Growth Stocks: ASML & Qualcomm

Investment thesis

Taking advantage of the battery of business data and the current macroeconomic context, we will explore in our next analysis the situation and growth prospects of ASML Holding N.V. (ASML.NL), which has managed its key risks effectively, demonstrating ASML's superior leadership and positioning in the semiconductor market. And secondly, to Qualcomm Incorporated (QCOM.US), which has benefited from the China reopening effect and why 2023 could be a good year for the firm.

Although basic ASML deserves a higher rating, from a risk/reward profile perspective, it might not be the winner in this case. However, ASML operates a monopoly, being far ahead of its competitors, which justifies an almost logical choice. Similarly, QCOM has great potential to improve the market's outlook and its historically low valuation levels.

ASML-QCOM relationship

ASML does not compete head-to-head with QCOM; both companies are part of the semiconductor supply chain. However, ASML is at the top of the supply chain, it ended up a near monopoly on its extreme ultraviolet EUV systems (EUV systems are used to print the most complex layers of a chip, while the rest of the layers are printed with various DUV systems). ASML's customers are Taiwan Semiconductor (TSM), Samsung Electronics and Intel Corporation (INTC.US), and advanced EUV proportional machines costing $200 million each.

In contrast, QCOM, a manufacturer that has no factories (engages in design and sale), does not transact with ASML but relies on ASML customers to manufacture its chips. Despite the fact that both companies are located at opposite ends of the supply chain, examining their perspectives provides insight into the direction of the industry.

In the image below we can get an idea of the complete ecosystem of the semiconductor market and the location in it of ASML and QCOM.

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Strong Demand for ASML Despite Recession

Much of the semiconductor industry is struggling with high inventories and weaker demand, which has led to a slowdown in demand for memory and next-generation hardware. This has a bigger impact on ASML competitors such as Applied Materials (AMAT.US) and Lam Research (LRCX.US).

Order intake for ASML reached €6.3 billion in the last quarter. While this is lower than the extreme booking levels seen in the previous two quarters, orders in the latest quarter remained strong and in line with recent trends. More than half are concerned about EUV systems, reflecting the expectation of potential demand from major chipmakers for high-end end products.

As orders again exceeded system sales by a wide margin, the order book expanded to more than €40,400 million. This level equates to more than 2.5 times system sales in 2022, significantly higher than in previous periods with favorable market conditions. As such, ASML can be optimistic and confident in sales growth this year and projects an increase of over 25%.

25% growth in 2023? But how?

In 2023, ASML projects a revenue increase of at least 25%, driven by €3.1bn ($3.4bn) "quick sends" through 2023, which have yet to be recognized. More specifically, these "quick shipments" are used to expedite the installation of your EUV systems; ASML delays recognition of your rates and avoids multiple factory inspections during a short shipment. During the chip shortages of 2020 and 2021, that practice became widespread, though it's less prevalent now as the semiconductor market slows.

Finally, management believes that similar amounts will be produced in 2024. In addition to the €3.1bn, management expects non-EUV revenue to grow by around 30%, while EUV revenue will be the key driver of growth it will push the top line by about 40%. According to ASML, "fast shipping" worth €3.1bn ($3.4bn) through 2023 will increase revenue by at least 25% in 2023.

However, based on ASML submissions, the EUV adoption rate continues to increase. Notably, ASML shipped 26, 31, 42, and 54 EUV tools from 2019 to 2022, respectively. The company remains on track to deliver at least 60 EUV instruments by 2023. Assuming estimates for 2023, ASML can achieve a remarkable 4-year CAGR of 23.3%, which strongly supports its growth prospects.

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In addition, the company expects underlying demand trends to remain favourable. In response to the economic conditions that are currently softening demand for chips, ASML forecasts that the chipmaking industry will cut production in the first half of 2023, after which the recovery should pick up in the second. TSMC's $32-$36 billion CapEx plan in 2023 compared to $36.3 billion in 2022 means ASML can still expect strong sales growth this year. TSMC's shipment growth for advanced 3 nanometer (nm) chips and large ASML backlog could contribute to growth. In addition, 2nm chip development at TSMC is on track, which could also support strong demand for ASML tools.

Source: YCharts

High Numerical Aperture (NA) Lithography Equipment Expected Soon

ASML could soon launch its new EUV lithography model. The new model will improve processing speed (performance) and pattern accuracy by about 20% over the current model, according to ASML. It is likely to be used to produce 2nm generation chips which may start around 2025.

ASML has a commanding position in the leading-edge photolithography market and a commanding position at the trailing edge. The technology roadmap shows continued demand for its machines which should fuel ASP growth and, in turn, gross margin expansion. The company's foundry customers such as TSMC and Samsung are investing aggressively in 3nm and 2nm technology and may require more EUV lithography equipment from ASML, which no one else provides. In addition, sales of higher gross margin deep ultraviolet (DUV) tools could remain robust due to growing demand for electric vehicle power semiconductors.

When first introduced, EUV lithography machines processed between 1,000 and 1,500 plates a day, but can now process around 3,000. Performance may be further improved as customers gain experience in photoprotection and advances in mask technology. ASML is also doing R&D on its next generation model "NXE4000F", which has a numerical aperture (NA) of 0.33. The ASML lithography machine that is now available is equipped with 0.33 NA exposure optics, and work has been done for the past four or five years to develop the 0.55 NA exposure optics, which will be the machine replacement.

ASML effectively owns and trusts Zeiss SMT

ASML expects to gain significantly from the sale of its EUV lithography tools for Intel's "Intel 4" and 3nm process nodes used by its foundry customers. However, the number of lithography systems that ASML can produce may be limited by the fact that one of the company's main suppliers, Carl Zeiss SMT GmbH, (SMT) is the exclusive source of ASML for lenses, mirrors, illuminators , manifolds and other essential optical elements. As a result, ASML's revenue and orders would suffer if SMT is unable to maintain and increase production levels.

In the latest 2022 Annual Report, ASML management noted:

"If Carl Zeiss SMT GmbH terminates its supply relationship with us or if Carl Zeiss SMT GmbH is unable to maintain production of optical products for an extended period, we will no longer be able to conduct our business."

There have been strong ties between ASML and Zeiss for some three decades. In 2016, the company made a strategic move and bought a 24.9% minority stake in Carl Zeiss SMT Holding GmbH & Co. K.G., which owns 100% of SMT shares to ensure the development of EUV imaging technology. and improve your offers. As a result, in fiscal year 2021/2022, ASML's total purchases from SMT and its subsidiaries increased by 27% in 2021 and 30% in 2022, reaching €2.7 billion and representing about 31% of total revenue from the Zeiss Group of 8.8 euros. and ≈100% of SMT revenue in 2022.

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The SMT segment led overall Zeiss group revenue for 2021-2022, increasing more than 19% year-on-year, or roughly double that of the next fastest growing segment. In light of the fact that Zeiss group orders have grown by 40% in 2021/22 and that 31% of the group's total revenue comes from the SMT segment, we can assume that ASML orders will continue to grow in high double digits. for the foreseeable future, all else being equal.

Also, overall ASML exposure to SMT grew in 2022; for example, SMT order advances were €982.8 million and €1.100 million in 2021 and 2022, respectively, while loans receivable nearly tripled to €364.4 million. For context, ASML's net exposure of €2,078 million in 2022 represents around 29% of the consolidated capital of the Zeiss group, which is a considerable amount, and around 90%-95% of the capital of SMT, assuming a capital proportional based on sales contribution. (31% x €7,170 million). ASML can theoretically control SMT, as it generates nearly all of SMT's revenue, making the ASML-Zeiss relationship virtually difficult to end.

ASML Annual Report 2022

QCOM Market Stabilization and China Growth

On the other hand, Qualcomm's (QCOM.US) positive outlook is largely based on its leadership in 5G technology, and the recent deal with Apple Inc. (AAPL) further validates its technological superiority. Therefore, it is reasonable to expect significant profits for Qualcomm's QCT division through the sale of 5G modems and RF front-end components to mobile device manufacturers and strong momentum in non-mobile markets. As a result, QCT's fiscal 2022 revenue saw a 39% increase compared to the prior year, driven by higher sales prices, a shift toward more high-end 5G products, and increased shipments of integrated circuits. for mobile devices and higher revenue from IoT (Internet of Things).

However, in the near term, Qualcomm is likely to face challenges such as high inventory levels and weak demand for mobile phones and IoT in the first half of the year, compounding typical seasonal challenges in the second and third quarters. However, Qualcomm could offset these challenges to some degree through new product launches, recent gains in market share, and a disciplined approach to operating expenses until the second half of the year, when the recovery is expected to begin due to seasonal factors and replenishment of depleted stocks. inventory.

Headwinds for the smartphone supply chain have been more pronounced than the decline in industry direct sales, which has also been called into question. The double-digit decline in full-year 2022 smartphone sales was not expected at the start of the year. As a result, manufacturers overstocked their inventory out of concern that they would be able to acquire supplies should demand improve beyond expectations. This excess inventory compounded challenges at the end of the year, as suppliers and manufacturers had to deal with large amounts of backlogged inventory, despite a slight improvement in actual sales throughout the year.

source: statista.com

Looking ahead to 2023, there are several reasons to be optimistic about QCOM's prospects.

First, the smartphone market is expected to stabilize after an 11% drop in 2022, and a recovery is expected in the China market due to the easing of COVID-related restrictions. Second, they will exceed the digestion of maximum inventories in the fourth quarter of 2022. Finally, there is the possibility of inventory replenishment in 2023, led by a return to normal seasonal growth trends. These three drivers are likely to improve investor confidence in Qualcomm (QCOM.US) stock and bring attention back to content-growth driven outperformance in the underlying markets.

The stabilization of the smartphone market is the first step towards the recovery of the supply chain of smartphone components, logical. The reopening of China is expected to lead to a return to normal seasonal sales trends. This should translate into a return to sequential growth in the second half of 2023 and restocking ahead of that growth. While there may be some uncertainty around inventory levels returning to previous levels, component companies are expected to benefit more and position themselves for growth, given expected restocking.

Market stabilization should refocus growth drivers on content growth and reassure investors on the limited downside of consensus estimates. While component inventory replenishment in the channel is likely to be a driver of volumes relative to a flat smartphone market, the main driver of sentiment on Qualcomm shares should be market stabilization. This should allow for a return in Handset revenue growth due to content growth opportunities, as evidenced by strong handset revenue growth in 2022 despite a declining market. Furthermore, this stabilization should also reassure investors about the limited downside of the consensus estimates.

Source: YCharts

Long-term trends remain positive

Investors are comparing the falling PC market and the smartphone market. The PC market peaked in 2011 and then declined between 2011 and 2019 before experiencing a rebound in 2020 and 2021 due to the pandemic. Despite the volatility in the PC market, it is expected to continue declining at a CAGR of -7% and moderate to a new level of 267 million units in 2023. This steady decline over a long period suggests that the cycles of replacement have not improved and are unlikely to change significantly from the long-term run rate of decline. By comparison, the smartphone market peaked in 2017 and declined in 2018 and 2019 due to long replacement cycles.

Source: canalys.com

The outlook for consumer spending in China in 2023 is more favorable than in 2022 despite some interruptions in November. During a meeting of the Communist Party of China on February 16, the government announced a new victory over COVID-19. The statement claims that China has effectively defeated the virus, providing medical care to 200 million people infected with COVID-19 since November 2022, including nearly 800,000 critically ill patients.

Chinese scientist George Gao has stated that the probability of new variants of COVID-19 emerging in China is low. This is supported by the China CDC's statement that its ongoing surveillance has not detected new strains of COVID-19 during the recent outbreak. Gao has assured the world that there is no need to worry about the emergence of new or unusual variants in China and that fears around this issue should be eased.

The glut of QCOM in the US could end soon

Qualcomm is likely to eventually remove the vestiges of its main US risk, legal risk, the FTC's failed antitrust challenge and its intellectual property licensing policies. Unfortunately, a consumer class action lawsuit that followed the FTC lawsuit partially survived dismissal in the first quarter, dragging out the remaining litigation. Still, the potency of that matter waned with an appeals court order revoking the class certification in the third quarter of 2021.

Qualcomm is likely to reject a consumer antitrust lawsuit over allegedly anticompetitive intellectual property licensing practices. However, the partial denial of your motion to dismiss on January 6 means the process will take longer than expected. Furthermore, given its strong position in the lawsuit, success in defeating the FTC lawsuit, and penchant for litigation, it is unlikely that Qualcomm will settle anytime soon. Even so, the judge's decision on January 6, which prolongs an already protracted case, brings the lawsuit closer to the possibility of an agreement just to put an end to the matter. This is especially true if the plaintiffs are again successful in obtaining class certification in the trial court.

Valuation review

Based on market consensus, QCOM's P/E multiple of around 12x is lower than the industry average and significantly below long-term multiples for more diversified semiconductor companies. As shown below, QCOM is trading substantially below its long-term average multiple, despite limited short-term earnings decline. By contrast, ASML is trading above its average 5-year P/E multiple of 40x, indicating its resilience and premium or excess valuation due to its near-monopolistic business.

Source: YCharts

Without a doubt, growth is the most important factor in a company's valuation, and considering the fact that both stocks share a similar 3-year CAGR of around 21%, well QCOM seems undervalued compared to ASML. Additionally, while ASML enjoys further growth in the long term, QCOM's headwinds could end in the second half of 2023 and return to double-digit growth in 2024.

Growth comparison. source: SeekingAlpha

Technical analysis

Both ASML and QCOM underperformed during 2022 with semiconductor supply issues playing an additional role in QCOM's declines of up to 40% by the end of 2022.

Source: xStation

It seems that the renewed bullish sentiment in 2023 allows these two companies analyzed to have a good stock market performance. Accompanied by the previously mentioned macro and business context, they could be the differentiating factor within the technology sector that many investors are trying to locate. While the European ASML tries to break the resistance above €640.00 per share, if the trend continues, the US QCOM's target would be at $140.00 per share. An increase of 7.8% and 13.5% respectively.

Last conclusions

With ASML's 90% market share in EUV and expected growth of 40% in this segment by 2023, the company is well positioned to protect its cash flows for the foreseeable future, justifying the valuation premium and making the company company to be recession resistant.

Although ASML shares are not particularly cheap, its monopoly and unique economic environment backed by patents, deep technology ties in the industry, reliance on other semiconductor companies, key chip manufacturing technology, and unrivaled pricing power justify more than its excess valuation. ASML is among the best semiconductor stocks for long-term investors to hold for the long haul.

Investors have been concerned about the potential downside of the estimates for a further reduction in consumer spending relative to the smartphone market. However, the stabilization in the smartphone market and the limited downside of Qualcomm's current consensus estimates offer an attractive point for the company.

Dario Garcia, EFA
XTB Spain