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

Okay. I think we'll get started. So welcome, everyone, to day 1 of Bank of America's Global Technology Conference. My name is Ruplu Bhattacharya, and I'm part of the equity research team here at the bank, covering IT, hardware and technology supply chain companies. This year is the first year that we are hosting this conference virtually, and we've had a great turnout. We have 150 corporates and about 800 clients attending the conference this year. [Operator Instructions] So today, we're honored to have with us Chris Stansbury, who is the Chief Financial Officer of Arrow Electronics. Arrow, as you all know, is one of the leading global IT distributors. Chris joined Arrow in 2014 as Chief Accounting Officer, and he was appointed CFO in 2016. Prior to Arrow, Chris served as CFO of the networking group at HP. And prior to HP, Chris held various financial positions at Pepsi Company. He also has an MBA from Wharton. So Chris, thank you so much for being part of our call today. I believe you have a presentation that you're going to run through. And then we'll come back for Q&A.

Terrific. Thanks, Ruplu. And thanks, everybody, for joining today. As I move through the presentation, I'll make sure to note which page we're on, because you guys will obviously have to turn those pages. I think -- just very quickly before I even get started, it's nice to actually be in front of investors and talk about our strategy. I think all of us have been in a remarkable environment for the last quarter or more and have had to react. And ultimately, even though we've refocused our efforts for more short-term pressing issues, the reality is, the strategy I'm about to talk to you about is why we have performed the way we have through COVID so far. And I think it will give you some insight into how well positioned we feel we are as we go forward. So why don't we go right to Page 3? And the key message here is that we really focus on innovations that make the world better. And we look at areas like smart agriculture, smart cities, smart transportation, and all of those things improve the health and safety of the food we eat, the places we live and how we get to where we're going. And ultimately, by doing those good things for society, we benefit. If you go to Page 4, it really talks to some of the real-world examples that we've done and how we have improved lives. And so I'll just highlight a few. We've talked over the years about our semi-autonomous car, the SAM car, that's allowed a paralyzed former racecar driver, Sam Schmidt, to return to racing. It's a remarkable story, and there's a lot of great video content on YouTube, as you're working from home and trying to fill a gap in your day. Unlimited Tomorrow is using AI to improve prosthetic limbs, really with a focus on kids. So you think about kids who have a prosthetic limb, well, the prosthesis hasn't really changed much in the last few decades, and they're expensive. And every year, a child grows, they need a new one. Well, how about putting an AI chip in the palm of the hand that, with sensors attached, is learning what the brain is telling the hand to do? And as that child grows, a 3D-printed arm is generated, and that chip is simply moved over and nothing is lost. Solar Suitcase, providing health care workers with reliable lighting, mobile communication and power for medical devices using solar electricity in parts of the world where there is none. And most recently, we worked with a major partner of ours, Analog Devices, on fostering innovative products and business ideas in Sub-Saharan Africa. So just some cool things that get our engineers excited, get our employee base excited and are, frankly, showing benefits to people who otherwise wouldn't benefit from technology. And if you zoom back out on Page 5, we do business around the globe and we specialize in managing complexity. We have customers in over 90 countries. That's a lot of languages and cultures and places where it isn't always easy to do business, and that's something that our supplier partners and our customers appreciate. And so in 2019, about 44% of our sales were in the Americas, about 30% in Europe and the balance in Asia. [indiscernible] on Page 6, back to the complexity. 80 transactions a second in our components business. That's 24/7, 365, that's not taking weekends off. It's 80 transactions a second, 2.5 billion a year. And that doesn't just get down to kind of part level. If you think about it, any given transaction can include hundreds of thousands of orders from dozens of suppliers. On Page 7, you can see what this amounted to last year, about $29 billion in sales from more than 175,000 customers. And that's supported by 19,000 employees around the world. And when you think about where our headquarters is located in Denver, it's really central, not just to the Americas, but also globally. Importantly, Denver is also a great source of talent for young engineers, which is something that we rely on very heavily to support our capabilities. On Page 8, really, what I'd encourage you to do is think of Arrow as the design, engineering, sales, marketing, supply chain and financing arm for our suppliers. 70% of our sales come from global components, where we sell semiconductors and passive electromechanical parts for our supplier communities. And 30% of our sales comes from the ECS business, enterprise computing solutions, where we're selling software-led solutions to value-added resellers, managed service providers and system integrators to implement those in turn for our customers. On Page 9, I'd just highlight that 2020 marks our 85th year in business. And recently, we were named, again, top in our category for Fortune's Most Admired Companies, and that's 7 years in a row for us, something we're very, very proud of. Slide 10 really starts to get into the strategy, and it helps give you a visual on what we do. And so if you think about Arrow, really helping our customers create, so design, right, make, manufacture and manage their products. And we can do that in an unprecedented scale. We essentially become the outsourced design, engineering and supply chain managers for our customers. And that is for customers around the world, whether they want to do business in a specific market or whether they have global reach with their offering. Importantly, though, to support that, because we do support customers from small to big, you've got to have the ability to meet the engineering, design and supply chain needs of customers from large to small. So at the very top of this pyramid, you've got a smaller group of customers, that's why it's the smallest slice on the pyramid, but it's also the most complex group of customers. So this is highly complex, bespoke systems, where we don't earn a lot of money by selling at scale, but we do earn a lot of money by providing high-end engineering services, software on a chip, if you will, to bring industrial IoT solutions to life. And then all the way at the other end, we've got our digital customers. And this has driven a lot of differentiated growth for Arrow, where our ecosystem of websites allows us to pull in customers to Arrow, people who are looking for help, looking for ideas. So the visual here is, think of fishing with a net rather than fishing with a hook, we'll find the fish before the fish has to find us or one of our competitors. And it's working. And that's really led a lot of supply shift over the years in our favor. And then in the middle, we've got our core engineering service centers that we've had for years. That's the traditional engineering motion. And then last year, we announced ArrowPlus, which is powered by Freelancer. And think of this as what we're doing right now, all working from home -- if a customer is okay with us using that facility, engineers from around the world can bid on helping do the design work. And that is kept confidential, and that build material and that design is kept on Arrow's IT. And no one else has that span of offering that Arrow does. On Slide 12, you can see the breadth of the services we offer. And as I said, no one really has the breadth and depth of services that we can bring to our customers. And as a result, it's not just the customers that appreciate it, it's the suppliers that appreciate it. It's why we're giving them differentiated growth, and it's why we're winning in the market. If you go to Slide 13, this is just a visual of our media properties and our digital properties. So this encompasses everything, from people looking for reference designs, people looking at editorial content. And ultimately, all of those clicks and views can get funneled back into arrow.com. This is a customer-generation engine. We didn't acquire these companies because they had huge revenues. We acquired these companies because it built the ecosystem to acquire customers. And so when you think about it, there's probably 10 million or 15 million engineers in the world, and we're getting 15 -- or sorry, 50, 5-0 million unique page views a month. That's pretty astounding. So long before someone contacts Arrow for help, we are in the minds of the engineers and the individuals looking for help. If you go to Page 14, this really talks to the markets that we serve. We really don't have exposure in a significant way to any one vertical or portion of the market, but we are participating in areas where we see long-term electronic content growing faster than the market. And some of those are highlighted here. So we don't have a customer that's bigger than 2% of sales. And I think that's one of the reasons why we're performing as well as we are, given the current economic environment. When you turn to Page 15, really, this highlights that the market that we're serving is really the higher-profit-potential customer, and it's faster-growing. So if you look at the share of total semiconductor consumption, the top 10 semiconductor consumers are 40% of all sales, and we don't sell to those customers. We all know who they are. We all carry their products every day. Everybody else is 60%, and it's the everybody else that Arrow focuses on and helps bring their ideas to life. So getting there first with those proprietary customer acquisition tools is critical. And then being able to scale efficiently the engineering to support their requirements is also critical. And we have both. On Slide 16, you can see that we focus on the areas where we have the most value. And if you look at the semiconductor industry, about half of what is consumed is in PCs and mobile devices. Arrow's exposure to that same segment is about 10%. So we're not in the business of really supplying those top 10 large customers for a reason. There's not a lot of value that can be added. Our focus is elsewhere. And as a result, you won't see our business move in the same patterns that you see the PC and mobility device market move. If you turn to Page 17, our enterprise computing solution business is also unique. And it's unique because it's really focused on software, right? If you looked at this chart 10 years ago, only about 25% of this would have been software. And today, it's 50% software, 15% services. So only 35% is hardware. And that hardware is important to the solutions we sell. But really, the complexity is in the software and the integration of that software, and that's where our focus is on that business. And so that gives us higher profit margins compared to other broadline distributors because of our focus. Page 18, this is one of the beautiful things in our model, and we saw it really transpire last year and it continues into this year, which is, we generate a lot of cash flow, and the way that works is, in a downturn, we generate more than we do in an up cycle. So if you think about it, our primary asset is working capital. And as inventory corrections take place, as industry slowdowns take place, we liquidate that working capital. So through Q1, in the last 12 quarters, we've generated about $1.2 billion in operating cash flow. And if you look at that, what that means is, is that, on a 10-year basis, we're at about 100% of GAAP net income is our cash flow. What you see on the graph, though, is that when we're growing rapidly in our components business, we generate less because working capital is building. So the model gives us cash when we need it most, and that's a great thing to have. And if you look at Page 19, we've really returned a lot of cash to our investors and shareholders over the last 5 years, right? $1.3 billion returned. That's almost 60% of cash flow from operations and 90% of free cash flow. So buybacks are definitely the way we return capital to shareholders. It gives us flexibility when we're growing because we're not tied to a dividend. And quite frankly, it gives us flexibility in a down cycle because it allows us to pay down debt. And as a result, our balance sheet is in tremendous condition today. So that's it for my prepared comments, and I look forward to questions. Thanks.

Chris, that was a great overview. Maybe to kick off the Q&A, if you can tell us about supply and demand trends by region?

Yes. So if you look at our components business, in Q1, our guidance did not include any adjustment for COVID. And so we said we'd get back to investors if there was an issue with that. And then if there was not an issue with that, we were within our guidance range. That's really driven by strength in Asia, and that continues. And then we were seeing softness in the Americas and in Europe, which also continues. So if you look at our Q2 guidance, that guidance, in part, was informed by April actuals and by -- at the time that we did our earnings call. And April was actually a record month for Asia. And backlog continues to grow. Not surprisingly, backlog in EMEA and North America was down, and that's why sequentially we're saying we'll be flat, which is down about 12% year-on-year. In the computing business, we had great strength from enabling remote work, and that gave us strong performance in Q1. Our Q1 was cut short versus last year. We missed the last few days of the calendar quarter, which are big for that segment. So if you look at that on a normalized basis, our Q2 guide is actually below seasonal. And I think that reflects the fact that the appetite for remote work product has largely been satiated. And now we're waiting for the SMB market to recover, where some of those more complex data center projects come back online.

Okay. I mean that's a good overview. Maybe I want to maybe ask you a higher-level question. When you look at this downturn, how is it different from what you saw in 2008 and 2009? And can you tell investors how you think Arrow is better prepared to face this downturn?

Yes. So 2008 and 2009 was really obviously a financial crisis that impacted a lot of people. It gave Arrow the opportunity and our competition, for that matter, to consolidate the industry because there was a lot of distressed distributors that came online. And so there was an enormous amount of consolidation that took place at that time. If you think about where we are today, thank goodness, the cycle, if you will, hit last year. And the inventory correction associated with that really had played out just before COVID hit. If we were sitting on the inventories -- if the industry was sitting on the inventories it was sitting on a year ago and COVID hit then, I think we would have been in much more trouble. So customers, distributors, suppliers went into this with balance sheets that were in much stronger position. And as it relates to Arrow, because of that, because of the fact that we've got the capabilities that I laid out in our strategy, because we've got the global ERP that we do that no one else has, I think we're in really good position. I don't like today's results, but I'm proud of the work that our sales teams and engineering teams and finance teams have done around the world to keep us performing where we are. And so coming out of this, we got engineering designs that are being done every day. There's just not a lot being bought on those. And so as volume starts to come back, the smallest bit of growth will show tremendous operating leverage through the P&L because our cost structure is not going to go up dramatically. There'll be flow-through on the GP that is substantial. And then you've got the added margin that comes with more people buying on those designs. So really, the capabilities that Arrow had built going into this, which have resulted in the competitive differentiation that we have, only serve us even better coming out of this. I think we've got a few competitors that are in tough, tough shape right now. And we're faring better. And I think that just means that coming out of this we'll be -- that, that gap will widen.

I want to touch on one thing that you touched on, and I think it's kind of misunderstood by some investors. Can you remind us of the mix of billings within components and ECS, specifically, like how much is really hardware versus software? And how is it different today versus maybe in 2009? I guess, because of the accounting rules, some investors may not get an accurate picture of the business mix. So if you can help us understand the mix of business between both segments?

Yes. So obviously, in the components space, pretty much everything that we sell is actually a physical product, okay? So that is a passive electromechanical device connector or it's a semiconductor chip. The big shift is really in the ECS business, where 10 years ago, 25% of what we sold was not hardware. Today, almost 2/3 of what we sell is not hardware. And that's a good thing. I mean, hardware is critical, but complexity and, therefore, margin resides on the software side. And there is confusion. So thanks for asking about how to read the P&L because we talk about that at a billings level. The industry, us included, generally does not disclose billings because we talk about net sales. And as you sell more software and services, a lot of those, not all of them, under GAAP agency accounting, get booked effectively at the gross profit dollar amount. So it tends to mute sales growth, but it also tends to drive up margins. And so we've seen a lot of mix shifts over the last few years. 18 months ago, there was a big, big push to get more new forms of storage into customers away from legacy. A year ago, there was a bit of a server refresh. We kind of shifted back to a normal balance pre-COVID. And then COVID changed everything, and it was heavily, heavily software-based. Obviously, there was a lot of PCs sold around the world, too. But then we don't participate in that, so we did not see that. So near term, there's been some noise, but the way we evaluate ourselves and we encourage investors to evaluate us is to look at the OI dollar growth of that business, which has admittedly been relatively flat over the last few years, which is predominantly a North America issue, driven by the way legacy suppliers have gone to market. In Europe, it was far more fragmented. Less so in North America. So in Europe, we benefit from a much broader array of suppliers. And as a result, we haven't seen those issues, whereas in North America we've had more exposure to legacy. So the long tail of suppliers in North America has been a real focus, and there's been some recent announcements, and there'll be more coming on supplier wins there that allow us to shore that up.

Got it. That's helpful. I want to touch on cloud, which is a trend that is impacting all of IT hardware. And some investors think that cloud, the growth of hybrid cloud will completely disrupt this industry and the supply chain. So maybe talk to us about what you're seeing in terms of the move to hybrid cloud. And do you think that is an opportunity or a threat to Arrow? And maybe for those investors who don't know, can you talk to us about what -- how Arrow is involved in the cloud? And talk to us about ArrowSphere, and what are you doing there?

Yes. So a great question, and it's interesting because when I joined Arrow back in 2014, the question was, will cloud wipe out distribution? And Arrow's answer at the time, it wasn't my answer, so I didn't come up with it was, no, we really believe that the world will end up in a hybrid environment. And the world will end up in a hybrid environment even at large-scale enterprise because at some level not all workloads run more efficiently on public cloud. And frankly, there's a lot of data that customers don't want to have on a public cloud for security reasons. And I think what's happened over the last 6 years is, as there's more and more industrial IoT, you get to a world where the need for real-time compute to run smart factories, smart cities, et cetera, means there can't be data latency. So hybrid is where the world has ended up and not just in small scale, but also large scale. And that's good. That's really good for Arrow because hybrid means complexity. It means that you've got -- you still have core of the data center operations where the crown jewels are held. And while that facility may be smaller than it used to be, now you're seeing more of the fog network, if you will, coming into play, where you've got all this edge-of-network compute to facilitate real-time compute power around data. And there's multi layers of security when you're starting to integrate IoT devices. There's analytics that are required. And so cloud, we can -- cloud is a big piece of our business. We sell Azure, we sell AWS. And those are good, profitable businesses for us. But importantly, your comment on -- or question on ArrowSphere, think of ArrowSphere as a tool, and it's a tool because, again, we sell to value-added resellers who sell to customers. A lot of our value-added resellers don't have the resources to put together complex hybrid environments, and they rely on us to do that. So ArrowSphere is a tool that allows the VAR to provision cloud services, which is complex. The contract administration around that is very complex. It allows them to meter and bill on their letterhead. So it effectively can allow the VAR to operate as a managed service provider for a customer and add more value to them. So everything I've just rattled off has multiple layers of complexity, and in complexity, there is margin. So we believe hybrid is here to stay, and we are best positioned to take advantage of that over any of our competition.

Great. That makes sense, and that's a great overview of the cloud business. Maybe I want to ask you a little bit about the balance sheet because I know that a lot of investors are focused on the balance sheets of companies. Can you talk to us about your confidence in the liquidity position that Arrow has and talk to us about uses of cash in the current environment?

Yes. So the balance sheet is definitely a focus, right? We -- one of the values we bring to our supplier partners and to our customers is we help finance the channel. We extend more credit to our customers than we are given from our suppliers. And so our ability to manage inventories, to collect on those receivables and to pay our suppliers on time is critical. Otherwise, the whole thing falls apart. And so when you look at what's happened over the last year, we paid down debt substantially. We're within probably $300 million at the end of any given quarter of having almost the entirety of our short-term borrowing facilities paid down. While we've been paying down that debt, we've also been buying back stock, and I referenced that in the presentation, and we'll continue to do that. But our leverage is in good shape. We spend -- I'm talking to our debt investors as well as to the debt rating agency [indiscernible] And to us, it's all about balance. It's not about running from one thing to the next. It's about bringing the debt down, buying back stock in a responsible way. And as the debt gets down to the point where there's not much more to pay down, that will leave more for buybacks. In terms of our capital allocation approach, it really hasn't changed over the years. The first is use cash to drive organic growth. That's the best return. Think about that as things like investing in engineers, the pyramid, right, that I showed, investing in our digital capabilities, et cetera. The second would be accretive M&A. And the reality is, in this space, there's not a lot of that left. The consolidation is largely done, and there's not a lot for sale. And what is for sale isn't at attractive prices right now. So we're doing a much better job growing organically and taking share because of our capabilities, and we'll continue to do that. And then the last is return what's left to shareholders through buybacks. And buybacks give us the flexibility to pay down debt more quickly in a downturn, and it gives us the flexibility to fuel growth in an upturn. But when you look at our performance over time, annually, our buybacks, not quarterly, admittedly, but annually, our buybacks look a lot like a dividend. We've had a fairly consistent pace in reducing our share count. I said 16% over the last 5 years. And aside from 1 year where we had significant supplier shifts, we've been fairly steady. In terms of unused liquidity, it's substantial. So there's lots of gun powder. We're ready for growth as the market returns. And our focus right now is just keeping our metrics up on collections and paying our suppliers.

Right. That's a great overview. In the time that we have left, I want to touch on Texas Instruments because it's been a talking point for quite some time now. So TI is consolidating its business away from other distributors. Some portion will go in-house, some through Arrow. How do you address investor concern that, given the TI business is predominantly fulfillment, that it's going to lead to lower margins? So can you just give us a sense of your thoughts on this and why management is confident that it can earn a good return on assets on that business?

Yes. A few things. Arrow has the most efficient supply chain and distribution today, and that's enabled by our ERP, which supports those 80 transactions a second that I talked about. So our operating model is one that can support that kind of business. And remember, TI is also a consignment business. So the margins at GP are definitely lower than our average. When you get to OI, that is much more muted in terms of its impact. And then from an investment standpoint, our investment is the spread between the credit we grant and the payment arrangement we have with TI. So from an ROIC standpoint, this will be accretive to Arrow's ROIC. So the shift is underway. We're pleased to have that business, excited to have it. And that transition is supposed to be complete by the end of the year.

Okay. Great. Now we're almost at the end of our time. So I just want to take this time to thank you again, Chris, for attending our chat today. I mean, it's been a great informative talk. I think investors have a good sense of why Arrow can succeed in this environment. So really appreciate your attendance. Thank you so much, and thanks to all of the investors who have dialed in. If you have further questions for Chris, please e-mail me, and we'll make sure we pass them on to Chris, and we can get you the responses. So thanks, everyone, for joining us today. Thank you, Chris.

Thanks, Ruplu, thanks, everyone.