Channel Stuffing: Keeping Distribution Arteries Clear

Electronic News, August 31, 1998 by Ed Rodriguez

In the first of two articles on channel flow issues, KPMG's National Industry Director of Electronics and Partner, Ed Rodriguez, examines the recent phenomenon of channel stuffing and its problematic consequences. In the next installment, Mr. Rodriguez will discuss effective channel techniques and strategies, and more importantly, how to identify, correct, and prevent potential channel inadequacies.

Signs indicate that the worst of the so-called channel flu might be over, as manufacturers and distributors recover from a nasty bout of backed-up inventories and slow-drip inventory buy-ins. Both sides are now trying to keep the pipelines with inventories down to four weeks and less. Despite a tradition of heavier buy-ins in the first and last quarters of each year, the aim is definitely to keep the products in the channel flowing.

Unfortunately, there are myriad problems in the channel. Shareholder lawsuits and bad publicity are pestering some of the high-tech industry's most respected firms.

Compaq Computer Corp. joined the lengthening line of respected electronics and high-tech companies to receive a barrage of bad press and litigation related to channel issues. Compaq's shareholders accused it in April of stuffing the PC channel to inflate revenues, in order to balance a slowdown in PC unit shipment rates. Compaq vigorously denies the claims and has since taken steps to reduce inventories in the channel to about 14 days' sales, including strong pricing and a slower production rate.

Elsewhere, 3Com Corp. has been up against its own shareholder lawsuit relating to its acquisition of US Robotics Corp. and reported channel stuffing by US Robotics prior to, and immediately following, the merger.

Revenue Recognition

In January of this year, Digital Lightwave Inc. saw its stock collapse after announcing that some product sales had been recorded, despite never having been purchased. This inconsistency between recorded sales and actual purchases resulted in the improper recognition of revenues from certain shipments to distributors. A spate of class action suits followed, claiming the company had overstated revenues and earnings for the second and third quarters of 1997 by as much as 50 percent and 83 percent, respectively. The company, which makes computers to control lightwave communications, blamed these financial reporting inaccuracies on the "discovery of certain errors in the timing of revenue recognition and a review of related accounting policies and procedures."

Media Vision Technology Inc. represents one of the most severe cases of alleged channel stuffing, combined with related securities fraud and insider trading. It hit the headlines in 1994, when its market value declined over 90 percent, following the discovery of allegedly falsely reported 1993 fiscal year revenues. In a civil complaint filed July 10, 1998, the Securities and Exchange Commission sued former executives of the firm, and a number of former executives have been indicted on criminal fraud charges.

Pressure To Perform

Under intense pressure from Wall Street to perform each quarter, some publicly-traded high-tech companies have found themselves in a bind, promising to deliver on increasingly unrealistic revenue projections. When these forecasts do not pan out, some manufacturers have sought assistance from third party resellers to help smooth the numbers.

Some resellers are beginning to take a harder line on these occasionally heavy-handed practices. Resellers are already under pressure to accept increasingly rigorous terms and conditions related to inventory levels and pricing, and they often do not appreciate being forced to take on additional, possibly unwanted, inventory. Companies such as Ingram Micro Inc. and CompuCom Systems Inc. have demanded that the stuffing be taken out of the channel.

If resellers require another reason to refuse unwanted inventory, they need only look to their competitors, the direct PC vendors. The longer that channels remain clogged, the greater the opportunity for their "direct marketing" rivals. Direct PC vendors such as Dell Computer Corp. have shifted the PC market from a build-to-forecast model to that of a build-to-order model with channel assembly as a key component. As a result, the supply-push model is moving toward a demand-pull market supply. When effective channel assembly can reduce warehouse requirements, lower system costs through fewer returned goods, and decrease inventory financing costs, financial pressures will inevitably increase on channel players.

Who's Responsible?

Although high-tech channel management appears much healthier now than just a few months ago, many underlying problems remain. Not least is the issue of responsibility. According to Eno Schmidt, partner in KPMG's Channel Management Services practice based in Silicon Valley, Calif., there are other reasons besides the pressure of quarterly results that give rise to channel stuffing practices.

"There is the perception by some managers that the inventory, once passed onto channel partners, no longer remains the responsibility of the company," said Mr. Schmidt, whose practice provides assistance to high-tech companies in effectively managing their sales and distribution channels. "Such managerial belief is delusional. Of course, if the product is returned by end-users or does not sell through the channel, then the company must take responsibility."