ASML: Competing with Moore’s Law - [Business Breakdowns, EP.117]

25:10The largest part of the cost of making semi -conductors is in the capital cost of building the facility. Once you've depreciated that, the cost of running these machines actually is relatively low. The actual marginal cost of production is pretty low. And what ASMR has been very good at is ensuring that once these machines are installed, that's not the end of it. They're able to continue to service them and upgrade them in the field so they get ever more productive. So the machine that's installed 10 years ago can have an upgrade put through that markedly improves its productivity. And that obviously is good for customers and that incentivized customers to keep buying from, because they know they get a machine today, that same machine can get better and better over the next 30 years.

25:49And do you have a sense of the breakdown of the revenue that they generate from new machine sales versus whether it's refurbishing, upgrading, or anything else. Yes, then new machine sales are came for about 75 % of revenues and the balance is from service and fuel options, which is essentially maintenance, not grades in the field. And how cyclical is that revenue stream? I assume that they're developing these machines, but there might be major breakthroughs at certain points in time, is there much cyclicality to it? What ends up driving the sales, whether it's a constraint on the amount of volume they can produce, demand, or anything else?

26:31The industry is cyclical, and SML and its history has been very cyclical. If you go back and look at the company's history, well from the 80s almost, but even just since it was IPO'd, its experience has gone through the pain of vicious cycles in the industry. Those have tended to become less severe in recent years. Partly that's times the fact that they've emerged as the sole producer of lithography equipment. There is no one else to go to. There's no competition on price that they have to cope with in that sense at the very leading edge. If you want to build a wafer fab to produce the next generation of ships, you have to get your order into ASMR because there's no other sure and time to get that lithography machine.

27:08And if you cancel your order because things are a bit tough this year, you're to the back of the queue when things start to look better again. There's no avoiding that. So what you've found in recent years at ASMR's revenues have become less cyclical. That's not to say it won't see another cycle. That's not to say you won't see a machine orders pushed out. You've seen obviously across the semi industry in the last few months in particular a series of companies coming out and confessing that things actually a little bit tougher than they were expecting to SMC recently cut their revenue guidance.

27:38So I would expect that there will continue to be cancellations and oscillations along the way. But these days it's much more about that secular structural growth, I think, in terms of that ability to keep producing leading -edge machines that are needed for leading -edge logic manufacturing and memory manufacturing. I did you said they sold just north of 300 machines last year. What could they do? Is that the limit to the capacity that they could produce? Do you have any sense of how much they can ramp that up? They had a capital market stay last year, and they've put out some pretty un -sheen numbers in terms of saying what they would like to be able to expand their capacity to.

28:17They are investing so they can produce 90 EUV machines per year. That compares to about 40 or so sold on each of the last two years. And 600 deep -volt of our machines for the next generation of equipment. So a very material step up, and also something approaching 20 high NAUV, the next generation of EU machines. by around 27, 28. So they're investing very hard at the moment to expand capacity. And a lot of that is around ensuring that you don't get bottlenecks. They're conscious that at the very leading edge of the semi industry they are the bottleneck and they don't want to be the bottleneck.

28:51They don't want to incentivize their customers to start thinking about different ways of making semi -conductors. So they're really being very explicit out there and saying, look we're going to do what we have to do in terms of making sure we've got the manufacturing capacity to produce as many EV machines as many EV machines as you need for as long as you can see forward into the future. And when it comes to the manufacturing capacity and the investment in that, when you mentioned before, a lot of this is actually completed on -site, so they might ship it in several different parts. When they invested manufacturing capacity, are they actually investing in large facilities that are used to produce certain parts, or are there other things that are playing a role, just trying to bridge those two things together.

29:37This is a manufacturing business. It's not really a manufacturing business. It's one of the quirks and one of the very special aspects of it. This of course has architects and integrators. They actually produce a relatively small proportion of the components to go into the machine, but they assemble. So relatively capital -like, what you really have is when they talk about building at the capacity, it's building out their capacity to assemble these parts. About 80 % of their cost of good sold is in components and materials that they're buying from right side of the business, and the remaining 20 % is coming from labor actually on site.

30:09So it's very much about components that others are making, and very specialist list of suppliers, that they then integrate and assemble into a single machine. It's a core strength of the business, but it's a core strength that actually has become a virtue, but it actually was born out of necessity at the company's beginning. back in the beginning everyone thought the best model was an iconic animal model where everything was vertically integrated they had lensed manufacturing in house and they could do the whole thing that meant they made better machines but ASMR didn't have enough money and they didn't have enough time when they started games to do anything like that so they went down this path of using suppliers of being an assembler and building a relationship with their suppliers that I think is probably second to none that is enabled the whole ecosystem to move forward together.

30:54It is a fascinating industry in that sense that there are so many fragmented pieces within the value chain. And it's something I've learned through these conversations. And I think the way you describe the architectural design and how key of an element that is in this overall process. It's really something I didn't expect from the outside until I went a bit deeper. We touched on cost of goods old a little bit and pricing a little bit. Can you talk about the margin profile of this business, how they go about setting price, particularly in a product where they seem to be the only supplier of that product.

31:28What does that look like over time and what does that look like today? The margin profile has, as you might imagine, improved over time as they've gone from strapping away from market leadership to becoming the dominant player. So they're gross margins and now around 50%. That's up from in the mid -40s last decade and are averaging around 30 % gross margins back in the 2000s. That translated last year to operating margin of around 30 % and that's likely to improve further from here as the next generation EV machine starts coming to production and the existing generation of EV machines starts to increase in volume.

32:06So there's room for those margins to improve but again what's interesting and I think what's been key to the success of ASML is in spite of the fact it's been the dominant market players for nearly 20 years now. It's never looked to price gauge. It's approaches incredibly collaborative and spoken a bit about their relationship with their suppliers, but it's also the same with their customers. This is an industry that is, I think, unlike any other in terms of the way that the companies collaborate in order to agree on and advance technologies. And that only works really if you're honest and open with your customers and they're honest with you and you can see the sharing of risk and reward.

32:42ASMR puts billions and billions into developing new machines. TSMC's business model, Intel's business model, Samsung's business model, they don't work if they don't have the equipment to make these advanced semiconductors. So, the needs to be sort of a quick pro quo in terms of well, I'm going to invest now, you're going to buy these at a price that enables me to generate an appropriate return for all that investment and risk that I've taken. But equally, you haven't supported me in developing these machines. The quick pro quo from me is I'm not going to gouge you. I know I'm the only in the patent town for an EV lithography machine.

33:12In theory, economic theory would say, here's the milk and jacket, the price is by twofold and tick what they like. But they know that if they took advantage of their position of pricing power, that just produces this massive incentive for their customers to look elsewhere, to look at alternative technologies, to look at alternative providers, and to seek money into providing themselves with an option. So you have this, what looks from the outside, quite a comfortable position in terms of having a relatively small number of customers who are in themselves incredibly powerful, but they're really co -dependent on each other.

33:43And the success of the relationship is born up to the born out of ASMR not trying to take advantage of this position, either with its customers or with its suppliers, but seeking to price its products solely on the basis of the improvement that they deliver to their customers. And they talk about trying to split 50 -50 in terms of the profitability improvements they hand on to their customers, they want to exploit the benefit that 50 -50 between themselves and their customers, then they need to share that benefit down their supply chain as well. Yeah, it's a fair point and seems like it's an incredibly important factor.

34:15If it's not going to be a vertically integrated industry, there needs to be some level cooperation on the supply chain side of things where no individual piece in that value chain is bottlenecking the overall industry and on the pricing as well, you're not extracting more value than you're creating or not sharing in that value creation. So it's a pretty fair point and an interesting point to make. You mentioned the concentration of customers. What exactly does that look like for ASML? So their top two customers were nearly 60 % of revenues last year. I guess they don't disclose the third customer, but I guess if you put that in, you'd be somewhere around 65%, 70 % of revenues.

35:01So it's a very constant customer base. There are relatively few companies left in the industry that are capable of making leading edge semiconductors. They are very large businesses and they have deep pockets. They are the customers. They are the only people who can afford to buy ASMLs equipment. And then the only people, frankly, that have the know how, of how to make the most of it and use that equipment to make the world's very best semiconductors. I think this is probably a fairly obvious question, but in terms of being an acquisition target, is that just a regulatory, absolutely not happening scenario?

35:36It seems like there's such an important piece of the pie. What stops one of these players from trying to acquire the business? I suspect the market cap provides a reasonable hurdle today. It's a fair question, if you roll it back, it's not that long ago that they had a market cap of $20, 30 billion. dollars and why didn't someone come in about that? I think it is an nature of the industry. Semiconductor industry has been successful because over a series of multiple decades, it's being carved up into a series of niches with companies playing their own role in different parts of it. Companies that are involved in design of semiconductors, companies that are over in manufacture, companies that are involved in making materials or equipment that's used in the manufacturing and companies that take the semiconductors and stick them into products that are sold to consumers are industry.

36:20And the success of the industry has generally been around these pockets of expertise being carved out to companies that focus and become world leading at it. And then you've seen concentration within those niches but you haven't perhaps seen so much in the way of vertical integration. Samsung or TSMC tried to buy ASMR in decade ago. I think the odds are they wouldn't have been able to develop the UV. They certainly wouldn't have had cooperation from the other major semiconductor manufacturers in funding the R &D that was necessary to make EUV work. So, everyone benefits really from ASMR being an independent company because Samsung is able to piggyback on the work that's being done by TSMC and work that's being done by Intel and the work that's being done by Minecraft and so on.

37:06Back to the financials, for reference, some of the investment that they're making into manufacturing capacity, what does the cash flow stream look like as an investor when you look at the business, you have a certain margin profile. How much of that is just immediately getting plowed back into the business in the form of capital investment or some other form of investment and how much is either being returned to shareholders or doing something different? The company's cash generation is actually pretty fantastic. Not least is help because customers pay a down payment, they pay for the equipment.

37:37Often there's only the development machines that are able to take deposits up front. So that's been helped to support as they've had to spend heavily on R &D in building our capacity. So the cash generation of this business has actually been fantastic over the years. So pretty much net income converts to free cash flow generation. And that free cash flow generation has generally been recycled, either into dividends, which is highly unusual for a company that is growing as rapidly as it is or share by banks, which the company has been pretty consistent about doing at modest levels, if you go back 10 years or more, but at fairly substantial levels over the last five years or so.

38:11So the company is able to continue to invest. It spends every year about 15, 16 % of revenues on R &D. It's investing as heavily as it ever has on CapEx, but it's still able to pay dividend and give its cash back to shareholders to buybacks. You mentioned capacity expansion, having leading edge technology, these seem like drivers of the business over the next several years. Is there anything else when you think about a bull case from an investor's perspective that stands out as an opportunity for ASMR or anything else we didn't talk about in that category. The opportunity really is the history of the company has been about smaller images, better resolution, faster throughput.

38:54That's what we do. Make things smaller, make them sharper, and make them faster. And that's going to be the core of this business for a very long time, because that in itself is just this massive structural growth story, because the number of as we need, the number of chips we do in the world is going to keep growing, unless something very dramatic happens, it's going to keep growing for a very, very long time. So simply delivering on that, I think will be a massive opportunity ahead of them. There are aspects that they are able to leverage more and more beyond the simple manufacturing or, say, simple, beyond the manufacturing of lithography equipment.

39:29And that comes around some of the computational stuff that's done around what they call the and the list of the lithography, you can't use an optical examination technique on leading edge semiconductors anymore because the feature sizes are so small, you just, you can't see them. So nowadays you need to fire electrons at the surface of a semiconductor to identify where the defects are arising. And they're able to do this down to a resolution of a single nanometer that's four silicon atoms and that's not a marketing spin that is actually four silicon atoms, why they're in to measure. So the better they get at doing that, the faster they can do that with the eBim patrology equipment.

40:04The better information they can feed into the computers, the better they can adjust, the manufacturing or the actual photography machine, the better the semiconductors coming out of the side will be. And really that's the cycle that they will go through. They'll keep working on that until Moore's Law runs out. I guess in terms of monitoring that as an investor, I can make the extreme comparison to something like biotech where you have a drug and there's very clear stages of FDA approval where you get to a point where you know whether this is going to be an economic liable product. Here, there's some level of technology that's being tested.

40:39How do these milestones get measured or the events that determine which, yes, this has been a success and we're able to go on and sell this. How has that been announced historically? Is it something that's coming from the company or from customers. And how do you expect that to evolve in the future? I'm just curious with something like a drug approval, these are kind of big announcements that have major impacts. What does that look like in this market? It's quite different, I think, would be that shortfall. The one thing that was maybe closest to say a biotech process would be maybe the development of the EV, which was a major generational shift in manufacturing.

41:14It was able to take 20 years on from the previous generation machines. It took a fundamental design of machine and it was a lot of uncertainties to whether it would work, because you were changing so many different things. You were changing the way that the light was focused, you were going from using lenses to using mirrors to focus the light. We have an entirely new light source that needed to be invented and created and powered up. And you had to do everything inside the machine in a vacuum because the light they were using was so delicate that it got absorbed by air particles. So that was a massive risk.

41:49We hope, and gradually it would report to the market on terms of test achievements, they had achieved a certain amount of power in their like source. But what are the, I think, strengths again or the ASMR businesses? A lot of the improvements are incremental and they're able to do this because they have a modular approach to design. Again, something that dates back right to the beginning of the company's history, it had to take an approach that enabled it to get something to market quickly and it worked rather than trying to make machine as one piece, they just break it down into components and and they make each of those in parallel and then put them together.

42:21And the great thing about that is it means that they can take the current machine and they upgrade a single part of that, take one of the modules and upgrade that. And there's risk obviously in upgrading that module, but if it doesn't work, it's not as if the whole machine falls over, we'll be working on another part of the machine as well. So a lot of the technological development, no incredibly high risk in the sense that you are pushing the boundaries of physics and boundaries of what most people would think was physically possible. The actual process they've developed for introducing each of these new improvements is as de -risk as I think you can possibly do it.

42:58So yeah, it's about monitoring it. It's about seeing things come through. Yeah, we'll be able to get some readouts on how things are going with the mirror development for high NA, which is the next generation of the UV equipment down the line. But a lot of the continuing improvement in terms of existing stuff that's in the market, that's pretty gradual incremental, it's happening all the time. And it's as low risk as everything to be when it says complex is what they're doing. They have de -risked it to a certain extent. That's actually incredibly helpful explanation. I didn't appreciate the incremental progress you can make on the various components of the overall machine.

43:33So that makes sense. When you do think about the risks to the business, what stands out the most to you? I would say there are probably three big things that I would worry about in terms of the key risks. The first one would be the ability of their supply chain to keep up with them. Their supply chain they would describe as their biggest competitive advantage. But it's also a vulnerability because they need their supply chain to be able to keep up with the technology enhance if they are trying to push. And over the years some of their suppliers haven't been able to do that and ultimately they've had to buy them in.

44:08So you saw that I mentioned previously in 2013 when they bought an Simon, they're like manufacturer. You saw that when they took a stake in Zeiss, their lens manufacturer, they don't own it, but they have a stake there. And that was just recognising that the amount of capital investment required to bring the next generation of equipment to market was beyond the budgets of Zeiss as an entirely standard company. So there is that challenge. Each of their suppliers needs to keep up. It's not just about what they're doing within their own R &D facility. So that is always a challenge, but it's something they've managed I think very, very well over the years and I think I would expect them to continue to manage it pretty well.

44:44The next thing would be disruptive technologies. Again, this is really comes down to the idea that ASMR's competition is not really another company, but it's more small. So people keep buying ASMR's machines as long as they're able to deliver the productivity improvements at a price that's acceptable. So as long as it enables next Apple trip to be produced at an acceptable price that makes it commercially viable product, then those machines will still be bought. If they struggle to do that, then the technology path might prove to be something different and you saw that a few years ago, about a decade ago in NAND, one of the types of memory that exists.

45:24they could see that EUV was not happening. It was not going to happen anytime in the near future back in 2012, 2013. And a new approaches were developed and started to be adopted and that was specifically going through dimensional. So instead of scaling it too dimensionally across the surface of the chip, they started to build up with on the surface of the chip. So essentially they went through dimensional. And by doing that, it meant they didn't need leading pitch lithography anymore in order to make more advanced memory chips of that type. They could simply build it up by layering more and more through action deposition.

45:58So the share of lithography, capex within that part of the market felt quite precipitously as a result. It doesn't disappear, you still need lithography there, and it still grows as that market grows. But it was a really big hit. And I think there's a really good example when ASMR can't deliver something quickly enough, the market has to keep moving. They're not going to wait around. So if that happens in another part of the market, If someone else comes up with a clever way of making transistors in a way that is cheaper and faster and more efficient than can be done using leading edge lithography, then the semi -industry will go down that path because that's the way it's got to be in order for Moore's law to continue progressing.

46:39So I think that's the risk again. You've got a back ASML in the near future in terms of their ability to keep delivering and the relationships that have their customers to see what each of their roadmap says, but that is one of these long -term challenges. And then the third one would be geopolitics. That's probably more of a near -term risk, but you can't ignore the fact that last year, we made nearly 40 % of sales were to Taiwan, nearly 30 % of sales were to South Korea, and give or take 50 % of sales were into China. Now you don't need to be particularly imaginative to work at things, could become difficult given that customer base.

47:15a very interesting and diverse set of risks there. When we wrap up the conversations, we always talk about lessons that you can pull away from looking at this business and potentially apply to others. What do you think stands out in that category for ASMR? I think there's probably three things in terms of takeaways that I've taken from looking at ASMR. The first one is the importance of looking beyond the cycle. I think a lot of people look at ASMR, that I confess when I first look today, There's this feeling that I know this is a cyclical industry, I know things are going to go down at some point and you say, worry about this, I'm not timing it right.

47:50Am I going to look silly if I decide to take a share of it now? And of course, the industry does remain cyclical and you can't ignore that. But that obsession on the perfect entry and exit point can blind you to the structural opportunity that's there to blind you to the excellence of the underlying business and the long -term prospects when you stretch it out of the 5, 10, 20 years. The other thing would be, I guess, this goes back to the very early days of ASMR, but don't underestimate the role that luck can sometimes play in the company's early years in terms of how it comes to be where it is.

48:20You look at the company's history before IPO, don't give me wrong. The history of ASMR was one of extraordinary ingenuity, tenacity and innovation excellent. But it's early as there were certain things that played that pretty well for them in terms of in 1986 when they were still didn't really have a product to market There was a massive recession and it killed a couple of their competitors I mean the others couldn't spend much in R &D So they were gonna catch up at the time when they were otherwise on their knees The business with the technology transfer on EUV the fact that they were the only other player versus the Japanese if they'd been a viable US player would they have been given such an easy road into that?

48:54I don't know and then the third thing was Because this is the really biggest part of things about looking at SML is not to underestimate the power of human engineering. Because I've looked at all the research we've written on SML going back over decades. And there's always been a huge amount of uncertainty about what this company is going to look like and what the semiconductor industry might look like five or ten years out. There's a great story back when Peter Veniky tells this story when he joined the company back in 1999 Before he did, he spoke to Martin Van der Brink and asked him, is Moore's law going to still be running?

49:29How long is Moore's going to run for? And Martin Van der Brink said to him, I think at least 15 years. And 15 years later, he compared to Peter to Martin and says, I'm still going, how long do you give it? Martin says, I think about another 15 years. And it's never been possible, even for the guy who's probably the smartest guy in this industry, you know, more right to them than the others, he's never been able to look forward to that. And we struggled to look forward five years. But what we don't appreciate is just how much is going on under the bond at ASMR and just how much innovation is taking place at that business and the drive there is to keep bringing through innovations that have kept advancing more's law many years beyond when people thought it would die.

50:11One of the things that I enjoy talking to you and your colleagues the most about is that deep history of notes and the deep history that you have with these businesses where you could reflect not just on what's happened in the past three years or five years, but often the past 20 years. And it shines such a light on how things often feel the same as they feel today. And if you look at the path that the business took 20 years ago when it was very much the same feeling, I might just provide a little bit of extra perspective on today. This was an excellent conversation, Tom. I really enjoy learning and every bit of this conversation was me learning about this business and this industry some more, so thank you very much for joining us.

50:52Thank you. To find more episodes of breakdowns ranging from Costco to Visa to Moderna or to sign up for our weekly summary, check out JoinColossus .com. That's J -O -I -N -C -O -L -O -S -S -U -S .com.