Recently, we touched upon the topic of inventories, focusing on the dark side. Given all of the bearish talk about the economy and, specifically, semiconductors, let's put on our rose-colored glasses and look at the bright side of the magic of inventories. However troubled the economy may be for the moment, it's nothing a little optimism and confidence can't fix.
A small dose of mathematics can go a long way in telling the story of inventories. Let's assume that there is only one electronics system company, named SysCo, and it buys from the only semiconductor company in the world, called SemiCo. Let's also propose that SysCo is stuck in a no-growth environment, and it has been consuming $1 worth of chips per year. Also, SysCo missed the bullet train of just-in-time manufacturing and still maintains a 365-day inventory. In this setting, SemiCo's annual revenue is $1. It has chip sales in the channel of $1; SysCo draws down and consumes $1 of inventory from the channel. This is an equilibrium state.
Thanks to the economic stimulation package put in place by the government, all of a sudden SysCo sees its business doubling in a year, going from using $1 in chips annually, to $2. Let's suppose that SysCo still hasn't learned how to improve its supply-chain management, so that it continues to keep a 365-day inventory. So the channel inventory of chips needs to double from $1 to $2, because 365 days times $2 per year consumption rate equals $2 of inventory.
Meanwhile, back at the supplier, something interesting is happening to SemiCo: Its business grows from $1 to $3 in the same period. Why $3? Well, $2 is used by SysCo, and the additional $1 goes into building up the inventory channel from $1 to $2. Not only does SemiCo double its sales, it must also double the size of its own channel inventory. So, when SysCo grows its business by 100 percent, SemiCo grows by 200 percent!
This bright side of inventories has nothing to do with such things as increasing silicon content, which has been the best explanation of why semiconductors continue to grow faster than the electronics business. It is also important to note that we do not have a situation of inventory overbuild, because the inventory days measure has remained constant. The best way to visualize this is to imagine that, in addition to SysCo, SemiCo also sells to another customer called "the channel," which always mimics SysCo's business, thus SemiCo's growth rate always doubles that of SysCo's.
Eric Chen leads semiconductor research at JPMORGAN H&Q Equity Research.
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