COMMENTARY--As we digest Cisco's mammoth inventory write-off, it might be constructive to study a little recent history from the PC sector.
The history of the PC sector has taught us two rules:
- Rule 1: Building products to meet a hypothetical sales forecast is a recipe for inventory disaster.
Rule 2: Building products to order is clearly the way to go.
To followers of the cyclical tech sector, these two rules aren't exactly a newsflash. But Cisco didn't get the memo. At least Cisco isn't alone--most of the networking industry has had write-offs of some sort.
Why? Cisco CEO John Chambers and other networking execs believed their own press clippings. They believed the hype spewed by information technology research firms that projected markets going from millions to trillions in a few years. After growing 50 percent a quarter, networking companies got cocky--they built up inventory to meet allegedly insatiable demand. A downturn was simply inconceivable--until now.
Here's how building to a forecast works. CEO floats revenue estimate to Wall Street. Sales folks get on board. Company then builds lots of stuff thinking the demand will come. It doesn't and the write-offs follow. A shortage of components--an affliction that has plagued both the PC and networking sectors--only makes matters worse.
What's going on in the networking industry has a familiar ring to it, said Needham & Co. analyst Tad LaFountain, who used to cover chip companies before following networking stocks.
In a research note, LaFountain noted that the PC industry had its own inventory debacles in 1983, 1984 and 1995. PC makers learned the hard way. In 1995, PC makers saw big growth ahead and hoarded components during a shortage to meet demand for Microsoft's Windows 95. They were a bit too optimistic about sales and found themselves with excess components. Intel had to take a $75 million write-off for excess memory chips, LaFountain said.
The numbers and industries are different, but the outcome is about the same. You can debate the merits of comparing the networking and PC sectors, but in the end you're still moving boxes to customers.
The PC debacles "led to the renunciation of the build-to-plan model and an embrace of build-to-order," he said. "Inventory accumulations and exposures have been relatively muted in the PC industry for the past six years."
The networking industry got itself into trouble largely because it never had to deal with a downturn in demand. In 2000, Cisco led the way in hoarding components--a move to counter a shortage--to meet projected sales. Woops. Enter Cisco's $2.25 billion inventory write-off, which execs were quick to tell investors was below the company's initial $2.5 billion write-off projection. However, Cisco wound up with $1.9 billion in third quarter inventory, up from its projection of $1.6 billion. Translation: It's a wash.
For the record, that Cisco charge consists of work in process ($450 million), memory chips ($300 million), optical gear such as lasers ($450 million), power supplies and similar components ($150 million) and non-memory chips ($900 million). Chambers said Cisco's problems were due to a new economy valley. Actually, management guessed wrong.
"When build-to-order becomes a more prevalent phrase and the orders are scrubbed for their reality, then the real problem will be solved," said LaFountain.
That's a point worth noting. PC makers seem to be better managed these days. Compaq Computer (NYSE: CPQ) said inventory levels are on target, and Apple Computer (Nasdaq: AAPL) and Dell Computer (Nasdaq: DELL) have proven to be adept at adjusting inventory levels to demand.
Inventory woes a symptom
A few analysts have pointed out that fretting about how Cisco will use its $2.25 billion inventory write-off to boost gross margins in the future is missing the point. Cisco's inventory problems are just a symptom.
Aside from falling for its own sales pitch, Cisco's biggest problem is structural. Craig Johnson, an analyst at the PITA Group, said the problems for Cisco are just starting.
Johnson paints the following picture of Cisco. From the bird's eye view, Cisco's strategy for the last two to three years has been to cultivate competitive local exchange carriers (CLECs) and Internet service providers so they all have networks powered by Cisco. With that beachhead established, it would offer all the applications and "solutions" to also dominate enterprise network architecture. Eventually, Baby Bells and established carriers would join Cisco in a potentially proprietary love fest.
If all of Cisco's plans to dominate the world worked out, the company would be able to supplant Lucent Technologies (NYSE: LU), Nortel (NYSE: NT), Ciena (Nasdaq: CIEN) and Alcatel (NYSE: ALA) at the core of telecom networks. Once you own the core, you win the game.
Unfortunately for Cisco, CLECs and most ISPs are toast because they can't turn a profit. On a conference call, Cisco said it couldn't provide guidance, largely because alternative carriers are falling apart. "Chambers was betting on air," said Johnson, who noted that Cisco's "100-year flood" was more like an ecosystem disaster. Nevertheless, Chambers is projecting growth of 30 percent to 50 percent in the future just like the old days. Of course, no one believes this long-term outlook.
Johnson also has an interesting theory about Cisco's inventory write-offs: It's just the beginning. Cisco tossed the kitchen sink into its write-off and don't be surprised if there's more to come. "Watch the balance sheet," said Johnson.
The food chain
For folks interested in the connection between telecom companies and their equipment vendors, you have to check out Epoch Partners' vendor matrix.
If you haven't used Epoch before you'll have to register, but it's worth it. Epoch gives a great overview of the networking food chain.
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