The British Empire long dominated international trade and geo-political affairs. It used an immense and effective Navy and supporting infrastructure that became steadily more expensive and complex over time. As steam power came to prominence, coaling stations became strategic points of importance to ensure the facilitation of commerce and fuel for the Navy. While old-power politics was based on the number of a nation’s ships, today what might be more significant is the smallness of their chips!

 India, which would become Britain’s most lucrative colony, and a source of durable advantage, became referred to as the “Jewel of  the Empire.” The sheer vastness of it’s resources and labor pool gave Britain an immense advantage and perpetual market in which to sell it’s goods. The ‘Great Game’ as it used to be called became a shuffle and rush for colonial assets that would give powers advantage over each other in the quest for supremacy. Britain was usually on top because of it’s jewel. While massive ships, packed coaling stations, and the vast expanse of India were where strategies clashed in an analog past, today the focal point of this perpetual geo-political competition has shifted to semi-conductors (microchips) and Rare-Earth Elements. Some may have noticed that after US technology bans on Huawei, President Xi shortly after made a publicized visit to a REE facility, which may highlight his preferred method of retalliation.  

ASML: The Jewel Of The Empire

Source: Cannon, The Information Network

The semi-conductor industry is perhaps, more than any other, what separates the human race from the 19th century and underpins modernity. The future viability of the semi-conductor industry depends almost exclusively on ASML. It is probably the most important company that you’ve never heard of.

Breakthroughs and improvements across virtually every industry are being made on the backs of the small, ever-more-complex tiny pieces of Silicon-Germanium that literally power human progress. When we talk about ‘Epicenter’ industries streamlining and modernizing, much of this actually equates to ‘digitizing’ and using semi-conductors and the data they can generate in new areas. The auto industry comes to mind; as manufacturing has been shut down by chip bottlenecks the complicated supply-chains and bespoke, high-end technologies that are the meat and bones of the semi-conductor industry are being viewed more and more in the light of a strategic national asset that should potentially be protected and subsidized. Intel just announced it would open two new fabs in AZ at a cost of $20 bn (it will need ASML machines for this). Many newer analysts may have missed the CEO’s use of the term ‘trusted foundry’ which harkens back to the day when military and other vital equipment was only produced by  government-vetted firms. The back-breaking capital intensity of the semi-conductor industry has led to consolidation and concentration. America, though still leading in the design of high-end chips has significantly fallen behind on manufacturing. Regardless of whether the chip producers get their capital expenditures right, you can bet that all 5 of the biggest spenders will be spending significant portions of their CAPEX on getting access to AMSL’s Extreme Ultra Violet (EUV) tech.  

ASML: The Jewel Of The Empire

Source: Semi-Conductor Industry Association

The concentration of the vast majority of semi-conductor manufacturing capacity at the door of an increasingly truculent China and earthquake prone region (TSMC) and also in the crosshairs of a nuclear-armed North Korea (Samsung) has only served to highlight and expedite the strategic importance of the industry to Western policymakers.  “We’re investing aggressively in areas like semiconductors and batteries, that’s what they’re doing and others, so must we,” said President Biden at a recent White House summit on technological competitiveness. This vital industry enjoys rare bi-partisan support. Government support in the tens of billions at least seems likely.

ASML: The Jewel Of The Empire

Source: Semi-conductor Industry Association, Boston Consulting Group

A Technology Monopoly That Western Governments Want To Protect, Not Break-Up

 The key strategic player’s location in the developing Sino-American great-game for technological dominance is not in Shenzen or Silicon Valley; it is in the Netherlands. Our subject, ASML, has developed a virtual monopoly on the only known technology that will permit chip manufacturing progress to continue as it has for the past half-century. ASML has a very dominant market position in photolithographic machines, which use light to imprint complicated structures on silicon. It dominates both the current cutting edge of technology below 76 nm and the next generation of 5 nm and less. Although EUV was necessary to produce Apple’s I-phone 12 chips, much of the industry doesn’t yet require it. That will change, and even though the cutting-edge EUV machines are a fraction of total machines sold, they already account for nearly half of the company’s revenue. This will grow to 75% by 2025.

ASML: The Jewel Of The Empire

Source: Semi-conductor Industry Association

 Without  ASML’s Extreme Ultra-Violet (EUV) technology or a viable alternative, China’s earnest gambit to catch up in the chip game is doomed. It’s semiconductor capacity will be rendered as vulnerable as Chinese ports were to British gunboats in the Opium Wars, competitively speaking. That’s probably exactly why the US has put pressure on the Dutch government to indefinitely delay sales to the Chinese. ASML’s CEO greatly opposes this and thinks technology bans will ultimately come back around to hurt his, and American companies. Nonetheless, the actions don’t dramatically affect current revenues all that much, but may curtail future plans to grow in the Chinese market. In addition to not wanting China to catch up, the chips produced are so complex they cannot be screened to monitor for surveillance functions. This is why you can bet on Western Governments keeping the ban intact. It should be noted the ban only effects EUV, of which there was only 1 order from a banned Chinese firm, SMIC.

ASML: The Jewel Of The Empire

Source: Company Reports

A Priceless Perch: ASML Is The Gatekeeper of Moore’s Law

Most people are familiar with Moore’s law, proposed by Intel’s co-founder, which states the processing power that can be packed onto silicon doubles every 18 months to 2 years. Many folks, however, are unfamiliar with what the industry jokingly refers to as Moore’s second law which is the reality that as chips get smaller and more complicated the techniques and technologies required to produce them become exponentially more expensive and difficult to produce. Like so expensive and difficult that only one company can do it, ASML. It’s not a competitive advantage that is easily supplanted either, after many fits and starts, billions of dollars and decades of research, the company finally perfected it’s edge. The famous law has run into the limitations of the laws of physics as the current scales are near the molecular level. ASML dominates both the 65 nm and below market using its Deep Ultra Violet (DUV) technology, which has higher margins than the higher growth EUV market, for now.

The cutting edge of semi-conductor manufacturing happening at the $17 billion TSMC Fab 18 (the most expensive factory ever built) makes building a hydrogen bomb or drilling a deep-water oil-well seem like child’s play. The  most advanced ability in the plant is what ASML provides. At the turn of the millenium, a cutting edge semi-conductor fabrication plant (fab) would have cost only about $1 billion and there were about 30 companies that had the will and wherewithall to do it. Now there’s 2 or 3 and the Fabs themselves cost 10 to 20 times as much. There’s one thing that all manufacturers who function on the cutting edge of chip manufacturing need; ASML’s tech. It’s visionary R&D and spirit of constant improvement have landed it one of the most enviable positions in all of modern commerce. Aside, from it’s technological advantage it is a well managed company that has a strong balance sheet and earnings growth momentum. Additionally, the company has a novel structure of getting the major semi producers (Intel, Samsung, and TSMC) to fund stakes in it’s R&D. This novel strategy helps ensure their R&D funds go where they will be most efficiently used and the end-user of their tech has integral influence. Profit margin growth should continue to outpace its main competitors for the forseeable future.

ASML: The Jewel Of The Empire

Source: Seeking Alpha

The semi-conductor industry may not get as much glory as it’s primary customers (Apple, Google, Amazon and Microsoft), but make no mistake, it is now one of the primary arenas upon which great power geo-politics have been focussed. China long ago realized  that it needed to be competitive in chip-making. In the last decade the CCP has given immense state subsidies to try to get it’s industry up to snuff, now the US is seeing bipartisan interest in government action to shore up capacity.

The Secular Tailwinds For Semi-Conductors

The semi-conductor industry is not only notoriously competitive, it is also notoriously cyclical and often subject to supply gluts and shortages, although few have been as significant and widespread (across technological generations) as the recent one driven by COVID-19. The advent of the fourth industrial revolution and the Internet of Things (IoT) also means that whereas uses were previously tied to human consumption, now the vast networks of sensors and chips will expand demand even further and raise the current rates of wafer per capita. Another trend in the industry of late that should benefit ASML, is the desire of companies like Apple and Amazon to do their own chip-design. As this trend continues, it puts an even higher premium on ASML’s process-simplifying technology and increases the economic incentive for these firms to get into design.

 COVID-19 has accelerated trends toward digitization, AI and data production and consumption that were already strong. Multiple CEO’s from Intel to Applied Materials and Lam Research Corp all see sustainable demand and a super-cycle for semi-conductor demand that may go on for a while. The storied cyclicality for semi-conductor manufacturers was partialy due to the concentrated nature of the market for semi-conductors in the past. If PC demand was down, then the whole industry would get hit. However, the economics are changing for suppliers of semi-conductor equipment; there are now so many applications and such a diversity of end-customers that the demand for equipment, particularly ASML’s has become a lot more steady. It will be one of the main beneficiaries of the major ramping up of CAPEX in the industry. Intel, Samsung and TSMC are spending hundreds of billions over the next decade. It’s hard to think of a company that will benefit more than ASML.

Regardless of what happens with big-power politics, ASML’s technological lead is significant and seems durable. They also have been experiencing great FCF margin growth. So, even though they do trade on many metrics that make them seem overpriced relative to peers, we think the forecasts for their future growth and profitability given their immense technological advantage is worth paying for. The company’s projections for future revenue seem low to us, especially since Intel will need a lot of their equipment to get their production capacity to the leading edge.

ASML: The Jewel Of The Empire

Source: Seeking Alpha

Risks And Where We Could Be Wrong

The main risk for a semi-conductor supply company is obsolecence and as we have discussed ASML is at less risk of befalling this fate than perhaps any other player in the industry. Even if it’s monopoly in EUV is broken miraculously by Chinese research efforts, or efforts to steal intellectual property, it is likely that it’s seasoned experience and the massive intangible asset of it’s human capital will likely be enough to keep an enduring moat around what may be the most lucrative and strategically consequential technology/intellectual property on Earth.

The EUV technology is great at simplifying production processes. Many analysts may have missed the fact that while EUV is currently the leading edge, it is required for very few functions currently. For example, EUV is not used or necessary in producing the older-generation chips the auto industry needs. Intel might be able to spin up some old plants to address those shortages. This makes the EUV technology perhaps even more attractive than initially meets the eye in what is one of the most capital intensive industries on the planet. If you want to be on the leading edge, you simply cannot do it with ASML. Going forward it’s technology will be one of the main ways that company’s make their capital expenditures worth it. In the world of semis, you definitely have to spend money to make it.

Geo-political tensions are of course a major wild-card here. However, the relative neutrality of Europe and the Netherlands in the US/China standoff could ultimately prove to be an advantage. One thing that ASML and many industry players dread is a complete bi-furcation of technological frameworks, one American and one Chinese. The technological prowess and advancement of the semi-conductor industry into one of Earth’s most advanced technologically has been at least partially helped by the liberalization of international trade. It’s reversal is thus obviously a key risk to ASML’s efforts to grow it’s business in China.

While this is a major risk for ASML, holding the aces is holding the aces. We believe that ASML’s downside is severely mitigated by it’s superior technology and the likely high barriers to entry a competitor would have to surmount to truly compete. Remember, ASML is not just dominant in the leading edge, but also in DUV. Even here, it has a near-monopoly market-share at over 90%. While we still like AMAT and LCRX from our article back in June, it should be noted that EUV technology has the potential to significantly diminish the need for some of the areas of the manufacturing process that these companies specialize in. Currency risk is of course also a factor for non-European investors.

ASML: The Jewel Of The Empire

Source: Samsung Company Reports

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