Jeff,
I sure hope you're wrong but I have to admit that tomorrow is probably a defining moment.
I came across comments on COMS home page (attached below) that Benhamou made in a conference call exactly one quarter ago tonight. While I'm sure that this has been posted before, I'm re-posting because it lays out the company's representations to Wall Street on the inventory problem.
For those who glaze over when the phrase "channel inventory" is used, let me translate. The company sells product through value added resellers (VAR) which includes Circuit City and other more specialized resellers of their products. COMS records a sale when it ships a modem, for example, to one of these resellers. So, the more product the VARs will take, the greater the COMS sales. But in a "just in time" economy, the VARs don't want to hold a lot of inventory which costs them carrying (i.e., interest) charges.
So the decision last quarter to reduce the channel inventory "model" was really COM'S customer telling the company that they wanted COMS to hold greater inventory and supply them "just in time." This change resulted in lower sales and earnings last quarter than had been reported in the previous quarter and much higher company inventory levels.
The big question in the next earnings report is whether the new reduced levels of channel inventory have been achieved. Then the next question is whether price concessions were required to get the reduced inventory and if so how badly those concessions hurt earnings. The last issue is how much growth in sales should COMS expect going forward.
I think Benhamou's comments provide a benchmark on the channel inventory issue. Near the bottom of his comments he provides the number of weeks of channel inventory under the old model with those planned under the new model. The new model calls for lowering channel inventory in NICs and modems two to four weeks and in systems two to five weeks.
If you listen to the conference call, listen for these numbers as they will be critical to the analysts' view of the company.
Finally, if we get past a day or two with no adverse announcements from the company, odds are high that there aren't any forthcoming. So enjoy the ride.
Regards
David
CEO's Comments on 3Com Reducing Channel Inventory
The following comments were made by Eric Benhamou, 3Com's chairman and chief executive officer, discussing 3Com's preliminary second quarter results on a conference call with financial analysts. These remarks have been edited.
INTRODUCTION
I will start with the business context. Last September, at the time when we published our results for our first fiscal quarter, we indicated that while we were pleased with the growth of our revenues and earnings, we suspected that the inventory of 3Com products held by our channel partners was at or slightly above the high end of the desirable range. However, we lacked the measurement tools to be able to determine precisely our actual channel inventory levels across our various channels and geographies, primarily because the management practices and information systems of our newly merged company had not yet been aligned. The internal plan that we formulated for Q2, our seasonally strongest quarter, was based upon selling more products through our channels than into our channels, thereby reducing channel inventory levels progressively, while at the same time improving our measurement systems and converging towards consistent practices with our channel partners around the world. As our fiscal Q2 unfolded, several events occurred that caused us to alter our course:
1-The September meeting of the International Telecommunication Union (ITU) standards body failed to resolve the differences between the x2 and K56Flex technologies and establish an international standard for 56Kbps modems. As a result, the continuing uncertainty around the absence of standard in this product category dampened the growth of the modem market worldwide. While the transition during these introductory months from V.34 to 56Kbps has been the fastest in modem history and 3Com has now established the leading share of the 56Kbps modem market, the size of this market today is still less than a third that of the older V.34 market as many customers (both enterprise customers and consumers) are postponing their modem purchase decision until such point in time as a standard is clearly decided. The unit and dollar volumes of modems selling through our channels are materially lower than we originally planned.
2-The Asian currency crisis that broke in October created much turmoil in that region and hurt many of our partners and customers. More broadly, the growth prospects for the entire region have changed from being the strongest (with growth rates in excess of 50% per year) to being the weakest (flat to declining) in the near term. 3Com is relatively more exposed to this downturn because of the large amount of business that we do in Asia, compared to many of our competitors. We are hopeful that Asia will work its way through this crisis and recover its strong economic growth rates, but this recovery is unlikely to happen any time soon.
3-We met with our major channel partners around the world in the course of the last quarter, and worked towards aligning our channel management organization, policies, practices, and inventory reporting systems. Three conclusions emerged from these discussions and this process:
a) in many instances, our inventory levels at the beginning of the quarter were indeed globally higher than the ranges in our model
b) our model may no longer be the most appropriate for the new 3Com and for our partners. As is the case in other parts of the computer industry, we may be better served with a new model that assumes far fewer products in the channel and is more responsive to changes and more economical
c) there is a strong desire among 3Com heritage and USR heritage partners to converge practices and contractual agreements as quickly as possible.
Taking these new factors into account, we were faced with three major alternatives:
(1) stay the course and attempt to meet our original Q2 plan, which would result in increasing channel inventory and deviating further from the desirable level,
(2) engage in a gradual course of inventory reductions over the next several quarters, which would still cause us to miss our plan while operating in a suboptimal business position for the next year or more, or
(3) make a sweeping correction of inventory levels and management practices this quarter and deal with this problem rapidly and decisively.
After careful examination of the pros and cons of each approach and consultation with our directors and advisors, we decided to follow the third approach.
NEW INVENTORY MANAGEMENT PRACTICES AND RAPID CONVERGENCE
Let me now comment on the specifics of the model. Our old model for channel inventory was as follows:
Major Product Line
Desirable On-Hand Channel Inventory (measured in weeks of supply)
NICs
6-10
Modems
8-12
Systems
8-12
Our new model for channel inventory will be:
Major Product Line
Desirable On-Hand Channel Inventory (measured in weeks of supply)
NICs
4-6
Modems
6-8
Systems
5-7
The new model reflects several changes:
1-We now believe we can manage our business with significantly lower levels of inventory in the channel without reducing our market coverage or materially increasing risks of stock-out situations. The new model is far more responsive to market changes, easier to manage in cases of product or technology transitions, and is more economical for both 3Com and for our channel partners.
2-The new model continues to reflect that the primary channel partners for our NICs are large distributors while the primary channel partners for our modems are large retailers. Retailers each have several hundred outlets and consume more inventory than distributors to achieve adequate market coverage. The new model also reflects that because our cycle time to build systems is longer than our cycle time to build NICs, we continue to need more channel inventory for systems than for NICs to achieve the same level of responsiveness to changes in demand.
3- While our inventory management tools are still imperfect, they are more robust than they were three months ago. As a result, we now have better and more reliable estimates for our global inventory position as we start Q3:
Major Product Line
Estimated position at end of Q2
NICs
5
Modems
10
Systems
9
We shipped far less to our partners this quarter than last, and estimate that we reduced inventory by 3 to 5 weeks over the course of Q2, depending upon product category. While our results for Q2 are not final and will not be released until December 18th, we estimate that our revenues were in the range of $1.22B to 1.24B and that we will post a slight profit for the period.
BUSINESS IMPLICATIONS
There are several business implications to the decisions we announced today:
1. First of all, for the past several weeks, the financial community have expressed concerns about the lack of visibility and risks associated with high channel inventory levels. We are taking decisive action to eliminate this issue and make these parameters of our business explicit and measurable. One of the clear benefits of these actions is to make our business more linear and more predictable. Our new channel inventory model also makes our relationships with our channel partners more balanced, more objective, more economical and more consistent. In general, it helps us complete the alignment of our company and it is a great simplification to the way we do business.
2. The second implication is as follows: In Q1, our level of sales into the channel was at or above our level of sales out of the channel. In Q2, our level of sales out of the channel was substantially higher than our level of sales into the channel, and also above our level of sales out of the channel from Q1. In Q3, we expect that our level of sales out of the channel will again be higher than our level of sales into the channel, as we intend to shave off the remaining excess of channel inventory in both modems and systems products relative to our new model. In Q4, we expect our level of sales out to be approximately in balance with our level of sales in, and we expect to operate within our new channel inventory model, both globally and for every major product line.
3. Third, from a gross margin perspective, the principal impact of our inventory reduction plan, every else being equal, is to constrain our shipment levels for a couple of quarters (Q2 and Q3). On the negative side, we will likely have higher levels of unabsorbed overhead due to lower volumes shipped, which will put more pressure on gross margins. On the positive side, assuming we are successful at linearizing our quarter, we will enjoy a more efficient selling, manufacturing and shipment process, which will relieve some of the pressure on gross margins.
4. Fourth, from an expense perspective, we plan to hold expenses roughly constant from Q2 to Q3, and most probably again from Q3 to Q4, as we begin to enjoy the benefits of a simpler and more economical channel inventory business model.
Besides the immediate effect of the operational changes I summarized earlier, we are not planning any changes to our business strategy. Our plans call for leveraging the beginning of a strong and broad new product cycle to lead the migration to next generation networks, and to exploit ten key transitions:
1. From shared 10 Mbps LANs to switched 10/100 Mbps LANs in the wiring closets, with our upcoming new generation of SuperStack switches
2. From Fast Ethernet to Gigabit Ethernet and from layer 2 switching to layer 3 switching in the data center, with our award winning CoreBuilder 3500 and our new Switch 9000 and CoreBuilder 9000
3. From V.34 to 56Kbps modem technology with our DSP-based x2 technology at both ends of the wire
4. From dumb access points to intelligent access points, with our rich TranscendWare software and its Dynamic Access capabilities, with our PC OEM partners and our Network Ready partners
5. From analog access lines to digital access lines, with our DSL and Cable Modem subscriber and head end products
6. From routed WANs to switched WANs, with our new AccessBuilder line and our new WAN partners Siemens and Newbridge
7. From enterprise only customers to small businesses, with our OfficeConnect product line, our small business initiatives and our emerging small business partners
8. From separate Voice/Video/Data networks to converged Voice/Video/Data networks with our Voice over IP developments for both LANs and WANs in partnership with Siemens
9. From Private Networks to Virtual Private Networks with our 3Access VPN services and our service provider partners like IBM's IGN
10. From desktops and servers only to connected laptops and palmtops with our leading MegaHertz product line and our best selling PalmPilot connected organizer
This completes my comments on today's announcement.
c 3Com Corporation |
