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

Good morning, everyone, thank you very much for joining us for our Annual Technology and Internet Conference. I'm Toshiya Hari, I cover the semiconductor and semiconductor capital equipment space here at Goldman. We're very excited and very honored to have Chris Stansbury, Senior Vice President and Chief Financial Officer of Arrow Electronics, with us this morning. This fireside chat will be about 40 minutes long. Chris will kick us off with opening remarks. I'll follow with a list of questions, but I'll also do my best to weave in any questions from the audience, which you can send through via the webcast. With that, Chris, thank you very much for attending and supporting the conference. The floor is yours.

Thanks, Toshiya. I wish we were in San Francisco. But hopefully, next year, we can do that. For those of you that aren't familiar with Arrow, we're a global distributor of electronic components, but also enterprise computing solutions. So if you look at those 2 buckets, our components business is about 2/3 to 70% of our total revenue, and 1/3 is enterprise computing solutions. The components business is global in nature. Enterprise computing solutions focuses primarily on North America and EMEA. And that business is really not about selling laptops or printers. We're not a broad-line distributor. We really focus on the complex side of data center and edge of network deployments, cloud, hybrid cloud, multi-cloud environments. And in that, we've really carved a niche for ourselves. The biggest business components has really gone under a significant transformation over the last number of years, and part of that's driven by industry trends as more and more suppliers consolidate, and there's been more exclusive global distribution arrangements that have come from that. Arrow has continued to invest heavily in service offerings around engineering, from very small to very large, around capabilities to help customers manage complex supply chains and to do more integration work at the edge of a network, software-on-a-chip kind of stuff. And as a result, what we've done is grown faster than market for our suppliers, and that has resulted in share shift to Arrow. We've remained very aggressive about those investments and the focus on that performance for our suppliers, and I think that bodes well for us. The business is countercyclical in cash flow, and the last few years couldn't have proven that more. So 3 years ago, we onboarded a lot of share. We used a lot of cash to onboard that share. And over the last 2 years, we've generated $2.2 billion in operating cash flow, and that has allowed us to pay down debt that builds when we grow and also buy back a lot of stock. And so with that, we're now obviously in a growth mode. I think margin is the opportunity as well as continued cash generation from our ongoing operations. And I think 2021 is setting itself up to be a challenging year but, ultimately, I think, a good year.

Chris, thank you so much for the overview. Super helpful. I wanted to start off by asking you to reflect on 2020. We'll definitely get to 2021, but wanted to get you to talk to 2020. It was a challenging year for all of us in so many ways, but Arrow performed really well. You held revenue flat, and in a very challenging backdrop, you grew earnings. What were some of the key highlights in your mind in 2020? And more importantly, what are some of the key priorities and goals that you've set yourself and the broader team going into 2021?

Yes. The business model just proved its resiliency really in 2020. I mean, if you recall a year ago, we were talking about nearing the end or being at the end of a semi-cycle inventory correction, and then we went into COVID. And so there was a secondary inventory correction. And what we saw is for many -- for all quarters, frankly, very high levels of engineering activity and, in some cases, record levels of requests for engineered designs from our engineers. So we saw pretty early on that even though this was a global pandemic, our customers weren't worried about there being a tomorrow. They were continuing to invest in the future. And to us, that was a very positive sign. And I think that was quickly bolstered by the fact that when people couldn't go out and spend money on travel and in restaurants and entertainment venues, they spent a lot in their homes. And ultimately, that product had a lot of electronic content in it, and that ultimately bolstered that business. To me, the shining star of the year was really the enterprise computing solutions business because, as I mentioned, we're really at the higher end of that market. And what we saw is that as people went to work from home, while we don't sell those PCs that people were buying in droves, we do sell the product that enables those environments to exist, right, the software that drives those remote work environments. And for us, that's lower-margin product. But the volumes that we were able to move, our value-added resellers, because we sell through a partner network who own the customer relationship, shifted a lot of product to Arrow because of our ability to deploy rapidly and on scale. And that ultimately gave us really strong operating income and cash flow from that business through the second and third quarters. And then in Q4, we saw it start to revert back to the mix that we really want to be selling. We saw margins rise and everything else. So I think that both sides of the business performed really well. And quite frankly, our employee base, their ability on very short notice to move entirely to work from home being -- servicing customers from at home, collecting cash at home, it was staggering. So super proud of the organization.

And Chris, key priorities and goals for 2021 for the broader team at Arrow.

Yes. So we've really done a good job of getting our -- continuing to grow but getting our cash conversion cycle down. In Q4, our cash conversion cycle was down about 20% year-on-year and down 11 days. We're obviously going to have to deal with quarter-to-quarter ebbs and flows as it relates to working capital investments in the environment that we're in. But I think really trying to, over time, manage that cash conversion cycle at or near the levels that it's at right now is really important. But beyond that, I think the focus is really, as we drive growth, it's back to increasing the margins. The margins, I think, held up really well through COVID. They were obviously down, but they held up well. As we go forward, we're pushing our teams really hard to drive operating leverage. As we see growth, there's no need to grow OpEx at the same rate of sales, so we'll see great operating leverage. I think we'll see more positive mix coming from more of those engineered designs starting to pull volume against them. We have obviously had an environment where a lot of the share shift that we gained last year was in Asia. And Asia was kind of first in, first out of COVID from an economic recovery standpoint, and that even though they're growing their margins, that has a negative impact on mix, and that should normalize over the course of the year. And then our service offerings, I think, continue to grow. And the ECS business is returning to the kind of margin profile we like. So the focus really for this year is let's drive margins as quickly and as hard as we can. I think an aggressive but achievable goal for us is to exit the year in our components business at 5%. We won't be at 5% for the year, but I think if we do -- if we play our cards right, I think we can exit the year at or close to that 5% level. So…

Got it. And we'll definitely come back to the margin -- the topic of margins. But before we go there, wanted to discuss the demand environment. In the components business, you guys saw a very significant upside in the December quarter. At the midpoint, you're guiding March to above seasonal trends. On the earnings call, you guys spoke to a fairly broad-based recovery across different applications, end markets and regions. But I was hoping, just given the breadth of your business, if you can kind of touch on what the key drivers are and what kind of stood out in Q4 and what the potential key highlights are going into Q1, that would be helpful.

Yes. In Q4, we really started to see a return to year-over-year growth in EMEA, which I think was really positive. The Americas stabilized, which is also a positive. Again, they were last in, so they're going to be last out. And the Asia business remained very strong. What we didn't know, and I think a lot of people were in the same boat, is we’re going to see a slowdown around the holidays, and we really didn't see it. So we closed very strong. And hence, we beat the top end of guidance on sales and EPS. And frankly, we beat our own internal estimates on cash as well. So that gave us momentum into Q1. The Q1 guide is strong, and it really continues those trends. We're seeing a strengthening in EMEA, and we're seeing early signs of a strengthening in North America, but it's not material to the guide, and Asia remains very strong. So I think there's been a lot written about automotive. I think, from our end market exposure, transportation of which automotive is a key driver, is less than 15%. And again, we're selling deeper into that supply chain than the automotive manufacturers themselves. We're selling to people that make seats and entertainment and NAV systems and braking systems, et cetera. So that, obviously, in Europe, will be a driver, right, in particular, but that's obviously an area of strength. But I think more broadly, the biggest bucket we have, which is just broader industrial, which is half of what we sell in components, we're starting to see signs of strength there, and that's very encouraging because those are the customers that rely more heavily on us for those engineered designs. And that's not just a good geographic mix play. It's a good -- it's good positive mix on our portion of design win business.

I want to talk a little bit about the supply constraints that we read and hear about literally every day from your suppliers, from your customers. Based on what you see in the market, Chris, how broad-based are the supply constraints? How meaningful is the gap between supply and demand today? And at what point do you think you and your suppliers can collectively start to meet demand, if you will?

Yes, yes. It's definitely the hot topic of the day. And when you look at what we're hearing, I'll match that up against what we're seeing. So obviously, the automotive suppliers are in real need of product. Now keep in mind, those manufacturers, a lot of the product that they use is specific to them, so they've got single-source supply. And when the chip doesn't show up, the car doesn't get built. So it's very critical to their supply chains. We're playing in a different space. Now we're not seeing any issues on the PEMCO side, the connectors and whatnot. It's really more on the semi side. We've seen price announcements, it hasn't all flowed through yet, from about 20% of our semi suppliers. And I would say that's largely focused. It's actually entirely focused on our suppliers who don't have their own fabs, right? So there's obviously, as automotive is screaming for product, and a lot of that product is going to come out of the same fabs where the more -- the less bespoke, I don't want to say commodity, but certainly the more widely available chips that go into a lot of things come out of the same vats. And so that's where we're seeing the issue. Typically, this kind of correction is a 2- to 3-quarter correction. I don't think that's necessarily going to be different in this case, but we'll have to wait and see. And I think we're well positioned. The good news is that the acid test is, are we getting irate phone calls from customers who are worried about lines going down, and the answer is not yet. What we are seeing, and we did talk about this on the earnings call, is we're definitely seeing elevated bookings and book-to-bill as a result. But what's really encouraging about that is, typically, we see pretty clearly into the future 90 to 120 days out, maybe a little bit beyond that. We're now seeing our order book 2 quarters out. So the elevation isn't driven by everybody panic buying, trying to fill their inventory right now. We're seeing elevated levels in the near term, which makes sense given what we're seeing in end markets. But what we're really seeing is customers getting their place in line for the next quarter out. And so I think we're seeing rational behavior right now, and that's also very encouraging.

Yes. So Chris, you've kind of answered my next question on potential double ordering. Given what you just noted about you having longer visibility as opposed to many of your customers coming in with rush orders, is it fair to say that at this point, you're not too concerned about double ordering and seeing sort of a cliff 120, 180 days out?

Yes, absolutely. And again, keep in mind, the way we started the meeting today, we're starting in an environment that is post cycle, post pandemic, right? So inventory levels are low. I think, inherently, customers that have weathered the COVID storm also don't want to create undue risk on themselves by having to take product because they panic bought. The other thing is, structurally, if you kind of compare where we are as an industry versus 10 years ago when we went through a major correction like this, is we've got a lot more customers who are on vendor-managed inventories. We've got much better data analytics to see and sniff out double ordering and try to keep that from happening. Many more of our suppliers also have better visibility into the channel and into customer inventories, and everybody is doing their best to not let that happen in an extreme way. Now will there be a correction at the other end of this? Of course. But if I think about what that correction looks like, let's just kind of look at it in reverse. In 2000 -- December of 2018, in Q4 of '18, just about every supplier was calling an end to the growth cycle. And we started to haircut our order activity with suppliers, even though customers were requesting products. So we hedged our bets. That product arrived in January, and we had to pay for it in Q1 of '19. Many of our customers started to push orders out saying, yes, I'm going to take it, but I just need it 1, 2 months later. That correction took place by the end of Q2 '19, so we were really talking about a 2-quarter correction. Until everything came back in balance, we had a bad cash flow quarter in Q1, we had a great cash flow quarter in Q2. And then by the time we got to Q3, everything was back to normal. I think that's what the other end of this looks like. I think it's a quick correction because those inventory levels just aren't going to be too high.

That's great context. In terms of pricing, obviously, we're hearing from a bunch of your suppliers about potential price hikes or price hikes that have already gone through given how tight supply is. I feel like we haven't seen price hikes to this extent -- to this breadth in a very long time. Can you kind of speak to the potential impact to your business? I think you sort of addressed it on your earnings call, but if you can kind of go through how you're thinking about the economic implications for your business, that would be helpful.

Yes. I mean, to the extent that there's price increases to us, those are going to get passed on to our customers. And for us, a little bit of inflation is actually a good thing for our model, right? Typically, this space is one of deflation, right, so we constantly chase that, but we make a margin on a cost. So to the extent that the cost of that part goes up in dollars and cents, then the margin dollars and cents off of that same margin is higher. And we're not adding a lot of OpEx in this growth mode because we are an operating leverage model. So that gives us opportunity. We haven't really seen it in any meaningful way yet, but that gives us opportunity to drive, I think, better leverage as we come out of this as well. So it's a tailwind, not a headwind. Obviously, there's a lot of work that goes into executing price changes, but that's what we do. So we just got to stay very focused on that.

And Chris, the price hikes, are they already kind of going through? Are you executing on some of those price hikes? Or are they mostly still on the come?

We -- I would say they're mostly still to come. There's some that have come through, but many of them have not flowed through yet.

Got it. You spoke to sort of the market share dynamics in your prepared remarks, I think. A little bit through the consolidation that we've seen over the past several years, I think Arrow has been on the winning side of that dynamic. You have about 10% market share in the distribution business per Gartner as of 2019. Can you speak to the aspirations that you have from a market share perspective, whether it be organic or inorganic, when you think about your business over the next couple of years?

Yes. I would say -- I may just answer you slightly differently than the way you asked the question. If -- we've got a chart that if we're there, we could show, and we're going to update it, but it looks at total global distribution. And if you look at Arrow, its main competitors, obviously, Avnet, WPG, WT, those 3 distributors represent, call it, 70% of total global distribution. And then from there, you get into smaller players that are more regional in nature. If you look at Arrow's volume share of those 3 and of the total, it has grown to be more than 1/3 of the 3. So -- and it's about -- I think the last time we looked, it was about 28% to 30% of total global distribution. If you look at our profit, and again, those 3 report, of those -- of the 3 biggies, the 2 As and the Ws, as the way we look at it, we're more than 1/3. We're about 40%, 45% of profitability. So that really speaks to the value-added that we have. Thank you. Steve is rescuing me. So yes, over the last 12 months, there you go, we're 42% of the operating income share on 28% of the volume share of the distributors that report externally. And so we're not quite that big as it relates to total distribution, but this represents about 70% of the total. So really, our focus has been on the value-added side. And what's happening, it's almost like a virtual circle. The more that we invest in engineering and are solving customer problems, the more customers want from us, which means we're growing at a differentiated rate. We're getting an increasing amount of the volume share, and suppliers then say, "Hey, I really want to be part of that more rapid growth, so I'm going to move more of my business to Arrow." So that's really the motion. The motion is about focusing on being first in a customer's door, acquiring customers at a faster rate and giving them differentiated services, so they want to do more with us. And ultimately, that's how we get the volume share. So it's not a volume share objective. It's a solving customer's problems objective that ultimately results in a higher volume share.

Got it. That's super helpful. As you pointed out, at the top, Chris, we're seeing continued consolidation of the semiconductor supplier industry. Quite a few big deals announced last year. We recently heard about the Renesas dialogue pending deal a couple of days ago. What are your thoughts on how consolidation continues to evolve and how that impacts your business? You also have companies like TI who are trying to go more direct to the end customer. Is that a concern for you guys? Or is that -- is this kind of business as usual for Arrow and you know how to navigate through all this? What are your thoughts?

I would say it's largely business as usual. But big picture, distribution has a place in the world of electronics. There's -- the amount of customer fragmentation is increasing, not decreasing. So the ability to efficiently reach a small customer and provide them credit and collect on that credit and distribute to them is something we do really well. So big picture, there's a place for distribution. What we do see happening though is as suppliers continue to consolidate, and we think that's not going to stop anytime soon, suppliers are looking for efficiency, and they're looking for differentiated growth. So within distribution, if we're providing both of those things, right, we'll provide you a very efficient fulfillment engine, but we will also -- if you choose to want those services, we'll provide very focused engineers to drive differentiated growth, then that to us is the winning formula within distribution. So the natural shift from distribution to direct will continue. That's happened since the dawning of time as customers get big, but there's still going to be a need to service that smaller customer. And right now, Arrow is winning and winning, I think, handily in that space, and we're not going to stop. So the gap between us and our competition is large, and we're going to continue to widen that gap. So I think there's a way for us to truly win coming out of this, but we've got to stay very focused.