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THE DAY AHEAD: Your write-off or mine?

COMMENTARY--Cisco Systems is in the running for partner of the year. Instead of leaving its outsourcing partners with tons of excess inventory for another quarter, the networking giant stepped up to the plate and said it will take a huge $2.5 billion inventory write-off in its April quarter. The move also saved the stocks of Jabil Circuit, Solectron and their peers.

Networking-equipment giant Cisco outsources most of its manufacturing to companies such as Jabil (NYSE: JBL) and Solectron (NYSE: SLR), which make the final products for other companies. And Cisco isn't alone. Cisco rival Nortel Networks (NYSE: NT) as well as PC makers all outsource manufacturing. Hewlett-Packard (NYSE: HWP) is already planning an inventory write-down.

That's why Cisco's inventory write-off was seen as good news for electronics manufacturing services (EMS) companies, also known as contract equipment manufacturers. In English, these firms make stuff for other companies that don't want to build their own plants.

Why was Cisco's write-down such a big deal to its partners? Cisco could have strung along EMS companies and left them with bloated inventory levels. Here's why Cisco took the write-down. If a contract equipment vendor had to take a big inventory write-down, it would have hurt sentiment on the whole industry, said Goldman Sachs analyst Michael Zimm. EMS stocks are popular because there isn't supposed to be much inventory risk.

Now Cisco has set a trend by basically handing a check to its EMS partners. Cisco CEO John Chambers said the write-off was important to maintain good relations with Solectron and Jabil.

The conversation may have went like this:

    Chambers: Whe-wee…we have 100-year flood of inventory.

    EMS folks: Tell us about it. We're holding way to much of your raw material.

    Chambers: Your write-down or mine?

    EMS folks: It's your inventory and our contract says you get the write-down anyway. All yours.

    Chambers: Damn.

"The inventory write-off is good news as it highlights Cisco's continued acceptance of responsibility for inventory, something for which it is contractually responsible anyway, but has been called into question just the same. We believe the majority of other large OEMs will likely behave in a similar fashion," said ING Barings analyst Patrick Parr.

Simply put, shareholders of contract manufacturing companies breathed a sigh of relief over the Cisco charge. The contract equipment business model hinges on low inventory risks. Under the usual terms of engagement, the inventory risks rest with the OEMs (original equipment manufacturers.)

However, the IT spending meltdown put contract equipment companies to the test. "If there ever was to be a significant test of the (outsourced) business model, particularly from what is arguably the industry's most important customer with the industry's worst inventory problem, this was it," Zimm said.

Getting stuck with inventory is no small matter--for any company. When most manufacturing is outsourced things can get really sticky. Cisco's inventory for its April quarter ballooned to $4.1 billion. That's a banner year in sales for most companies.

Analysts said it's impossible to know how much of Cisco's inventory its outsourcing partners were holding, but it was enough to rattle EMS shares leading up to the networking giant's profit warning.

Paul Fox, an analyst at Banc of America, said Cisco's write-down "probably relieves at least some of the pressure that this inventory issue has been generating."

But there's still pressure. Although the inventory risk has waned for contract equipment vendors, Cisco's profit warning, along with Nortel's and a host of other telecom equipment companies' warnings, can't be good news. Jabil gets 16 percent of its sales from Cisco; followed by Solectron, 12 percent; Flextronics International (Nasdaq: FLEX) and Sanmina (Nasdaq: SANM), 10 percent; and Celestica (NYSE: CLS), 5 to 10 percent.

"Cisco management did little to suggest that market conditions for communications hardware are likely to improve anytime soon, with the U.S. weakness spreading globally--not good news, in our view, when this hardware segment comprises about 40 to 50 percent of the top-tier EMS firms' sales," Parr said.

Other ripple effects
Chip equipment makers should rejoice at Cisco's write-off and Intel's move to maintain its 2001 capital equipment spending at $7.5 billion.

Cisco's inventory write-off means excess communications chips won't be lying around for long. Intel's commitment to invest in advanced processing technology means companies like Applied Materials (Nasdaq: AMAT) will continue to gain.

"We believe that while the current downturn is likely to last for some time to come, the news from Intel and Cisco are early indications that the downturn could be shorter," said Robertson Stephens analyst Sue Billat. She said Applied and Novellus Systems (Nasdaq: NVLS) are among the companies to emerge from a downturn stronger.

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