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

Perfect. So I am Joe Quatrochi, the components distribution analyst here at Wells Fargo. I'm happy to welcome Arrow Electronics' CFO, Chris Stansbury as well as Steve O'brien, the VP of IR. I've got a list of questions to go through. But if anyone on the webcast would like to ask a question, please e-mail me at [email protected]. Chris, Steve, thanks for joining us.

Great to be here.

So maybe first, for those that are less familiar with the Arrow business, can you maybe first talk about what do you think -- give an overview of the company a little bit. And then maybe what do you think investors are missing or not understanding about the Arrow story.

Yes. So Arrow at its highest level, I'd say, 65% to 70% of what we sell is in the components space. We're a distributor of electronic components globally. And the remainder of the business is enterprise computing solutions, really focused on the more complex end of that. We don't deal with laptops, consumer devices, printers. It's really about core of the data center, cloud deployment, et cetera. I think the thing that is not really well understood about Arrow is just how much the industry has changed and how much Arrow has led that change in terms of bringing new value to customers and suppliers. And what I mean by that more specifically are services around things like engineering, supply chain management, integration and the investments that back that up. Investments in a global ERP, investments in engineers. We even announced additions of engineers in the middle of COVID. So the business has transformed significantly over the last number of years. I think that's why you see Arrow taking share and really differentiating itself in our space. But I think that the opportunity remains for the stock to revalue as we go forward because of those things. So that's what we're going to stay focused on.

That's helpful. And maybe let's dive into the subsegments. On the component side, how should we think about your business relative to maybe the global economy? Is it more of a leading or a trailing indicator? And you guys have done a really nice job in the most recent kind of market downturn amidst COVID, pivoting your business to address demand in Asia. So can you maybe talk about what that demand is that you're seeing? And is it the addition of new customers, further penetrating existing customers? Kind of touch on some of those.

Yes. So it's -- typically, we would say we actually lag, right? We would lag any movement that suppliers see by a quarter or 2. And the reason is, we're selling to Tier 2 and Tier 3 level customers, whereas the suppliers are selling directly to Tier 1 customers. And those demand signals are much quicker at Tier 1 rather than they are in Tier 2 and Tier 3. I think the interesting thing is that we're seeing in Q3 is that there wasn't that lag. So we saw suppliers with strong performance, and we were seeing that same performance. So I think what's happening right now is a bit of an anomaly because customers -- end customers are sitting on very lean inventories. We went through an inventory correction in the semiconductor space a year ago, and that was followed by a pandemic. And so I think customers are happy with where their inventory levels are given a pandemic environment. But as soon as there's an uptick in demand, they need product to meet production right away. So they're not building inventory. It's going right into production. So if anything, we haven't seen that lag of late. As it relates to Asia, I think there's a few things going on there. The first is they were first into COVID. They're first out of COVID. And broadly speaking, I think the East did a better job of managing COVID than the West. And so I think we're seeing the results of that and their economic performance. We've also had share shift over there. And there's been some, over the last year, discussions around share shift. And the bulk of that happened in Asia. The interesting thing is, is that with that share shift, we've also identified a number of customers that we haven't been selling to. So that provides us additional opportunities as we go forward. But even ex that share shift, the business is performing very well vis-à-vis the market, and we measure it that way.

That's helpful. And maybe going back to kind of the demand that you saw in the last quarter. I mean talk about what's the -- your Arrow's visibility into the -- to the in-customer demand? And I guess, right now, kind of, I think the bull case is that we're seeing maybe the people obviously can't travel. They can't enjoy services. They're consuming a lot more goods, they consume a lot more semis. How do you think about that relative to things kind of maybe normalize from a demand perspective?

Yes. I think really what you're touching on is an important point. And I think what we're starting to see in broader markets is that COVID has, in some respects, accelerated change that was going to take many years to happen, whether it's work from home, some of these other trends. And ultimately, environmental, I think, if anything, coming out of COVID, when we saw that people were in their cars less and traveling less and the impact -- the positive impact that had on the environment. So all of those things, I think, ultimately benefit the space that we serve because electronics, to your point, will be a big part of how the world evolves to that. Now in terms of visibility into the end customers, we obviously do an enormous amount of design engineering for those customers, and we can see the products that they're working on. Obviously, we don't talk about what that is. But those innovations continue. We've talked about record levels of design activity over the last 2 quarters. And really, over the last 4 quarters, a very high level of design activity, which is unlike what we saw in the last major downturn in the financial crisis, where customer stock design. So we view that as a very positive indicator about their -- towards the future. And so that's, I think, ultimately a good thing as well.

And can you just remind us, how do we think about the timing from design activity to when we start to think about revenue recognition for Arrow in terms of those products being put in place?

Yes. Typically, it's a number of quarters. So we say that the average life of a design is 18 to 24 months. So if you take a midpoint, right, in any point in that timeline, say you're at 9 to 12 months, that's where, depending on how early people are designing, we could be looking at a number of quarters until we see that. I do think one of the trends that we've seen in the near term is that the smaller customers globally, the ones that rely on us more heavily for those engineering services have been more negatively impacted by COVID than bigger customers. Again, it doesn't mean that they're going out of business, they're still designing. It doesn't mean that they're just not buying as much. So I think there's a tailwind for us coming out of this that ultimately helps GP because those designs are obviously, higher margin, and we've just got to get volume pulling against those.

Right. And so I guess, when we talk about or think about the strong design activity you're seeing, and kind of couple that with the strong demand you're seeing in Asia, is that predominantly where you're seeing that growth? Or is it more broad-based from Americas and Europe as well for the -- on the design front?

For -- on the design front, it's definitely more broad-based. In terms of, obviously, what we're seeing in results, one of the headwinds to margin in the near term is the fact that Asia has gotten so big, right, because of the share shift, because of their recovery versus the rest of the world. But if we look at where backlog sits today, I would say that the backlog trends are strong globally. So I think that's encouraging. I think we're obviously all seeing the markets respond to continued positive news on vaccines, not just in terms of efficacy but also availability and the fact that, that timeline may be shortened. I think all of those things would help the West in particular, but the backlog does look strong.

Okay. That's helpful. And then maybe kind of going back to the demand that you're seeing. Talk about what you're seeing in Americas and Europe. And have you seen any change with, call it, the second wave of lockdowns in Europe and maybe kind of a lesser extent here domestically?

Surprisingly, no. And I think it goes back to the -- your earlier question, which is people aren't spending on travel, so they're spending on other things that consume semiconductors. When we did the guide for Q4, we were obviously starting to see Europe go into kind of that second wave of restrictive activity. And it hasn't really dampened demand. So we haven't seen orders being pushed out. We saw the backlog. The backlog hasn't shifted. Orders haven't really been canceled or pushed out. So I think that's encouraging. And we'll continue to monitor, but so far, so good.

That's helpful. And then I think in the past or last quarter, you talked about maybe lead times for certain products starting to maybe slip a little bit can you help us understand what type of categories you're seeing that in? And is there a particular maybe submarket or vertical that's driving that?

I wouldn't say that it's a submarket or vertical. And again, I want to be careful with my answer because we're not signaling big shifts in extensions. When we talk about small changes, we talk about a week on what is a 10- to a 20-week kind of average, depending on what it is we're talking about. I would say, broadly speaking, it was in the passes, think a little bit on MCUs, but nothing that's earthshattering in any one category. Now I think to the extent that we do have positive tailwinds here from vaccine and whatnot, we could see that continue to grow, and we'll watch that closely. But I think Arrow typically fares better than the market, if you will, better than average because the customers that we serve are generally high profit customers for our supplier partners. And so we typically fare well in getting the product that we need and doing a little better than the market. And that's really evidenced by what we experienced a couple of years ago with the MLCC extended lead times. We really didn't have too many problems getting product for our customers.

That's helpful. And there's been several kind of shifts in terms of supplier revenues from -- into distribution over the past several years, and you knew I was going to ask this. But can you talk about -- are you seeing a more kind of material benefit from one of the large suppliers that has changed their distribution plans over the past year? Just kind of help us understand maybe how to think about that opportunity? How do we think about the gross margins associated? Because I think that's more of a consignment revenue model than maybe some of the other design specific type of revenue that you see.

Yes. I mean, really, when you think about what we do, right, we're here to serve the supplier community, and those suppliers all have different strategies. And some suppliers don't want our engineering services to help support their brands. Others do. And so we are happy to do what the supplier wants done to support their strategies to reach those Tier 2 and Tier 3 customers that we talk about. And so over the last year, there was a shift a couple of years ago, right? And that was based off a one strategy. Over the last year, there's been another shift. And in that situation, it's definitely a lower gross margin initiative because we don't do any design activity for that supplier, but it is a consignment model. So at the OI line, because there's not a lot of OpEx behind that, it's relatively neutral. It's accretive at returns because of the working capital model. But while we were doing that, we were also adding hundreds of engineers to support other supplier lines. And we continue to do that. So we don't put all of our eggs in one basket, and we want to make sure we're performing across all of those critical suppliers.

That's helpful. And so maybe for those that are a little bit less familiar, the working capital that's associated with a consignment model is relatively minimal, right? So maybe what are the kind of services or capabilities that Arrow offers why you're winning those businesses -- that business rather?

Well, it's really, as I said, I think our -- and there's been a lot that's been written about this, and I'll let people do their own research. But we will, as I said, support the needs of the supplier depending on how they want to go to market. I do think our global ERP and the visibility that we provide to supplier community, the efficiency with which we can get product to customers is unparallel. And I think that weighed into this particular decision. I think in other decisions, it's around that and our engineering capabilities and the reach we have, our ability to acquire customers at a rate that's above market because of our digital properties. So it's -- we're not sitting still. We continue to focus on ways to drive differentiated growth for our suppliers. Because if we continue to do that, then we're giving them something that no one else can. And that's our focus every day. And that's -- there's different ways to do that depending on the strategy of those suppliers, but that's really our focus.

That's super helpful. Maybe talk about -- I think, in the last few quarters, there's been a lot of questions around your confidence in getting back to that 5-plus percent EBIT margin on the component side. Maybe talk to that, how do we think about just given the strength and increase you've seen in your Asia mix to revenue. Is it -- do -- should we think about a different level of revenue now to hit that? Or how do we think about the, I guess, the leverage in the model and getting back to 5%?

Yes, it's the right question, it's the question, if you will, right now, I think, in investors' minds. And the first thing you will absolutely see and we're guiding it a little bit in Q4. As you'll see operating leverage, right? A little bit of volume growth results in more than a little bit of OI growth. We definitely drive operating leverage through the model, given our cost structure. As a rule of thumb, our variable costs, for example, are roughly 2% of sales. So we -- you will see OI growth faster than you will see sales growth, that's the first thing. The second thing is at the GP line, you'll see those designs start to kick back in. You're also seeing today in the numbers, the impact of growing services businesses around things like managing complex supply chains and those businesses will continue, I think, to thrive and provide some tailwind. And so -- and then, frankly, as North America and Europe turned back on, you're not going to see Asia stay at close to 50% mix of the components business. I don't think we'll be at 40%, but we'll be in the 40s and a little bit of shift there goes a long way. So that's the pathway back to 5%. We feel strongly we will get there relatively quickly. It's not going to be a quarter or 2. It's going to take a few quarters, obviously, to get there. But that's something that we continue to have confidence in. I think the way we get there changes from, say, the way we got there 10 years ago, right, or 5 years ago or 2 years ago as we continue to add more and more services to the mix, but our ability to do that remains very high, and we have to prove that.

That's helpful. Maybe shifting gears from, the time we've got left, the ECS business, maybe spend a minute or 2 kind of just giving us a little bit of an overview for those aren't as familiar with that piece of the business. I think there's a little bit of a different type of accounting treatment there. I mean you've definitely seen, I think, some good demand or been able to kind of address this remote work, I guess, phenomenon that we've seen this year. So maybe talk about the demand you're seeing there and maybe particularly around the software, I think, you're seeing maybe stronger growth than the reported numbers might suggest.

Yes. So the accounting treatment issue is its agency accounting is what it's referred to. And really, when you look at a lot of the software that we sell, a lot of the cloud product we sell. What it means is that we report at net sales, we report effectively what is the gross profit of those items. So you end up with a diluted impact on sales growth because we're not reporting that gross number, we're reporting a net number. But you've also got margin expansion associated with that. Now in the near term, you're right. I mean really in Q1, Q2, even into Q3, a lot of product that supports remote work environments. Again, we're not selling the laptops that people were struggling to get. But we are selling the software that lets those environments operate, Citrix, VMware, whatnot. And some of those items are lower margins. So margins were hampered a bit in the near term, but I'll tell you, we were -- we knew our capability, but I would say we were even surprised at just how resilient that business has been in its ability to pivot from core of the data center to remote work product and generate very respectable operating income through a tough window. As we look forward, though, I think the reason for being for that business, the strategy that we've been focused on, I think, is stronger than ever. And that is we feel that the world is going to end up in hybrid and multi-cloud environments and that's clearly where the world has shifted. And in the space that we serve, that's more true than ever. So our ability to efficiently deploy products through ArrowSphere, which is our platform for the deployment of cloud, and software product is very strong. It's a very competitive tool in its space. It's something that a lot of our competition does not have. It's particularly evolved in Europe and growing. So there's more opportunities in North America. And we're actually working with cellular carriers in Europe to deploy cloud product over their network. So I think that thesis remains. I think that the only thing that's holding us back right now is the ability to get on-prem for the on-prem piece of that work just because of the COVID restrictions, but that will come. Those things aren't going away because of COVID, they're just delayed. And I think as we get to midyear next year, we'll start to see some nice momentum there.

That's helpful. And so maybe when we kind of think about that business and looking into 2021. How do we think about just the revenue of the ECS business that's coming from maybe kind of like software annuity type revenue that you have pretty good visibility? I mean are we starting to get to a point where that kind of becomes the lion's share of that business where we can see kind of a point to grow off of?

I think I wouldn't say lion's share, but I will say we are growing rapidly, and we'll disclose at some time in the coming quarters. The size of the -- of that ratable revenue backlog. So a lot like what the suppliers saw a year ago, 2 years ago, in terms of the shift from upfront licenses to more ratable. That's definitely a trend for us. I think it's a real positive because, obviously, that's just an annuity of future revenue. And so that, I think, bodes well for us, and it definitely continues to grow. So you'll hear more from us on that in the coming quarters.

That's -- I look forward to that. I think that will be helpful for investors. Can you talk about your enterprise spend? Do you guys have like an enterprise spending kind of outlook for 2021 at this point? Clearly, you talked about a little bit the on-premise maybe starting to improve as we get into maybe the middle part of next year.

Yes. It's really -- when you look at spending in that space, it mirrors GDP growth, right? IT spend mirrors GDP growth. You can look at Gartner, you can look at other resources. You got to obviously exclude the things we don't sell. If I try to narrow that in a little bit. I expect it's still going to be bumpy as we move through Q1 and Q2 just because of the timing around the world of when we can get back in places. I'm very encouraged by the fact that we're seeing news that people, certainly in the U.S. anyways that want the vaccine will have access to it by June. I think that bodes well for certainly the second half. It's just a question of around the world, what's the timing of those things. So big picture, will move with -- will move the GDP. But more near term, it's just really going to depend on when doors start to open again.

Okay. In the last couple of minutes, we've got left, let's talk about free cash flow. You guys have been generating a lot of free cash flow over the past several quarters. But as revenue continues to kind of start to grow again, there's typically some working capital requirements that are required. So maybe can you talk about -- in the past, I think, it's been like a 10% kind of growth threshold of where you start to need to make some inventory investments. Is that still the right place to think about -- level to think about? And maybe what are the things you guys are doing around working capital?

Yes. That's, I think, the right benchmark to think of for now. When we hit that 10% growth rate in components, we're definitely going to need to stage inventory. And by the way, I'm talking exclusive of any share shifts. Share shifts, obviously, have bigger upfront investments, and we'll certainly give some color around that, should that unfold. But as it relates to just broader market growth, if we really see some spikiness in that, and we're above that 10% level, you will see us have to build inventory to support the backlog, and then we're obviously extending credit beyond the credit we're granted against that inventory. That said, despite that kind of near-term growth that could happen, I would say that we're going to continue to manage Arrow very tightly. We're really at record levels of percent current on our AR, and we're going to try to keep it there. And so longer term, I think, our goal would be that, that 10% number could creep up a bit in terms of where we ultimately have to be investing. And some of that's because of different supplier models that we've already talked about consignment, but some of it's because of our efficiency. So Mike Long alluded to that on our earnings call, but it's still a little early yet for us to put a number around that. We've got a little more experience under our belts.

That's helpful. And then just last question here. Update on use of cash, share repo versus debt paydown.

Yes. So there's really no M&A activity in the pipeline right now. I think things are pretty quiet there on the -- on debt. We like where our debt is. I don't think there's any need to pay down debt further. We've done a really good job of putting ourselves in a good position for growth there. So the focus is buybacks in the near term.

Perfect. I think we're out of time. Thanks for joining us, guys.

All right. Thanks, Joe. Thanks, everybody.