Business Breakdowns
· Matt Reustle
[00:00:00] S0: It 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 described 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 sold 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? What does that look like over time? And what does that look like today?
· Tom Walsh
[00:00:00] S1: The margin profile has, as you might imagine, improved over time as they've gone from stepping away from market leadership to becoming the dominant player. So their gross margins are 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 EUV machine starts to come into production and the existing generation of EUV machines starts to increase in volume. So 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 marketplace for nearly 20 years now, it's never looked to price gouge. Its approach is incredibly collaborative, and I've 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. ASML puts billions and billions into developing new machines. TSMC's business model, Intel's business model, Samsung's business, they don't work if they don't have the equipment to make these advanced semiconductors. So there needs to be sort of a quid 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 having supported me in developing these machines, the quid pro quo from me is I'm not going to gouge you. I know I'm new and have some time for an EUV lithography machine. In theory, economically we would say, ASML could jack up the prices by twofold and take what they like. But they know that if they took advantage of their position of pricing power, that produces this massive incentive for their customers to look elsewhere to look at alternative technologies to look at alternative providers and to take money into providing themselves with an option.
· Tom Walsh, Matt Reustle
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 and comparatively powerful, but they're really codependent on each other. And the success of the relationship is being borne out of, ASML not trying to take advantage of this position, either with its customers or with its suppliers, but seeking to price these 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 split the benefit of that 50-50 between themselves and their customers, then they need to share that benefit down the supply chain as well. [00:00:00] S0: Yes, it's a fair point, and it seems like it's an incredibly important factor. If it's not going to be a vertically integrated industry, there needs to be some level of 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?
· Matt Reustle, Tom Walsh
[00:00:00] S0: Yes, it's a fair point, and it seems like it's an incredibly important factor. If it's not going to be a vertically integrated industry, there needs to be some level of 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? [00:00:00] S1: 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 and you'd be somewhere around 65%, 70% of revenues. So it's a very concentrated 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, and they are the customers, they are the only people who can afford to buy ASML's equipment. And they're 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. [00:00:00] S0: 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? It seems like there's such an important piece of the pie, what stops one of these players from trying to acquire the business?
· Tom Walsh
[00:00:00] S1: I suspect the market cap provides a reasonable hurdle today. And it's a fair question. And if you roll it back, it's not that long ago that they had a market cap of $20 billion, $30 billion. And why didn't someone come in and buy that? I think it is the 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 the design of semiconductors, companies that involve in manufacture, companies that are involved in making materials, equipment that's used in the manufacturing and companies that take the semiconductors and stick them into the products that are sold to consumers of industry. And 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're seeing concentration within those niches, but you haven't perhaps seen so much in the way of vertical integration. Samsung or TSMC tried to buy ASML a decade ago. I think the odds are they wouldn't have been able to develop EUV. 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 ASML 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 Micron and so on.
· Matt Reustle, Tom Walsh
[00:00:00] S0: Back 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? [00:00:00] S1: The company's cash generation is actually pretty fantastic, not least, it's helped because customers pay a down payment. They pay for this equipment often there's only the development machines that are able to take deposits upfront. So that's been helped to support as they've had to spend heavily on R&D and building out 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, all share buybacks, 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 5 years or so. So 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 a dividend and give its cash back to shareholders through buybacks.