Manufacturers Ditch the Jack Sprat Look

Lean inventories, in vogue for so long, suddenly look less compelling.
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If you want to check in on how business is going, don't bother looking at inventory figures.

In the wake of the Sept. 11 terrorist attacks, many companies found that just-in-time business practices -- essentially, cutting costs by keeping few parts on hand -- turned from an asset into a liability. With air shipping and cross-border shipping constrained, manufacturers were cut off from their suppliers, forcing them to cut back on production.

Ford

(F) - Get Report

shut down five North American assembly plants;

Compaq

(CPQ)

warned that it wouldn't meet analysts' earnings estimates for the third quarter, in part because of "chaos in the tranportation system."

Now, managers everywhere are considering whether to back away from just-in-time inventory management. Some will, boosting business at suppliers in the near term. But that very boost could give investors an unrealistically sunny view of how well business has rebounded from the terror attacks.

So Efficient

Though hard to quantify at this stage, reports abound of companies deciding to carry higher inventories to prevent further production bottlenecks. Diane Swonk, the Chicago-based deputy chief economist at Bank One, says that among her manufacturing clients, "There's a pretty strong consensus at the moment that they're going to be holding onto more inventory."

Manufacturers insist they are just as committed to just-in-time as ever. "You design a logistics system around predictable events," Ford director of communications for manufacturing and purchasing Della DiPietro says -- not around the possibility of exogenous shocks. But she goes on to admit that "on a temporary basis, we're taking a look at whether it's prudent to increase inventory levels on specific parts at a few key plants."

Efficiency Experts
U.S. businesses inventory-to-sales ratio falling

Source: Commerce Dept.

To what degree the automakers will raise parts inventories is unknown, even by the companies themselves, at this point. Everything is still in flux. But assuming they do carry higher inventory levels for at least the intermediate term, their suppliers will see increased business. Or to put it in a better way, in a declining economy their business won't fall as much as it would otherwise. "Instead of demand falling 10%," suggests J.P. Morgan auto analyst David Bradley, "maybe it falls 5."

That would make it difficult to figure out exactly where the industry is headed. Typically, any kind of turn in inventories would be taken as an assessment by the car companies that they expect an upturn in sales. But in this case that simply wouldn't be true. Moreover, investors need to be careful not to be duped if auto suppliers like

Dana

(DCN)

or

Delphi Automotive

(DPH)

end up posting better-than-expected results in the final quarter of the year.

Trade! Trade!

Of course, different industries may experience the disruption of shipping patterns in various ways. The car business appears fairly well insulated, considering its size and importance to national economies. But other businesses may be more disrupted.

"I would guess that the Canadian and American governments will work pretty hard to find ways to minimize problems," says University of Michigan Business School professor and onetime

General Motors

(GM) - Get Report

chief economist Marina Whitman. "Both sides would be very concerned about having the efficiency and productivity of their automakers drop." In order to keep cross-border shipping running well, both countries, along with Nafta partner Mexico, will probably try to beef up security along their perimeter borders.

The automakers and most other old-line manufacturers are fortunate that their North American production facilities are not dependent on suppliers from outside of the free trade zone. Moreover, air freight is not an important cog in the supply chain, and is used only in emergency situations -- when a car company starts shipping parts by plane, it's usually a sign that somebody goofed.

Technology companies are not so lucky. Many of the components they depend on (particularly semiconductors) come from suppliers outside of Nafta, and many of them are air-freighted. Expectations of a prolonged falloff in air travel will affect them.

"If there are no passengers flying, you aren't going to be able to put cargo in the bellies of those planes," says Candace Bouchard, spokeswoman for Danzas AEI, the world's largest air-freight forwarder. Beefed-up security may also slow things down, she says. "There will be sacrifices in the supply chain," says Bouchard. "Cargo, no matter how valuable, is replaceable. Lives are not."