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A Rising Star on the Chipmaking Scene

By Richard Tortoriello In 2002, Netherlands-based ASML Holding became the third-largest supplier of semiconductor equipment by sales, surpassing Japan's Nikon Corp. And data from market research outfit VLSI Research show ASML (ASML) with 45% share of the important semiconductor lithography market in 2002, ahead of Japanese conglomerates Nikon (NIOC) with 25% share and Canon (CAJ) with 20%. In 2001, ASML had a 25% share, behind Nikon's 40%.

While part of this improvement may be due to relative weakness last year in the Japanese market, where Canon and Nikon dominate, we believe that ASML has also gained share due to the technological strength of its equipment. It also reports that every announced 300-millimeter (mm) fab -- the next-generation semiconductor manufacturing plants -- outside Japan has purchased its equipment.

ASML makes lithography equipment, known as step-and-scan systems, used to transfer circuit patterns onto silicon wafers. Lithography is one of the most critical steps in semiconductor production, and the second-largest semiconductor equipment market, worth $3.5 billion in 2002, according to VLSI.

FINER RESOLUTION. The lithography process uses a light source, typically in the ultraviolet light spectrum, along with a highly complex wafer exposure system to reproduce a circuit pattern on a light-sensitive material, or photoresist, that has been coated on the surface of a wafer. The photoresist is then developed, and the circuit pattern is etched into the wafer and further processed to form the chip's active and passive components.

The fineness of the electronic feature that can be resolved on the wafer depends upon the wavelength of light used by the lithography system. Today's most advanced lithography systems use 248 nanometer (nm) and 193 nanometer light wavelengths, which with special techniques are capable of resolving semiconductor features as small as 130nm and 90nm, respectively.

The move toward these complex 248nm and 193nm lithography systems, as well as a move to larger 300mm silicon wafers (from the previous leading-edge size of 200mm) has enabled ASML to increase the average selling price of its systems from about $5.5 million in 2000 to about $9 million in 2002.

FAVORABLE RULING. In 2001, ASML introduced its TwinScan product, which has a dual wafer stage that allows one wafer to be exposed while the next wafer is being aligned and prepared for exposure. The advantage of this technology is it eliminates virtually all downtime, allowing continuous wafer processing. To date, the TwinScan is the industry's only dual-stage lithography system.

In other developments, ASML recently divested its money-losing track (photoresist processing) and thermal operations, which should help it achieve profitability by the fourth quarter (ending December) of 2003. In addition, in March, 2003, ASML won a favorable ruling from the U.S. International Trade Commission in a patent-infringement suit that had been brought against it by Nikon.

ASML shipped 205 lithography systems in 2002, and 197 in 2001. We forecast that it will ship approximately 200 systems in 2003 and 270 in 2004. We expect that average selling prices of ASML's lithography systems will continue to rise gradually in 2004, as an increasing number of higher-priced 193nm systems are shipped. These advanced systems will be needed to pattern the next generation of chips.

POSITIVE SIGNS. The semiconductor-equipment market is in the process of recovering from a severe two-year-plus downturn that caused industry sales to fall 60%. We expect overall semiconductor-equipment spending to rise 5% to 10% in 2003, with better growth, perhaps as much as 20%, in 2004.

Bolstering our view are signs that spending on information technology has finally stabilized and has begun to rise slowly. Negative earnings preannouncements by technology companies have decreased. According to Thomson Financial, the ratio of negative to positive earnings preannouncements in the tech sector for the second quarter of 2003 (as of July 3) was 1.8 times, vs. 2.0 a year ago and 2.4 for the first quarter.

In addition, the technology and electronics component of durable goods rose 1.2% in May from April, the third straight monthly increase. Also, orders for semiconductor equipment, as tracked by trade organization Semiconductor Equipment & Materials International, have remained above January, 2003, lows for four consecutive months, indicating that the industry is stabilizing.

LESS PRICEY SHARES. ASML has reduced its headcount by over 25% since 2000 and is on track to achieve its goal of building cash to $1 billion by the end of 2003, from about $700 million in 2002. We expect it to lose 15 cents per share in 2003 and earn 60 cents per share in 2004, vs. a loss of 19 cents per share in 2002.

The shares, which traded at $10.74 on July 10, sell for 2.5 times sales, below the company's historical average of 3.7 times sales and an average 5.6 times sales for large-cap equipment makers.

On a price-earnings basis, ASML sells at 18 times our 2004 earnings per share estimate, vs. an average of 37 times for the four other large-cap wafer-processing-equipment makers, Applied Materials (AMAT), KLA-Tencor (KLAC), Lam Research (LRCX), and Novellus Systems (NVLS).

Our price target for ASML stock is $15, based on its historical average price-to-sales ratio of 3.7 times, using our 2003 sales estimate of $1.94 billion. With signs that a semiconductor industry upcycle is under way, and with ASML gaining market share, we at S&P have a 4-STARS (accumulate) recommendation and view the shares as attractive. Analyst Tortoriello follows semiconductor equipment stocks for Standard & Poor's

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