ASML Analyst: Recommendation: BUY DATE: 18.10.2015 Industry: Semiconductor Share price 77,55 Homepage www.asml.com Ticker ASML.AS Number of shares (000) 433.700 Target price 104,5 Market Cap 33,8 B 52 week L/H 70,25 / 104,85 Upside potential 34,8% In mil 2014 2015 e 2016 e 2017 e Sales 5.856 6.237 6.237 6.674 Gross profit 2.497 2.811 2.811 3.145 EBIT 1.524 1.410 1.335 1.977 Net income 1.442 1.286 1.217 1.802 Gross profit margin 42,6% 45,1% 45,1% 47,1% EBIT margin 26,0% 22,6% 21,4% 29,6% EPS 3,28 2,94 2,81 4,18 ROE 17,2% 14,4% 13,0% 17,7% Price/Earnings 23,64 26,36 27,64 18,55 Price/Sales 5,82 5,43 5,40 5,01 Price/Book value 4,08 3,79 3,59 3,28 Price/Cash flow 24,81 23,71 23,55 22,27 Excluding non-reccuring items Preformance 1M 3M 6M 12M ASML -2,4% -17,1% -13,1% 7,8% I initiated the coverage of ASML with BUY recommendation and 12-month target price of 104,5, which at current share price offers 34,8% upside potential. Although the company sees less investments next year from their key costumers, current price offers substantial reward in case they achieve certain milestones set by the company for next generation EUV lithography machines. This is also the companies biggest risk. In their latest report the company said that: EUV faces normal new technology introduction challenges but its adoption is now a matter of WHEN not IF. My recommendation also comes from this company's ability to always be at the forefront of technology innovations which helped them raise their market share from 45% six years ago to today's 65%. If EUV proves to be functional, and since there are only few other companie's in the world that make lithography machines, but are not involved in development of EUV, ASML's market share could further increase. Gigaphoton is the only other company involved in development of EUV. It also need's to be kept in mind that Internet of things (IoT) can become one of this industries biggest movers in near future and its development won't be possible without machines made by ASML. 1
UNDERSTANDING BUSINESS Asml (ASML) provides semiconductor manufacturers (chip makers) with highlyadvanced imaging tools (lithography systems) that make the smallest, most advanced and cost-effectively produced electronic chips. These chips, or integrated circuits, are used in most computers, TV and hi-fi systems, mobile phones, tablets, MP3 players, cameras, banking cards and automotive control systems. In fact, they are at the heart of most electronic equipment used in the home, the office and on the move. The guiding principle here is continuation of Moore's Law towards even smaller, cheaper, more powerful and energy-efficient semiconductors. About ASML In plain English, Intel, TSMC and other large chip-making companies use Asml's lithography machines to make a chip. Around 50% of all costs related to making a single chip comes from lithography and only three companies in the world make such machines; Asml, Nikon and Canon, and Asml is by far the market leader. Because every chip has to be made with a litho machine, potential benefits for this companies are extremely high. Asml derives its revenue also from holistic (metrology) lithography and costumer service, both with high margins. What is lithography, how it works and why is it so important in this line of business. Business Description Lithography is arguably the most important and critical part of the chip production process: it determines how much circuitry can be packed onto a chip controlling the size and shape of all chip components, connections and contacts it is used in making every layer of the chip typically, that s about 30 steps to selectively grow, modify and etch out the features in every chip. The main goal of lithography is to put as many transistors onto a chip as possible. Today's chips, the size of 36 x 24 millimeters, contain over billion of transistors and connections between them. If you count that the smallest resolution you can print onto a wafer is around 35 nanometers (nm) and that the flu virus has around 70 nm, you can imagine what kind of precision lithography equipment has to have. Because of high capital requirements and great knowledge needed for making such equipment, barriers to entry are extremely high. This also adds value to the company. 2
Main problem that lithography machine makers have today is explained in the next formula. The minimum feature size that a projection system can print is given approximately by: Where CD (critical dimension) or resolution is the minimum feature size k 1 (commonly called k1 factor) is a coefficient that encapsulates all other process-related factors, and typically equals 0.4 for production. (lambda) is the wavelength of light used NA is the numerical aperture of the lens as seen from the wafer. Formula shows that to print smaller and smaller images onto a chip they have to lower k 1 and, or make NA bigger. That is what lithography machine makers have been doing since beginning. Next table shows improvements over the years: 1970 2010 Improvement Wavelength (nm) 436 193 (ArF) 2.3X Numerical Aperture (NA) 0,16 1,35 8,4X k1 Factor 1,0 0,25 3,5X Overall Resolution (nm) 2700 40 68X Source: http://www.lithoguru.com/scientist/che323/lecture48.pdf If I put numbers in formula CD = 0,25 x (193/1,35) we get that the smallest printed image has the size of 36 nm. Since EUV has a wavelenght of only 13,5 nm it can printe images that are much smaller in size. There are three main features of lithography machines: Imaging or resolution ability to consistently print the ever smaller features Overlay modern chips can easily have 30 or more layers. Overlay is a measure of a systems ability to print these layers accurately on top of each other Productivity or throughput higher lithography productivity means manufacturers can produce more wafers a hour at lower cost. With today's technology it is impossible to print smaller images. Even though some methods are being developed to increase resolution (double pattering etc.), EUV is probably the next generation of litho machines that will drive the industry for the next 10 years. ASML is investing large amounts of R&D into bringing this technology to the market and 2016. could be the braking point for this company. Closely behind them in developing EUV is Gigaphoton, but with much less resources. 3
ASML and competition Competition to Asml comes primarily from Nikon and Canon. Sales by the industry as a whole, units sold and Asml's market share can be seen in the next table: Competitive Positioning Year ended 31.12 2009 2010 2011 2012 2013 2014 Total units shipped 128 304 376 252 243 232 Total value (in mil. $) 2,485 6,414 8,225 6,058 6,085 6,854 Cost per unit (ASP) (in mil. $) 19,41 21,10 21,88 24,04 25,04 29,54 Of that ASML Units 70 197 222 170 157 136 Value (in mil. $)* 1,175 3,895 4,884 3,802 3,993 4,242 Cost per unit (ASP) (in mil. $) 16,79 19,77 22,00 22,36 25,43 31,19 Market share 47% 61% 59% 63% 66% 62% From Gartner Dataquest report and ASML presentations * Excluding services provided by ASML We can see that Asml's market share has been growing over the years, and I expect it to grow in the future. The reason for lower market share in 2014. and 2015. is weaker Japanese yen which makes Nikon's and Canon's machines cheaper. Canon is also falling behind and is focused mainly on older versions of litho machines (KrF and i-line steppers). You can also see that the cost per unit or average system price (ASP) has grown from 19 to almost 30 mil $ in six years and that Asml has done even better. That growth is also seen in higher margins that continue to expand. EUV machines will cost around 100 mil $ each. 4
Historical overview Sales by product Sales by country (2014) Source: ASML Source: ASML 10Y Revenue (mil ) Gross profit and net income Source: ASML Source: ASML Gross and net profit margin Operating Cash Flow and CAPEX Source: morningstar.com Source: morningstar.com 5
STRENGHT WEAKNESS Extensive experience and strong references in the market The development of lithography systems requires very thorough specialist knowledge High and growing margins Low level of debt Pre orders from Intel for 15 EUV machines Biggest costumers (Intel, TSMC, Samsung) own around 22,3% of outstanding shares and invest lot of money in ASML's R&D program High R&D costs Possibility that EUV wont be developed in time Revenue derived from small number of products and customers Skilled workers hard to find Mirrors and lenses, one of the crucial part of lithopraphy machine, bought from a single supplier Foreign currency fluctuations OPPORTUNITY THREAT Very close in commercializing next generation of lithography machines (EUV) and becoming a singe supplier of such machines in the world Market leader in highly concentrated market Extremely high cost and barriers for entry Internet of things can be a next big driver for this industry as smaller and more energyefficient chips will be required. Demand for lithography machines highly sensitive to changes in business cycles New technologies being explored outside EUV (E-beam-lithography, DSA...) Lithography technologies becoming more complex Frequent new product introductions and enhancements Shorter product life cycles Gigaphoton building EUV before ASML 6
FORCESTS AND VALUATIONS Semiconductor industry is highly cyclical and that makes predicting future revenue and cashflow growth extremely difficult. I will use FCFF model, with 5 year time horizon, because I consider it to be most adequate to the capital structure of Asml. Calculations are based on company's, industry's and my own projections. Since Asml provides all of its revenue from lithography machines and businesses related to them, while other competitors (peers) derive only small portion of their business from such machines, relative valuation model wont be used. Although company believes that they can achieve sales of 10B by the 2020., I believe that such assumptions are too optimistic since a lot of it depends on introduction of EUV, and overall industry, in a sense that it acquires time to adopt new technologies. I used more conservative approach in calculation of overall input data with lower target values. Such approach values Asml's stock a bit lower, so upside potential is higher then downside. Risk Factors Assumptions for Model Development Five year forecast period Current debt ratio will remain the same during forecast period Capital and debt weights in WACC are calculated based on market and not book values WACC of 7,7 was calculated using risk free rate of 0,45% in real terms (2,15% yield of the USD-denominated 10 year bond, and inflation of 1,8%), and beta of 1,28 (2 year weekly change to index). Equity risk premium is based on historical average of Netherlands stock market and its AAA credit rating Terminal growth rate is projected to be 2,1% in real terms (growth of world economy adjusted for inflation) For projected period I used marginal tax rate (not effective) Changes in working capital are based on 10 year average to sales Company's outlook for next year is flat revenue and earnings as in 2015., so I will start my model there and later expect CAGR 5,94% for the projected period (2015-2019). A bit lover assumptions were given for semiconductor industry as a whole. Although 5,94% seems a bit high I believe that such growth can be achieved if EUV proves to be functional, and even become much higher in upcoming years. Intel also pre ordered 15 of new EUV machines, and it is highly possible that other companies will follow. Asml's holistic lithography could also bring revenue opportunity of 1B within next 3 years (>20% per year). Revenue/Earnings Forecast 7
Projection of sales Projection of Gross profit, EBIT and EBIT margin Source: my estimates Source: my estimates Net profit, ROIC and WACC R&D projections Source: my estimates Source: my estimates My projections see revenue at around 7,75B in 2019 with gross profit of 4B and gross profit margin of around 52%. That margin can be easily achieved since new products will have much higher costs per unit. In, and after projected period, once new technology becomes operational, margins could further substantially improve. This could give Asml competitive advantage for many years to come. Operating profit and net income for this and next year will fall given much higher R&D cost but will increase at higher pace once costs for developing EUV fall to 10 year average. R&D costs will increase next year by 1% from current levels, and will fall to stable 11,50% of sales by 2019. WACC of around 7,7 is much lower then ROIC for projected period and could be even lower if company used more debt to finance its operations. Nevertheless Asml's capital structure at this level gives much room for improvement. I haven't capitalized R&D costs but if I had 344 mil should be added to first years projected operating profit and 2B would be added to capital. That would lower projected returns. Operating leases are too small and wouldn't have material affect if capitalized. 8
WACC Year 31.12.2015 e 31.12.2016 e 31.12.2017 e 31.12.2018 e 31.12.2019 e 31.12.2020 TV Risk free rate 0,45% 0,45% 0,45% 0,45% 0,45% 0,45% Equity risk premium 6,46% 6,46% 6,46% 6,46% 6,46% 6,46% Beta 1,28 1,28 1,28 1,28 1,28 1 Cost of equity 8,72% 8,72% 8,72% 8,72% 8,72% 6,91% Cost of debt 4,02% 4,02% 4,02% 4,02% 4,02% 4,02% Tax rate 10,00% 10,00% 10,00% 10,00% 10,00% 10,00% After tax cost of debt 3,62% 3,62% 3,62% 3,62% 3,62% 3,62% Equity weight 0,8 0,8 0,8 0,8 0,8 0,8 Debt weight 0,2 0,2 0,2 0,2 0,2 0,2 WACC 7,70% 7,70% 7,70% 7,70% 7,70% 6,25% FCF calculation 31.12.2015 e 31.12.2016 e 31.12.2017 e 31.12.2018 e 31.12.2019 e 31.12.2020 TV NOPLAT 1.268.846 1.201.487 1.839.170 2.100.369 2.454.553 + Depreacion expense 405.401 392.927 413.758 446.859 487.076 - Capital expenditure 392.927 355.505 353.697 381.992 416.372 -/+ Change in working capital 240.122 240.122 256.931 277.485 302.459 FCFF 1.041.198 998.787 1.642.301 1.887.751 2.222.799 Terminala value growth 2,10% Terminal value 54.665.146 Discounted cash flow 966.770 861.097 1.314.686 1.403.149 1.534.084 40.367.617 Enterprise Value 46.447.404 Minorities 0 Non-operating assets Net debt 1.125.000 Other adjustments 0 Equity value 45.322.404 Number of regular shares 433700 12M target price 104,50 Current price 77,55 Up/down 34,8% Scenario Analysis Terminal growth rate 1,10% 1,60% 3,10% 2,60% 3,10% 6,70% 86,13 94,53 104,94 118,20 135,63 7,20% 85,92 94,26 104,78 117,98 135,43 7,70% 85,70 94,09 104,50 117,76 135,22 8,20% 85,49 93,88 104,29 117,55 135,02 8,70% 84,28 93,67 104,17 117,34 134,82 Conclusion For EUV to become functional, lithography machine has to have system availability of > 80%, productivity of 1500 wafers/day and source power of 250 W. Asml, till today, produced results of 1000 wafers/day with system availability of over 70% and source power of 125 W. They believe that they can achieve satisfactory results by the end of 2016. If that proves to be right value of the Asml stock should be revised up. That upside potential is very high, and it could be the main driver of Asml's revenue in the future. As I already mentioned, company believes that it is not a matter of IF but WHEN. Still, no new results in development have been reported since February, and that keeps investors on the edge. Even so, I still believe that current stock price provides enough discount to stocks intrinsic value and that now is a good time to buy. Also, my calculations for revenue growth have been quite lower than those provided by management and there is a good chance that my valuations are too low. Some calculations, like beta, are much lower on some sites, and my manual weekly calculations could be wrong. Both of that adds value to the stock in case I made a mistake. 9