ASML Holding (ASML -0.20%) has an incredibly unique position in the semiconductor industry. It holds a monopoly on extreme ultraviolet lithography (EUV) equipment, the technology used to "print" the most intricate electrical circuits within the most advanced chips.
And yet ASML has had some difficulty in fully realizing its potential in EUV -- or at least its immediate-term potential. The Dutch government has not granted an export license to ASML for EUV equipment sales to China. The U.S. is reportedly trying to further limit ASML's sales to China, even though ASML is a Dutch company.
What do such actions mean for ASML stock? Is it a buy anyways?
A headwind that won't subside anytime soon
ASML's crown jewel is its EUV systems. The result of nearly two decades of research, the company won't see any serious competition on this front for many years (if ever). Deep ultraviolet lithography (DUL), which prints most of the other layers in an advanced compute or memory chip (used in things like cloud computing and AI), has some competition from Japanese conglomerates Canon (CAJ -0.69%) and Nikon (NINOY -2.80%), but ASML nevertheless is a leader in all things ultraviolet lithography.
Sales of these advanced and expensive pieces of manufacturing equipment can be quite lumpy from quarter to quarter. For example, in Q2 2022, EUV technology accounted for 48% of system sales, while DUL made up much of the balance. In Q1, though, EUV was only 26% of total China revenue. China can't obtain ASML's EUV equipment, but it can buy DUL. Thus, in quarters like Q1 2022 where DUL is a larger slice of the pie, sales to China can be significant. ASML said 34% of revenue came from China in Q1 due to DUL orders, while the percentage fell to 10% in Q2 when EUV sales were higher.
But here's the rub: The U.S. is trying to widen the limits on the advanced chips and chip fab equipment China can buy. Reports suggest the U.S. wants to put restrictions on the DUL equipment China can buy from ASML too. ASML is a Dutch business, but it has acquired several U.S. companies over the years to accelerate its development of DUL and EUV equipment, so lawmakers in Washington, D.C., could have a little leverage here. It is worth noting, though, that ASML says these discussions are not new, and no decision to widen a sales ban has been made yet.
Nevertheless, a limit on DUL equipment similar to the restriction on the more advanced EUV technology would be significant. About 16% of ASML's total revenue came from China in 2021.
Relief from the U.S. Chips Act?
ASML and its peers in the chip industry got beaten up in the last year, and not just because of geopolitics between Washington and Beijing. After a chip shortage-induced boom during the height of the pandemic, the chip industry at large is showing signs of slowing down to more sustainable long-term growth rates. As a result, ASML's stock price is down 44% from all-time highs -- although the stock has still more than doubled over the last three-year stretch.
But a potential elimination of sales to China would be a further headwind. Could something fill the void? Enter the U.S. Chips Act, which was passed in July 2022. This legislation aims to rekindle semiconductor manufacturing in the U.S. According to the Semiconductor Industry Association, U.S. chip manufacturing capacity has fallen from 37% of the global total in 1990 to just 12% today. The Chips Act aims to dole out $52 billion in funding and provide a 25% tax credit to companies investing in U.S. semiconductor fab operations.
This could be a boon for chip giants like Intel (NASDAQ: INTC), which is largely hanging its hat on its chipmaking capabilities. Intel is an ASML customer, placing a big order with ASML worth hundreds of millions of dollars early in 2022. Deals like this could ramp up in the years to come as other chipmakers lay down plans for big new facilities in the U.S. As for EUV in particular, various estimates point toward equipment sales rising north of 20% per year through the next few years.
In other words, advanced chip manufacturing outside of China should rise to fill any void left by restrictions put on ASML.
It's going to be a bumpy ride, though, especially considering ASML stock trades for 32 times trailing 12-month earnings. The valuation looks far more reasonable at 19 times enterprise value to free cash flow. But suffice to say there's a premium on ASML stock, as investors expect the company to outpace its peers like Applied Materials (AMAT -2.62%), Lam Research (NASDAQ: LRCX), Canon, and Nikon in the chip fab equipment space.
But is the stock a buy? After getting a beat down by the bear market of 2022, ASML stock trades for a far more reasonable valuation than it did last year. Chip equipment can be a volatile space, so a lower valuation makes sense, even for a high-potential company like ASML. But at this juncture, I'm ready to dive in. If you decide to buy too, I'd advocate prudence and suggest you acquire shares in batches, perhaps buying monthly or quarterly until you reach the desired position size in this chip industry leader.