Morgan Stanley Global Chipwatch - January 2005


Near-term fundamentals remain challenging and earnings risk remains high
Although we believe that end-market demand generally met expectations in the fourth quarter, a broad-based inventory correction and the need for a high level of turns business continued to promote a large number of negative earnings surprises, and we believe that the bias to earnings estimates is still negative.

Inventories need to decline further, but seasonally weaker demand makes this more challenging
Despite seeing a meaningful reduction in supply-chain inventories during the fourth quarter, we believe that the average semiconductor company still out-shipped the key end markets by 10?15 points in 2004, and we expect the inventory correction to continue to pressure results in the first quarter.

Excess capacity should pressure semiconductor prices and capital spending
A slowdown in global GDP growth and the ongoing inventory correction has led to excess capacity, and we expect it to promote a more aggressive pricing environment once the inventory correction is completed. In addition, it should pressure semiconductor capital spending, which we expect to decline 11% in 2005.

Fundamentals should bottom in 1H05 and we expect 8–12% semiconductor revenue growth in 2006
Despite our near-term concerns about growth rates, margins, and negative earnings surprises, we expect easier comparisons and a recovery in unit demand (once the inventory correction is completed) to support a reacceleration of revenue growth in 2H05 and 2006.

Recent decline suggests stocks have reconnected with fundamentals again
After reaching a 52-week low at 351 on September 8, the SOX index rallied sharply and outperformed the overall stock market until early December, even though fundamentals were deteriorating. Since then, the SOX has declined sharply and underperformed the broad market, but we view SOX 400 as an equilibrium level.

Global Industry Views on Page 8
Our favorite global stock idea is Samsung Electronics.

Morgan Stanley Global Chipwatch Part 1 of 1 (47 pages)