ASM Lithography Powers On

Jul.11.12 | About: ASML Holding (ASML)

Here is one company from our native the Netherlands that is a world beater and will have a bit of a boost as a result of the declining euro. It's ASM Lithography (NASDAQ:ASML). What does it do? They provide extremely complex lithography equipment for the semiconductor market. This is really high-tech stuff, consisting of tens of thousands of parts and costing upwards of $30M.

This equipment is used to etch circuits, the intricate patterns that infuse microchips with their intelligence, onto silicon wafers.

The quest is to make these patterns ever smaller, in order to put ever more transistors on chips or expand the memory capabilities. Apart from using light with ever shorter wavelength, you run into some frontiers of the physical possibilities, which is one reason why these things are so complex and expensive. If you're interested in the technical side you can find an explanation here.

Like chip manufacturing itself, this technology has become increasingly capital- and R&D-intensive; large up-front investments are necessary which suggest a slow concentration going on in the industry. As fellow Seeking Alpha contributor Robert Castellano has set out, this is indeed what is going on, and remarkably favorable to ASML.

ASML has been able to capture significant market share from its two Japanese rivals, Nikon and Canon, especially in the high end, and most lucrative part of the market. This is clear from the following observation:

while ASML held a 57.0% share of unit shipments in 2011, it held an 81.6% share of revenues. [Castellano]

ASML has a near monopoly in the high-end stepper market (the ArF and EUVL) steppers. As any student of Michael Porter's business strategy books would expect, this gives it a powerful position in the high-end chip supply chain, where ASML products command high margins, much higher than the competition.

Clients
Such a powerful position can make clients a bit nervous. Having early access to the latest lithography technology is crucial for companies like Intel (NASDAQ:INTC), Texas Instruments (NASDAQ:TXN), TSMC (NYSE:TSM), Samsung (OTC:SSNLF), all of which are clients of ASML already. You may have noticed that there is a bit of a chips war going on in the tablet/PC market, for instance.

Intel used to dominate the PC market, but the arrival of tablets working on chips from designer ARM Holdings (NASDAQ:ARMH), and the slow cannibalization of PCs by tablets has unsettled Intel a bit. These chips, while not as powerful, are significantly more energy efficient, and the top line chips in this sector, like the Tegra 3 from NVIDIA (NASDAQ:NVDA), the Snapdragon chips from Qualcomm (NASDAQ:QCOM) are powerful enough to run tablets smoothly.

These different chips are starting to encroach on each other's natural territory. Intel has made a chip that is now going into a few mobile phones (traditionally the territory of energy-efficient chips based on the ARM design) while ARM family chips are going into servers like those of Hewlett-Packard (NYSE:HPQ) and Dell (NASDAQ:DELL). Even Microsoft (NASDAQ:MSFT), traditionally a strong ally of Intel, has introduced a tablet based on ARM design chips.

Now, in this war Intel holds a couple of trump cards. It is the most financially sound company, and therefore has most to win from an acceleration in technology, which is terribly capital-intensive and needs billions of up-front capital. Intel also has a lead in making chips with the smallest circuitry, which gives Intel a cost advantage as more chips can be made out of the same waver, apart from making the chips faster and more energy efficient.

ASML's lithography equipment is pretty crucial for that ability; hence one should not be surprised that these companies announced today that Intel is going to spend more than $4B to buy a 15% stake (5% upon shareholder approval) and bankroll ASML's research.

This capital injection allows ASML to:

speed the adoption of the next generation of chip manufacturing processes from ASML by as much as two years. That will require intensive capital investment, but delivers billions of future savings by cutting chip production costs, analysts said. [Reuters]

It is interesting to see that ASML itself announced this program as a "customer co-investment program" aimed at accelerating innovation:

As part of this program, ASML may issue up to an aggregate 25 percent minority equity stake to customers. The entire cash proceeds from the share issuance will be returned to ASML shareholders (not including participating customers). Alongside these equity investments, participating customers would fund a significant portion of ASML's research and development (R&D) activities for the next five years.

Intel is only mentioned as the "first participant in the customer co-investment program"; that is, Intel's competitors shouldn't get nervous that they will be reduced to second class customers of ASML (it's non-exclusive), but in case they're not quite convinced, they're welcome to join and fund another part of ASML's R&D efforts.

Whoever thought of this strategy, we have to say it's brilliant. It accelerates lithography development and the move towards 450mm wavers.

"The transition from one wafer size to the next has historically delivered a 30 to 40 percent reduction in die cost," Chief Operating Officer Brian Krzanich said in a statement.
RBC Capital analyst Doug Freedman estimates Intel can save about $2 billion a year on 450mm processes, versus the current standard of 300mm. [Reuters]

So it's good for customers, Moore's Law seems to live yet another day, and it's certainly good for ASML, the shares of which moved 6% on the news.

Are ASML shares a buy?
Long-term, we're quite sure. Steps like this are cementing its lead in the industry. Short-term, there is likely to be some headwind from a slowdown in the chips markets. ASML is a cyclical stock, but with a powerful structural uptrend, as you can see from the three-year chart below:

Click to enlarge

Quarterly results will be out on July 18, any further euro declines should help the bottom line. For the year as a whole, analysts expect $3.63 in earnings per share, rising to $4.89 next year, giving it a forward p/e of 10. That seems cheap - very cheap for such a high-tech market beater - but it's the cyclical nature of the industry that it reflects. Still, the shares are certainly a long-term buy.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.