ASML (ASML 1.14%) is a linchpin of the global semiconductor market. The Dutch company is the world's largest manufacturer of lithography systems, which are used to etch circuit patterns onto silicon wafers. It's also the only supplier of high-end extreme ultraviolet (EUV) lithography systems, which are used to produce the world's smallest and densest chips.
The world's most advanced chip foundries -- Taiwan Semiconductor Manufacturing (TSM 2.71%), Intel (INTC 1.77%), and Samsung -- all rely on ASML's lithography systems. As a result, it generates stable revenue growth, its gross margins are expanding, and its stock still looks reasonably valued at 35 times forward earnings.
I believe ASML is still a solid long-term investment, but four red flags have also appeared since the beginning of the year. Let's discuss these challenges and how they could throttle ASML's near-term gains.
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1. The fire at its Berlin plant
On Jan. 3, a fire broke out at ASML's factory in Berlin. It says the production of its older deep ultraviolet (DUV) systems experienced "some disruption regarding components," but that it wouldn't affect the segment's output and revenue targets.
The fire also affected the wafer clamp, a module used to produce its EUV systems. During its fourth-quarter conference call later that month, CEO Peter Wennink said the company could manage that damage without suffering a "significant impact" to its EUV system output in 2022.
Those statements suggested the situation was under control, but the fire still rattled investors because a single DUV system costs $60 million and a single EUV system costs $150 million. Therefore, the delayed production of even a single system could drastically reduce ASML's revenue and cause it to miss analysts' expectations for 20% growth (to 22.3 billion euros, or $24.2 billion) in fiscal 2022.
2. Russia's invasion of Ukraine
The Russian-Ukrainian war, which started in late February, generates two significant headwinds for ASML.
First, the conflict is disrupting the global supply of neon gas, which ASML uses in small quantities for the gas-phase lasers in its DUV systems. Ukraine is the world's largest producer of neon gas, and ASML gets roughly a fifth of its supply from Ukraine and Russia. ASML has been seeking out alternative sources to maintain a stable supply of neon, but the soaring price of the gas could squeeze its gross margins until the conflict ends.
Second, ASML is one of the most valuable tech companies in Europe. Therefore, any escalation of tensions between Europe and Russia will likely drag down ASML along with the broader European indexes.
3. More headaches in China
ASML sells DUV systems in China, but the American and Dutch governments have repeatedly barred it from shipping its top-tier EUV systems to Chinese chipmakers -- which could enable them to catch up to TSMC, Samsung, and Intel in the "process race" to manufacture the world's most advanced chips. That ban represents a major flashpoint in the ongoing trade and tech wars between China and the United States.
In response, China has started to develop its own DUV and EUV systems -- and it might be copying some of ASML's designs. Just last month, ASML accused Dongfang Jingyuan Electron, a Chinese producer of software for chip manufacturing procedures, of stealing its intellectual property -- which suggests that some of its technologies have already been leaked to Chinese chipmakers.
ASML generated 16% of its system sales from mainland China in 2021, and that business could face unexpected challenges if state-backed Chinese companies suddenly roll out their own lithography systems.
4. TSMC's better-than-expected yield
TSMC is ASML's top customer and comprises most of its system sales to Taiwan, which accounted for 44% of its top line in 2021. TSMC's early adoption of ASML's pricey EUV systems gave it a major advantage against Samsung and Intel in the production of smaller chips.
ASML's current-generation (multi-patterning) EUV systems can be used to manufacture chips as small as 3nm. Its next-generation (high-NA) EUV systems, which are expected to be mass produced in 2025, can be used to produce 3nm chips and even smaller nodes. Therefore, ASML needs to sell a steady supply of current-gen EUV systems -- which generate much higher revenues than its DUV systems -- until those high-NA systems are launched.
However, a recent research report by Morgan Stanley declared that TSMC's initial 3nm production yields were "higher than expected," which suggests that it will actually require fewer EUV systems to hit its production targets. That's all speculation for now, but a reduction in EUV shipments to TSMC could significantly throttle ASML's growth.
Why I'm still bullish on ASML
I personally own shares of ASML, and I'm still bullish on its prospects because it's a crucial gatekeeper of the chipmaking market. That said, I believe these near-term headwinds will prevent ASML's stock from rallying anytime soon. So for now, investors should just sit tight, accumulate some more shares if the stock drops, and focus on its long-term growth.
