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👋 Introduction

Hello readers! We’re picking back up with ASML, a Netherlands-based equipment manufacturing company that supplies TSMC and other chip foundries with the machines needed to print ever-smaller transistors on the latest GPUs. Get up to speed with the previous two articles:

• Understanding the industry

• Understanding the product

What did we learn? ASML builds a lithography machine that uses extreme ultraviolet light (EUV), a feat of engineering that many scientists and engineers thought was impossible. The EUV machine is required for foundries to be able to print 7 nm and smaller chips, and is therefore widely credited with having saved Moore’s Law. In fact, many argue that the present-day AI boom is only made possible because of ASML’s EUV machines. It was a feat of technological and engineering brilliance that made these machines a reality, and ASML has been rewarded with a global monopoly.

How has ASML’s product excellence translated to financial success? That’s what we’re going to find out today.

Let’s dive in!

Understanding the financials

If you haven’t seen it already, I wrote a financial glossary that explains all the terms you’ll need to know for this section. If you get confused at all, read the glossary here.

Is ASML making money?

Revenue is consistently growing, with a 19.7% CAGR over the last 6 years ($10.11B in 2017 to $29.79B in 2023). In 2023, 33% of their revenue came from EUV ($9.86B) and 32% came from DUV ($9.7B). This shows me that even their older technology is still very relevant and profitable. They don’t have all their eggs in one basket.

Additionally, they’ve had very steady growth over time. There’ve been no sudden spikes, which indicates a sustainable, repeatable sales model.

If I zoom in to look quarterly, it’s remarkably consistent at $7-7.5B each quarter. The only outlier is in 2024 Q1, which dipped to around $6B. That’s worth looking into more.

Net income follows the same trend as revenue, which means their processes scale well. 24% CAGR, growing from $2.33B in 2017 to $8.47B in 2023; it also mirrors the down quarter in 2024 Q1.

But free cash flow (FCF), often considered the hardest metric to fake, doesn’t tell the same story. It peaked in 2021 and has been decreasing since. Granted, even with the dip, FCF has had a 13.3% CAGR, which is pretty good! If I take out the dip, and only calculate from 2017 → 2021, then ASML has had a FCF CAGR of 63%. That was the post-EUV boom and is surely unsustainable in the long run. While it makes sense that the free cash flow growth rate decreased, I still wanted to dive deeper into the sub-line items.

The funds from operations didn’t change; this means that they were still selling the same number of products. What did change, however, was their working capital, specifically in two sub-sub-line items:

• Changes in inventories

• Changes in liabilities

See how first one, then both, go negative by 2023? For a company that couldn’t keep up with customer demand, why would that happen? It doesn’t add up.

Let’s keep this in mind as we continue looking at the financial metrics.

Are they making money efficiently?

As usual, we’ll look at 2 metrics here: gross margin and net margin.

Gross margin is healthy, consistent and sustainable. Over the last 5 quarters, it’s been right at 50%. That’s a number that I’m happy with. Over the last 6 years, it’s increased steadily from around 43% to the aforementioned 50%. This tells me that their processes continue to improve as EUV technology matures.

Net margin tells the exact same story. Over the last 6 years, it’s increased from 23% to 28%. I like the slow, steady growth.

As a point of reference, you can see how ASML is outperforming its competitors.

Because the margins stayed healthy, without dips, it tells me that the post-2021 downturn is not due to their processes changing. Those stayed efficient. We have to look closer at the accounting.

What are their liabilities?

Let’s look at the numbers first, then assess a few macro concerns.

In terms of net debt, it’s not bad. Both in the short and long term, their assets significantly outpace their liabilities - they’re not stretched thin. Every year for the last 5 years, their debt has been less than both their free cash flow and their cash on hand. They’re displaying fiscal responsibility.

But, liabilities have grown faster than assets on a yearly percentage basis over the last 6 years. Assets doubled ($22B → $44B) but liabilities tripled ($9B → $29B). Liabilities are scaling up faster than assets. That’s not terrible for a short period of time, but consistently over the course of 6 years? Less great.

At a more zoomed out level, ASML has a serious China problem. The US pressured the Dutch to apply export restrictions to ASML’s EUV technology. A grand total of zero EUV lithography machines have been shipped to China. This is the US’s way of preventing China from catching up in the chip manufacturing race.

ASML has abided by this restriction, only selling refurbished DUVs to China. But there are real concerns that there may be additional sanctions on ASML’s exports. All UV lithography machines could be banned from being exported to China, which would seriously impact ASML’s bottom line. In 2021, 16% of their total sales ($2.2B) were from China. In 2023, that number had grown to 26% ($7.84B). Another way of looking at that - 81% of their DUV revenue came from China. In both dollars and percentage terms, ASML’s reliance on China as a revenue stream is continuously growing. If that were to disappear, suddenly the company’s books would look a lot different.

How likely is that export ban? From my research, it’s more likely than the risks facing any of the other companies we’ve talked about so far. I’d say this is something that legitimately needs to be factored into an investment decision.

Last, in looking at the equity ownership for the company, I found that management had a relatively small share of the company. The two biggest investors were large hedge funds in the US. Management came in third, but a distant third. I’m not fully sure what to make of this, but I know I expected a much larger ownership stake from the people that had helped grow this company over the last 30-40 years. It’s just something that’s itching at the back of my brain.

I like to see management having a large stake in the company. That means incentives are strongly aligned.

I find ASML’s ownership breakdown to be puzzling, at the very least.

What caused the slowdown in 2023 and 2024?

Let’s finally get an answer to this question. We know there’s a slight decrease in revenue, but nothing concerning; we know there’s a worrisome free cash flow issue that appears to stem from changes in inventories and liabilities; we know margins are staying healthy; and we know that liabilities have tripled over the last 6 years.

What does this all add up to? We turn to the investor letters to find out.

There’s a singular root cause that kicks off a chain of events. Let me lay it out, step by step:

1. In 2023, some ASML customers experience crippling cash flow issues as a result of the 2022 economic downturn. While these companies are in dire need of additional UV lithography machines, they don’t have the cash to buy hundred-million-dollar equipment.

2. ASML makes a decision to extend payment terms to these customers, allowing them to take delivery of the UV machines. This impacts ASML’s free cash flow, because they log the transactions under changes in investing activities.

3. Customers who are already on payment terms don’t continue to grow their annual orders, so 2024 begins to look stagnant. ASML predicts that 2024 will continue what was started in 2023, which they refer to as a “transition year”.

4. Referencing the cyclical nature of the semiconductor industry, combined with new foundries being built (TSMC in US, Japan, and Europe), ASML predicts that the stagnation will end by 2024. They claim that 2025 and 2026 will be years of massive revenue growth, but they’re concerned about being able to meet all the demand.

5. To prepare for the demand, ASML makes an historic decision. For the first time in the company’s history, they begin to pre-build inventory. This is what shows up on the cash flow statements as changes in inventories.

The sudden decrease in ASML’s free cash flow can be traced back to their customers experiencing a down 2022. By extending payment terms and then pre-building inventory, their FCF looked starkly different. Here is the ASML CFO addressing the issue:

Before we go on, that’s wonderful business jargon speak. “A slight shift in demand timing”… kudos. Ok, back to Roger:

And then again talking about 2024 inventories:

Additionally, we can see evidence of the “transitional” 2024 year. In the first two quarters of 2024, net sales are down 15.5% compared to 2023. That’s significant, especially considering 2023 was already stagnant.

There’s two ways this plays out:

1. ASML is right that 2025 and 2026 will be huge growth years, and they look like geniuses for helping out their customers in a time of need. When customers come to them for the latest EUV machines, ASML has their inventory ready to go, and is able to meet demand promptly. The customers’ loyalty is won forever, and ASML experiences record sales over the next half decade. Or…

2. ASML’s customers remain in a tenuous cash flow position, and don’t order more multi-hundred-million dollar lithography machines. ASML finds itself sitting on billions of dollars of inventory, negative cash flow, and no one to sell their products to. Prices are slashed, margins decrease, and suddenly their balance sheet is unrecognizable from a few years ago.

It’s really a boom or bust situation. I don’t see a middle ground playing out here. It’s a high risk situation, but one could argue that ASML has become this successful by taking risks throughout its history.

Regardless, this analysis highlights a liability in their monopoly - what if their few customers suddenly no longer purchase machines? It’s a highly concentrated risk profile, and one that adds to the delicate nature of their monopoly.

What is the predicted growth over the next 5-10 years?

From an industry perspective, growth is expected to be very healthy until the end of the decade. One market research firm predicted the EUV market will grow from ~$9B in 2024 to ~$17B in 2030, a CAGR of 11.2%. Another research firm was more conservative, providing an estimate of 8.5% CAGR (~$14.7B EUV market in 2030). ASML themselves, for what it’s worth, predicted a 9% CAGR for the EUV market (~$15B in 2030).

ASML made a few other predictions. They expect the second half of 2024 to rebound and be significantly higher than the first half. That would then lead into the high growth, high sales years of 2025 and 2026. ASML predicts doubled annual revenue by 2030 and a gross margin in the high 50s. That would be quite something if it came true.

As an exercise, let’s see how successful their previous predictions have been. Near the end of 2023, this is what they said about 2024 Q1:

ASML hasn’t done a bad job of predicting their sales, but the miss on EUV units is concerning. When you’re dealing with products that cost hundreds of millions of dollars, being off by even a few can make a big difference.

Nonetheless, I expect sustained growth in the lithography market over the next half decade, if not more. There’s no reality I see in which we, as a society, no longer need smaller and more powerful chips. As such, we’ll continue to need advancements in the manufacturing equipment too. ASML will be a leader in the lithography space, but will its monopolistic success still translate to such a robust financial statement? Or will they have to make more compromises with their customers to keep inventory moving? The answers to those questions will make all the difference.

Takeaways

ASML is making a lot of money, which isn’t a surprise when you’re a company that sells products for $200 million. But it’s unclear whether their future prospects will look the same. The industry looks poised for growth, but it doesn’t necessarily mean ASML will be able to dictate pricing terms like they've done for the last decade. Late 2024 and early 2025 will provide strong indicators of which direction the company is headed in.

Let’s summarize the three articles so far:

Things continue to go well for ASML presently, but more question marks arise about their future. We’ve got a very interesting company on our hands. The dichotomy between their undeniable current success and their less-certain future creates a tough but high-leverage decision for potential investors. The task that remains is to decide if we have enough conviction in which direction the company is heading.

Next week we’ll look at the company’s valuation and wrap everything up. I’ll make my final decision on the ASML investment opportunity and explain why.

Thanks for reading, have a great week, and see you soon!

Agree? Disagree? Would love to hear your thoughts - leave a comment.