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SARS - Should you boost inventories?

From: ASAP


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Manufacturers are boosting inventories in case the virus shutters suppliers -- a trend that makes a tech rebound that much harder to spot

Normally, no electronics company wants extra inventory. Operating under the rigors of "just in time" delivery, businesses can afford to carry only a few weeks' -- or sometimes even just a few days' -- worth of extra parts. In the electronics hubs of China, such as the Pearl River Delta in southern Guangdong province, so many suppliers have built factories that it's easy to get parts quickly. And that's essential: With prices falling because of the prolonged tech slump, corporations more than ever need to keep down their manufacturing costs. And that means they need to keep inventory levels low.

That's the situation in normal times. But with severe acute respiratory syndrome (SARS) wreaking havoc with economies in Greater China, things are anything but normal these days . That's why some electronics outfits are doing a sudden reversal: Rather than reducing their inventory levels, they're actually increasing them. The goal is to provide some buffer in case of a shutdown if somebody at their factory -- or at a supplier's factory -- becomes a suspected SARS carrier.

BULGING WAREHOUSE. Lite-On Technology, one of Taiwan's biggest suppliers of PC parts for U.S. and Japanese customers such as IBM , Dell , Hewlett-Packard , and Sony , is a case in point. Lite-On hasn't had any SARS cases at its 18 factories in China, but Chief Financial Officer Ignatius Wei says it isn't taking any chances. The manufacturer is boosting inventory for some of its products.

Here's why. Usually, Lite-On carries two weeks of inventory at its just-in-time logistics hubs in the U.S. and other locations close to its customers. Shipments from China to the U.S. (including customs clearance as well as the time crossing the ocean on a ship) take about four weeks. The issue for Lite-On, explains Wei, is whether that's enough time.

"Is that adequate in case I have a 10-day shutdown at a factory?" he asks. (The incubation period for SARS is about 10 days.) If Lite-On had to shut down production at one of its factories in China because of SARS, its logistics hub would come uncomfortably close to running through its supply. "If they deplete the just-in-time inventory, I have a two-week gap at the end," Wei says.

"SAFETY INVENTORY." For some Lite-On components, the problem is easily solved. "If a product is light and small, it can be air-shipped, and then we won't need to put on extra inventory," he says. But bulkier items are too expensive to send via air. That's why Lite-On is adding two weeks of additional inventory for some products.

Other outfits are likely to be taking similar steps. Writes UBS Warburg Asia tech analyst Sean Debow in a recent report: "Our research suggests that inventory levels may be more likely to rise than staying put or falling. Why? 'Safety Inventory'.... Let's keep a bit more on hand in-case of disruption, is the thinking in this camp. To date, we cannot find anyone who is putting their hand up to say they have built inventory, but body language suggests to us that few would be shocked to receive this request."

According to UBS, inventory is "slightly higher than normal" for cell phones and noticeably up for PC motherboards and DRAM chips.

FOGGY FIGURES. Inventory buildups because of SARS will not only add to the costs of electronics companies in Taiwan but will also make it harder to say whether the tech sector worldwide is finally recovering. Encouraging signs have been emerging from some U.S. outfits, thanks to positive first-quarter earnings announcements from IBM, Intel, and Dell. That's leading many investors to bet on a tech turnaround.

Yet the picture from SARS-land -- i.e., greater China -- isn't as bright. "There are some signs of moderate improvement that started in the fourth quarter of 2002 and continued in the first quarter of 2003," says John Brebeck, head of research and market strategist for Taiwan with J.P. Morgan Securities (Taiwan). He says shipments of microprocessors and PC motherboards in the first quarter were slightly stronger than normal. "But," Brebeck adds, "are we seeing strong recovery? No. I don't see any significant acceleration in demand for the major electronics end-markets."

Anti-SARS strategies will make it even harder for a recovery to take hold. The Taiwanese government last week announced that any Taiwanese returning from China, Hong Kong, Singapore, or Canada would have to go into a 10-day quarantine. Anyone else coming from those countries would not be allowed in at all.

FALSE HOPES? Since Taiwanese electronics concerns are so dependent on production in China, that's a big symbolic blow -- symbolic because most companies already had no-travel policies in place even before the government's announcement. The organizers of Taiwan's biggest electronics show, Computex, just called off this year's event, which was supposed to take place in early June. Now, it's unclear when it will happen.

Moreover, if demand ticks upward, it may just be because of companies like Lite-On that are increasing production, thanks to SARS worries. "Any increase in orders may not necessarily be real sell-through -- it could well be inventory build," says Debow. "This worries institutional investors."

Lite-On has another card to play, though. It has 15 plants outside of China and is now putting its factories in Mexico, Thailand, Malaysia, and the Czech Republic on alert for extra orders in case customers want to shift production away from SARS areas.

That might help to bring inventory levels back to normal. But since manufacturing in China is so much cheaper than just about anywhere else, it might also increase costs. In the age of SARS, that's just one of the problems that'll be complicating the situation for electronics companies doing business in China.


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