ASML is Seeing an Upturn in Business Conditions

Photolithography is the process in which a light source is used to expose circuit patterns from a photomask onto a semiconductor wafer. Technological advances here are the major drivers behind the march toward smaller circuits in chip devices. ASML holds the leading position in the lithography market, according to Gartner, but faces competition from Nikon and Canon.

With more than 20 years of experience, ASML has developed extensive technical expertise in a highly complex field. The firm has numerous collaborative relationships with various entities, including leading chipmakers and research institutions, positioning it at the forefront of lithography technology. The in-depth know-how and large research and development expenditures required to remain competitive in lithography make it extremely difficult for new rivals to enter the market.

Lithography tools, which have price tags of $10 million-$20 million, account for a major portion (15%-20%) of chipmaker capital spending. However, ASML is susceptible to pricing pressures from Nikon, which has comparable technical capabilities, and to a limited extent Canon, which has become less of a competitive threat in recent years. Further, the firm is subject to the buying power of a concentrated customer base, including chip industry bellwethers such as Intel and Texas Instruments, making it difficult for ASML to generate large profits. To worsen matters, demand is tied to the health of the semiconductor industry and is therefore highly cyclical. In addition, because of the complexity of certain components, ASML depends on a limited number of key suppliers such as Cymer for light sources and Zeiss for lenses, thereby reducing its ability to control costs.

ASML's financial performance can fluctuate wildly over a full industry cycle. After reporting operating profits of more than EUR 800 million in 2006 and 2007, the firm posted an operating loss of EUR 165 million in 2009, as the chip equipment industry was mired in a severe cyclical downturn. However, a rebound in chipmaker capital spending should allow ASML to have a solid 2010.

ASML has focused on operational efficiency and cost reductions to lower its break-even level in the past several years. The rollout of state-of-the-art immersion lithography tools, which use fluids to enhance resolution for imprinting smaller circuit patterns, has helped provide a technological differentiator for the firm. Canon, for example, has fallen behind technologically in recent years, reducing its threat to ASML.

Valuation
We are raising our fair value estimate to EUR 16 per share from EUR 12. After being hampered by a severe cyclical downturn in the semiconductor equipment industry during 2009, the firm is now seeing a strong rebound in demand for lithography tools. In our model, we expect revenue to jump 140% in 2010, followed by average sales growth of 4% from 2011 to 2014. Our growth forecast is based on estimates of the number of lithography systems shipped and increases in average selling prices for newer systems. ASML has seen its profit margin profile improve in recent years because of its focus on cost-cutting and its technological edge in immersion lithography. The firm reported an operating loss in 2009, but we expect it to achieve an operating margin of 23% in 2010. Over the longer term, we believe that relative buyer and supplier power will prevent ASML from sustaining margins among the industry elite, and we forecast operating margins eventually settling in the upper teens over the longer term.

Risk
ASML must maintain its leading technical expertise in lithography to remain competitive. A concentrated customer base with buying power adds risk. Demand for lithography tools depends on the deeply cyclical semiconductor industry. Because of long product lead times, customers order beyond their business visibility during industry upturns, which leads to growing backlogs. During downturns, however, customers quickly cancel their orders, resulting in large losses for ASML. In addition, ASML relies on a limited number of suppliers for several key components. Although lens supplier Zeiss has a strategic alliance with ASML, any disruption in their relationship would have a large negative impact on ASML.

Management & Stewardship
Eric Meurice replaced Doug Dunn as president and CEO in 2004. Meurice previously was an executive vice president of the television division of Thomson. He has also held management positions at Dell and Intel. Aside from executive vice president Martin van den Brink, who has been with the firm since 1984, most of the current executive team joined the firm between 1997 and 2000. Relative to peers, management's compensation looks reasonable. Option grants are also modest, with outstanding options accounting for 3% of total shares. However, besides roughly 1.6 million options and conditional performance-based stock awards, management has virtually no ownership stake in ASML.

Overview
Growth: After a cyclical downturn in 2009, we expect ASML to see a strong rebound in revenue in 2010. In the long term, we expect manufacturing capacity expansion and continued technological advances toward smaller circuits to drive growth.

Profitability: Historically, ASML has not been particularly profitable relative to other major chip equipment firms, because of pricing pressures from major competitors and a powerful base of concentrated customers. However, the firm has been able to achieve better profitability as it has cut costs and strengthened its technology position relative to competitors.

Financial Health: ASML is in solid financial position. It has EUR 1.1 billion in cash and EUR 0.7 billion in debt on its balance sheet.

Profile: Founded in 1984 and based in the Netherlands, ASM Lithography is a leading manufacturer of photolithography systems used in the production of semiconductors. ASML markets its lithography systems to semiconductor manufacturers in the United States, Asia, and Europe.

Strategy: ASML's strategy is to leverage its market leadership and technical expertise to provide superior tools for customers in order to generate profitable growth. The firm's modular approach to development and manufacturing, achieved through various strategic alliances with suppliers in which risks and rewards are shared, allows for specialisation in specific lithography tool components. ASML also has numerous research and development collaborations with research institutions and other firms, such as Philips, to maintain technological innovation. In addition, ASML is focused on operational efficiencies to achieve its goal of profitability throughout an industry cycle.

Bulls Say
1. ASML is a market leader and innovator in photolithography, an integral part of chip manufacturing.

2. The extensive technical expertise needed to develop lithography tools, which are highly complex and play a critical role in semiconductor manufacturing, serves as a barrier to entry.

3. ASML has focused on operational efficiency in recent years to improve profitability throughout industry cycles.

4. The modularity of ASML's lithography tools allow the firm's suppliers to focus development on specific key components of the systems, thereby allowing ASML to offer state-of-the-art technologies.

5. As a market leader, the firm has close working relationships with major chip companies, including Intel, where ASML is well positioned for future generations of photolithography equipment.

Bears Say
1. ASML depends on a handful of powerful customers and will sell only several hundred systems each year.

2. Dependence on a limited number of suppliers for key components exposes ASML to pricing power and possible disruptions to its supply chain.

3. The firm depends on the deeply cyclical semiconductor industry for demand.

4. ASML faces competition from Nikon and Canon. These rivals have better insight and customer relationships in their home market of Japan, where firms tend to prefer domestic suppliers.

5. ASML's margins and returns on capital have historically been inferior to other industry leaders', which we think is partly because of buyer and supplier power and partly because of operational inefficiencies.