Jamie Ross, Fund Manager of Henderson EuroTrust, provides a snapshot of the typical analysis undertaken on every company considered for the portfolio. In this case, he explains the rationale behind the inclusion of the Dutch technology company ASML.
When considering an investment for the Henderson EuroTrust portfolio, we tend not to focus on market noise or any technical factors; the main thing we are doing is trying to establish whether what we are looking at is a good company or not. This is a key part of the research process.
There tend to be many featres that most good companies have in common, but there are myriad characteristics and features to analyse that will be unique to each and every business. By undertaking detailed analysis of the 50 or 60 companies we have on our radar (a portfolio of ~40 positions and a watch list of 10-20 names) we try to ascertain whether a business is a good business and if so, whether now is the right time to be invested or not. In this article we will highlight aspects of our process using one of our portfolio companies, Dutch lithography tool manufacturer ASML.
What does the company do?
Based in Veldhoven, Netherlands, ASML is the global leader in the production, sale and aftermarket care of lithography tools. Lithography tools are used by semi-conductor manufacturers to etch 3D patterns onto silicon wafers; an essential part of the complex process of building up a transistor.
Over time, ASML has built up an extremely strong market position. Historically, it has had two competitors (Nikon and Canon), but the huge investment burden (capital intensity and research & development intensity) has taken its toll on its competitors, leaving ASML with a market share of roughly 85% (80% share in immersion technology ‘DUV’ and 100% market share in next-generation EUV technology). Without significant technological change, it is very difficult to see ASML’s market share being challenged in the medium term. Crucially, ASML’s strong market position has been partly created through the support (equity investments) of their main customers (Samsung, Intel and TSMC).
Does this company generate strong Return on Invested Capital (ROIC)?
The firm’s gross margins (total revenue minus cost of goods sold) are high at 47%; and are expected to climb to more than 50% by 2020. The high overall gross margin is driven by the company’s market position and ensuing pricing power.
Research and development (R&D) costs are relatively high at about €1.5bn per annum making up around 14% of sales - the equipment used in the lithography tool-making process can be the size of a bus and cost several hundred million Euros; so the R&D burden is a big barrier to entry. Other operating costs make up only a few percent of sales leaving an operating margin of around 28%. In terms of invested capital, most is tied up in working capital and in fixed assets used in the production process. Whichever way you cut the numbers, the above financial characteristics result in a business generating strong double digit ROIC, well above market/industry averages.
What are the risks to the business and to this ROIC profile?
ASML currently has a very strong market position with very few clear challenges. In the absence of significant technological change, ASML is likely to continue to generate a very strong ROIC. However, this is a field of complex technology. It is more difficult to have a strong insight into this industry than with other more straight-forward businesses, like a drinks company, for example. With complex technology, big changes can happen very quickly that you don’t see coming at all and new players can come in with a completely new technology or approach. So the risk with ASML is the unknown; that a competing technology could come in and challenge the business’ market position, achieving the same thing but in a different, better way.
Aside from the company’s ROIC profile, the other risk with ASML, as with any good company, is that the share price valuation is high. This is a relatively expensive stock with a 2019 price-to-earnings* (P/E) ratio of around 27x, which is high versus other companies in the market. The high valuation means any doubts from the market about the company’s ability to deliver on its targets could see the share price underperform. So, the valuation itself makes it risky.
Is there scope for growth?
To some extent, we have covered the ‘supply-side’ of the business above. As to the ‘demand-side’, a medium term outlook of sustained (but cyclical from quarter-to-quarter) demand growth looks likely. Microchips have gone from something we associated mainly with computers, to something that we now see in televisions, mobile phones, watches, heating systems, fire alarms and locks, to name but a few – microchips have become completely ubiquitous, so we know the demand side is very healthy. The demand for microchips is likely to grow very strongly over the next 5-10 years as the trend towards the ‘internet of things’ continues to drive adoption.
For us, ASML fits into a buy and hold strategy; we find the business very attractive on a long term basis and see a medium term outlook of high, sustainable ROIC together with plenty of means of capital deployment (an attractive and rare feature of a high return business). We might trim or add exposure around different events but principally we want to hold it for as long as possible.
Price-to-earnings (P/E) ratio: A popular ratio used to value a company’s shares. It is calculated by dividing the current share price by its earnings per share. In general, a high P/E ratio indicates that investors expect strong earnings growth in the future, although a (temporary) collapse in earnings can also lead to a high P/E ratio.