ASML (ASML 2.04%) is a linchpin of the semiconductor sector. The Dutch company is the world's largest manufacturer of lithography systems that are used to etch circuit patterns onto silicon wafers. It's also the only producer of high-end extreme ultraviolet systems (EUVs), which are required to manufacture the world's smallest and densest chips.
ASML's monopolization of this crucial technology makes it a reliable long-term investment in the semiconductor sector. It expects its revenue to have a compound annual growth rate of 10% to 14% from 2022 and 2030, and for its annual gross margin to expand from 50.5% in 2022 to anywhere from 56% to 60% in 2030.
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I own shares of ASML and remain bullish on its potential, but I also think it's important for investors to examine the bearish arguments and see if they meaningfully challenge the bullish thesis. Let's review three recent red flags for ASML -- and if they'll cast a shadow over the lithography leader's future.
1. Dutch export curbs on its equipment sales to China
In 2019, Dutch regulators barred ASML from exporting any EUV systems to China amid the escalating tech war between the U.S. and China. But that ban didn't prevent ASML from selling its lower-end deep ultraviolet (DUV) lithography systems, which produce older and larger chips, to Chinese chipmakers.
ASML still generated 14% of its sales from China in 2022, which makes it the company's third largest market after Taiwan (38%) and South Korea (29%). But Dutch regulators recently approved additional export curbs that would prohibit the company from selling some of its newer DUV systems to Chinese chipmakers without a government permit.
Those restrictions took effect on Sept. 1. ASML is allowed to fulfill its existing contracts with Chinese chipmakers through the end of the year, but it doesn't expect Dutch regulators to approve its exports of three newer DUV systems to China next year. Those export curbs will likely check the growth of its Chinese business in 2024.
2. China's alternatives to EUV systems
The chip sanctions against China also barred Chinese chipmakers from outsourcing the production of their high-end chips to the world's most advanced chip foundries -- TSMC (TSM 1.26%), Samsung, and Intel (INTC -9.20%) -- which use ASML's EUV systems to manufacture their smallest, densest, and most power-efficient chips.
In response, China accelerated its own development of advanced chips, which include 7-nanometer (nm) chips, 5nm chips, and even smaller nodes. Last year, China's largest contract chipmaker, SMIC, developed its own 7nm chip without using an EUV system. But it accomplished that by pushing older DUV systems to their limits (as TSMC also did before it switched to EUV systems), which resulted in a much less cost-efficient method of producing 7nm chips.
SMIC is now attempting to crack the 5nm barrier, which only TSMC and Samsung have done so far using ASML's EUV systems. Meanwhile, a team at Tsinghua University in Beijing believes it can use particle accelerators as a novel laser source to mass-produce smaller chips more cost-efficiently than DUV or EUV systems.
It could take a few years for those efforts to pay off, but they might eventually enable China to eliminate its dependence on ASML and other Western tech companies. If that happens, ASML's entire Chinese business could collapse, and its smaller competitors could also copy China's technology to develop competing chip manufacturing systems.
3. Canon's entry into the high-end market
One of those hungry competitors is Canon (CAJ 3.72%), the Japanese producer of cameras, lenses, optical equipment, medical equipment, and printers. It's also one of ASML's only remaining competitors in the DUV market.
Canon only holds a single-digit share of the lithography systems market, but it recently launched a new "nano-imprint" chip-manufacturing system called the FPA-1200NZ2C -- which the company claims can produce the equivalent of 5nm to 2nm chips. Unlike its lithography systems, which etch circuit patterns with lasers, the company says the new technology imprints the pattern like a stamp without any optical equipment.
Canon hasn't revealed the prices or sizes of these new systems, but they could potentially challenge ASML's EUV systems -- which cost about $200 million apiece and are as big as buses -- if they can produce top-tier chips at much lower prices.
Do these three red flags change my opinion about ASML?
These three issues could generate long-term headwinds for ASML. Its sales to China could dry up, Chinese chipmakers could find ways to produce high-end chips without ASML, and Canon might disrupt the EUV market with its nano-printing systems.
I won't sell my shares of ASML anytime soon, but I'm keeping a close eye on these recent developments. If the company fails to address these three threats in a timely manner, I'll reevaluate my bullish thesis -- which relies heavily on EUV systems remaining indispensable cogs in the semiconductor market for the foreseeable future.
