On wednesday I spoke of the importance of understanding the cycles of a business. It is only then that you will be able to feel the rhythm of a company or industry. And there are many such cycles to understand. Let me review a few of them with you:

Industry cycles: These are often demand/supply cycles and we see them most often where supply comes into the market in "big chunks" and where there is little differentiation of product. Examples would include LCD panel production, long distance fiber optic line capacity and semiconductors. The "chunkiness" results in a lot of burps in the industry--though demand continues to grow, the chunks of supply that come onstream outstrip the ability of the end market to absorb. What happens then is what we see in everyday life--15 inch LCD screens give way to 17 inch; 256mb DRAMS give way 512 mbs and prices drop like a rock. Eventually this supply overcapacity gets corrected as companies no longer have the capacity to re-invest--their profits are replaced by red ink--and either they lack the cash or their stock price considerations act as a brake on further investment. Supply then tightens and profits return. The length of the cycle will vary in accordance with the time it takes to add capacity in the industry.

In the semiconductor business this can be as long as 9-12 months to build the fab and an additional 6-9 months to fill the fab with equipment. We have been waiting for four years for an upturn in the backbone telecom industry--those companies that provide backbone lines to corporations and other telecom providers. It has not materialized because these companies laid a lot of dark fiber during the bubble period which can be readily lit and come online--so supply is easily replenished even though demand keeps doubling every year (or less a period) for "bit" demand. Eventually the dark fiber will all be lit and we will be back to the days of shortages--and prices will go up. But when is the magical question and there have been a lot of predictions with a lot of false starts.

Working Capital Cycle: The working capital cycle in a sense is closely related to the above supply demand cycle. As you know, the working capital cycle refers to the conversion of inventory (work in process production and post-production) into receivables and finally into cash. The cycle has become shorter and shorter over time--with management innovations such as just in time inventory management and demand pull inventory systems, which force the vendor to hold inventory. Also (and importantly) better supply chain management tools and software have contributed to the compression of this cycle.

Despite these improvements, the working capital disruptions will still flare up from time to time. Intel, for example, this quarter saw a significant build in inventory which had the effect of depressing margins and revenue. In the disk drive business, recessions in the industry are caused by over-supply which usually shows with too much inventory in the channel. Remember we say that high tech inventory is like sashimi--it declines rapidly in value with time. This only contributes to further pricing pressures in the market. In enterprise software, the time to be wary of the working capital cycle is during new product introductions--the accounts receivable balance is a sure sign of the quality of the product--dissatisfied customers don't pay.

So if you want to know the general health of the industry, watch the supply-demand cycle and the working capital cycle--especially inventory. I will comment later on the other cycles that we see in IT.