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Inventory in Semiconductors Looking Lean


Anything less than the current figure would be problematic.

Usually once each quarter, I opine on the state of inventory within the technology and telecommunications supply chain based upon the more than 400 companies that I monitor. We're at a point today where there have been some significant improvements, but the reality is, that improvement is far from universal.

When demand literally disappeared in the fourth quarter of 2008, each rung of the supply chain attempted to slash inventory as quickly as possible. Using Intel (INTC) as a proxy, it saw more than $2.0 billion of anticipated revenue disappear in less than 60 days. The result of those dramatic changes was to inflate supply-chain inventory to levels well above optimal.

What you see in the graph below is total supply-chain inventory measure in days-of-inventory (DOI) for the last 16 years. I separate the supply chain into two segments: semiconductor companies, where the products start; and customers, the hardware OEMs, contract manufacturers, distributors, and retailers who handle the inventory on its way to the end-customer.

There are two interesting characteristics of the chart below in the days prior to the bubble bursting. First, inventory days were extremely volatile with rather dramatic swings over very short periods. Second, since the bubble burst there's been an overall reduction in supply-chain inventory as well as a perceptible shift of inventory from the customers to the semiconductor companies.

From my perspective, the optimal level of inventory stands at about 113-116 days versus years ago when it was quite common to be north of 130 days. Currently, at 112 days, it would appear that we're very lean as many sell-side analysts have suggested. Anything much below that figure becomes problematic because it can take anywhere from 8-13 weeks to process a semiconductor wafer from wafer start to package and test. Consequently, there needs to be some slack in the supply chain. Despite the current figure, the composition of the inventory is just as important as the actual number.

As you can see below, inventory at semiconductor companies currently stands at 61 days. Since the "shift" took place post-bubble, that's almost unheard of. What appears to be the optimal level is generally in the 68-70 day range. We don't have 100% of the monitored universe of semiconductor companies having reported yet, but of those that have reported, they represent about three-quarters of total semiconductor inventory. Consequently, the numbers are unlikely to change much.

On the customer-side of the equation, we have a problem. DOI are currently at 51 days whereas the optimal range is about 44-46 days. Unlike the semi-side, this figure will decline despite the fact that nearly 80% of the inventory is reported. Cisco (CSCO), Dell (DELL), and Hewlett-Packard (HPQ) have yet to report and, given their size and lean business models, they're likely to knock two to three days off the current figure.

Another "mixed" data point is the sequential change (second quarter to third quarter) in inventory in the current year versus the recent past. This gives you a sense of what's happening compared to normal seasonality. Here again, if you look at the graph below, you'll see a decided difference between the two sub-groups. Inventory at semiconductor companies has declined 1.4% from the June quarter versus a normal increase of 1.7%. That's a big swing! On the customer side of the equation, inventories are up 2.9% versus a "normal" seasonal change of 2.1%. All of that increase has come from hardware OEMs because the contract manufactures and distributors are down sequentially.

This raises the question as to what they (the OEMs) are expecting in the December quarter and why. But if the OEMs are wrong, the semiconductor companies are in a far better position to withstand another "correction" than they were at this time last year.

It's important to remember why inventories are important and how the levels impact the numbers. The quick answer is that inventories don't finance themselves. They tie up working capital but without them, you stand to lose sales -- particularly if demand is stronger than anticipated. When they build up to levels above optimal, working them down can put extreme pressure on margins -- particularly if your business model includes high levels of capital investment.

It's a balancing act, but the reality is that the supply chain has become much better at dancing on the head of a pin in recent years and reacting when it's necessary.
No positions in stocks mentioned.
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