The Business Of
Semiconductors | ASML | Outlook
Morning All!
TGIF! Hopefully those who’ve finished exams can enjoy a nice, sunny weekend! But before we get there, we’ve got one final newsletter to round off The Business Of ASML and also The Business Of Semiconductors! Let’s have a quick recap of some of the fun, surprising things we’ve learnt about ASML this week…
How Do They Make Money - Netflix have 231 million customers. ASML have way less than 100.
What Are Their Margins - ASML’s EUV lithography machine has over 100,000 separate components!
What Do They Do With Their Profits - most of ASML’s cash over the last 2 decades has been spent on stock buybacks… which can be good and bad!
So, usually on Friday’s newsletters, I’d crack on with a little outlook on the company. However, because today is the last day on semiconductors. I actually want to do something different. But (hopefully!) better. I want to do a little recap of the last 3 weeks. Because there are so many great insights we realise when we analyse all 3 companies - Nvidia, TSMC, and ASML - together! But warning - there’s far fewer GIFs today. And more numbers and technical stuff!
From iPhones To AI…
Let’s start with semiconductor revenues. And the biggest driver of semiconductor demand during the 2000s and even up to the late-2010s, was mobile phones. Back in 2007, when Steven Jobs introduced the iPhone to the world, ~3.3 billion people globally had a mobile phone. Which was roughly ~50% of the world’s population. Now, that number has grown to ~7.3 billion. Which means that ~91% of the global population now have a mobile phone!
As phones have become smaller and needed to carry out more functions. The semiconductor chips used within these phones have also become more advanced. And this has fuelled growth for TSMC (who provide chips for the iPhone). And ASML (who provide equipment for TSMC). However, we saw that phones weren’t the end-market driving growth for Nvidia. It was gaming! Interestingly though, the chart below shows that from 2004-2013, the jump in revenues that all 3 of these companies experienced was fairly similar. With Nvidia and TSMC seeing revenues rise 2.3x over this period and ASML 2.1x.
Okay, so that was till 2013. But then from 2013-2022, we see a very different picture. The graph below shows us that from 2013-2022, TSMC and ASML again experience a similar jump in revenues to each other. Of 3.8x and 4.0x respectively. However, look at Nvidia’s revenue growth! Nvidia’s revenues grew from $4.3 billion in 2013 to $26.9 billion in 2022! A rise of 6.3x. So, what’s behind this?
Well, as the heading for this section tells us. Over the last few years, the main growth driver of the semiconductor industry hasn’t been mobile phones. It’s been all things AI. But you may be wondering, why does the end-market really change things? And it’s a really good question. Because it doesn’t change much for ASML - they still produce lithography equipment, whether it’s mobile phones or AI. And it doesn’t change too much for TSMC - because the most advanced chips (3nm/5nm) are used for both phones and AI.
But who it does change things for is Nvidia. Because now, they go from an end-market (gaming), where the end-user is an individual consumer. Who pays ~$1,000 for a graphics card. To an end-market (AI) where the end-user is a huge corporation. Who pays ~$100 million for the chips powering their supercomputers! And so, this change in customer profile. Is one of the main reasons why Nvidia’s revenue growth has far exceeded what we’ve seen at TSMC and ASML!
A Cyclical Industry… For Most Companies!
Okay, so we’ve seen that when it comes to revenues. Nvidia takes the crown. But let’s move onto margins. And think about a buzzword we commonly hear about the semiconductor industry. And that buzzword is cyclical. The semiconductor industry is notorious for being a very cyclical industry.
And if we look at the chart below. We can see that the EBIT margin for both Nvidia and AMSL fell during the Global Financial Crisis (GFC) downturn in 2008. As demand for phones/graphics cards/laptops, etc. suddenly came to a halt. The prices of these products came sharply down. And so companies like Nvidia had to mark down their GPUs. And ASML found less buyers for their expensive machinery! The weak macro environment right now has had a similar impact on Nvidia’s 2023 margin!
But, hold on. What about TSMC? Their revenue growth was negative (-11%) in 2009. So then, how come their margin stayed so flat during this period? And the reason for this is because of how TSMC’s costs are structured. Nvidia and ASML are somewhat blind to downturns due to their high fixed costs. Nvidia order chips from TSMC 6-12 months before they’re needed. And it takes ASML a similar amount of time to produce one of their lithography machines. And if the economy turns, both these companies are left with high costs, but weak demand for their products.
However, in the case of TSMC, they have more visibility and a lower fixed cost burden. And thus can adjust their costs much quicker. When the economy turns bad, TSMC can scale back the number of lithography machines they purchase. They can reduce their employee count. And reduce their raw material purchases. And so as we see from the earlier chart, TSMC’s margins are much more recession-proof!
Okay, one final thing on margin. And it’s a question we posed yesterday. But why are ASML’s margins (at 31%) much lower than TSMC’s (at 50%)? Especially given that ASML is a monopoly! And one of the main reasons is because of scale. ASML’s 2022 revenues (€21bn) were less than a third of TSMC’s ($74bn). And this huge scale gives TSMC a massive advantage. To make a like-for-like comparison. The chart below compares how ASML’s margin stacks up vs TSMC and Nvidia when TSMC and Nvidia had ~$20bn in revenues. So, a similar level to ASML.
And as we can see, the margin difference is reduced massively! When TSMC had a similar level of revenues as ASML, their EBIT margin was 35%. ASML’s in 2021 was actually higher at 36%. So, the mystery of why ASML’s margin is so much lower than TSMC’s despite their monopoly position is hopefully solved! However, if you want some further reading on why scale is so important for margins. Then this explainer on Investopedia should help!
A High EBIT Margin Is Great… But Cash Is King
Right, hopefully you’re coping with the lack of GIFs today! But there’s a couple more super interesting and important topics to cover. Which I think will help your understanding of semiconductors and businesses. For this whole series, we’ve talked about how impressive TSMC’s EBIT margin is. And how that level of profitability (~50%) is just incredible.
But then yesterday we saw that TSMC also spends so much more of their cash on capex than Nvidia or ASML. And some of you may be wondering - if TSMC have higher margins, but Nvidia and ASML need to spend less on capex. Maybe there’s a better way to compare the 3 companies? And guess what, there is. And it’s name is free cash flow (FCF). Let’s look at a definition of what free cash flow actually is…
I don’t want to get too technical. But the problem with just using EBIT is that EBIT misses out elements from the cash flow statement. Such as capex and working capital changes. And so if you had 2 companies with identical EBIT (e.g. $10 million). But one had no capex and one had $8m. The one with no capex has much more cash to give back to their shareholders. And this would be more valuable. But EBIT wouldn’t have told you that.
So, let’s look at free cash flow. And the below chart shows us how well our 3 companies convert their EBITDA to FCF. And we can see that Nvidia and ASML are near 100%. What does this mean? Well it means that pretty much all of the EBITDA that we see on the income statement is actually cash. That can be distributed to shareholders. Or used for M&A. Or reinvested back into the business. It’s FREE cash to be used. However, for TSMC, we see the ratio is much lower at 32%. This is because of the massive capex investments the company does with its building of fabs and buying of lithography machines!
Okay, so that’s how well the companies convert their EBITDA to FCF. So then, does it make sense to see how their margins compare in terms of FCF? Yes! And the chart below shows us that when we look at FCF margins, instead of EBIT margins. We see a very different picture between the 3 companies.
Nvidia and ASML have strong margin trends. Like we saw with their EBIT margins. But TSMC’s margin trend is so different than what we saw previously! Their FCF margin is less than half their EBIT margin! And in fact, we see a reversal from before. With ASML having the strongest FCF margin of the 3 companies.
What does this all mean? Does this mean TSMC really aren’t all that great? Well, no - it doesn’t mean that at all. TSMC are still great! This free cash flow section is here just to help you realise that when you’re comparing companies with different capex profiles. EBIT doesn’t tell you the full story. You need to look at free cash flow.
But surely it’s a worry that TSMC’s FCF margin is much lower than Nvidia’s and ASML’s? And so they aren’t as able to return cash to shareholders in the form of dividends or buybacks? And again, no, it’s not a worry! And why not? Well, it’s something we looked at when we covered Netflix. There are two types of shareholder return. Cash return - from dividends. Or stock appreciation - selling your shares at a higher price. And whilst TSMC are investing lots in capex, and reducing their potential for dividend payments. What’s the purpose of their capex? Growth! More fabs, means more capacity, means more revenues, means more profits, means higher stock price (hopefully), means higher stock appreciation for investors. Happy days!
You Have £100… Which One Should You Have Invested In, In 2003?
Okay, just to round up, let’s have a bit of fun. And look at what’s happened to the stock prices of each of our 3 semiconductor giants. And we’ll split things into two periods again - like we did with revenues. (i) 2003-2013 and (ii) 2013-2022.
The first chart below shows us that if you had invested $100 in each of these stocks in June 2003. Your ASML shares would have performed the best by 2013. With that $100 becoming $1,099. Maybe slightly surprising to see ASML outperform Nvidia and TSMC so much. Given the revenue growth between the 3 companies was very similar as we saw earlier today. And margin trends were also similar. Investor sentiment was clearly high for the Dutch giant though!
Now, if we re-base. And invest $100 in each of the 3 companies in June 2013. How much would that $100 be worth today? Well, the results are quite incredible. A $100 investment in Nvidia in June 2013 would be worth a staggering $9,206 now! But whilst the ASML return previously might have surprised us…
… the Nvidia outperformance makes slightly more sense. The company has grown quicker than ASML/TSMC. Due to the increased focus in the AI space. And the company’s margins have expanded the most. Increasing 3x from 12% in 2014 to 37% in 2022! It’s no wonder investors have jumped on the Nvidia stock!
So, let’s put it all together. And if we had a time machine, where should we have invested our $100? And the answer is clearly Nvidia. That $100 in June 2003 would now be worth $17,226! Not too shabby!
It is interesting to see how much worse TSMC’s stock has done vs the other two. Especially given I’ve been singing the praises of the TSMC business model for the last fortnight! But it shows how the stock market is driven by expectations. People know what to expect from TSMC and it may have been trading on a high multiple already. Whereas the jump in Nvidia and ASML’s stock prices were more to do with both companies outdoing investors’ expectations. And then seeing multiple expansion.
There’s a more detailed explanation. But maybe another day!
And That Is That For Semiconductors!
So that brings us to the end of The Business Of Semiconductors: Part 3. We hope you enjoyed understanding The Business Of ASML this week. To go back and read any of the previous newsletters from Monday-Thursday, you can find them here. You can also find newsletters for Tesco, Deliveroo, Man United, Ninety One, LVMH, Cineworld, Netflix, Disney, Nvidia and TSMC there too!
But it’s not quiteee the end because I’m going to resend the Career Talk I released on Monday. My chat with Katerina (Assistant Manager @ KPMG) really is a brilliant one for students to learn from. So that’ll be hitting your inbox shortly! Next week, we’ll be taking our scheduled week off! So you don’t get sick of us aha! And so we can build up our content and take a little time out.
But we’re back next, next Monday (29th May) with a brand new series: The Business Of Junk Food. And I’m super excited for this one. Because McDonald’s, Coca-Cola and PepsiCo - their business models aren’t all they seem! Plus, we should hopefully have some exciting careers talks + learning material to share again.
A lot to look forward to. Have a cracking day… and weekend! And best of luck with exams!
The Business Of Team