ASML And The Obvious - Weak Trends And A Bid For Cymer

By Stephen D. Simpson, CFA | October 17, 2012 AAA

In contrast to Applied Materials (Nasdaq:AMAT), which has repeatedly made moves and comments that have left investors scratching their heads, ASML (Nasdaq:ASML) continues to operate and report along highly predictable lines. Although there's evidence that industry conditions are even weaker than previously supposed, ASML didn't really surprise with its third quarter earnings, nor its announcement that it's acquiring Cymer (Nasdaq:CYMI). What is frustratingly less obvious, is what constitutes a fair price to pay for ASML today.

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Tough Third Quarter Results
As reports from Applied Materials, Lam Research (Nasdaq:LRCX) and Intel (Nasdaq:INTC) would all back up, conditions for semiconductors and semiconductor equipment are pretty lousy. Even still, ASML basically stayed on track for the third quarter, though management took down expectations for the fourth quarter. Revenue fell 16% from last year's third quarter and ticked up very slightly from the second quarter. New system sales fell about 25% from last year, while total system sales fell almost 30% from last year and 10% from the second quarter. ASPs looked alright, however, and the company's stronger than expected service revenue helped the top line performance.

Profitability was a mixed bag - not bad relative to expectations (and not bad relative to other capex players), but not strong in objective terms. Gross margin held steady on a sequential basis (and increased a point from last year), due in part to that service revenue. Operating income fell 22% from last year and 4% from the prior quarter, though.

SEE: Understanding The Income Statement

Still No Good News in Chip-Land
Investors have been waiting all year for good news in the semiconductor sector, but it has been in vain as even quality companies like Linear Technology (Nasdaq:LLTC) and Broadcom (Nasdaq:BRCM) are struggling to make headway.

The worse news for ASML is the ongoing weakness in PCs. Tablets and smartphones continue to predate on low-end PCs, hurting DRAM and flash demand and, by extension, new equipment demand from the memory chip makers. Orders fell a worse-than-expected 12% in the third quarter, and fourth quarter orders seem to be tracking down by double-digits as well. With that backdrop, ASML management lowered guidance for the fourth quarter and seems hesitant to call a big turn in 2013.

Finally, a Deal For Cymer
That ASML is buying Cymer is about as surprising as Friday following Thursday; if there's a surprise, maybe it's in why they didn't do the deal sooner. In any case, ASML is offering $20 in cash and about 1.15 shares of ASML for each CYMI share - a deal that valued Cymer at $80 at the time of the announcement.

This isn't a cheap deal, with ASML paying a 65% premium and close to four times fiscal 2012 estimated sales. Nevertheless, this deal ought to be accretive down the line for ASML.

SEE: Analyzing An Acquisition Announcement

Extreme ultraviolet (EUV) is driving this deal. ASML has made the development of EUV tools mission-critical, creating an investment partnership with major customers Intel, Samsung, and Taiwan Semi (NYSE:TSM) to accelerate R&D development. Thus far, the stability of Cymer's light sources has been a gating issue for EUV tool productivity and ASML clearly needed to get this issue ironed out to keep its development schedule on track. By bringing Cymer in-house, ASML should be able to better control the pace of R&D, not to mention perhaps reaping some margin benefits down the line.

I will be curious to see whether there are any antitrust issues with this deal. Cymer does sell to ASML competitors Canon (NYSE:CAJ) and Nikon (OTC:NINOY) and though it sounds like the DUV division (the one that sells to Canon/Nikon) will operate independently, how happy will they be about this? On the flip side, will regulators in Europe or the U.S. concern themselves much with protecting Japanese equipment companies?

The Bottom Line
Valuation on ASML shares is tricky. If the company is at/near trough earnings, then the valuation is consistent with past troughs. On the other hand, ASML has been a market-beater at a time when most other equipment companies have lagged the market significantly.

The biggest question is what EUV products mean for the next peak cycle. I believe that ASML can get to over 8 billion euros in revenue and close to 2 billion euros in free cash flow in 2016, but what then? In my free cash flow model, every 1% of estimated growth between years six and 10 (2017 and 2022) means about $1 per share in fair value. Just 1% growth works out to a fair value of $42 and an overvalued stock today, while today's market price imputes about 8% growth.

That seems like a lot of expected growth, so I'm tempted to avoid ASML shares for now. I really like this company, but even aggressive growth estimates don't seem to leave a lot on the table at today's prices.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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