This article was originally published on October 19, 2022, when this ad started running — the stock has soared, so that turned out to be a well-timed pitch, but they are running the same ad again pretty aggressively, without any real changes, so I’m re-posting our “answer” article here for you. I’ve posted some minor updates in the Quick Take above, but what follows has not been updated or revised since last October.

I got a few questions over the past week or so about a new “most important company in the world” pitch for Motley Fool Stock Advisor ($59/yr), and it’s all about semiconductors… so what’s the story?

Well, let’s start with a little taste of the ad… and see what clues we can unearth. The pitch starts with a string of messages from Eric Bleeker to Sam Barker, showing Bleeker’s excitement about a company that most people don’t know about…

“[9:30 AM] One of the craziest things about chips – which you may know

[9:30 AM] There is just a single company responsible for all cutting-edge chips

[9:30 AM] Like, if this company ceased existing the world economy would go into a depression

[9:31 AM] Just always blows my mind that .0001% of people know the name of this company

[9:31 AM] And its …. Probably the most important company in the world”

So what is it? Here’s the next batch of clues from the ad:

“… with the 2022 CHIPS and Science Act passed into law and over $52 Billion pledged to increasing chip manufacturing…it’s only months before this company could be on every investor’s radar.

“You see, this European company supplies a proprietary technology that constructs the circuitry of semiconductors. This advanced technology can construct narrow and complex circuits on silicon that can create faster components that perform better than previous chips.

“These chips make up much of what we use today: laptops, smartphones, televisions, video game consoles, cars, and other consumer electronics. These advanced chips even have military applications, and the government has set aside $2 billion for DoD-related microelectronics applications.

“And they rely on this one company to help them do it.”

So what is it? It’s not Intel (INTC) or NVIDIA (NVDA), the two largest US chipmakers… it’s not the big equipment makers Applied Materials (AMAT) or LAM Research (LRCX). Thinkolator sez, if we’re talking about a monopoly or near-monopoly on constructing those teensy little circuits, and it’s a European company, this must be the Dutch lithography leader ASML (ASML).

Here’s the summary of the company’s business from YCharts:

“Founded in 1984 and based in the Netherlands, ASML is the leader in photolithography systems used in the manufacturing of semiconductors. Photolithography is the process in which a light source is used to expose circuit patterns from a photomask onto a semiconductor wafer. The latest technological advances in this segment allow chipmakers to continually increase the number of transistors on the same area of silicon, with lithography historically representing a meaningful portion of the cost of making cutting-edge chips. Chipmakers require next-generation EUV lithography tools from ASML to continue past the 5-nanometer process node. ASML’s products are used at every major semiconductor manufacturer, including Intel, Samsung, and TSMC.”

And the stock has been a barnburner over the years… though it also got a bit over its skis in the 2021 growth stock mania, so the price is down more than 50% from its peak late last year, and just a hair from its 52-week low at the moment. They’ve got a lot of company in that neighborhood, and the big semiconductor equipment companies have all tended to trade pretty much in unison of late — this is the three-year chart of Applied Materials (AMAT, blue), Lam Research (LRCX, green), ASML (ASML, purple), compared to the Nasdaq 100 index of (mostly) tech stocks (in orange), and to the shares of Taiwan Semiconductor (TSM, pink), the biggest chipmaker in the world… ASML has had the highest highs, and the best overall performance, but none of those companies really stand out as bucking the trend recently:

And, as luck would have it, ASML just reported its results early this morning… so we’ve got some fresh data to work with.

There are generally three warring narratives to deal with when it comes to chipmaking equipment companies: The first is that they’re very cyclical businesses, and semiconductors have tended to go from shortage to glut as the cycle proceeds, leading to a surge of capital investment that’s followed by a bust after capacity gets overbuilt… we went through a rapid phase of that with COVID, and it’s unclear where we are now; The second is that China is both the world’s biggest consumer of chips and the most aggressive, in recent years, at adding chipmaking capacity… and US restrictions on China and a burgeoning cold war is threatening to reduce sales at the “western” chip companies and chip equipment companies, as those firms are forced to stop selling some high-end stuff to Chinese customers, so that’s a near-term headwind for a lot of chip-related companies; and the third is that there may be an ongoing boom in chip equipment companies as the world tries to bring supply chains back home, moving more semiconductor production out of Taiwan and China and “onshoring” with big semiconductor foundries being built in Japan, the US, Europe and elsewhere, which is probably good for the equipment makers. Eventually. It can take five years to build a big new semiconductor foundry, so often the cycles of capital investment don’t line up perfectly with the economic cycles.

Still, there seems to be no chance that the world will stop using semiconductors or needing more of them… or that the technology will stop advancing, even if perhaps there is a physical limit on how tiny a circuit can become. So there is a strong long-term backdrop for the industry, even if the revenue can be lumpy year to year, and it has been challenging for any company to stay in the technological lead for very long.

And what’s up with ASML now? They reported a quarter that was pretty much flat with a year ago — their profit fell from €1.71 billion to €1.70 billion, and their sales rose by about 10% to €5.78 billion, and they had record bookings this quarter of €8.9 billion, so demand remains very strong, even with the uncertain economic backdrop. The company sounded more optimistic than most chip-industry investors and analysts feel right now, and they beat most of the relatively pessimistic analyst estimates. We should probably assume that the operators of the business know it better than the investors do, and they’re pretty pleased with how things are working out so far.

Their sales forecast for the fourth quarter, which is generally what investors care about most from an earnings report (we want to know the future more than we want to know the past), was a little higher than the average analyst estimate, with the midpoint of their forecast being about 3.5% higher than the estimates… and whaddya know, the stock rose by about that much this morning at the open, with a pop of roughly 4%.

They also downplayed the impact of the recent export restrictions from the US, mostly because they’re not a US company, and they say that their sales to China don’t depend on US technology. That could change, of course, and perhaps government entities will more meaningfully pressure ASML to restrict its sales to China more meaningfully at some point… but the leverage the US has over a Dutch company is inherently limited, particularly if that company is not using a lot of proprietary technology from US companies.

Right now, ASML expects to have revenue of €21.1 for the full year, with gross margins that are still remarkably high at around 50% (that’s higher than many of the other big semi equipment companies, but not dramatically so — a lot of them are in the high-40s). The stock probably looks better to Dutch investors than it does in the US, since the falling Euro currency makes that number look less impressive in dollars than it would have a few months ago, but that also helps their gross margins, since a lot of their costs are in euros and they sell a lot of equipment in dollars, so much of the currency upheaval gets washed out eventually.

In valuation terms, they’re trading at about the lowest valuation relative to free cash flow that they’ve had in the past five years (about 16X free cash flow), and the PE ratio is down to about 25 (it bottomed out around 22 back in 2019). The challenge, as with a lot of companies in this space, is that they had blockbuster earnings last year, are widely expected to have lower earnings this year, and analysts are having trouble estimating the extent to which earnings growth will restart in 2023 and 2024. At this point, they’re in the trough part of a three-year period during which analysts think they’ll average about 11% earnings growth (from almost $16 in earnings per share in 2021 to a bit over $21 by 2024)… but that’s skewed by the fact that they’re expected to have only about $13 in earnings per share in 2022, so next year’s earnings growth could well, if analysts are correct, be a far more dramatic 40%+.

With that kind of backdrop, you have to form your own opinion about how much of a multiple to pay… are you buying a company that’s having a pretty flat year this year, and maybe even shrinking a bit, or a company that’s expected to see surging growth again next year?

Right now, at about $420 per share, ASML trades at about 23X forward earnings estimates. That would have been an average valuation last year, though it’s a pretty rich premium to the market right now, and I’d say a premium is deserved, given the growth at ASML and the likelihood of future growth… but it’s also always true that the price you pay matters. Near-peer very large companies in this same semiconductor capital equipment space, albeit with different technologies and products, mostly trade at about 10X earnings today (Lam Research (LRCX), Applied Materials (AMAT) and KLA (KLAC), for example), so ASML trades at an even bigger premium to their sector. Mostly because the growth profile is much more dramatic — those firms have mostly had earnings growth over the past five years in the 15-20% neighborhood, and are expected to slow down to about 7-10%, while ASML has grown at 30% for five years and is expected to keep growing at 25% for the next five. Those analyst projections will not be specifically correct, of course, nobody can predict the future — but they tell you why ASML is more expensive: Expectations are much higher.

On balance, that’s probably a pretty reasonable valuation for a near-monopoly equipment provider in an industry that should have huge growth in the next five years as the US, Japan and South Korea, in particular, are providing substantial government incentives to push forward in building more advanced semiconductor manufacturing. Every time you build a new plant or upgrade to make better and faster chips, the demand for ASML’s machines should grow… but it’s not a steady business, as we saw from the rush to install new equipment last year and the pullback this year. And it is extremely reliant on just a few very large customers, most of the time — last year, more than 80% of their revenue came from their three biggest customers, Taiwan Semiconductor, Intel, and Samsung, and, while they are trying to expand into new areas, including into memory chipmakers to extend the dominance they have in logic chipmakers, that reliance on the largest chip makers in the world will probably continue.

Those are tight relationships, and were started as really collaborative partnerships — ASML gave shares to those companies a decade ago, as part of building their collaborative work in developing next-generation machinery, and a lot of those shares have since been sold, but the close relationship with those mega-customers appears to persist. Which both makes them volatile when capital spending plans at those companies change, like when TSMC cut its capex budget for this year by about 10%… and probably helps them in fending off the competition.

Will that always be the case? I don’t know. ASML pioneered the extreme ultraviolet lithography that is the market-leading technology right now, and the estimates that I’ve seen say that they have better than 60% market share in photolithography in general, and are both taking share and improving their margins… but I’m not at all an expert in the hot trends in semiconductor manufacturing, and perhaps something better will come along in the next few years. Or perhaps Chinese companies will get away with stealing the technology from them, as they’re currently alleging in court (ASML has a lot of lawyers, and defending their patents, as they continue to innovate, is a big part of the business).

I’d feel relatively confident about ASML, if only because chipmakers tend to be very slow to adjust to new technologies and revamp their fabs for new equipment. Once they’ve adopted a technology that is reliable and effective, it’s not easily supplanted — you don’t take risks with these kinds of plants. Which might mean they have an unusually strong tailwind here, since we’re on the cusp of maybe the most aggressive expansion in large high-end semiconductor foundries that we’ve ever seen, inspired by the worries about Chinese and Taiwanese dominance of the semiconductor supply chain — if all those new foundries are built with ASML equipment installed, they could further cement their market leadership for a long time into the future. And though Taiwan Semiconductor itself might end up being a political flashpoint if China gets more assertive with its neighbor, and that could upset in the business in the short term because TSM is probably ASML’s largest single customer, it’s also good for ASML that TSM is trying to become more global and further spread its footprint — they’re moving forward with major new foundries in both the US and Japan, and I’d be surprised if those new foundries aren’t filled up with ASML equipment.

But this is definitely a grow-grow-grow business — they depend overwhelmingly on equipment sales, with their high-end lithography machines costing upwards of $250 million each, and the part of a business that is often more appealing to conservative investors, the ongoing recurring revenue for stuff like maintenance and service contracts on that equipment, is pretty low (it was 28% of sales back in 2017, and 27% last year). It is growing, though, almost as quickly as the overall sales in most years, so it should gradually become a more important part of the business as the installed base grows, which might smooth things over time (some of the “service and field options sales” growth, recently, has really been from selling “upgrade” packages for their existing equipment, helping their customers ramp up production to deal with the spike in demand last year without buying new machines, and that won’t necessarily be recurring). I’d be happier if there was more of a recurring revenue business associated with their equipment, but the overall growth is so dramatic, including their bookings growth that should result in higher future sales, that it’s not so hard to overlook that.

No guarantees, of course, but things actually look better than I expected they would for this stock, particularly after briefly considering it a few times over the past year or two and dismissing it as “too expensive”. It’s still a “growth stock,” and sentiment about that group is volatile right now… but the valuation is more reasonable than I’ve seen at ASML in many years. I don’t own it and can’t buy it for at least three days, since I’m writing about it for you today, but I can see reasons to begin to get interested here — hopefully the shares will fade back down in the next panic and give us a cheaper buy opportunity, one is always tempted to be greedy and hope for a real washout these days, but, given the strong growth in their order book and their optimism about the next generation of their equipment over the next few years, the valuation looks pretty rational right now.

And the Motley Fool covers ASML with free articles, too, not just these teased “premium” reports — so you can also get a sense of what the buzz is about the stock over there, they posted a “bull vs. bear” piece on ASML over the weekend. And if you’d prefer to hear from the company itself, ASML’s results announcement this morning is here, including the conference call and an interview with CFO Roger Dassen if you’d like to dig in a bit deeper.

Color me tempted, but not currently invested. Seeing red or green with this one? What do you think the ASML future holds? Worthy a buy? Let us know your thoughts with a comment below. Thanks for reading!

Disclosure: of the companies mentioned above, I own shares of NVIDIA. I will not trade in any covered stock for at least three days, per Stock Gumshoe’s trading rules.