The Economics of Stock Analysis: ASML, high-tech but highly cyclical

In our series ‘The Economics of Stock Analysis’ Dutch ASM Lithography (ASLM). It’s a good example that even industry leaders very high-tech, knowledge intensive sectors cannot escape some unfortunate economic realities.  

Here’s a funny snippet of news. Company post a profit warning (actually, to be more precise, a revenue warning), but its stock rises nevertheless. Quite a bit, as it happens, 16% for the week.

Little things like that make me curious, can economics shed light on this intriguing situation?

The stock in question is ASM Litography, the leading supplier of machines that make it possible to etch the tiny lines on wafers of silicon which are then baked into microchips.

  • These machines are very expensive and they require an enormous amount of research and development.
  • So costs are largely fixed, and markets must be large, these companies compete in worldwide markets
  • Because of these technical complexities, there are only a few competitors (mainly Nikon and Cannon in Japan)
  • Consequently, entry barriers are very high, knowledge is for a significant part tacit and proprietary, the result of long-term learning-by-doing

If we pause here, one would expect this to be a terrific business, with high margins, and a super expensive stock multiple to reflect such a near unassailable position. However, ASML trades at a rather modest  (trailing) multiple of 11 (forward multiple actually worse, 13, reflecting it’s worsening outlook).

So this can’t be the whole story. Far from it, as this industry is as cyclical as steel. We’re missing something, which can only be the markets they sell in:

  • They are delivered to industrial clients, those that fabricate chips (which, in turn, sell their output to device makers, putting these chips in all sorts of things like pc’s, ipods, etc.)
  • Producing chips involves such a large amount of fixed cost that (variable) labour cost hardly matters (so it’s not even necessary to migrate to cheap labour countries)
  • When a largely fixed cost business meets with variations in demand, prices absorb the difference, as it is a prime concern of producers to operate plants at as close to full capacity as possible (to recoup those fixed cost)
  • So, in a downturn, chip prices (apart from those that have specialist functions) will go down a lot. Cutting output is hardly an option as most costs are fixed and have already been incurred
  • Producers cannot really respond by cutting supply, so they cut on investment instead, which hurts ASML’s business. Producers can pretty easily keep their existing Litography machines humming a little longer.

We’ve arrived at the conclusion that ASLM’s business is highly cyclical. The cyclicality of large parts of the chip markets (like flash memory and RAM modules) reverberates upwards in the supply chain. How unfortunate.

So, although ASML is a world leader in a terribly complex and knowledge intensive industry, it goes through the same cycles as, say, steel or agricultural products, and one can argue that despite that seemingly unassailable position, it should not really be priced a whole lot differently.

What about that 16% rise for the week (which was two weeks ago, and it has since risen some more)? Well, it turned out that it was rising on Intel figures, which turns out to be a major client of ASML.

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