ASML: A Top AI Stock To Buy, Even At All-Time Highs (NASDAQ:ASML)

ASML Holdings’ (NASDAQ:ASML) shares reached new all-time highs this week as demand for AI infrastructure products is surging. Specifically, semiconductor firm Taiwan Semiconductor Manufacturing (TSM) on Wednesday reported strong preliminary revenue results for its second-quarter which helped drive new interest in ASML as well. According to this company’s revenue update, TSMC saw 40% year over year growth driven by strong demand for AI chips from hyperscalers. ASML, which has Taiwan Semiconductor Manufacturing as a customer, is therefore also set to report strong second-quarter results next week. Although shares of the semiconductor company just reached a new all-time high on strength in AI-related semiconductor demand, shares could be an attractive buy for investors ahead of ASML’s earnings report.

AI boom and ASML’s long term framework for growth

Chip stocks like Nvidia (NVDA) and AMD (AMD) are benefiting from the corporate sector’s soaring demand for graphics processing units which is part of a massive ramp in infrastructure spending. Corporations and tech companies are investing billions of dollars in Data Centers that run AI-customized chips in order to train and deploy large language systems. Nvidia has been at the forefront of the AI revolution through early investments in the H100 flagship AI GPU that companies that are flying off the shelves right now.

Another company that benefits from the AI gold-rush is ASML which provides lithography systems that are needed to produce microchips. These microchips can be found in consumer electronics products, like smart phones, computers, tablets, cars, industrial equipment and so on. By using extreme ultraviolet light systems, companies like ASML provide the equipment Taiwan Semiconductor Company needs in order to manufacture microchips at scale. TSMC, which dominates the foundry market with a share of more than 60%, manufactures AI chips on behalf of companies like Nvidia or AMD and, therefore, ASML and TSMC both sit at the very heart of the AI boom.

Because ASML’s lithography systems are a critical component in the manufacturing process for semiconductors, the company has seen a massive ramp in its revenues in the last year: since FY 2020, ASML’s revenues about doubled to €27.6B ($29.9B). Between FY 2020 and FY 2023, the company’s average annual top line rate calculated to 25% and its revenue growth accelerated in FY 2023 to 30%. In Q1’24, ASML generated €5.3B ($5.7B) in revenues and the outlook for ASML in terms of revenue, gross profits and free cash flow is favorable.

Because of strong demand for AI chips, ASML and TSMC are both benefiting greatly from accelerating demand for their chips and there are no signs that the AI-related revenue boom for critical companies in the semiconductor supply chain is coming to an end any time soon.

Given Taiwan Semiconductor Company’s preliminary results for Q2’24 on Wednesday, which showed 40% year over year top line growth (compared to an estimate of 36%), I believe ASML is in a great position to exceed its own guidance and beat market expectations for its EPS next week.

Analysts expect $3.98 per-share in adjusted earnings next week and analysts could revise their EPS estimate upwards, considering that TSMC is not seeing any slowdown in its business at all.

ASML guided for Q2’24 net revenues of €5.7-6.2 billion ($6.2-6.7B) and a gross margin of 50-51%. The gross profit trajectory is ASML’s greatest strength, in my opinion: ASML’s gross profits are surging on growing strength for EUV system sales and the company has begun shipping its newest lithography machine, the NXE:3800E system, to customers. This lithography system allows for higher-volume chip production and could, potentially, support ASML’s revenue growth acceleration going forward.

ASML’s longer term growth framework states that the company wants to achieve €44.0-60.0B ($47.7-65.0B) by FY 2030 in annual revenues and gross margins in the region of 54-56%. The outlook seems sensible and realistic given that ASML has seen a consistent increase in its revenues in the last three years, with an acceleration also taking place in FY 2023. As of the latest quarter, Q1’24, ASML generated a gross margin of 51% with expansion in gross margins coming mainly from higher sales of EUV systems.

Free cash flow ramp and capital return potential

ASML generated €2.4B ($2.6B) in TTM free cash flow on revenues of €26.1B ($28.3B) which calculates to a free cash flow margin of 9.1%. With ASML striving to grow its revenue base to at least €30.0B ($32.5B) and up to €40.0B ($43.3B) by year-end FY 2025, a stable FCF margin of ~10% implies annual free cash flow potential of €3.0-4.0B or $3.3-4.3B.

A large portion of this free cash flow is set to get returned to investors as well and we know this because ASML has already been generous with its capital returns. ASML buys back its own stock and pays a dividend. If revenues ramp up as much as projected, I would expect the chip equipment company to potentially accelerate its capital returns.

ASML is still a good deal…

ASML, like most chip stocks, has had a good run, but not as great a run as other AI chip companies up the value chain. As a critical EUV equipment manufacturer, ASML occupies a valuable position in the semiconductor supply chain and it should therefore continue to benefit from growing demand for AI chips in Data Centers across the world.

ASML is currently valued at a price-to-earnings ratio of 34.2X which does not make the company cheap, obviously. However, the growth potential is also there: ASML is projected to generate 56% Y/Y EPS growth in FY 2025 and semiconductor manufacturers continue to demand more efficient lithography systems for high-volume chip production… which will benefit ASML.

The industry group of high-performing chip companies — including Nvidia, AMD and TSMC — has a forward (FY 2025) P/E ratio of 31.9X. The average is skewed downward, however, due to TSMC’s low valuation factor of 23.3X. Just including ASML, NVDA and AMD, the industry group has an average P/E ratio of 34.8X. Even before TSMC reported preliminary Q2 figures, I rated the fab a strong buy, in part because of its valuation advantage over other chip plays: 3 Reasons To Buy This Semiconductor Play.

I have also evolved on Nvidia’s valuation which is currently leading the industry group with a P/E ratio of 36.8X. The reason why I changed my opinion on Nvidia is that I underestimated the company’s impressive Data Center-related growth and the strength of demand for its AI GPUs. Specifically, Nvidia’s profit explosion is why I upgraded shares to buy, despite a lofty valuation.

In my opinion, ASML could trade at a price-to-earnings ratio of 40.0X, under the condition that its EPS growth continues to accelerate and that the chip equipment manufacturer delivers a strong Q2 earnings sheet next week… which, given the indication provided by TSMC, is highly likely. A 40.0X P/E ratio implies a fair value range of $1,288 and 18% upside revaluation potential.

Risks with ASML

Infrastructure spending in the Data Center market is ramping up big time with companies like Meta Platforms (META), Amazon (AMZN) and Alphabet (GOOG) currently filling the GPU order books for Nvidia especially. If this spending on AI GPUs drops off, however, slowing demand will trickle down to EUV system manufacturers like ASML and the company could quickly see a deteriorating gross margin picture… which in turn would put the aggressive, longer term growth plan at risk.

Final thoughts

Given that Taiwan Semiconductor Company reported impressive preliminary results for its Q2’24, ASML is set for a strong earnings release next week as well and I believe the odds are in favor of ASML beating its own guidance for revenues and gross margins. Demand for AI infrastructure is still soaring which considerably benefits those companies, like ASML and TSMC, which are sitting at the nexus of the semiconductor industry. Shares of ASML just reached a new all-time high, but the company’s revenue ramp and gross margin expansion are significant. With shares trading at a 34.2X P/E ratio and earnings/FCF set to ramp up nicely in the coming years, I believe ASML could be a speculative buy ahead of Q2.