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

[Audio Gap] Stifel Cross Sector Insight Conference, which is virtual. And we're happy to have with us now, Arrow Electronics, the largest semiconductor and electronic component distributor as well as a major distributor of IT products and solutions. We've got Chris Stansbury, CFO; and Steve O'Brien, who heads up IR. Chris is going to run through some slides, and then we'll go into some Q&A. We want to remind people that there is an opportunity to ask questions on the webcast, just punch your question, and then we'll ask it as we go along. Chris?

Thanks, Matt, and thanks, everybody, for being here today. I know this is a new world of remote, so we'll do our best to move through this. I'll take about 15 minutes to go through the slides here. So on Slide 3, really, the whole point of Arrow's being is that we care about doing things and helping create innovations that make the world a better place. And so we're focused on areas like smart agriculture, smart cities and transportation and things that improve the health and safety of the food that we eat, the places we live and how we get where we're going. On Slide 4, you can see some of those real-world examples. We've talked a lot over the last couple of years about our semi-autonomous mobility car, the SAM Car, that's allowed a paralyzed former IndyCar racer, Sam Schmidt, to return to racing. He's raced Pikes Peak, no guardrails, only driving with his head, which is terrifying to think about being in the car with him, but it's pretty remarkable technology. Bouncing around a little bit. Unlimited tomorrow, fantastic, fantastic device that's using AI to improve prosthetic limbs with a focus on kids. So think about prosthesis hasn't changed a lot over the years, but think about an AI smart chip in the palm of that arm, if you will. And as the child grows, they print a new arm and they put the chip in it, and that hand already knows what those nerve endings are trying to communicate through the device. And then in the lower right, Silicon Savanna, we worked really closely with one of our major partners, Analog Devices, to foster innovative products and business ideas in Sub-Saharan Africa. So really, really cool stuff and things that we're proud of and our employees are proud of. If you go to Page 5, just a picture of the globe. We are global. We serve customers in over 90 countries. And there's a lot of complexity in that when you think about languages and cultures and frankly, places that aren't always easy to do business. So in total, if you look at last year's sales, about 44% were in the Americas, 29% in Europe and 27% in Asia. On Page 6, I think is a really important point. We manage complexity well. In our global components business, 24/7/365, so we're not counting for weekends and holidays, 80 transactions a second, 2.5 billion transactions a year. And any one engagement with a customer can have thousands and thousands of line items with parts from dozens of suppliers. And when you think about that and you go to Page 7, that results in $29 billion in sales from more than 175,000 customers. These sales are obviously managed by our 19,000 employees around the world. And our physical headquarters is in Denver. That's where we are right now, which allows us, really, on a central basis to reach not just the U.S. efficiently, but we can get anywhere in the world pretty quickly. On Slide 8, really think about Arrow as the design, engineering, sales, marketing, supply chain and financing arm for the suppliers we do business with. 70% of what we sell come from global components, where we're selling semiconductors and passive electromechanical parts. And 30% comes from enterprise computing solutions where we're selling software-led solutions to value-added resellers. So this is a 2-step selling process and managed service providers as well and system integrators, and they manage the customer relationship. On Slide 9, 2020 marks the 85th year of Arrow doing business. And recently, we were again named the top in our category in Fortune's Most Admired Companies. And that's 7 years in a row. That's something that we're proud of and we do not take lightly. On Slide 10, Arrow's helping our customers create, make and manage their products at unprecedented scale. And what you can see here is we can essentially become the outsourced design, engineering and supply chain managers or frankly, any one of those modes for companies that want to manufacture and sell their products just about anywhere in the world. And that's backed, on Slide 11, by an engineering capability that's really unparalleled. And we've spent a lot of time building this. But if you think about it, we can go from large to small. So eInfochips can go to the level of complexity for, say, an industrial IoT application of writing software that resides on a chip, and sometimes that could be a custom chip that they design. And we work with our suppliers to get developed. At the very other end, you've got digital, where we're able to offer engineering services around the clock around the world online and give customers the ability, the smaller customers to get the kind of support that they need to bring their ideas to life. And in the middle, we've got our core engineering service centers that had been around for a long time. But we've also got something we added last year, which is ArrowPlus, which is powered by Freelancer. And that gives customers access to on-demand engineering from our proprietary network of Arrow-certified engineers. So think about variabilizing the cost of engineering. So that's a pretty robust level of capabilities that allow us to meet that make -- manage demand of our customers. On Page 12, just more detail on the breadth of the services that we offer. So the point here is that no one else in the industry has the breadth that we have or the depth of services. Customers are appreciating this as are suppliers, and that's why we win. And that's why we continue to see share shifts, and that's why we continue to outgrow the market, and that's a core focus for us to bring value to our supplier partners. On Slide 13, our media properties funnel engineers, designers and investors back into arrow.com. This is the customer generation engine of Arrow. This is what no one else has, and this is what allows us to grow our customer count so quickly and what allows us to outgrow the market on the volume side. Think about this as rather than fishing with a hook, we're fishing with a net. So if somebody is looking for information on any one of these properties, we're going to funnel them into Arrow. Our media properties also help us market the products of our suppliers in a way that no other company can match. And that's important. A lot of suppliers have come to us and asked us to do that. And when you think about there being 10 million to 15 million engineers in the world, the fact that we're getting 50 million unique page views a month is pretty astounding. And so that just gives us, I think, a sense of the scale of just how much eye time we get from engineers before they even work with us to design a product or start to buy a product from us. On Page 14, you can see the markets we serve. We really don't have any significant exposure to any one vertical or a portion of the market. We are, however, focused on the areas where there's more and more electronic content, and that's also something that enables us to grow faster than the market. So no customer bigger than 2% of sales and no vertical bigger than 15% of sales. On Slide 15, when you think about the semiconductor industry in total, we're really serving a long tail of smaller customers, right? So the top 10 customers of semiconductor product in the world, we all know who they are, consume 40% of all output. The 60% is what we're focused on. And those are smaller, faster-growing and higher-profit potential customers. And by definition, we would expect there to continue to be new customers coming into that space, and that again gives us that growth in margin that we strive for. The goal is, with these customers, is get there first because if you get there first, it tends to be sticky. And that back to the customer generation engine and all those web properties, that's how we do that. On Slide 16, we're focusing on the areas where we can add the most value. So we avoid the commoditized and consolidated industries like PCs and mobile devices. That's half of semiconductor industry consumption. That's only about 10% exposure for Arrow. And we don't have any supplier bigger than 9% of sales. Our differentiated approach here results in higher profit margins for our ECS computing solutions business. Sorry, I flipped to Page 17. And it's because we're unique in our software-led selling approach. If you look at our billings mix, half of what we sell is software, 65% is nonhardware. And in that is also complexity. We're dealing with hybrid cloud environments. We're dealing with software as a service. We're dealing with on-prem. We're dealing with edge of network. And that is a high ground we hold and we strive to continue to hold, and that's what gives us differentiated margin over the long term. On Page 18, we've got very attractive countercyclical cash flow. We've seen that alive and well really over the last 3 years, where 3 years ago, as we were growing above 10% in components, we really didn't see much cash flow. We have to invest in inventory and working capital in advance of the EBITDA. And then it catches up over time. The flip side is also true. When we went into a correction about a year ago now, a little over a year ago now, we started to generate significant cash flow. And over the last 4 quarters, we've generated $1.2 billion. And that's allowed us to pay down debt and buy back stock. And that's just, frankly, a great thing about the model because we're getting the cash when we need it most. On Slide 19, we do have a disciplined approach to our capital allocation. Over the last 5 years, $1.3 billion has been returned to our shareholders through buybacks, which is 58% of cash flow from operations and 90% of free cash flow. And we've reduced about 16% of our shares. So over time, while this ebbs and flows depending on how much working capital demands exist in the business, the reality is we have been a steady repurchaser of our stock. So I think that's it, Matt. If there's any questions now, let's jump into those.

Okay. Great. That was a good overview, Chris, and certainly, some of the examples in terms of what you're doing is interesting. I want to come back to that in a second. But first, I do want to sort of ask the obligatory questions about the demand environment. We're hearing from some of your peers and suppliers and customers at this conference this week. And I'd say that in sum, it sounds like there aren't any major or significant changes from when companies talked about earnings or gave guidance or directional guidance a month or 5 or 6 weeks ago. But to the extent that you can sort of update us on what you're seeing. Arrow is a little bit of an outlier in terms of you were guiding sort of flat sequentially which was somewhat surprising for some, although it makes sense if you think about you'll see sequential growth in Asia. You've got some share gains as well as more production offset by weakness in Europe and North America.

Yes. And I think, Matt, that what you just said in terms of what others are saying is very consistent with where we are. So we felt good that we could not just provide guidance, but also provide the guidance that we did. We feel we had a relatively strong guide given what's going on, and I think that speaks to our strategy. And when we did the guide a few weeks back, we did have April under our belt. And yes, we were seeing strength in Asia. We actually saw that strength start in March, backlog up. That trend hasn't changed really. And we saw then and continue to see the expected softness in EMEA and North America, relatively flat sequentially simply because of where those markets were in the COVID cycle. So we're getting to the point where things are starting to turn back on. We'll see what happens over the next few weeks and what Q3 looks like, which we're just starting to look at. I do anticipate, Matt, that there's going to be some fits and starts here as businesses turn back on. This is unprecedented time. So all the analysis in the world is not going to accurately predict what people needed in terms of inventory more or less. And I think we'll be working through that in Q3. But as things come back online, that's all good news.

Could you comment on any of the book-to-bill trends that you're seeing? I know it was positive at the beginning of the quarter. And one of your competitors talked about it still being positive. But then some suppliers, I had one supplier on earlier today talk about seeing some cancellations, although maybe primarily in automotive. But could you share some color there?

Yes. I mean, I would say no major changes from what we said earlier either. I would tell you that we're probably a little less focused on book-to-bill in the near term only because as the denominator gets worse, right, that metric can look better. It's really more about backlog and cancellations, to your point. And we're not seeing an increase in cancellations, which is very encouraging. We're also not seeing changes in our percent current on AR. We had a very high level exiting Q4. We've been able to maintain that. There are some requests for some pushouts. But for the most part, if somebody ordered product that was supposed to be delivered in the quarter, then our expectation is they take it in the quarter. So by and large, I would say, no major change at this point.

And are you starting to see a little bit of lift in North America and Europe just on production beginning to come back? Because I do know that you also had good growth just from some inventory stocking going into the quarter, right?

Yes. There was definitely some of that, hard to read. I would say that at this point, it's too early to call. And remember, with Germany, for example, turning automotive back on, our level of engagement with those big German manufacturers is at the Tier 2 and Tier 3 level, so the demand signal is going to lag a little bit before it gets to the customers that are part of that supply chain that we service. So I'd say it's a little early for us to call that yet.

Okay. Great. Okay. And then in terms of your own facilities and your customers' production levels, are you starting to see more normalization? Particularly, I mean, you've got some big operations down in Mexico. We've heard some of the EMS players this week that, for the most part, they're back to normal. But are you starting to see that?

Again, we're at the very early end of that. I think our exposure to EMS, while it's an important part of the business, but I think it's less than some of our competitors. It's just early. I think, again, my caution to everybody is, don't read too much into the molecular detail at this point because there's going to be all kinds of little adjustments. The big one is, right, we know that Europe is going to come back online. It is coming back online. But what I'm hearing from my team is the European holiday season is going to be unchanged. People are still going to go on vacation. And Q3 is a September-weighted quarter as a result. And so you got companies coming back online. You've got an uncertain demand environment. You've got a large population of people that are going to be taking their summer vacations. Now I just think that specific level of detail is going to be very misleading. You've got to look at the bigger picture, and it's just too early to call.

Yes. I think that's completely fair. And we've heard that earlier today, too, in terms of visibility. Although, I guess, in auto, and I think you have some exposure there, Chris, where you'll see it just in terms of more production days. But your point on Europe and normal seasonal shutdowns, it looks like that's going to continue to play out. Just another question regarding electronics, Chris, and that pertains to one of your big customers, TI, which has been shifting some share from some of your competitors. And I know there's been talk about ramping some incremental revenue there. It doesn't look like there was much in Q1, but then there's been talk about that rewinding from their other competitors by the end of the year. So could you update us on that? And was that part of the guidance, too, some incremental share gains?

Yes. So I guess a couple of things. So TI is obviously a big supplier of ours, not a customer, just for clarification. And look, I want to be careful, too, because we are very, very focused on all of our suppliers. And if you look at those suppliers that want us to do engineering for them, we're continuing to see growth in those design wins. That bodes very well for the future as business recovers. And those engagements are critical to us. They're all critical to us. And we're very focused on that. As it relates to this specific share shift, we did see business come in, in Q1, but we also saw business go back out because there's a big portion of what we had that does go direct. What's been published, and you published numbers, Matt, I think, are an accurate representation of where things will end up. We are on track to have that happen by the end of the year. That will be driven by the supplier because the supplier owns the inventory. And so we expect that to fully transition by the end of the year. That was definitely incorporated at some level into the guidance for sure. But even in total, if you kind of take an annualized quarter, we're well below that. There's still strong underlying performance, namely in Asia outside of that, that is benefiting us in the quarter. So that's how I'd answer that.

Okay. That's helpful. And as you bring on some of that revenue, we know that the gross margin is going to be lower because it's more fulfillment, but it's also very asset-light with that consignment program. So what does that do in terms of impacting the P&L and the balance sheet?

Very little impact at the OI line in terms of margins. But it's very returns accretive because it is balance sheet light given that model, right? But what I would say is that when you look at our GP progression quarter-on-quarter in global components, we're going to see relative stability, maybe even a little bit of improvement, despite the share shifts, despite faster growth in Asia because we continue to more tightly manage the GP decisions that we can make with customers internally. But we're also growing more margin accretive businesses, businesses that are, for example, engaging on a fee basis as a manager, if you will, for large supply chain engagements using the strength of our ERP that no one else has. So think about large volumes of product being moved that we don't own, but we're in the middle managing highly, highly complex supply chains and getting paid by our customers to do that. Those are very sticky relationships. That business is growing. And we believe we're the only ones in the industry who can do it because of the complexity involved and the ERP we have. So that's a tailwind that allows us to maintain our margins in a relatively stable way going forward. And then coming out of COVID, because we continue to design for smaller customers who have been more negatively impacted in the near term, those designs because they're continuing, as soon as volumes start to recover, that's margin accretive. And then I think there's an opportunity here. Again, given the engineering capabilities that I laid out, as bigger customers that haven't traditionally used our engineering as much, I think there's a possibility that we can pick up some of that as they cut costs and look for ways to outsource. So I don't know how that will all play out or if it will play out, but I would say that I see far more tailwinds from where we sit today than headwinds. The big question is underlying end market demand. And on that, I'll just jump right into it, Matt. I saw some interesting data last week just on credit card spending. And it was week-by-week comparisons year-over-year for specific industries. And not surprisingly, the stuff that was most negatively impacted were hotels, restaurants, airlines, whereas everything else was more neutral. It's definitely down a bit, but more neutral. I think what we're seeing in terms of global GDP, I think down 5%. That's going to be largely driven by softer automotive, softer commercial airlines and the sectors I just outlined. So the question is, those other sectors are okay. The question is, do they recover nicely because people get back to work or is there softness on the horizon because people don't get back to work? That's the open question at this point, and that's what we're all watching.

Yes. Yes. Okay. Yes, that was helpful. Particularly some of the things you're doing on the engineering side, really leveraging all those investments and as well as the supply chain. Because 5 years ago and longer, we were seeing you and competitors disengage from some of those supply chain agreements because you weren't making margins or returns. And it sounds like because of your efficiencies in your systems and perhaps a recognition from your suppliers or OEM customers that, that value is important to them and they're willing to pay for that.

Yes.

Yes. And I mean, do you think that then we'll see incrementally some share opportunities in terms of more supply chain agreements? Or do you want to sort of balance it out so that you still have some accretive margins on the engineering side and the demand creation business?

I mean that obviously is the core of what we do, right, is to help bring, per the strategy, per the presentation I did, is to help people bring those ideas to life. So that's still there. Look, I think the industry has gone through a lot of change. I think suppliers are looking for value-added from distribution, be that in efficient supply chain management or differentiated growth through customer acquisition and engineering. And so the toolkit is in place. There'll be smaller investments along the way. But importantly, we've been very focused on putting a moat around those capabilities during COVID, not cutting any of those resources. And so the fact that we're able to earn very respectable profits and generate very respectable cash flow in this environment, yet maintain the strategy is, I think, critical. And so I think if we can maintain that, I think we actually, from a competitive landscape standpoint, exit COVID stronger than when we went in. And so if we continue to do that, the rest of the world will pick and choose how they want to go to market the way they will, but I think we are very well positioned.

Okay. That was great. We don't have a lot of time left. I did want to leave a little time for questions on the IT business and your enterprise solutions and computing business, where you've seen a shift over time toward more services, away from hardware. You sounded, again, a little bit better than some competitors in terms of your outlook, and it could also be where you're focused in terms of services and products and also end market exposure. But could you just update us on what you're seeing there?

Sure. So I mean, we had a strong Q1 driven by remote work product, which we talked about on the call. And we know that our VARs shifted a lot of that to us because of our ability to execute quickly. We got a lot of positive feedback on that. As we looked at our Q2 guide, well, sequentially, it looked reasonably good. The reality is, if you adjust Q1, because remember Q1 cut off a few days before the end of the calendar quarter. Those last few days are big for that business. If you normalize for that on a seasonal basis, we guided below seasonal in ECS, and that really reflects the fact that just like Arrow, we're at about 50% back in the office now. There is no way anyone from -- who's a nonemployee could get in our front door right now. And so the guide really reflects that, which is I think what a lot of the suppliers are saying, where projects are getting pushed out. They're not getting canceled. That's good. It's just a question of when those buildings open up so that we can get back in and get those projects back online. So we're in a bit of a pause motion. It's certainly not meltdown territory by any means, but it's definitely a bit of a pause. And so that's why the guide was what the guide was. And I think that was appropriate. And we'll see how things evolve in the coming quarters. We do continue to see growth in our ratable revenue business, which is good. That obviously helps us through times like this. And when that gets to $1 billion in billings, we'll let you guys know, but we're getting close to that. So I think there's been some really good things that have happened in that business, but unfortunately, in the current environment, they're hard to see. I will also say though, suppliers are extending us more credit to work with customers, and that ultimately, for us, will be positive at cash flow.

Okay. That was a good sum up on that. I appreciate it. Looks like we're out of time. But Chris and Steve, we certainly appreciate it and appreciate everybody listening in, and we'll talk to you guys soon.

Great. Thanks a lot.