The Road Ahead: Networkers Confront a Mountain of Inventory

Those nasty inventories.

The past few quarters have seen the networking giants

Cisco

(CSCO) - Get Report

and

Nortel

(NT)

, perhaps blinded by their brilliant sales growth of recent years, keeping the purchasing pedal to the metal even as customers slam on the brakes.

Needless to say, this hasn't developed as a very fortunate intersection of trends. Analysts and investors say the resulting buildup in inventories at both companies could reduce sales growth in coming quarters, adding to the woes of an economic slowdown and an industrywide pullback in telecommunications equipment spending. Any revenue slowdown will likely be felt by shareholders who have bought these stocks expecting to cash in on the rapid growth of the Internet. And Cisco, whose continued good fortune is

inextricably linked to a rising stock, is feeling additional pressure as its customers slow the pace at which they pay for goods. Cisco and Nortel didn't immediately return calls seeking comment.

Rubbernecking

Cisco's inventory totals illustrate the extent of the pileup. Over the past year, Cisco's inventory jumped 261% to $2.5 billion at the end of last month, from $700 million at the end of January 2000. Revenue growth for the same period lagged far behind, at 60%. Nortel was also caught in the buildup, though not quite as severely, with a 63% rise in inventory more modestly outstripping a 42% revenue gain.

In trying to describe why suddenly so much less was going out the door while so many chips, components and raw materials continued to pour in, Cisco's CEO John Chambers halfheartedly joked on the company's recent earnings conference call that his customers were using Cisco's computer networking equipment to figure out that they couldn't afford any more Cisco equipment.

The timing of these mammoth inventory surpluses presents a challenge as the nation's economy continues to slow, corporate profits fall and new equipment purchases are delayed or even canceled as businesses conserve cash. Working off the stockpile of goods will be even more difficult in these adverse buying times.

"It could take a couple quarters or it could take much longer" for Cisco to work off the inventory overhang, says a Southern Californina based hedge fund manager who has no position in Cisco.

Fram Oil Filters

Over the past year, Cisco also showed alarming growth in accounts receivable, which doubled to $3.5 billion. This means Cisco isn't getting paid in a timely fashion for goods it ships. This only makes matters worse by combining slower payments with already slower sales. That hasn't been an issue at Nortel, where accounts receivable grew apace with revenue.

Having lowered the bar a bit in forecasting that revenue will be flat to slightly lower this quarter, Cisco could stage a comeback even in a slow economy. And if the economy regains its feet, those inventories will surely start to decline by the end of the year, as the company has repeatedly said it expects a second-half bounceback in demand. But comments from any number of tech companies in recent weeks have suggested that, in truth,

no one really has any idea of how the rest of the year is going to look.

If Cisco can pull through the economic slowdown and the attendant inventory pileup, management will finally deserve the high praise it has received,

Robertson Stephens

analyst Paul Johnson said Monday during the Robertson Stephens Technology 2001 Conference. But if the company's results continue to suffer and measures like inventory and accounts receivable continue to grow, some doubters will see evidence that Cisco's success was merely a good run in a very favorable economy.