The Business Of

Semiconductors | ASML | What Are Their Margins?

Morning All!

So, yesterday we dug into how ASML makes money. And we saw that in 2022, the company only sold 345 products (lithography machines). We saw that the average price of these machines was ridiculously high at ~€45 million! And we saw that TSMC was their largest customer, making up ~40% of ASML’s revenues.

I also tried using ChatGPT to test my hypothesis! That no company makes more revenue than ASML with fewer customers…

Unfortunately, ChatGPT wasn’t too helpful though…!

I tried aha! But anyway, enough with revenues. Today, we’re going to switch gears and look at what costs are required for ASML to run their operations. The chart below shows us that the huge majority of expenses are to do with cost of revenues and R&D.

As we’ll see further in this newsletter. The margin structure for ASML is actually quite different to what we saw with Nvidia and TSMC. But before we get there, let’s dive into cost of revenues. And see what this cost line is actually made up of!

100,000 Parts, 5,000 Suppliers, 1 Machine

Okay, so like we did with TSMC. To really understand the cost of revenues, let’s remind ourselves of the value chain with the same example we used last week. Let’s look at a PC gamer buying a Gigabyte graphics card, powered by a Nvidia Geoforce RTX GPU chip.

• So, for the PC gamer, their cost is the graphics card. And they pay Gigabyte, the graphics card manufacturer.

• For Gigabyte, their main cost is the GPU chip in the card. And they pay Nvidia, the GPU chip designer.

• For Nvidia, their cost is the cost to manufacture the chip. And they pay TSMC, the chip manufacturer.

• For TSMC, their main cost is the lithography machine used to draw the patterns on the chips. And they pay ASML, the machine provider.

• Now, for ASML, what’s their cost? And who do they pay?

Well, for ASML, their costs are the costs to produce their lithography machines! Now, when I say ‘produce’, what I really mean is ‘assemble’. Because ASML’s EUV lithography machines require an extraordinary 100,000 separate components! And as you can probably guess, ASML don’t produce all 100,000 parts. In fact, ASML only actually produce ~15% of these parts. With the other 85% of parts produced by external companies that ASML use as suppliers. ASML’s annual report says the company worked with ~5,000 suppliers in 2022!

Now, as you can imagine, sourcing all these parts costs quite a bit of money. Last year, the cost of revenue from machine sales - which is mainly parts - totalled €7.6 billion. And the chart below shows us that these costs have increased from just €1bn in 2003. Which translates into a healthy 11% increase per year. However, what’s important to look at here is how ASML has managed their payments to suppliers.

And to do that, we need to compare this 11% increase in costs with ASML’s revenue growth! Well, as we saw yesterday, ASML’s revenues have increased by a CAGR of 15% since 2003. From €1.3bn to €15.4bn in 2022. And so, what this means is that, whilst ASML’s revenues have grown by ~12x over the last 20 years. The costs they’re paying suppliers has only increased 7x! This means ASML have done a pretty great job at negotiating prices with their suppliers.

And what happens when costs grow slower than revenues? That’s right… margin expansion! And the chart below shows us that ASML’s gross margin has increased handsomely from ~24% in 2003 to ~51% in 2022. It’s more than doubled!

A final word on cost of revenues. Because, what does this 51% gross margin really tell us? Well, remember we calculated yesterday that the average price of a machine ASML sells is ~€45 million. If the gross margin on that is 51%. It means it costs ASML ~€23 million to make and sell that machine. €23m million!

Now, not all of that €23 million is ASML paying suppliers for parts. That also includes the cost of engineers and other costs. But what it does tell us, is that ASML absolutely have to charge millions for their machines. If ASML sold their machines for less than €23 million on average, the company would actually be losing money!

I Can’t Play Golf Like Tiger, No-One Can Do EUV Lithography Like ASML…

So, as we’ve seen, ASML are great assemblers of this incredibly important machine. But if they just find suppliers to create their machine. Are they really that impressive? I mean, they’re not actually producing much of the machines themselves are they? Couldn’t TSMC just contact all of ASML’s suppliers and get them to make the same machine for them? And so completely sidestep ASML?

Well, no, not quite! Because yes, whilst ASML outsource a lot of the production of the lithography machines. Their secret sauce is their technology. It’s the actual process of EUV lithography that makes ASML such a special company. And it’s not something that can be replicated easily!

I’m going to use an outlandish analogy here. But if TSMC (or any other company) assembled all the 100,000 components required for the lithography machine. And tried to replicate ASML’s EUV lithography process. It would be like me buying all of Tiger Woods’ golf clubs. And thinking I could play golf like Tiger. It’s just not going to happen!

Why? Well, it took years of practice and trial and error for Tiger Woods to become Tiger Woods. And it took years - 20 years in fact - of R&D and trial and error for ASML to create EUV lithography. The technology is so complex and precise that if you shone the laser used in ASML’s machines from space. You could accurately aim for and hit a coin on Earth! That is how unbelievably advanced this technology is. So, like how I can’t play golf like Tiger. No one can use EUV light in lithography like ASML can! They haven’t spent the time or money to try and figure out the technology.

What this means is that ASML has a monopoly in the EUV lithography machine market! And the crucial cost line for this technological superiority is R&D. The chart below shows how ASML have invested heavily in this area over the last 20 years. With R&D growing from just €287m to €3.3bn during this time period. At a growth rate of 14% CAGR.

Interestingly, Intel during the 1990s were thinking of investing in R&D for EUV technology. But they were convinced that there was so little chance that it could work. They they decided not to pursue it. And even ASML’s competitors in the less advanced DUV space, Canon and Nikon. Haven’t bothered trying to explore EUV technology because of how complex it is!

Putting It All Together

Okay, so we’ve gone through ASML’s cost of revenues. And the R&D expenses too. And I’m hoping that I’ve helped you understand how challenging this EUV technology is to develop!

Now, to wrap up, let’s see how profitable ASML really is. And the chart below gives us the answer. After a shaky period in the 2000s, ASML’s margins grew to a much more stable level in 2010. And since then, margins have grown nicely as ASML have leveraged supplier relationships and controlled R&D expenditure. Last year, ASML had a strong EBIT margin of 31%. Slightly down from their all-time record of 36% in 2021. But still mighty strong!

Now, if we looked at this in isolation, we’d say great. Any company with a margin over 30% is really, really impressive. It was only a few weeks ago that we were super excited by Ninety One’s EBIT margin of 32%. So, why am I not so excited by ASML’s margin? Well, because this analysis of ASML isn’t in isolation. It’s a part of our series, The Business Of Semiconductors.

And some of you may be wondering, like I was - okay, ASML’s EBIT margin is good at 31%. But why is it so much lower than TSMC’s (50%) or Nvidia’s (37%)? Especially as ASML is a monopoly in its industry unlike the other two! And if you are thinking that - great! Because it’s a super interesting question. And one that will help our overall understanding of the semiconductor industry. But it’s a question that we’ll explore on Friday… because this newsletter will get too long otherwise!

17th May 2023

Nigel Jacob CFA