ASML Holding's (ASML) CEO Peter Wennink on Q4 2016 Results - Earnings Call Transcript

January 18, 2017

ASML Holding N.V. (NASDAQ:ASML) Q4 2016 Earnings Conference Call January 18, 2017 9:00 AM ET

Executives

Craig DeYoung – Vice President-Investor Relations
Peter Wennink – Chief Executive Officer
Wolfgang Nickl – Chief Financial Officer

Analysts

Weston Twigg – Pacific Crest Securities
Kai Korschelt – Bank of America Merrill Lynch
Sandeep Deshpande – JPMorgan
C.J. Muse – Evercore ISI
Timothy Arcuri – Cowen & Company
Amit Harchandani – Citigroup
Gareth Jenkins – UBS
Francois Meunier – Morgan Stanley
Farhan Ahmad – Credit Suisse
Jagadish Iyer – Summit Redstone
Andrew Gardiner – Barclays
Douglas Smith – Agency Partners
Robert Sanders – Deutsche Bank

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the ASML 2016 Fourth Quarter and Annual Financial Results Conference Call on January 18, 2017. Throughout today’s introduction, all participants will be in a listen-only mode. After ASML’s introduction, there will be an opportunity to ask your questions. I would now like to open the question-and-answer queue. [Operator Instructions]

I would now like to turn the conference call over to Mr. Craig DeYoung. Please go ahead, sir.

Craig DeYoung

Thank you, Arenth, and good afternoon and good morning ladies and gentlemen. This is Craig DeYoung, Vice President of Investor Relations at ASML. Joining me today from ASML’s headquarters in Veldhoven, The Netherlands is ASML’s CEO, Peter Wennink; and our CFO, Wolfgang Nickl.

The subject of today’s call is ASML’s 2016 fourth quarter and annual results. As always the length of the call will be 60 minutes and questions will be taken in the order that they are received. This call is also being broadcast live over the Internet at asml.com and a replay of the call will be available on our website.

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

With that, I’d like to turn the call over to Peter Wennink for a brief introduction.

Peter Wennink

Thank you, Craig. Good morning, good afternoon ladies and gentlemen, and thank you for joining us for our fourth quarter 2016 and 2016 annual results conference call. Before beginning the Q&A session, Wolfgang and I would like to provide you with an overview and some commentary on 2016, the fourth quarter and beyond. Wolfgang will start with the review of our annual 2016 and fourth quarter financial performance with some added comments on our short-term outlook and I will complete the introduction with some additional comments on key 2016 accomplishments and some of our near-term expectations.

Wolfgang Nickl

Thank you, Peter and welcome everyone. 2016 was a remarkable year for ASML, both financially and strategically. I would like to first highlight some of our financial accomplishments and then finish with our view of the coming quarter. 2016 was a record breaking year in many financial respects with total net sales, gross profit, net income and earnings per share all reaching record levels.

In addition, we finished the year with the highest backlog ever, which combined with our current business view allows us to look forward to another great year in 2017. We are EUV becomes an integral and growing part of our system revenues, contributing significantly to our top-line growth through the balance of this decade and beyond.

Turning to our Q4 results, net sales came in at EUR1.91 billion, net system sales accounted for EUR1.22 billion, driven by logic which represented 61% of net system sales with memory returning to strings versus Q3 accounting for 39% of net system sales. System sales included EUR144 million of EUV revenue, in line with the guidance given during our earnings call in October.

Net service and field option sales for the quarter came in strong as expected at a level of EUR684 million, driven by ongoing strong demand for holistic lithography options, high value upgrades and our growing install base. Furthermore, we closed the acquisition of HMI in November and net service and field option sales includes about EUR25 million for this new and exciting part of our business.

Our gross margin for the quarter came in at 47.2%. This includes starving the amortization of intangibles, as well as the effects from the fair value assessment of HMI’s inventory as of the closing date of the acquisition. The negative impact on gross margin for both of these purchase price allocation related items was approximately one percentage point.

R&D expenses came in at EUR287 million, slightly higher than guided due to both the R&D expenses of HMI and the start of our partial funding of Zeiss SMT for our High-NA EUV program. SG&A expenses came in at EUR107 million also slightly higher than guided due to the inclusion of HMI. We also had an impact from foreign currency revaluations on transactions and balances relating to the HMI acquisition. You may remember that this was an unfavorable effect of about EUR28 million in Q3 as reported during our last call. For Q4, we had a more than offsetting favorable effect of about EUR83 million. These effects are reported in the interest and other line in our P&L.

Moving to the order book. Q4 system booking s came in at EUR1.6 billion for 44 systems including six 3400 EUV systems. Strong bookings continued in the logic sector and support of the 10-nanometer RAMs and in support of EUV insertion at the seven nanometer node. Memory booking strengthened further from its strong Q3 level, supporting expected strength in memory shipments continuing in 2017, driven by DRAM. Continuing order flow for EUV systems brings our total year-end EUV system order book to 18 systems. Our overall systems backlog now stands at nearly EUR4 billion.

Turning to the balance sheet. Quarter-over-quarter cash, cash equivalents and short-term investments came in at EUR4.06 billion. A major driver was our free cash flow of EUR1.1 billion in Q4. As we experienced in the last quarter of 2015, we saw a significant level of early payments from customers, which will impact Q1 2017 cash flows. Also as already mentioned before, we closed the HMI acquisition during the quarter and also issued a EUR750 million bond to support part of our planned strategic investment and Zeiss SMT, which is expected to close in Q2 of 2017.

With that I would like to turn to our expectations and guidance for the first quarter of 2017. We expect continuing sales strengths in Q1 with total net sales of approximately EUR1.8 billion of which an estimated EUR30 million will be deferred EUV revenue. Foundry shipment strength supporting 10-nanometer RAMs will continue in Q1 and will be firmly supported by memory shipments.

We also expect to ship our first NXE’s 3,400 EUV system in the quarter, we expect to record the revenue for the system in the third quarter of the year, since this system will ship in a non-final configuration.

I would also like to mention here, that one of the EUV systems that we expected to ship early this year postponed from Q4 last year due to a customer readiness issue, will not ship this year as originally planned. Due to other exonerating circumstances, this customer has now decided to place a system upgrade order for this tool and will take delivery of it in 2108, where it will add to two other systems at the customer site to be shipped this year.

This leaves our system output plan at 12 new systems and our shipment plan at 13 considering the one additional system that missed delivery for material availability reasons in Q4, 2016.

We expect our Q1 service and field options revenue to again come in above EUR650 million driven by continued demand for holistic lithography options, high value upgrades and our growing installed base.

For now, we will report HMI revenues under field options and services. But margins for Q1, is again expected to be around 47% including the effect from the purchase price allocation for the HMI acquisition. The negative impact of these purchase price allocation adjustment for Q1 is more than one percentage point. The impact for the full year, is about EUR90 million, and will reduce to about EUR40 million per year from 2018 onwards.

R&D expenses for Q1, will be about EUR328 million and SG&A is expected to come in at about EUR95 million. The uptick in R&D spend is driven by the inclusion of HMI and accelerated investments in pattern fidelity metrology. Our contributions to SMT’s High-NA developments, our own High-NA development acceleration and the strong U.S. dollar.

As a reminder, regarding our share buyback program, last year, we purchased EUR400 million worth of our own shares before the program was paused during our acquisition of HMI. It remains paused for the time being, as we closed our planned investment in Zeiss SMT. The transaction is in the regulatory approval process in the required jurisdictions. We’ve already received the approval in South Korea and expect the approval from Germany and China in time to close the transaction in Q2, 2017.

And finally, an increase of our annual dividend from EUR1.05 to EUR1.20 will be proposed at our Annual General Meeting of shareholders in April. With that, I would like to turn the call back over to Peter.

Peter Wennink

Thank you Wolfgang. 2016 was indeed a remarkable year for ASML, not only financially as highlighted by Wolfgang but strategically and product technology wise as we continue to prepare ourselves for continued growth in the coming decade and beyond. I’d like to take a moment to highlight some of these key events.

Firstly, our acquisition of HMI will enable us to move from simple imaging and imaging placement significantly in a direction of full pattern fidelity control, which is a key requirement and value provider for our customers at 7-nanometer and below. This along with an expansion of our current products into broader types of applications, allows us to lay the foundations for future growth in our holistic lithography products group.

Secondly, we brought a key supplier partnership to the next level by agreeing to acquire a minority stake of Carl Zeiss SMT our major critical optic supplier for the purpose of not only securing the extension of EUV imaging technology but also strengthening the current combined businesses of the two companies to improve co-operation and governance.

The co- investment of about EUR760 million, over a 6-year period centers on the R&D investments of next- generation lenses and related capital expenditure also referred to as High-NA, which is critical in meeting our customers’ imaging roadmaps throughout the next decade.

Lastly and probably more significantly, the industry has turned the corner on the EUV. Throughout the year, we continue to execute on mutually agreed performance milestones, which allowed our customers to grow confidence in the technology and tool performance. This resulted in customer decisions to allocate the most critical layers of the next generation nodes to EUV, beginning with the industry 7-nanometer logic node.

With customers backing this confidence up with orders, we ended the year with an EUV backlog of 18 systems as mentioned. Together with the anticipated Q1 orders, this will cover our 2017 and early 2018 EUV output.

As mentioned before, our output capability for 2018 will be around 24 systems, based on the timing of high volume manufacturing introduction of the advanced logic and memory nodes as announced by our customers, it is realistic to assume that this production capability will be fully utilized by our customers. This means we would expect the continued order flow in the coming quarters.

As we move into the next phase of industrialization of EUV. Our focus will remain on continued improvement of key HPM, performance metrics very much inline with what customers expect of our DPV offering, above 90% availability and productivity per tool specifications.

Furthermore, we are heightening our focus on our supply chain to provide the required number of EUV systems on time and on preparing a competent and sufficiently sizable EUV field service organization capable of supporting our customers in the volume manufacturing insertion plants.

With respect to our core product lines, we continue to develop industry leading imaging systems evidenced by the introduction of our latest emerging product offering the NXT:1980 which has demonstrated the fastest ramp of a new product in our history, with 46 systems shipped in 2016.

For our Holistic Lithography product line, 2016 was also a good year, where we launched new products by penetrating new large customer accounts, promising significant new business in the years to come.

Together with the aforementioned progress on the EUV product performance and related business opportunities, we feel confident in further anchoring our leadership position in the semiconductor equipment market place.

And turning to the short-term, as Wolfgang mentioned, we expect to build upon a record 2016 seeing further significant opportunities to grow in 2017. We see a continued ramp of the foundry logic the nanometer node as recently confirmed by one of our large foundry customers with memory strength driven by expected stronger big growth in 2017.

In addition, service and field option sales are again expected to continue to grow in 2017. This will continue to be driven by sales of scanner system upgrades and our growing holistic lithography product offering. In 2017, we’ll see the first real impact of EUV system sales with the recognition of system shipped in the calendar year as well as pieces of remaining revenue recognition from system shipped in the past.

For 2017 our opportunities and challenges are crystal clear. The commitment of our customers to EUV is now bound and evidenced by our significant and growing EUV backlog. Supporting our customers’ intent or moving EUV into volume production in the coming 24 months will remain our number one priority in order to ensure that our customers can deliver the next node transitions as planned. ASML remains committed to do everything within our capability and power to bring EUV to manufacturing [indiscernible] as soon as possible.

With that we would be happy to take your questions.

Craig DeYoung

Yes, thank you for letting us to take some extra time to review in some depth key events of 2016 and their impact on our future. The operator will instruct you momentarily on the protocol for the Q&A Session, but beforehand, as I always do, I’d like to ask you kindly to limit yourself to one question and one short follow-up if necessary. This will allow us to get as many callers in the hour as possible.

Now Arenth, could we have your final instructions and then the first question please.

Question-and-Answer Session

Operator

Of course yes thank you. Ladies and gentlemen at this time we will start the question-and-answer session. [Operator Instructions] One moment please for the first question. First question comes from Weston Twigg [Pacific Crest Securities]. Please state your company name followed by your question.

Weston Twigg

Hi thanks sir, Pacific Crest. So my question is related to the memory strength, you mentioned that it should be stay strong through 2017 particularly in the DRAM side with big growth. And I was just wondering if you’re seeing new DRAM capacity being installed, given the pricing trends or if these are tools that are being shipped in the end and then replaced in the DRAM fabs?

Peter Wennink

Yes, it’s more of the latter. So we’ve seen significant re-locations from DRAM capacity into NAND throughout 2016 or we starting 2015. And as really feeling it, it all back up. Like we said in the previous call, we saw quite a significant capacity drop in 2016. In terms of wafer starts per month in DRAM, which is a double-digit drop and that’s being filled up with new DRAM capacity.

Weston Twigg

Okay. And then I guess, as my follow-up, are those upgrades on the NAND side or those being upgrades that are contributing to your field and service options or is that a different revenue line? Those that are being upgrading.

Peter Wennink

It’s the first, it’s in there – these are the upgrades that are in the field service and option line.

Weston Twigg

Got it, thank you.

Operator

The next question comes from Kai Korschelt [Bank of America Merrill Lynch]. Please state your company name followed by your question. Please go ahead.

Kai Korschelt

Yes, good afternoon. It’s Bank of America. The first one was, Peter, just to clarify your commentary around the EUV shipments next year. I think I heard you say there is, it’s realistic to expect 24 tools. What would be the sort of puts and takes on kind of whether you would ship capacity or maybe potentially, slightly less in terms of adoption and capacity.

And the second question was on the Chinese CapEx I think you said something on the video on your website, some of the data points that has been making the rounds of the press suggests that could be 10 of billions of dollars spend on new memory fabs in China. So I’m just wondering in terms of the phasing, timing or magnitude, how much visibility do you have on those projects? Thank you.

Peter Wennink

Yes, okay, thanks. On the 2018, the determining factor is not so much our capability or the performance of the tool. It is really as you can understand the next nodes of our customers have complexities in that are not only driven by our capability or our lithography capability. This is really based on the introduction timing of our customers. So when our customers, all our major customers make public statements about when they want to introduce their next nodes and start using EUV, we take those statements and actually we don’t only take public statements to be honest, we have very detailed discussions with those customers on those public statements and what that means.

So we get very detailed plans of when they need, what tool and when. And that is really driving let’s say realistic assumption that when we have 24 units to sell, we will sell 24 units when they stick to their plans. So this is basically what it is. There is nothing more to it than that. So customers will decide. And that could be that if one customer says, I need to for whatever reason, we need to do an introduction six months or later, there will be a six months rescheduling. That’s what really drives the business.

China CapEx. Yes, it’s interesting, I mean, we’ve also very – we have a lot of interest following every comment that comes out of China, on the tens of billions that will be invested in all kinds of fabs all over the place, but you also have to look at what impact that will have on our short-term business. Now short-term, yes there are many ceremonies of fab openings or fab extensions I would say, the number of real new fabs is limited. Or let’s say Chinese old companies, of course the foreign companies that open fabs in China, but I think they reference to the 10s of billions are really Chinese-owned companies.

That is definitely I promise, however, if we look at the next 12 months to 18 months, it is good. There’s some good logic opportunity, there’s some memory opportunity there, but it’s all within the realms of good business and not the extraordinary growth that some people are portraying. That will very likely happen. But it’s very likely also going to take a bit more time than the 2017, let’s say slash 2018 timeframe.

Kai Korschelt

Okay great. Thank you.

Operator

Next question comes from Sandeep Deshpande [JPMorgan]. Please go ahead please. State your company name followed by your question.

Sandeep Deshpande

Hi, this is Sandeep Deshpande, JPMorgan. Just a quick question, Peter on the order intake. I mean, in the fourth quarter you took orders for six EUV tools, at the same time, I mean we have some expectation that you will sign volume purchase agreements with some of your large customers for these EUV tools.

So, is it now that you will be taking these EUV orders as a normal part of the business as you seem to have done in the fourth quarter or are we to still expect volume purchase agreements in the next few months? And I have one quick follow-up question on the 2018 shipments.

Peter Wennink

Yes on the order intake in Q4, that was based on a volume purchase agreement for the – you could say the 3,400 delivery, it does not include yet the additional options that they need on those 3,400. So you could say if there’s a fully signed and closed volume purchase agreement with the customer, not entirely because the options are still under discussion, what they need and the economics of it.

But yes, those orders were indeed taken under the agreements that we have on the pricing and the pricing models. That’s just for one customer. I mean, other customers will follow suit, as we continue in 2017. And for those who will introduce EUV later, those VPAs will be also signed later on in 2018. So it’s, as you said, it’s the normal course of business.

Sandeep Deshpande

And then following on the 2018 shipments, I mean you’re going to have this capacity for 24 tools and potentially and then you’ve already got six of those orders at this point. By which point do you need to get all your order, so that capacity will be readied for the customer because I mean you’ve said in the past, that you take almost a year to ship these tools. And then there is a time which the customer takes to install the tool in their own facility and get it stabilized?

Peter Wennink

Yes. Well, the time to ship and install is about a year. So it’s not plus, plus. So it’s not for us to time as a year to ship the tool or what. Our time is we can ship an EUV tool, so we can install an EUV tool in about three months, three to four months. And we have currently and into a order cycle time in the factory of about six months. So overall for us it’s takes about nine months from start of the tool to get it installed at the customer side, not then the customer needs to of course start to qualify the production. The issue is in their supply chain and in their supply chain we need lenses, we need a large mechanical modules, that need to be reproduced and this is limiting our output capability right now.

However, having said that to your earlier questions, we are in very intense and deep discussions with customers on volume purchase agreements. And it is also clear that those customers need those tools at a certain moment day and time. And taking into account our cycle time reduction plans, it is not absolutely necessary throughout 2017 that we need to keep on to this two year timeline, that will go down, that will be shorter, because we’ll reduce the cycle time as volumes go up. However, to be able to ship 24 units in 2018, those systems need to be booked by the end of the year – so in this year, now if you’re going to ask me when do those orders come in is it Q1, is it Q2 or in early Q3 I don’t know yet and its not very important but what I do know is that if we need to ship 24 units by – in 2017 those orders need to be in.

Sandeep Deshpande

Thank you.

Operator

Next question comes from C.J. Muse [Evercore ISI]. Please state your company name, followed by your question.

C.J. Muse

Good morning, good afternoon. I’m with Evercore ISI. So I guess first question, can you walk through how we should think about the gross margin for EUV through calendar 2017 and particularly interested how we should think about the inclusion of deferred 100% margins through the year? Thank you.

Wolfgang Nickl

Okay.

Peter Wennink

Yes, I will take that, I don’t know if it’s for CJ I mean. We painted the picture at our Investor Day as well. The starting point is a gross margin if you take everything into consideration of about minus 75% in 2016. Our objective is to get this business breakeven from a gross margin perspective in 2017. And then in 2018, you will make another significant step forward we are thinking somewhere in the 20s also. Of course there are a few things that contribute to that and you are right, some of the catch-up revenue that essentially comes at no low cost, what will help but it also will help that this year we are shipping the 3,400 which has a less price of about 20 million higher than the 3,350. We are also going to continue to make a progress on the cost side, we still have significant amounts of fields upgrade that we have to do for no charge, E&O charges we have learning to do. We are making progress on that front as well.

And if you then taken into consideration also the service business were as you know we are charging per wafer out, but we got a mind growing installed base that is not productive in churning out a lot of wafers. So we are still spending a significant amount of money on this without revenue coming in. But if you take it all into consideration we are targeting around breakeven. As it relates to the total business we were about 45% gross margin in 2016. I think we are going to continue to make progress in both businesses EUV, going from minus 75% to about breakeven.

But also the non-EUV business because the mix is shifting towards applications and more higher value systems will make progress as well. But overall I think for your modeling purposes, you should assume that the total company gross margin will was somewhat go down because you’re growing the revenue significantly on the EUV line. So we should expect a little bit of a step back there before then in 2018. We are marching towards the 50% plus that we’re targeting for 2020.

C.J. Muse

Just as a quick follow-up there, are you thinking closer to like 43% or 44%. And then I guess, as my follow-up on the foundry side orders ex-EUV came in fairly weak I think sub EUR300 million in December quarter. And I guess how should we think about the timing of the pickup there is that simply turns were they will place the order upon your shipment and therefore really not an issue and how do we think about the trajectory as we contemplate 10, 7 nanometer ramp?

Wolfgang Nickl

Yes, without tying it down to a specific number, but I think with everything that we gave you between Peter on the shipments, on EUV and the margin I think you are on the – in the right ship code there on the gross margins relates to orders. First of all, we are thrilled be it in overall backlog of EUR4 billion. Having said that, the same story as in prior calls, we published the backlog because it gives you a decent structural view on what’s happening in the business you see memory picking up, you see a lot of EUV orders coming in.

But we always say that just merely looking at bookings or backlog should not be your main input barometer in the outlook, because if you know the order at the end of the day in particular for the more mature business is merely an administrative act. We have VPAs with all of our customers and we get every other week, we get a detailed sales forecast and order forecast against that. And that is what’s giving us the confidence in the numbers. So we will not the slightest bit disappointed about bookings last quarter.

C.J. Muse

Excellent. Very helpful. Thank you.

Operator

The next question comes from Timothy Arcuri [Cowen & Company]. Please state your company name, followed by your question. Please go ahead.

Timothy Arcuri

Cowen & Company. Thank you. I have two. I guess, Wolfgang, first of all in the presentation on the metrics around EUV, you definitely showed some continued improvement in availability. You had two tools that showed a four week average of greater than 90% versus one last quarter. But there was no improvement in productivity. Is that because it’s not your focus right now? I guess I would have thought maybe you had seen more than just one tool producing 1500 wafers per day over that three day period?

Peter Wennink

Let me answer that Tim. First of all, the reason why we put those metrics in there is one, to be able to communicate to you, but also to our customers. What we believed at that time when we created those metrics, the most relevant milestones were that customers used to get convinced that EUV was going to be the choice of the next generation leading edge litho production.

Having said that, meeting those targets – not only those targets, it was the continued, let say, showing off of those targets throughout the year that actually raised the customer’s confidence to the level those also publicly state we’re going to use EUV, and they follow that up with orders as you have seen. Now just for your information, we are over 200 wafers, which will actually provide as way more than 1500 wafers per day and that’s what we shown the customers. That’s all. It is about the confidence that we will be at the high volume production requirements by that time the customers need and that’s what shown with those targets.

The targets going forward – I would like to relate to other targets that they need for higher volume introduction, like I said in my introductory comments. It’s likely Deep UV where we’re moving into debt, in all direction like Sandeep said, this business as usual, we will be over – we have to be and we’ll be over 90% availability when they need it, when we start HPM production and we’ll be at the productivity of wafers per day as specified by the tool specifications, i.e. 125 wafers per hour.

This is where we are and this is why we’re absolutely confident that we’re going to get there and that’s why it is the last time, we are going to give you these targeted numbers because those milestones have been now met evidenced by their customer orders.

Timothy Arcuri

Got it. Okay, Peter, thank you. And then I guess as just as it relates to backlog on EUV. So you have 18 systems of backlog, you have slots for 12 this year. So obviously, six of those are going to ship next year. Since you have 24 slots, give or take next year, does that mean that backlog can only be 24 exiting this year or it is the policy such that you’re, – if you get an order even if it’s going to ship 18 months from now, you’re going to put in backlog, so that the backlog exiting this year can be actually a lot higher than the 24 slots that you have in next year. Thanks.

Peter Wennink

That’s correct. I mean like I said, we have currently, if you would – in 2016 we had 24-month lead time that will go down, but it’s not going to be a 12 months by the end of this year. So it’s very likely that they’re going to be 2019 orders in there.

Timothy Arcuri

Got it. Okay, Peter, thank you so much.

Operator

The next question comes from Amit Harchandani [Citigroup]. Please state your company name, followed by your question.

Amit Harchandani

Good morning and good afternoon. It’s actually Amit Harchandani from Citigroup. And thanks for taking my questions. So, if I may. Firstly, my question is with respect to the technical milestones that you refer to earlier. Could you maybe talk about what are the key areas of improvement that you’re working on within the tool that need to be completed this year or on the verge of being completed that would take you to the targets you’ve talked about for commercial introduction in terms of the technological progress.

And secondly, could you also give us a sense of what’s happening in the wider ecosystem, particularly around defectivity and say, pellicles, and any other complements within the ecosystem. If you could kindly share any updates around those? Thank you.

Peter Wennink

Yes. I make some of the notes. Yes, only the key areas of improvement. Well, it’s really focused on lifetime extensions of parts. So it’s the industrialization of those price, lifetime extensions, taking out some of the quality issues that we know what to do. That actually brings us to those targets that customers need for high volume introduction, 90% plus availability and productivity at spec.

On the ecosystem, I think two things, resist and pellicles. Resist, good progress and we get progress reports every now and then. And over the last couple of weeks we’ve got some good progress reports of photoresist. And on photoresist sensitivity on line edge roughly, data and information that give customers good confidence that by 2010 – end of 2018, 2019 we’re going to get what we want.

On the pellicle, we have started to outsourced pellicle production to a supplier that actually should make the pellicles for the industry for our customers. Initially, there was a process that yielded low because pellicle still had some defects on it on the pellicle itself, as you can imagine pellicle is a membrane sitting in front of the photomask, you don’t want any – a defect on that all pellicle because they’re big, they will actually print.

Now by the end of the year, we actually received first defect free pellicle, and also there you are seeing progress that everybody is looking for. It is not our main concern, what our concern is, yes, that the supply base of those pellicles will be maturing also, so we get a constant flow of defect free pellicles. But if you look at the progress that we have made in the last six months that gives us the confidence that also by the time where we need the edge volumes, the HVM requirements, we will be there.

Amit Harchandani

Thank you, Peter. Just a couple of clarifications on what you’ve said. Firstly, with respect to the technical progress with respect to your tool, just for that I understand correctly there are all incremental improvements really around lifetime extension, but there is no radical improvement that you need to do all of that is behind us in 2016. That would be a correct statement to make technically.

Peter Wennink

Correct.

Amit Harchandani

And secondly, is the topic of actinic inspection tools, when it comes to EUV behind us or does that still come up in your conversations that you think their workaround is pretty much accepted now by all the customers who are looking to move on with EUV?

Peter Wennink

That’s correct. I mean we do not have any discussions on actinic inspection at this moment and they work around. So we currently have either to the pellicle use already or the wafer inspection using EBM tools. That is really what the solutions are that customers are currently using. Now the discussion on actinic inspection tools over time and in the next decade might come back, but we’ll see how effectively current solutions are.

Amit Harchandani

Thank you very much.

Operator

Next question comes from Gareth Jenkins [UBS]. Please state your company name followed by your question. Please go ahead.

Gareth Jenkins

Yes, thanks. It’s Gareth Jenkins from UBS. One follow-up please and one question. Just a follow-up on memory, you’re slightly more positive tone on this, so this include in addition to the 1980s – that you’re talking about some KrF business. And secondly, I just wonder whether you could talk about your expectation in terms of conversion. The 7-nanometer node for your large foundry customers from 10. Thank you.

Peter Wennink

Gareth, on the last question, could you be a bit more specific on your last question on the conversion, what do you want to know?

Gareth Jenkins

I just like to know the sort of level of conversion that you expect between the 10 and 7 node, you had given the similarity or the commonality between the tools. So would you expect to be more or less than kind of we saw over a prior nodes?

Peter Wennink

Okay. On the memory, presumably, yes, it’s got, but only in 1980s. We always ship if you add some extra capacity some KrF, but going back to an earlier question, this is really backing up the installed capacity that was relocated to NAND, which were basically immersion systems, where they were upgraded in the NAND space. So, it’s predominantly an excuse, but we always have some level of capacity space that is in existing fabs, which also need some KrF, but it’s largely NXTs.

The level of conversion 10-nanometer to 7-nanometer – 10-nanometer, that’s always a level of conversations from 10 to 7, which would include upgrades. So the level of commonality from a platform point of view is always there, but it’s really the performance of overlay and focus that drives really upgrades. So, when there is a reuse of an existing body in the 10-nanometer space or a previous node on to the new node, then you see a upgrade business. And this is a part of the business that we are seeing – that we see growing. In 2017, where we indeed see the number of upgrades in the logic space, but also in the memory space from, let’s say previous platforms to the newest specification of the NXT platform really happening. And that is part of the business growth that we see in the services and options. So as not much different than previous nodes, it does lead to a lot of new business in terms of system upgrades.

Gareth Jenkins

Can I just follow-up and just ask what your expectations for the top 10s. I think you’ve always talked about wafer starts some 10 and 7 geometries combined. I wanted to – whether there’s been any change in the full process around the starts on the 10 and 7.

Peter Wennink

No, no, currently, not. The only thing that we can say is that of course, we discussed with customers their business and their plans. I only can say that the 10 plus 7-nanometer confidence that our customers have in being a big node driven by more than just the smart phone applications. I mean they are talking about and it’s real because, well about customers in the automotive space, customers in these space that is dealing with artificial intelligence and augmented reality, virtual reality, big data and big data analytics.

They are seeing customer applications in that space, and that is driving their confidence on the node sizes, and they keep repeating to us that, they get strongly believe based on what they see in the tape outs that are coming, that is going to be a big node.

Gareth Jenkins

Thank you.

Operator

Next question comes from Francois Meunier [Morgan Stanley]. Please state your company name followed by your question.

Francois Meunier

Yes, it’s Francois Meunier from Morgan Stanley. So yes, and some of the question around the gross margins and like billions of around it, but there is one I would like to understand a bit more. I think you guys have been talking about PPA of – when they gets impact. That seen of around €90 million, so it’s actually in the non-cash impact, so like when you guide for 47% gross margin in Q1, actually the cash gross margin is more like 48%, 48.2% or something for Q1. Is that the right way to look at it?

Peter Wennink

Yes, be careful with the cash because of other cash non-cash related items but in principle, you’re right, we’re guiding to about 47% and if you just look at the two elements one being the amortization of intangibles, we said that’s going to be about €40 million per year that’s linear, so it’s about €10 million and then we said there is €50 million that results from the revaluation of the inventory to a fair value or market value at the time of closing. We’ve got to work ourselves through this, and as you can imagine this is going to be a bit more skewed to the front of the year rather than the back of the year. And therefore there is as you state – probably closer 1.2% impact on the gross margin in Q1 or in other words, as we not done the acquisition and to deal with the purchase price allocation, we would have been north of 48% in the first quarter.

Francois Meunier

I got that clear.

Peter Wennink

But I wouldn’t associated with cash and non-cash because of other stuff.

Francois Meunier

There is also things going on, okay.

Peter Wennink

Yes.

Francois Meunier

Okay, very interesting. Thank you very much.

Peter Wennink

Francois, thanks.

Operator

Next question comes from Farhan Ahmad [Credit Suisse]. Please state your company name followed by your question.

Farhan Ahmad

Hi, Credit Suisse. Thanks for taking the question. I have a question related to EUV. What are some of the risk factors that you see going forward? Is there anything that you have to deliver for EUV to be adopted or should we take these orders as a sign that EUV is now at a point that we can count on its delivery in 2018. And also can you remind us again on what the lead time as for EUV going forward?

Peter Wennink

Yes. I think, ultimately, the approval – is when the customers give you an unconditional commitment to pay you a lot of money, which I think is happened. I think that decision, which I think most customers have been public about EUV, when they want to use it or how they want to use it. Just following this up by orders. So, I think it is true that as somebody asked a question earlier is that, what could be – what could happen to make 2018 a year where you’re not going to fully ship your production capacity.

In a way I just answered, one the things is, I don’t know the customer roadmaps might change, but what they’re telling us today and we know the number of layers that they want to use EUV on. Now we have to use that capacity. And only if a customer changes their minds, I think we all will change, but that’s not the case today.

A lead time. Yes, a lead time like I said lead time 2016 was just a 2-year, we had a supply chain that we have to kick out of hibernation. Well, they’re now awake. Look I can assure you. So lead times will also compress somewhat also throughout 2017. I’d love to have a lead time by the end of the year of about 18 months.

Farhan Ahmad

Got it. Thank you. And can you talk about how do you see the linearity of 2017. Do you see some of your peers have indicated like there is a stronger first half related to second half, is that something you see also. And related to the China 500K wave starts, is any of it hitting this year or next year?

Peter Wennink

Two questions. So on the linearity, yes, it’s too early to say. I mean, generally, we have lead times of about six months for our tools, so customers probably give us a very clear indication of the next six months, which looks very good. The rest of the year is a bit driven by expectations and so that’s always a bit more uncertain to a certain extent. So that might be the reason why some of our peers focus more on the first half. It’s just visibility.

On China 500K wave starts next year. We don’t see 500K wave starts next year it’s too much I mean, it will be there, in here but I said earlier is going to take a bit of time. With some of our customers, we’ve been talking about building new fabs now for 2.5 years, in that same timeframe, our logic customers built the fab and we’re shipping tools. We’re still talking about the other.

So we are that this has to kick into a different gear also. That’s 500K wave start next year is absolutely not what we expect good business. Yes, we will expect shipments into new pedestals for our tools into fab expansions and perhaps a new fab, but nothing to the level that you just mentioned.

Operator

Next question comes from Jagadish Iyer [Summit Redstone], state your company name followed by a question.

Jagadish Iyer

Summit Redstone. I’ve two questions. First, Peter, if you look at your immersion revenue systems. It has been pretty much stable through the last three years, and in fact has trended up. So just wondering if EUV started to progress. How should we think about the immersion system trajectory over the next 12 to 24 months. Then I have a follow-up.

Peter Wennink

Yes, the next 12 to 24 months I do believe that when you look at what is driving our customers business is this 10 nanometer logic and its memory, and that still needs those immersion systems. So I think next 12 to 18 months I don’t see I think you will see as a lot of change. Although, longer term when complexity of chip design increases, the number of layers will also go up.

The increase of the incremental areas are very much the critical ones, which is going to be EUV and as EUV progress in terms of maturity and productivity, also EUV will grow into the realm of Deep UV leading edge Deep UV but it’s about its all how you look at it and it is also, I think clearly discussed at our Capital Markets Day immersion and Deep UV will be with us forever.

And also means over the next 10 years or so we’re going to be very significant part of our business, for the next 12 to 18 months is going to be the majority part and the key part of our business given the fact that those nodes that they are being designed into harder nodes are we’re currently using and ramping, which is not in EUV node, 10 nanometer is an immersion node and high teens DRAM is an immersion node. So that will be with us for the next 12 to 18 months.

Jagadish Iyer

Okay, Then briefly so on the six EUV system orders that you got us VPA. Is it fair to conclude that you have met the 7 nanometer initial insertion specification with this key customer. Thanks.

Peter Wennink

Yes.

Jagadish Iyer

Okay, thank you.

Operator

Next question comes from Andrew Gardiner [Barclays], please state your company name followed by a question.

Andrew Gardiner

Good afternoon, it’s Barclays. Thank you, guys. Just one on to your outlook for 2017. You’ve given fairly sort of clear messaging around what you see on the logic space and on the memory space and of course, services and options continue to grow. Just the statement around significant revenue from EUV for the first time. If I go back to the Capital Markets Day in late of October, you seem to be indicating at that point something on the order sort of below €1 billion mark as a combination of rev rec at shipment as well as the deferred revenue coming through.

Is that still a reasonable assumption, given --, sort of given a sort of better visibility into and how you see EUV trending for this year? And also within services and options for this year now that HMI is closed the new in the integration process. What are your expectations for that business over the next couple of quarters? Thank you.

Wolfgang Nickl

Okay, I’ll take that Andrew. Hi, EUV, yes, what we said before continues to apply, we said we can ship a maximum of steady in tools, which is a 12 plus one carryover. Revenue recognition is now close to shipment, with shipment for a majority. And yes, there will be some catch-up revenue from last year, where we shipped systems with no revenue recognition. So without tying it down too much, but I think the number will have a one in for sure and some will NOLs of 1.2 is clearly within the realm of possibilities. Service and field options will continue to grow even if you stop by – that was excluding HMI, we grew a 7% to 8% of this year. And also based on some of Peter’s comments on the upgrades, we think it will grow at least by that level. It could go a 10% or so a year-over-year.

And then we have HMI, which are going in for like two months last year and we are not intending to break this out in the future. But you know from their stand-alone reporting that they should be somewhere in the 200 million zip code that is incremental. I think you will see us announcing new products during the year, but they will not lead to any significant revenue in the year.

So, EUV field options and services and HMI whole gross drivers and then you have the rest of the business that is stable and in some cases up a little bit. So, like we said in our prior remarks it should be a pretty good revenue year in 2017.

Andrew Gardiner

Thanks for the clarification.

Operator

The next question comes from Douglas Smith [Agency Partners], please state your company name followed by question.

Douglas Smith

Hi, it’s Doug Smith from Agency Partners. I’m wonder – can you break down the 18 EUV systems backlog into your foundry and memory and IDM groups?

Peter Wennink

Yes, we could but we generally say we’re not doing it, because it will be very customer specific, because you could easily say who is who. So that’s not what I want but there are few memory orders in there and that’s just less than a handful. And the rest is most is logic and IDM.

Douglas Smith

Okay. And just a clarification, you are saying that the six EUV orders in Q4 were all from one customer?

Wolfgang Nickl

No, there were five for one customer, one was an addition.

Douglas Smith

Okay. So five from one customer…

Wolfgang Nickl

One memory customer and one logic customer.

Douglas Smith

Okay. And the one that was in this group of five was what’s you call the kind of quality PPN?

Wolfgang Nickl

Sorry, quickly – I think that was all logic – sorry six were all logic, there were two customers from and one at five one and one.

Peter Wennink

On the 18 systems we have said before that, its five customers in total, but it’s not like only the five customers in total that have orders and with us.

Douglas Smith

Right. And if the one that had the five, which were I think that you call the kind of quality VPN?

Wolfgang Nickl

Yes.

Douglas Smith

Okay. Thank you.

Peter Wennink

Ladies and gentlemen, we have time for one last question. So if you are unable to get through as always feel free to contact the Investor Relations department will get back to you as soon as we possibly can to try to help. Now operator, if we can have the last caller, please.

Operator

Of course, sir. The final question comes from Robert Sanders. Please state your company name followed your question. Please go ahead, sir.

Robert Sanders

Yes. Good afternoon. Just a question about the 3400. So the shipments that customers have ordered, are you going to upgrade the source to 250 watt at a later stage and it’s a free upgrade. And then the second question would just be on the HMI business, it does seem to be tracking below expectations from June when you acquired it. I was just wondering, what’s the update there on the outlook and how that business is tracking? Thanks.

Wolfgang Nickl

Although Peter alluded there is no major source upgrade just cranking up the power as all that is not necessary, the source is the source, and will be capable of doing 250 watt at least, it’s going to be above 205 watts whereas 250 that we met because a 205 worth than 225 wafers per hour and that’s the throughput specification. That a 250 by the way is also not with this particular source design is not our end product. I think with this particular design, we can go higher. We can go 300 watts and above. On HMI below the expectations.

Peter Wennink

Yes, I mean there is no significant difference in what we have seen already during our due diligence time. And since this is a growing business, more importantly, the roadmap going forward. It’s well aligned not only within us and HMI more importantly also was a signal to you folks at the customers. So we’re looking forward to a significant opportunity like we said at our October call which could be up to a $1 billion by 2020.

Peter Wennink

Yes. Rob. And you have to remember that in 2017, we still have the majority of the HMI sales or you would call the standalone HMI sales. What we really looking at is, when you may remember the presentation that we had at the time of the acquisition that the area where we believe we will have a significant growth opportunity is the combination of the holistic lithography or the computational lithography competencies of ASML with the HMI capabilities, creating a new product. That is where we think there is going to be a big market and a big growth opportunity. And that’s not for 2017. It will be 2018 onwards.

Robert Sanders

Thanks a lot.

Peter Wennink

Okay. Yes. Thank you.

Craig DeYoung

Good. Well, thank you everybody on behalf of ASML’s Board of Management. We’d like to thank you for joining us in the call today. And operator, if we could have your formal conclusion to the call, we’d appreciate it. Thank you.

Operator

Of course, sir. Ladies and gentlemen, this concludes the ASML 2016 fourth quarter and annual financial results conference call. Thank you for participating. You may now disconnect your line.