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

Chris?

Great to be here. Thanks, Matt.

So let's start off, obviously, you've had a few one-on-one sessions I know already, and I'm sure the big question is the whole supply demand imbalance that we've seen actually worsened that have we gotten through into the year here. A lot of questions on inventory, about book-to-bills and demand continuing to hold up. So maybe just update us on, kind of, an overview of what you're seeing or what you've been seeing as up to your earnings?

Yes. I mean, really, it's a continuation of what we talked about when we closed Q1 and gave Q2 guidance, which is, the market is still tight. We see -- we haven't announced book-to-bills in a while just because the numbers really don't make a lot of sense, obviously, with customers ordering out much further than normal. So if you think about our normal patterns, we'd be out a solid quarter to 2 quarters, and we're now 3 quarters plus. So that continues. I think the demand environment remains strong. When you think about Asia having recovered from COVID and Europe and North America starting to recover. I think those demand trends are going to continue. On the supply side, I think we're hearing the same things that others are, which is, hopefully, supply starts to improve sequentially bit by bit starting in Q3. Now as of right now, I would tell you that things are still tight. We don't have as much inventory as we'd like to have. But I think by and large, we're able to help customers keep the wheels moving. And it's one of the things we do. So I would say that we're probably in this for a while in terms of the supply-demand imbalance. And certainly through the end of this year, and we'll see where next year takes us.

Okay. So would you say that conditions have sort of -- they're sort of as bad as they have been, but maybe not getting any worse, because it sounds like you have a little bit of visibility into some incremental supply in the fall.

Yes. I would say that it really hasn't changed much. I think that's a good assessment. So it hasn't gotten worse, and that's good. One of the things that we've seen is that often we'll get a signal from suppliers at the beginning of the quarter. As to how much they'll be able to provide us. And then we're often able to do a little better than that as they find more supply in their systems. And so that's good, and that's part of what we do. It's part of the relationship we have with suppliers. So that was true in Q1 as well. So that's not new news. It's just a continuation of where we are.

Yes. And I know that a lot of suppliers have pointed to very low channel inventories, right, well below normal levels across semis and now even passive components, which hadn't been as tight as they are now. At the same time, some semi suppliers have said that this cycle, they're actually running things a little different where they're running more direct relationships and direct sales and not putting as much inventory in the channel, where it used to be, put it in the channel. And then if you're on allocation, you go to the distributors, right? And it seems a little different is that impacting your business channel? Have you seen that broadly? Or is that just a one-off?

No, it's interesting. I've heard that, too. And frankly, if I were on the supply side of things, I'd say that, too, right? Because when you've got big multinational customer screaming for product, the last thing you want to say is that you're going to focus on the channel. I think the reality is the suppliers in a tough environment, do need to keep the big customers happy. And in some cases, there's political pressure like there is around automotive in Germany, and certainly in the Americas and Japan. So I think there's a truth to that. The other truth, though, is that the channel distribution is the highest profit, highest return route to market that the suppliers have. So I don't think it's certainly not an all or nothing thing. There may be individual decisions that are getting made along the way. But I wouldn't say that we've seen a fundamental change. As I said earlier, if anything, as quarters progress, we tend to do a little better than perhaps was signaled at the beginning of the quarter. And I think that's a positive sign.

Yes. Okay. For sure. And you talked about customers now placing orders well beyond a quarter, 2 quarters plus. How real are those orders? Are they still the right for the customer to cancel at some point so that -- obviously, the concern is when things are overheated like this, you typically end badly. Countering that is that you do have multiple growth drivers happening. But on the other hand, all of a sudden, more supply comes online, then you see cancellations and then it all backs up?

Yes. I mean, that's a possibility. What I would say, though, is let's look at some data points in recent history. If I go back to -- and it obviously wasn't the same conditions as today. But the closest parallel we have is kind of Q4, Q1 of 2018, 2019, where there was a lot of demand, remember, MLCCs were in shortage. And people were ordering pretty hot. And in Q1, things slowed down, we didn't really see orders get canceled. We saw orders get pushed out. So we had a tough Q1 '19 where cash flow wasn't great because we were receiving product that customers had pushed the orders out, but they took the product. I would tell you that at this point, we're not seeing cancellations rise. Certainly, when we get to the point where a customer orders the product and we get to ordering with the supplier. The customer is going to be obligated to take the product. So if they're going to do any adjustments, they'll need to do them in advance of that. And we haven't seen that yet. I think the other thing that's just really important to keep in perspective is, let's not forget, we're coming off a base that was post semi cycle post pandemic. So inventory levels are really, really low at customers. It is hard to see double ordering, but the reality is, I don't think that's widespread at this point. When we receive product, it's shipping out, customers are using it, and new orders are coming in. So as economies are rebounding, and as inventory levels are trying to recover from those super low levels. I think there's a lot of room until we get back into balance. To your point, Matt, there is going to obviously be a correction. But I just can't imagine that it's going to be a multi-quarter correction, given the fact that demand is so widespread, I think it's going to look similar to what we had in early '19.

Okay. And on the -- we're hearing about price hikes, right, across the board. Littlefuse, this morning, talked about multiple price hikes. I'm sure that you're seeing that from a lot of your suppliers and able to pass that through. So what does that do in terms of the economics of your business that there's some inflation. So the revenue sort of boost the revenue growth what about on the profitability side there? And are you able to pass those prices along?

Yes. We definitely will pass-through price increases to the customer, for sure. If anything, it's everything in moderation, right? A little bit of inflation is actually good for our business because this is the only space that I'm aware of where there's deflationary pressure on pricing every year versus, say, if we were distributing industrial cleaning products, there'd be inflationary pressures. So a little bit of inflation is a good thing. We're able to control our costs. Our debt's in very good shape should interest rates adjust. And so I feel good about that. So the pricing is getting passed through. It is helping in the near term. We haven't quantified that, but that is a little bit of what you're seeing on the margin front. But most of what you're seeing on the margin front is really driven by the near-term operating leverage we drive with volume. And then coming behind that, we're going to have more of the design wins that we want during COVID start to have volume pulled on them as Europe and North America recover. So there's -- I think there's more tailwinds in margin going forward than headwinds at this point. So that's a good thing.

Okay. Yes, I do want to touch on margins in both businesses and also talk about the enterprise computing but just on components, again, relative to the end markets, it sounds like you've seen growth and good demand across the board. Are there any areas where things are still weak commercial aerospace, for instance, it sounds like that's starting to come back a little bit.

Yes. Commercial aerospace is a little soft. Medical had a good run during COVID. I think it's a little softer now. But again, we really sell to broader industrial. If you think about just automotive and heavy equipment as a vertical, that's sub 15%. So we -- I think Arrow really looks like the broader economy, and that's why we tend to move with GDP. So I think, as I said, as we see, Europe grew 20% in the first quarter, the Americas grew 10%. And we obviously are seeing growth in the guidance. That's all positive for us.

Okay. And just in terms of the growth, I think some of that growth, a lot of it was organic. And I know you did have some significant share gains, particularly with your largest supplier of TI and that company represents, I guess, at least 20% of your component sales. I know it's a fulfillment only relationship, so different than the relationships you have with other suppliers. But is that -- is there a concern at all about that exposure? And/or maybe concern from a competitive standpoint with other analog suppliers that you do business with?

I think -- so, obviously, we don't talk about individual supplier relationships. So I'll talk more broadly. I mean our role as a distributor is to be, at least in part, the sales force for the supplier. And just like a salesperson that works with inside of Arrow, if they're performing, they're going to do well. And if they're not performing, they're going to be gone. Arrow continues to win business from suppliers because we're driving differentiated growth at the customer level in the way the suppliers want us to do that. Most of our suppliers want us to invest in the engineering, in many cases, dedicated engineering that we have and we continue to add through COVID to help end market customers drive solutions that ultimately drive increased consumption of the suppliers' product. In other cases, they just want us to perform a fulfillment role. And so we have the capability to earn good returns on both models. And we'll continue to make sure that we do business in the way that suppliers want us to do. So no, I think we're winning because we are outperforming in end markets and growing at higher than market rates in those end markets because of the capabilities we have. So it's hard work that we have to continue to earn each day. But I think the reason you see share shift is performance-driven.

Okay. Yes. And indeed, you have had several significant wins in addition to TI. And as you look forward, do you see additional opportunities for that?

Yes. I think, the reality is that as we continue to see supplier consolidation, I think the new norm is you will continue to see consolidation of distribution under those suppliers as they seek to get synergies out of those mergers and acquisitions. So I think this is the new norm. And I -- as a result, if we keep performing well, then yes, I think it is an opportunity. But we -- again, we don't take that for granted. We have to do that every day, and that's our focus.

Yes. Yes. Okay. Okay. And then you could talk about margins earlier, where you've seen some nice margin expansion over the last couple of quarters. And I know you've been targeting 5% plus EBIT margin for components. How are we -- and that makes it a little bit more difficult is the fact that you have a lot more Asia exposure as a percentage of revenue than you did a couple of years ago when you were hitting those margins. So I guess the question is, how do you improve margins in Asia overall, and you think demand creation is part of that. And how do you sustainably keep above or at 5% in maybe throughout a cycle and not just up cycles?

Yes. Great question. And one of the things that we're really pleased with is, even when we look at Asia in isolation, they have shown tremendous improvement in their margins over the last couple of years, to your point, as they add more design activity. But quite frankly, also as they're driving more operating leverage. They've just done a phenomenal job. Now that said, Asia is always going to be lower margins. But it's also a lower tax rate, it's faster turning inventory. So our returns in that business are very good. And returns is obviously what we're driving. Now all that said, Matt, 5% is still the goal in components. And I think we've got line of sight to getting there. As I said earlier, I think we've got more tailwinds and headwinds. So with Asia now kind of in recovery mode, but -- and I really have been there for a few quarters. As the Americas and Europe turn on, that's a tailwind. More design win pull-through on the designs that were done for the West during COVID is a tailwind. Pricing in the near term, yes, we'll take that what we can. We're driving great operating leverage, which is helping margins. And then longer term, we're seeing more and more demand for Arrow to help bigger customers that we normally wouldn't do business with to manage their supply chains. And I think when you look at the current environment where a lot of companies have gotten to the point where they're having difficulties managing the supply chain around the electronic component part of that bill of material think automotive. I think there's increasing need for the kinds of services that Arrow can bring. So that's a longer-term play. But the reality is one thing we do really well is move product and that can be really complicated. And we've got the IT and the warehousing knowledge to do that. So I think that's something that as time marches forward will be another tailwind to the margins or another -- yes, another tailwind on the margins.

So that's a kind of a separate services, kind of, business? Would that be also for customers, where you're selling them components so you basically take over a lot of supply chain as possible...

I think it could be both, but it could also be just one. It might be -- we could very well be sitting in a situation where customers buying direct from suppliers, but they stick us in the middle and pay us a management fee to move the product around. And so that's a higher margin, higher return opportunity.

Okay. And you mentioned demand creation also being a key part of that. Maybe for people that don't know how that works, maybe walk us through the design registration, your right to sell that product, the margin you might guide on that. And how important that is to the relationships and the life cycles and time cycles, et cetera?

Yes. So our customer will ask for quotes to do a Board assembly. And they will provide a specification that they want that Board assembly to meet, whether it's compute power, heat generation connectivity, et cetera, et cetera, right? And so aero and other companies will provide designs in attempt to win that business. And in most cases, we'll provide multiple designs. We'll give the customer alternatives. If Arrow is awarded that business, then over the life of that Board assembly. So I think in the world of electronics, 18 to 24 months kind of life cycle, you -- we will earn roughly 300 to 400 basis points higher gross margin because the customer -- the supplier will pay us that for effectively giving them secure demand on that product over the life of that product. And so that's been part of what Arrow has done for years. We've been very aggressive, far more aggressive than our competitive set on adding engineering capability over the years to do that. And we also have the IT capability where we can do that remotely. So Matt, if you were working on something, our engineers could on a secure pipe, share designs and work with you through the computer. We've got our engineering service centers, where ultimately a field application engineer will show up at your location. And then we've got einfochips, which is a company in India we bought 3 years ago, which does very, very complex engineering, including the writing of software, and if necessary, the designing of chips, to deal with highly complex solutions, largely around industrial IoT, and they can go to prototype. So we can meet the full range of engineering capabilities that small to large customers bring our way, and it's a way that we can make incremental margin.

Okay. And what percentage of your revenue is derived from demand creation?

We haven't disclosed that. There was a comment made a few years ago on one of our earnings calls that roughly 30% of what we do should have a design associated with it. I would tell you that today, we're below that in total. And part of that is because of the cycle correction, part of it is because of COVID, because the design registrations and wins have been at record levels. So that's a really good predictive metric of what's to come. And the fact that our engineers stayed as busy as they did through COVID, I think, is a good indicator that there will be some solid demand pulled on those in the coming quarters.

Okay. Great. Any other things I didn't bring up or worth mentioning on components before we move to enterprise computing?

No, I think that's it from a high level, I would say, obviously, one question, Matt, you didn't ask is what Arrow thinks about our inventory levels right now. And they're a little low. I think ideally, we'd like to see inventory a little higher, $400 million, maybe $500 million higher than where it is. And so in time, we'll get that back. And that's really about us having product available for customers. It's one of the services we provide. So as the supply environment recovers, I think you'll see that investment in inventory recover a bit. But even with that, I think our cash flow prospects are strong as we go forward.

Yes. Well, I guess I would say the follow-up is in theory, your profitability is going to go up, but working capital requirements as well. So how -- so are we still thinking in terms of seasonality in terms of free cash flow dynamics or maybe different this cycle?

Yes. I mean, I think seasonality kind of has gone out the window in the near-term because, again, we're selling what we can get. And it comes in and it goes right back out. I do think that we'll be cash positive. We're not going to be big users of cash even though we're growing a lot right now because the inventory is down. And again, at some point in time, there will be a bit of a rebalance. But again, I think that's going to be over the course of a quarter or 2, and then we'll be back to normal. So I don't think it's an earth-shattering event when it happens.

Okay. Okay. Good. Thanks for bringing that up. So on enterprise computing, that's an area where, over the years, you really evolved from broadline to really focused enterprise solution provider, helping these really higher end VARs that are helping customers in terms of infrastructure, security software. On the top line, really haven't seen much growth recently, partly because of the netted down and maybe partly because of the acceleration to the cloud for the on-prem. But maybe -- but we've seen gross profit dollars improve. And I know ROC has been strong. So maybe just give us an overview of that business and how you are situated now and then we could talk about demand and margins, et cetera?

Yes. No, it's really interesting. That business, if you wind the clock back a little over a year ago, I was really concerned about how that business has performed through COVID because the core premise of our ECS business is the ability to deliver complex data center and edge of network compute environments to CIOs. And that really relies on things like security, which are obviously in high demand right now, data analytics, infrastructure. We can do it in on-prem. We can also do it through cloud. So hybrid environments have become a specialty of ours. But with COVID, we didn't know where it would go. And really, what happened is almost instantaneously, is that with the rush to work from home because we don't sell PCs and smartphones and tablets, but we do sell a product that enable those environments, for example, Citrix, right? And so we did really well because of our ability to rapidly deploy product to build a backbone of those remote work environments. And the business was very resilient through COVID as a result. We're now in a window where what we really started to see in Q1, was that business turned back to more of the traditional core data center edge of network environments. And to your point, as there's more and more SaaS, the sales line is always a goofy thing. That's why we look at OI dollar growth. We had OI dollar growth in Q4, again in Q1. We're guiding it again for Q2. So the business is, I would say, more back to normal. The real point of recovery, though, is ultimately going to depend on when we can get on-premise. There was work to be done 15 months ago that got put on hold. There's been work that's built up, certainly with the amount of news that we're seeing today about cyber attacks. I think the need for security has definitely not abated. And so it's just as soon as we can get back on-premise, that I think we should have some nice tailwinds there.

Yes, for sure. And I mean, are you seeing a pipeline now from your solution provider customers where there...

Yes, the pipeline has remained strong. Again, it's just the ability to get there to be able to execute against it. I would say that Europe is probably a little stronger than the Americas right now, but that's okay. I would expect the Americas to follow. At -- in reality, it's what we've said before multiple times, right? Asia was first in the COVID. The Americas were last into COVID. And I think that's how you're going to see these things recover.

Yes. For sure. And then if you look at a lot of your suppliers, your vendors on the hardware side have talked about their own problems getting supply, right, and pushing that out HPE, a few companies. Are you seeing that? You're obviously seeing that too, right? And are you just working with customers or are you working with management.

There's benefit of it. It's not been too bad for us. Again, remember that in the ECS business, roughly 1/3 of what we sell is hardware because we really are more focused on the software and services side. And in the case of that 1/3 that is hardware. 2/3 of that is storage. So there has been some noise, Matt, but I would not say that it's having a significantly material impact on us at this point.

Okay. Just on that story, you talked about Saas, and we're starting to see a lot of storage as a service on the public clouds now. And all the storage suppliers have talked about an acceleration of their revenue run rates there. When that happens, are you -- do you participate there and a conversion of a customer says, okay, instead of going from hard disk to all flash, we're going to just move half of it to the public cloud and then use NetApp software or pure or whomever. Are you involved in that?

Yes. And again, if you think about our offering today, we go so far as to help deploy some of the public cloud product that we all hear and talk about, right? And the reason is, is that when you're targeting the size of customer that we're targeting, typically, the large suppliers of those cloud offerings do not want the headaches associated with how do I make all that environment work at the customer level. So we're working with our VARs who are working with the end customer to help create those environments. In many, many cases, they're hybrid environments. So there's a piece that will reside on the public cloud. There's a piece that may reside on private cloud for security issues, and there's a piece that's on-prem because of data latency or whatever the issues are. So all of those things woven together create complexity and complexity is our friend because in complexity, there is margin. So...

Yes. Okay. Okay. Great. It looks like we're almost out of time, but that's really been helpful here. Is there anything else we didn't bring up that you wanted to mention?

I would just say, Matt, on the capital allocation front, in near term, no big M&A opportunities. We've obviously focused our cash generation over the last couple of years on both share repurchases and getting debt realigned. I would say that the debt is where it needs to be. It certainly doesn't need to be any lower. We still think there is tremendous value in the stock and evaluate that regularly with outside parties. So Arrow is going to be buyers of its stock as we generate cash in the near term.

Okay. All right. Fair enough. Okay. Thanks so much, Chris. Appreciate it.

All right. Thanks, Matt.

Okay. We'll talk to you soon.