How Low Can Inventories Go?

They may shrink further, delaying recovery

At this point during the last economic slowdown, in the early '90s, Behlen Mfg. Co. wouldn't have been caught dead with its current low level of inventories. Uncertain about the economy, the Columbus (Neb.) metal fabricator would have wanted its inventory-to-sales ratio to run about 1.6, or 160% more inventory on hand than total monthly sales. If demand picked up, says CEO Tony Raimondo, that's what he'd have needed to cover orders. But in this slump, that ratio is now 1.4. And by keeping a brake on supplies, Behlen hopes to be at 1.2 in six months.

Behlen has reduced inventory through better "just-in-time" management techniques. And while that's good news for the company, that may mean more sluggish times ahead for the economy.

Since last fall, the pileup in business inventories, both in Old Economy companies and the high-tech sector, have been a huge drag on the economy. As companies have cut production to get stock back in line, business inventories have fallen steadily since January. As a result, many economists now believe that the inventory decline could be close to done. That in turn would mean a turnaround as companies begin to restock in the third quarter. "Businesses aren't going to let inventories fall forever," says Benjamin Herzon, an economist at Macroeconomic Advisers, a St. Louis forecasting firm.

But have just-in-time inventory methods lowered the level of stock companies need to hold, meaning more sharp cuts instead? In congressional testimony this year, Federal Reserve Chairman Alan Greenspan suggested that the threshold has indeed fallen. And Richard Berner, an economist at Morgan Stanley Dean Witter & Co., says that the shift to just-in-time portends inventory cuts in the third quarter just as sharp as those in the second. The Commerce Dept.'s Aug. 24 durable goods report, which showed a 0.6% dip in July inventories, indicates that aggressive trimming continues. "In the just-in-time world, lean and mean is much lower than historical norms would suggest," Berner says.

MORE CUTBACKS. Moreover, better inventory management doesn't mean companies are any better at forecasting demand--as the tech sector has amply demonstrated since fall. At computer manufacturers and makers of other electronic products, the inventory ratio has risen steadily from 1.21 last September, to 1.59 in July. With sales still falling faster than they can slash inventories, more production cutbacks are ahead. Semiconductor giant Texas Instruments Inc. has already cut inventories by 12% in the first half, yet they were four days above last year's midpoint.

So what is the optimum level of inventories to spur a recovery? According to the Census bureau, the inventory-to-sales ratio for all businesses hit 1.43 in June. That's still well above the low of 1.37 hit in March, 2000, near the height of the tech boom. Morgan Stanley's Berner predicts businesses will continue to get back to that level or even lower. That means there could still be plenty of destocking left to do.

By Robert Berner in Chicago, with bureau reports

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