ASML Acknowledges Dangers Of Forcing China To Reinvent The Wheel

Investment thesis: As is increasingly the case with many companies, ASML’s (NASDAQ:ASML) future is now tied to geopolitics. Geopolitics provides an opportunity to sell many more of its lithography machines, as the US and the EU are both looking to re-shore some of the semiconductor manufacturing that our economies need as vital inputs. At the same time, a senior ASML executive recently admitted that the US efforts to create a tech bottleneck meant to contain China’s technological rise are forcing the Chinese to innovate their way out of the resulting predicament and create a domestic semiconductor industry of their own, with as few Western inputs as possible. They are doing so, in order to insulate from any future attempts to undermine Chinese tech companies or the broader Chinese economy. Some recent developments as well as hints at how China might opt to address the challenge of being denied access to certain technologies suggest that the threat to ASML’s business may be real, and it may arrive sooner than expected.

ASML continues to see stellar financial results and growing sales of its lithography machines.

The monopoly that ASML has in lithography machines needed to manufacture the high-end chips that power most of our mobile devices, and are also crucial in many high-performance computing needs is certainly paying off in financial terms.

As we can see, ASML saw a revenue influx of 21.2 billion euros ($22.9 billion), and achieved a net income margin of 27%, given the 5.62 billion euro net income reported in its 2022 financial report. Revenue growth was substantial for the year, coming in at 14%, but net income declined slightly. This should not come as a surprise given the growing input price growth that most industrial producers in Europe saw last year. While I do not expect those input prices to decline this year, I also do not think that we will see a significant increase this year. ASML expects to see continued revenue growth for the year.

An increase in revenue and profits is what the market is expecting to see. ASML stock is currently trading at a P/E ratio of about 33, therefore continued robust growth would be needed in order for fundamentals to match the market cap.

ASML expects sales to increase 25% in 2023, and it expects profit margins to improve. I do believe the sales increase expectations are solid, especially if measured in euro terms, but the profit margin issue is far more complicated. Manufacturing and transport costs in the EU are becoming increasingly unpredictable. The exchange rate of the euro versus major currencies is also likewise very unpredictable, so the market cap we see above, expressed in USD terms may or may not match the company’s euro-based performance going forward.

ASML executive sounds the alarm on the danger of putting tech squeeze on China.

While the overall picture for this year looks bright for ASML, by the recent admission of ASML’s Holding NV Chief Executive Officer, Peter Wennink, the recent push to restrict China’s access to certain technologies may have some unwelcome, negative consequences for ASML. The worry is that something I have been suggesting for a while now, namely forcing China to reinvent the wheel may occur, and if they can be successful at it, the outcome for our own tech sector will likely be unpleasant, although perhaps not terminal by any means.

If Chinese companies working together with the government can innovate their way to produce the key breakthrough technologies that will allow them to put together their own domestic hi-end semiconductor industry, with as few foreign inputs as possible, it could be a global-scale game changer in terms of a possible shift in the global balance of tech dominance to Asia. All China has to do is match more or less some of the high-end chip producers. In many cases, it doesn’t even have to do that, because not all semiconductor needs are high-end. Furthermore, a slight shortfall in quality can be offset by an outsized price differential, mostly stemming from China’s unmatched manufacturing capacity. Not to mention the growing desire that seems to be spreading fast around the world to reduce dependence on Western financial as well as technological inputs, which is one of the main negative fallouts from the recent weaponization of those assets.

It remains to be seen to what extent Chinese entities can match Western technological sophistication while limiting Western intellectual inputs along the supply chains. Huawei seems to be leading the way in trying to match ASML on lithography technology, based on recent news of its patent fillings. China is also looking at adopting graphene as a replacement for silicon-based semiconductors, in what may be an arguably long-shot attempt to leapfrog the entire silicon chapter of the global IT era. It remains to be seen to what extent either of these avenues is likely to play out for the Chinese. As I wrote in my first article of the year, this could end up being the investment story of the year, regardless of whether the market will wake up to this fact or not. Based on some seemingly concerned voices among ASML’s leadership, it may indeed turn out to be a very important factor for ASML, for the global tech sector, and ultimately for the entire global economy.

Investment implications:

With a forward P/E ratio of about 33, ASML is priced for revenue and profit growth, which in my view is not in any doubt for this year and even next year. If however growing noise of Chinese breakthroughs in semiconductor technology, ranging from design to production processes turns out to be real, 2025 may already become an uncertain year for ASML’s future prospects. At the very least, we could see a break of its near monopoly on high-end lithography machines, with the likes of Huawei potentially muscling its way into a monopoly-challenging position, with its own sanctions-proof machines. The sanctions-proof aspect of it might even become a feature that has the potential to make it more attractive than ASML’s machines, even if Huawei’s assumed future lithography machines will be slightly lower in overall quality. At this point, it seems there is a growing premium around the world for anything that reduces reliance on Western inputs, especially if those inputs can be used for coercive actions.

There is a reason why ASML is at the moment enjoying monopolistic power over the technology used to make high-end semiconductors. It is a very complex technology, with few alternative avenues available as a path to similar results, without infringing on existing patents, at least when it comes to silicon chips. It is by no means guaranteed therefore that China will succeed in developing its own domestic semiconductor industry, but it is trying to, with the government and private companies seemingly working together with a high degree of urgency, in order to try to get it done.

With multiple avenues being explored, including Huawei’s efforts to more or less duplicate what ASML does, even as it tries to avoid infringing on already existing patent designs, but also more daring avenues, such as moving on to graphene, at least for some high-end semiconductor needs, it is increasingly likely that a breakthrough will occur. Knowing how fast China tends to move, it may happen sooner than expected, going from the lab concept to mass production at a blinding pace. If this occurs, and we might see signs of it happening already this year, then ASML’s future outlook beyond this year and next needs to be re-evaluated.

If the Chinese initiatives to break the tech squeeze will succeed, it will make it more likely that something that others warned about for a few years now might happen, namely a global tech split between China & the US. For ASML, this would mean that even as it might retain a monopoly over the chip production processes in North America, the EU, Japan, Taiwan, & South Korea, it will find itself largely shut out of the rest of the World, where Chinese chip production technology will be likely to become dominant, even if not monopolistic to the same degree as ASML will be in the core area of the Western alliance. With reduced global demand for semiconductors produced within the Western alliance, inevitably ASML’s machines will suffer significant demand erosion, therefore its long-term outlook should factor in significant long-term risk, which only now we are starting to become somewhat aware of.

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