Earnings Call Transcript - ASML Q2 2020

Operator, Operator

Thank you for standing by. Welcome to the ASML 2020 Second Quarter Financial Results Conference Call on July 15, 2020. Throughout today's introduction, all participants will be in a listen-only mode. After ASML's introduction, there will be an opportunity to ask questions. I would now like to open the Q&A – question-and-answer queue. I would now like to turn the conference call over to Mr. Skip Miller. Please go ahead, sir.

Skip Miller, Vice President of Investor Relations

Thank you, operator. Welcome, everyone. This is Skip Miller, Vice President of Investor Relations at ASML. Joining me today on the call is ASML's CEO, Peter Wennink; and our CFO, Roger Dassen. The subject of today's call is ASML's 2020 second quarter results. The length of this call will be 60 minutes and questions will be taken in the order they are received. This call is also being broadcast live over the internet at asml.com. A transcript of management's opening remarks and a replay of the call will be available on our website shortly following the conclusion of this call. Before we begin, I'd like to caution listeners that comments made by management during this conference call will include forward-looking statements within the meaning of the Federal Securities Laws. These forward-looking statements involve material risks and uncertainties. For a discussion of risk factors, I encourage you to review the Safe Harbor statement contained in today's press release and presentation found on our website at asml.com and in ASML's annual report on Form 20-F and other documents as filed with the Securities and Exchange Commission. With that, I'd like to turn the call over to Peter Wennink for a brief introduction.

Peter Wennink, CEO

Thank you, Skip. Welcome, everyone, and thank you for joining us for our second quarter 2020 results conference call. First of all, I hope all of you and your families are healthy and safe. Before we start our normal quarterly results review, I would like to provide you a brief update on the COVID-19 situation. Thanks to the commitment, engagement, and creativity of our people, we managed the quarter very well, which translated into growth in both revenue and profitability. Roger will provide some details on those results. We experienced some challenges early in the quarter around supply delays and increased absenteeism, but we did not encounter any new disruptions due to COVID-19. We continue to operate with special measures in place around isolation and contamination protocols to ensure the safety of our employees and to reduce the risk of operational disruption. Although this created some initial inefficiencies and production delays, operational capabilities are largely back to normal. Regarding transportation, logistics, and customer support, we were able to secure flights to meet customer shipping requirements, and we have managed to provide support for our customers in this challenging environment. We have significantly increased our teams' capabilities in the field to more independently support customers and continue to deploy more novel remote diagnostics and augmented reality support. The majority of this remote technology has accelerated throughout this COVID period, and we expect to deploy even more in the future. In summary, we have been able to navigate through the current environment successfully, and our operational capabilities are largely back to normal. We will remain vigilant to ensure the safety of our employees while providing the best possible customer support. I would like to turn to our normal quarterly results process. Before the Q&A session, Roger and I would like to provide an overview and commentary on the second quarter, as well as our view on the coming quarters. Roger, if you will?

Roger Dassen, CFO

Thank you, Peter. Welcome, everyone. I will first review the second quarter financial results and then provide guidance on the third quarter of 2020. Net sales came in at €3.3 billion. We executed quite well considering the risks in the COVID-19 environment, translating to strong growth of more than 35% over Q1. We shipped nine EUV systems and recognized revenue on seven systems in the quarter. Considering the additional approximately €260 million of revenue from the two systems we didn't recognize in Q2, this would hypothetically have resulted in revenue of around €3.6 billion and a growth of around 50%. Similar to Q1, some EUV systems were expedited for shipment without factory acceptance testing in Q2. We expect to recognize revenue on these systems at site acceptance in the second half of the year. Net system sales of €2.4 billion were again more weighted towards Logic at 62%, with the remaining 38% coming from Memory. Although Logic remains strong, Memory has been growing as a percentage of system sales. Installed Base Management sales for the quarter came in at €887 million, bringing the total of installed base revenue in the first half to around €1.7 billion. Gross margin for the quarter was 48.2%, a significant improvement over Q1 due to the Deep UV mix and an improvement of the EUV installed base gross margin. Operating expenses in R&D came in at €567 million, and SG&A expenses were €131 million. The effective tax rate was higher at 18.5% based on a one-off tax assessment recorded in Q2. Net income was €751 million, representing 22.6% of net sales and resulting in an EPS of €1.79. We ended last quarter with cash and short-term investments at €4.4 billion, which is €300 million higher than Q1. Moving to the order book, Q2 system bookings came in at €1.1 billion, including €461 million from three EUV systems. Order intake was balanced between market segments with both Logic and Memory at 50%. Logic demand continues to be strong, but Memory has increased as a percentage of bookings over the past three quarters. For the third quarter, we expect total net sales of between €3.6 billion and €3.8 billion. We expect our Installed Base Management sales to be around €850 million, driven by strong demand for field upgrades and growing service revenue with a more meaningful contribution from EUV service. Gross margin for Q3 is expected to be between 47% and 48%, which is slightly below Q2, primarily due to Deep UV mix with fewer immersion systems. We have highlighted a number of levers that could positively impact gross margins in the second half, including a richer mix of Deep UV, more immersion vs. dry, mainly driven by Memory recovery. We expect to achieve 50% gross margin in Q4. The expected R&D expenses for Q3 are around €545 million, and SG&A expenses are expected to be around €140 million. Our estimated 2020 annualized effective tax rate is still expected to be around 14%. In terms of capital allocation, we expect to generate significant free cash flow in the coming years, with cash not required for future growth being returned to shareholders through a combination of growing dividends and share buybacks. We plan to keep CapEx at previously communicated levels to support future technology and required expansions. Working capital is being managed as we transition from not taking down payments on contracts to requiring them, which means a temporarily higher level of working capital in 2020. We expect to see an increase in free cash flow generation in the second half of this year, which will enable us to resume our share buyback program once risks in our ecosystem are under control. With that, I would like to turn the call back over to Peter.

Peter Wennink, CEO

Thank you, Roger. As Roger highlighted, we had a strong quarter with over 35% growth in revenue and improved profitability. In this challenging macroeconomic environment, we saw growth in both Logic and Memory markets, reflecting our customers' drive to innovate and invest in future technology nodes. With significant work-from-home and remote learning activities continuing, segments such as data centers and communication infrastructure remained strong. Demand for consumer-related electronics, for example, smartphones, may be under some near-term stress due to the economic impact from COVID. Our customers indicated they see continued strength in end markets requiring advanced nodes, which is reflected in stable demand. For 2020, our growth expectations, which we indicated at the start of the year, are largely unchanged despite the disruptions caused by the worldwide COVID crisis. We expect a year of double-digit growth in sales and profitability. In Logic, customers continue to ramp advanced technology nodes of seven and five nanometers. In support of the digital infrastructure buildup, applications such as 5G, AI, and high-performance computing require leading-edge equipment, which have longer lead times and qualification schedules. We expect Logic demand to remain healthy, which continues to drive the monthly review systems as well as our other products. In Memory, customers are continuing to indicate that they are seeing signs of recovery; driven by healthy demand in data centers and expectations of improved demand in consumer electronics. There's an increasing talk of utilization levels supporting this view, and with this continued trend in mind, we expect additional demand in the second half of the year. This is supported in our bookings with Memory increasing as a percentage of bookings over the past three quarters. Sales to China continue to grow and accounted for 23% of our system's revenue this quarter, driven by demand from Logic and Memory customers in China. We expect sales growth from the China region this year. As for the changes to the U.S. export rules that went into effect at the end of June, we expect minimal impact on our business. It's difficult to determine how near-term dynamics will evolve due to recent U.S. restrictions, but with the growing digital economy and secular growth drivers like 5G, AI, and high-performance computing, the demand for semiconductors will continue and will fuel future innovations. Wafers and products to support this technology will be produced globally, requiring advanced lithography. Regarding our installed base business, we expect significant growth this year. We realized revenue of around €1.7 billion in the first half and expect a similar level of business in the second half. Our services business will continue to scale as our installed base grows and EUV service revenue will become more meaningful as these systems run more wafers in volume manufacturing. We expect significant amounts for upgrades as customers use them to increase capacity and improve imaging and overlay performance. This EUV technology has now entered the realm of high-volume manufacturing, becoming integral to our core operations. With nine shipments this quarter, we've delivered 13 systems in the first half of the year. As COVID-related transportation and support risks are now lower, we plan to resume the normal qualification process, including factory acceptance testing, meaning we expect to recognize revenue on all systems shipped in Q3. We target revenue of around €4.5 billion from 35 systems this year. EUV service margins are expected to breakeven in the second half, and the EUV system gross margin is on track to meet or exceed the 40% target for the year. We plan to produce and ship 45 to 50 systems next year; currently, we have an order backlog of 54 systems, including 28 orders for 2021 delivery. Customers are currently reviewing how COVID will impact the global economy, and we hope to have more clarity on this as we move through the second half. In our Deep UV business, we shipped the first NXT:1470 to a customer, which is the first dry NXT system, featuring significant improvements in matched machine overlay and productivity. The higher output per fab area from an NXT system will also maximize customer profitability. In summary, while the macroeconomic environment poses challenges, we see stable demand and a strong second half. Our expectations for 2020 sales growth have not changed. We anticipate continued growth in Logic demand, with a recovery in Memory in the latter half. We still expect double-digit growth in sales and profitability this year, underscoring the opportunities driven by the expanding digital economy as seen through 5G, AI, and high-performance compute. Our growth trajectory remains intact. We'd be happy to take your questions.

Skip Miller, Vice President of Investor Relations

Thank you, Roger and Peter. The operator will instruct you momentarily on the protocol for the Q&A session. Before I hand off, I'd like to ask you to kindly limit yourself to one question with one short follow-up, if necessary, to allow as many callers as possible. Now operator, can we have your final instructions and the first question, please?

Operator, Operator

Thank you. At this time, we will begin the question-and-answer session. The first question comes from Mr. Mitch Steves. Please state your company name followed by your question.

Mitchell Steves, Analyst

Yes. Thanks for taking my question. Mitch Steves from RBC Capital Markets. I'm just going to ask two upfront. The first one is about the commentary on Memory demand being stronger, and you guys are still seeing high-quality bookings in Logic. Is there a scenario for 2021 where you could actually see growth in both DUV and EUV units in a more bullish scenario, or do you see customers opting to just buy more EUV systems? Secondly, I wanted to double-click on the gross margin comment. I think that was supposed to be up a little bit more in Q3. What is the trajectory for both EUV and the corporate margin as we move towards Q4 and beyond?

Peter Wennink, CEO

Is your question directed for 2021? You just started your question with Memory demand picking up and strong, healthy Logic. Could you clarify if your question for 2021 is directed at both Memory and Logic combined or just one of those?

Mitchell Steves, Analyst

No, so my focus is on total DUV and EUV units. Is there a scenario where both of those are up due to high demand, or does it have to be more one versus the other?

Peter Wennink, CEO

If you see a continued uptick in the Memory market, it could positively affect the Deep UV immersion systems, so you could see growth in both. However, it's worth noting that the more EUV layers customers choose will displace Deep UV layers. If there is a capacity ramp in both Memory and Logic continuing, then you could see both numbers increase.

Roger Dassen, CFO

Let me take the question on gross margin. The best way is to give you the bridge between the three quarters. Moving from Q1 to Q2, improvements in gross margin stemmed from two main drivers: the Deep UV mix and the improvement in the installed base management margin. This helped raise gross margin to 48.2%. For Q2 to Q3, we anticipate a slight deterioration in gross margin due to the less favorable Deep UV mix, with fewer immersion systems anticipated in Q3 compared to Q2. From Q3 to Q4, we believe achieving 50% gross margin is feasible based on our current plans. Key drivers include more immersion systems in the mix and improvements in EUV service gross margins driven by reduced costs per EUV machine and increased wafer output as these tools enter high volume manufacturing. This summarizes the bridges and potential for gross margin across the three quarters.

Mitchell Steves, Analyst

Understood. Thank you very much.

Operator, Operator

The next question is from Mr. Andrew Gardiner. Please state your company name and ask your question.

Andrew Gardiner, Analyst

Thanks very much. Andrew Gardiner from Barclays. Roger, one for you regarding comments on cash flow and capital allocation. You mentioned CapEx expected at previously communicated levels, which is clear. But in terms of working capital, can you help quantify the pressure further? There was significant working capital outflow during the first half of the year. Is that expected to continue into the third quarter, perhaps start to improve by the fourth quarter? It would be useful to get some guidance on that. Also, regarding share buybacks, is that something we could expect by the fourth quarter of this year or is it more likely to extend into next year?

Roger Dassen, CFO

Yes. You're right. In the first half, we experienced negative free cash flow, but by the second quarter, it had started to become positive. While it will still be negative for the full half, we expect significant improvement in working capital and free cash flow generation in the second half. Key reasons include negotiations moving towards requiring down payments on EUV tools and the transition period from existing contracts providing for extended payments to customers. Our expectation is for a sizable recovery in free cash flow generation in the second half, similar to last year, though perhaps not as pronounced. Once we see that free cash flow generation become healthy and determine that risks in our ecosystem are under control, we can resume share buybacks, potentially in Q4 of this year.

Andrew Gardiner, Analyst

Okay. Thank you. And just a quick follow-up. Given the COVID-19 issues this year, you stopped the buyback and didn't declare an interim dividend this year. Would the plan be to return to that sort of phasing in 2021?

Roger Dassen, CFO

Just to clarify, the interim dividend is one we would declare at the year's end. We declared an interim dividend last November and planned to do the same next year, barring any unforeseen circumstances.

Amit Harchandani, Analyst

Thank you. Good afternoon, everyone. Amit Harchandani from Citi, and thanks for letting me on. Regarding 2021, I would appreciate your thoughts on litho intensity and capacity. Logic has remained elevated since 2019, while Memory is picking up. What are your customers discussing for 2021, and what is the level of visibility?

Peter Wennink, CEO

When we look to 2021, the level of uncertainty regarding the GDP environment has certainly increased compared to six months ago. Despite this uncertainty, innovation and roadmaps from our customers continue. For DRAM and the seven and five nanometer expansions, there is confidence in continued development, but it's tough to be quantifiable. If you consider our guidance for 2020, we see potential for double-digit sales growth in 2021 based on current discussions with our customers. However, the level of uncertainty makes it difficult to provide a precise outlook.

Amit Harchandani, Analyst

Understood, Peter. That's helpful. As a clarification, could you help us understand the mix of shipment of 3400C and 3600D tools for 2021? What does that mean for ASP, and how will that affect the 45 to 50 capacity discussed?

Peter Wennink, CEO

The shipments will involve a mix of both the 3400Cs and the 3600Ds. The first half of 2021 will likely be more skewed towards the Cs, while the second half will involve more Ds. We plan to ship our first 3600D this year, and it will be a ramp-up process through 2021, with the capacity being prepared for 45 to 50 systems.

Christopher Muse, Analyst

Yes, Evercore ISI. Thank you for taking my question. Expanding on the previous query regarding the 3600D, can you help us understand the mix between Logic and Memory in the three tool orders, as well as provide geographic distribution? Additionally, as we think about the deramping through 2021, what are the gross margin implications?

Peter Wennink, CEO

The orders were mixed, but at least one was for a Memory customer, meaning all our major Memory customers now have EUV orders and shipments. More importantly, the overall demand profile shows confidence on both Logic and Memory sides.

Roger Dassen, CFO

In terms of gross margin, we anticipate a 15% or potentially greater increase in ASP on the D models. We're targeting over 40% gross margin on EUV systems this year and see potential to match corporate gross margin at 50%.

Christopher Muse, Analyst

That's very helpful. In terms of the 2050 immersion and 1470 dry systems, how should we consider gross margins into 2021 alongside the D model? Should we expect 50% or could there be more upside?

Roger Dassen, CFO

The combination of the 1470 and 2050 should lead to roughly a 1% uptick in corporate gross margin. That's how you should view it.

Krish Sankar, Analyst

Hi, it's Krish from Cowen. Thanks for taking my question. In the second half, with the Memory strength persisting, how do you segment the growth between China, DRAM, and NAND? What is driving the incremental strength?

Peter Wennink, CEO

Growth is being driven by both our Chinese customers and traditional DRAM customers. In the second half, the emphasis will likely lean more towards traditional DRAM customers, but both segments contribute to overall demand.

Krish Sankar, Analyst

Thank you very much.

Sandeep Deshpande, Analyst

Can you discuss EUV and Memory? Earlier in the year, you indicated shipping EUV to DRAM. What are your thoughts on the rollout of EUV layers in DRAM for next year?

Peter Wennink, CEO

The EUV business for next year will largely focus on Logic, but we will ship a limited number of EUV systems for DRAM applications. The first EUV applications in DRAM will be limited to one layer initially, although this ramp will grow over time as the DRAM roadmap accelerates.

Sandeep Deshpande, Analyst

How do you see EUV margins trending compared to Deep UV margins, and when do you expect crossover?

Peter Wennink, CEO

The right time frames for the crossover between the margins will be in 2022 and 2023, with distinctions in gross margins recognized within the Deep UV categories.

Achal Sultania, Analyst

The bookings number of €1.1 billion for this quarter is much lower than previous quarters. How much is this due to customers holding back due to already having a large order backlog, and how much is due to decreased visibility due to macroeconomic uncertainty?

Peter Wennink, CEO

As you noted, we had seen stronger bookings in earlier quarters. Customers are confident in their secured capacity ramp, with €10 billion in the order backlog. The COVID crisis has increased uncertainty in boardrooms, but we're optimistic for continued EUV bookings throughout the year.

Achal Sultania, Analyst

Regarding the 35 EUV shipment target for this year, can you provide a mix between Logic, Foundry, and DRAM?

Peter Wennink, CEO

This year, the majority of our shipments, approximately 80-90%, will come from Logic, with only a limited number for DRAM customers as we shift towards broader adoption.

Pierre Ferragu, Analyst

China continues to improve manufacturing capabilities, which raises questions about potential ability to assemble manufacturing lines amid new regulations. How do you see this affecting the equipment industry?

Stephane Houri, Analyst

On the Logic Foundry side, spending appears to be robust. What is driving this prolonged strength, and how do you see logic demand evolving in the upcoming quarters?

Peter Wennink, CEO

The acceleration in roadmaps has contributed to increased Logic demand, with new applications in 5G, AI, and other advanced technologies driving the need for new nodes. In discussions with customers, we believe they'll continue to leverage these innovations, resulting in a condensed cadence of design results and equipment orders.

Skip Miller, Vice President of Investor Relations

Thank you. The operator will inspect you momentarily on the protocol for the Q&A session. Now operator, can we have your final instructions, and then the last question, please?

Operator, Operator

Thank you, sir. The final question is from Mr. Joe Quatrochi. Please state your company name followed by your question.

Joseph Quatrochi, Analyst

On the foundry/logic side for 2020, you indicated it would be relatively flat, implying revenue in the second half may drop in the low double-digit range year over year, despite EUV's backloading. Is my understanding correct? What are the key factors driving this?

Peter Wennink, CEO

Indeed, while we expect a mix of EUV and Deep UV, year-on-year, Logic is expected to remain flat. Yes, EUV is anticipated to see increased contributions in the second half compared to the first half, but overall revenues might remain flat

Roger Dassen, CFO

Logic sales for the first half, recorded at €2.7 billion, mean we will need €3.9 billion in net sales for the second half to maintain flat revenue year-over-year. That indicates an increase in the second half, with contributions from both EUV and Deep UV.

Peter Wennink, CEO

Ultimately, variations in customer requirements will impact shipment timelines. It’s wise to look at our performance on a yearly basis to better assess trends and avoid drawing conclusions from short-term fluctuations.

Operator, Operator

Ladies and gentlemen, this concludes the ASML 2020 second quarter financial results conference call. Thank you for your participation. You may now disconnect your line.

Peter Wennink, CEO

Thank you.