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

Okay. Thanks, everybody, for joining. My name is Adam Tindle. I cover the IT supply chain along with connected devices and security software here at Raymond James. Very happy to have the team from Arrow Electronics. Chris Stansbury is going to lead our conversation here. He's the CFO. The format is going to be a 40-minute fireside chat. So if you do have questions, you'll notice a Q&A button in the top left-hand corner of your screen. Alternatively, you can e-mail me, [email protected], and I'll try to get your question answered. So with that, Chris, thanks again for joining us today. And maybe just to start, I think we're -- a lot of us are familiar with Arrow as a distributor with a uniquely higher profitability profile than peers over multiple businesses of scale. But for those not as familiar, maybe just give us a quick background of the business as it fits today and how it's evolved over time.

Sure. Great to be here, Adam. Thanks for -- to you and really to Raymond James for continuing with this despite the challenges that we all face today. Arrow really has been focusing on driving value added for our customers in both segments of our business. About 2/3 of our businesses is the sale of components, electronic components, and 1/3 is the sale of enterprise data center product, really around the deployment of cloud and multi-cloud environments. And those businesses have performed very well through COVID, I think, because of some of the things that we've done to differentiate ourselves around services. So in the case of computing, that business was able to pivot very quickly to deploying product that supports remote work environments. We don't sell laptops and mobility devices, but we do sell the backbone of work-from-home software. And that's been a boon to us over the last few months and has really allowed us to generate nice profitability in that segment despite the challenges. And in the components business, we continue to design new products for customers that are now starting to take hold as those businesses turn back on and we see backlog building. So as we exit COVID, high level, I think the business is in very good shape to capitalize on the things that we've done to differentiate ourselves. And I think we'll see that in the coming quarters.

Got it. And maybe we'll just start on components. Since it's quite topical, we'll start at a high level. You obviously have a good feel for where we are in the semi cycle, if you want to call it that anymore. You generate about $20 billion in revenue with exposure to all major regions. So maybe to start in components, can you update us on the pace of business with some color by region and also how leading indicators are trending, book to bills, cancellation rates, et cetera?

So if you look at the way the region performance has flowed through COVID, it really is following the path of COVID, right? So Asia was the first to experience the challenges of COVID, and they're the first to enter the recovery. So that business has been strong for a number of quarters. Part of that's been aided by a share shift. But even if you strip that out, the business is outgrowing the market over there, but that market is growing. As we look at backlog trends in North America and in Europe, we see those strengthening, I think -- which is an indication of the recovery that we're seeing. And we're not seeing customers back away from those orders as they are experiencing more lockdowns in those regions. So that's actually a good thing. Factories are staying turned on. I think what is most interesting though is that unlike previous recoveries, we're not seeing Arrow's business lag that of the suppliers by a quarter or 2. Typically, because we're selling it below Tier 1 in terms of customers, that demand signals a little slower. But in Q3, it wasn't. And we believe that that's because customers are sitting on very low inventories because the pandemic obviously followed a semi cycle correction, and so they need product to go right into production right now. So backlog continues to build. It's not just in absolute dollars but I think a little further out. Customers want to make sure that they've got their place in line if there's any shortages. Their payment behavior is very strong. So we're seeing percent current on our AR in the 95th percentile. And that's because customers again want to be in a good position should things tighten up. So all in all, things look good. They continue to look good, and that's a nice way to start 2021.

Yes. So you touched on this a little bit but -- so demand trends, obviously very healthy. But inventory levels, I know we kind of ran lean into this up cycle. So just kind of a twofold question on inventory. First, at the customer level, how has the pace of restocking been trending? How long do you think we'll see tight supply conditions? And then on the distributor level, for Arrow's own inventory levels, what are you looking at right now? When do you determine when to attenuate inventory investment? So customer and distributor inventory commentary.

Yes. So Arrow's inventory build really follows that of the customers. We don't take speculative positions. It's based off the order book. I mean we may haircut that at times. We're not doing that right now. Certainly, Q4 of '18, we started to haircut it because we saw the downturn coming, and that helped us. But right now, when you look at the demand patterns, we're not seeing behavior that would suggest a lot of double ordering or anything like that. But I think customers are in the position now where they are starting to build to the extent that they can. I mean it's an interesting recovery, right, because the customers may or may not be in the strongest financial position, but they're paying on time. So their ability to go until that business turns back on and really make bigger positions on inventory, I think, is a little bit muted. And so we continue to watch that. But certainly, customers do need to be building their inventory positions as the economies around the world start to strengthen.

Okay. And then maybe more near term in topical. We've heard some of the supplier base on the component side has publicly stated the intention to start increasing some prices. And we've also heard that some of the other suppliers are telling distributors to try to push orders to calendar Q1 because Q4 is fully allocated. So maybe just comments on what you're seeing from a price increase standpoint at the supplier side. And then to the extent that you could push orders to Q1, is that possible? Are you trying to do that?

We're not trying to push anything into Q1 at this point, but I think the quarter -- we gave our guidance. The quarter looks strong. And we typically are not in the business of trying to move stuff further out. I mean, remember -- and this won't always be the case. But if you go back to the last shortage scenario that we had around MLCCs a couple of years ago, Arrow was able to get everything that it needed to meet customer demand. And that was important. And I think that we always bode well in that environment. We tend to do better than the average in terms of our ability to source product. But to your point, in Q3, we even indicated that in some areas, MCUs, some of the passives, we were starting to see lead times extend a bit. There was obviously, to your point, a supplier announcement on Friday about a price increase. We're not hearing more that's inevitable, but I don't think that will be the last one just given where we are and given ordering behavior. So if I was to make a prediction, I think we'll see a continued extension of lead times. I think we'll see some pricing around that to try to mitigate some of that, and Arrow will simply pass that on to our customers. We make a margin on a price. That's what we did with MLCCs. When prices didn't go up, we didn't try to arbitrage the market, and we'll do the same here.

Okay. And do you have a feel for the elasticity of demand, so to speak? How much can the market bear in terms of price increases? And shouldn't that help you on the margin front? All else equal, I just think about inflation being a good thing for a distributor.

Yes, it is. I mean typically, in the electronic space, we see deflation on pricing, right? It's just one of those few areas in the broader economy where that takes place. So price increases in that regard are good for margins, to your point. Obviously, it's a double-edged sword because it depends on how bad those shortages are. But in terms of pricing, I couldn't tell you. I guess it would have -- really have to be part by part. Some are going to be more sensitive than others. And again, that's up to the suppliers to figure out. We will just pass that along.

Fair. And just talking about general trends in the component space. At the supplier level, M&A seems like almost a constant at this point, but it's accelerated here again recently. So I just want to maybe talk through some of the similarities or differences to this cycle of the Xilinx, Maxim, et cetera, versus 4, 5 years ago, ADI, Linear, et cetera, where those resulted in a number of exclusive deals, many of which went in your favor. What would be similar or different to Xilinx, Maxim this recent cycle?

Yes. I think the big difference really between this and past is the starting point. And the starting point, we have scenarios where in both cases, the companies being acquired, Maxim and Xilinx, aren't distributed by Arrow today at all, right? Whereas in the past, we -- and our major competitor all had at least partial distribution, if not more than that. So the starting point is very different. It becomes, I think, more of a binary decision, right? Now what we don't know is what will the suppliers do. Will they continue with the exclusive relationships that exist between the 2 companies? Will they shift to the exclusive relationships in terms of preferred partners that they have today? It's too early to say. They have to go through the work that they do. But I would say that from Arrow's standpoint, we've continued through COVID, frankly, to invest in our capabilities, including adding engineers, more so by far than any of our competition. And we're going to continue to do that. So we have to eat what we kill, so to speak. But the reality is that I think we've positioned ourselves well, and we need to stay aggressive in terms of maintaining, if not growing, the gaps that we've created. So that's our focus. And then hopefully, the rest sorts itself out in our favor.

And a question that was emailed. And again, if you do have a question, please use the Q&A function or just e-mail me, [email protected]. The question is on the lines of suppliers, just any big observations from the recent move in 2020 for a big supplier to fully move to a consignment model. Is it creating any differences that you're observing in market share? What has been the customer response given you're basically now the only game in town from the distributor side? Just general comments on -- that you've seen.

Yes. I don't really want to get into kind of differing suppliers' share. I think that's left to others. What I will say is, again, we have suppliers, some of whom compete with each other. They just have different strategies. And the supplier reference has a very focused strategy around fulfillment only. So it's obviously lower margin at the gross margin line. It's OpEx light because we don't have a lot of engineers focused on that business. So for us, at the OI line, it's relatively neutral. But to your point, because it's consignment, it's returns-accretive, and that's really our focus. So really, our view is that we have a number of supplier partners. We are here to support their strategies, whatever they are. Some want more services. Some want less. And we'll adjust accordingly. And I think we've proven that we can do that. We can actually have 2 very different operating models for 2 differing suppliers. And we'll continue to make sure that we're building the capabilities to support that. Because ultimately, we're an extension of those suppliers. We're here to be their selling arm into the channel, and we need to respect the strategies that they want to employ.

Fair. Maybe on your specific components business, I mean it's operated at a 5% operating margin in the recent past, currently a little over 100 basis points below that. But maybe just talk about the potential to get back to that sort of a level, the timing and the key drivers for that.

Sure. I think the 2 big headwinds are known, right? It's geographic mix, right, continued growth in Asia. The other would be, obviously, a pressure on fulfillment margins as suppliers continue to consolidate. But I think those headwinds are more than offset by the tailwinds that exist around our ability to drive more engineered solutions that drive GP, our ability to drive more services, so integration services, supply chain management services that are much higher margin. And then as the economies of the world start to recover, I think that Asian mix will moderate somewhat. It's still going to be the majority, but it's not going to be 50% of the components business. So when you put all those things together, even if you exclude pricing and you combine that with some volume growth that immediately for us gives us operating leverage -- that's just the way the model works and we're effectively -- we effectively guided that for Q4, that's how we get back to 5%. So we're confident we can do it. And we've -- there were questions about our ability to sustain 5% before we went into the semi correction. There were questions around our ability to generate cash. I think we proved that one. So now we've got to prove we can get back to the 5%, and I'm confident we'll do that.

Good. And you talked about the supply chain services, and it sounds like it's increasingly becoming important to the model. Maybe just take a step back for investors not as familiar with this. How does that differ from the core business? And any metrics you can share around how accretive that sort of a business is relative to the core.

Yes. We won't give a lot on the metrics side at this point. But what I will say is this isn't a new business. I would say it's been definitely enabled by our ERP, our global ERP. But these are situations where customers who buy directly from suppliers need our help to manage those supply chains more efficiently. So we're not buying and selling components. We're here to sell our services as a company that manages complexity really well. I mean one of -- and I think I shared at the conference in March, but one of my favorite statistics about Arrow is in our components business, we do 2.5 billion transactions a year. So that's 80 a second, 24/7, 365. And each one of those transactions could be hundreds of line items. So the amount of complexity that we're managing to make sure that the right part gets to the right place when it's needed is very, very high. And so that core competency is something that's valuable even to customers that we wouldn't normally work with because they have buying power to buy direct. So that's really what the business is. It's really helping those customers and suppliers manage that more efficiently.

Interesting. Do you think there's a long tail of opportunity there? And would you -- the type of relationship you're describing, we've heard some supply chain companies do this sort of procurement for hyperscalers, for example. Is that the type of customer that you might engage with?

It's really a very broad base of customers that could be the target. It could be large, multinational conglomerates that are building products all over the world. It's really more around how complex is their business. So yes, this definitely has growth potential. We have a proven capability to execute well. The really hard relationships to stand up, they're complex. There's a lot of tax and treasury issues that have to be sorted through. There's often IT that has to be put in place. So this is a slow selling cycle, but customer relationships tend to be sticky, and it's definitely something we're focused on.

Interesting. Well, I want to switch gears into the computing business, been a very unique year. Maybe just take a step back and talk about the pace of business as 2020 has progressed. The major observations as we approach the -- I don't know if you even want to call out a year-end budget flush anymore nowadays, but just kind of take us through the progression and what it looks like sitting here in Q4.

Yes. I mean I would say that probably the single biggest surprise for me as we've moved through COVID at Arrow is frankly just how nimble and resilient that ECS business has been. So at its core, that business really focuses, as I said up-front, on the core of the data center with a focus around the deployment of complex hybrid and multi-cloud environments. That's our sweet spot. And we've got a lot of tools around that deployment. We've got a great platform in ArrowSphere that helps us with that. And we continue to broaden the long tail of suppliers that enable all that. But when we went into COVID -- and it was clear that, that was going to be an issue not just in Asia but beyond, that business almost immediately pivoted to the deployment of product that supports remote work environment. And while that's lower margin product, we all know kind of the suppliers in that mix, it's -- I don't want to say it's a commodity, but it's definitely a more volume, lower margin kind of sale. That demand was so robust that our value-added resellers started pivoting the deployment disproportionately to Arrow because of our ability to execute. And I had calls from the CFOs of those suppliers that reinforce that. So we were in the right place at the right time. We were very nimble. And that really carried us through Q2 and Q3 and even into Q4. And the good news is even though it's lower margin, it gave us great OI. And quite frankly, into the future, I don't think anybody is going to back away from remote work capability. That's just now a future IT deployment that needs to be maintained, and that's good news. What we're starting to see though is the business pivoting back to that core competency, that -- the deployment of those hybrid and multi-cloud environments. And so when you look at our Q4 guide, it implied, I think, strong margins more consistent with what we would see in a Q4. And I think the future looks bright. I don't think the demand for those environments is going to get less. If anything, I'd make a strong argument, it gets stronger. I think the uncertain thing about that business, not for Q4 -- and Q4 is in good shape, is until we can get on-prem, is that business have a little bit of a moderated impact, a muted impact say in the first half of the year. That's the part we're trying to understand a little better right now, but that's a timing thing. I think in terms of where the business is positioned, it's very strong.

Okay. That's helpful. One of the questions just got e-mailed on compute. Maybe just speak to your enterprise versus middle market mix and your view of has either group underinvested over the past 9 months. And then also any compute products where you're seeing supply limitations sort of tightening supply like you did in components?

Yes. So the last one first. I mean again, 30% of what we sell is hardware. So it's not the core of what we do. We're not seeing major shortages at this point. And by the way, of that 30%, 2/3 of that is storage. Our storage line card really reflects the market. So no, nothing yet, and we'll keep an eye on that. Sorry, what was the first part of that question, Adam? Just refresh me.

Customer vertical, customer vertical mix, yes.

Oh yes. So again, we don't deal with really small customers in that space, but we're also not necessarily dealing with Tier 1 customers. But think of them as the -- when we talk about small and medium-sized business, it's really more medium, right? We're not selling to the local dentist office. It needs to be more complex than that. So we will be perhaps supporting a VAR that's working with a hospital chain, for example, in a state or whatever it is. It's that kind of customer, end customer that we're targeting. Now what we did see in COVID, which is interesting from a mix standpoint, is that the larger VARs definitely took share. So we're dealing with 20,000 VARs in North America and Europe when we're selling these solutions. They own the customer relationship. But the ability to deploy the remote work product definitely leaned towards the larger value-added resellers. We'll see how much of that mix comes back post COVID. But a lot of those VARs are focused on specific verticals and our experts in that area, and they need our help to build out a more complex environment. So we'll see how that potentially, or not, shifts post COVID.

And another e-mailed question, kind of a similar question by region. You're in 2 major regions in this business, not in Asia, but maybe just talk about dynamics by region that you're observing.

Sure. Europe, over the last couple of years, has definitely been the gem within that portfolio. And if you think about it, Europe really evolved as a business in a way that was very consistent with the way the suppliers went to market. And in that case, the suppliers picked kind of best local distributor to go to market. So it's very fragmented. And as the consolidation took place in Europe, we ended up with a very broad line card. That compares to the North America business, where that business has traditionally been more skewed towards the legacy tech providers. So as things have evolved, that fragmentation in Europe is why we developed ArrowSphere, our platform. So it's a little further advanced as well. The good news is that we've got a model that we can now reverse engineer in North America, and we are. So the long tail of suppliers is growing in North America. The usage of ArrowSphere is growing. It remains an opportunity. But that's really the difference between the 2 businesses. It's really how they grew up, and there's good learnings that we can apply across, and that's starting to show.

Would it make sense to expand that business into Asia similar to how components is?

Certain parts of Asia, and we are in Australia and New Zealand right now. That just rolls up under North America because it's small. But in terms of going into the core of Asia, I would say no. I mean it's a very different animal. It's much more broad line distribution. And that's not a core competency of ours, and we're not going to try to compete in that regard.

Fair. Kind of along those same lines, maybe just taking a step back strategically. Just talk about the competitive environment in the computing business. There's actually been quite a number of changes here over the past couple of years, much to my -- the detriment of my coverage universe, shrinking. But competitive environment, how it's changed and how you see it evolving over the next few years.

Yes. So really, I think what we've seen in the space is companies going private, right? And there's a great cash flow model inherent in these businesses because they're working capital light. And I think that's what's attracting that kind of activity. I think the opportunity for us is that it's that old axiom, right? The first thing people say when they go private is "Thank goodness. I don't have to talk to Wall Street every quarter." And then they quickly realize that they got to talk to their new owners on a far more regular basis than quarterly. So I think in near term, there's an opportunity for us in that. I think there will be even more pressure given the amount of debt that's been raised to do fund some of these acquisitions and the desire to catch up on things like ArrowSphere. I think there will be enormous pressure on operating results that ultimately provide an opportunity for us, and we're very focused on that. So yes, it's a changing environment, but we're focused on our strategy. We believe it's the right strategy, and we believe that's really starting to show signs of promise not just to us but to the outside world. So that's our focus.

And then maybe strategically talk about the synergies of having both components and computing together and what would be the dissynergies associated with separating those businesses.

Yes. So the synergies really are on multiple fronts. As time goes on, the lines are definitely blurring between the 2 segments. And without naming names, I can reference a supplier that has been a long time supplier to the enterprise Computing Solutions business that came to us a little over a year ago to help them deploy artificial intelligence, effectively semiconductor product in the components side. And so there's that. One of the reasons why we have won -- there's many, but one of the reasons why we've won more of the share shift on the component side is because we have a compute business. And as the world moves to more integrated solutions, suppliers see a value in that in terms of growth. And then the last one, as I mentioned, is cash flow. I mean when you look at the amount of business that Arrow brought in on an exclusive basis back in 2017, ADI when they got LTC, Cypress, Silicon Labs, Altera, the amount of investment that was required to stage inventory to support that shift, as you know, was significant. The cash flow of that business is -- was critical in allowing us to do that because we were also raising debt but couldn't go above certain debt levels. So it's really all of those things combined that make it a critical part of the portfolio.

What about the idea of adding a catalog distribution business under the covers? It's typically working capital intensive. It's higher margin. You could fund it from some of the better cash terms businesses that you have. Maybe just comments on that.

Yes. I think -- I mean you never say never, but I think right now, when you look at the spaces where we can win around services, I think that's a bigger play for us in terms of our resource deployment. The core of distribution is critical to what we do, but we do have an online business. We continue to grow that organically. But to go pay a big price for something that's existing and then have to integrate the IT side of that because that's the only way you can drive the efficiency, that becomes really expensive and a big distraction. So again, not saying no because right place, right time, right price. Anything is possible. But we have to be mindful because the strategy is working and I don't want to do anything -- we don't want to do anything that would distract us from that.

Understandable. And it doesn't appear to have been a differentiator at least in the near term from those that may have that model. Just going to go into the last topic of capital allocation and maybe last call for questions. Please go ahead and send them over now if you do have them. But Chris, cash flow has been significant during this downturn. So I want to give you a chance to recap and highlight this because I know there was questions on it when it wasn't so robust. So you take a little bit of a victory lap first. And then going forward, talking about growth picking up and accelerating here, so how should we think about the right level of operating cash in this environment?

Sure. Thanks, Adam. Yes, we're definitely taking it on the chin as we should have really for -- in some of the quarters where cash flow was less than we'd like it to have been. But there was also this bigger thing of share shift and everything else, a lot of rapid growth. And the rules of thumb are above 10% components growth, it's hard to generate cash. Like when you get into that 15% range, it's almost impossible because the working capital build proceeds, the sale and the cash conversion impact from that. Over time, we're hopeful that, that 10% number comes down a bit. And that can be driven by things like a supplier that wants to consign their inventory, right? That can help us. So that will moderate and measure as we go forward and provide some feedback. But really, what you've seen over the last year, 1.5 years is the fact that this business is countercyclical on cash flow, right? When things turn down, we liquidate working capital. And I think we did a very good job of that. I think our credit teams did a phenomenal job. We're 95th percentile, 1% current on AR right now. So the cash conversion cycle, where it is, we like. Could we use working capital in any given quarter? Of course. If we have a situation where growth really spikes or we have a situation where there's another share shift and we have to stage inventory, yes. But we'll give you insight into that. But longer term, I think you'll see us generate cash -- operating cash flow that is in the 90% range of non-GAAP earnings. And our use of that cash, we say, first and foremost, is organic investment. And on that, I think our CapEx at $120 million or so is about right for now. We make the engineering investments as needed in our OpEx. The second is accretive M&A. There's not a lot of that right now. So I don't think there's going to be much. And the third is use what's left to either get that back in order, which is now done, or buy back stock. So what that really means is we'll be buying back stock given where debt levels are. And over the last -- I forget about a period of time now. We bought 1.3 -- I think it's 5 years. We bought $1.3 billion in stock. So we're going to be active buyers of stock.

Okay. And I'll...

Oh, Steve's going to jump in. I think he's going to correct me.

Yes. Steve, please.

No, I'm not going to correct you. I was just going to say you're 100% right, Chris, in 5 years.

All right. So I want to just kind of go to wrap up. And I do want to ask, when you're in meetings with Mike and the Board and you're looking at the success that you've seen relative to the stock performance versus your semiconductor suppliers, there's a disconnect here. I guess how do you help investors solve that disconnect? How do you help investors better appreciate valuation? What are the kind of the key things? It's certainly been a disconnect relative to your closest competitor and acknowledge that, but maybe just touch on Board and Mike's conversations around...

Yes. I mean really, those conversations are focused on continuing to push the strategy forward. I mean, we firmly believe that the choices we're making are the right ones. We think that that's proven itself out certainly in the performance differential. The disconnect with valuation, I think, has really a couple of aspects to it. As it relates to Arrow, it's the belief in the sustainability of that strategy. And can you generate consistent cash flow? Can you get margins back? So each one of those questions, as they get answered -- I think we've answered the cash flow one, we've got to answer the margin one, I think, gives confidence that, yes, this is sustainable. The second thing really relates to the competitive environment. And when you have a competitor that's troubled, it hangs a cloud over everything, which is will they fight back? Will they do something irrational? Will they destroy what you've done? And I think that valuation question mark is really what's overhanging the industry. Again, that's a time thing. I think the longer time goes on, the longer we see that, that really doesn't impact us, what impacts us is our ability to perform. And everybody else's ability to perform to their strategy is actually less and less relevant. This isn't a business where it's easy to go pick a price fight. It's definitely not an easy business to go put in a 10-year ERP build that costs hundreds of millions of dollars or to go recreate the digital properties that we have and the customer reach or to catch up on the thousands and thousands of engineers we have in terms of a lead. Those are things that took us years to get here. We're not laying down on that. We're staying aggressive. And it's not something that any one of our competitors can do quickly. This is a very, very hard gap to close.

Yes. I think people underestimate the moat to these businesses. And when you go through the transactions per second calculations, I think it definitely highlights that. So we'll wrap here. I think you kind of went into this, but is there one kind of key message that you want to resonate with investors as they think about Arrow in 2021 and beyond?

Yes. I think we're really looking at a brighter future. I mean the one thing I haven't said here and I firmly believe, I think COVID has accelerated change in the world. And I think we're going to see industries pop up. I think we're going to see more focus on things like technologies that support the environment. Every single one of those things is ultimately linked back to the business that we do, right, electronics and providing solutions. So I think the future is very bright. And I think the acceleration of some of that change is a very good thing for us. We've just got to, like everybody else, navigate through the next few quarters until we can get to a safer world post vaccine.

We'll leave it there, Chris. I always enjoy the conversation. Appreciate you attending our conference, and thanks, everybody, for joining.

Yes. Thanks a lot, Adam. Thanks, everybody. Bye.