Concerns over bulging inventory are adding to the growing list of issues plaguing Electronics Manufacturing Service (EMS) providers, despite positive financial results for the companies during the second quarter, according to iSuppli Corp.

Inventory in the second quarter increased by 18.6 percent for a sample of leading publicly-traded EMS providers, including Flextronics, Sanmina, Solectron, Jabil, Celestica and Benchmark. Flextronics led the pack with a 29 percent spike in inventory. Jabil's inventory increased 24 percent, while Solectron's grew 20 percent. As shown in the figure below, the rate of inventory increase outpaced the rate of revenue growth by 8.6 percentage points during the second quarter.

The EMS providers as a group are 3.3 days over iSuppli's target level for optimal days of inventory and, as a result, they are responsible for 10.3 percent of the excess semiconductor stockpiles in the electronics supply chain, according to Rosemary Farrell, iSuppli's chip inventory analyst.

The variance between revenue growth and the inventory increase during the past 90 days is approximately 8.6 percent. While iSuppli would rather see those two metrics grow in tandem, we believe the inventory increase is understandable given current market requirements. EMS providers now face a host of challenges, including margin erosion, old and new restructuring programs, operational issues, strategic challenges and lack of investor confidence. In comparison, the inventory spike appears to be a relatively minor concern at this time.

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iSuppli believes five reasons account for the higher-than-usual inventory bulge:
-- Seasonality. EMS providers are preparing to capitalize on the broad-based demand trends announced by EMS senior management in their second-quarter earnings reports. In particular, consumer-electronics builds will impact several providers - specifically Flextronics, Celestica, and Jabil - as back-to-school and holiday promotions entice retail buyers.
-- New program ramps. Jabil, Flextronics, Celestica and Sanmina all have indicated that new programs are in the process of ramping. In anticipation of these ramps, inventory has been purchased and staged to satisfy post- New Product Introduction (NPI) runs. According to reports, $140 million, or 58 percent of Jabil's inventory increase during the second quarter, will be used for new programs.
-- Cisco's inventory pushback to the EMS. Cisco's �€œLean�€� initiative, is forcing inventory back into the EMS node of the supply chain. During the quarter, Jabil became the first manufacturing partner of Cisco to implement its Lean process roll-out. As a result, Jabil added $49 million in inventory during the second quarter. It is expected that $50 million more in inventory will reach Jabil's balance sheet during the third quarter and more than $250 million will flow back to Solectron's and Celestica's balance sheets toward the end of 2006 and the beginning of 2007. Considered a temporary situation, Cisco's Lean initiative will bulk up EMS inventories only to be worked off during the following quarters.
-- Mergers and acquisitions. Following its acquisition of select Nortel assets, Flextronics added more than $175 million onto its balance sheet during the quarter. Flextronics' inventory grew the most of all EMS providers during the second quarter, at 29 percent. Jabil also incurred additional inventory in the quarter as its balance sheet increased by $50 million due to its acquisition of the Indian-centric EMS provider, Celetronix.
-- The RoHS directive. With the Restriction on Hazardous Substances (RoHS) directive having commenced on Jul. 1, a few inventory issues have been noted by Benchmark and Celestica regarding compliant and non- compliant components. Ultimately, due to RoHS, EMS companies are forced to manage two sets of part numbers. Yet, large-scale supply chain disruptions as a result of RoHS have not been detected. In fact, Mike McNamara, Flextronics' chief executive officer, recently stated the company maintains 100 percent compliant facilities and that no major issues specific to RoHS have impacted its supply chain. McNamara said that preparation for RoHS/Electrical and Electronics Equipment Directive (WEEE) implementation has been ongoing at Flextronics for several years.

iSuppli's EMS/ODM Market Tracker will continue to monitor the recent surge of inventory in the contract manufacturing node of the supply chain. While the sudden increase of inventory appears to be manageable, the situation could worsen if end-market demand does not follow through in the second half of the year. EMS providers now hold 10.3 percent of all excess semiconductor inventory, while the chip suppliers themselves have 86.1 percent of the stockpile overage. If the EMS percentage should increase relative to the other nodes, additional problems could occur for EMS providers that would compound their existing challenges.