Tech Sector: A Battle-Scarred Edge

The recent thriftiness and insistence on lean inventories could keep tech companies well-positioned when the economy starts to heal

After bearing the brunt of the economic downturn at the beginning of this decade, the technology sector looks as if it may be among the best positioned to benefit when the global economy recovers from the current recession.

Of course, that's partly because it's not tech's bubble that burst this time. Real estate and finance have that distinction. Yet tech companies also appear to have learned tough lessons from the Internet bust that have helped them manage through the latest slump. Many cut costs and made other hard choices early on, and now look poised to profit if corporate and consumer demand begin to climb. "Have we learned from previous mistakes? Absolutely," says Niklas Savander, executive vice-president at phone giant Nokia (NOK). "Not everyone has managed perfectly, but I would say the tech industry has managed it better than others."

Investors are betting that's the case. The tech-heavy Nasdaq has rallied in the past month and is up 5% for the year, while the Standard & Poor's 500-stock index and Dow Jones industrial average are down. Shares in Cisco Systems (CSCO), IBM (IBM), Research In Motion (RIMM), and Apple (AAPL) have risen at least 10% in 2009. "Right now, the stocks are on the bargain table," says Jerome I. Dodson, CEO of Parnassus Investments. "If there is even a small increase in demand, I suspect that tech stocks will take off."

These could be misplaced hopes. If the economy continues to slide, tech companies won't see much benefit from their belt-tightening and other moves. And the economic outlook remains cloudy. Tech retail sales, for example, slid 10% in March, according to government data, far worse than the 4.1% drop in February. "It's still pretty ugly," says Bill Whyman, senior managing director at International Strategy & Investment.

Cisco's Inventory Vigilance

Tech companies have taken a number of steps to position themselves for a recovery. They've laid off workers, closed facilities, and outsourced even more of their production. Many companies have also hoarded cash for years, even in the face of investor complaints. Now as other companies scramble for financing, tech giants such as Cisco, Apple, IBM, and Microsoft (MSFT) have billions on hand for acquisitions, research and development, and other long-term plans.

Perhaps most important is how aggressively tech companies have managed production and inventories. Whyman figures that while hardware sales fell 5.8% from the third to fourth quarter of last year, inventories dropped even faster, by about 9%. It's a sign tech companies quickly throttled back on making new PCs, mobile phones, and chips in anticipation of weak demand, saving themselves from having to write off excess inventory, as they had to do in years past.

Take Cisco. In April 2001 the networking giant made one of the more painful confessions of the Internet bust: It had let so much networking gear pile up in inventory that it had to take a $2.5 billion charge for equipment no one would ever buy. Ever since, it's been working to make sure such a thing never happened again. Supply chain chief Angel Mendez is grilled at monthly reviews by CEO John T. Chambers and other top brass, and Cisco has half the inventory it did in 2001 even though it is twice as big. "It didn't take John eight years to start asking questions [about inventory levels]," says Mendez. "He asks about every eight minutes."

Nokia, Intel (INTC), and others also slowed production last fall within weeks or even days of seeing demand slide. They brought supply chains—often involving dozens of companies—to near hibernation. A few shut down. David Yoffie, a vice-president at server maker Rackable Systems (RACK), sent an e-mail to hundreds of partners last November telling them to stop all production immediately. "Customers had hit the brakes hard," he says.

Smartphones, the Smart Bet

It takes more than a wary eye to pull off such feats. Robert B. Carter, chief information officer at FedEx (FDX), says high-tech and life sciences companies have "the most advanced supply chains of any industry," thanks to investments in new technologies and talent. Just as Apple customers can go online to track exactly where their new iPhone is en route to their door, tech companies and their suppliers, manufacturers, and distributors typically share the same real-time view of actual demand.

That's led to other innovations. In the past, companies only air-freighted goods when inventories of a hot product ran out. Now, that's become quite common for small, light, high-end products. Although air mail is 10 times more expensive than shipping by boat, the products arrive in a day or two instead of three weeks, so they can be shipped after a customer places an order rather than in anticipation of demand. "If there is a spike in demand we can increase production. If not, we don't overbuild," says Liam Casey, CEO of PCH International, which helps Western companies produce and distribute products from China.

Still, even the leanest companies need growth to turn investors' heads. Research In Motion's shares have risen more than 50% this year in part because of strong revenue growth in the latest quarter. And because it cut inventory so drastically, the outlook for both sales and profits is promising. Some big phone companies have no more BlackBerrys on hand for their subscribers, says Neil Mawston, an analyst at Strategy Analytics in London. "Because of the de-stocking, there's going to be a restocking," he says.

Some see signs of better times in even the most savaged segments of tech. Take chips, where many companies took a huge hit by cutting production to less than 50% of capacity, vs. 80% in flush times. "A lot of them over-corrected in the fourth quarter," says Wedbush Morgan analyst Patrick Wang. But having taken that tough medicine, they're now positioned to sell the latest chips when big customers begin to rebuild their own stocks.

And yet the cautious optimism about the economy in recent days could well prove false. Wang says most companies admit they can safely forecast just a month into the future now, as opposed to four months in normal times. Companies such as Intel have stopped forecasting their revenue because of the lack of visibility. "There are lots of signs that things are getting less bad," says Whyman. "But we're not out of this yet."

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