Problems plaguing the networking industry can hardly be pinned on a single company, but the severity of the decline in end-equipment demand came home to roost last week when it was revealed that Cisco Systems Inc. had halted component ordering in the March quarter.
Cisco has enjoyed a reputation as a savvy supply chain manager, keeping its operations lean by relying on contract manufacturers to procure 50% of the parts it uses. But its very reliance on contract partners
to help it manage inventory may have gotten the company into trouble, according to observers, as the EMS sector overextended itself in 2000-particularly in the area of networking communications.
"Given that half of the products Cisco sells don't flow through their own operations, that would indicate the 88 days of inventory they have on their balance sheet as of the end of the second quarter is in fact more like 175 to 180 days worth of real inventory, which would indicate they do in fact have a major problem," said Tad LaFountain, an analyst at Needham & Co. Inc., New York. "Any Draconian measures undertaken to cut down on the inflow of components would be a reasonable step."
Spreading the pain
While the financial impact of Cisco's move wasn't immediately known, what was abundantly clear was the pain will be felt throughout the supply chain. Analyst Eric Ross of Thomas Weisel Partners LLC in San Francisco, who claims to have uncovered the problem, said the entire network infrastructure pipe is backed up with roughly 12 months of inventory-parts no one wants to carry on their books for too long.
Two suppliers that will likely be hit the hardest, according to Ross, are Altera Corp. and Xilinx Inc., programmable logic chip makers that attribute 75% or more of their revenue to sales in the networking space. "Demand went from 60 to zero very quickly," Ross said. "We believe Cisco has stopped ordering components altogether, while orders from other key customers, including Nortel, Lucent, and EMC, are likely severely diminished as well."
Altera, Cisco, and Xilinx, all based in San Jose, declined to be interviewed for this report. Neither Lucent nor EMC could be reached for comment.
But Nortel Networks Corp., Ottawa, added to last week's bad news when it lowered its earnings forecast for the second time in a quarter and said it will cut another 5,000 jobs on top of the 10,000 layoffs it previously announced. "I think this is going to end up being more serious than people believed," Ross said.
The question is, who will be left to clean up the mess? According to observers, that's subject to compromise, regardless of who is contractually responsible for the problem.
"There will be some write-offs that have to be taken somewhere along the line," said Rob Hagen, president of the Integrated Materials Services unit at Avnet Inc., Phoenix, which distributes products for Cisco's suppliers. Historically, if overages are caused by a faulty forecast, the burden falls on the end customer, "but not without some tough negotiations," he said.
Avnet, a major distributor of Xilinx parts, is somewhat insulated from Cisco's supply chain woes because it contracts with the OEM through EMS providers, Hagen said. "If there's any stop order, it would be put on the contract manufacturers, not on us," he said. "We're still shipping stuff in [to EMS], relative to the contracts."
Hagen declined to say whether Avnet has been pressured to take any backflow from the EMS channel, but acknowledged a general slowdown in networking infrastructure business.
"The issue in the supply chain today is with all of our customers in the networking sector. The problem goes much deeper than Cisco," he said.
Meanwhile, no consternation was apparent among contract manufacturers that are heavily exposed to Cisco and other makers of networking gear. "We've seen dynamics in the marketplace in terms of people cutting programs, but there's nothing special from our perspective," said Andrew Gort, executive vice president of global supply chain management at Celestica Inc., Toronto. "There's the normal ordering, cancellations, and expediting-like last quarter."
Citing the "quiet period" prior to reporting results in mid-April, Gort would not go into specifics of Celestica's inventory position relative to any customer or business segment. But Banc of America Securities LLC estimates 9% of Celestica's 2000 fourth-quarter revenue was from sales to Cisco, while as much as 10% was from sales to EMC.
Inventory write-downs expected
Thomas Weisel's Ross noted that because of weak demand in the networking area, Altera and Xilinx may each be forced to write down as much as six months of inventory, or roughly $500 million to $700 million per company.
Standard products such as PLDs are easier to stockpile, with the belief the inventory can be burned off elsewhere. But at some point they become obsolete and have to be written down or dumped into the spot market, analysts said. Inventories at Altera and Xilinx swelled to eight and seven months, respectively, in March, Ross said. Memory suppliers that sell to networking and server customers could be sitting on at least four months worth of parts, he added.
Because weak suppliers are not in an OEM's best interest, customers are expected to "share a little of the pain," said analyst Roger Norberg of JP Morgan H&Q, Minneapolis. Now that business has skidded to a halt, supply chain partners "will begin an iterative process of everybody trying to find a place to put [the inventory]," he said. "People have made the decision to, by midyear, liquidate the channel, however that happens."
Some companies have already begun quietly leaking inventory into the spot market. An industry watcher, who asked to not be identified, said there has been "considerable availability" of Altera and Xilinx parts in the excess-inventory channel from a variety of OEM and EMS companies.
Cisco bought an estimated $2 billion to $3 billion worth of components in fiscal 2000.
Additional reporting by Jeanne Graham and Jennifer Baljko Shah