ASML: Competing with Moore’s Law

Sector

Semiconductors

Background

Tom Walsh is a portfolio manager at Baillie Gifford. We cover the science and architecture behind lithography machines, how ASML became the undisputed masters of EUV technology, and what factors drive the market for semiconductors more broadly.

Cover

Date

June 28, 2023

Episode Number

117

Background and Overview

ASML was founded in 1984 as a spin-off from Philips in Eindhoven, Netherlands, initially viewed as a "problem child" with no revenue, no commercially viable product, and a demoralized workforce housed in makeshift barracks. Despite these inauspicious beginnings, ASML leveraged two industry-leading technologies developed at Philips, a team of tenacious engineers, and a timely technological transition in the lithography industry to carve out a niche. By the mid-1990s, ASML had emerged as one of three leading players alongside Nikon and Canon, overtaking Nikon as the industry leader in 2002. Today, ASML dominates the market for extreme ultraviolet (EUV) lithography machines, critical for producing the world’s most advanced semiconductors.

ASML’s journey reflects a combination of resilience, innovation, and strategic opportunism. Its nontraditional path—starting as the 10th of 10 lithography players with no clear competitive advantage—highlights the importance of seizing industry transitions and maintaining a relentless focus on technological advancement. The company’s current leadership, including CEO Peter Wennink (since 2013, previously CFO from 1999) and CTO Martin van den Brink (with ASML since 1984), has been instrumental in navigating industry cycles and pioneering EUV technology.

ASML operates in the semiconductor equipment industry, specifically within the photolithography segment, which is the gating technology for Moore’s Law—the doubling of transistors on a chip approximately every two years. The company employs around 40,000 full-time equivalents (FTEs, estimated based on its scale) and is headquartered in Veldhoven, Netherlands, with a global supply chain and customer base concentrated in Taiwan, South Korea, and China.

Ownership and Valuation

ASML is a publicly traded company listed on the Euronext Amsterdam and NASDAQ (ASML). As of the podcast date in 2023, its market capitalization was approximately €250 billion. The company has not been subject to recent acquisitions due to its size, strategic importance, and the semiconductor industry’s structure, which favors specialized niches over vertical integration. In 2012, major customers Intel, Samsung, and TSMC co-invested €1.4 billion for a 23% stake to fund EUV R&D, a move that underscores ASML’s collaborative business model but also its independence. Regulatory barriers and ASML’s critical role in the global semiconductor supply chain make it an unlikely acquisition target.

Key Products and Value Proposition

ASML’s core product is photolithography machines, which project circuit patterns onto silicon wafers to create integrated circuits (chips). Its flagship offering is the EUV lithography machine, which uses extreme ultraviolet light to produce the smallest, most advanced chips (e.g., 5-nanometer and 3-nanometer nodes). ASML also offers deep ultraviolet (DUV) machines for less advanced nodes and provides services such as maintenance, upgrades, and computational lithography solutions (e.g., E-Beam metrology for defect detection).

Value Proposition:

1. Enabling Moore’s Law: ASML’s machines allow semiconductor manufacturers to shrink transistor sizes, increasing chip performance and capacity at a lower cost per transistor, driving advancements in computing, AI, and consumer electronics (e.g., iPhones, NVIDIA GPUs).
2. High Precision and Productivity: EUV machines achieve unparalleled precision (patterns measured in single-digit nanometers) and throughput, critical for high-volume manufacturing of leading-edge chips.
3. Longevity and Upgradability: Machines have a 30+ year lifespan, with 90% of units sold in the last 30 years still operational, supported by ASML’s service and upgrade offerings.
4. Collaborative Innovation: ASML’s open collaboration with customers and suppliers ensures shared risk and reward, fostering trust and long-term partnerships.

Product Breakdown (Estimated from Transcript):

Note: Revenue contributions are estimated based on 75% from new machine sales (€15.75B) and 25% from services (€5.25B), with EUV machines being the dominant driver due to their high price.

Segments and Revenue Model

ASML operates as a single-segment business focused on photolithography equipment and services, with no distinct product or geographic segments reported in the transcript. However, revenue can be analyzed across two economically separable units:

1. New Machine Sales (75% of revenue, €15.75B in 2022): Sales of EUV and DUV machines to semiconductor foundries (e.g., TSMC, Samsung, Intel).
2. Services and Field Options (25% of revenue, €5.25B in 2022): Maintenance, upgrades, and computational lithography solutions for installed machines.

Revenue Model:

• New Machine Sales: ASML earns revenue by selling high-cost, low-volume machines (345 units in 2022). EUV machines, priced above €150 million, are the primary growth driver due to their necessity for advanced chips. DUV machines, priced lower, cater to legacy nodes but are still significant.
• Services and Upgrades: Recurring revenue from servicing the installed base (90% of machines sold in 30 years remain operational) and providing upgrades to improve productivity. This segment is higher-margin and less cyclical, providing stability.
• Customer Collaboration: ASML’s pricing is based on shared value creation, splitting profitability improvements 50-50 with customers, avoiding price gouging to maintain long-term relationships and deter alternative technologies.

Splits and Mix:

• Customer Mix: Highly concentrated, with the top two customers (likely TSMC and Samsung) accounting for ~60% of revenue, and the top three ~65-70%. This reflects the consolidation of leading-edge semiconductor manufacturing.
• Geographic Mix: In 2022, ~40% of sales were to Taiwan, ~30% to South Korea, and ~50% to China (likely a typo in the transcript, as these sum to 120%; assuming China is ~20-30%). This concentration exposes ASML to geopolitical risks.
• Product Mix: EUV machines are the fastest-growing segment

Headline Financials

Key Metrics (2022):

Revenue Trajectory and Drivers:

• Historical Growth: ASML’s revenue has grown significantly since its IPO, with a compound annual growth rate (CAGR) likely exceeding 10% over the past decade, driven by its rise to market leadership and EUV adoption. The transcript notes 2022 revenue of €21 billion, reflecting strong demand for EUV machines.
• Revenue Drivers:
• Volume: Low unit volume (345 machines in 2022) but high average selling price (ASP). ASML plans to increase capacity to 90 EUV machines and 600 DUV machines annually by 2027-2028.
• Price: EUV machines priced above €150 million, DUV machines at €10-50 million (estimated). Pricing is based on value creation, not market power, to maintain customer trust.
• Mix: Shift toward EUV machines (higher ASP, higher margins) is driving revenue growth. Services (25% of revenue) provide stable, high-margin recurring income.
• Aftermarket: Services and upgrades are sticky, with 90% of machines sold in 30 years still operational, ensuring long-term revenue from maintenance and upgrades.

Cost Trajectory and Operating Leverage:

• Cost Structure:
• Variable Costs (~80% of COGS): Components and materials sourced from specialized suppliers (e.g., ZEISS for lenses, Cymer for light sources). Bulk purchasing and long-term supplier relationships mitigate inflation risks.
• Fixed Costs (~20% of COGS): Labor for assembly and integration, plus overhead (facilities, R&D). High fixed costs in R&D (~15-16% of revenue) drive operating leverage as revenue scales.
• Gross Margin: ~50%, reflecting economies of scale and EUV’s premium pricing. Historical margins were 30% (2000s) and mid-40s (2010s), showing significant improvement.
• Operating Margin: ~30%, with potential for expansion as EUV volumes increase and fixed costs are spread over higher revenue.
• Operating Leverage: High fixed costs (R&D, assembly facilities) mean incremental revenue drops to EBITDA at high margins, enhancing profitability as sales grow.

Capital Intensity and Allocation:

• Capital Intensity: Relatively low for a manufacturing business, as ASML is an “architect and integrator,” outsourcing 80% of COGS. CapEx is focused on expanding assembly capacity (e.g., for 90 EUV machines/year by 2027-2028).
• Capital Allocation:
• R&D: ~€3.15-€3.36B annually (15-16% of revenue) to maintain technological leadership.
• CapEx: Heavy investment in capacity expansion, though specific figures are not provided.
• Shareholder Returns: Dividends (unusual for a high-growth company) and consistent share buybacks, particularly substantial over the last five years.
• M&A: Strategic acquisitions (e.g., Cymer in 2013 for light sources) and stakes (e.g., ZEISS) to secure supply chain capabilities.
• Free Cash Flow (FCF): Strong FCF generation, nearly equal to net income, due to customer down payments and low working capital requirements. FCF supports R&D, CapEx, dividends, and buybacks.

Value Chain Position

ASML operates midstream in the semiconductor value chain, between upstream suppliers (e.g., ZEISS for lenses, Cymer for light sources) and downstream customers (foundries like TSMC, Samsung, Intel). Its role is to design, assemble, and service photolithography machines, which account for 20-25% of wafer fabrication equipment costs (higher for logic chips, lower for memory).

Primary Activities:

• R&D: Developing next-generation technologies (e.g., EUV, high-NA EUV).
• Procurement: Sourcing specialized components from a tight-knit supplier ecosystem.
• Assembly: Integrating components into modular machines, assembled on-site at customer facilities.
• Service: Maintaining and upgrading the installed base, ensuring longevity and productivity.

Go-to-Market (GTM) Strategy:

• Direct Sales: ASML sells directly to a concentrated customer base (top two customers ~60% of revenue), leveraging long-term relationships and collaborative R&D.
• Value-Based Pricing: Prices reflect the productivity and cost improvements delivered to customers, with a 50-50 split of profitability gains.
• Service Contracts: Recurring revenue from maintenance and upgrades, tied to the long lifespan of machines.

Competitive Advantage:

ASML’s value-add lies in its technological leadership (EUV monopoly), modular design (enabling incremental upgrades), and collaborative ecosystem. Its position as the sole provider of EUV machines makes it indispensable for leading-edge chip production.

Customers and Suppliers

Customers:

• Concentration: Top two customers (likely TSMC and Samsung) account for ~60% of revenue, top three ~65-70%. Customers are large, deep-pocketed foundries capable of affording €150M+ EUV machines.
• Dependency: Customers rely on ASML for leading-edge lithography, with no viable alternatives, creating high switching costs.
• Geographic Exposure: ~40% Taiwan, ~30% South Korea, ~20-30% China, exposing ASML to geopolitical risks.

Suppliers:

• Specialized Ecosystem: ASML sources 80% of COGS from suppliers like ZEISS (lenses) and Cymer (light sources). Long-term relationships ensure quality and innovation alignment.
• Risks: Suppliers must keep pace with ASML’s technological advances. Past acquisitions (e.g., Cymer) and stakes (e.g., ZEISS) mitigate supply chain bottlenecks.

Pricing

• Contract Structure: Long-term, high-value contracts with down payments to fund R&D and capacity expansion. Contracts are collaborative, with pricing tied to value creation.
• Pricing Drivers:
• Value-Based: Prices reflect productivity and cost improvements, with a 50-50 split of profitability gains to avoid gouging.
• Mission-Criticality: EUV machines are essential for leading-edge chips, justifying premium pricing.
• Elasticity: Low price elasticity due to lack of alternatives, though ASML avoids exploiting this to maintain trust.
• Visibility: High visibility due to long order backlogs and customer commitments, reducing cyclicality.

Bottoms-Up Drivers

Revenue Drivers:

• Volume: Low unit volume (345 machines in 2022) but high ASP. Capacity expansion to 90 EUV and 600 DUV machines by 2027-2028 will drive growth.
• Price: EUV machines (>€150M) and DUV machines (€10-50M) reflect premium technology. Pricing is stable due to value-based approach.
• Mix: Shift to EUV (higher ASP, margins) and stable service revenue (25%) drive growth. Services are less cyclical, enhancing stability.
• Organic Growth: Driven by EUV adoption, capacity expansion, and secular demand for chips. No significant M&A contribution noted.

Cost Drivers:

• Variable Costs: ~80% of COGS (components, materials). Stable due to long-term supplier contracts and bulk purchasing.
• Fixed Costs: 20% of COGS (labor, overhead) plus R&D (15-16% of revenue). High fixed costs drive operating leverage.
• Margin Expansion: Gross margin (50%) and operating margin (30%) benefit from scale and EUV’s premium pricing.

FCF Drivers:

• Net Income: High due to strong margins and revenue growth.
• CapEx: Moderate, focused on assembly capacity. Not capital-intensive relative to revenue.
• NWC: Low working capital requirements due to customer down payments, leading to a short cash conversion cycle.
• Cash Conversion: Near 100% conversion of net income to FCF, supporting reinvestment and shareholder returns.

Market Overview and Competitive Landscape

Market Size and Growth:

• Total Addressable Market (TAM): ASML accounts for 20-25% of wafer fabrication equipment spending, part of a ~$100B global semiconductor equipment market (estimated). The market grows with chip demand, driven by AI, 5G, IoT, and automotive applications.
• Growth Drivers:
• Volume: Increasing chip production for consumer electronics, data centers, and emerging technologies.
• Price: Stable equipment pricing, with premium for EUV machines.
• Absolute Growth: ~5-7% CAGR for semiconductor equipment, with ASML growing faster due to EUV dominance.
• Industry Growth Stack: Driven by population growth, real GDP growth, digitalization, and inflation.

Market Structure:

• Consolidated: ASML has a ~100% share in EUV and ~90% in DUV, with no direct competitors. Historical competitors (Nikon, Canon) exited EUV due to cost and complexity.
• Barriers to Entry: High capital requirements (>€10B in EUV R&D), technological complexity, and supply chain dependencies create insurmountable barriers.
• Minimum Efficient Scale (MES): Large MES due to R&D and capacity needs, limiting competitors to a few large players.
• Industry Cycle: Cyclical, but ASML’s monopoly and long order backlogs reduce cyclicality compared to historical norms.

Competitive Positioning:

• Matrix Positioning: Premium pricing, targeting leading-edge foundries. ASML’s EUV monopoly positions it as the only option for advanced nodes.
• Risk of Disintermediation: Low due to technological lead and customer dependency. Large players (e.g., TSMC) benefit from ASML’s independence, reducing acquisition risk.
• Market Share: ~100% in EUV, ~90% in DUV. Growing faster than the market due to EUV adoption.

Hamilton’s 7 Powers Analysis:

1. Economies of Scale: High fixed costs (R&D, assembly) create operating leverage, lowering unit costs as volume grows. Large MES deters new entrants.
2. Network Effects: Limited direct network effects, but ASML’s ecosystem (suppliers, customers) creates indirect flywheel effects, reinforcing its position.
3. Branding: Strong reputation for reliability and innovation allows premium pricing and customer trust.
4. Counter-Positioning: ASML’s assembler model (vs. Nikon/Canon’s vertical integration) enables agility and cost efficiency, difficult for incumbents to replicate.
5. Cornered Resource: Proprietary EUV technology and supply chain (e.g., Cymer, ZEISS) are unique and unattainable by competitors.
6. Process Power: Modular design and collaborative R&D enable incremental innovation, derisking technological leaps.
7. Switching Costs: High for customers due to machine longevity (30+ years), integration into fabs, and lack of alternatives.

Porter’s Five Forces:

1. New Entrants (Low): Insurmountable barriers (capital, time, technology).
2. Substitutes (Moderate): Potential for disruptive technologies (e.g., 3D NAND reduced lithography needs), but unlikely in the near term.
3. Supplier Power (Moderate): Specialized suppliers (e.g., ZEISS) have some power, but ASML’s acquisitions and stakes mitigate this.
4. Buyer Power (High): Concentrated customers (top two ~60% of revenue) have leverage, but dependency on ASML limits bargaining power.
5. Rivalry (Low): No direct competitors in EUV; limited price competition due to monopoly.

Strategic Logic

• CapEx Cycle: Offensive investments in capacity (90 EUV, 600 DUV machines by 2027-2028) to avoid bottlenecks and maintain leadership.
• Economies of Scale: ASML operates at MES, with no diseconomies due to its assembler model and focused scope.
• Vertical Integration: Limited to strategic acquisitions (e.g., Cymer) to secure supply chain, avoiding full integration to maintain agility.
• Horizontal Expansion: Potential in computational lithography (e.g., E-Beam metrology), leveraging existing expertise.
• Geographic Expansion: Global customer base, but geopolitical risks (Taiwan, South Korea, China) require careful navigation.

Valuation

With a €250 billion market cap and €21 billion in 2022 revenue, ASML trades at 12x revenue and ~38x operating profit (€6.5B). This premium valuation reflects its monopoly, high margins, and growth potential (EUV adoption, capacity expansion). FCF yield is likely ~2-3% (assuming FCF ~€5-6B), supported by strong cash conversion. The market expects continued revenue growth (10%+ CAGR) and margin expansion (operating margin >30%), driven by secular chip demand and ASML’s unmatched position.

Key Takeaways and Unique Dynamics

1. EUV Monopoly: ASML’s 100% share in EUV lithography, developed over 25 years with >€10 billion in R&D, creates an unmatched competitive moat. The complexity (e.g., laser-tin plasma light source) and supply chain dependencies (e.g., Cymer, ZEISS) make replication nearly impossible.
2. Collaborative Business Model: ASML’s 50-50 value-sharing with customers and suppliers fosters trust, reduces price gouging incentives, and ensures long-term partnerships. This contrasts with traditional monopolistic pricing strategies, preserving customer loyalty and deterring alternative technologies.
3. Assembler Model: Unlike Nikon and Canon’s vertically integrated approach, ASML’s architect-integrator model (80% COGS outsourced) enables agility, cost efficiency, and scalability. This necessity-driven strategy became a core strength, allowing rapid innovation and supplier ecosystem alignment.
4. Long-Lived Assets: With 90% of machines sold in 30 years still operational, ASML’s service and upgrade business (25% of revenue) provides high-margin, recurring income, stabilizing cash flows and enhancing customer stickiness.
5. Operating Leverage: High fixed costs (R&D, assembly) and low variable costs (80% COGS outsourced) drive significant operating leverage, with gross margins (50%) and operating margins (30%) poised for further expansion as EUV volumes grow.
6. Geopolitical Exposure: ~60-70% of revenue from Taiwan and South Korea, plus ~20-30% from China, exposes ASML to geopolitical risks, a critical near-term concern.
7. Incremental Innovation: Modular design derisks technological leaps, enabling steady improvements (e.g., high-NA EUV) while maintaining reliability and customer confidence.
8. Secular Growth Driver: ASML’s growth is tied to chip demand (AI, 5G, IoT), ensuring long-term relevance as long as Moore’s Law persists.

Unique Dynamics:

• EUV’s Technological Leap: The transition to EUV, requiring mirrors, vacuum chambers, and a novel light source, was a 25-year, €10 billion bet that redefined the industry. ASML’s persistence, backed by customer co-investment (€1.4B from Intel, Samsung, TSMC), highlights its ability to align stakeholders around a shared vision.
• Customer Dependency: The concentrated customer base (~60% from top two) creates mutual dependency—customers need ASML’s machines, and ASML needs their orders and R&D support. This symbiosis drives collaboration but also concentrates risk.
• Supply Chain as Competitive Advantage and Risk: ASML’s supplier ecosystem is both a strength (enabling innovation) and a vulnerability (suppliers must keep pace). Strategic moves like acquiring Cymer and staking ZEISS reflect proactive risk management.
• Cyclicality Mitigation: ASML’s monopoly and long order backlogs reduce cyclicality compared to historical norms, transforming it into a more stable, secular growth story.

Business Lessons

1. Look Beyond the Cycle: ASML’s structural growth (EUV, chip demand) outweighs short-term cyclicality. Focusing on long-term excellence avoids missing opportunities due to timing concerns.
2. Luck and Resilience: ASML’s early survival (e.g., 1986 recession killing competitors, EUV technology transfer) underscores the role of luck, but its tenacity and ingenuity turned opportunities into dominance.
3. Human Ingenuity: ASML’s ability to push Moore’s Law beyond expectations (e.g., Martin van den Brink’s 15-year predictions) highlights the power of innovation to defy limits, a lesson for any technology-driven business.

This analysis reveals ASML’s unique position as a linchpin of the semiconductor industry, driven by its EUV monopoly, collaborative model, and operating leverage. Its ability to balance innovation, customer trust, and supply chain management ensures sustained leadership, though geopolitical risks and disruptive technologies warrant vigilance.