The zero inventory myth

February 19, 2001: 12:04 p.m. ET

Debunking the tech daydream: warehouses are still filled to capacity
By J.P. Vicente

SAN FRANCISCO (Red Herring) - Just a year ago, Wall Street was intoxicated by the idea that technological advances would help companies achieve the nirvana of business management: zero inventory. But today, with warehouses starting to bulge despite millions spent on inventory management efforts, investors and CEOs alike are left with a bitter taste in their mouths.

The theory contended that technologically driven improvements in inventory management -- like "just-in-time" production, direct online sales, and supply-chain management software -- would prompt increased efficiency and allow managers to tailor output to match demand exactly. That, in turn, would increase working capital, boost margins, and help companies smooth out the ups and downs in the business cycle.

Dell Computer (DELL: Research, Estimates) epitomized the zero-inventory dream era with its built-to-order production model. Its net margins in 1998 and 1999 were 7.7 and 8.0 percent, respectively, while rival Gateway (GWY: Research, Estimates) had corresponding margins of 4.6 and 5.0 percent.

Investors liked what they saw and drove Dell's stock price up 400 percent from early 1998 to early 2000. Not surprisingly, many companies, old and new, jumped on the bandwagon.

Giants like Compaq Computer (CPQ: Research, Estimates), IBM (IBM: Research, Estimates) and Apple Computer (AAPL: Research, Estimates) all began mimicking Dell's manufacturing model.

Time for a reality check. A sharp drop in consumer demand in the second half of 2000 prompted a slump in sales, stoking a huge surge in inventories and forcing many companies to revise their earnings outlook downward. Investors responded in the fourth quarter by driving technology stocks to their lowest level in 13 months.

Apple, for example, saw its retail inventory levels soar to 11.5 weeks in November 2000 from a mere 3.9 weeks in the same period of 1999, according to marketing research firm ARS. Same story at Compaq, which, despite all the hoopla about streamlined production lines, saw its distribution channel backlog jump to 8.4 weeks in November from 5.6 weeks the prior year.

While Hewlett-Packard (HWP: Research, Estimates) looked a little better with 5.2 weeks of retail inventory in November 2000, that was still a jump from 3 weeks in the same month of 1999.

What's in stock?
And while those inventories surged, stock prices sagged. In the 12-month period ended November 30, Apple, Compaq, and HP's stock prices dropped 66.3 percent, 12 percent, and 14.6 percent, respectively. "Despite advances in inventory management technology, there's no such thing as inventoryless models," says Matt Sargent, an analyst with ARS.

But the phenomenon is not confined to the PC sector. According to investment bank Thomas Weisel Partners, optics giant Nortel Networks (NT: Research, Estimates)'s inventory-to-sales ratio jumped 15 percent to 0.55 in the quarter ended September 30, 2000, from a level of 0.48 in the same period in 1999. Meanwhile, Lucent Technologies (LU: Research, Estimates)'s ratio surged 27 percent to 0.65 in the quarter ended September 30, from 0.51 in the prior year.

For the equipment vendors, inventories jumped from 49 percent of sales to 70 percent. This percentage translates into a jump from 82 days to 103 days.

Intel (INTC: Research, Estimates), for example, saw its inventory-to-sales ratio rocket 44 percent to 0.26 in the December quarter, from 0.18 a year earlier.

U.S. Department of Commerce data show that technology is not the only industry with growing inventory. The overall U.S. business inventory-to-sales ratio hit 1.36 in November, the highest since April 1999. What these numbers show is that despite the large amount of money that corporations spent on software for inventory and production management, zero inventory remains a dream.

"The economic downturn and the sudden drop in consumption proved that technology alone is not enough to rule out the effects of the business cycle," says David Jones, chief economist at financial research firm Aubrey G. Lanston & Co.

Technological advances have helped create the longest economic expansion in modern history, with unemployment hovering around 4 percent, submissive inflation, higher productivity, and gross domestic product growth rates that surpassed 3 percent during the past two years. And technology does allow businesses to adjust levels of production more quickly, which, in turn, should help them better weather the fluctuations of the business cycle.

But more effective production management addresses just the supply part of the problem. Figuring out when demand will suddenly drop or pick up depends on factors beyond individual companies' control, like monetary and fiscal policy.

The debunking of yet another economic myth of the information age reinforces a key lesson for investors and companies alike: Don't buy into hype, whether you're allocating an IT budget or a portfolio.牋牋