Stock answers.

Investment bank Bear Stearns is reporting that inventories among EMS players are on the upswing, reaching their highest point in four and a half years. This is cause for concern as the buildup of stocks to tremendous levels created a tremendous drag on the assembly market and ensured that the hangover from the dot.com bubble lasted several more quarters than it might have. But is there more to it than meets the eye?

In a market that is consistently going up, rising inventories are less an issue because sales growth in future quarters will eat up the excess parts. It's when business slows that they become a problem. Having suffered so much a few years back, many thought the inventory-build mistakes of the past would not soon be repeated. However, I would argue that what's behind the pattern is not so much poor inventory management at EMS companies but rather a blatant attempt by their so-called supply-chain partners--aka the OEMs--to use their contractors as corporate warehouses.

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How do I know this? I maintain a database of the financial metrics of roughly 40 EMS companies, all publicly traded. Over the past several quarters the majority have seen the value of raw materials in stock and finished goods rise faster than revenues.

In trying to determine just what is happening, I excluded from my study those firms that are traded on non-U.S. exchanges, plus Three-Five Systems, which went bankrupt, and Probe Manufacturing, which just went public this year and for which some of the inventory data aren't yet available. That pared the list to about 30. Then I eliminated those companies which besides providing contract services also make other products. That brought the count to 18. (Admittedly, it's not a huge sample, but it's a start.) For the sake of consistency, I looked at revenues and inventories using SEC 10Q and 8K filings from the most recently reported quarter and compared those numbers to the same from a year ago.

Who has done well in keeping inventories in check? Just two companies saw revenues climb faster than inventories: SigmaTron (52.35% and 45.56%, respectively) and Winland Electronics (49.5% and 48.7%, respectively). One company, Suntron, actually saw stock levels drop, but revenues there fell 4%.

Less stellar are the results at Flextronics, whose sales from continuing operations rose 4% year-on-year through the June quarter while inventories climbed 48% during that time. SMTC saw inventories rise 43% on 7% sales growth. Pity poor IEC: while sales climbed 33%, inventories soared 155%.

What's the cost of excess inventory? At a $10 billion-plus company the inventory valuations are into the billions. Take Solectron, for example. As of May 31, the Tier 1 EMS firm was sitting on $1.48 billion worth of inventory. Should an extra 0.2% to 0.5% of it be determined to be excess and obsolete, the company's gross profit would have dropped by $3 million, its operating income by $7.4 million. Simclar, a $60-million EMS company, wrote down $1.86 million in parts due to obsolescence during its March quarter--nearly 10% of its total inventory valuation of $18.4 million. The company's net income that period? $720,000.

Poor parts management? In many cases work-in-process is falling while and raw materials and finished goods are on the rise. At Samnina-SCI, WIP dropped 7% from April 2005 to April 2006 yet raw materials climbed 31% and finished goods 7%. At Raven Industries, WIP down, raw materials and finished goods up. At Suntron, WIP is down 10% but overall inventories are up 0.5%. At firm after firm the story is the same. (In this regard, Plexus is the outlier. There, raw materials are up 197% and finished goods have increased 70%. But WIP has shot up 221%.)

So what's going on? Clearly, assemblers are building stocks at rates faster than revenues. But the declining WIP-to-stocks ratio suggests that it's not because contractors suddenly forgot how to manage inventories. Most of the imbalance has occurred in the past seven quarters, the timing of which suggests greater upfront purchases of various hard-to-get (and potentially soon-to-be obsolete) components due to events like the RoHS deadline. I would also submit that, in a few cases, manufacturers are buying finished goods from other EMS companies, in effect contracting to contractors, in order to avoid adding internal capacity or to meet customer demand. But anecdotally, many EMS firms tell me that customers are pushing them to hold finished product, which makes the OEMs' books look better but eats a big hole in the wallets of their suppliers.

Holding inventory on behalf of customers is worthwhile only if you are getting paid for it. OEMs should take note that, despite three straight years of solid-to-terrific growth, precious few EMS companies are making money. If your business model is predicated on bleeding suppliers dry, what happens when there's no more blood to be had?

Mike Buetow, Editor-in-Chief

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