Reversal of Fortune: Really?

For the first time this year, warning bells are going off regarding semiconductor inventory levels. Nothing has exactly been pointing to a yearend run on stock. However, given the ongoing assurances by the supply chain that communication and visibility efforts continue to improve between suppliers and their channel partners, the industry could expect a more balanced picture than the one IHS is offering.

The research firm, which published a report last week about the industry, said the level of semiconductor inventory is a significant concern.

Adding to widespread worries, the industry has not been able to reduce inventory within the channel or at chip suppliers. Given the excess inventory, end-equipment manufacturers have been delaying the placement of orders for additional components. The result on the whole is that chip suppliers aren’t running their manufacturing operations optimally, and also are manufacturing products solely based on historical demand. In some instances, projected demand also does not materialize, adding to the already slow-moving inventory pile.

Manufacturing to seasonality is a common practice, but we've been hearing all year long about demand trends running counter to cyclicality and to expectations, particularly in the distribution channel. IHS isn't implying that the excess is a surprise to anyone, and, of course, the industry has been hoping for an uptick toward the end of the year. Still, I think the industry could do better than basing its capacity entirely on "historical demand." IHS also says:

The complete reversal -- from positive expectations to negative numbers -- is indicative of how distressing conditions have become for the industry, and the downward pressure on sales has not eased. With final numbers yet to come in, fears abound that industry revenue could decline by as much as 3 to 5 percent when the year finishes, if economic conditions do not improve.

If there is any surprise, I guess it's that manufacturers weren't listening to their own executives or their channel partners for the past few quarters. The industry's largest distributors, Arrow Electronics Inc. (NYSE: ARW) and Avnet Inc. (NYSE: AVT), have voiced uncertain demand during their last two analyst conference calls. Both companies reported softness in all major geographies in the third quarter, and they said their book to bill barely reached parity. According to IHS:

As the year ends, the market finds itself at a difficult juncture, with no significant drivers in sight that will increase demand for silicon suppliers during the near term. All of the initial orders for manufacturing electronics systems that were anticipated for the holiday selling season have already been completed. And while the next opportunity for increased silicon demand will take place at the end of November when companies reorder components, market demand at that time will be small.

Here are a few predictions for 2013. I'd expect an uptick in inventory in the independent channel as companies take advantage of excess inventory and pressure on yearend balance sheets. I'd also expect more inventory showing up within the authorized channel. Chip makers may be able to eke out a less-than-disastrous fourth quarter, but the inventory isn't going to go away until demand ticks up.

IHS ends on a hopeful note: "Prospects brighten next year, with silicon shipments tentatively expected to climb 11 percent by the time the first quarter ends, when companies achieve equilibrium between inventory and demand." In other words, if chip makers do nothing for a few months, inventory will begin to balance out. That's not much of a growth strategy for the most astute manufacturing industry in the world.

What do you think? Could the industry have planned better?