ASML Helps Shrink Chips, But Could Help Your Portfolio Grow


While certainly not a household name, ASML has more impact on the average digitally connected consumer than you may think. How you ask? First, some background:

Based in the Netherlands, ASML is the dominant leader in manufacturing photolithography equipment used in semiconductor foundries (i.e. the factories where chips are made). The machines they produce, known in the industry as "steppers," are responsible for printing intricate circuit patterns onto silicon wafers. These patterns are later chemically etched into the wafer as it proceeds toward becoming functioning chips.

Improving Lithography Makes Moore's Law Work
Continual increases in lithography "resolution" represent perhaps the most important and technically challenging hurdle that must be overcome to increase chip performance. In the semiconductor business, the name of the game is packing more features (namely transistors) into a given sized chip (or "die size"). Since commercial production of semiconductors began in earnest in the early 1970s, the transistor counts have generally increased in accordance with Moore's Law - that is, roughly doubling every two years.

In order to accomplish this, the distance between transistors must continually shrink. Current leading edge chips are manufactured on a process where features are spaced 22nm apart, approx. 1/450 the width used in 1971. It's difficult to comprehend just how small this is, but the image below provides some frame of reference.

Source: Wikipedia Commons

Needless to say, printing an image at a resolution that is an order of magnitude smaller than the shortest wavelength of visible light is incredibly challenging. To date, it has been accomplished through the use of specialized lasers as light sources, coupled with a variety of ingenious workarounds including refracting light through water (known as "immersion") and splitting up patterns before printing them at an offset (known as double or triple patterning).

EUV: The Next Generation of Lithography
It's these workarounds that have allowed for most of the shrinkage over the last 5-6 years, but the physicists who work on such things are running out of tricks. In the not too distant future (most likely by the 10nm node in late 2014/early 2015) the only viable option will be to move to a new, much shorter wavelength light source known as Extreme Ultra-Violet, or EUV.

In semiconductor circles, EUV is infamous for the many delays the technology has faced over the last decade. The reasons behind the numerous delays are way beyond the scope of this article (and probably beyond the understanding of anyone lacking a graduate degree in physics), but in layman's terms the primary issues have been related to generating a strong enough laser that can operate at a commercially viable throughput without requiring an insanely large amount of power.

ASML has an Effective Monopoly in Leading-Edge Photolithography
ASML has been leading the charge on introducing the first EUV steppers. To this end, last year they acquired Cymer, the leading light source maker, and convinced the three largest semiconductor manufacturers - Intel, Samsung, and TSMC - to take a 23% equity stake in the company and contribute EUR 1.38 million to EUV research and development costs over five years.

The investment is paying off, as ASML will be the first company to ship a EUV device. During its third quarter earnings conference call on Wednesday, October 18 , CEO Peter Wennink confirmed that three commercial systems will be shipped to customers in the fourth quarter, with full revenue recognition on one of the three (ASML does not recognize revenue until a system is fully installed and qualified). Each device is expected to ring in at an average price of 70 million -80 million euros, nearly double the 40 million -45 million price for current state-of-the-art immersion steppers. The company currently estimates 12-15 EUV units will ship in 2014, with the potential to double each year at least through 2016.

Even if EUV shipment slips further, as it has been prone to do, ASML still stands to benefit. Analysts, such as Bernstein's Pierre Ferragu, expect lithography's share of total semiconductor capex spend to increase from 11% in 2012 to 17% in 2015 due to its increasing importance with each successive node shrink .

As was highlighted in this morning's call during the Q&A between Mr. Wennink and BofA analyst Didier Scemama, this means that even if chipmakers choose to further delay adoption of EUV at the 10nm node, they will have to compensate by buying more immersion based equipment in order to implement the multiple pattern techniques that would be necessary as an alternative. This "worst case scenario" would likely result in similar, if not better, revenue levels and certainly higher gross margins for ASML over the short to mid-term.

Taken as a whole, ASML looks poised to continue on with its near-monopoly position in leading edge lithography equipment. The company has been steadily taking market share from its only two competitors, Nikon and Canon, over the past decade; its overall lithography share is estimated to be in the low 70%-range, with its share of immersion machines near 90%.

A Very Strong Business Worth Buying on Any Weakness
The market is clearly aware of ASML's strong position, as the stock has rallied 42% since April. Shares are currently trading at about 22x next twelve months earnings, which is in the upper third of the range it has traded in over the last 10 years, excluding the height of the financial crisis in late 2008/early 2009. That said, the semicap equipment space is known for its earnings cycle volatility, and given the low volume, high price nature of ASML's products, the loss or gain of a few orders can have a dramatic impact on near term results and the stock's price.

Look to any significant pullbacks as buying opportunities, because in the long run, ASML is really the only game in town if chipmakers intend to come close to following their announced roadmaps. In the meantime, now you know a little bit more about the technology behind the chips that drive the ever-thinner and faster smartphones, tablets, and laptops you use each day.

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