4 Green Flags for ASML's Future

Last year, shares of the Dutch semiconductor equipment maker ASML Holding (ASML 0.55%) soared 63% as the global chip shortage highlighted the importance of its extreme ultraviolet (EUV) lithography systems.

These massive systems, which only ASML produces, cost about $150 million each and are used to etch circuit patterns onto silicon wafers. The world's top foundries -- including Taiwan Semiconductor Manufacturing (TSM -3.04%), Samsung, and Intel (INTC -1.17%) -- all use ASML's EUV systems to manufacture their smallest and densest chips.

ASML's monopolization of the EUV market, along with its dominance of the broader market for older lithography systems, made it a linchpin of the global semiconductor market and a top beneficiary of the global chip shortage. As a result, ASML's stock hit an all-time high of $895.93 a share last September -- which valued the company at 57 times forward earnings.

Image source: Getty Images.

Unfortunately, that high multiple also left ASML exposed to rising inflation, which reduces the value of its future cash flows and earnings. The threat of higher interest rates, which need to kick in to tame inflation, also caused investors to rotate toward more conservative investments. Those headwinds caused ASML's stock price to drop nearly 30% from its all-time high.

But after that steep pullback, ASML's stock looks like a compelling investment again. Let's examine five green flags that suggest the stock will stabilize and continue to rise over the next few years.

1. ASML has robust revenue growth

ASML's revenue rose 33% to 18.6 billion euros ($21 billion) in 2021. That marked its strongest growth in four years.

Source: ASML. YOY = Year over year.

The market's demand for lithography machines ebbs and flows, but ASML usually still grows through cyclical slowdowns.

For example, ASML's growth decelerated significantly in 2019 as the smartphone and memory chip markets stagnated. However, it offset that slowdown by selling lithography machines to other end markets.

ASML's business is cyclical, but its current growth cycle won't cool off until TSMC, Samsung, Intel, and other foundries install more of its systems to resolve the ongoing chip shortage. Last month, Intel's CEO Pat Gelsinger predicted the shortage would last until at least 2023. Therefore, analysts still expect ASML's revenue to rise 19% in 2022 and 12% in 2023.

2. ASML has constantly expanding margins

ASML has plenty of pricing power in the high-end lithography market because it doesn't face any meaningful competitors.

It's too expensive for new companies to enter the market, and it's too technically difficult for chipmakers to develop their own EUV systems, a process that ASML has perfected over the past three decades. As a result, ASML's gross margins have consistently expanded -- except for a brief contraction during the slowdown in 2019 -- over the past five years.

Source: ASML.

ASML's gross margins have also expanded with each new system launch. It already sells its EUV systems, which generated 34% of its sales in 2021, at higher margins than its older systems.

It will also sell its newer high-NA EUV systems, which will be used to manufacture the world's smallest 3nm and 2nm chips from 2022 to 2025, at even higher margins. That's why analysts expect ASML's earnings per share to grow 22% in 2022 and increase another 17% in 2023.

3. ASML is confident about long-term forecasts

Last September, ASML set new long-term growth targets during its investor day presentation. It expects to generate 24 billion to 30 billion euros ($33.9 billion) in revenue in 2025.

That represents a big jump from its previous investor day target in 2018, when it told investors that it would generate just 15 billion to 24 billion euros ($27.1 billion) in annual revenue in 2025. It actually hit that range four years ahead of schedule with its 18.6 billion euros in revenue in 2021.

ASML expects to hit the low end of its new guidance even if the chip shortage ends and cyclical demand for new chips cools off. It expects to hit the high end of its guidance -- which implies its revenue will grow at a compound annual growth rate (CAGR) of 12.7% from 2021 to 2025 -- if the secular growth of the 5G, cloud, data center, automotive, and Internet of Things (IoT) markets sparks a prolonged "super cycle" of chip upgrades.

ASML also expects its gross margin to expand to 54%-56% in 2025. That's also significantly higher than its previous gross margin guidance of 50%.

4. The stock looks reasonably valued again

ASML's stock, like many other tech stocks, got a bit overheated last year. But after its recent pullback, it now trades at 35 times forward earnings.

That price-to-earnings ratio might still seem high relative to those of other blue-chip tech stocks, but ASML is also expected to generate double-digit revenue and earnings growth for the foreseeable future.

Furthermore, ASML's control of a crucial semiconductor technology, its impenetrable moat, its unmatched pricing power, and crystal-clear plans for the future all justify that slight premium. That's why I believe investors should start accumulating shares of ASML today even as other tech stocks stumble.