[October.2024]The crown jewel of chip manufacturing: how to read ASML's earnings report

In high-end chip manufacturing, $ASML Holding (ASML.US)$ from the Netherlands is a key player, dominating the global supply of EUV lithography machines.

Driven by the booming chip industry and its market leadership, ASML's stock has surged over tenfold in the past decade, far outpacing the S&P 500.

The secret to ASML's success may be uncovered in its financial reports. On October 16, UnitedHealth will release its latest earnings report. Each release may signal a potential investment opportunity, but investors need to know how to interpret the data.

Key areas to focus on may include performance growth, competitive advantages, cash flow, and shareholder returns.

1. Performance growth

As a key supplier in the chip industry, ASML's performance is closely tied to the sector's development. The chip industry is characterized by cyclical fluctuations but also holds long-term growth potential. Therefore, $ASML Holding (ASML.US)$ can be seen as both a growth stock and a cyclical stock.

ASML's growth is evident in its consistent revenue increase. From €5.25 billion in 2013, the company's revenue surged to €27.56 billion in 2023—an impressive 4.2-fold increase over ten years. This translates to a compound annual growth rate (CAGR) of approximately 18%, with every single year marking an increase without exception.

ASML's cyclical nature is apparent in its revenue growth rates and net income fluctuations. During industry upswings, ASML's revenue growth typically accelerates, while during downturns, its growth rate tends to decelerate.

For instance, in 2020-2021, the chip industry boomed due to increased demand for remote work solutions during the pandemic, leading to accelerated revenue growth for $ASML Holding (ASML.US)$ . By 2022, as chip inventory accumulated and the industry slowed, ASML's revenue growth also declined. However, by 2023, as the chip industry began to recover, ASML's revenue growth rebounded accordingly.

This cyclical pattern is even more pronounced in ASML's net income fluctuations. In the high-demand year of 2021, ASML's net income growth exceeded 60%. Conversely, during the downturn in 2022, net income declined by 4.4% year-over-year(YoY).

To gauge ASML's current standing, it's important to monitor the latest revenue growth rates in their financial reports. If growth rates continue to rise, it may indicate a favorable industry cycle, potentially boosting ASML's stock price. Conversely, declining growth rates could pressure the stock.

However, since $ASML Holding (ASML.US)$ operates at the top of the chip supply chain, there is typically a lag in how downstream demand impacts its revenue growth. For instance, while most chip design companies are seeing revenue increases, ASML reported year-on-year declines in revenue for Q1 and Q2 of 2024, leading to a sharp drop in its stock price.

Revenue performance can sometimes lag, so it's beneficial to consider downstream demand indicators. Inventory turnover rates in chip design companies, such as NVIDIA, serve as valuable metrics. A significant rise in NVIDIA's inventory turnover rate may signal strong demand, positively impacting ASML's revenue growth. Conversely, a drop in this rate could indicate an impending slowdown for ASML.

By closely watching these indicators, investors can better navigate ASML's cyclical trends and make informed decisions.

2. Competitive moat

A company's long-term success hinges on the depth of its competitive moat. The deeper the moat, the stronger the competitive barriers, making it easier for the company to thrive.

ASML's moat is largely built on its technological leadership. Lithography machines are classified by their light sources: EUV (Extreme Ultraviolet) is the most advanced, used for sub-7nm processes, while DUV (Deep Ultraviolet) is for 7nm and above.

Advanced chip processes require cutting-edge technology. Since ASML commercialized EUV lithography machines around 2018, it has maintained a global monopoly. This technological edge has secured ASML's dominant market share. In 2022, $ASML Holding (ASML.US)$ held 82.9% of the lithography market and 100% of the EUV segment, according to Khaveen.

To gauge if ASML can maintain its technological advantage, we can look at two financial indicators.

First, the R&D expense ratio. ASML consistently spends around 15% of its revenue on R&D, showing its commitment to innovation.

Second, the gross margin. Gross margin reflects a company's competitive strength and its pricing power. Over the past three fiscal years and Q1 2024, ASML's gross margin has exceeded 50%, up from approximately 45% in previous years. This increase may suggest that ASML's competitive advantage and moat remain robust.

Monitoring these indicators in future financial reports may help assess ASML's ongoing commitment to innovation and the strength of its competitive moat.

3. Cash Flow and Shareholder Returns

Unlike chip foundries like TSMC that need constant upgrades to keep up with evolving chip technologies, $ASML Holding (ASML.US)$ , as an upstream equipment manufacturer, enjoys healthier cash flow. Since 2013, ASML's capital expenditures for property, plant, and equipment amounted to €8.24 billion, less than a quarter of its total net income. During this period, ASML's free cash flow reached €34.75 billion, nearly matching its net income.

With robust cash flow, $ASML Holding (ASML.US)$ has the capacity for substantial shareholder returns. In the stock market, many companies reward shareholders through dividends and buybacks. Dividends provide direct returns, while buybacks increase earnings per share and inject liquidity into the market, benefiting shareholders.

Since 2013, $ASML Holding (ASML.US)$ has distributed €29.39 billion in dividends and net buybacks, accounting for about 83% of its net income over the same period. This demonstrates generous shareholder returns.

For future financial reports, it may be important to monitor whether $ASML Holding (ASML.US)$ can sustain its strong cash flow and shareholder return practices.

Having read this far, you may now have a deeper understanding of how to interpret ASML's financial reports. It's noteworthy that the release of earnings reports from prominent companies may present unique trading opportunities for different types of investors.

For instance, if an investor, after analyzing past reports and considering recent developments, believes a company's latest earnings will send positive signals and boost the short-term stock price, they might consider taking a long position. This could involve buying the underlying stock or purchasing call options.

Conversely, if the investor expects the earnings to be unfavorable and potentially pressure the stock price, they might consider taking a short position, either through short selling or buying put options.

If the report's outcome is unclear but volatility is expected, they might use a straddle strategy, buying both calls and puts.

However, investors should carefully assess their risk tolerance, particularly when considering high-risk trades like short selling or options, before making any trading decisions.

Summary

When analyzing ASML's financial reports, we may focus on four key areas: performance growth, competitive moat, cash flow, and shareholder returns.

1. Performance Growth:

1. ASML exhibits both growth and cyclical characteristics.

2. Monitor revenue growth rates and industry inventory turnover to understand its cyclicality.

2. Competitive Moat:

1. ASML's market dominance is driven by its technological edge in lithography machines, particularly EUV technology.

2. High R&D spending ensures continued technological leadership.

3. A high gross margin reflects a strong competitive advantage.

3. Cash Flow and Shareholder Returns:

1. Historically, ASML has had robust cash flow and has been generous in returning value to shareholders through dividends and buybacks.

2. Future financial reports should be watched to see if this stable performance continues.