Emerging Tech0705

77
Comment Please see analyst certification and other important disclosures starting on page 73. Page 1 Industry Equity Research North America Morgan Stanley does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Customers of Morgan Stanley in the United States can receive independent, third-party research on the company or companies covered in this report, at no cost to them, where such research is available. Customers can access this independent research at www.morganstanley.com/equityresearch or can call 800-624-2063 to request a copy of this research. Industry Overview July 15, 2005 [email protected] [email protected] [email protected] [email protected] [email protected] [email protected] Emerging Technology Trends [email protected] [email protected] [email protected] [email protected] [email protected] [email protected] [email protected] [email protected] [email protected] [email protected] [email protected] [email protected] [email protected] At a recent offsite, Morgan Stanley US tech analysts presented thoughts on emerging technology trends Ten years into the launch of the commercial Internet, we believe we have entered a new period of tremendous global innovation and change (read growth and disruption). Our presentations touch on some of the trends we will continue to focus our research on, including wireless and consumer electronics semiconductors; wireless Internet; VoIP; broadband Internet; digital music; on-demand software; security; biometrics and offshoring. Common links for the themes are: 1) connectivity; 2) productivity; 3) global acceptance; and, to an extent; 4) consumer usage A tremendous amount of technology-related change has occurred over the past decade. That said, we believe the degree and pace of change is accelerating - it appears that the events of the last ten years were simply a set up for what’s about to come. We will endeavor to stay ahead of the trends and determine which companies will win…and which companies will lose. Overweight-rated companies that match the trends highlighted in this report include… Apple, Cadence Design, Cisco, Cogent, Google, Motorola, NVIDIA, Polycom, RSA Security, salesforce.com, Tata Consultancy Services, and Yahoo!. All of Morgan Stanley’s equity research reports are available on the Internet through Client Link at https://secure.ms.com . If you wish to receive this service, please contact your institutional sales representative. Additionally, this report (along with other technology overview reports) is available at: http:// www.morganstanley.com/techresearch/ GICS SECTOR INFORMATION TECHNOLOGY Strategist's Recommended Weight 13.9% S&P 500 Weight 15.2% Technology

Transcript of Emerging Tech0705

Page 1: Emerging Tech0705

Comment

Please see analyst certification and other important disclosures starting on page 73.

Page 1

Industry

Equity Research North America

Morgan Stanley does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Customers of Morgan Stanley in the United States can receive independent, third-party research on the company or companies covered in this report, at no cost to them, where such research is available. Customers can access this independent research at www.morganstanley.com/equityresearch or can call 800-624-2063 to request a copy of this research.

Industry Overview July 15, [email protected] [email protected] [email protected] [email protected] [email protected] [email protected]

Emerging Technology Trends

[email protected] [email protected] [email protected] [email protected] [email protected] [email protected] [email protected] [email protected] [email protected] [email protected] [email protected] [email protected] [email protected]

• At a recent offsite, Morgan Stanley US tech analysts presented thoughts on emerging technology trends Ten years into the launch of the commercial Internet, we believe we have entered a new period of tremendous global innovation and change (read growth and disruption). Our presentations touch on some of the trends we will continue to focus our research on, including wireless and consumer electronics semiconductors; wireless Internet; VoIP; broadband Internet; digital music; on-demand software; security; biometrics and offshoring.

• Common links for the themes are: 1) connectivity; 2) productivity; 3) global acceptance; and, to an extent; 4) consumer usage A tremendous amount of technology-related change has occurred over the past decade. That said, we believe the degree and pace of change is accelerating - it appears that the events of the last ten years were simply a set up for what’s about to come. We will endeavor to stay ahead of the trends and determine which companies will win…and which companies will lose.

• Overweight-rated companies that match the trends highlighted in this report include… Apple, Cadence Design, Cisco, Cogent, Google, Motorola, NVIDIA, Polycom, RSA Security, salesforce.com, Tata Consultancy Services, and Yahoo!.

All of Morgan Stanley’s equity research reports are available on the Internet through Client Link at https://secure.ms.com. If you wish to receive this service, please contact your institutional sales representative. Additionally, this report (along with other technology overview reports) is available at: http:// www.morganstanley.com/techresearch/

GICS SECTOR INFORMATION TECHNOLOGY Strategist's Recommended Weight 13.9%S&P 500 Weight 15.2%

Technology

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Technology – July 15, 2005

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Morgan Stanley Global Technology Research TeamHardware U.S. Enterprise Systems & PC Hardware Rebecca Runkle ([email protected]) (212) 761 6466 Kathryn Huberty ([email protected]) 6249 Fei Chen ([email protected]) 0227 U.S. EMS/Components/Distribution Bernie Mahon ([email protected]) (212) 761 6274 Aaron Husock ([email protected]) 7678 Tatiana Feldman ([email protected]) 7134 Japan Electronic Components Tomohiro Murata ([email protected]) +81 3 5424 5341 Mikiko Kayama ([email protected]) 5924 Asia/Pacific Systems and PC Hardware Ellen Tseng ([email protected]) +886 2 2730 2864 Asia/Pacific Hardware Components/ODM Evelyn Ou ([email protected]) +886 2 2730-2866 Jasmine Lu ([email protected]) 2870 Bonnie Chang ([email protected]) 2861 Asia/Pacific Hardware Components Shawn Kim ([email protected]) +822 399 4939 Jonathan Rhee ([email protected]) 4846 Asia/Pacific TFT LCD/DRAM Frank Wang ([email protected]) +886 2 2730-2869 China Technology Viktor Ma ([email protected]) +852 2848 5903 Flora Lau ([email protected]) 5636 Danita On (danita.on@morganstanley) 5214

Communications U.S. Communications Equipment Scott Coleman ([email protected]) (212) 761 6055 John Marchetti ([email protected]) 8940 David Feinberg ([email protected]) (415) 576 2189 Europe Telecom Equipment Adnaan Ahmad ([email protected]) +44 (20) 7425 9227 Peter Dionisio ([email protected]) 3504

Rupert Lion ([email protected]) 3436 Asia/Pacific Media/Entertainment/Publishing Minyan Liu ([email protected]) +852 848 6729 Asia/Pacific Hardware Components Shawn Kim ([email protected]) +822 399 4939 Jonathan Rhee ([email protected]) 4846 China Technology Viktor Ma ([email protected]) +852 848 5903

Consumer Electronics Devices Asia/Pacific Technology Sunil Gupta ([email protected]) +65 6834 6732 Praveen Choudhary ([email protected]) 6744 Japan Electronics Masahiro Ono ([email protected]) +81 3 5424 5362 Shima Nakao ([email protected]) 5378 Kayo Sano ([email protected]) 5332 Tomohiro Murata ([email protected]) 5341 Mikiko Kayama ([email protected]) 5924 Naoki Sato ([email protected]) 5927 Kazuo Yoshikawa ([email protected]) 5389 China Technology Viktor Ma ([email protected]) +852 848 5903

Internet & PC Applications Software U.S. Internet & PC Applications Software Mary Meeker ([email protected]) (212) 761 8042 Brian Pitz ([email protected]) 4133 Brian Fitzgerald ([email protected]) 4276 Ramji Srinivasan ([email protected]) 6281 Dan Silver ([email protected] ) 4967 Europe Internet & Media Javier Marin ([email protected]) +44 (20) 7425 3503 Edward Steel ([email protected]) 4486 China Internet Richard Ji ([email protected]) +852 2848-6926 Korea Internet Services Mitchell Kim ([email protected]) +82 2 399 4936

Semiconductors U.S. Semiconductors Mark Edelstone ([email protected]) (415) 576 2381 Louis Gerhardy ([email protected]) 2391 Harlan Sur ([email protected]) 2359 Sonia Kimotsuki ([email protected]) 2388 Jay Iyer ([email protected]) 2607 Sanjay Devgan ([email protected]) 2382 U.S. Semiconductor Capital Equipment Timm Schulze-Melander ([email protected]) (415) 576 2324 Sashin Shah ([email protected]) 2615 Europe Semiconductors/Semi Cap Equipment Stuart Adrian ([email protected]) +44 (20) 7425 3299 Kirsten Parker ([email protected]) 8617 Rudolf Dreyer ([email protected]) 9895 Japan Semiconductor Production Equipment Naoki Sato ([email protected]) 5927 Kazuo Yoshikawa ([email protected]) 5389 Aya Kurita ([email protected]) 5334 Asia/Pacific Semiconductors Keon Han ([email protected]) +822 399 4933 Jonathan Rhee ([email protected]) 4846 China Technology Viktor Ma ([email protected]) +852 2848 5903 Asia/Pacific Technology Sunil Gupta ([email protected]) +65 6834 6732 Praveen Choudhary ([email protected]) 6744

Software & IT Services U.S. Computer Services & IT Consulting David Togut ([email protected]) (212) 761 6388 Charles Murphy ([email protected]) 4990 Laurie Kennedy ([email protected]) 7038 Dhruv Chopra ([email protected]) 3867 U.S. Specialized IT Services Julie Santoriello ([email protected]) (212) 761 8582 Matthew Spiegelman ([email protected]) 4130 Xuying Chang ([email protected]) 4217 U.S. Enterprise Software Ross MacMillan ([email protected]) (212) 761 0156 Andrew White ([email protected]) 6126 Keith Weiss ([email protected]) 4149 U.S. Securities Software Peter Kuper ([email protected]). (617) 856-8751 Brian Essex ([email protected]) 8753 Europe Software & IT Services Gary Rollo ([email protected]) +44 (20) 7425 4619 James Dawson ([email protected]) 9646 Jonathan Tseng ([email protected]) 6609 Japan Software & IT Services Masaharu Miyachi ([email protected]) +81 3 5424 5321 Hiroko Ando ([email protected]) 5324 India Technology Anantha Narayan ([email protected]) +91 22 209 7161 Parag Gupta ([email protected]) 7915

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Technology – July 15, 2005

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Emerging Technology Trends Introduction The technology landscape may be going through a period of change at a pace not ever witnessed. The Internet’s expansion helped drive what we have called “a boom ! bust ! boom-let period for new-company creation and a boom-let ! bust ! boom period for wealth creation.” That said, the underlying trend of technology investment has remained relatively constant (see Exhibit 1). The unrelenting stream of private investment may be one indisputable data point - not only has venture capital remained healthy throughout the past ten years, in the midst of the bubble bursting, technology actually increased as a total percentage of all venture capital investments and has remained above levels seen during the increased attention in the late 90’s.

1999 and 2000 were clearly very aggressive years for venture investment. While a large portion of the those investment dollars will never generate a return, a relevant portion drove investments that have been developed, cured and are being converted into products / services. It's notable that if we look at the four year period before 1999 and compare the aggregate tech venture investment of $20B with the four year period after 2000 when aggregate tech investment was $50B - overall tech investment rose 150% for the period.

Exhibit 1

US Venture Capital Technology Investment Relative to Total Venture Capital Investment

0%

20%

40%

60%

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Semiconductors

Computers andPeripherals

IT Services

Networking andEquipment

Software

Source: PricewaterhouseCoopers/Thomson Venture Economics/National Venture Capital Association MoneyTree™ Survey

Exhibit 2

US Venture Capital Technology Investment Relative to Total Venture Capital Investment (US$ in Millions)

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004Software $1,120 $2,249 $3,339 $4,496 $10,242 $23,587 $10,015 $5,147 $4,228 $5,014Semiconductors 224 288 593 605 1,224 3,531 2,211 1,438 1,626 1,986Networking Equip 328 598 989 1,486 4,508 11,643 6,059 2,448 1,730 1,546IT Services 176 454 624 1,080 4,120 8,637 2,438 1,113 760 718Computers & Periph 347 400 392 368 826 1,731 656 348 358 535Total Tech $2,195 $3,990 $5,937 $8,034 $20,920 $49,128 $21,378 $10,495 $8,701 $9,800

Other 5,658 7,004 8,710 12,869 32,653 55,730 19,455 11,044 10,513 11,198

Total $7,853 $10,993 $14,647 $20,903 $53,573 $104,858 $40,833 $21,538 $19,214 $20,998

1995-1998 Total Tech $20,1552001-2004 Total Tech $50,374 Source: PricewaterhouseCoopers/Thomson Venture Economics/National Venture Capital Association MoneyTree™ Survey There are multiple other data points that suggest we are in the midst of a groundswell of technology innovation and growth. The headlines tell the stories (whether it’s the acceptance of blogging, podcasting or investments in broadband over power lines [BPL]) and the data does the same (see The Global Technology Data Book at: http://www.morganstanley.com/institutional/techresearch/global_techdatabook0605.html) Portable computing devices are quickly becoming more powerful, heavier draws on the rapidly-expanding wireless Internet; entrepreneurs are selling everything from cakes to cars over the Internet…Technology is indeed a robust investment opportunity.

Unfortunately, successful investment is more demanding. As much as we would like it to be a “rising tide lifting all boats phenomenon,” it isn’t. For public market investors, it is a stock pickers market - ever since the NASDAQ pierced the 2,000 level over four years ago (week of March 15, 2001) it has been unable to free itself from the gravity pull of that surface for more than 10% upside. Yet stock picking is an essential key to making money. And that rule must be applied even within so-called “hot” sectors. For example, that same week of March 15, 2001 where the NASDAQ pierced 2,000, Checkpoint Software (CHKP, Underweight-V, $21) closed at $63.19. Today the stock is worth just one-third of that at $21 per share. Yahoo (YHOO, Overweight-V, $37) on the other hand has leapt five-fold - having gone from under $8 to nearly $40 over the same time period.

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Exhibit 3

CHKP vs. YHOO: Price Performance Past 5 Years

'01 '02 '03 '04 '05

20

40

60

80

100

120

10.00

20.00

30.00

40.00

50.00

60.00

70.00

21.21 -0.14 -0.66% 03:03:31 PM 7/14/2000 - 7/13/2005

Check Point Software Technologies Ltd. (Right) Yahoo! Inc. (Left)

Source: FactSet. Within this report, we have summarized a number of key trends across the technology landscape to give investors a relatively seamless reference to identify, if not capitalize on these trends. From wireless, to broadband to VoIP, there are concurrent threads running through each sector (never mind the software and security to maintain performance). It is our intent to use these specific trends to identify some of the potential winners most impacted by these emerging trends. Our first pass list follows.

Wireless / Consumer Electronics Semiconductors NVIDIA (NVDA, Overweight-V, $28, Edelstone): In the consumer electronics space, NVIDIA has leveraged its expertise in graphics processing to deliver leadership products in the game console market (PlayStation 3), cellular handset market (through its wireless media processor family), and consumer desktop/notebook market. From a longer term perspective, we believe the company is solidly positioned to capture more silicon and dollar content in consumer electronics products as digital media processing and broadband communications requirements continue to proliferate.

Cadence Design (CDN, Overweight-V, $15, Sur): We believe Moore’s Law will help serve as a key enabler in the consumer electronics market as products integrate more features, functionality, and software into fewer integrated circuits. We believe Cadence is solidly positioned to benefit from the increasing chip and system complexity as they provide the advanced chip design software tools to enable complex digital and mixed signal chip designs. Additionally, the company’s leadership in chip and system-level verification tools should help customers

speed time-to-market by enabling hardware and software co-verification in a single integrated platform.

Wireless Internet Motorola (MOT, Overweight-V, $19, Coleman): In the short-term, Motorola is poised to capture mobile handset market share in China and Western Europe. Over the next few years, Motorola’s experience across wireless, broadband, and video positions it well for how networks evolve, services converge, and consumers’ demand “any content, anywhere.”

VoIP Cisco (CSCO, Overweight-V, $20, Coleman / Marchetti): Cisco has not only has leveraged its dominance of the enterprise networking market into a leading position in the enterprise voice market with its IP-PBX offering, but is also a major participant in the consumer VoIP market with its Linksys product offering. Going forward, we expect Cisco to be the main beneficiary of functional integration within enterprise networking equipment, like VoIP and security operation built directly into routers and switches.

Polycom (PLCM, Overweight-V, $16, Coleman / Marchetti): Polycom benefits from VoIP in two ways. First, it supplies VoIP handsets to several smaller PBX vendors, IP conference phones to Avaya, Cisco and Nortel, and has joint development agreements with Avaya, Microsoft, and Nortel for voice and video products. VoIP the fastest growing aspect of Polycom’s business over the past year. Second, the proliferation of VoIP networks drives video-over-IP deployments (i.e., V2oIP) as the underlying IP network lowers total cost of ownership for video and improves ease-of-use.

Broadband Internet Google (GOOG, Overweight-V, $296, Meeker / Pitz): If Google continues to execute in online advertising as well as Web products/services innovation, it should be well positioned to benefit from (and help drive) ongoing, secular Internet user, usage and monetization growth.

Yahoo! (YHOO, Overweight-V, $37, Meeker / Pitz): Yahoo! should continue to be a beneficiary of the share shift to online advertising, both in branded advertising and

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sponsored search. In our view, Yahoo! should be primed to capture share of both offline and online ad dollars.

Digital Music Apple (AAPL, Overweight, $38, Runkle / Huberty): Apple isn’t likely to stand still in the digital consumer market, and we believe the company is likely to release new iPod devices between now and year-end. Based upon Apple patent applications, job openings, Apple’s current strategy and user trends, Apple should introduce wireless and video-based product over the coming 12+ months. These features, when combined with the iTunes, iPod and Mac platforms, should continue to differentiate AAPL’s offering and maintain the company’s lead in the burgeoning convergence market.

On-Demand Software salesforce.com (CRM, Overweight-V, $24, MacMillan): Salesforce.com is the leader in the On-Demand software market, which is gaining share over the traditional enterprise software model. Subscription revenues at salesforce.com have grown over 80% Y/Y for the past 6 quarters and the company has been winning hands-down in the On-Demand CRM market for some time (it added more than 2X the number of subscribers in its last reported quarter than Siebel On-Demand did in its entire last year). We expect revenue growth to decelerate over coming quarters, as growth in ASP and the subscriber base begins to plateau, but we think the company’s guidance is conservative. We are encouraged by emerging opportunities within enterprise customers, new signings (such as Merrill Lynch), the validation provided by the strategic partnership with Accenture, and, longer-term, by the potential of the company's vision — becoming a platform, where ISVs and customers write applications on top of a managed, shared, secure database.

Biometrics Cogent (COGT, Overweight-V, $40, Santoriello): Cogent is the first, pure-play, publicly traded biometric systems provider with a solution that is already mainstream and a business model that is both high growth and high profit today. Cogent could prove to be a unique, long-term investment opportunity for four reasons: 1) technology and price/performance leadership, 2) high barriers to entry, 3) opportunities for commercial adoption, and 4) strong revenue and EPS growth.

Security RSA Security (RSAS, Overweight, $17, Kuper): RSA's core products focus on authentication which remains a cornerstone of security. With a strong foundation of established authentication technology we do not see the death of the token at hand as others have predicted. RSA stands to benefit from numerous trends we have identified in our sector. These include embedded technology, inclusion/exclusion, and data protection. With the ability to provide alternative authentication form factors (USB tokens, smart cards, etc.) to products experiencing competition, the company continues to work on building out its complimentary web access and single sign on businesses. Current fears of data leakage in the consumer and enterprise markets make a good case for the benefits of strong authentication. The consumer market appears to be gaining some momentum as evidenced by the popularity of the company's E*Trade tokens and the potential for authentication revenue from Microsoft. Core business concerns such as token volume erosion and pricing pressure are already built into our model.

Offshoring

Tata Consultancy Services (TCS.BO, Overweight-V, $29, Narayan): Over the past twelve months, we have seen strong growth in offshore demand and we believe a disproportionate share of revenue growth has gone to larger companies. TCS is the largest provider of offshore IT services and should continue to grow ahead of industry rates. TCS has the largest proportion of fixed-price business among its large offshore peers and has among the highest operating margins (excluding the domestic CMC business) relative to peers. This is despite higher proportion of onsite revenue and higher client concentration. In our view, this reflects solid execution of fixed price business. We view the large proportion of fixed price and solid execution positively as we believe that more and more offshore work, especially large-sized projects, will gravitate towards being fixed price in nature. The stock trades at 15%+ discount to top peers which presents an opportunity in our view.

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Wireless and consumer electronics are two key verticals that should deliver some of the most attractive new product cycles in the semiconductor industry over the next 5 years

Equity ResearchWireless, Cons. Elec. Semis

Morgan Stanley Technology Research

1

Wireless & Consumer Electronics SemiconductorsPresented by Louis Gerhardy, Harlan SurCovered by Mark Edelstone, Louis Gerhardy, and Harlan Sur

Integration of wireless regimes into a seamless global service remains a major opportunity

Equity Research Wireless, Cons. Elec. SemisMorgan Stanley Technology Research

2

• Wireless semiconductors represented about 21% of the semiconductor industry in C2004 and should be one of the fastest growing semiconductor end markets over the long run as innovations in satellite, WWAN, WMAN, WNAN, WLAN, and WPAN are introduced.

• We focus on wireless handsets that represent about 70% of the wireless semiconductor opportunity. Handsets are the likely point of convergence for (a) the disparate wireless services offered today and (b) consumer electronics.

-

10,000

20,000

30,000

40,000

50,000

60,000

70,000

2002 2003 2004 2005 2006 2007 2008 2009

Mill

ions

of $

Other Mobile Communications

Mobile Comm Infrastructure

Wireless LAN AccessPoint/Bridge

Wireless LAN Client Access

Wireless Broadband Access

Pagers & Messaging Devices

Mobile Handsets

Digital Cordless Phones

Analog Cordless Phones

Nomadic

Cordless

Fixed

Data Rate

2G(IS-95,

Cellular)

Mobility

High

PSTN Phone

Cordless WLAN

Broadband (xDSL)

DMB3G

(W-CDMA)

Service PositioningService Positioning

2.3GHzWibro

Nomadic

Cordless

Fixed

Data Rate

2G(IS-95,

Cellular)

Mobility

High

PSTN Phone

Cordless WLAN

Broadband (xDSL)

DMB3G

(W-CDMA)

Service PositioningService Positioning

2.3GHzWibro

Wireless Semiconductors

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It’s harder to send bits through the airwaves than through copper wires

Equity Research Wireless, Cons. Elec. SemisMorgan Stanley Technology Research

3

The Fundamental Challenge/Opportunity

Technology Cost/Megabyte

Cable/DSL 1x

CDMA2000 1x EV-DO ~3x

CDMA2000 1x ~7x

WCDMA/UMTS ~8x

GPRS ~40x

Source: Morgan Stanley estimates and Qualcomm

0

1

10

100

1,000

10,000

100,000

1970 1975 1980 1985 1990 1995 2000 2005Th

eore

tical

Dow

nloa

d (k

bps)

Wireline

Wireless

300bps

2.4kbps

9.6kbps

1.2kbps

56kbps28.8kbps

128kbps

100MbpsVDSL2

3MbpsCable

9MbpsADSL

14.4kbps

9.6kbps

64kbps

153kbps

625kbps

2.4Mbps

• The cost to send a bit of data through the airwaves (versus a piece of copper) is higher. Minimizing the price differential through technology innovation (cost reduction) is a key opportunity.

• Disparate wireless services need to be integrated to provide seamless and uninterrupted sessions. Semiconductor companies providing a complete solution may take all.

• New modulation and air interface schemes are increasing the bandwidth and spectrum efficiency.

OFDM and OFDMA are poised to deliver more wireless services

Equity Research Wireless, Cons. Elec. SemisMorgan Stanley Technology Research

4

Wireless Semiconductor Technology Evolution

1G 2G 3G 4G 5GAMPS TDMA/AMPS CDMA/TDMA OFDM/CDMA ?/OFDM

AMPS CDMA/AMPS CDMA/CDMA OFDM/CDMA ?/OFDM

Note1) Standards based on TDMA technology include GSM, GPRS, IDEN, and TDMA2) Standards based on CDMA technology include CDMA2000, WCDMA, UMTS, etc.

Technology Evolution• Getting the modulation and access scheme right is

critical to success in the baseband (or DSP) market.

• The baseband revenue opportunity ranges from 25% to 50% of the semiconductor opportunity in a wireless handset.

• We do not believe innovation stops with CDMA, and many standards based on OFDM technology are emerging and worth monitoring very closely.

Technology Technology

- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -

……. Standards ……. Standards …….

3G XGTDMA-Time Division Multiple Access

TDMA

2GOFDMA=Orthogonal Frequency Division MultiplexingCDMA-Code Division Multiple Access

CDMA

OFDM

802.

11 W

LAN

FLO

Qua

lcom

m

802.

20 F

LASH

-OFD

M F

LAR

ION

802.

16 W

IMAX

TD-S

CD

MA

WC

DM

A

CD

MA

2000

1X

EV-

DO

Rev

. 0/A

CD

MA

IS95

A/B

IDEN

TDM

A

GPR

S

GS

M

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More innovations beyond modulation and access are needed to drive traffic to wireless

Equity Research Wireless, Cons. Elec. SemisMorgan Stanley Technology Research

5

Other Key New Product Areas• Analog: Battery management (charging and protection), voltage regulation, DC/DC conversion,

power supervision, load switching, port power, and current limiting. (Linear Technology, Maxim, National, Semtech,Texas Instruments)

• Applications Processors: DSP and microprocessors, 3D graphics, MP-3, digital camera. (ATI, Nvidia, Qualcomm, Texas Instruments)

• Image Sensor: Higher resolution (CMOS versus charge coupled devices (CCD). (Agilent, Cypress, MagnaChip, Micron, OmniVision)

• Location: Global Positioning System (GPS), E-OTD, TDOA, AOA, GLONASS, and GALILEO. (Motorola, Qualcomm, SiRF)

• Magnetic Storage: Low power/small form factor for HDDs. (Agere and Marvell)• Memory: DRAM, NAND, PSRAM. (AMD, Cypress, Intel, Micron, SanDisk, ST Micro)• Packaging: Multiple semiconductor devices in a single package. (SIP, MCM, MCP) and stacked die. • Radio Transceivers: CMOS radios, CMOS power amplifiers, new frequency bands, MEMS. (Atheros,

Infineon, Qualcomm, Silicon Labs, Texas Instruments)• Streaming: MPEG-4 and more sophisticated audio coders/decoders. (Broadcom, Qualcomm, Texas

Instruments)• TV: Satellite to tower to handset (FLO, DVB-H) or satellite to handset. (DMB).

Sanyo SCP-5500

Profits in wireless semis concentrated at Qualcomm and Texas Instruments

Equity Research Wireless, Cons. Elec. SemisMorgan Stanley Technology Research

6

For Now, a Wireless Duopoly• Most wireless semiconductor companies (ANAD,

RFMD, SWKS, TQNT,…) orbit around Qualcomm and Texas Instruments who control the “heart” of a cell phone…..and a majority of the profits.

• Qualcomm held ~21% unit share of the wireless handset baseband market in C2004 and realized about $2B in pre-tax profit from this business ($900MM from semiconductors an $1.1B in licensing).

• Texas Instruments’ C2004 unit share was likely >2x the size of Qualcomm’s and TI realized about $800MM in pre-tax profit from wireless.

• No coup d’etat just yet, but a number of existing and new wireless semiconductor/technology innovators are worth watching closely.

Texas

Qualcomm

Instruments

RFMD

ANAD

TQNT

SWKS

FSL

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We see deceleration in global wireless handsets in 2005 and 1H06 as gross adds and replacement demand cool off

Equity Research Wireless, Cons. Elec. SemisMorgan Stanley Technology Research

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Highlights and Risks

• Innovation, execution, and time-to-market.

• Service provider driven model.

• Consumer driven market.

• Political.

1999 2000 2001 2002 2003 2004E 2005E

Total Wireless Subscribers 482 728 960 1,160 1,401 1,693 1,977 New Subscribers 170 247 232 200 241 292 284

Y/Y Growth 58% 45% -6% -13% 20% 21% -3%Forecasting slowing new subscriber growth

Total Handset Sales (units) 295 415 413 427 520 674 730Y/Y Growth (Units) 68% 41% -0% 3% 22% 30% 8%

Replacement Units 125 169 182 227 279 382 446Y/Y Growth (Units) 82% 35% 8% 25% 23% 37% 17%

Forecasting replacement rate will slow

Replacements % Total 39% 42% 41% 44% 53% 54% 57%

WCDMA units 3 22 51WCDMA Average Selling Price $475 $400 $321 Price too high for major unit

upside in 2005 and 1H 2006

Source: Morgan Stanley Estimates

Incumbents must innovate and out-execute newcomers to maintain share

Equity Research Wireless, Cons. Elec. SemisMorgan Stanley Technology Research

8

Conclusion-Wireless Semiconductors• There are significant opportunities for innovation in wireless semiconductors and a virtual flood of

new product cycles await the winners. Incumbents will likely get upset if they do not constantly innovate and out-execute the competition.

• More bandwidth and higher levels of spectrum efficiency require new modulation and access schemes. These capabilities reside in baseband integrated circuit that represents the “heart” of a cell phone and the point for forward integration.

• Beyond the baseband and DSP, many new products and technologies are emerging to reduce cost, add features, or facilitate seamless service.

• Wireless semiconductor companies will likely need to rapidly expand the breadth of their capabilities to help drive the convergence of a variety of wireless services (satellite, WWAN, WMAN, WLAN, WPAN) and the integration of consumer electronic devices (digital camera, MP-3, GPS, electronic wallet, etc.).

Page 10: Emerging Tech0705

Technology – July 15, 2005

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Page 10

FCC DTV mandate, popularity of digital video recording drive digitalization of audio and video MP3 players should continue to grow as price per MP3 megabit continues to decline

Equity Research Wireless, Cons. Elec. SemisMorgan Stanley Technology Research

9

Emerging Trend Highlights: CE Semis•Wireless Broadband to and in the home

– WiMAX (to the home), MIMO WLAN (in the home), UWB (between devices)•Digitalization of the A/V infrastructure

– Digital TV, MP3, Home media servers, DSC•Home control/automation/security

– ZigBee (802.15.4), intelligent sensing systems (i.e. biometrics), GPS, RFID•Mobile entertainment

– Quest for the ultimate gaming experience wherever, whenever•Convergent products

– MP3/DSC, LCD TV/DVD/DVD-R/DVR, PSP

Look for increasing silicon dollar content as more functionality and features are embedded within CE systems

Equity Research Wireless, Cons. Elec. SemisMorgan Stanley Technology Research

10

Consumer Semi Trend Background/History

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

2001 2002 2003 2004E 2005E 2006E 2007E 2008E11.0%

12.0%

13.0%

14.0%

15.0%

16.0%

17.0%

18.0%

19.0%

20.0%

21.0%

Total ConsumerSemiconductor($M)

Semi $ Content(%)

Source: iSuppli, 2005

CE Semis:9% CAGR2001-2008

Page 11: Emerging Tech0705

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Page 11

Moore’s Law to drive digital, analog, and RF integration into fewer chips Challenge: to design complexity while delivering more value to customer Key: collaboration with OEMs and value migration

Equity Research Wireless, Cons. Elec. SemisMorgan Stanley Technology Research

11

Implications for the Semi Industry• Moore’s Law will continue to drive performance and cost for CE Semis

– 1999: chip design statistics: 75% of designs < 4M gates– 2004: chip design statistics: 50% of designs> 4M gates, 25% > 32M gates– Digital, analog, and RF integration is key

• Silicon design evolution: dealing with complexity, delivering more value– More collaboration (NVIDIA/Sony, ATI/Microsoft, Apple/PortalPlayer)– Chip suppliers deliver silicon, software, and reference design (LSI/DVD-R, TI/DSC)

• Need to have competencies in DSP, broadband, GPU, analog, software and systems– DSP: CE is all about algorithms – MPEG, H.264, QAM, Viterbi, FFT, WCDMA– Broadband communications: required for universal content delivery, modulation – GPU: performance driven, need hardwired solution for speed, some programmability– Analog: real-world interface, power consumption– Software and Systems – not just chips but full reference platforms

Equity Research Wireless, Cons. Elec. SemisMorgan Stanley Technology Research

12

Moore’s Law

100

1000

10000

100000

1000000

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

# of

Tra

nsis

tors

(000

s)

Intel MPUNVDA GPUMoore's Law (24m)TI DSP XLNX (Normalized Logic Cells)

386

486 DX

Pentium

Pentium IIPentium Pro

Pentium III

Pentium IV Prescott

RIVA

TNT 2

GeForce 2GeForce 3

GeForce 4

GeForce FX

320C50

320C5510

320C556x

Source: Intel, NVIDIA, Texas Instruments, Xilinx, and Morgan Stanley

100

1000

10000

100000

1000000

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

# of

Tra

nsis

tors

(000

s)

Intel MPUNVDA GPUMoore's Law (24m)TI DSP XLNX (Normalized Logic Cells)

386

486 DX

Pentium

Pentium IIPentium Pro

Pentium III

Pentium IV Prescott

RIVA

TNT 2

GeForce 2GeForce 3

GeForce 4

GeForce FX

320C50

320C5510

320C556x

100

1000

10000

100000

1000000

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

# of

Tra

nsis

tors

(000

s)

Intel MPUNVDA GPUMoore's Law (24m)TI DSP XLNX (Normalized Logic Cells)

100

1000

10000

100000

1000000

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

# of

Tra

nsis

tors

(000

s)

Intel MPUNVDA GPUMoore's Law (24m)TI DSP XLNX (Normalized Logic Cells)

386

486 DX

Pentium

Pentium IIPentium Pro

Pentium III

Pentium IV Prescott

RIVA

TNT 2

GeForce 2GeForce 3

GeForce 4

GeForce FX

320C50

320C5510

320C556x

Source: Intel, NVIDIA, Texas Instruments, Xilinx, and Morgan Stanley

TI (DSP) and NVIDIA (GPU) will need to continue to take advantage of Moore’s Law to compete in the CE Semi market

Page 12: Emerging Tech0705

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Page 12

Complexity growing exponentially CE value migrates from product OEMs to semi suppliers

Equity Research Wireless, Cons. Elec. SemisMorgan Stanley Technology Research

13

Examples

500

1000

1500

2000

2500

DSP OPS(Billion MAC/s)

2002 2003 2004 2005 2006

Voiceover IP

HDTV,MPEG4

Videoover IP

3G Wireless/WCDMA

4GWireless

FutureBroadband

Source: Xilinx

DSP Processor Performance Roadmap

DSP performance requirements for new communication technologies

DSP performance requirements

CE to follow same evolution as wireless handset mkt

1999DigitalBaseband IC

2004•Digital Baseband IC•Firmware, RTOS, Apps SW•Motherboard design•FTA approved reference handset

Low barriers to entry in emerging products OEM partnerships open door for smaller chip players

Equity Research Wireless, Cons. Elec. SemisMorgan Stanley Technology Research

14

Key Issues and Risks

• Successful OEMs in high volume markets may eventually choose an ASIC solution to achieve lower costs

– Example: Nokia in handsets, Apple iPod?• Opportunity for smaller, focused chip companies to gain entry into the market

– Examples: PortalPlayer (MP3), Atheros (WLAN) • Disruption in the traditional supply chain

– Rise of ODM model provides opportunity for small chip companies and or Asian chip companies to gain entry into the market

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Page 13

Required: successful execution and solid management team Also need competency in at least one consumer/ communications-centric product category

Equity Research Wireless, Cons. Elec. SemisMorgan Stanley Technology Research

15

Potential Winners• Winners: Semiconductor Suppliers• Texas Instruments - DSP, Broadband, wireless, analog, systems development capabilities• Qualcomm – wireless intellectual property (IP) and systems development capabilities• NVIDIA - GPU, broadband, multimedia• Broadcom - Broadband, DSP, wireless, systems development capabilities, analog / RF• Linear Tech, Maxim - High Perf. Analog real-world interface and power mgmt expertise• Xilinx, Altera – DSP, programmability (time-to-market)• SanDisk – IP, vertical integration, brand

• Winners: Chip Design Software suppliers• Cadence - advanced digital/analog SOC design tools, systems design/verification software

• Winners: Semi IP suppliers• ARM - focus on lower power and CE, highly penetrated architecture

Page 14: Emerging Tech0705

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Page 14

Equity ResearchWireless InternetMorgan Stanley Technology Research

1

Wireless InternetPresented by David Feinberg and Ramji Srinivasan

Mobiles should have access speeds comparable to PCs by 2007 Migration to always-on, fast connections key to adoption of mobile Internet services

Equity Research Wireless InternetMorgan Stanley Technology Research

2

Global Footprint – Wireless Infrastructure

1980s 2000 to 2004 2005 2007+1G 2.5G 2.75G 4G

GPRS EDGEHSCSD Release 99 Release 5 (HSDPA) WiMAX

AMPS 9.6 Kbps 57.6 Kbps 171 Kbps 384 Kbps 1.92 Mbps 10 Mbps 802.16e*70 Mbps

CDMA2000 (1xRTT)IS-95-A IS-95-B Rev. 0 Rev.A

down link 14.4 Kbps 57.6 Kbps 307 Kbps 2.4 Mbps 3.1 Mbpsup link 14.4 Kbps 57.6 Kbps 153 Kbps 300-600 Kbps 1.2 Mbps

* We expect 802.16e standard to be ratified by mid-year 2005.

2005 to 20071990sM

orga

n St

anle

y Eq

uity

R

esea

rch

Estim

ate

CDMA

3G2G

GSM UMTS = WCDMA

CDMA EV-DO

First to Fourth Generation Wireless Internet with Maximum Data Rates

Page 15: Emerging Tech0705

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Page 15

Growth drivers for wired and wireless Internet likely to be similar

Equity Research Wireless InternetMorgan Stanley Technology Research

3

Internet Background / History

Wired Internet – Selected factors behind its growth

Cheap Hardware

Sub $1,000 PCs

Unlimited Service

Unlimited monthly usage schemes

Rich Applications

Broad selection of readily available content

First innings of figuring out killer data apps Text messaging (SMS) and ringtones dominate, picture messaging not popular Data still less than 10% of carrier revenue WW

Equity Research Wireless InternetMorgan Stanley Technology Research

4

Recent Highlights / Metrics

(1) Source: CTIA, 3/04.(2) Morgan Stanley Research.

Nokia – Largest Seller of Digital Cameras (1)

Ringtones – At $3.5B, account for 10% of music industry revenue (1)

But data is only 5-10% of carrier revenue, globally and in the US (2)

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Lower G3 handset price points ($150) critical to mass adoption Like early wired Internet, content only available in walled gardens… …But walls are coming down (T-Mobile)

Equity Research Wireless InternetMorgan Stanley Technology Research

5

Key Issues – Handsets & Content

Video

Data

Voice

“Walled Garden” of Content & Services

Converged Devices $200+

Handsets and PDAs have smaller screens, slower data connections, less computing power than PCs

Equity Research Wireless InternetMorgan Stanley Technology Research

6

Industry Structure Today… and TomorrowThe Wired Internet is coming to Wireless Devices, via applications like Opera’s mobile browser…

…but full content in a handset form factor is still an awkward end-user experience

Wired Webpage Wireless Webpage Handset•Opera’s mobile browser was included on 3MM mobiles (+103% Y/Y) in CQ4:04 (1)

•10MM+ installed based of Opera Mobiles as of 4/05 (1)

(1) Source: Opera, Morgan Stanley estimates.

Page 17: Emerging Tech0705

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Page 17

Skype’s sweet spot could arrive with reliable, widespread WiMax

Equity Research Wireless InternetMorgan Stanley Technology Research

7

New Applications: Skype – The BasicsSkype develops software for calling people on their computers or phones

How Skype Works

User and Headset

PC with Skype Software

+

PC with Skype Software

Regular Telephone User

Free Skype-to-Skype

Per-minute SkypeOut

Skype provides developmental ground for new VoIP apps

Equity Research Wireless InternetMorgan Stanley Technology Research

8

New Applications: Skype Testing Ground

Skype Quick Facts

•45MM registered users as of 7/05

•100+ employees

•1.2MM registered users of SkypeOut, launched 7/04

•10B+ minutes served, as of 7/05

•Source code released CH2:04

•1,000+ open-source developersSource: Skype, CNET (4/05).

•Initial developers under the Skype creating VoIP applications that mimic the basic functionality of mobiles—SMS, voicemail, ringtones, etc.

•As developers mature, believe that innovation on the Skype platform could spawn commercially viable applications

•Like eBay, ecosystem and innovation could be potentially self-reinforcing

Ecosystem

Page 18: Emerging Tech0705

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Page 18

Emerging applications in Internet telephony leverage immediacy of voice and network intelligence

Equity Research Wireless InternetMorgan Stanley Technology Research

9

New Applications: Tellme

Tellme Quick Facts

•168 employees

•2B+ speech transactions processed and 3MM+ utterances transcribed

•411 provider for Verizon in NY, NJ, Delaware, eastern Pennsylvania, Idaho, Washington, Nevada, Oregon, Arizona and California

•1B minutes committed by enterprises on TellmeVoice Application Network in 2001

Source: Tellme, Verizon (4/05).

•Basic premise – Overlays speech recognition over Internet and telephony network to create “world’s largest Voice Application Network”

•Applications – Powers services like AT&T Wireless VoiceDial voice portal

•DialTone 2.0 – Pick up the phone and speak your request (“I’d like to buy two tickets to Meet the Fockers”)

Freeing of content helped wired Internet grow T-Mobile’s removal of its proprietary site a first step in wireless Internet evolution

Equity Research Wireless InternetMorgan Stanley Technology Research

10

Industry Structure Today… and TomorrowWired Internet – Selected factors behind its growth

Inexpensive Hardware

Sub $1,000 PCs

Unlimited Service

Unlimited monthly usage schemes

Rich Applications

Broad selection of readily available content

Wireless Internet – Parallel factors could drive growth, in our view

Inexpensive Phones

Sub $200 Converged Devices

“All-you-can-eat” Data

Unlimited monthly usage schemes

Rich Applications

Yet-to-be invented

?

Page 19: Emerging Tech0705

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Page 19

Equity Research Wireless InternetMorgan Stanley Technology Research

11

Potential Winners and Losers

ServicesOperators

Winners

Losers

Mobile Local Search, Ads

?

Mobile Content, Ads

“Killer App” – Still not invented

Mobile Content Infrastructure

Windows Mobile uptake in question

On-the-Border

Slow-moving yellow page providers

Handsets, and Infrastructure

Leading GSM Vendor WW

?3G “Must Have”Mobile Device –Still not invented

?Service Providers – who will be first to cut prices + open the Walled Garden”

Handsets represent 80% of sales

Page 20: Emerging Tech0705

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Page 20

Equity ResearchVoice over IP (VoIP)Morgan Stanley Technology Research

1

Voice over IP (VoIP)Presented by Scott Coleman and John MarchettiCovered by Scott Coleman and John Marchetti

Next-generation wireline (and eventually wireless) voice protocol that treats voice conversation like data transmission

Equity Research Voice over IP (VoIP)Morgan Stanley Technology Research

2

What Is VoIP?• VoIP transmits telephone calls over a data network like a LAN or the

Internet. – Lower cost. IP networks tend to be more efficient that circuit-switched

networks. Cost synergies possible if running a single voice and data network. – Increased functionality. Calls can be routed wherever you plug into the

network, for example. – Can be less reliable. Security issues, power outages, latency, etc.

• Voice over Internet Protocol (VoIP) can mean several things:– IP trunking– IP to the end-user– IP end-to-end

• We break VoIP into three categories:Service Provider Equipment Vendor

• Carrier AT&T, Comcast, Time Warner Sonus, Cisco, Nortel• Enterprise NA Avaya, Cisco• Best Effort Skype, Vonage NA

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Page 21

In last 12 months, legacy wireline carriers and new entrants have seriously targeted VoIP

Equity Research Voice over IP (VoIP)Morgan Stanley Technology Research

3

VoIP Background / HistoryKey Point: It’s Still Very Early

1995 PC-to-PC connection using Internet phone software, a sound card and a microphone

1998 Gateways enable PC-to-phone and eventually phone-to-phone connections using IP

Apr 1999 CableLabs releases DOCSIS 1.1 specificationMay 2000 Sonus Networks (SONS) goes publicSept 2000 Avaya introduces IP-PBX and IP telephonesJan 2001 Vonage foundedSept 2002 Cisco introduces its VoIP PBX (Call Manager v2.2)Aug 2003 Skype foundedFeb 2003 Tekelec buys Santera (private)Mar 2004 AT&T launches CallVantageMay 2004 Lucent buys Telica (private)July 2004 Verizon launches VoiceWing Sept 2004 Alcatel buys Spatial Wireless (private)Oct 2004 Time Warner Cable launches VoIP in NYC

VoIP’s drastically lower cost of service changes business model for voice

Equity Research Voice over IP (VoIP)Morgan Stanley Technology Research

4

How VoIP Works and Money is Made• Changing service provider business models:

– Attacking the service provider model: all-you-can-eat replaces distance-based pricing.– No longer need to own a network, but is this sustainable (virtual network operators)?– Network convergence: combining the wireline/wireless and carrier/enterprise networks

• Changes in the equipment providers landscape:– Carriers will augment and eventually replace circuit switches with soft switches and media

gateways. This opens the door to new entrants (whither the LEMMNS?)– Enterprises consolidating to a single platform? Does voice or data win? Do services?– Incumbency can be very meaningful … if you have the products.

• Vonage case study:– Customer acquisition costs of $150 (mostly advertising and a router)– Monthly ARPU around $22– Monthly opex of $13 (mostly for access charges)– IRR = 15% – Adding $2 regulatory tax reduces IRR to 0

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VoIP service optimized for next generation IP networks

Equity Research Voice over IP (VoIP)Morgan Stanley Technology Research

5

Global Footprint

Deep impact across wireline value chain

Equity Research Voice over IP (VoIP)Morgan Stanley Technology Research

6

Recent Highlights / Metrics• Best Effort VoIP

– Vonage adding 15,000 subscribers a week (~550k subscribers)– Skype has 135m downloads, 1.2m SkypeOut customers, and 10bn minutes served

• Cable VoIP– Time Warner Cable is adding 11,000 VoIP subscribers a week and had 200k subs as of

YE2004 (~2% of homes passed for telephony)– Cablevision has deployed VoIP to its entire footprint and had 282k at YE2004 (~6% of

homes passed) – Rich B. estimates cable telephony subs grow from 1.5m in 2004 to 12.3m in 2010– Over 109 cable modems and 34 CMTSs have been certified for DOCSIS 1.1

• Enterprise VoIP market – IP-PBX market around $2.5b in 2004 growing at a 20% CAGR through 2009, although

mostly offset by declines in the traditional PBX market.– Avaya and Cisco are market leaders with 23-24% market share in 2004– Cisco has shipped 4m IP phones out of the industry total of 11m over the past four years.

• Carrier VoIP– AT&T CallVantage has around 53,000 subscribers– Carrier VoIP equipment market grew 55% in 2004 to $942m and is forecasted around $5bn

in 2009 (44% CAGR). Mostly offset by declines in the TDM switching market, which was $10bn in 2004.

– Leaders in the carrier VoIP equipment market are Cisco, Nortel, and Sonus.

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2005 should be pivotal in accelerating growth

Equity Research Voice over IP (VoIP)Morgan Stanley Technology Research

7

Key Drivers / MetricsWW Packet Voice Minutes of Use (MOUs)

Bn M

OU

s

Source: Probe Research, Inc.

VoIP Carrier Equipment Market

Source: Synergy

200720062005200420032002

9018

15553

281

144

463

309

736

550

1050

822

0

250

500

750

1,000Long-distance Local

WW Packet Voice Minutes of Use (MOUs)

200720062005200420032002

9018

15553

281

144

463

309

736

550

1050

822

0

250

500

750

1,000Long-distance Local

Source: Morgan Stanley.

US Cable VoIP Subs

-

5

10

15

20

25

2004E 2006E 2008E 2010E 2012E 2014E

VoIP

Sub

s (m

)

0%

5%

10%

15%

20%

25%

Pene

tratio

n of

Hom

es P

asse

d

0

1

2

3

4

5

2001 2002 2003 2004 2005 2006 2007 2008

Rev

enue

($Bn

))

0

10

20

30

40

50

60

70

Ports

(mm

)

Revenue ($ billion) Ports (m)

0

100

200

300

400

500

2003 2007PB

X Li

nes

TDM lines IP lines

Global PBX Lines

Source: Avaya

Equipment vendors, service providers face risks Regulatory change a wild card

Equity Research Voice over IP (VoIP)Morgan Stanley Technology Research

8

Key Issues and Risks• Business Risk for Equipment Vendors

– Technology shifts create risk and opportunity– Changing port-to-user relationship may reduce the revenue opportunity

• Business Risk for Service Providers– Open access, open networks– Deflationary impact of VoIP

• Technology Risk for Service Providers– IP is less reliable than TDM– E911, CALEA, numbering issues unresolved– Higher bandwidth is needed for quality of service

• Regulatory Environment Likely to Change– Information service vs. telecom service– Who pays the taxes?

• access charges: saves VoIP providers 1-6 cents/minute• subscriber line charge: $6 monthly charge• universal service fee: 6-7% of gross revenue

Page 24: Emerging Tech0705

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Page 24

Incumbents vs. new entrants — carriers

Equity Research Voice over IP (VoIP)Morgan Stanley Technology Research

9

Winners and Losers: Carrier Market

Yes 4%0%Tekelec

Yes17%0%Sonus

Yes15%0%Cisco

Yes7%10%Siemens

No0%14%NEC

Yes22%7%Nortel

Yes2%15%Huawei

No0%3%Ericsson

Yes2%12%Lucent

Wireless only4%22%Alcatel

VoIPTDM

VoIP Solution?

2004 Market Share

Incumbents vs. new entrants — enterprise

Equity Research Voice over IP (VoIP)Morgan Stanley Technology Research

10

Winners and Losers: Enterprise Market

11%28%0%Cisco

1%2%0%3Com

12%5%17%Siemens

16%12%21%Nortel

7%3%10%NEC

2%0%3%Ericsson

12%24%8%Avaya

11%14%10%Alcatel

Enterprise VoiceVoIP TDM

2004 Market Share

Page 25: Emerging Tech0705

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Page 25

Equity Research Voice over IP (VoIP)Morgan Stanley Technology Research

11

Disruptive Technologies – Skype…• As of 7/05, Skype has more than 45MM registered

users and is adding 140K+ new users per day, with 134MM total downloads

• On average, 2.6MM people are simultaneously using Skype to place calls.

• Skype is seeing a 22% growth in minutes of traffic which is currently at 1.5B minutes per month; this accounts for 46% of VoIP traffic in North America

• Announced partnership with Boingo Wireless for $7.95 unlimited calling from Boingo Wi-Fi hotspots

Since Skype began licensing / giving away its source code in CH2:04, 1,000+ programmers have joined, creating dozens of free and commercial products for the skype service...

…And as, Microsoft CEO Steve Ballmer drilled into the heads of Microsoft employees, building a viable developer community is a key step in the evolution of software dynasties.

Page 26: Emerging Tech0705

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Page 26

Equity ResearchBroadband InternetMorgan Stanley Technology Research

1

Broadband InternetPresented by Brian PitzCovered by Mary Meeker, Brian Pitz, and Brian Fitzgerald

Broadband penetration has hit an adoption sweet spot - 30%+ household penetration in the US

Equity Research Broadband InternetMorgan Stanley Technology Research

2

The pace of online innovation continues at an unprecedented pace…

• Through blogs, syndication, RSS• With digital media and web services• On mobile devices, linked to the Internet

In first generation of the Internet, or Web 1.0, we had the “dial-up” experience: growth around basic email, chat rooms, message boards, homepages, and rudimentary sites

Through the later part of the Web 1.0 experience, we believe residential broadband ramp has served as an important inflection point for Internet usage, with broadband (vs. narrowband) users spending more time and money online, owing in large part to…

• Significantly faster speed• “always-on” functionality• higher user satisfaction

Overview

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Page 27

Internet today like early TV and cable — viewers out of sync with revenue (ad dollars)

Equity Research Broadband InternetMorgan Stanley Technology Research

3

Overview

Source: Media Dynamics, Television Bureau of Advertising, Veronis Suhler, Universal McCann, as quoted by Yahoo! at company’s 5/04 Analyst DayNote: Cable shows all wired households.

Still believe that the development of the Internet is still in its early stages – we parallel this to the stage of network and cable TV during the 20th century

Broadband users spend more time and money online

Equity Research Broadband InternetMorgan Stanley Technology Research

4

Overview

•Broadband users spend an average of 13 hours per week online vs. 8 hours for dial-up users

•Residential broadband users spent 64% more purchasing dollars online (to $868) over previous 12 months than those with dial-up access

•Per comScore, only 34% of US Internet users were “broadband”, but this group accounted for 55% of the total time online, reinforcing the point that broadband users spend significantly more time online

Source: comScore Media Metrix – March 2003; *Arbitron/Edison Media Research

The broadband “inflection point”…according to a survey* of US consumers...

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Page 28

See 41% broadband subscriber growth in 2005, driven by Asia-Pacific, Europe, Latin America

Equity Research Broadband InternetMorgan Stanley Technology Research

5

Global Broadband SubscribersC2000 C2001 C2002 C2003 C2004 C2005E

Global Broadband Subscribers (000's) 12,759 30,221 57,057 96,791 147,997 208,797 Y/Y Growth -- 137% 89% 70% 53% 41% Q/Q Growth -- -- -- -- -- --

North America 6,759 13,481 20,991 29,361 39,038 48,447 Y/Y Growth -- 99% 56% 40% 33% 24% Q/Q Growth -- -- -- -- -- --

Europe 983 2,872 9,966 24,693 42,225 60,301 Y/Y Growth -- 192% 247% 148% 71% 43% Q/Q Growth -- -- -- -- -- --

Japan 625 2,836 7,806 13,641 18,295 23,526 Y/Y Growth -- 354% 175% 75% 34% 29% Q/Q Growth -- -- -- -- -- --

Asia-Pacific 4,351 10,707 16,991 26,836 44,115 69,935 Y/Y Growth -- 146% 59% 58% 64% 59% Q/Q Growth -- -- -- -- -- --

Latin America 41 324 1,304 2,259 4,324 6,588 Y/Y Growth # -- 689% 303% 73% 91% 52% Q/Q Growth # -- -- -- -- -- --

Source: Morgan Stanley Research, Rich Bilotti, Simon Flannery, Paul Marsch, Mitchell Kim, Nick Sebrell, Vera Rossi

US Broadband penetration in the 25-30% sweet spot

Equity Research Broadband InternetMorgan Stanley Technology Research

6

Broadband Ramp in 25-30% Sweet Spot…

0

10

20

30

40

50

60

70

80

2002 2003 2004 2005E 2006E 2007E 2008E 2009E 2010E 2011E

US

Res

iden

tial B

road

band

Su

bscr

iber

s (M

M)

0%

10%

20%

30%

40%

50%

60%%

of T

otal

US

Hou

seho

lds

US Residential Broadband Subscribers % of Total US Households

Morgan Stanley Research.

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Many metrics document broadband Internet revolution

Equity Research Broadband InternetMorgan Stanley Technology Research

7

Recent Highlights / Metrics

•Strong recent growth momentum, up 45% Y/Y in CQ1:05 to 151MM global broadband subscribers; Sub/user multiplier could be more than 2x.

•“This Land” and “Second Term” JibJab videos viewed an estimated 80MM times

•Jordan Eason (Chief CNN News Executive) and Dan Rather’sresignations, spurred by bloggers

•917MM streaming sessions (primarily music videos) on Yahoo!, up 119% Y/Y in CQ4:04

Expect 20-30% global broadband Internet growth over next several years

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•Still in early stage with 30% US household penetration, which could reach as high as 50%+ penetration by 2010, in our view

•Estimate 20-30%+ broadband growth over next several year to continue to help creation of the Internet as premier information / distribution channel, bringing it to the next level of development (call it “Web 2.0”), which, at a high-level, should consist of:– rich, creative and personalized media content– a high-degree of user-interaction– more accessibility (including various mobile devices, as well as the PC

desktop) and integration than ever before

Broadband Internet Outlook

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Global broadband Internet growth over next several years drives user, usage and monetization growth

Equity Research Broadband InternetMorgan Stanley Technology Research

9

Global Internet Thesis

10-15% user growth

20-30% usage growth

30%+ monetization growth

Internet ad spending low relative to Internet media consumption

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Internet Media Usage to Ad Spend

(1) Adapted from SRI-Knowledge Networks, Fall 2003. (2) Adapted from Universal McCann, (6/03); Internet Advertising Bureau (3/04). (3) Veronis Suhler Stevenson (2003), Yahoo! Analyst Day (5/04). Youth defined as age 17 and under. Ratios are calculated as percent of US media usage on a medium divided by percent of US ad spending on a medium.

US Media Usage (1) to Ad Spending (2) Ratios

4.7x

0.0

2.0

4.0

6.0

8.0

10.0

12.0x

Newspapers+ Magazines

Total TV Radio Internet

Youth Media Usage (3) to Ad Spending (2)

Ratios11.3x

0.0

2.0

4.0

6.0

8.0

10.0

12.0x

Newspapers+ Magazines

Total TV Radio Internet

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eBay’s advertising mix may signal the direction advertising budgets are shifting

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Advertising Moving Online at Rapid Clip

eBay Advertising Spending (2)

Offline38%

Online62%

Global Advertising Spending (1)

Offline97%

Online3%

(1) PricewaterhouseCoopers, 2003 totals (6/04). (2) eBay (2004), Morgan Stanley.

Online advertising inventory remains in its early stages

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Inventory!

• Video

• Mobile

• User-Generated Content

• In-Game

• IPTV

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User-generated content: An example…

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Video

You just heard you missed one of the greatest golf shots in the history of the game. You want see it and you are happy to pay to watch it or perhaps view an ad in front of the footage. You just want to watch it…

Can’t find the video on Google or Yahoo!

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Google / Yahoo! Search Don’t Help

Search: Tiger Woods 16th hole Augusta video

• Lots of news stories• No video

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Can’t find the video on Google or Yahoo! video search

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Google / Yahoo! Video Search Don’t Help

Search: Tiger Woods 16th hole Augusta

• Pictures, text• Not video we’re looking for

But the video is posted on a blog

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What Does Help?

• Blogger posts video in the spirit of creating a prototype Nike ad

• It’s downloadable, it’s free, but potentially missing appropriate permissions…

Source: Blogger.

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17

The Shot!

Note: Adobe Acrobat Reader 6.0 or greater required to play video clip.

(Click image to play video.)

Content creators and distributors, in tandem with payment mechanisms, need to come to the bargaining table to make it happen-and they just might make it up on volume

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We Want it – Make it Easy!

Content / Rights Owners

User searches for content

Search Engines

Content owners receive payments via payment mechanism or ad

User gets content

Advertisements Such as…Payment Mechanism

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Monetization opportunites…

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Making Money on Online ContentYahoo! — 917MM streaming video (mostly music) sessions (CQ4); < 10% preceded by streaming ads (rising to 50%, in our view) with compelling CPMs

Korea — TV channels allow users to download shows for ~$1

Google — launched upload.video.google beta (4/05)

Camera Phones – 263MM sold globally in 2004

Digital Music — 300MM iTunes / 16MM iPods sold

Digital sales could rise to as much as 25% of global music sales in five years…At long last the threat has become the opportunity… -- IFPI, Digital Music Report, 2005

PayPal — 72MM accounts (CQ1); 22MM active users; 110MM payments with $6B in volume; 3-8% of iTunes

Online Paid Content — $1.8B US revenue in 2004 per OPA

Consumers want intergrated content, when they want it

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Center of Content is Consumer not Device

• Play games, check email, watch videos on handhelds

• Watch high-quality video stored on PVRs or Media Center PCs

• Program PVRs / similar devices / open garage door from mobile phone

• HD video and audio on the consumers’ schedule, allowing consumers to create their own prime time

• Listen to purchased music at home / work / in car without having to carry around many devices, mediums or wires

Consumers want integrated content, when they want it

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User-generated content, from reviews to blogs and uploaded videos, is a key component of the broadband experience

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User-Generated Content…

eBay Feedback RatingsYahoo! Movie Reviews

Blogs

Google Video Search

Next-generation and user-generated content should continue to gain traction

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Broadband Internet Outlook

1. “Next-generation content” / “user generated content” should gain traction in both usage and users, and discover an appropriate revenue model

– Blogs

– Rising usage of RSS syndication by content providers, continued ramp in the production of blogs and other user-generated content, easy-to-use integration of RSS feeds and blogs for end users of content

– According to Pew Internet research, 7% of the 120MM US adults who use the Internet have created a blog (8MM people), while 27% of Internet users say they read blogs, up 58% in 2004, but only 38% of all Internet users actually know what a blog is

– Increased Usage of Premium Online Video Content

– Short-Form - JibJab, AtomFilms, Yahoo! Launch, news items, sporting events, TV-like sitcoms and other programming

– Long-Form – MovieLink and other distributors, made-for-Internet movies…though this will not likely be as much of a factor until much later in this decade

– Continued Growth in Online Music Usage… (Covered in more detail next by Katy Huberty)

Specific broadband-enabled opportunities as we see them taking shape…

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Personalization and localization online will be the norm

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Broadband Internet Outlook

2. Increased personalization and localization likely to become more of the norm online, and especially in ads

– Personalization of everything from Internet searches to online purchases, will likely become more of the norm on the Internet. Personalization integrates user behaviors and profiles based on past history and user-defined attributes for everything from news alerts, start/home pages or search preferences to when and where to buy groceries, contact lenses or dog food

– Localization, basically one of many attributes of personalization, will also likely become more important. Roughly 25% of searches are local and ~10% of local searches have commercial intent, per the Kelsey Group, so targeting consumers on a local level continues to increase in importance. Site such as Google already uses national/regional/local IP targeting for delivering language specific content, advertisements and other information, which we believe will become even more prevalent in the future

Specific broadband-enabled opportunities as we see them taking shape…

See Microsoft as a leader in next-generation digital rights management solutions (DRM)

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Broadband Internet Outlook

3. Digital Rights Management

– Legislation has been proposed to require government-approved copy protection to be engineered into all devices capable of playing digital media

– Consumers continue to push against DRM solutions for music, video and written content, as they demand flexibility in how, when and where they can use their purchased content

– Microsoft is a leader in the development of DRM solutions – they have formed a group called the Next-Generation Secure Computing Base (NGSCB)

Specific broadband-enabled opportunities as we see them taking shape…

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Broadband Internet increases need for data storage

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Broadband Internet Outlook

4. Data Storage Becomes Increasingly Important in the Broadband Internet World

– Content-collection and hoarding is now the norm – with digital content everywhere – JPG picture files, MP3 audio files and MOV video files in abundance, consumers do not have time to consume all of this media at once, and require mass archives to recall (and back-up) the media on demand. PVR’s such as TiVo have also been helpful in creating a sense that the user needs mass storage for content

– Consumer storage needs versus physical space needs become more obvious - a consumer can save 10,000 photos on a chip that is thousands of times smaller than a stack of 10,000 paper photos…the same goes for CD jewel cases and DVD cases as well

– …and all the while storage costs continue to come down -- one can easily buy an extra 250GB of space for $200

Specific broadband-enabled opportunities as we see them taking shape…

Interactive entertainment and online gaming here to stay

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Broadband Internet Outlook

5. Online Broadband Interactive Entertainment (Games) are here to stay

– MMORPG’s (massively-multiplayer games) been drawing role-playing gamers online for hours and hours a day for a number of years; Examples are Sony’s Everquest or the Legend of Zelda

– Broadband-only, subscription-based online gaming services will continue grow, and at an accelerating pace – driven by collaborative and integrated infrastructures such as Microsoft’s Xbox Live that provides a relatively seamless user experience across a myriad of titles that should continue to pay off for the company

– In less than one year, Microsoft has achieved over 1MM paid subscribers on its Xbox live platform, more than twice as fast as other media services including cable (HBO), online (AOL) or even TiVo

– MSFT’s next-gen Xbox platform, major focus seems bent on online gaming – including online marketplaces with “microtransactions” and “gamer cards” helping players connect over the Internet, among other features (Buy a bigger sword for $0.10; Buy a stronger spell for $0.05; Download the latest U2 song and have it play as background music for $0.50; etc.)

Specific broadband-enabled opportunities as we see them taking shape…

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Mobile Internet a significant growth area, though killer app still to come

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Broadband Internet Outlook

6. Mobile opportunities – Gaming (Shanda, EA), Local Search (Yahoo!, Google), Content (Yahoo!, MSN), Messaging (Yahoo!, AOL) – but the killer application still isn’t here yet…

Specific broadband-enabled opportunities as we see them taking shape…

Many potential beneficiaries on the broadband Internet

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Potential Winners• Content creators –content remains key, and those that develop new, compelling content and applications (including video, music, or other user-generated content) to be delivered over broadband, will succeed; We believe that the mainstreaming of Web syndication technology such as RSS though such services as My Yahoo! or Blogger could help to create a new business model / revenue stream for freelance Web journalists and content providers, as well as content distributors

• Content extenders – similar to content creators, those using the broadband internetto enhance the value of offline content such as broadcast, cable or movies, should also benefit

• Internet leaders – Next-generation broadband content should positively affect Internet leaders and content aggregators such as Yahoo!, Google and eBay, as they continue to leverage their distribution channels and/or content and services

• Digital rights management providers – that can provide a very flexible, but robust, DRM system to consumers; Microsoft appears to be leading the charge on DRM to date, though we believe there will be other significant players that will emerge in this space

• Online interactive broadband entertainment platforms – i.e. Microsoft Xbox Live, or other similar offerings from competing platforms in their next generations (Sony and Nintendo)

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Legal battles likely over content and privacy, consumer resistance to pay-for models as well as technology limitations

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Key Issues and Risks• Continued legal battles on sharing / distribution of “Next-generation content” will likely continue to

plague the industry – resolved through advances in digital rights management (potentially led by companies such as MSFT or AAPL)

• Advances in online personalization will likely result in increasing privacy concerns – leading to slower and more costly implementation of broadband applications that “think like the user”

• Increasing threat of content distributor disintermediation – by content creators given new, robust, distribution channels

• Consumer resistance – to paying for content

• Limited network capacities

• Lack of single integrated platform – for content consumption (the TV vs. the PC), as well as a lack of common file standards for content (MP3 vs. WAV files or MOV vs. MPG files)

• We are not there yet – even in places where broadband is built out, it is often not the easiest experience to hook up, or connect to, broadband connections or content. When even the quintessential “techie” has a hard time logging on to a given network, it means there is still a long way to go in terms of standardization and user friendliness for the average online user

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Equity ResearchEmerging Technology TrendsMorgan Stanley Technology Research

1

Digital MusicPresented by Katy HubertyCovered by Rebecca Runkle, Katy Huberty

Apple’s latest move: free podcast support Could introduce video content, related players over next 6-12 months

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Digital Music Trend Background / History

+ + +

1999 2001 2005Most important is “What’s Next?”

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Owning the player + iTunes software + accessories gives Apple more flexibility than other MP3 and music store players

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Hardware: Profitable in most cases today (unlike cell phones)

Content: Mixed profitability but a large portion goes to content owners

Value of Customer Installed Base: Winners will leverage the installed base. In Apple’s case:

•Accessories

•Systems

•And more content...

Digital Music Trend Background / HistoryHow Digital Music Works & Money is Made

Apple offers more content (roughly 500K more songs plus podcast support) than other digital music providers iTunes bread-even target may give Apple an edge over others’ need for profits

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Apple iTunes Napster Rhapsody Yahoo! MusicEst. Online Music Market SharePay-per-song market 85%+ ~1-2% ~5% NMOnline subscription market NM ~10% ~50% NM

Business Model Pay-per-Song Subscription/Per Song Subscription/Per Song Subscription/Per SongCost for Song / Album $0.99/$9.99 $0.99/$6.95+ $0.89/$8.99 $0.79/NMCost for Subscription (monthly) NM $14.95 $14.99 $6.99

Number of Songs Available 1.5 million 1 million 1 million 1 million

Number of Songs Downloaded 400,000,000Number of Subscribers 400,000+ 1,000,000

File Technology protected AAC WMA MP3, WMA, unprotected AAC WMA

Number of compatible Devices iPod only 75 100 13(1)

Inception of Service 2003 2000 2001 2005

2004 Revenue $220M(2) $46.7M $266.7M NM

2004 EPS break even / slight loss ($1.43) ($0.14) NM

Stated Business Goal Break Even Profit Prof it Profit

How Digital Music Works & Money is Made

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International iPod growth key going forward

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5

Global FootprintLargest PC penetration with

30% with 2 PCs

Mobile email, music mainstream

Mobile gaming, video just starting

30% of homes with PC, 20% with 2 or more

Broadband more expensive but one of the fastest growth regions

PC Ownership similar to Europe

Broader use of mobile technology with 3G infrastructure

Largest number of broadband users

23M in 2004(1) 16M in 2004(1)

10M in 2004(1)

(1) Number of portable music players shipped.

Apple has sold over 480 million songs as of 7/7/05 iTunes users downloaded over 1 million free podcasts in first two days post iTunes 4.9 launch

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6

Recent Highlights / Metrics•Apple iTunes alone sold roughly 340 million songs over the past 12 months (implies 50+ songs purchased per iPod)

-

20.0

40.0

60.0

80.0

100.0

120.0

140.0

3Q03

4Q03

1Q04

2Q04

3Q04

4Q04

1Q05

2Q05

Quarter

Mill

ion

Song

s

-

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

18,000

iPod

Inst

alle

d B

ase

(K u

nits

)

iTunes Sold iPod installed base

Source: Morgan Stanley Research

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Estimate 10-15% of US music purchases digitally downloaded in 2004

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7

Recent Highlights / Metrics•Despite strong 2004 growth, digitally downloaded music accounted for only 7% of global music purchase

Source: Morgan Stanley Research

2,556M units

200M units

Digitally Downloaded Traditionally Sold

Equity Research Emerging Technology TrendsMorgan Stanley Technology Research

8

Recent Highlights / Metrics•Over 30 million portable digital audio players shipped globally last year; growing 34% through 2008

-

20.0

40.0

60.0

80.0

100.0

120.0

2003 2004 2005 2006 2007 2008

Year

Mill

ion

Uni

ts

0%

20%

40%

60%

80%

100%

120%YT

Y G

row

th

HDD Flash Total MP3 Unit YoY Growth

Source: IDC and Morgan Stanley Research

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9

Recent Highlights / Metrics•Transition from geek toy to lifestyle accessory (age 35-54 is forming a growing segment)

Source: Morgan Stanley Research with help of 3rd party research firm

33%

11%5%

3%

49%

Weekly iPod Usage

Q18. How many times per week do you use your iPod?

Every day

4-6 daysper week

2-3 daysper week

Once a week

Less than once a week

Base: (200)

17%19%

9%

24%

32%

Weekly MP3 Player Usage

Every day

4-6 daysper week2-3 days

per week

Once a week

Less than once a week

Base: (54)

= Significantly higher than non-iPod owners at the 90% confidence level= Significantly higher than non-iPod owners at the 90% confidence level

Broad usage patterns of iPod vs. other MP3 players indicate that Apple can expand into new content, portable, and Mac offerings

Equity Research Emerging Technology TrendsMorgan Stanley Technology Research

10

Recent Highlights / Metrics

89%

52%

25%

22%

20%

18%

12%

6%

Q20. Please indicate all the ways you use iPod.Q21. Please indicate when you listen to your iPod.

Uses for iPod Use iPod While . . .

68%

67%

53%

50%

30%

Working/Studying

Exercising/working out

Commuting (not in a car)

Driving

Hanging out with friends

Working/Studying

Exercising/working out

Commuting (not in a car)

Driving

Hanging out with friends

To listen to music(through headphones)

To listen to music(through home stereo)

As a portable hardrive

To play games

To listen to books

As an address bookand calculator

To take voice notes

To listen to music incar/through stereo

To listen to music(through headphones)

To listen to music(through home stereo)

As a portable hardrive

To play games

To listen to books

As an address bookand calculator

To take voice notes

To listen to music incar/through stereo

Base: (200) Base: (200)

(Average nearly 3 types of occasions)

•Uses span beyond just music....

Source: Morgan Stanley Research with help of 3rd party research firm

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Expect Apple peripherals revenue to grow from $1.2B in FY04 to $3.4B in FY06, driven by iPod and Mac unit growth

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11

Recent Highlights / Metrics•iPod customer base purchased an average of 2.8 accessories to-date

Source: Yahoo.com, CNET.com, and Morgan Stanley Research with help of 3rd party research firm

64%

46%

46%

44%

37%

27%

3%

Q24. What accessories have you purchased for your iPod?

Headphones

Car Connectors

Power Chargers/Adapters

Cases/Arm Bands/Sleeves/Travel bags

Docking Station

External Speakers

Other

Headphones

Car Connectors

Power Chargers/Adapters

Cases/Arm Bands/Sleeves/Travel bags

Docking Station

External Speakers

Other

Base: (200)

(2.8 accessories per person, on average)

•iPod has the lion’s share of the accessory market, based on the number of items found at Yahoo! and CNET

iPodDell

JukeboxCreative

Zen RioYahoo! 4,875 4 32 339CNET 353 2 9 11

Equity Research Emerging Technology TrendsMorgan Stanley Technology Research

12

Key Drivers / Metrics

Digital Music is just the beginning of something that is potentially huge. What to watch:

Broadband adoption...fatter pipes for digital content

Resistance from the content owners...watch the buck

Perpendicular disk drive technology...shipping later this year

Cell technology...could be game changer

Power consumption an issue in small form factors

Product and content availability will continue to be key -

Gaming, video, broadcast downloads, podcasts, photo...

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Podcast support through entire HDD-based iPod product line All classic iPods now offer a color LCD screen. Apple could launch video-capable iPods over next 6-12 months

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•Signs of an appetite for additional functionality within the current iPod customer base

•Apple’s recent move to combine the classic and iPod photo lines acknowledge this trend

Source: Morgan Stanley Research with help of 3rd party research firm

Q9. Earlier, you indicated you owned an Apple iPod. Which type of iPod do you currently own?Q25a/b. If you lose your iPod tomorrow and have to replace it, what brand of MP3 player would you most likely

buy? And which specific type of iPod would you be most likely to buy?

4%6%

5%

7%

10%24%

22%

59%42%

17%

iPod

iPod Photo

Currently Own

(200)

iPod Mini

iPod U2 Special Edition

iPod Shuffle

Future Purchase

(141)

""""

""""

= Significantly higher at the 90% confidence level= Significantly higher at the 90% confidence level

70% of current iPodowners said they would

repurchase an iPod.

Key Drivers / Metrics

Digital music-capable cell phones complement rather than compete with traditional music players

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•Global cell phone appetite is also shifting towards more advanced, converged devices

Source: Morgan Stanley Research with help of 3rd party research firm

0

100

200

300

400

500

600

700

800

900

1000

2001 2002 2003 2004 2005 2006 2007 2008

Year

Mill

ion

Cell

Phon

e U

nits

0

0.05

0.1

0.15

0.2

0.25

0.3

YoY

Gro

wth

%

Entry Midrange High-end Converged YoY global unit growth%

11.6% CAGR

Key Drivers / Metrics

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Intel’s new Pentium D chips have embedded DRM to protect content

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Key Issues and Risks

•Digital Rights Management: At the end of the day everyone wants a piece of the pie.

•Getting the Infrastructure Right

•Industry Standards: Success is majority of content available at one source and can work on many devices.

•Business Models also at Risk: Players need to manage growth and Investment based on technology and infrastructure availability. Leap-frogging is also a risk given the ever evolving market.

Apple looks best positioned to go after digital living room from investment, brand, product perspectives

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Industry Structure Today … and TomorrowFuture – “Digital Hub”Most Likely Near Term

• Wireless functionality (iPod, iMac)

• Video functionality (iPod, iMac)

• iPod cell phone

Garage

Today

iPod

Stereo System

Home

Monitor

“Mini-Mac”

Wi-Fi,Airport

TV

•Storage, Content increases in importance

•Ease of use and software remain important

•Does “Intel Inside” expand beyond PCs?

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17

Potential Winners and Losers

Potential Winners Potential Losers Unclear

Still very much a debate but some initial thoughts...

Vendors with integrated solution, strong brand;

related component suppliers

Point-product providers It is unclear whether companies that benefited from the client-server era will also benefit from the

digital consumer era

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18

•Apple iPod brand recognized most for ease of use, reliability and functionality (including iTunes)

Key Drivers MetricsPotential Winners and Losers

64%

58%

53%

48%

48%

44%

35%

30%

26%

5%

Q12. Please indicate the reasons why you chose to purchase the Apple iPod over all other brands.

Base: (200)

Easy to use

It is a brand I trust

It offered all the features I was looking for

Compatible with iTunes

It's the most popular player around

A friend recommended it

The price was right

It is the player that all my friends have

The best accessories are only available for the iPod

Other

Easy to use

It is a brand I trust

It offered all the features I was looking for

Compatible with iTunes

It's the most popular player around

A friend recommended it

The price was right

It is the player that all my friends have

The best accessories are only available for the iPod

Other

(Average about 3 reasons per person)

Source: Morgan Stanley Research with help of 3rd party research firm

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Apple should help grow the overall MP3 market Can continue to gain share with new content offerings, expanded retail distribution), and international expansion

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19

•Windows based players (HDD-based) still haven’t caught up, although some introduced their products before the iPod

Potential Winners and Losers

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

Apple Creative Labs RIO iriver Samsung RCA OtherVendor

Last

12

Mon

th U

nits

(in

000s

)

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Mar

ket S

hare

%

Units Market Share

Source: NPD and Morgan Stanley Research,

Equity Research Emerging Technology TrendsMorgan Stanley Technology Research

20

•iPod Shuffle took 47% of U.S. flash memory based MP3 player market share just 3 months after debut

Key Drivers MetricsPotential Winners and Losers

0

50

100

150

200

250

300

350

400

450

Apple Sandisk iriver RIO RCA MemorexSamsung Creative Sony OthersVendor

Last

3 M

onth

Uni

ts (i

n 00

0s)

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

Mar

ket S

hare

%

Units Market Share

Source: NPD and Morgan Stanley Research,

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Page 51

Equity Research

On-Demand SoftwareMorgan Stanley Technology Research

1

On-Demand Software Delivery ModelsPresented by Ross MacMillanCovered by Ross MacMillan

On-Demand, subscription models challenge the traditional software business model

Equity Research On-Demand SoftwareMorgan Stanley Technology Research

2

What is the On-Demand Model?

Software delivered as an Online Service that offers immediate benefit without the substantial cost, resource, and time investment associated with enterprise software.

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On-Demand models attractive to risk-averse customers, may expand addressable market

Equity Research On-Demand SoftwareMorgan Stanley Technology Research

3

On-Demand Changes the Economics

For the Customer•Lower risk and cost•Faster go live and payback•Lower upgrade costs•Broader access to complex functionality

For the Vendor•Higher adoption rates•Lower development and support costs•On-Demand model should not lower the revenue opportunity

On-Demand promises lower customer TCO with similar lifetime revenue for vendors Systems integrators are real losers

Equity Research On-Demand SoftwareMorgan Stanley Technology Research

4

Lower the Total Cost of Ownership

Source: Morgan Stanley Research Estimates, Yankee Group

*

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Lower initial investments make subscription models attractive to risk-averse buyers Subscriptions should offer vendors similar payback longer term

Equity Research On-Demand SoftwareMorgan Stanley Technology Research

5

Annuity-Like Subscription Model

Year 1 Year 2 Year 3 Year 4 Year n. . .

$

Traditional Perpetual License Model

Year 1 Year 2 Year 3 Year 4 Year n. . .

$

Subscription Model

• Longer term, revenues should be similar

• Reasons why the subscription model is more attractive

– faster ROI

– no large upfront investment

– higher flexibility

– switching cost remain high

Area under the curve should be similar

On-demand model associated with a handful of high-profile start-ups, but usage fairly widespread Several established suppliers offer subscriptions

Equity Research On-Demand SoftwareMorgan Stanley Technology Research

6

Growing Universe of On-Demand Models

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Valuations look high on traditional metrics, rarely look cheap even on free cash flow

Equity Research On-Demand SoftwareMorgan Stanley Technology Research

7

Out Performance of On-Demand Vendors

Vendor Ticker Price Market Cap Revenues CustomersFree Cash Flow

CY04 Operating Margins

CY05 Forward P/E

salesforce.com CRM $20.11 $2,132 86.0% 56.2% 301.6% 3.7% 125.7X

WebEx WEBX $25.43 $1,143 33.4% 26.4% 56.5% 28.1% 22.1X

Websense WBSN $54.04 $1,292 35.5% 19.2% 41.4% 34.6% 36.5X

Growth Metrics (2002 to 2004)

0

50

100

150

200

250

6/6/

2003

8/6/

2003

10/6

/200

3

12/6

/200

3

2/6/

2004

4/6/

2004

6/6/

2004

8/6/

2004

10/6

/200

4

12/6

/200

4

2/6/

2005

4/6/

2005

6/6/

2005

Composite - (CRM/WBSN/WEBX) Softw are Holders Index

Relative Stock Performance of Select On-Demand Vendors

On-Demand models still the exception, but potential for disruption to status quo remains

Equity Research On-Demand SoftwareMorgan Stanley Technology Research

8

What Does the Future Hold?

•On-Demand model becomes mainstream

•Incumbent vendors get more involved

•New competition emerges

•Ultra-value tier emerges: On-Demand + Open Source combo

•Cross-over with internet assets

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Page 55

Equity Research

Evolution of SecurityMorgan Stanley Technology Research

1

Evolution of SecurityPresented by Peter KuperCovered by Peter Kuper

Security solutions can’t be static given varying vectors, threats New technologies exacerbate problem

Equity Research Evolution of SecurityMorgan Stanley Technology Research

2

•The security market is rapidly evolving– External, perimeter-facing defenses losing investment to internal,

application and data-focused defenses– Evolving threats rendering classic security products mostly useless– Open source no easy answer – critical updates for mozilla on the rise

•Evolving attacks creating persistent demand for innovation– No end in sight of evolving attacks with increasing intensity and

duration – Witty Worm a major warning – destructive payload – New products/protocols create new vectors (wifi, bluetooth, RFID,

VoIP)

Create Debate: Security EvolutionSecurity Quickly Evolving

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Still not fully protected

Equity Research Evolution of SecurityMorgan Stanley Technology Research

3

•Security has been an afterthought– Massive tech build out of the late 1990’s was entirely focused on access– First wave was reactionary – shut down the outside threat but runs

counter to intentions of e-commerce, insider threat realities

•And despite all the spend, still losing the battle

Create Debate: Security EvolutionLagging Behind Threat Evolution

“Given the widespread use of automated attack tools, attacks against Internet-connected systems have become so

commonplace that counts of the number of incidents reported provide little information

with regard to assessing the scope and impact of attacks. Therefore, as of 2004, we will no longer publish the number of

incidents reported.”

-CERT0

20,000

40,000

60,000

80,000

100,000

120,000

140,000

160,000

1995 1996 1997 1998 1999 2000 2001 2002 2003$0

$1,000

$2,000

$3,000

$4,000

$5,000

$6,000

$7,000

$8,000

$9,000

(mill

ions

)

Incidents Security Software Revenue

Paradigm shift is coming – invest accordingly

Equity Research Evolution of SecurityMorgan Stanley Technology Research

4

•New model required – Inclusion/Exclusion– Migration to contextual, conditional access paradigm requires

spend concentrated in different security segments– Internal focus will shift spending from perimeter

•Spending on traditional, mature areas will be less given refocused efforts, embedding of technology in other products and services.– This will drive all technology providers to become security

companies

•Security will become a technology and business enabler, not a multi-billion stand alone industry

Create Debate: Security EvolutionA Different View of the Model

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Market dynamics will sway stocks – play the trends

Equity Research Evolution of SecurityMorgan Stanley Technology Research

5

• Suites and appliances to rule– Buyers want to deal with fewer vendors, plug and play capability. Ease of use

a big issue with the multi-pronged framework of effective security.• Bundling drives pricing lower

– As buyers seek more protection from any single vendor, pricing goes lower as suppliers look to maximize total dollars per client, not dollars per product.

• Security to be included as a part of the product – 99.999% uptime– Large tech providers are incorporating security to make the core product more

reliable – whether a load factor or a hacker, availability still the main requirement

• Security as a business enabler, contra-expense– Security has been the priority given pressing needs however enterprises are

realizing hindering business is also a risk. A balance between secure and operational is being sought.

– For providers, security is becoming more a way to lower costs, improve satisfaction

Create Debate: Security EvolutionToday’s Market

Avoid the “market is so big” argument – it’s not that big on average

Equity Research Evolution of SecurityMorgan Stanley Technology Research

6

Create Debate: Security EvolutionMarket Sizing Reality CheckNot enough to go around

• Market not big enough to support all players

• Looks even worse considering revenue concentration

TotalIDC 2008 Total Security Market $16,000,000,000Est companies in the market today 700 Average sales for the year $22,857,143

-SYMC,CSCO,MFEIDC 2008 Total Security Market $11,500,000,000Est companies in the market today 697 Average sales for the year $16,499,283

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Examples support our embedded argument Industry moving beyond traditional direct, stand-alone model

Equity Research Evolution of SecurityMorgan Stanley Technology Research

7

Create Debate: Security EvolutionEmbedded Security & Commoditization

Source: Boston Globe

ISP’s Free Security Catching On• Get Embed! Hardware, Software, Service are each including security

– Large providers using security to sell core wares

• Cisco switch, router• Microsoft XP• AOL service

• Embedding to have dramatic impact on distribution, models

– pure play security vendors become OEMs – Any technology provider will consider security COGS

Cisco and Microsoft investing billions into security; certain segments likely absorbed Interoperability key for security vendors to survive if not flourish

Equity Research Evolution of SecurityMorgan Stanley Technology Research

8

Create Debate: Security Evolution3 Letters Drive Consolidation

Source: Morgan Stanley Research

NAP/NAC Both Expected To Have Impact• NAP or NAC – both will have impact.

– Tech titans are already plotting their embedded strategy. The Microsoft Network Access Policy (NAP) and Cisco Network Admission Control (NAC) will dictate security shift.– Partnerships and acquisitions allow best of’s to flourish as security is too critical to the core business for big boys to try and dominate the security “market”.

Communications Perimeter Network Data

A/VA/V

VPNVPN

F/WF/W

Access ControlAccess Control

SvrSvr SecuritySecurity

Data Level ProtectionData Level Protection

Ris

k Ex

posu

re

Solution Focus

+

_Commoditization line

IDS

Communications Perimeter Network Data

A/VA/V

VPNVPN

F/WF/W

Access ControlAccess Control

SvrSvr SecuritySecurity

Data Level ProtectionData Level Protection

Ris

k Ex

posu

re

Solution Focus

+

_Commoditization line

IDS

Microsoft

Cisco

GeCadGiant

Sybari

Okena

Protego

Airespace

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Page 59

Compliance and associated data leakage issues create new opportunities… … As will new technologies

Equity Research Evolution of SecurityMorgan Stanley Technology Research

9

•Acceleration of M&A in 2005 as big players step it up and IPO market still debatable

•Compliance will not ease issues, but will further complicate IT security – CorZox & ROI (Risk of Incarceration)?

•New technologies will create new security issues – VoIPwill create any number of problems some probably not even imagined

•But new technologies will also look to incorporate security as part of the solution – SOA/XML a good example

Create Debate: Security EvolutionNear-Term Drivers

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Page 60

Equity Research

BiometricsMorgan Stanley Technology Research

1

BiometricsPresented by Julie SantorielloCovered by Julie Santoriello

Long history in law enforcement Today’s opportunity in civil government Future opportunities in commercial applications

Equity Research BiometricsMorgan Stanley Technology Research

2

Background on BiometricsBiometrics is a $1.2 billion market,forecast to grow at a 40% CAGR through 2008

Biometrics Market: $1.2B, CAGR 2004-2008: 40%

Fingerprint Share: 65%, CAGR 2004-2008: 35%

Non-fingerprint Share 35%, CAGR 2004-2008: 49%

Identification (AFIS) Share 62%, CAGR 2004-2008: 24%

Authentication (non-AFIS) Share: 38%, CAGR 2004-2008: 49%

Civil Government Share 50%, CAGR 2004-2008: 32%

Law Enforcement Share: 50%, CAGR 2004-2008: 13%

Commercial and Civil Government

Source: International Biometric Group, 2003

END MARKETS –Past, Present, and Future

Law EnforcementMost mature opportunity;

upgrade cycle- 13% CAGR through 2008

Civil Government- Nascent market, but globalDriven by increased security concerns post-9/11Applications for border control, voter registration, national ID- 32% CAGR through 2008

CommercialMass adoption still likely 3-5 years away……but recent developments,

such as those in payment systems are encouraging- First inroads likely to be in security-sensitive regulated industries like finance, transportation, healthcare

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Fingerprint technology the sweet spot More accurate and proven than other biometrics, in our view

Equity Research BiometricsMorgan Stanley Technology Research

3

Background on BiometricsWhy the focus on

fingerprints?1. Highly accurate2. Easy to capture3. Non-intrusive4. Mature technology makes it

affordableA century of experience in criminal law enforcement

5. Many large, existing fingerprint databases for matching

Source: 2003 IDC IT Managers Survey

FBI started collecting fingerprints in 1924; now the largest database in existence with 47MM prints

1 2 3 4 5

Face

Keystroke

Signature

Hand

Iris

Voice

Fingerprint

Viability Cost TechnologyNote: 5 indicates "very viable" and 1 indicates "not viable at all."

Department of Homeland Security US VISIT database has over 5MM fingerprints today, could grow to >100MM

Numerous states and localities have police fingerprint databases, including CA, NY, TX, OH, FL, PA, CT, RI, AZ, HI, and LA County

Fingerprint systems have been used internationally for years, such as EURODAC, which tracks EU asylum seekers

Near-term opportunity in fingerprints Watch evolving opportunities for eye, face technologies

Equity Research BiometricsMorgan Stanley Technology Research

4

Background on BiometricsFingerprints should remain the market share leader through 2008

But facial and iris recognition will likely gain traction, and many systems will ultimately use two or more biometrics

middlew are7%

iris6%

signature2%

voice4%

hand7%

face9%

fingerprint (non-AFIS)

31%

fingerprint (AFIS)34%

2004

middlew are9%

iris8%

signature2%

voice5%

hand3%

face17% fingerprint

(non-AFIS)32%

fingerprint (AFIS)24%

2008

Source: International Biometric Group

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Page 62

Identification technologies have healthy margins, but profits are scarce in authentication

Equity Research BiometricsMorgan Stanley Technology Research

5

How Biometric Security Works and Money is Made

• Biometric security is about MATCHING• Two applications, Two business models:

– Identification: to determine the identity of an unknown person

• Requires a one-to-many match• Complex, proprietary, and costly solution• Suited to law enforcement and civil government applications• Few competitors; heavy R&D; strong margins

– Authentication: to establish whether an individual is whom he or she claims to be

• Requires a one-to-one match• Simpler, lower cost solution• Suited to commercial applications• Many competitors; standards exist• Profit margins below those for identification• Favors providers who can deliver scale and complexity

Examples of Identification:

1. Determining whether a suspect is a known criminal2. Determining whether a traveler is a known terrorist

Examples of Authentication:

1. Gaining access to a PC or handheld via a fingerprint sensor2. Entering the door to a restricted area via an iris scan

Leading technology: automated fingerprint identification systems (AFIS) Complex, long-term development = higher barriers to entry, high margins

Equity Research BiometricsMorgan Stanley Technology Research

6

How Biometric Security Works and Money is Made

The Fingerprint Identification Process

Fingerprints have proven best for identification – the primary money-making market for biometrics today

Other biometrics are likely to find acceptance in authentication, but money is not being made there today

Offering: Hardware

Examples: Capture devices

Technology: Standard

Suppliers: Many

Solution

Software Algorithm, Processors, Database

Proprietary

Few

Fingerprint Acquired

Minutiae Extracted

Algorithm Looks for Match

IMAGING STAGE AFIS STAGE(Automated Fingerprint Identification System)

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Cogent Systems the only pure play on AFIS

Equity Research BiometricsMorgan Stanley Technology Research

7

How Biometric Security Works and Money is Made

Only 4 companies provide highly accurate, large-scale AFIS systems that can search millions of fingerprints

Sagem 48.8%NEC 14.8%

Cogent 8.6%

Others 9.0%

Motorola 18.8%

2003 AFIS Worldwide Market Share • Bulk of the AFIS market is still law enforcement

• But civil government is the growth area

• Cogent has emerged as the dominant competitor in civil applications (>90% of company revenue)

• Motorola, NEC, and Sagemderive majority of revenue from law enforcement

Source: International Biometric Group

Fingerprint identification building momentum – major deals announced on all continents over past 12 months

Equity Research BiometricsMorgan Stanley Technology Research

8

Global FootprintLarge scale fingerprint identification systemsdeployed or under consideration:

• Law Enforcement– Widespread use in police forces and intelligence agencies in

the Americas, Europe, the Middle East and Asia – Technology upgrades needed

• Civil Government– Visitor screening

• U.S., UK, EU, Japan, Algeria

– National ID Card Systems active or pending:• Hong Kong, Pakistan, UK, Morocco

– Voting applications• Venezuela, Haiti, Iraq

• There are over 6.3 billion unique identities in the world today

• Growing at 1 billion every 10 years

• 95% reside outside of the U.S.

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Page 64

Biometrics becoming technology-of-choice for security; Mandates in multiple areas of civil government

Equity Research BiometricsMorgan Stanley Technology Research

9

Recent Highlights / Metrics• With US VISIT, biometrics moved out of the realm of law enforcement and

into a new growth phase driven by civil government adoption#Conclusion: The war on terror means continued funding for border

entry/exit systems, and the U.S. will likely serve as a reference implementation for other nations.

• The PIV (Personal Identity Verification) standard will enable the identification and authentication of all federal government employees using biometric-enabled smartcards

#Conclusion: By mandating the use of biometric-enabled ID cards for all federal employees, and establishing the PIV standard, the federal government has laid the groundwork for adoption by the commercial sector

US IDENT system – rolled out early 1990s

- 15 sec response time- 12MM person database- 25,000 tx/day

US VISIT system – rolled out Dec 2003

- 5MM person database going to >100MM

- 14,000 tx/day initially, going to >1MM

- 4 sec response time

PIV standard – introduced in Feb 2005, exp roll out in 4Q06

- 10MM person database incl all fed employees & contractors

- Could equate to same # of authentication transactions daily

- Plus roughly 1MM+ identification tx annually

Look beyond US borders for growth; commercial channels also adopting

Equity Research BiometricsMorgan Stanley Technology Research

10

Recent Highlights / Metrics • International adoption of biometrics for civil government applications is

accelerating, with recent implementations in Venezuela, Algeria, Haiti, and Morocco

#Conclusion: Security is often an even greater concern in the developing world than in the United States, and governments are increasingly using biometrics to prevent terrorism and fraud

• Biometrics are gaining traction in the commercial-sector, especially with retail payment systems as several supermarkets are piloting fingerprint authentication to access stored credit card and checking account data to make payment.

#Conclusion: Allowing consumers to pay by touching a fingerprint sensor can simplify checkout, enhance consumer loyalty and increase store throughput

Governments that have implemented civil biometric systems:- United States- European Union - Venezuela- Hong Kong- Jordan- Algeria- Morocco- Pakistan- Indonesia

Retailers that have conducted pilots of biometric payment systems:- Piggly Wiggly- Pick n Save - Cub Foods- Thiftway- Albertsons- Co-op (U.K.)- Combos

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Who do you trust? Biometrics enable identification and authentication

Equity Research BiometricsMorgan Stanley Technology Research

11

Key Drivers of Biometrics AdoptionFinding a better way to secure against:• Criminal activity

– Background checks– Physical access control

• Terrorist activity– Border control– Transportation of people and hazardous materials– International commerce, cargo

• Fraud– Credit card and other financial transactions– Identity theft– Healthcare records and other privacy concerns

• Data Integrity– Networked systems access– Protection of IP

Government implementation paving way for private sector adoption

Equity Research BiometricsMorgan Stanley Technology Research

12

Key Issues and Risks

•Expense – better security alone may not justify it

•Privacy concerns

•Quality, Accuracy – under a microscope

•Customer base – large, but limited, near-term

•Many commodity device suppliers – profitable?

•Timing of commercial adoption

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See adoption spreading from government into mass commercial market within 3-5 years

Equity Research BiometricsMorgan Stanley Technology Research

13

Industry Structure Today … and Tomorrow

GovernmentRegulated Industries

Commercial (Mass Adoption)

Law enforcement

DOD

Financial

m-commerce

e-commerce

Healthcare

Transportation

TransactionsFederal Agencies

National ID & Passport Programs

DHS

We are Here today

Enterprise Security

Access

Point of Sale

Source: Identix, Inc.

Expect more losers than winners in biometrics, but winners could win big

Equity Research BiometricsMorgan Stanley Technology Research

14

Potential Winners and Losers

• Potential Winners– Vendors with strong government relationships

• Hardware and services providers

– Smart card systems makers and integrators– Customers who can realize more than improved security from

a biometrics system• Credit card issuers, online retailers

• Potential Losers– Providers of less effective security solutions

• PKI vendors, encryption software, physical security personnel

– The Nth maker of capture devices• In commoditizing hardware category, must be top 2 or 3

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Page 67

Equity ResearchOffshoringMorgan Stanley Technology Research

1

OffshoringPresented by Anantha NarayanCovered by Anantha Narayan

Current global market share just 3% after 30% revenue 5-year CAGR – IT offshoring could be disruptive

Equity Research OffshoringMorgan Stanley Technology Research

2

0.8%1.1% 1.2%

1.7% 1.8% 2.0%2.4%

3.1%

5.2%

0%

1%

2%

3%

4%

5%

6%

C19

90

C19

91

C19

92

C19

93

C19

94

C19

95

C19

96

C19

97

C19

98

C19

99

C20

00

C20

01

C20

02

C20

03

C20

04

C20

07E

Negligible

0.1 0.2 0.2 0.3 0.5 0.7 1.1 1.8 2.6 3.45.3 6.2 7.1

9.2

12.2

24.4

0

5

10

15

20

25

F199

1

F199

2

F199

3

F199

4

F199

5

F199

6

F199

7

F199

8

F199

9

F200

0

F200

1

F200

2

F200

3

F200

4

F200

5E

F200

8E

Offshore services – more steam leftIT services exports from India (US$ Bn)

India’s market share in Global IT services spending

Source: NASSCOM, Morgan Stanley Research

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Page 68

Gradual shift in revenue mix toward package software implementation and infrastructure management… …retail and healthcare…

Equity Research OffshoringMorgan Stanley Technology Research

3

Banking, financial services & insurance

37%

Healthcare6%

Others25% Telecom service providers

7%

Retail6%

Telecom equipment

9%

Manufacturing13%

IS outsourcing0.2%

Network infrastructure management

2.9%

Hardware support & installation

0.4%

R&D services24.9%

Custom application development and

maintenance38.5%

IT education & training0.2%

Packaged Software support

& installation6%

IT consulting1.3%

Systems integration1.5%

Network consulting & integration

0.5%

Application Outsourcing

23%

Financial services were a key driver …Main Locations in India

New Delhi

Mumbai

Bangalore

Hyderabad

Noida

Pune

Calcutta

Chennai

Chandigarh

F2004 Key Service Revenue Split

F2004 Industry Revenue Split

Source: NASSCOM, Morgan Stanley Research

… and Europe

Equity Research OffshoringMorgan Stanley Technology Research

4

… and so was the US geographyGlobal IT Services Spending

206159

12

10

11

7

151

120

41

35

34

19

C2002 C2007EUS$ Billion

455

350

US$ 8.7 bn (68.3%)

US$ 143.3 mn (1.1%)

US$ 104.9 mn

(0.8%)

US$ 80.6 mn

(0.6%)

US$ 385.4 mn (3%)

US$ 2.9 bn

(22.6%)

Exports from India (F2004)

F2004 Growth in F2005E

IT services exports 9.2 26%

ITES exports 3.6 42%

Total 12.8 31%Source: NASSCOM, Morgan Stanley Research

Indian IT services and ITES export market (US$ bn)

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Page 69

Three drivers: – 30-40% cost savings – Availability of highly skilled labor – Stringent quality processes

Equity Research OffshoringMorgan Stanley Technology Research

5

Offshore = Costs + Availability + Quality

Labor Supply in IndiaF2004 F2005E F2006E F2007E

Number of engineering graduates 215,000 284,000 348,000 382,000

Number of IT (Comp.Sc, Electronics, Telecom) professionals 141,000 165,000 181,000 193,000

Number of IT professionals entering the workforce 80,000 94,000 103,000 109,000

Number of non-IT engineers entering IT workforce 40,000 40,000 40,000 40,000

Number of graduates (other discipline) entering the IT workforce 30,000 30,000 30,000 30,000

Total fresh IT labor supply 150,000 164,000 173,000 179,000

Cost Savings

Source: Infosys, Morgan Stanley Research

Source: NASSCOM

Global Quality No of IndianAccreditations companiesISO 9000 14ISO 9001 267ISO 9002 16SEI CMM- Level 5 85- Level 4 35- Level 3 24

PCMM- Level 5 12- Level 3 & 2 10

CMMi Level 5 21BS7799 40COPC 11Six Sigma 30Others 24

Client Estimation of Cost

100 Estimation of Work

90

Productivity Improvements

10

Offshore Revenue

26

Onsite Revenue

27

Management Costs

10

Global Delivery Benefits

37

Last 12 months were strong; given high revenue visibility, employee additions point toward robust next 12 months as well

Equity Research OffshoringMorgan Stanley Technology Research

6

48%

68%

38%

63% 58%

47%

0%

10%

20%

30%

40%

50%

60%

70%

Cognizant HCLT Infosys Satyam TCS Wipro

38% 40%

47%

38% 37%

57%

0%

10%

20%

30%

40%

50%

60%

Cognizant HCLT Infosys Satyam TCS Wipro

70%

48%52%

61%

35%

83%

0%

20%

40%

60%

80%

100%

Cognizant HCLT Infosys Satyam TCS Wipro

Growth rates have accelerated

Addn during Addn as % of Employees asF2005 Mar-04 base at Mar-05

Cognizant 6560 63% 17050

HCLT 7251 49% 22034

Infosys 11495 46% 36750

Satyam 5996 43% 20028

TCS 10871 36% 40992

Wipro 13355 47% 41857

Total 55528 45% 178711

F2005 YoY Revenue Growth EBIT Growth

Net Income Growth

Source: Company Data, Morgan Stanley Research EstimatesNote: HCL Tech has a June year-end and Cognizant has a December year-end. F2005 numbers are adjusted for March year-end

Employee additions

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Page 70

Risk #1: Pricing power? Increasing expansion by multinationals in offshore locations will pressure wages

Equity Research OffshoringMorgan Stanley Technology Research

7

Multinationals pressurize wagesIndia expansion by multinational companies

Company Current Number India Plans Update DateAccenture 11,000 Inc offshore headcount to 33% May-05

of total headcount over next 5 yrsBearingPoint 100 2,000 in 2 years Jul-04Cap Gemini 2,000 Started 3rd center in Mumbai May-05

(capacity = 740)Convergys 10,000 20,000 within next 2 years Feb-05CSC 2,400 3,000 by end of 2005 Jan-05EDS 2,200 4,400 by end Dec 2005 May-05GE Capital 13,000 Nov-04HSBC 4,000 Feb-04IBM Global Services 10,500 Jun-04Keane 1,750 2,750 by end of 2005 Mar-05Oracle 6,900 Mar-05PeopleSoft 400 1,000 by end of 2005 Jan-05SAP 1,300 3,000 by end of 2006 Jan-05

Source: Various Newspapers and Websites, NASSCOM, Morgan Stanley Research

At the margin, aggressive expansion of low-cost units by global companies could dilute the pure-plays’ USP.

High recruitment levels have taken wages up, especially for mid-level employees.

Source: Dataquest-IDC

Salary change in F2004Experience Bracket Average Salary (US$) % Change over 2003

Less than 2 years 5500 - 6500 -12%

2 to 5 years 8000 - 9000 11%

5 - 10 years 11000 - 15000 24%

Over 10 years 21000 - 27000 26%

Risk #2: Talent pool and shortage of project management skills in current high-growth environment

Equity Research OffshoringMorgan Stanley Technology Research

8

Supply: Sufficient but gaps in some areas

2008 employee projections for the Indian sector

• The number of students that graduate each year is large and can potentially ensure sufficient supply for the next 3-4 years, at least.

• However, there appears to be a shortage in areas such as project management, where wage inflation is significant. The rapid hiring is also adding to wage inflation currently. 44% of total advertisements made in Indian newspapers and internet sites during Nov and Dec 2004 were by the IT and ITES sector, of which 40% were from Bangalore.

• The government proposes to set up new schools (including IITs) and expand existing ones.

460,000

520,000

140,000 592,000

528,000

1,120,000

0

200,000

400,000

600,000

800,000

1,000,000

1,200,000

IT ServiceExports

DomesticMarket

Products andTechnology

Services

Total Demand Current Pool New Supply

460,000

520,000

140,000 1,120,000

0

200,000

400,000

600,000

800,000

1,000,000

1,200,000

IT ServiceExports

DomesticMarket

Products andTechnology

Services

Total Demand Current Pool New SupplyRequired

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Page 71

Risk #3: Managing headcount from new offshore locations, possible competition from new players

Equity Research OffshoringMorgan Stanley Technology Research

9

Other offshore centers could develop

India $195,000 export focused IT professionals

$ IT employee cost –US$5,000-12,000 per year

$Low-cost, high-quality labour

% Average infrastructure

$Robust project management experience

Canada $ 45,000 export focused IT professionals

% IT employee cost –US$36,000 per year

$High-cost, high-quality labour

$Good infrastructure

$Near shore and compatible culture with US and UK

Israel $15,000 export focused IT professionals

$ IT employee cost –US$15,000 per year

$High-cost, high-quality labour

$Good infrastructure

% Regional unrest

Ireland $21,000 export focused IT professionals

% IT employee cost –US$25,000-35,000 per year

$High cost, high quality labour

$Good infrastructure

$Significant offshoring precedent

Philippines $20,000 export focused IT professionals

$ IT employee cost –US$7,000 per year

% Moderate quality labour

$Good infrastructure

% Low availability of project managers

China$26,000 export focused IT

professionals

$ IT employee cost –US$9,600 per year

% Average infrastructure

$Proximity to Japan and Korea

% Project management experience weak

Source: NASSCOM, Morgan Stanley Research

Risk #4: Currency movements – 1% rise in the rupee against US$ hurts operating margins by 30-40 bps

Equity Research OffshoringMorgan Stanley Technology Research

10

-7.4%

-22.9%

-19.3%

-9.9%

-0.7%

-3.1%

-8.4%

-2.5%

-11.9%

-4.2% -4.2% -4.7%-2.9%

4.3%2.8% 3.1%

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

Dec

-90

Dec

-91

Dec

-92

Dec

-93

Dec

-94

Dec

-95

Dec

-96

Dec

-97

Dec

-98

Dec

-99

Dec

-00

Dec

-01

Dec

-02

Dec

-03

Dec

-04

YTD

200

5

Rupee appreciation is a concern

Rupee appreciation

v/s US$

Rupee depreciation

v/s US$

Source: Bloomberg, Morgan Stanley Research

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Page 72

Winners: Tier-1 offshore players and multinationals with low exposure to offshore threat or high offshore capacity

Equity Research OffshoringMorgan Stanley Technology Research

11

Relative winners and losers

Source: Morgan Stanley Research

Pure-play offshore

companies should gain

market share

Incumbents with either low exposure to offshore threat or

high offshore capacity

Incumbents with either high exposure to offshore threat or

low offshore capacity

.

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Page 73

Analyst Certification The following analysts hereby certify that their views about the companies and their securities discussed in this report are accurately expressed and that they have not received and will not receive direct or indirect compensation in exchange for expressing specific recommendations or views in this report: Mary Meeker, Brian Pitz, Brian Fitzgerald, Mark Edelstone, Rebecca Runkle, David Togut, Ross MacMillan, Louis Gerhardy, Peter Kuper, Julie Santoriello, Timm Schulze-Melander, Harlan Sur, Scott Coleman, Kathryn Huberty, Laurie Kennedy, Bernie Mahon, John Marchetti, Charles Murphy and Anantha Narayan.

Important US Regulatory Disclosures on Subject Companies The information and opinions in this report were prepared by Morgan Stanley & Co. Incorporated and its affiliates (collectively, "Morgan Stanley"). The following analyst, strategist, or research associate (or a household member) owns securities in a company that he or she covers or recommends in this report: Mary Meeker - eBay (common stock), Microsoft (common stock), Yahoo! (common stock); Brian Pitz - Yahoo! (common stock). Morgan Stanley policy prohibits research analysts, strategists and research associates from investing in securities in their sub industry as defined by the Global Industry Classification Standard ("GICS," which was developed by and is the exclusive property of MSCI and S&P). Analysts may nevertheless own such securities to the extent acquired under a prior policy or in a merger, fund distribution or other involuntary acquisition. As of June 30, 2005, Morgan Stanley beneficially owned 1% or more of a class of common equity securities of the following companies covered in this report: eBay, Google, Yahoo!, Apple Computer Inc., Cogent, Motorola, NVIDIA Corporation and salesforce.com. Within the last 12 months, Morgan Stanley managed or co-managed a public offering of securities of Google, Cogent and Tata Consultancy Services. Within the last 12 months, Morgan Stanley has received compensation for investment banking services from eBay, Google, Microsoft, Cadence Design, Cisco Systems, Cogent, Motorola, NVIDIA Corporation, Polycom, RSA Security, salesforce.com and Tata Consultancy Services. In the next 3 months, Morgan Stanley expects to receive or intends to seek compensation for investment banking services from eBay, Google, Microsoft, Yahoo!, Apple Computer Inc., Cadence Design, Cisco Systems, Cogent, Motorola, NVIDIA Corporation, Polycom, salesforce.com and Tata Consultancy Services. Within the last 12 months, Morgan Stanley has received compensation for products and services other than investment banking services from eBay, Microsoft, Apple Computer Inc. and Cisco Systems. Within the last 12 months, Morgan Stanley has provided or is providing investment banking services to, or has an investment banking client relationship with, the following companies covered in this report: eBay, Google, Microsoft, Yahoo!, Apple Computer Inc., Cadence Design, Cisco Systems, Cogent, Motorola, NVIDIA Corporation, Polycom, RSA Security, salesforce.com and Tata Consultancy Services. Within the last 12 months, Morgan Stanley has either provided or is providing non-investment banking, securities-related services to and/or in the past has entered into an agreement to provide services or has a client relationship with the following companies covered in this report: eBay, Microsoft, Apple Computer Inc., Cadence Design, Cisco Systems, Motorola, NVIDIA Corporation, Polycom and RSA Security. The research analysts, strategists, or research associates principally responsible for the preparation of this research report have received compensation based upon various factors, including quality of research, investor client feedback, stock picking, competitive factors, firm revenues and overall investment banking revenues. Morgan Stanley & Co. Incorporated makes a market in the securities of eBay, Google, Microsoft, Yahoo!, Apple Computer Inc., Cisco Systems, Cogent, NVIDIA Corporation, Polycom and RSA Security.

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Stock Ratings Different securities firms use a variety of rating terms as well as different rating systems to describe their recommendations. For example, Morgan Stanley uses a relative rating system including terms such as Overweight, Equal-weight or Underweight (see definitions below). A rating system using terms such as buy, hold and sell is not equivalent to our rating system. Investors should carefully read the definitions of all ratings used in each research report. In addition, since the research report contains more complete information concerning the analyst’s views, investors should carefully read the entire research report and not infer its contents from the rating alone. In any case, ratings (or research) should not be used or relied upon as investment advice. An investor’s decision to buy or sell a stock should depend on individual circumstances (such as the investor’s existing holdings) and other considerations.

Global Stock Ratings Distribution (as of June 30, 2005)

Coverage Universe Investment Banking Clients (IBC)

Stock Rating Category Count % of Total Count

% ofTotal IBC

% of Rating Category

Overweight/Buy 680 35% 263 40% 39%Equal-weight/Hold 880 46% 300 46% 34%Underweight/Sell 362 19% 91 14% 25%Total 1,922 654 Data include common stock and ADRs currently assigned ratings. For disclosure purposes (in accordance with NASD and NYSE requirements), we note that Overweight, our most positive stock rating, most closely corresponds to a buy recommendation; Equal-weight and Underweight most closely correspond to neutral and sell recommendations, respectively. However, Overweight, Equal-weight, and Underweight are not the equivalent of buy, neutral, and sell but represent recommended relative weightings (see definitions below). An investor's decision to buy or sell a stock should depend on individual circumstances (such as the investor's existing holdings) and other considerations. Investment Banking Clients are companies from whom Morgan Stanley or an affiliate received investment banking compensation in the last 12 months.

Analyst Stock Ratings Overweight (O). The stock’s total return is expected to exceed the average total return of the analyst’s industry (or industry team’s) coverage universe, on a risk-adjusted basis, over the next 12-18 months. Equal-weight (E). The stock’s total return is expected to be in line with the average total return of the analyst’s industry (or industry team’s) coverage universe, on a risk-adjusted basis, over the next 12-18 months. Underweight (U). The stock’s total return is expected to be below the average total return of the analyst’s industry (or industry team’s) coverage universe, on a risk-adjusted basis, over the next 12-18 months. More volatile (V). We estimate that this stock has more than a 25% chance of a price move (up or down) of more than 25% in a month, based on a quantitative assessment of historical data, or in the analyst’s view, it is likely to become materially more volatile over the next 1-12 months compared with the past three years. Stocks with less than one year of trading history are automatically rated as more volatile (unless otherwise noted). We note that securities that we do not currently consider "more volatile" can still perform in that manner. Unless otherwise specified, the time frame for price targets included in this report is 12 to 18 months. Ratings prior to March 18, 2002: SB=Strong Buy; OP=Outperform; N=Neutral; UP=Underperform. For definitions, please go to www.morganstanley.com/companycharts.

Analyst Industry Views Attractive (A). The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be attractive vs. the relevant broad market benchmark named on the cover of this report. In-Line (I). The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be in line with the relevant broad market benchmark named on the cover of this report. Cautious (C). The analyst views the performance of his or her industry coverage universe over the next 12-18 months with caution vs. the relevant broad market benchmark named on the cover of this report.

Stock price charts and rating histories for companies discussed in this report are also available at www.morganstanley.com/companycharts. You may also request this information by writing to Morgan Stanley at 1585 Broadway, 14th Floor (Attention: Research Disclosures), New York, NY, 10036 USA.

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Other Important Disclosures This research report has been published in accordance with our conflict management policy, which is available at www.morganstanley.com/institutional/research/conflictpolicies. For a discussion, if applicable, of the valuation methods used to determine the price targets included in this summary and the risks related to achieving these targets, please refer to the latest relevant published research on these stocks. Research is available through your sales representative or on Client Link at www.morganstanley.com and other electronic systems. This report does not provide individually tailored investment advice. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The securities discussed in this report may not be suitable for all investors. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a financial adviser. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives. This report is not an offer to buy or sell any security or to participate in any trading strategy. In addition to any holdings disclosed in the section entitled "Important US Regulatory Disclosures on Subject Companies", Morgan Stanley and/or its employees not involved in the preparation of this report may have investments in securities or derivatives of securities of companies mentioned in this report, and may trade them in ways different from those discussed in this report. Derivatives may be issued by Morgan Stanley or associated persons. Morgan Stanley & Co. 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