Sometimes investing in the companies that supply the tools necessary to make a product is a better bet than investing in the company making the product. For the chip world, ASML Holdings (ASML -1.00%) is the only (more on that in a bit) company that provides the machines necessary to make chips with the most transistors possible.
However, a recent patent application from Chinese tech giant Huawei threatens ASML's monopoly. Is this a potential sell signal? Or is ASML still an investible company? Let's find out.
Competition is coming, but it's far away
ASML's extreme ultraviolet (EUV) machines allow users to etch the world's smallest transistors on a chip. If you've heard of a 7nm (nanometer), 5nm, or 3nm chip, it was made using ASML's machines. ASML has very few customers, with only companies like Samsung, Taiwan Semiconductor, and Intel buying its products.
Image source: ASML
Huawei potentially entering the EUV game is a problem for ASML's technological monopoly. However, filing for a patent and producing EUV machines aren't the same. There is still plenty of time before Huawei's machines are up and running. Plus, given how exclusive this technology is, it's unlikely the Chinese government will let it be sold to foreign companies -- it wants foreign companies to buy from Chinese chipmakers. The real problem comes from Huawei being able to make these tiny chips, which might hurt ASML's customers if they have to compete with a Chinese product.
Still, it's a risk investors must understand, although the threat is still currently small. If ASML can maintain its superiority, its impressive financials will combine to make it an excellent investment.
ASML Holdings is in a robust financial position
EUV machines aren't cheap. One estimate pegs the cost of an EUV machine at around $150 million a piece, and they are about as large as a school bus. As a result, ASML's revenue can be quite chunky, because producing a handful of extra machines in a quarter could cause it to miss estimates. To understand how the business is doing, it's worth looking at a metric like net bookings (the amount from sales orders that have been accepted). In Q3, this rose to 8.9 billion euros, a new record.
ASML is also quite profitable, generating 1.7 billion euros in net income from 5.8 billion euros in sales -- a 28% margin.
Its fantastic margin profile allows ASML to generate impressive amounts of cash. Over the past 12 months, ASML had free cash flow of $9.6 billion, which allows it to repurchase its stock. At its investor relations day in November, ASML announced a new repurchase program to buy back 12 billion euros' worth of stock (about 5% of its market cap). The following chart shows the effect of these repurchases over the past five years.
ASML Shares Outstanding data by YCharts
This program isn't as aggressive as some companies', but it's better than nothing.
However, my biggest indicator of what makes ASML a buy is its free-cash-flow yield. Free-cash-flow yield is a metric that relates how much free cash flow a company generates in relation to its market cap, much like a dividend yield. With ASML yielding 4.4%, it's higher than a 10-year Treasury note. This is one indication that the stock is currently undervalued. With ASML near its decade-high free-cash-flow yield, I'd say now is a great time to take a position in ASML.
While Huawei may be getting closer, ASML has a massive head start. Moreover, with the stock at a reasonable valuation and with a record backlog of new business, buying ASML is a top way to invest in the chip space without the cyclicality of chipmakers.
