Moore Is Less as Obsolete Inventories Whipsaw Tech

If you run a pencil factory and you run into an inventory problem, getting through it is just a matter of cutting back on production and letting your excess stock get run off. You can lower prices to speed the process along, but it's not a necessary step. You have this kind of flexibility because pencils don't change: They have been made essentially the same way since the late 17th century, the last true innovation coming in 1858, when erasers were attached.

The tech companies that have lately run into trouble, however, obviously have a different sort of problem. It is bad enough that many of them have no experience dealing with excess inventories (for most of their short histories, production had a hard time keeping up with demand). But they also have a big problem that the pencil company probably doesn't have to deal with: Every day that stuff in the warehouse doesn't get cleared out, it's worth less. Call it the downside of Moore's Law -- if performance doubles every year-and-a-half, who wants to own stuff that's a year-and-a-half old?

This, alas, is the problem that continues to stare tech investors in the face, even after tech stocks jumped sharply in the wake of the Fed's latest move to reduce interest rates.

Dress for Success

The obsolescence problem makes sitting on top of any inventory at all, waiting around for warmer days, a dicey strategy. A useful analog may be what happens in retail, where nobody wants to get caught going into the winter with a bunch of last summer's dresses.

"It's incumbent on retailers to get rid of the inventory as soon as possible to make way for new goods," says Sanford Bernstein retail analyst Emme Kozloff. "They mark stuff down and they move it on out."

Full Closets Six-month change in tech inventories

Source: Census Bureau

The resulting fire sale can depress prices severely, however, particularly if the inventory problem is, as appears to be the case in many areas of technology, sectorwide. In such a case, says Salomon Smith Barney economist Steven Wieting: "You tend to see massive price declines as companies try go get rid of stuff. And in some cases, they never get rid of it."

Though such a sale may help a company through a tough quarter, it can hurt later business. For one, some customers, taking advantage of lower prices, will make a point of improving their systems now, putting off later upgrades. The more serious concern is that once you condition people to discounts, they come to expect them.

The Ottoman Empire

"The balance of power is shifting toward the consumer," J.P. Morgan strategist Doug Cliggott says of the tech market. "They can buy at their pace, they can pay at their pace."

This puts technology companies in the same boat as department stores, where we've become so used to sales that many of us won't shop unless one is on. Perhaps the one wrinkle in that analogy is that even in the worst of times, department stores know that plenty of potential customers are out there -- they just may not be buying now. By contrast, think of what's going on with a company like Cisco (CSCO). Many of its customers are cutting back on spending or even filing for bankruptcy, and even plans to write down $2.5 billion in excess inventories ain't going to bring them back. And this situation holds for many of the companies once lauded as the pick-and-shovel makers of a networked economy. Many customers have gone away, and that means the ones that are still around really get to call the shots.

It will be an incredibly hard process to reverse: Unless companies can convince customers their products are truly innovative and unique, a return to a sellers' market seems unlikely. And profits, the ultimate arbiter of stock values, will continue to suffer.

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