Supply chain wrestles with the ‘trust’ deficit

Trust is a scarce commodity in the electronics supply chain. Everyone wants it but few are willing to be fully transparent with partners. Analysts and observers say the negative effects of the industry’s cycles are often worsened by the cautiousness with which executives handle sales projections and other forecasts shared with them by customers, suppliers and other supply chain partners. The unexpectedly high inventory levels that companies are reporting in first quarter financial results announced so far confirm the industry’s huge trust deficit and the need to tackle this problem, distribution executives said.

A recent survey conducted by the Electronic Components Industry Association (ECIA) confirmed the depth of the problem. Asked to name their wish list for managing their businesses efficiently, distribution executives overwhelmingly picked visibility, transparency and the opportunity for full collaboration with partners. These three factors hinge on trust and are important to distribution executives because they remain intransigent problems that show up during each downcycle, wreaking havoc on enterprise financial performance, they noted.

“The biggest concerns change quite quickly amongst distributors. Covid went from the top of the list to literally the bottom of the list. It is never a stable situation,” said Dale Ford, chief analyst at the ECIA, in a podcast. “Players in the supply chain continually must stay on top of a very dynamic environment. The greatest concern that they have now is ‘how do we manage this process to avoid this inventory overhang?’ It came down to visibility, transparency and collaboration. That is what they kept coming back to.”

Distributors will not say to customers that their forecast numbers are not reliable. They just know the figures must be checked and constantly revalidated due to changing market conditions and possible errors in the data collection process. But they were not the first to institute this trust-but-verify mechanism. Having been repeatedly burned by erroneous customer forecasts and orders, semiconductor suppliers have long learned to doublecheck forecasts provided during market upturns. Desperate to secure parts during periods of shortages, OEMs and contract manufacturers would place orders for the same parts with different suppliers, jacking up backlogs at vendors and increasing the opacity of demand-supply conditions. Cleaning up the financial mess that results from the double-ordering was often left to suppliers.

The solution suppliers developed was to more tightly manage component orders and shipments to OEMs and distributors alike. The financial risks to distributors were limited, though. They enjoyed the right to return most unsold parts to suppliers and, in many cases, had non-cancellable agreements with OEM customers. That shield has its weak points, though. The financial seesaw and lack of visibility into actual market demands made it difficult for even distributors to properly plan their capital allocations, analysts said. Plus, whatever ails their suppliers would eventually result in weak sales at distributors too. As a result, distributors now closely monitor OEM forecasts, orders and inventories. Market leader Arrow Electronics Inc., for example, said it kept verifying orders during the first quarter to ensure they were in line with actual customer requirements. 

“We spend as much time as we can to help our customers deliver on their production schedules even as they change. And as you might imagine, there’s a fair bit of change in this environment,” said Sean Kerins, Arrow’s CEO, during a conference call with analysts in May. “Our backlog is down from its all-time high, but it’s still well beyond historical levels. Our teams do a good and active job throughout the world to continue to validate that backlog. And we believe the majority of it is still firm compared to forecast. And that work yields or has yielded certainly more reschedules and pushouts than cancellations. So, we feel pretty good about the backlog.” 

Cristiano Renno Amon, president and CEO, Qualcomm

Inventory debacle

Arrow may have a good handle on its backlog, but the industry is today undoubtedly awash in parts that OEMs stacked up during the scramble to secure supplies only a few months ago. Inventories at OEMs, suppliers and distributors alike have shot up year-over-year across the industry although executives say the bulk of the increase was due to the higher pricing environment. At Apple Inc., for example, first quarter inventories rose to $7.5 billion from $5.5 billion in the comparable quarter of 2022. Sales during the same period dipped, however, to $94.8 billion from $92.3 billion, indicating softening demand. One could argue, therefore, that the higher inventory could not be solely due to the higher cost of components. As has happened during previous periods of intense growth, many companies appear to have increased their purchase of components in anticipation of higher sales, which did not materialize.

Semiconductor companies are reporting higher inventories, too, even as revenue growth has slowed dramatically. Nvidia offers an example of this trend. The company’s revenue fell in the three months ended January 31, to $6.1 billion, from $8.3 billion, in the comparable year-ago quarter. Inventories continue to grow, though, rising during the same period to $5.2 billion, up 63 percent, from $3.2 billion, in the year-ago quarter. The company splurged on inventories during the recent shortages and was not able to reduce stocks as it had committed itself to purchasing the components from its contract semiconductor manufacturer. Collete Kress, CFO at Nvidia attributed the revenue decline to the “impact of channel inventory correction, which is largely behind us.”

Nvidia is not alone. NXP, Qualcomm and many other chipmakers are in the same muddle. These companies all spent a boatload of money on inventories over the last two years, believing that the upturn would last longer than it did. The opposite happened and the suppliers are now left with too much inventory at their suppliers and distributors. The revenue drop at Qualcomm was staggering. The company’s sales fell in the first quarter to $9.3 billion, dropping 16.9 percent, from $11.2 billion, in the first quarter of 2022. Inventories kept growing, though. The company closed the first quarter with inventories valued at $6.9 billion, a 50 percent increase, from the $4.6 billion in parts it reported one year ago. 

“The evolving macroeconomic backdrop has resulted in further demand deterioration, particularly in handsets, at a magnitude greater than we previously forecasted,” said Cristiano Renno Amon, president and CEO of Qualcomm, in a discussion with analysts. “As a result, we’re operating under the assumption that inventory drawdown dynamics remain a significant factor for at least the next couple of quarters. Additionally, while expectations are for a rebound in China demand in the second half of the calendar year, we have not seen evidence of meaningful recovery and are not incorporating improvements into our planning assumptions. While the challenges we are facing are impacting the semiconductor industry, we remain focused on managing what is within our control and will continue to execute on our diversification strategy and leading technology and product roadmap.” 

Companies are now moving to shave down their component stocks, according to analysts. This is typically the first step on the road to recovery, said Malcolm Penn, founder of semiconductor market consulting firm Future Horizons. The industry must whittle down its excess inventory before getting clearer visibility into actual current demand levels, Penn noted. That process may last several quarters and could reach into next year, depending upon the amount of stocks and strength of a market recovery. 

Semiconductor shipments have already slowed as manufacturers move to reduce inventories in the channels. Future Horizons said weekly unit shipments have fallen 24 percent, to 6.2 billion, from 8.2 billion during the recent bout of shortages. Shipments are trailing market consumption by as much as 15 percent, with the trendline continuing now for about 4 months, according to Penn who adds that “the inventory burn is in progress.” 

For distribution, what the lower shipment means is sluggish performance over the next several quarters. As customers work on cutting down inventories, they will demand less from distributors, observers noted. Even so, distribution executives largely say they are comfortable with the size of inventories on their balance sheets. Most of the parts are being held for OEMs that have committed to purchasing them during the period of shortages, they said. “The sequential increase is not something we’re at all concerned with,” noted Arrow’s Kerins. “We feel good about the quality of the inventory we’ve got on hand. I’m very confident in our ability to sell it. And I think the most important point is, if you look at our turns in the core global component business at Q1 exit, we were right on or slightly above our historical targets and expectations, both for semiconductor and IP&E.”

Dale Ford, chief analyst, ECIA

The optimism does not negate the fact that orders may come under pressure throughout the industry, however. Only a few companies—STMicroelectronics, for example—are showing year-over-year growth. Europe-based ST reported sales rose to $4.3 billion in the 2023 first quarter, up from $3.6 billion, in the first quarter of 2022. Most of ST’s rivals in the semiconductor market are reporting double-digit sales declines, which confirms cutbacks in orders from OEMs and contract manufacturers. This will eventually flow through to the distribution market, observers said.

This is why distributors say they are reviewing current backlogs to ensure these are viable orders. Clarity about the market conditions may not be easily achieved, though, according to the ECIA’s Ford. It will require that distributors, suppliers and OEMs work more closely with each other, collaborating on production output, lead-times, customer demand and insights into economic conditions. Unfortunately, the industry is not noted for such extensive collaboration or trust, Ford observed, adding that changes may be slowly taking place, however. 

“We’re seeing the downturn, in terms of demand in the marketplace, but also in unwinding the inventories,” Ford said. “Two things are lacking in the supply chain. One is visibility. The other is collaboration. Machine learning certainly provides the basis to make things more visible and transparent, but at the same time, it won’t work without collaboration among companies who are participating in providing data. That’s going to be up to the supply chain people.”