Channel Stuffing

How should a publicly traded company measure its sales? Sales in vs sales out method?

In a sales in method is measured the sales from the manufacturer to a distributor and in the sales out method it´s is measured from a distributor to a customer (system integrator or end user). In sales in sometimes the products are still in the distributor´s warehouse. In the sales out it was sold to the customer which is a reliable sale.


Can you clarify what you are asking? Specifically what do you mean by 'a sales in method'? Do you mean a multiple of sales? Like if a company does $100 million in revenue, it should be worth x times that revenue? Or?

In a sales in method is measured the sales from the manufacturer to a distributor and in the sales out method it´s is measured from a distributor to a customer (system integrator or end user). In sales in sometimes the products are still in the distributor´s warehouse. In the sales out it was sold to the customer which is a reliable sale.

A manufacturer typically register a sale once they have a legal agreement and have shipped out a product. It generally does not matter who this is with and could be a distributor, integrator or end user.

The risk of sales to anyone but the end user is that the sales figures can essentially be inflated if the channel (distributor / dealer / integrator) do not eventually or quickly re-sell it to an end user. In the short term, this can make performance look better than it really is but will ultimately result in a let down / drop.

Fun term: channel stuffing, (unrelated: channel surfing.)

Good article from the WSJ on channel stuffing.

Also, was not aware until now that this has legal ramifications for publicly traded companies.

...this has legal ramifications...

Though apparently not financial ones, as they expect 'insurance to cover any accord'. WTF? Who is really paying for the fraud, then? Should the insurance balk at the implied fraud and simply stiff on the stuff?

But if they can't because the policy was written so as to explicitly to cover any size shareholder claim, it had to be pricey? Should the shareholders now sue to recover the premiums paid to cover their fraud? Or the increase in the new policy?

It's a Win/Win/Lose scenario, I'm just not sure which is which...

What insurance policy covers that type of action?

The challenge is when the practice becomes 'channel stuffing'. It seems to me a grey area. Most manufacturers who use distribution will sell some amount of product to the channel that is not immediately turned around the customers (and is a legitimate tool of selling). How much is needed / how far does one have to go to make it a legal / SEC issue?

What insurance policy covers that type of action?

Shareholder Liability Insurance. Here's a book that just came out on it.

One scenario described(Monster?)is as follows, product demand unexpectantly decreases, revised internal sales forecasts predict missing 'the number on the street', execs file neccesary paperwork for insider transactions, company continues to 'sell into the channel' even as sales slow, once insider waiting period requirement met - execs sell stock at high price, reported sales drastically decline, stock tanks, shareholders sue, execs settle easily with shareholders/SEC as long no criminal action has to be admitted, insurance pays because no actual fraud is proven, insurance rates skyrocket, end loop...

It seems to me a grey area. Most manufacturers who use distribution will sell some amount of product to the channel that is not immediately turned around...

It's not as grey as one might imagine because although channel levels will rise and fall due to demand, the key metric is how many days it takes to turn the inventory once, and when this number starts to rise beyond historical norms, there better be some extraordinary reason for it...

What's difficult about tracking days it takes to turn inventory is that the inventory is held by a third party.

Let's say I am CrappyCam, a publicly traded company, and I sell to DirtyDistributor and ComplicitChannelCo. An investor can see this metric change if CrappyCam is holding this inventory. However, the whole point of channel stuffing is to move the inventory into a third party where one does not have the visibility (i.e., does DirtyDistributor and ComplicitChannelCo have way too many CrappyCams?).

What's difficult about tracking days it takes to turn inventory is that the inventory is held by a third party.

Correct, the Ignorant Investor, cognizant of continuing Crappy sales, will stay true to his name, and gladly drive Crappy Cam's valuation ever loftier, that is until the Crap in the channel backs up all the way to the source, causing the stock to go 'in the $h!tter' or simply 'take a dump'. At this point the Incensed Investor contacts the Attacking Attorney who involves the Responsible Regulator, who at this point has no problem determining that slimy stuffing has occurred, that's when the sh!t hits the fan.

But I was actually answering this question

How much is needed / how far does one have to go to make it a legal / SEC issue?

And the answer is that it is not difficult to figure inventory turns a year later, Yes/No? That is when the SEC is involved.. Unless your in an industry big enough to make it worthwhile for someone to research supply chain levels, (ipads, autos?), there is little recourse until its over.

"at this point has no problem determining that slimy stuffing has occurred"

I am not sure it's that straightforward, unless the drop in revenue is massive all at once. Even if it is, the manufacturer could still argue that what happened was an unexpected drop in demand / deteriorating market conditions, etc.

I certainly agree that eventually the stuffer needs to deal with a return to reality but it can be ran to great success, moreso than if the company never stuffed.

Diebold wrote the book on this one with ATM contracts. But they paid the price in fines. And everyone got fired.

And everyone got fired.

and rich? ;)

I am not sure it's that straightforward, unless the drop in revenue is massive all at once. Even if it is, the manufacturer could still argue...

Yes and No. The crime is 'Channel Stuffing', not 'Stuffed Channel', and since evidence of the latter does not in and of itself prove the former, one has to prove management's intention to 'stuff', which may or may not be hard, depending on size of stuff, frequency of stuff, timing of stuff and a whole bunch of other 'stuffs'.

Although at the same time I think you are not recognizing how much simpler is to detect 'Stuffed Channel' in hindsight than in foresight. The reason should be clear: the whole point of the stuff is based on the inappropriate and substantial shifting of one periods items into the next period (and vice versa). So the 'stuff' HAS to be 'seen' on the P/L and the balance sheet, most likely in the next accounting period, (could be hidden a little longer in industies with extremely long sales cycles, 787s, quantum computers, etc.). You reap what you sow stuff. As in:

1. Sales Decrease

2. Returns Increase

3. Discounts Increase

4. A/R Decrease

5. Handling costs Increase

So there is quite a bit of 'stuff' to give it away in the post mortem, compared with almost nothing while it is occuring.

My question is: why do the Dirty Disties allow Stuffing Suppliers to Shamelessy Stuff, since it increases the Dirty Distys Dusty inventory at the same time the Dirty Disty is stuffing the Indifferent (Insolvent?) Integrators themselves? Maybe the Disties are less likely to be public?

but it can be ran to great success, moreso than if the company never stuffed.

Now this I have never heard before. I always thought of Stuffing as an organic, creeping process that just happens... e.g,

COO: Are we Stuffing yet? CFO: Let me run the numbers... No, we're fine. COO: How 'bout now? CFO: I'm waiting on those 'revised' sales numbers. COO: And now?? CFO: Get a lawyer!

But you make it sound like a go to market strategy or something. Whose 'great success', the shareholders at large or management? Surely the lack of confidence that results, from a couple of these incidents can't be better in the long run for anyone?

"why do the Dirty Disties allow Stuffing Suppliers to Shamelessy Stuff"

Because the channel gets additional discounts or other financial incentives. So the channel partner says, "Hey, I am saving 10% this way or getting free training or custom development for a future project, etc."

To make stuffing work, you don't just do it with 1 or a few partners. You continue to expand it into each new region / partner / etc.

"But you make it sound like a go to market strategy or something. Whose 'great success', the shareholders at large or management?"

It's definitely a market strategy and the prime beneficiaries are management, who gets to make their number and trigger the corresponding short term bonuses - commissions, stock options, etc.

In my experience, channel stuffing is rarely strategic. It is usually opportunistic sales people trying to hit their numbers at the end of the quarter. And it grows on itself since at the end of a subsequent quarter the distributors are already suffering indigestion from the preceding quarter's purchases. The CFO normally doesn't become aware of a problem until a couple of quarters down the road when faced with a big stock ballancing request. Not to say it is never a senior management strategy.

Good feedback!

I agree that the CFO is unlikely to be aware / involved. However, VP of Sales typically is. S/he's the one setting the numbers and approving deals / terms. And though sales person are being opportunistic to hit those numbers, its sales management that pushes / forces them to get there.

I also agree that it's difficult to keep pushing existing channel partners. To that end, it has greater probability of success when you are expanding your number of partners / going into new territories, etc.

It's definitely a market strategy and the prime beneficiaries are management, who gets to make their number and trigger the corresponding short term bonuses - commissions, stock options, etc.

Well not to split hairs, but then one would have to say its *not* a market strategy of company, per se, but just of some people in management, for their own personal gain/loss avoidance purposes. Much like 'check kiting' is not any company's 'strategy', although bookkeepers have been known to perpetuate such fraud, (tip: its always the guy with the most accrued vacation time).

However in digging around to disprove your systemematic stuffing strategy statement, I came across quite a few examples when a company knowingly and legally stuffs for gain. Though in these cases its not trying to shift future revenue into earlier periods. One reason is when Vampire Vendor cuts discounted deal with Duped Distributor solely to suck working capital from the now Debt-laden Distributor so that when Sluggish Supplier comes calling there is none left.

Even more sophisticated is target stuffing of just individual lines, i.e Spoiling Supplier gets early wind of Creative Companies new product launch, before announced, and stuffs 'to the gills' all members of Complicit Channel with competing product, often amazingly with space eating demo stations and consigned invertory if need be, just to deny physical space to competitors...

Re: strategy -

Take an early stage company that did $10 million in revenue last year. They are on track to grow 20% this year. At the end of the year, they get deals with 3 channel partners to take on $1 million in sales / channel 'stuffed'. Because of this, the company grows 30% increasing their valuation 50% since such companies are valued heavily on growth rate, so instead of being worth, say $20 million, the company is valued at $30 million. They can raise capital at this higher valuation, etc.

While I agree some companies do this opportunistically / tactically, there are real benefits for companies to do this. Yes, they can't do it forever, but they can do it long enough to cash out and / or (hopefully) improve the fundamentals to deliver the higher growth sustainably.

I am not saying its ethical or recommended, but there's real potential in pursuing this.

The Dizty Disty has finally wizened up!

Occasionally, distribution channels such as large retailers have been known to identify the practice of channel stuffing in their suppliers, and use the phenomenon to their advantage. This is done by holding back on orders until the end of the suppliers’ quota period. The supplier’s sales force then panics, and sells a large amount of the product under more favorable terms than they would under ordinary circumstances. At the beginning of the next period, no new orders are placed, and, barring any action, the cycle is then repeated. This has an impact on customers, with gluts and shortages as buyers turn to competing products.

Channel Puffing Anyone?

Ok, you're gonna love this: A comprehensive whitepaper on management driven channel stuffing, complete with detailed mathematical modeling, written by Pontificating Professors... From the intro:

...managers have better information about the firm’s internal operating environment. In practice, the most common way for investors to retrieve information about a firm’s performance is through financial reports. As these reports indirectly impact the managers’ compensation, it is not surprising that managers may have incentives to intentionally manage the operation to influence the reports. For example, managers may be tempted to sell excess units of inventory and report higher sales in order to obtain a favorable short-term capital market reaction, even if it is costly for the firm in the long run. This is known as “channel stuffing.

Maybe yes. But just a few.