Jul 27, 2020
As we cross the halfway mark of 2020, it’s a good opportunity to look back and reflect on what has been an incredibly volatile period for global equities. While in January markets were wrestling with the prospect of a full-blown conflict between the US and Iran, attention quickly shifted to the growing incidence of COVID-19 around the world. Thankfully, our portfolios have navigated these unprecedented times with few casualties, in part due to our focus on business model resilience, stable cash generation and balance sheet strength. Nonetheless, even within our universe there have been winners and losers. In this piece, we will discuss how the pandemic has impacted two of our larger positions: Booking Holdings and ASML.
Figure 1: COVID-19 has affected Booking Holdings and ASML in significantly different ways
Source: Bloomberg, total return in USD, 30 June 20
The Online Travel Agent (OTA) Booking Holdings has been held in the fund since mid-2016. Our ownership of Booking has seen share price volatility, most notably as the company engages in competitive skirmishes with other OTAs (e.g. Expedia and AirBnB) and Google. Clearly these pale into insignificance compared to the steep drawdowns in the share prices of travel stocks over the first half of 2020. Many operators in the value chain – most notably airlines – have been badly hurt by the severe travel restrictions imposed in virtually all countries. However, despite these challenges, we view Booking as strategically well placed to emerge in a strong competitive position as global travel restrictions are gradually lifted and consumers can begin thinking about a return to their annual holiday schedules.
Firstly, it is worth noting that as an OTA, Booking is fundamentally different to traditional hotel groups. Booking.com is one of the worlds most valuable booking platforms and as a result the company generates profit margins which are more similar to a software company than a hotel group. Even as hotel groups have gradually reduced their ownership in physical hotels, moving to a model of franchised or managed hotels, they struggle to compete with the economics that Booking is able to generate.
Figure 2 compares the common sized income statements of Booking to that of global hotel group Marriott International. Booking lacks any direct costs, with the company instead taking a royalty on transactions booked on its platforms, rather than offering any hotel management services. Moreover, exactly one third of Booking’s revenues are typically spent on advertising, to drive web traffic to its platforms. While Booking has increased the proportion of brand versus performance advertising over time – the latter being more closely linked to traffic and therefore transactions – there remains an incredibly strong correlation between advertising spend and bookings. During times of stress, Booking is well positioned to slash advertising spend and protect profitability.
Figure 2: Booking’s lack of direct costs ensures it has tremendous flexibility
Source: Company reports, 31 December 2019
Other, more qualitative, reasons also exist for our positive predisposition towards the company. Booking is heavily weighted towards leisure versus business travel. Early indications suggest that leisure travel will return quickly once it is safe to do so, while serious doubts exist as to how quickly business travel will normalise. This will resonate particularly strongly with many of us, having got used to the concept of remote working. Moreover, Booking has a not insignificant exposure to domestic, rather than cross-border, travel. While governments are unlikely to allow unrestricted movement of people until the pandemic is truly under control, the so called ‘staycation’ is no doubt going to grow in prominence. Finally, given the nature of the platform it is, in our view, reasonable to assume the company over-indexes to younger consumers, who might be more willing to travel ahead of the eradication of this deadly disease. As a result, we are optimistic that Booking will be able to capture its fair share of this segment of the travel market.
Finally, in an environment of depressed travel, incremental bookings become more valuable than ever. As the premier booking platform, particularly in Europe, we view Booking.com as growing in importance among its fragmented base of hoteliers. Booking’s largely unfettered financial resources leave it well positioned to compete in a post-COVID world, and – unlike the wider market – we would expect the company to capture market share at an even greater rate than before the pandemic.
Having owned semiconductor equipment supplier ASML in the portfolio since mid-2018, we have been pleased to see the company as a notable contributor to relative and absolute performance. At first glance, a supplier of hardware into a cyclical end market such as semiconductors might seem like an odd choice for a franchise portfolio. However, ASML occupies the enviable position of owning a near monopoly in photolithography. The company designs and manufactures the lithography machines that clients use to create the microchips used in many electronic devices, such as smartphones and laptops. As such, ASML’s ongoing innovation cycles are one of the main drivers of the semiconductor industry’s never-ending pursuit of Moore’s Law, which states that the number of transistors on a microchip doubles every two years. Lithography equipment allows semiconductor manufacturers to squeeze more and more transistors onto chips, thereby increasing computing power at a truly exponential rate. This unique position affords ASML supreme pricing power, so long as it can innovate in bringing new, more advanced lithography systems to market.
To this point, ASML is in the early stages of rolling out its latest product iteration, Extreme Ultraviolet (EUV) lithography. This represents a huge technological leap forward relative to legacy Deep Ultraviolet (DUV) lithography. As a result, ASML achieves a >3x uplift in pricing, with each tool costing customers more than €100 million apiece. Demand is high as semiconductor manufacturers attempt to produce ever faster chips; this is well reflected in ASML’s order book, which boasts enough EUV tools to keep the company busy for well over a year, in the very unlikely event of no new orders. As EUV grows in ASML’s annual shipments of tools, revenues increase, gross margins expand as cost savings are captured and the end result should be a significant expansion of profits, from already healthy levels.
Figure 3: ASML’s new EUV lithography should further boost its profitability
Source: Company report, Ninety One estimates as of July 2020.
In the absence of COVID-19, ASML’s growth prospects were already bright. However, the pandemic has brought about two tangential phenomena. Firstly, concerned by the prospect of a more prolonged lockdown, customers asked ASML to ship systems earlier than usual, before all necessarily quality control checks were conducted. Aside from an artificial shifting of revenues between quarters – which has no impact on the long-term value of the business – it again evidences ASML’s importance to its customer ecosystems. Secondly, and more importantly, COVID-19 has caused an accelerated drive toward remote working and everything ‘cloud’, a trend which has also benefited a number of other portfolio holdings, notably Microsoft. This has in turn provided a boost to the logic and memory markets, the latter of which was facing something of an oversupply issue as we entered 2020. Companies typically struggle to reach their full potential when their customers are under pressure, so this COVID-tailwind has provided an incremental boost to the nearer term investment case for ASML.
We believe that equity markets remain in a slightly precarious position. While investors await the ugly impact of lockdown on companies’ second quarter results, many broader market indices have recouped most of the losses endured during February and March. At the same time, we expect the market to continue to value those business which are able to offer sustainable growth and above average returns on capital. Now more than ever it is important to have a deep understanding of the opportunities and threats posed both directly by the pandemic and from the continued evolution of an increasingly competitive corporate environment. We continue to focus our research process and portfolio holdings on those companies which we believe have the potential to emerge from these difficult times quickly, in a position of strength and on the front foot.