. The chipmaker “took delivery of its first EUV lithography system” in late 2022 at its Ireland fab. The machines are key to Intel’s 4 nodes and 5-year technology roadmap stipulated in its IDM 2.0 turnaround strategy, with EUV lithography viewed as a critical link in putting Intel back on the map as a competitive chipmaker and manufacturer by 2025. ASML has also disclosed reservations for its next-generation High-NA EXE EUV systems from more than a year ago, even though commercial shipments are not expected until mid-decade. Takers include TSMC, which will likely be needing these machines to facilitate its global footprint expansion over the coming years. And all of this remains intact, whether Apple will generate sufficient demand in the near-term or not.
Near-term cyclical headwinds are not expected to have as much of a lasting impact on ASML’s cash flow prospects as compared to chipmakers situated lower in the semiconductor value change given their direct exposure to fluctuations in end-market demand. Admittedly, any adverse impact to guidance could impact the stock’s near-term performance, especially given the elevated cost of the capital environment which bodes unfavourably for capital-intensive business models like ASML’s, despite the company’s sustained growth and profit trajectory backed by its mission-critical technology moat.
We also view any near-term impacts to EUV shipments would be merely a shift in timing due to the weaker than expected cyclical recovery. While the industry had previously expected the chip inventory glut to normalize in 2H23, recent commentary from the latest earnings season from PC and chipmakers have highlighted a more tepid pace of recovery than expected, though the correction cycle and slow shipments have likely troughed in Q1. Such an occurrence of tepid recovery through the remainder of the year is reasonably expected, considering the economic outlook is still a “mixed bag”, especially with monetary policy likely to normalize into a more restrictive set-up.
But longer-term tailwinds for ASML include the build-out of domestic manufacturing capacities, which is not stopping now and will harbinger a requirement for new equipment including the EUV systems to facilitate long-term demand for next-generation chips. This also precedes an anticipated upgrade cycle to support next-generation HPC and AI chip architectures for addressing computing demands of increasingly complex workloads. More importantly, ASML is a key enabler of these technologies, underpinning its long-term growth and profit prospects. While any near-term underperformance or under delivery to guidance could drive volatility in the stock, ASML remains a name we’d like to add to partake in its longer-term upside potential.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
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