six months in the making

ASML says it began negotiations six months ago with its largest customers about  their contributing to R&D and making commitments to purchase next-generation machines.  As far as I’m aware, no one has yet said who initiated the talks.  It wouldn’t surprise me if INTC got the ball rolling.  The salient points would be that:

–INTC needs next-generation equipment in four years, not six;

–it would contribute a significant amount of money to the required R&D effort; and

–it was going to partner with someone, but would prefer that the partner be ASML.

Because every supplier studies his customers extremely carefully, it’s equally possible that ASML anticipated INTC and made the first move, giving the same rationale.

the major provisions of the agreement

1.  A group of customers will provide up to $1.7 billion in R&D money to ASML.  The funds will be spent on next-generation lithography and on migration from machines that use 12″ silicon wafers to 18″.  Part of the money will be treated as an advance on purchase of next-generation equipment and will be returned through a lower price on machines bought.  Part won’t.  We don’t know the proportions.

By doing this, ASML reduces the amount it will have to put up itself of the several billion dollars it will cost to develop the new equipment.  At the same time, it locks in customers for its next-generation equipment.  ASML scientists will doubtless get excellent access to its partners’ R&D staffs, as well.

INTC, which has agreed to put up 60% of this money, estimates it will get next-generation machines two years earlier than it would otherwise.

ASML is still talking with TSMC and Samsung–and possibly with others.  In my view, it’s not a sure thing, however, that any others see the same pressing need INTC does.

2.  ASML intends to sell up to a 25% ownership interest in itself to the R&D partners, at a fixed price of €39.91 per share.  The share purchase will presumably be proportionate to the R&D commitment.

INTC has agreed to buy 60% of this stock, or about $3 billion worth.

The stock that customers purchase will be restricted by being placed in a special trust.  Under normal circumstances, the stock will have no voting rights and will not be transferable to another party.  So the customers will truly be passive investors.

We’ll know more clearly why the equity sale is necessary when the trust documents are available.

My take is that this is a provision insisted on by INTC, not ASML.   I see it as protection against the possibility that current management might lose control of the company, either to an activist investor group or to a bid from a semiconductor equipment conglomerate.  The worry would be that the R&D partners might lose access to the fruits of next-generation research, or that a new owner might slow down the pace of progress or shut down the next-generation project altogether.

3.  ASML won’t keep the money it gets from the stock sale.  It will distribute it instead to shareholders (ex the customers).

Why?

ASML’s market cap would be about $25 billion after the share sale, if it did nothing–and if the stock continued to trade at yesterday’s price.  The company would have net working capital, after repayment of all debt, of around $8 billion.  Most of that would be cash.  I think the temptation to a prospective acquirer of a large acquisition-funding cash pile would be too great to pass up.  And ASML doesn’t need the money.

4. ASML will conduct a “synthetic buyback” of shares from existing shareholders in the same amount it sells to customers.

Here’s where things get a little weird.  But ASML has done this before, in 2007.

I think I understand what’s going on, but don’t count on it.

With shareholder approval, ASML will

–use accounting legerdemain to transform the proposed payment to shareholders into a return of capital, meaning (I think–but don’t bet the farm on my read) it won’t be subject to tax

–make the distribution

–proportionately reduce each shareowner’s holding (ex the customers) through a reverse split, so that the number of outstanding shares will be the same as before the sale to customers.

The result of all this will be to transfer ownership of up to 25% of the company away from existing shareholders to the customer group, without triggering any tax effect.  So existing shareholders will be able to lighten up, near the peak of this semiconductor equipment cycle, and at a price about 4x the low of late 2008–all without having to pay tax.  Who’s going to complain about that?

what to watch for

I think this is a really good deal for both INTC and ASML.  I’ll be interested to see if TSMC or Samsung sign up as well.

They might not.  They could do nothing.  Or they could cut a similar deal with another lithography company.  Yes, the others would be Japanese, who are notoriously difficult to deal with and who are part of a legal and cultural environment that is not friendly to foreigners.  But the Netherlands is no walk in the park for an outsider, either.

How the others act will give us a good read on how much of a lead, if any, ASML has in EUV or 18″.

For what it’s worth, I think ASML is a great company, but I haven’t owned it for years and have no intention of buying it now.  I do continue to own INTC, though.