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Report Chills Chip Futures

A Merrill Lynch report released Monday may heave a wet blanket on two hot years of semiconductor sales, but it is not completely out of bounds.

The report expresses the analyst firm's doubts about whether chip manufacturers will be able to maintain the inventories needed to support their double-digit growth estimates for the next 12 months. Analyst Joe Osha said there is certainly a risk that instead of a third year of strong growth that the industry "moves closer to supply/demand equilibrium in 2004, and into oversupply in 2005."

"We believe that there's an increasing risk that buyers of semiconductors will seek to keep inventories under control for the remainder of the year," Osha said in the report. "That's especially true now that some end-market segments, most notably the cellular handset business, are less likely to encounter undersupply conditions in the second half of the year.

"If inventory levels were to remain static for the remainder of the year, which is admittedly a pretty downbeat assumption, the result would be negative for our unit growth target for 2004 as well as 2005. We believe that more modest inventory build assumptions could drive our unit growth estimates from 19 percent this year and 10 percent in 2005 to 13 percent this year and 8 percent in 2005."

The firm is also keeping an eye on other economic indicators, such as factory ISM (Industrial, Scientific, and Medicine) and the OECD (Organization for Economic Cooperation and Development), which Merrill said are at "high but stable levels."

Accordingly, the research firm said it must readjust its total forecasted 2005 revenue growth from 16 percent year over year to 6 percent.

But trade organizations are finding Merrill's numbers more fact than fiction.

John Greenagel, director of Communications with the Semiconductor Industry Association (SIA), said that, after two strong years of back-to-back sales, the market is due for a slow down. The San Jose, Calif.-based consortium reported an 18 percent growth period between 2002 and 2003 and recently updated its 2004 forecast to reach 28 percent over the 2003 estimates. That would establish the semiconductor sector as a $214 billion industry.

"This is hardly a disaster for the industry," Greenagel told internetnews.com. "People are free to draw whatever conclusions they want, but the industry won't go off the cliff -- especially when factory capacity is utilization above 90 percent in most products, but especially in the main categories."

The SIA estimates the industry will see approximately a 10 percent yearly growth rate and will be very lucky if it actually sees a full 10 percent. The group's current outlook for 2005 is 5 percent growth.

"I suppose there is a huge physiological impact going from 18 percent to 5 percent, but on a purely factual basis, we are not seeing a collapse in demand," Greenagel said.

The SIA initially predicted sales in 2004 to increase by 19.4 percent to $194.6 billion with a slight dip in 2005 and light growth in 2006. But in its annual forecast for 2004-2007 released last month, the trade group reported that it is anticipating sales of $223 billion in 2005, $221 billion in 2006 and close to $250 billion in 2007.

The Merrill report comes at the start of a week of earnings from Intel, , AMD and IBM . The companies are expected to report better-than-average earnings for the quarter, but analysts will be keeping a close eye on each company's future statements to determine how the summer selling season should shape up.

Merrill's Osha noticed that the relationship between stock price performance and the rate of growth in the semiconductor business has broken down, which supported a continued positive stance despite an April/May peak in the industry's rate of growth.

"Any weakness in average selling prices will feed through quickly to profit margins and earnings," he said. "We believe that the risk of a material downward adjustment in the financial outlook for the semiconductor business is higher now than at any point since early 2002. Additionally, we think that we're closer to a peak in margins and earnings than we previously expected."

Greenagel said that it may be too early to determine a trend and much more should be revealed after the next two weeks of earnings and during the SIA's November forecast for 2004.