I’m twiddling my thumbs here, watching the wild volatility in the market today and trying pretty hard to not do anything extreme… so I thought I’d spend a moment explaining a recent Motley Fool Stock Advisor ad for you…

This pitch is for an “exclusive AI report” they call the “AI Supercycle”, and Apple is the bait to drag us in, as they hint at Apple’s “AI Trojan Horse”…

“While companies like OpenAI ushered in the AI generation, and giants like Microsoft and Meta shifted strategy overnight, Apple remained largely on the sidelines.

“However, that recently changed, with Apple unveiling their comprehensive AI strategy, and some are calling it a ‘Trojan Horse’ that could disrupt everything.

“In fact, this swivel is eerily similar to early 2007, when Apple entered the established smartphone market. Taking on established giants like Blackberry, Nokia, and Motorola, Apple’s iPhone rose to the top to become one of the most successful products in history, proving that Apple doesn’t need to be first in the market…so long as they’re the best in the market.”

That’s a common refrain, and for good reason — Apple has historically had great success in turning not-first products into market-leading products that create new pockets of consumer demand. That hasn’t worked more recently, with the Apple Vision Pro headset falling kind of flat, but one slow start doesn’t define an era. Plenty of folks believe that Apple will be an AI leader, once they really get the bit in their mouth and start to figure out what consumers want. That doesn’t necessarily help today, since the stock was put under pressure this morning by the news over the weekend that Berkshire Hathaway shockingly sold half of its huge Apple stake last quarter, and that Apple is delaying the launch of its hotly-anticipated “Apple Intelligence” features in the next iPhone operating system, but sure, Apple will gets its AI headlines eventually.

So what’s the “Trojan Horse?” I guess it’s that they’ll be sneaking in AI features to make life easier, without being as flashy as Google or Microsoft or OpenAI, perhaps, but what the Fool is really trying to say is that there’s a smaller stock which will be a bigger AI winner, I suppose “sneaking in” to the public’s consciousness like those Trojan warriors in the belly of the equine gift.

Here’s how they put it…

“… while you could just invest in Apple shares, Apple’s market cap already sits at over $3 trillion, and it could take a lot to move the needle significantly. Instead, there could be a smarter, savvier way to bet on the AI Revolution…

“And that involves one company 8X smaller than Apple that might be the most important company in the world…the backbone of this entire industry.

“And almost NO ONE has even heard of it.

“In fact, when I was at Nvidia’s GTC conference in March, there was not a single mention of this incredible company.

“But, according to The Verge, manufacturers pushing this magical technology forward are “wholly dependent” on this one tiny company.“

And the final tease:

“… while we love Apple and still recommend it to our members (and members who bought on our initial recommendation in January of 2008 are already up over 4,000%***)…

“This one small company (not Apple) is providing the technology behind these powerful components, and we see it as one of the true, enduring leaders in this futuristic technology.

“And this report pinpoints this incredible opportunity for investors looking to scoop up an under the radar AI behemoth at a fraction of the size of Apple.”

So… hoodat? Thinkolator sez that the Motley Fool is again teasing the Dutch semiconductor equipment company ASML (ASML). Which is indeed the near-monopoly provider of advanced UV photolithography equipment that’s needed for advanced semiconductor manufacturing.

And to their credit, they similarly pitched this as the “most important company in the world” when the markets were looking quite a bit uglier, in October of 2022, and it was a good call then — I only regret that I got too nitpicky about missing the bottom that I didn’t buy some shares of ASML back then (they briefly touched $400 at the time, so they have roughly doubled since — over three years they’ve gone from $800 down to $400, back up to $1,100, and now are sitting near $800 again).

There are generally three warring narratives to deal with when it comes to chipmaking equipment companies:

The first is that they’re very cyclical businesses, and semiconductors have tended to go from shortage to glut as the cycle proceeds, leading to a surge of capital investment that’s followed by a bust after capacity gets overbuilt… we went through a rapid phase of that with COVID, and seem to be still in the midst of an AI-focused semiconductor boom now, which has put the highest-end chips in high demand but isn’t really helping non-AI consumer or industrial products get any traction.

The second is that China is both the world’s biggest consumer of chips and the most aggressive, in recent years, at adding chipmaking capacity… but US restrictions on China and a burgeoning cold war are threatening to reduce sales at the “western” chip companies and chip equipment companies, as those firms are forced to stop selling some high-end stuff to Chinese customers, so that’s a near-term headwind for a lot of chip-related companies (ASML has gone through some fits and starts while the Dutch try to stay on President Biden’s good side in not selling AI-empowering equipment to China, but also not hobble their most important company).

And the third is that there may be an ongoing boom in chip equipment companies as the world tries to bring supply chains back home, moving more semiconductor production out of Taiwan and China and “onshoring” with big semiconductor foundries being built in Japan, the US, Europe and elsewhere, which is probably good for the equipment makers, though not necessarily every quarter. Selling new machines for new foundries is a big help, though in some cases the ongoing service and supply business for this equipment is as important as the initial equipment sales, which means they can’t afford to lose their customers in China and Taiwan.

It can take five years to build a big new semiconductor foundry, so often the cycles of capital investment don’t line up perfectly with the economic cycles… especially when projects are delayed, as has happened with most of the big new foundry projects in the US, or when the companies developing those projects hit quicksand for other reasons (like Intel, which has big projects in development but also seems to be in panic mode as their stock has fallen 60% so far this year).

I can’t tell you what the risks are of a real trade embargo over Taiwan, or a shooting war, but the chipmakers are probably mostly more concerned about more typical semiconductor issues right now — have they overbuilt, and are we heading into a recession, with slumping demand? That typical cycle might not play out the same way as it usually does, since the strategic imperative to build foundries outside of China is pretty overwhelming, and should keep activity fairly high for the next decade — but it could certainly have a big impact in a shorter period of time, like a year or two.

So what do the financials tell us about ASML? Seems to me, they’re still telling us that there will be high revenue and earnings growth ahead, even though their earnings will very likely be lower in 2024 than they were in the boom year of 2023 — that’s not new, earnings dipped from 2021 to 2022, and from 2018 to 2019 — this is a dominant, monopolistic company, but because so much of their revenue comes from selling a small number of truly massive machines, the fact that they don’t sell the same number of machines each year makes their revenue and earnings a little lumpy.

In valuation terms, the current valuation is not terribly compelling — they’re trading at more than 100X free cash flow (that was down to ~16X free cash flow in late 2022), and at about 40X earnings (they bottomed out at about 19X earnings pre-COVID, and were around 25X two years ago). At this point, like late 2022, they’re in a bit of a trough, but the expectation of growth coming out of this trough is now MUCH higher — they grew earnings about 10-12%/year from 2021 through 2023, but are expected to now average more than 20% earnings growth per year once growth kicks back in in 2025.

With that kind of backdrop, you have to form your own opinion about how much of a multiple to pay… are you buying a company that’s having a pretty flat year this year, and maybe even shrinking a bit, or a company that’s expected to see surging growth again next year? And yes, much of that rides on how much more capacity is needed to meet the need for all those new NVIDIA chips, and for whatever the other big AI projects might be… and whether those new foundries in the US and Europe really are developed on schedule over the next few years.

Near-peer very large companies in this same semiconductor capital equipment space, albeit with different technologies and products, mostly trade at much cheaper valuations today… but that’s been true for years.
Lam Research (LRCX), Applied Materials (AMAT) and KLA (KLAC), for example, were available at about 10X earnings in late 2022, when ASML traded at 22X earnings… and today they range from 20-35X earnings, with ASML at 44X trailing earnings.

That’s theoretically because the growth profile is more appealing for ASML — those firms have mostly had earnings growth over the past five years in the 15-20% neighborhood, and were expected to slow down before the AI surge but now again have 12-17% growth projections, while ASML grew at 30% for five years and is expected to keep growing at 20%+ for the next five. Those analyst projections will not be specifically correct, of course, nobody can predict the future — but they tell you why ASML is more expensive: Expectations are much higher.

But prices matter, too — here’s how those four big companies, all of whom are major semiconductor equipment suppliers to most of the big foundries in the world, have done over the past decade… that’s ASML in purple:

And I didn’t cherry-pick — you can see some periods where that purple line has popped to the top, so it’s had some share of the lead in this sector, too, on occasion… but over five years and three years, ASML was also the worst performer.

It’s an appealing business, and everything I read tells me that ASML has more of a monopoly position than the other chip equipment companies — but it also almost always trades at a fat premium to those companies, so in the end investors have usually done better by buying the almost-as-good companies in this space. Even if you bought during that really appealing dip for ASML, in October of 2022, those other three companies still had better investor returns from that point — because although they’re not quite as sexy, these stocks almost always travel in a pack, and they did also dip in price at the same time. They’re also sometimes a little less volatile, since they trade at lower valuations.

It’s been a really strong sector, though — those four companies did also all beat the S&P 500 pretty handily over the past five and ten years (not so much over the past 2-3 years).

I want to love ASML, and tell you that it’s worth any price because it’s got a monopoly position… they’ve got higher gross margins, which makes it appear that they have pricing power, but they also have much higher operating costs than the others, including higher R&D spending needs, and relies on just a few customers for many of its orders, including Taiwan Semiconductor, so there’s not much evidence that they’re really holding their customers’ feet to the fire and maximizing profits on the back of that monopoly… maybe partly because the business has in many ways developed in partnership with its customers, including early funding from major customers to get ASML going years ago. As an investors, it looks to me like ASML is more beloved by investors, which gets it a better valuation… but because of that higher valuation, it hasn’t generated better shareholder returns than the other large chip equipment companies. Given my lack of expertise in this sector, I’ll have to let the financials tell me that valuations matter, and ASML is still pretty pricey.

If you want to dig in and convince yourself that ASML is worth a much higher multiple, I’d suggest starting with the Business Breakdowns episode on ASML — it’s about a year old now, but it’s still pretty compelling.

As always, when it comes to your money, the choice is yours to make — are you ready to buy ASML, as it holds up pretty well during today’s little panic? Think it’s too expensive? Somewhere in between? Let us know with a comment below…

Disclosure: Of the companies mentioned above, I own shares of Berkshire Hathaway and NVIDIA. I will not trade in any covered stock for at least three days after publication, per Stock Gumshoe’ trading rules.