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

Okay. Thanks, everybody, for joining today. My name is Adam Tindle. I cover security software, IT supply chain and connected devices here at Raymond James. Very happy to have the team from Arrow Electronics here today. You probably know Arrow as an industry-leading technology distributor across many different end markets that investors care about. With me from the company, we have CFO, Chris Stansbury; as well as VP of IR, Steve O'Brien. In terms of our format today, Chris is going to take us through a presentation just to -- for those who are perhaps not as familiar or revisiting the story, call it, 10 or 15 minutes or so presentation and then we'll save the remainder for a Q&A fireside. [Operator Instructions] And with that, Chris, thanks again for joining us today. Floor is yours.

Thanks a lot, Adam. Thanks, everybody, for joining today. As Adam said, I'll just walk through an overview of Arrow for those of you that are less familiar and then we can get into Q&A. So Steve's going to flip the slides. Why don't we keep going here? So we've got the safe harbor statement. I think that the key thing is that Arrow sits in a great place, right? We -- we're a distributor, but we're more than that. And we're really about bringing solutions with our customers to market and helping use technology to close the gap that exists around the world today. And so some of the things that you may or may not have heard about, we've done semi-autonomous mobility for a long time, the SAM Car, a former IndyCar driver. You've heard us talk about that a lot. I think the exciting next step there is you will see us later this year sharing some work that we're doing with Sam to help him walk. It was a promise that we made to Sam years ago that we could do that, and he could walk his daughter down the aisle and she's getting married this summer. So some exciting news there. Digitruck, we brought the Internet to kids in orphanages in Sub-Saharan Africa. And then we've done big innovations like working with Unlimited Tomorrow. This is an AI-powered prosthetic company where the AI chip learns the motions of the body and the nerve endings so that as kids grow and they need a new prosthetic, you just pop the chip into the new prosthetic, and it already knows what the body is trying to tell it. And other projects really around the world to bring technology to solutions that [ meet ] problems. We really do a good job of managing complexity. We've got business in 85 countries, 260 sales locations and over 40 fulfillment centers around the globe. We go to the next slide here. And that's, in our components business, 2.5 billion transactions a year. This is my favorite aero nerd fact. I mean that really translates into about 80 transactions a second, 24/7, 365. So we do complexity well. We're located just in the Greater Denver area in Colorado, just under $30 billion in sales and just under 20,000 employees around the globe. We -- we've got about 2/3 of the business in components and 1/3 roughly in our enterprise computing solutions business. And you can see what that looked like last year in terms of operating income and EPS. The business really has been growing in Asia. You can see $9.3 billion in Asia, which is entirely components over the last year, and that's because of share shift, that's also because of growth in the region. And frankly, it's because Asia was really first out of the pandemic in terms of that impacting region mix. And if you look at key milestones in our business, we really started in 1935, right down where the World Trade Center site is. We've done a lot of acquisitions over the years, really in the '80s and '90s to consolidate distribution. We moved to Colorado in 2011. And we've been at the top of Fortune's Most Admired list for 8 years in a row. So we're really proud of that. What do we do? I think this chart shows it well. We don't just distribute product, we will help customers create new ideas and bring them to life. And that's everything from ideation and design to new product introduction. We'll help them make it, right? We'll help them find routes to market. And then we'll help them manage it, whether that's maintenance or it's life extension of the products or it's iterating into the next design. So we've got capabilities to fill all of those gaps. And this engineering stack really speaks to that. We've had our core engineering service centers for years, but we've added digital capabilities. We've added eInfochips and other engineering capabilities. So the engineering stack, the way to read this is, we can serve as many, many small customers, tens of thousands of small customers, through a digital online engineering engagement at the bottom. And then we can deal at the very top with bespoke customers. eInfochips, 75% of its business comes from Fortune 500 customers. And last year, they created over 30 world's firsts in terms of invention. So we've got the engineering stack and we can scale our engineering services to the right size customer given the engagement. If you look at services -- I mean our services really are complex. I won't go through all of these. But unlike any other distributor, we can provide media services and SaaS services to our customers. So AspenCore is a media house that can help with new product introductions. SiliconExpert is the world's largest database on silicon. So as customers are looking for managing the life cycle of their components, so they could be looking for a way to mitigate tariffs. They could be looking for something that helps deal with an end-of-life situation. We can bring that kind of value to our customers. We've talked about engineering supply chain, again, 80 transactions a second. We do this well. So we have customers that buy directly from suppliers coming to us to manage that motion and manage the movement of product because we do it well. We can do integration services, edge of network kinds of capabilities, IT and OT coming together, unlike anybody else. And then obviously, we can provide managed services around not just financial but professional services and whatnot. These are the media properties, and this is really, really interesting. It's -- if you look at what we reach, we reach about 80% of the global engineering community on a regular basis. We have about 15 million monthly visitors with over 50 million page views. And this reach is of huge value to our suppliers and our customers. And quite frankly, it's a way for us to source customers. It's been a big, big -- a vehicle for us to add customers and drive differentiated growth for our suppliers over the last number of years. If you think about the markets we serve -- and I think the key thing I would say is the biggest discrete vertical that we track is transportation, which includes -- says mobility here, that includes automotive but it also includes industrial and rail. And that's sub-15%. So what that really tells you is we are not exposed to any one vertical. There's a broader kind of all other industrial bucket, that's about 50% of our business. And so we don't have any customer bigger than 2% of sales. And as a result, we tend to move with GDP. Our global components business really does service those smaller customers. If you think about total semiconductor consumption globally, the top 10 customers in the world, we don't serve them, consume 40% of all production. We're really focused on the 60%, and that's where we can drive a differentiated profit. The breadth of our customers, as I mentioned earlier, not just from a vertical standpoint, but just more broadly, helps reduce volatility. So if you look at the semiconductor industry, half of what is produced goes into the things that we use every day, the PCs, mobility devices. For Arrow, that exposure is only 10%. And again, that's -- that all other industrial bucket that we're focusing on. About 2/3 -- or sorry, about 3/4 of what we sell is semiconductors. The balance is PEMCO as well as computer products and memory. And in our enterprise computing solutions business, this is a business that we've really focused very hard over the years at pivoting to hybrid and multi-cloud environments. And that's bode well for us. So we have a business today that is 65% software and services. Hardware is driven by storage. But really, the hardware we sell is part of a solution, it's not hardware-led. We're dealing with value-added resellers and customers. It's a 2-tier selling motion that need our help to develop complex solutions to bring hybrid and multi-cloud environments to life. And part of that is driven by ArrowSphere, which is a proprietary tool that we've built, which really allows our value-added resellers to act as managed service providers. They can do their provisioning of cloud services, their subscription management, their metering and billing, reporting analytics, et cetera, for the customer. And ArrowSphere today is being used very heavily in Europe to the point where a number of cellular providers are using ArrowSphere to drive their sale and deployment of cloud services over their networks. So this is a great growth opportunity for Arrow. If you look at the cash flow on our business, I mean, this has really been proven over the last couple of years, we do generate very strong countercyclical cash flow. If you start on the right, you can see that when we have components growth that gets into double-digit territory, our trailing 12-month cash flow declines. If you look at over time, over the last 10 years, our cash flow from operations is just under 125% of GAAP income, and it's about 90% of non-GAAP income. Over the last 2 years, we've generated $2 billion in cash, and that really speaks to the countercyclicality. If you look at how we use that cash, the first priority is organic investment. So it's those engineering and service capabilities I've talked about. We will also look at accretive M&A, although the consolidation opportunities are largely complete. It would really be around services. There's nothing imminent right now. And then the balance is used to return cash to shareholders through buybacks. Now over the last couple of years, we've done that as well as reduced debt. Our debt is in great shape right now. We've got a lot of balance sheet capacity to fund the next wave of growth. But as I mentioned, we've returned a lot to shareholders over the last 5 years, about $1.5 billion, which is 50% of our cash flow from operations and about a 20% reduction in shares. So that's the whirlwind presentation, Adam. It -- why don't we jump into Q&A? I'm sure there's some tough questions you got for me today.

Always, always. Well done, helpful overview. I think it's helpful for the discussion to maybe kind of bucket it in 2 different areas. So we'll tackle components and then we'll get into computing. And guys, keep the questions coming. I already have a couple loaded up. Please continue to send those over. So Chris, just at a high level, starting in the components business, you obviously have a good feel for semi cycles and what's going on in the semiconductor end markets. I think this last quarter, Asia had outperformed Americas in a bigger way and also Europe. So Asia really coming up, but Western region is still lagging. So maybe just you can start updating us with the pace of business with some color by region and how this has changed as we sit here on March 2.

Yes. So our Q1 guide, and I'd say that's held true as we kind of move through the quarter, was for continued strong growth in Asia. Good, solid double-digit growth in EMEA, and that continues. And some more modest growth in the Americas, and we're seeing that as well. So I think just as we saw Asia go into COVID first, followed by EMEA, followed by the Americas, that's really how we're seeing it come out. I would say if you look at our order book and backlog, those trends are strong in all regions. And so as we finish Q1 and look into Q2, I think we're definitely on the road to recovery. Keep in mind that some of the Asia growth is driven by share shift last year, and we're obviously lapping that for the -- certainly the first couple of quarters this year. But even excluding that, that market has remained strong. So pretty much the motion that we saw in Q4 starting to happen is what we're seeing in Q1, and then as I look at backlog, further out.

Any nuances to this year from a timing perspective? I know Chinese New Year was a little bit different timing. So just curious how the start of this year compares to previous years.

The timing is a little different. I think the bigger difference as it relates to the start of this year is unlike anything any of us have ever lived through, we're turning the lights back on following a semi-cycle correction that was followed by a pandemic. And so we've got really lean inventories at customers. And as a result, I think that's why you're seeing order books doing what they're doing. I mean we're seeing -- and we mentioned this on our earnings call for year-end. Typically, we'll see order activity a quarter out, maybe a little longer than that. We're seeing 2 quarters out. Customers are getting their place in line because they want to make sure they've got access to products. So that gives us a good signal of what's coming, and it looks strong.

Yes. And I wanted to ask a little bit more on inventory levels. That's an important topic for investors because the view is demand is still strong and yet we haven't been able to build inventory. So maybe this could last for a little bit longer. So just touch on how you see current inventory levels at customers? How has the pace of restocking been trending? How long do you think we'll see tight supply conditions?

Yes. So inventory levels are low. Again, it's postcycle, postpandemic, right? Levels and customers are definitely sitting on less than they'd like. We, like you, hear about shortages. I think the most noise is around automotive. For us, the products that go into Tier 1 automotive were not distributing. And in many cases, those products are very specific to one manufacturer. So they're very tied to a handful of suppliers that have to make the parts specifically for them. The customers we serve are buying complex parts, but they're used in multiple end use cases. And so we can smooth out some of those bumps for our customers. But there are still shortages. We're still able to, in some cases, sell more than we're able to get. But I wouldn't say it's worsening. I'd say it's pretty much what we saw at the end of the year. It's not across all suppliers. It's certainly more isolated to those suppliers that don't have their own manufacturing capabilities, their own fabs. How long? That's a tougher question. Just that -- what we're hearing and then conversations I've had with some of our CFO partners on the supply side, I think we're looking at a 2 to 3 quarter kind of rebalancing here. I don't think it's going to be prolonged.

Yes. That's helpful. And I had an investor question on auto, so I think you tackled that one. But on this point of shortages and demand outpacing supply, we get some questions on inflation. It's an increasingly relevant theme, I think, across all industries, but tech, in particular, is typically used to deflation. So maybe you could take a second to perhaps touch on what potential inflation could mean for a tech distributor. How would it flow through the model?

Yes. I mean inflation is like a breath of fresh air, right? I mean it's -- because to your point, we're usually dealing with deflation, that's probably the biggest headwind that we face in electronics distribution. We've got a lot of tailwinds in terms of being in the right space at the right time. But on pricing, that's the hard part, right? Industrial supplies go up in price every year, electronic components tend to do the opposite. So in the current environment, as suppliers raise prices, we will pass that along to customers. And because we make a margin, a percent margin on a dollar cost, a higher dollar cost means a higher dollar gross profit, and that flows through. So pricing is good for us. It's obviously a lot of work to make sure that those prices get deployed properly, but we're focused on that, and we'll handle it as it comes through.

And what's the typical lag time? I'd imagine that some customers have some aspect of contractual pricing. I don't know if there's any period of time where it might be a headwind near term and a tailwind long term, maybe just the lag between pricing...

Anything that would be contractual either has the option to change pricing if suppliers raise the prices to us. Or if it doesn't, it's very, very short term, so it's not something you'd really see. I'd say the bigger operational headache for us is if a supplier gives us a very short period of time to raise prices, that's -- that causes more stress on the organization. But again, it's what we do. So we -- we're geared up for that.

And in terms of the macro environment to -- in component distribution, M&A at the supplier level seems like a constant at this point, and has been a relatively good thing for Arrow compared to competitors, but it's accelerating again here recently. So I was thinking about asking this question in terms of perhaps the similarities or differences to the cycle of Xilinx, Maxim, ADI versus ADI Linear and the others a few years back where it resulted in a bunch of exclusive deals that many went your way.

Yes. I think it's just more of the same. I think -- when we went through that cycle 3 years ago, that was a new a new thing, right? The industry had seen very little in the way of exclusivity. And I think we're going to see more of it. I mean just by the numbers, as suppliers continue to consolidate, by definition, you will end up with exclusive relationships. And you'll end up with competing product lines in one distributor as a result, as the supplier universe gets smaller, fewer, bigger suppliers. So I think we're seeing that this is becoming more of a permanent trend. I think what's incumbent on us to continue to drive the differentiated growth and the service offerings that can help with that differentiated growth that I talked about, we've been very focused even through COVID of continuing to add engineers and keep our lead, which is sizable on our capabilities and our ability to drive growth above market. So how all this sorts itself out in the end? Obviously, none of us know. But I think we've been very focused on continuing to do what's worked for us and our suppliers. And hopefully, that results in more good news for Arrow going forward.

And one of your major suppliers decided to move to a consignment model. Maybe just for those that are not familiar, recap what that means, talk about the adjustments you had to make internally to support that tailwind to you. And is that something that you think you could continue to scale if others decide to move that direction?

Yes. I mean consignment in itself is good, right, because it reduces the working capital load on Arrow. It becomes more of a receivables and a payables working capital model than one that also includes inventory. So if you think about today, we've got a cash conversion cycle that's in the low 40-day window. Our payables, we're paying for product before we're receiving from customers. And so if you take the inventory out of that equation, it helps a lot. So yes, there was a supplier that did that. They don't pay for demand creation. So that's how we're able to actually earn a good return is -- and maybe lower margin, but the investment requirement on the working capital side is a lot less.

And I had an investor question kind of along these lines. There's a view that entering into that relationship could ultimately hurt other supplier relationships that Arrow has. I think kind of referring to does ADI rethink their strategy, for example, given how large the other supplier has become as a percent of components. So just wanting you to potentially -- however you want to address that question, how you thought about getting into that consignment relationship. And why or why not it would lead to potential negative repercussions with other suppliers?

Yes. Look, I don't want to talk about specific supplier relationships, but I will tell you this. If I were selling against Arrow, I would say exactly the same thing. So kudos to those who are suggesting it. That said, ultimately, it's going to come down to capabilities and are we performing. And the answer is we're performing, and we continue to perform and we continue to invest while those that are suggesting this could be an issue are not. So that's ultimately the choice that our suppliers have to make. And if we're doing our job, we're going to make that a tough decision, right? I do think, though, the point that I made earlier is an important one, which is whether it's now or later, with continued consolidation, there's going to be more and more of these collision points going forward. And justifying multiple distributors so that those collision points don't exist is not going to be possible as the universe continues to consolidate. So I think it really does, longer term, come down to capabilities and giving the suppliers what they need to support their strategies, and we've got to keep doing that.

E-mailed question from an investor. Will potentially more exclusive deals hurt margins as distributors bid for the big contracts? So maybe you could just talk about trade-off in margins and how that's...

Yes. There will definitely be negotiations that take place as suppliers consolidate, and suppliers will use that consolidated power accordingly, and you would expect them to. The flip side is that in addition to the services and the things that we can wrap around new volume engagements that are margin accretive to help offset that, the biggest single driver in a distributor is operating leverage. And so depending on the model, depending on what the margin commitment is from the supplier and the agreement with Arrow as to how much we're putting into engineering, the -- those pieces aside, every incremental dollar that we sell comes with very little OpEx. And so just like the suppliers are consolidating amongst themselves, as they consolidate with distribution, distribution has significant opportunity to drive operating leverage. And look, even in a non kind of consolidation mode, you could see that operating leverage really flow through Arrow in Q4, and you'll see it again in Q1 as we grow. So...

Yes. And good questions, guys. Keep them coming, please. Chris, on the topic of margins and components, it -- that business has operated at a 5% operating margin in the past. You've hinted out the potential to get back to that level. Maybe just touch on the timing and key drivers to that.

Yes. It's -- I already touched on operating leverage. That's the first thing you'll see. You'll see geo mix continue to improve over the year as Europe and North America turn on. That's beneficial. You'll see more impact at the GP line as those regions turn back on and more customers are buying through design wins. Our services portfolio really helped us through the pandemic. I think that's why you didn't see the margin erosion that you might have otherwise expected in that environment. And that will benefit us. In terms of timing, tough to call. I will definitely -- I will commit to the fact that you will continue to see margin progression through the year. I would like -- internally, I'm pushing the team to see if we can exit the year at or very close to 5%. We'll see if we can get there. That's tough -- a tough hurdle. But you will definitely see margin accretion as we move through the year this year. And as a result, if it's not by the end of the year, Adam, I'd say, certainly, by next year, you'll see us back at 5%.

Got it. We've got about 10 minutes left, so I want to make sure to save some time to talk about the computing business. And maybe I'll just lead with an audience question. You talked about ArrowSphere being a proprietary tool. What is proprietary about it? What do competitors have?

I would say all of our competitors have varying degrees of marketplaces, if you will, that you can buy product. I would say that there's really -- we've done a lot of work ourselves. We've also hired some experts to look at what's on the landscape. I would say that there's probably only one other -- I won't name it, but there's probably one other tool out there that is close to what we have, but the capabilities beyond that aren't really that strong. So what's proprietary about it is the fact that not only do we have the broad line card, but that it will do all the things that I said. It will do the metering and the billing and the provisioning and the contract administration. And it allows the customer to act in a more kind of self-service manner. And so it's a very efficient way to deploy. And we continue to develop that tool. So we're now many years into it. We spent -- invested a lot into it as part of our regular operating model, and we'll continue to do so. It's not an easy thing to pick up and replicate.

And maybe that's a good dovetail into just the broader competitive environment for the computing business. Maybe just touch on who the main competitors are and how you see that evolving over the next few years.

Yes. I mean the big players in the data center, I mean, obviously, we've got ATEC that has the business that they bought from Avnet. I would say that, that business is not as evolved as ours in terms of its capabilities. There's a lot of investment that's required there. And they've said they will do that. I mean they're very good operators. We've got to watch them. Ingram, obviously, no longer under Chinese ownership, is out there. And they have -- they've done some acquisition activity and have some strong offerings. And obviously, SYNNEX with the spin-off, our competitor. So the landscape is a tough landscape, but again, the position that we hold, I think, is a unique one. It gets tougher and tougher. But I'm pleased with how that business adapted through COVID. And I'm equally pleased with how quickly it's kind of -- as we get to the end of COVID, it's pivoting back to what it does well, in terms of these complex solutions. And that's really what we started to see in terms of the mix in Q4 and again in the guide for Q1.

Yes. And maybe we can talk a little bit more about the demand environment because I know investors are particularly interested in the data center business. Demand was understandably subdued for most of the year, couldn't even get on-premise for -- to install some of these data center projects. So would just be curious what your observations are coming out of prior down cycles in this business and what it could mean as investors think about 2021. Is there a case to be made for catch-up as projects were pushed? And are you seeing that?

For sure. Yes. We've definitely seen that in the past, right? When there's a downturn, all companies pull back on the amount of IT spend that they're doing it, that definitely follows a cycle. So as we enter a growth spurt, particularly one that is following a year of inability to be on-premise to do work in the data center -- I mean I know our CIO has work that he wants to get done in the data center as soon as he can have people back in our building. So some of that is definitely pent up, whether it's in the core data center, whether it's in edge of network environments. And so there's the natural work that would have come that the CIOs want to do, but there's also some catch-up work. So I feel good about where we are as we get kind of to mid- to late Q2 when we expect Europe will start relaxing a lot of its restrictions as well as North America. I think that will be added -- an added boost to our growth in that business.

Yes, yes. I had an e-mailed question that goes back to components just for a second. One of your other competitors has sort of a hybrid model between core and specialty distribution in components. Would you consider a model like that? Why or why not?

I'm not sure I'm following the base of that -- the question. What I would say is this, is we -- our core business, we're going to protect and we're going to protect it aggressively. And that's something that -- that's the foundation of what Arrow is. The specialties that we're bringing to market, I would say, are less about distribution and more about services that are wrappers around that core business. And so that strategy has been a long-standing one as you saw us build out digital, you saw us add more in engineering, you saw us buy eInfochips. And now it's expanding into media and shortage management and end-of-life management and supply chain management. And so I think you'll continue -- there's enormous growth opportunities organically there, and I think you'll continue to see us build and add capabilities. Because remember, when you're selling a lot of these services, you're not selling them to Tier 2 and Tier 3 customers. You're selling them to Tier 1 customers you otherwise wouldn't engage with. And when they realize -- so they start with one service, and they realize you've got these others, they tend to drag into those relationships. And so that's where you're going to continue to see us focus, and that's why we're able to drive the differentiated growth for the suppliers that we are. And so it's working. I don't think you'll see us change that right now.

Okay. Yes, I think it was a nod to specialty/catalog distribution, TTI, Mouser, Digi-Key.

Got it. Yes. No. Those -- just on those, those guys do that really, really well. And so to try to go compete there, I think we've got better places to compete than that right now.

Got it. Just a couple of minutes left. I do want to touch on capital allocation. You showed that great slide with cash flow. I think investors understand the model. Maybe just talk about near-term dynamics. You generated a lot of cash last year. Model's still working. But what can investors anticipate for the cadence of cash flow this year? I think you've said that could be positive despite growth picking up, so maybe just touch on that dynamic.

Yes. I would expect that cash flow will still be positive for this year. Again, we've gotten, I think, smarter about how we manage our working capital. And I -- while I expect there will be investments, we're going to work really hard to keep things like percent current on AR as tight as we can keep it and a lot of the benefits that we've earned over the last couple of years trying to hold those. The -- while cash flow will be less than last year, I think that our buybacks could look a lot like last year because the difference is we don't need to reduce debt any further. I think our debt is in great shape. It gives us lots of gunpowder for growth here. And so the cash that we generate, a little bit will go to CapEx and the balance will go to buybacks.

Good. Well, we've only got 1 minute left. It's been a great discussion. I know we covered a lot of topics always with you. So I definitely appreciate that, and I appreciate you attending. Maybe just bring us home with some closing thoughts. What's the key message that you want to resonate with investors as they think about Arrow in 2021 and beyond?

Yes. Thanks, Adam. I would say this, that there was a lot of questions about whether the strategy was going to work, whether it was resilient. And I think moving through a cycle, followed by a pandemic, if anything, the gaps between us and the competition widened. So the strategy is sound. The business can generate enormous cash flow in a downturn as we get bigger, which it did. I think the key thing is we've now -- gets right back to the question you asked earlier. We've got to prove that we can get margins back up as we move through a complete cycle, and I believe we're going to do that. And I think when we've done that and hopefully continue to take some share along the way, I think what investors will see out of Arrow is very different than what they will see out of our competitive set.

Good. Well, that's a great place to leave it. Thanks, again, Chris. Helpful discussion. Thanks, everybody, for joining today, and we'll leave it there.

Thanks a lot.