Arrow Electronics, Inc. (ARW) Earnings Call Transcript & Summary

Okay. Great. My name is Mark Delaney, and I cover Arrow at Goldman Sachs. I'm pleased to be hosting Chris Stansbury, Arrow's CFO. Thanks very much for being here.

Yes. Good to be here.

Arrow is a leading global distributor with more than $28 billion of annual revenue. And I thought we could start out, Chris, with a near-term dynamic that's on a lot of investors' minds right now is the unfortunate health crisis in China. The company spoke a little bit about this on your earnings call that was pretty recently. But maybe just elaborate a bit more on what Arrow has seen operationally? And to what extent you're able to size the potential business impacts?

Yes. From an operational standpoint, I would say that we've been able to manage through it fairly effectively. The reason we didn't guide last week is there's things we knew and things we didn't know. So obviously, customs was closed. The national holiday was extended till the 10th. We -- the good news is we did see the border open. And we did see some cities come back online, although that's going to be a phased motion. So our ability to receive goods has been maintained. Our ability to ship them from our warehouse in Hong Kong, into Shenzhen, and then after that is opening up again. So I don't think there's any real holes in the system. The bigger question is, how quickly will demand recover? How quickly will factory workers and our customers get back to work? And how quickly will those factories ramp? That's the big unknown at this point. But the good news is, is, fortunately, so far, we haven't had any employees that have gotten a virus, and we've been able to manage through that.

That's good news. Just in terms of the scenarios and thinking through potential implications. In some past periods of potential supply chain disruptions, you've actually seen pull-in of demand. Do you think Arrow has seen any of that?

I don't think we've seen any of that in the near term. And remember, if you think about the other 2 regions, the order of the slowdown first impacted Asia, then the Americas, then Europe. I think Asia is at the early stages of recovery, kind of ex coronavirus, but we're still in a period of softness in North America and Europe. So if anything, the timing of this coinciding with the softness in the west, I think, has muted some of that behavior that otherwise would have happened so.

And then sticking with the components part of your business, the company said its book-to-bill was right around 1 for last quarter and saw some signs of stability. What is Arrow seeing regionally? And any inflections or deterioration potentially, I guess, in the month of January that you can talk about from a book-to-bill perspective?

Yes. No real change. I mean, again, I think the tone of the call pretty much said it all, still bouncing along the bottom. Obviously, some good feedback from suppliers, which we watch very closely because we know we're going to lag the supplier community by a quarter or 2. And then to your point, it's only 1 data point, but some stability in the book-to-bill, sequentially stronger year-over-year, stronger, all good. That said, I don't think we're looking at any kind of a prediction. Arrow certainly not making a prediction of a rapid recovery or a significant growth in the next quarter or so. I think if -- to the extent that there is recovery, at this point, we'd say that's probably more back half.

Any verticals that are standouts, either to the positive or negative side?

Really, all verticals have been impacted. The -- there's no real standouts at this point. I would say the bright spot is really just broader consumption in Asia, and that market starting to improve.

There's been some margin pressure, which is not unusual in a downturn. Maybe you can talk a little bit more specifically to pricing? And if you're seeing any intensification in the pricing dynamic?

Really no, pricing didn't benefit us a lot when things were growing rapidly, and it hasn't really hurt us in the downturn. So no significant changes there. To your point, margins are suppressed, typically, we see that for about 5 quarters. We're 3 quarters into it. The good news is that as volume does recover, we will get immediate operating leverage benefits. We clearly demonstrated that when we were growing 18 months ago, and in addition to that, we've taken out $130 million in OpEx. So that just gives us a head start, if you will. The other good news is that we have kept the pipeline full of engineered designs. So unlike the downturn 10 years ago, where customers stopped engineering, we continue to see very strong design registrations. We saw year-over-year growth in Q4 globally. We saw sequential growth in every region, in Q3 to Q4. So those are all very good signs as well in terms of where we head when the market recovers. And then in addition, we have not slowed our pace of innovation as it relates to new services that customers can use that are also margin accretive. So all of those things, I think, bode well as the market recovers. The only other data point I would give you is that we have seen the margin improvement start in Asia, which is typical of what you would see as those markets recover, and we are effectively guiding to sequential margin improvement in Q1 so.

Maybe if you can talk a little bit more on the demand creation efforts, and ties closely to the longer term margin expansion potential for the company. Maybe give us a rough sense, if you can, about how much of your components revenue is tied to demand creation? And where that could potentially end up over the longer term?

Yes. We don't talk a lot about that. We have said in the past that roughly 1/3 of our volume in the components business should have a design associated with it. We'd obviously like to drive that higher. We -- as you know, when we took on significant share starting a couple of years ago, when that share shifts, it -- you don't get demand creation with that. You have to earn that as the refresh cycles move along. And so we dipped below that. We were seeing it grow at a healthy pace as we were winning more and more of those designs. And then obviously, when we went into the downturn, we've talked a lot about mix. The biggest impact on mix is that while customers are continuing to engineer, the smaller customers that rely more on our engineering services have been disproportionately impacted on a negative basis than the bigger customers that rely on us for less of those services. So we feel good because they continue to design, but we are definitely below that 1/3, and we would see that recover when the market recovers.

Arrow's certainly making a lot of investments to drive that business forward over the longer term, even if temporarily the demand creation mix is a little bit less. The eInfochips, I think, is a good example of that. There's some intellectual property assets, like EE Times, that Arrow acquired. How comfortable are you with the portfolio of capabilities that Arrow has today? And any other investments you think you may need to make?

We really are proud of what we've created. And you've touched on a couple of things. But our digital properties have allowed us to grow our customer count, basically double it in 3 years, which gives us differentiated growth for our suppliers. I think that's why you see some of the activity that you've seen. And to put a little more color around that, we get 15 million unique page views a quarter. And so that's significant in terms of that business and the inflow of customers to us. eInfochips is kind of at the other end, though, Mark, and that's really very, very high-end engineering capability. So all of those things have bolstered our position in the market. I think you'll continue to see us make those kinds of investments. We've made investments in other areas and other services around managing supply chains for customers, et cetera. So we're not done yet. We've got more to do, and we feel good about where we are.

Maybe we can touch on another geopolitical topic that's impacted the supply chain, which was the trade war? And deescalated a bit, but not totally resolved. Maybe you can talk about tariffs, which was something that, again, it wasn't a particular focus 6 to 12 months ago. And how successful was Arrow at passing on any incremental tariff costs?

We have passed those costs along. I mean it's -- we've been pretty clear from the beginning that we felt strongly that tariffs were the wrong way to go. And that they were not healthy for the business environment anywhere. And I think that's played out. We're kind of back where we were a year ago or so, but with a lot more administration involved and a lot of uncertainty that's been created. And I certainly think what's going on in Europe is directly tied to what's happened in China as the Chinese consumer has lost some level of confidence in the Chinese economy, they're buying fewer German goods, and that's definitely impacted. So the good news is, yes, it does appear that we're in a period of at least stabilization. I think that, in part, is why we're seeing China start to show signs of recovery. And hopefully, coronavirus in the short-term aside, that continues, and we believe it will. And ultimately, that will lead to recovery in other markets around the world so.

One of the ramifications of the tariffs has been the shift of where manufacturing has been taking place. Arrow has talked on some of the recent earnings calls, including one last week about how tariffs on the products coming in the United States has caused manufacturing to leave the United States to other regions. Maybe we can talk about where is Arrow seeing that manufacturing leave the U.S. and go to? And also talk about potential margin implications, where are they? Because I think the U.S. tends to be a pretty high-margin region, there is more demand creation opportunity here. So if that manufacturing shifts elsewhere, is there an implication around margin potential?

Yes. It's -- we're definitely continuing to see manufacturing leave the U.S. That has not slowed at all. It's continuing to move to low-cost locations. Predominantly, still Asia and still into China. It's not that people aren't going to China. Obviously, there's been growth in other markets in Asia as well. And we've seen some growth in South America as people are avoiding the tariff situation in the Americas. As it relates to our margin, it's interesting because if you look at Asia, it's definitely -- as it's held up better through taking share through good execution than the other regions. The impact globally on our margins hasn't been all that significant. So while Asia is lower margin, we are seeing improvement in Asia margins. And from a return standpoint, it's effectively neutralized. It's -- the inventory turns faster, there's a lower tax rate, et cetera. So we're less concerned about shifts, geographic shifts as it impacts our margin and return structure over time. It's really more in the near term, that issue we mentioned earlier about the mix of engineered solutions. And that's the bigger thing we've got to focus on.

Okay. Another potential byproduct of the trade war has been discussion in the investment community around how well positioned will U.S. companies be in China 5 years from now or 3 years from now? And China for a long time has had a goal to build out a tech-eco system of their own. And I think trade war maybe accelerates that ambition and Arrow has a pretty sizable presence in China. Are you seeing business conditions, putting coronavirus to the side for a minute, but are you seeing the competitive dynamic and business operating environment get more challenging in China because of the trade war?

In the near term, no. I mean, if you think about it, we're a significant part of helping Chinese customers succeed, just as we do with other customers around the world, and they rely on us for their supply chain. No matter what it is, they're sourcing. And so we have the capability to do that. But more specifically, near term, we're really not seeing changes. I think your question is a good one. I think it's a fair one. And we just have to monitor that over time. But we will be prepared to make sure that customers get what they need from Arrow.

Talking about changes in the supply chain, the biggest analog company, Texas Instruments, announced they will be ending their relationship with several of your competitors. So multiple of distributors they had previously used, they're going to end those relationships over time. And they have a goal of doing more in house, but Arrow has been maintained as the global distribution partner for TI. Maybe just talk a little bit about what incremental fulfillment business could mean for Arrow to the extent some of that business does come into Arrow's business model? How should investors think about that?

Yes. And we don't like to talk about specific supplier relationships, so I'll talk in generalities. And obviously, there's been some public information that's been shared. And I think that's the best that's out there. But broadly speaking, our ability even at a fulfillment level to give the customer and supplier what they want and earn a very good return on that is high. And I think that's what you can expect in this scenario as well. I think the bigger question is timing. And as you mentioned, at least some of our competitors can ship product through the end of the year. And so just like with past shared shifts, the timing of when customers choose to make that switch is uncertain, but we're ready to manage that as it comes and are resourced appropriately. But at this point, we haven't seen a whole lot.

Speaking generally about demand fulfillment business, the gross margin profile and that type of a sale is typically a single-digit gross margin percentage. But I would think ramping incremental revenue, the incremental EBIT margins should be -- so relatively good. Do you think a 5% incremental EBIT margin is achievable in that sort of a scenario?

Well, again, I won't talk about specific supplier relationships. I would tell you that I think our global components margin target of 5%, overall, more broadly, is absolutely the right target. If you think about where we are today versus where we were a year ago, we finished 2019 at 5% for the components business. We're obviously well below that now. But since then, we've taken out $130 million of cost. I think as soon as you see volumes start to recover, you'll immediately see some leverage benefits. We've proven that leverage model out, I think, soundly through the growth period. And as I said earlier, the pipeline is full in terms of engineered solutions. So that kicks in as well as volumes start to recover. So I think our ability to get back to where we were in much shorter time frame than we've experienced in past cycles has much improved. So 5% is still a good target.

Do you think other semiconductor companies will choose to do more direct business going forward? Or is this more of a one-off situation?

No. I don't know. And I think it's not Arrow's place to really try and predict that. I think our place is to make sure that we have the capabilities to give the suppliers what they need, no matter how they go to market. And frankly, we're not done creating new ways to bring value to our customers and, therefore, our suppliers. I think if we continue to do that, the field of play continues to change. We continue to bring new capabilities that no one else has. And some of those capabilities will be attractive to some suppliers and not to others. But that will be determined over time. The key thing is we're not sitting still. We haven't sat still through the downturn. We haven't slowed investing in those capabilities, and I think that positions us very well vis-à-vis the competitive set.

I will get to enterprise solutions in a minute. But maybe before we move to ECS, we can talk about a business that spans both components and enterprise solutions, which is IoT and Arrow has made the point to having this broader capability set between hardware, software, services and components gives Arrow an advantage on IoT. Any update you can give us in terms of a revenue sizing or even just examples of programs that are good illustrations...

I would still say we're in early innings. I don't want to overplay it. And I think that's a big growth opportunity as we go forward. And frankly, having that ECS business, I think, is attractive to many of our suppliers because they see that on the component side because they see that as a pull-through of potential product. We've talked about, recently, an example where a major airport, it's public information, Pearson Airport in Toronto wanted to use data analytics package from one of our ECS suppliers to run their airport more efficiently, to improve the customer experience. The issue is there was no data. So having Arrow be one-stop shopping to create that ecosystem of sensor devices that are tracking people movement and luggage movement and down to consumption of water at the water fountain. And feeding that into the data analytics tool. That's a pretty powerful example. Now if that was a one-off sale, that's not a great return for Arrow. The issue is, you've now got the ECS supplier selling that solution, Arrow's value-added resellers selling that solution to airports around the world. So those are the early kind of examples that we're seeing. And I think you'll continue to see more and more of that, particularly, as you see, the ECS suppliers talk increasingly about edge of network. I mean that's what the edge is. The edge is the connective layer between components and compute power. And so our ability to connect that whole ecosystem together is unique. No one else in our space has that ability. And we think that's really a growth vehicle for the future.

Maybe we can talk a little bit more on the Pearson Airport example. But was that a situation where Arrow identified the opportunity and said here's this process position? Or VAR came to Arrow and said, we're trying to do this design. Can you help me on this side?