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The Starting Line: Investors brave Ingram Micro forecast

Wall Street overlooks the tech distributor's weak market demand and zeros in on its positive points.

Ingram Micro's near-term outlook is dismal, but Wall Street doesn't care. Investors are more interested in how the company is getting through it.

The technology industry's largest wholesale distributor reported pro forma earnings of 4 cents per share on third-quarter revenue of $5.83 billion. And despite a gloomy estimate for the fourth quarter, Ingram Micro shares bounced up on Wednesday. Investors looked past the negative elements to focus on the company's ability to cut its overall costs while keeping up growth in certain segments of its business.

But first, the bad news from Ingram's report: Technology spending continues at levels far below those of last year. If that report surprises you, please accept our warmest welcome back. We trust your long journey away from Earth was worthwhile.

For everyone else, the fact that Ingram Micro predicted a year-over-year decline in fourth-quarter revenue isn't a surprise. Analysts this week dutifully lowered their sales estimates to match the company's prediction of $5.7 billion to $6.2 billion in sales for the last quarter of the year. Not that a forecast with a $500 million margin of error offers much of a guide.

"It's too tough for us to call region by region," Ingram Micro Chief Executive Kent Foster told analysts during the company's quarterly conference call. "No one really knows. I wish I could give you a better answer than that, but (I) really can't."

For the majority of research firms polled by financial data provider First Call, that technology market uncertainty makes Ingram Micro something for investors to avoid. Five of eight brokerages in First Call's survey stuck with "hold" ratings on Ingram Micro.

Yet shares of Ingram Micro rose nearly 3 percent Wednesday, while the Nasdaq composite index increased less than 2 percent and Standard & Poor's 500 index actually lost a bit of ground.

Ingram Micro continues to cut costs and improve profit margins, which is why analysts' latest estimates for profit didn't fall as much as those for revenue. Wall Street was particularly pleased with the company's inventory management during the quarter; Ingram Micro maintained a pace that would have resulted in inventory turning over 14 times in one year, which would be the company's best rate ever.

Operating expenses for Ingram Micro fell to $282 million, down $10 million from the second quarter. Fortuna estimates operating costs of $1.16 billion and $1.09 billion for this year and next, respectively, compared to $1.2 billion in 2000.

Skeptics could point out that Ingram Micro's operating expense cuts failed to keep up with the revenue decline, but that's more a reflection of the overall technology market's rapid slowdown than ineptitude on Ingram's part. In fact, the company reported a third-quarter gross profit margin--revenue minus cost of goods--of 5.27 percent, compared to 5.25 percent at the end of June.

"Gross margin stability (and some small increases) in a weak demand environment is impressive indeed and begs the question of how much better gross margins might become in a more normalized economic climate," Merrill Lynch analyst Steven Fortuna wrote Wednesday.

End to price wars
Ingram's performance says good things for its industry as a whole. The company improved gross margins slightly because tech distributors in recent quarters have ceased their price wars. Instead of cutting prices furiously in an attempt to create demand, distributors like Ingram Micro and Tech Data are cutting their own costs.

"I think we do have reasonable price stability," Foster said. "It's a tough pricing environment. It's not an easy market, and that's because of the anemic demand. But it is not irrational."

Credit (or blame, depending on your perspective) the pricing bottom to a lack of competition. As Ingram Micro and its chief rival Tech Data swept aside smaller competitors in the United States, fire-sale prices for tech products disappeared, allowing the surviving distributors to focus on profits. Look for the trend in Europe as well, company executives said.

"The trend toward vendors consolidating the number of distributors...has been good to the pricing and the margin math in the U.S.," said Kevin Murai, president of Ingram's U.S. region. "I suspect the same thing will be true in Europe, something that will (have) a very positive effect. That's something you should pay attention to."

Not only have prices stabilized, but certain product segments--namely software and networking--are distinguishing themselves in Ingram's results.

Distribution of systems and peripherals generates 60 to 75 percent of Ingram's revenue, but those hardware sales lately have been lagging behind the rest of the company's business. The phenomenon fits theories floated by many analysts who point to U.S. industry's unprecedented level of investment in hardware in recent years. Several observers argue that many companies are content with their hardware because these systems, especially PCs, are more than adequate for typical business applications.

Meanwhile, software and networking products--currently about 25 to 40 percent of Ingram's sales--appear to have more room for growth, especially for related services. Software and network-related sales grew faster than Ingram's average, executives said.

Software licensing revenue rose 30 percent in the third quarter. Services and support through programs such as IM Logistics are the fastest growing parts of Ingram Micro's business, and much of that is related to software such as Microsoft's recently introduced Windows XP.

"With the XP launch, we've touched the vast majority of the XP product that found its way to market," Murai said. "Software's been one of those categories that we've seen actually achieve some pretty good success in driving to much more of a fees-for-service business...so a lot of the volume that we do on IM Logistics has been on the software piece."

Value-added resellers are one of Ingram's largest customer segments. Now a growing software business has turned Ingram into a value-added distributor.