The Biden administration is expected to impose additional curbs on sales of semiconductor equipment and AI memory chips to China but these seem to stop short of the strictest measures (foreign direct product rule) that were previously being considered, which would have allowed the US to directly curb sales of foreign companies to China. The latest proposal is set to add a lesser number of Chinese companies to the trade restriction list than previously expected, with the notable omission of memory chipmaker ChangXin Memort Technologies, one of Huawei's key suppliers.
These measures have been subject to multiple rounds of deliberations between US & its allied countries (Japan & Netherlands) and domestic chip makers have also vehemently opposed tougher measures, citing significant harm to their future economic prospects. The markets had already started to price in the worst case scenario in our opinion, with multiple semiconductor equipment manufacturers being subjugated to a sharp downward re-rating in their valuation multiples which has had a significant bearing on their respective stock prices.
A combination of trade restrictions and elevated earnings expectations (and hence valuations) have driven underperformance in the broader semiconductor space and specifically for equipment manufacturers. A less than onerous set of trade policies and substantial pullback in absolute and relative multiples, provides attractive opportunities in ASML and KLAC
- ASML Holding NV - Netherlands based wafer fab equipment manufacturer which we see as an out and out monopoly play, especially when it comes to the most advanced chip making tools.
The company is the pioneer in the EUV lithography technology space, which is the most advanced chip making technology invented till date and is extensively used for manufacturing chips that are smaller than 7nm in size at a significant scale and the company has been barred from selling this equipment to China. The increasing digitization across multiple industries and the ongoing transition towards more complex chips on the back of the advent of AI & high performance computing is likely to translate into sustained growth in demand for EUV lithography machines.
ASML was particularly impacted by the chatter surrounding the imposition of the foreign direct product rule due to a significant chunk of its 2023 and 2024 revenue coming from China. However, we believe that this was an anomaly due to the supply constraint related order push outs seen in 2022 and early 2023 which bunched up a large number of orders from Chinese customers. We expect the share of revenue from China to pull back from the near 50% levels seen earlier this year to more normalized 20% levels, given that much of the China related order backlog has now been cleared.
The combination of market's concerns surrounding the company's China exposure subsiding; Management reaffirming its long term 2030 financial guidance and renewing spend on WFE by the largest chip fabrication companies sets up ASML for sustained earnings growth in the coming 3-5 years and we also see scope for its P/E ratio to be re-rated higher given that it currently trades well below its historic average and what we feel is justified for a high quality business that generates an ROIC of nearly 100%, while growing its earnings.
- KLA-Tencor Corp. - Leading company in the Semiconductor Process Control market, with a market share of 57%, which is four times its nearest competitor.
We see the semiconductor process control market as a growing market as more fabs are built out and the use of semiconductors in general continues to expand and the transition towards more complex chips also causes a need for more advanced process control equipment which is beneficial for KLAC as its decades long experience in the industry and ability to bring forward technological advancement before its competitors helps its take even more share of this growing market and at the same time charge top dollar for its products, which has a favorable impact on its margins, steadily improving from 25% to 40% over the past 10 years.
The business also has a stable and growing services segment, which contributes about a quarter of the company's topline. This is a high margin business, that is less exposed to the cyclicality of the semiconductor industry and one that we expect to continue to act as a growing annuity form of income, given the expanding installed base of the company's equipment which is in need of routine maintenance and servicing.
The company's track record of growing its topline (13.1% CAGR over the last 10 years) and earnings (19.1% CAGR over the last 5 years) at a robust pace provides comfort to us in terms of the company's ability to maneuver cyclical volatility and we expect the same to continue in the future as well, with current market expectations expecting the company to post earnings growth of 12.1% over the coming 5-years. This increase in earnings, coupled along with potential re-rating in its valuation multiple, which currently stands at 20.57 times 1-year fwd. earnings (down from 31 times, seen not so long ago in June 2024) can stand to deliver very attractive share price performance in the coming 3-5 years in our opinion.
We are also expecting an additional boost to EPS growth to come from the management's prudent capital allocation decisions especially on the buy back front, something the company tends to conduct on an opportunistic basis, as seen during the market correction in 2022, when they bought back shares worth nearly $5 billion, retiring about 7.3% of the shares outstanding.
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