Several months ago, I wrote a two-part series about the exciting topic of inventory. It may not be exciting compared to viewing the double star Albireo in the constellation Cygnus, but inventory is the lifeblood of many companies.
Under certain conditions it can also choke a business, however, and the mini-series was designed to point out those conditions.
One of the companies I talked about was Cree (Nasdaq: CREE), a compound semiconductor materials maker that specializes in silicon carbide and gallium nitride. Its products go into LEDs, radio-frequency (RF) components, and other devices. We considered this company at one point for inclusion in the Drip Port, but shied away from its volatility.
When I wrote the columns, I warned that Cree's inventory picture was somewhat worrisome, and might be foretelling future discounts or write-offs. With a couple of quarters reported since then, we can look back and see what's transpired.
Total % change Quarter ended (in thousands) (from prior year) ------------- -------------- ----------------- Sep 01 Revenue 43,166 15% Total Inventory 16,922 60% -Raw Materials 4,530 94% -Work-in-process 7,067 108% -Finished goods 5,325 10% Dec 01 Revenue 41,092 -1% Total Inventory 18,244 37% -Raw Materials 3,867 36% -Work-in-process 8,190 79% -Finished goods 7,315 24% Mar 02 Revenue 33,376 -37% Total Inventory 14,812 -7% -Raw Materials 4,029 -3% -Work-in-process 7,844 19% -Finished goods 8,927 74%
The above shows Cree's inventory picture for three straight quarters ending March 2002. Each quarter saw inventory increasing on a year-over-year basis at a faster rate than sales -- the first red flag. In addition, the different components were moving on a negative path: Finished goods was ballooning while raw materials was declining.
A buildup in raw materials is usually a good sign, because it could mean a company is ramping up to meet increased demand. It might point to higher revenue and profit down the road. But if finished goods is increasing at a faster rate than raw materials and work-in-process, it could be a sign the company is having trouble selling some of its products. Such finished inventory, sitting in a warehouse, is costing money and is also in danger of being discounted or written off entirely -- especially in the high-tech world where yesterday's wonder chip could be obsolete by tomorrow.
As it turned out, Cree did have a problem with some of these issues. Management assessed some LED and wafer inventory to be "slow moving or obsolete," and took a $784,000 reserve, which was recorded as a cost of revenue. Another $1 million of "XBright" LED chips were written off as a research and development expense, because improved chips were developed.
The Cree Microwave unit, which makes components for wireless infrastructure applications, also had problems. The unit (then known as UltraRF) was purchased from Spectrian a couple of years ago under the condition that Spectrian buy a certain amount of product from UltraRF each quarter. Spectrian was not able to live up to the terms of the agreement, however, and settled out of the contract last November.
With the settlement, Cree was left holding customized parts that could not be sold elsewhere. They were written down over three quarters and added to cost of revenue, and another $417,000 worth of devices were written off as research and development expense last quarter.
To summarize, Cree's bottom line over the past couple of quarters was hurt by several inventory-related events. Instead of being sold for a profit, some of the company's products were scrapped and recorded as expenses against revenue or research and development.
I believe that analyzing the inventory components last July gave us an indication this might happen, and said as much: "All of this translates into the company still having quite a bit of finished goods on hand that it may have to discount, or write off entirely, in the future. And if this happens, it will hurt earnings."
In a stunning display of how little it helped to know all that, however, I sold off a portion of my Cree holdings back then, and the stock has risen about 25% since. Oh, well.
What about the future? Here's how the inventory picture has developed since then:
Total % change Quarter ended (in thousands) (from prior year) ------------- -------------- ----------------- Jun 02 Revenue 37,800 -15% Total Inventory 17,966 18% -Raw Materials 3,908 -14% -Work-in-process 6,629 7% -Finished goods 9,724 85% Sep 02 Revenue 48,811 13% Total Inventory 15,923 -6% -Raw Materials 4,075 -10% -Work-in-process 6,094 -14% -Finished goods 8,432 58% Dec 02 Revenue 56,727 38% Total Inventory 15,144 -17% -Raw Materials 4,507 17% -Work-in-process 5,311 -35% -Finished goods 8,242 13%
Things are, I'm happy to say, much better now. After one more quarter of growing faster than sales, total inventory fell 6% in the September quarter while revenue was up 13%. The finished goods component was still disturbing, though, increasing by 58%.
But by the end of December, revenue was up 38%, finished goods rose just 13%, and total inventory actually fell 17%. In fact, raw materials grew faster than any other component, which is another positive.
The company says the backlog for LED products remains strong, and that its North Carolina facility is operating at full capacity. It appears the market for its products is picking up again. I think these factors are largely responsible for the stock's recent ascent, and the inventory picture reflects the improving business conditions.
The thing Cree must do now to break out even higher and fulfill some of its oft-discussed potential is start getting new products to market. Long-time Cree watchers have heard about blue lasers, microwave devices, moissanite jewelry, power devices, and solid-state lighting for a long, long time. To be blunt, the company has fallen behind its own timetable and frustrated many investors.
In my opinion, there is no person or department to fault for this -- this is extremely hard stuff to make and produce in commercial quantities, after all. I still think Cree will be able to produce successful products in some of these areas, or I wouldn't still own the stock. But as each quarter passes with LEDs still comprising the vast majority of revenue, more and more frustration sets in.
For a great overview of these problems, check out this discussion board post from SEA99, one of my favorite Fools.
Rex Moore has fought long and hard to move the letter M up a few spaces in the alphabetical order, but he's too tired to carry the battle through. At press time, he owned shares of Cree... as can be seen on his profile page. The Motley Fool's disclosure policy is brought to you by the letter Z, which always goes last.
