ASML Holding Is Positioned for Long-Term Profits

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Jan 20, 2010
Cowboy daredevils have their bucking bulls and broncos to ride. And thrill-seeking teenagers can strap themselves into rollercoaster’s with loops, corkscrews and 400-foot drops when they need a rush.

But investors looking for the same intense up and down motions – and the charge of holding on for dear-life – can get their kicks from the notoriously volatile semiconductor industry… and even more so from the companies that manufacture its equipment.

Of that sub-sector, lithography – the business of writing interpretable codes on hard surfaces like computer chips – brings in the largest revenue amounts.

In 2008, it accounted for almost a quarter of the $22 billion the larger semiconductor equipment industry made. But despite that impressive amount, even the lithography machine market leader, Dutch company ASML Holding NV ADR (ASML, Financial), suffers significant ups and downs in business and stock price regardless of the larger economy.

But even with its natural volatility and the current market climate, ASML practically promises one profitable ride for any investor daring enough to climb on board.

Breaking Down ASML Holding

As evidenced by the equipment it makes, ASML doesn’t waste time on the small stuff. Each of its lithography machines or “tools” consists of large cabinets about the size of two SUVs put together, and serves as the key component necessary for creating computer chips.

They sell for up to $45 million each and with good reason, considering the complicated and sensitive work they perform, burning the image of a computer chip’s circuitry on to each necessary layer of silicon at high speeds with pinpoint accuracy.

It’s a highly competitive field where some of the finest, scientific minds test the limits of technology every day. Intel co-founder Gordon Moore practically insured that it would be when he predicted that the number of transistors a chip can hold would double every two years, thereby increasing computer power and capabilities.

But even in that aggressive environment, ASML has retained its leadership position for years now by following a unique business model built on financial discipline, a value it learned the hard way after the Internet bubble burst ten years ago.

Of course, the company has to spend large amounts of money on research and development in order to maintain its lead. But it copes by outsourcing over 50% of that spending through start-ups and research institutes close by, or through the same suppliers that deliver 90% of its production.

ASML relies heavily on those smaller businesses but keeps a positive rapport with them by sharing its profits, thereby ensuring that they survive despite varying economic conditions. Naturally, that breeds loyalty and especially efficient service.

CFO Peter Wennink proudly calls his company a “system architect” at the helm of a “co-operative knowledge network.” And it’s an apt description. So while ASML has the lowest gross margin in the industry since it gives its suppliers first pick of the profits, it also has the highest operating margin since it doesn’t have the same fixed-cost infrastructure that traditional assembly-line companies have.

And that includes its two main competitors, Nikon ADR (NINOY, Financial) and Canon ADR (CAJ, Financial).

The Future for ASML Holding

In the short term, ASML Holding does have notable competition from Nikon as they both battle to dominate the laser-based generation of immersion tools meant for chip manufacturing – a technology that has reached its physical limit in regard to how thin and precise the beam can get.

Both companies have already shipped pre-production models to customer for testing in a head-on competition, and they expect to hear back within the next few months. Whomever wins will naturally capture the largest market share of the lithography market for the next 2 – 4 years.

And while ASML most definitely wants to claim that prize, it’s also focused on longer-term goals, like preparing the next generation of lithography machines for customers like Intel to start testing out. If everything goes according to plan, the first six of the pre-production models should be shipped out within the next few months.

These new, highly sophisticated machines work off of extreme ultraviolet (EUV) light, which requires a vacuum inside the machine and mirrors instead of lenses to focus the light on the silicon. So far, ASML is far in the lead on this technology, since Canon has no published plans to work with it and Nikon has only indicated it will start production in 2014… two years after ASML.

Investors shouldn’t be surprised at that strong lead, considering how the company’s market share has risen over 65% in the 25 years since it spun off from Philips ADR (PHG, Financial). It has outgrown its rivals, it says, because its cooperative model allowed faster innovation.

Whatever the reason, ASML looks set to dominate the market for lithography machines for years to come.

Good investing,

Tony Daltorio

http://www.investmentu.com/