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Inventory Tug-of-War: Destockers vs. Restockers


Endless back-and-forth sign of an atypical recovery.

Inventory Reduction and Restocking

During the first quarter of 2009, US economic production resembled something along the lines of deer in headlights. The silence of consumption was deafening,and companies continued to work off their existing inventories in order to become leaner and meaner to compensate for further weak economic conditions.

When plotted, almost every economic graph looked akin to the trajectory of a cliff diver you see on a Caribbean commercial who's doing a swan dive into the pristine ocean below. It should come as no surprise that certain inventories do have to be replenished at some point (albeit likely at much lower levels than previously held).

What we essentially have going on right now is a tug-of-war between those who destocked too much and those who still have significant inventory to work through. Many companies have recently confirmed the inventory tug-of-war thesis during the first quarter. I've posted examples of such below:


Maxim Integrated Products (MXIM) April 30 earnings release: "Inventory restocking by some of our larger customers also contributed to sales exceeding expectations."
Customer restocking.

Brush Engineered Materials (BW) April 30 earnings re: "Part of the expected second quarter sales increase from the consumer electronics-oriented markets is driven by the reduction of inventory levels in the supply chain during the first quarter." Expected restocking due to prior destocking. BW is one of the largest manufacturer's of specialty alloy materials that are used in virtually every industrial industry.

Celanese Group (CE) April 28 earning release: "However, as we moved out of the first quarter, we believe that the majority of inventory destocking through our customer supply chains is behind us."
Customers have started restocking.

Potash (POT) April 23 conference call: "Destocking efforts that kept customers out of the fertilizer market over the past 8 months are nearly complete. Company sees signs markets are preparing to return."
Customer restocking to come.

Peabody Energy (BTU) April 15 earnings release: "There are early signs of stabilization, steel destocking has slowed." Coal companies supply metallurgical coal to steel companies.

March 26 conference comments: Samsung executive says the market will begin seeing spot shortages of memory chips as inventory is inadequate already.
Forecasted restocking (and was correct).


Eaton (ETN) May 19 conference call: "ETN executives saying that second-quarter revenues could come in $100 million below previous forecast because customers continue to reduce inventories."
Customer destocking

Emerson Electric (EMR) May 19 8k filing: "Unfortunately, we have seen a sequential deterioration in our underlying orders from the month of March to April and believe orders are still reflecting a volatile economic environment where customers continue to reduce inventory, backlogs and business spending levels."
Customer destocking

Cliffs Natural Resources (CLF) April 30 conference call: "The company usually builds inventory in the first quarter, but less cash was laid out this year."

Cadbury Schweppes (CBY) April 30 earnings release: "Reported a sharp slowdown in sales in the first quarter, driven by a combination of customers destocking inventory and weakening demand in North America and Europe."
Customer destocking (from a boring business, no less).

Dow Chemical (DOW) April 30 earning release: "Volume declined 19% compared with the same quarter of 2008, while price was down 20%, reflecting the effects of the ongoing recessionary business climate and continued inventory destocking in most value chains." Customer destocking.

CSX Corp (CSX) April 15 conference call: "Destocking activity through will continue through the second quarter at some of the major industrial segments."
Customer destocking

Alcoa (AA) April 7 conference call: "The collapse and demand was due not only to weaker end markets, but also to the significant destocking occurring throughout the supply chain." Customer destocking

In summary, what we're likely experiencing is a restocking in consumer electronics and other industries that have short order-lead times and tightly control their inventory; while at the same time, undergoing a continued destocking by long-cycle industrial companies that arguably started last November.

The markets have traditionally keyed off of short-lead-time industries for signs of recovery (e.g. technology). The problem with this is that any signs of short-order strength or industrial strength are merely a result of temporary inventory restocking or inventory hoarding, ala China - more on that below.

The chart below is the US Inventory to Sales Ratio (Inventory/Sales). You can see the persistent trending down of this ratio dating back 17 years until June 2008. Either companies have universally chosen to keep more inventory on hand since summer of 2008 (insert loud laughter), or we have a huge amount of excess inventory to work off before any meaningful restocking can occur.

Manufacturers' only hope at the moment is that global economic growth will revive itself and chew through said excess inventory. Good luck with that. There's little doubt in my mind that the inventory will be slowly worked off with respect to time rather than a sudden burst of growth.

The wild card in this is the US dollar. If the formerly almighty buck drops low enough to make consumption of these inventories much cheaper for foreigners to import rather than produce domestically, then the unwinding process will be quicker, but not by much. The US Capacity Utilization numbers that came out yesterday at 69.1% (new lows) also reaffirm that demand for new or additional plant and equipment won't be coming to fruition any time soon.

Click to enlarge

Click to enlarge

You can also find similar comments in the April ISM Manufacturers Index (formerly known as the NAPM Index) press release from May 1, where the Chairman of the ISM Committee stated:

"The Customers' Inventories Index indicates that channels are paring inventories to acceptable levels after reporting inventories as 'too high' for 8 consecutive months. The prices manufacturers pay for their goods and services continue to decline; however, copper prices have bottomed and are now starting to rise. This is definitely a good start for the second quarter."

The concern I have is that over the past few months, numerous commodity producers have announced plans to curtail or shut in production. Industries such as ferrous and non-ferrous metals, natural gas, potash and even most recently (gasp) coal, finally came to grips with reality and turned off the spigot. Therefore, commodity prices we're seeing in the marketplace are not so much based on increasing demand with constant or dwindling supply as much as they're based on what currency they're priced in, and more importantly, supply diminishing at a greater rate than that of demand.

The resulting price action has lead some to conclude that rising prices are foretelling of world economic growth getting back on track. Copper is a good example of this. Yes, I know this is Economics 101. What isn't Economics 101 is what's led to the global consumption contraction, and what happens after any temporary blips in demand for inventory run their course. Perhaps Socioeconomics 101 would be a better course for that lesson.

You can see this already starting to happen by reading the end of the ISM comment posted above regarding copper. Beware the song of the sirens.

As you know, I feel the recovery will be atypical, and this back-and-forth tug-of-war is a good example of the type of economic chop we're in store for; fits and starts represented by the blade of the hockey stick.

Over the last 2 months, Chinese economic activity has been sparked by internal stimulus, government stockpiling as well as Chinese industrial producers' restocking their own raw-material inventories. The more reliable CLSA economic numbers also confirm such. Chinese manufacturers aren't ignorant to economics, and they're rebuilding these inventories from companies such as RIO, Rio Tinto (RTP) and Billiton (BHP) at substantially discounted rates (20-50% y/y discounts). In fact, at a conference in Beijing on April 28, a China Ministry of Industry Official, Jia Yinsong, said China's iron ore imports in March exceeded demand, which led to port congestion. So while inventories are being replenished, it's occurring at substantially cheaper prices. Sound familiar?

Take a look at the bases that have formed -- and in some instances experienced breakouts -- in numerous commodities such as copper, coal, lumber, aluminum, zinc, nickel etc. I'm referencing GSCI spot for the industrial metals. Some have broken out of their supply-constrained bases while others are still trading within them. The reason for each commodity's respective action is what's important to remember.

If certain oil-producing nations weren't so desperate to sell oil to meet their domestic obligations (e.g. certain Latin American countries and Russia) I suspect you'd be seeing oil prices tracing out a similar pattern as the aforementioned commodities. In fact, it still might.
No positions in stocks mentioned.
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