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

Hi. Good morning, everyone. Thanks for joining us on day 2 of our global technology conference. This year, like last year, it's a virtual setting. But hopefully, in a few months, things will be more back to normal and maybe next year, we can all meet face-to-face. But for those of you who don't know, my name is Ruplu Bhattacharya, and I'm part of the IT hardware and technology supply chain team, equity research team at Bank of America. Today we're honored to have Chris Stansbury here, the CFO of Arrow Electronics. As you know, Arrow is one of the largest distributors in the world. About 70% of their revenues is from components, so things like semiconductors and passive. And then just under 30% of revenues is from the ECS segment, the Enterprise Computing Solutions segment, where they provide very complex data center solutions. Chris has been with Arrow for -- since 2014. And he's got a lot of industry experience even prior to Arrow. He was with HP and then prior to that, he was with PepsiCo. So he is an industry veteran, and so we are really likely to have him today. So Chris, thanks so much for joining us today.

Thanks, Ruplu. Great to be here.

Great. So we have a lot to talk about, but maybe what I'll start with is the most recent reported quarter, your revenues had strong growth partly because of easy compares, but the economy is reopening as well. So maybe just give us your thoughts on the sustainability of revenue growth at this point in the cycle?

Yes. It's interesting. We're getting a lot of questions on that, obviously, with the supply and demand imbalance right now. And as we look near-term over the balance of the year, I don't think we see either one of those things kind of coming back into balance. I don't think we're going to see demand slow down. And really, that's driven by the fact that Asia is largely through the pandemic from an economic recovery standpoint, their economies are strong. And as evidenced by our Q1, we had 20% growth in EMEA. 10% in the Americas. And I think that's going to continue as the West comes back to life economically, and people are returning to work. So I think, certainly, as we look through the balance of this year, I think the demand environment will remain strong because the stimulus worked. We've got a lot of businesses that survived and they're getting back to business.

Yes. No, that makes sense. So I want to touch on both of these things, both on the supply side as well as on the demand side. So maybe on the supply shortages, maybe can you talk about how concerned are you about semiconductor shortages? And which parts are actually in short supply? How are lead times trending? So any thoughts on the component side?

Yes. When we started going into the shortage environment back in Q1, it was really limited to semis and even a basket within semis. MCUs were talked about a lot. I would say at this point, it's really spread beyond semis. We're seeing shortages in connectors as well, our PEMCO, Passive, Electro-mechanical products as well. The good news is it's not getting worse. So I would say that while lead times are extended, backlog is out many quarters now, which is a lot further than typical. The good news is I don't see that trend accelerating. I think it's stabilized. And what we're hearing is, we haven't really seen it yet, but what we're hearing is that sequentially, the supply environment should start to get better bit by bit starting in Q3. So I don't think we're going to be in equilibrium by the end of the year necessarily, but I do think we're going to start to see some supply recovery as we move into the second half.

Got it. And maybe what I want to also address at this point is, how do you see your inventory spending as well as inventory in the supply chain? Because some investors are concerned that in an environment like this, people tend to over order, right? Your customers might be ordering directly from the suppliers as well as from you. So can you talk about your view of inventory at yourself, at your customers and do you think that how are turns versus -- are they where you would think they should be at this point in the cycle?

Yes. I mean I think the turn environment is what you would expect in a shortage environment. I think that said, inventory is all low and I think what we need to remember something that David West who runs our components business has been reminding all of us internally as, we are still not back to 2018 levels and remember -- in '19, we had a semi cycle correction. So everyone reduced inventories and that was about to enter recovery when we were hit with COVID and so then inventories were reduced again. So well, I'm sure there's some level of attempts to double order. The reality is right now when Arrow receives product on the dock, it doesn't stick around long. It goes right back out the door because customers need it to be in production today. So I'm not too worried about double ordering impacting the business in the near term. I think that becomes more of a longer-term thing. But the good news there is that I think we're going to see the capacity coming in time for customers to adjust. In other words unlike past cycles were the supplier environment was far more decentralized, the suppliers many of them had their own fabs. Today the addition of that capacity is far more centralized and I think logical. So you -- I don't think we're going to see a big massive increase in capacity that all of a sudden floods the market and then customers have to adjust at that point. So I think because of the slow build of the supply, I think because of the low current inventory environment, it gives customers a chance to adjust and move forward in time. And hopefully, that's what they'll do. From an Arrow standpoint, we are light on inventory versus where we would like to be, probably $400 million, maybe $500 million or so in inventory. So when we can build more we will, but I don't think it's not a massive increase that we need. It's just more getting that level back up a bit so that we can meet the availability requirements for customers which is part of what we do.

Got it. And you said things might improve starting maybe the next quarter. But I mean, do you think the shortages and the lead times remain extended going into next year?

There's -- I think that's the consensus view right now, yes, is that we're not going to see things normalize until sometime next year. I think that's harder to predict. But certainly, I think it will get a little better, but I still think we're going to see extended lead times as we close out the year.

Got it. And maybe the last question on this. In terms of shortages on the ECS side, is your revenue impacted because of not being able to get any product from suppliers? Or what's the situation on that side of the business?

We've heard of issues. I know there's been a few delays, but nothing of major consequence to Arrow at this point. Again, you laid out really well the mix of our business between components and enterprise computing at the beginning. But within that 30% that's enterprise computing, only 1/3 is hardware. And so -- and 2/3 of that is really storage product. So our exposure to hardware is far less than...

Right. Right. Got it. Okay. Maybe now turning to the demand side. Maybe can you talk about what you're seeing in terms of demand by vertical or by region and also by the size of customer? What are you seeing in small business and enterprise demand?

Yes. So in the enterprise segment, we're seeing strong growth in EMEA. We're seeing slightly softer growth in the Americas, which isn't surprising given the way COVID rolled around the world, obviously, starting in Asia, then EMEA, then the Americas. The good news is, is that what we're really starting to see is a return to the mix that benefits Arrow. So when we went into COVID, my biggest concern for Arrow, frankly, was the ECS business because so much of what we do relies on being in the data center or the edge of network dealing with complex integrations of hardware, software, cloud product, hybrid environment. And the inability to be on-premise could have really thrown a curveball to that business. But what we found is the business was very resilient because of our ability to deploy on very large-scale remote work product. So we sold a lot of virtualization product through COVID. It kind of plays with the P&L a bit because that's lower margin, but it gave us some great underlying income. When we got into Q1, we really started to see that mix return to that more complex solution kind of mix that arrow is known for. And that's continuing. That's the good news. The bad news is we're still not able to get on-premise to the extent that we'd like. So we feel that there's strong backlog in that business. There's projects that got delayed 15 months ago when COVID hit. And there's new work that has come in that needs to be done a lot of it around things like security. You think about just the concerns over the hacking and whatnot that's going on. So there's good pent-up demand there. It's just getting back on-premise. And that's happening slowly, but we would expect more when we get deeper into Q3 in Europe.

Got it. You mentioned a couple of things. Maybe I want to touch on them a little bit. So last year, from what I remember, even though there was this COVID environment, you still had pretty good design wins. When do those roll in? I mean, how long does it take for them to roll in? And when should we see them impacting the P&L? Like you said, there were some projects that were delayed. So we see them coming in towards the second half of this year?

Yes. It's -- that's exactly right, Ruplu. So we had really high levels of design activity, record levels in some quarters through COVID, which to us was a very strong signal that unlike the financial crisis, 10-plus ago, we're not seeing customers say, I'm concerned about tomorrow. They kept designing. So they were thinking about tomorrow. That activity was global. So we have seen some of that pull-through in Asia as Asia has recovered, our Asia margins are at record levels for Asia right now. But as the West turns back on, we'll see a lot more of those pull-through. So big picture, when you look at our margin profile and how that plays out, I think there's far more tailwinds than headwinds to our margin right now. Obviously, in the near term, there's some pricing benefit. But the design wins will impact GP, more mix from EMEA and North America will impact the GP. We're driving operating leverage with higher volumes, which is obviously benefiting OI in addition to the 2 things I just mentioned. And then we're obviously doing more work around helping bigger customers manage their supply chains as that gets more and more complicated, and that's a higher-margin opportunity for us. So I think we sit in a really good place right now, and we've just got to stay focused on execution.

That makes sense. You talked about pricing. Maybe the question that we keep getting is, is an inflationary environment, is that positive or negative for Arrow? I mean, does that benefit you when prices are going up? And how are your contracts structured? Are you able to pass price increases from suppliers on to your customers? And so just how do you see pricing trending in ECS and components and this inflationary environment, how does that impact you?

Yes. I mean, pricing is good. So everything in moderation, right, a little bit of inflation for Arrow is a good thing because we sit in the space where the product, the underlying product that we distribute every year is deflationary in value, right, as new and new technologies come to market, the older technologies reduce in price. So that's a headwind that our industry has -- just faces and has to manage. So a little bit of inflation shores that up because we are able to pass-through any price increases, and we make a margin on a cost. So if that cost goes up, then that gives us a little more dollar profit as we pass that through. So, high inflation doesn't help anybody because ultimately, that will impact the demand environment. But a little bit of inflation is a good thing, and we're seeing some of that start to flow through the model, I would say, primarily in components, but certainly, as component costs start to impact hardware costs, we'll see some in ECS as well.

Got it. I want to ask a general question about the industry. On one hand, you've got suppliers. And I want to ask 2 things about them. One is you've seen TI consolidate to you basically as their primary distributor. But we've also heard of some suppliers in this supply-constrained environment going direct. So I mean, can you help us understand what's happening? I mean, are you seeing suppliers going more direct? And at the same time, do you think there'll be more consolidation and what are the things that you're doing that helps you gain business? Like you're winning against your competitors. So what are some of the things that differentiate you and your offering?

Sure. So if I -- let me deal with the direct thing first. Certainly, if I were a supplier, I would want to be signaling to my largest customers that they're my priority, right? And I think we've seen the politicization of the automotive industry globally, right? So goes, automotive, so goes Germany, right? And as an example. So I think the need to make sure that those bigger customers are serviced is something that any supplier is going to take very seriously. That said, the highest profit route to market for a supplier is through distribution. The margins are higher. We're extending all the credit. We're managing the working capital and having to finance that. So the returns through distribution are higher. So Arrow hasn't really seen a shift away as -- in terms of suppliers taking more direct because it's really more, I would say, a balancing game. They want distribution. They need distribution to efficiently reach the customer that we reach, but it also happens to be better profits and returns. As it relates to the kind of industry structure, I think consolidation is the new norm. We're going to continue to see suppliers merge with each other. I think 5 years from now, there'll be fewer suppliers than there are today as they seek to drive additional scale. And what is happening and what has started to happen in distribution is following that. I think you'll continue to see suppliers look for synergies and efficiencies when they do merge, and distribution will be part of that. Now for Arrow, the way that we've been winning is we've made investments in capabilities, whether that be in digital or engineering, et cetera, that is giving us the ability to grow faster than market. And in today's world, that's what the suppliers are looking for. There's less and less benefit in terms of multiple distribution in terms of trying to extract margin. It's really about who's going to give me differentiated growth. And so Arrow has been very focused on that. We have added a lot of resources. We continue to add a lot of resources, but do that in a very efficient way. And as a result, we've been the beneficiary of that consolidation. So it's nothing we take for granted. We've got to stay very focused on that, and we are.

And one of the things that I think it's important for investors to understand is that you're very good at -- you earn a good return even on fulfillment business, right? So primarily, TI is a fulfillment business, but that's actually a good business for you. So can you talk about how you're able to manage that and make it a profitable business?

Sure. I mean, Arrow is known for our engineering capabilities and many, many, many of our suppliers want us to continue to invest in that engineering capability and in some cases, to provide dedicated engineers to help engineer their product into end solutions. Well, I don't want to talk about specific suppliers. Yes, there are -- there's an example of a supplier that wants us to just do fulfillment. And in that case, I think the key is, that arrow is very focused on going to market the way suppliers want to go to market. And so that's a very efficient model. There's no engineering dedicated when a supplier just wants us to do fulfillment. We're going to do the activities around the fulfillment and only that. And we can do that and earn a good return. And that's really how we look at it. It's margin is obviously important and margin can drive returns. But the working capital and balance sheet side of it also comes into play. And again, across suppliers, there's multiple different ways of going to market. Some suppliers own the inventory that sits in our warehouses and we do the receivables and payables. So it's really looking at both the P&L and the balance sheet implications to make sure that we're driving accretive returns. And if the model works, then we're going to pursue it.

Got it. Got it. I want to ask you a question about 2 secular themes that are impacting the industry. Like a lot of companies are moving to the cloud and more so to a hybrid cloud environment. So how has that impacted your business model? How have you had to change your business operations for that? And the second thing is as a service. So more and more companies, HPE, for example, has said that eventually, they'll go to a complete as a service model. So how has that impacted your business as well?

Yes. It's a great question. I came to Arrow in 2014, and there was the beginnings of a lot of noise around the shift to cloud at that point and they persisted for many years. And our hypothesis at that point, and it's kind of proven to be true is that the world was going to end up in a hybrid place. Not everything was going to move to public cloud. And that was because of scale efficiencies, data latency and just protecting really important data. And so what's evolved is exactly what you said. It is hybrid. And it's not just hybrid in terms of on-prem and cloud. It can be hybrid in terms of multi-cloud environment. So I'm going to have some of my operations be on premise. Some are going to sit in a public cloud. Some are going to sit in a company-owned cloud that allows me to manage my data, the most efficient way that I would like to do. And so that complexity, especially when you start layering on security and data analytics, that's our friend. That's why Arrow has been able to hold the high ground in that space in terms of complex solution offerings, working with our VARs. And so as more and more suppliers are talking about as a service, that fits right into that model. And as I said earlier, only 30% of what we sell in that business is actually hardware. So we've already made a lot of that shift, and it's something that we do well. So we're excited about it. Now the way that impacts the P&L is a little odd because we don't report gross billings. We report net sales. And a lot of those as a service offerings, cloud offerings, under agency accounting, your sales line is diluted and your GP margin actually looks a little better. So we really encourage people to focus on OI dollar growth, which is how we measure ourselves, and we had growth in Q4 and again in Q1. So goals for that to continue.

Got it. I want to move a little bit into things that impact your -- the financial model, the P&L and the balance sheet. But before that, just 2 more questions. When you were talking about the demand environment, I don't know if you answered this. Can you just talk about what's happening in the end markets, like what's happening in aerospace, what's happening in different verticals? And also on the ECS side, how is demand for storage trending? I mean, just any thoughts you can give on the demand environment.

Yes. Again, I would say, on the ECS side, we're starting to see a mix shift back to the more complex solution-oriented environment. So we are seeing more sales of software product around things like security. Storage will be up or down in any given quarter, servers are relatively small. But again, I think we're sorting out right now the market is sorting out when we can get back on-premise. So I don't put a lot of weight in what we're seeing very near-term in that business. In the case of components, our biggest tracked discrete vertical is transportation. So that's automotive and heavy equipment, and that's sub 15%. Beyond that, you get into aerospace and defense, medical, whatnot. I would say commercial aerospace is soft. Medical devices is post COVID post kind of ventilator builds is a little soft, but everything else is strong. Half of our business is broader industrial. And that's really what's driving the growth along with automotive communications, all the other verticals. So for the most part, it's pretty solid growth across the board.

Got it. Just wanted to mention for the attendees who are attending the call today. There should be a window in your interface. Again, if you have a question, please feel free to type it in. I'll see it and I can convey it to Chris. So happy to take your questions as well. Maybe, Chris, one more industry question. The Synnex, Tech Data merger, any thoughts on that? Does that -- how does that impact the industry and impact Arrow?

I would say in the near term, it provides us an opportunity because anytime, obviously, 2 companies are coming together, it creates a level of confusion and work. So we're very focused on that. Again, we hold the high ground. We need to maintain that. We feel good about our ability to do so. We've got one of the strongest digital platforms in that space in Aerosphere in terms of our ability to deploy product remotely. And so we're going to stay very focused on that. But again, I think the consolidation in that space is expected. But because of the special slice of that industry that we play in, we feel good about where we sit right now.

Got it. Now I want to move more into the financial details. When we think about margins, let's talk about both the components and ECS segments. You have a long-term target of getting to 5% operating margin for components. How should we think about that in this constrained environment? Do you think you will see a gradual progression? Or is it more of a step function change? And also, on the ECS side, you guys -- you've talked about how there's a mix shift to more netted down items. So again, can you just talk about your thoughts on margin progression also on that side of the business?

Yes. So in components, I would say that it's more of a sequential progression as we go forward rather than a big step change. As I mentioned earlier, there's far more tailwinds than headwinds in this kind of environment. We drive great operating leverage whenever we see growth of significance. And that's certainly a play right now. We are seeing some pricing. And what's still to come is better margins from more mix of product coming from the West, EMEA, North America and then the design wins, as we talked about. So I think as we move through the year, we'll continue to see progression towards that 5% goal. In ECS, again, the focus there is really OI dollar growth. Now to your point, as you're seeing sales more muted, but OI dollar growth, you will see margin expansion. So I wouldn't say there's a target there per se. It really is about let's show meaningful OI dollar growth and the margins will fall.

Got it. Another metric that a lot of people follow in the industry is free cash flow, right? So in this constrained environment, can you talk about how you see the working capital base trending? And also your CapEx needs? And how does that impact free cash flow?

Yes. It's a really good question because investors love the counter-cyclicality of our cash flows. I think over the last 2 years, last 2 fiscal years, we've generated about $1.6 billion in operating cash flow, and that allowed us to pay down some debt and to buy back quite a bit of stock. Investors ask a lot of questions right now about, okay, is there going to be a big user of cash to fund working capital with all this growth. And I would say, outside of the inventory being a little lower than we'd like. And we'd like to get another $400 million, $500 million in inventory in here over time. That's about the only adjustment. So our cash conversion cycle right now is probably a little suppressed because of that inventory variable. But in terms of DPO and DSO, we got the cash conversion in very good shape through the semicycle and COVID, and we're going to keep it there. So over time, we would expect that our conversion of non-GAAP income into operating cash flow should be at about 90%. So if you look at over time, operating cash flow is about 90% of non-GAAP net income. So that will be, I think, where we end up. In the near term, we are generating cash. Debt is in good shape. There's no big M&A opportunities. So that cash will be focused on buying back stock because we still think there's value there. And in terms of Capex, we're going to be around $100 million or so, maybe a little lower, maybe a little higher in any given year, but that's about what we need right now.

Got it. And just in terms of leverage, I mean, how -- like how much leverage are you comfortable with? Right now, there's no opportunity for M&A. But I mean, in general, like what is your leverage target? And would you maybe take on more debt to do buybacks? I mean, I think the stock is fairly -- it's not expensive. So I mean, how do you see the trade-off between delevering or levering up and doing more buybacks?

Yes. Again, great question. So the important variable for us is that we cannot have our debt-to-EBITDA be above 3x. We need to maintain investment grade. And the reason we need to do that is we effectively are financing the channel on behalf of our suppliers for the customers. And so if we were ever to lose that credit rating, and we put that at risk. And so that's something that we take very seriously. Currently, our debt sits at about 2x. And that differential, we feel we need, should there be a great acquisition, should there be enormous growth that required investment. If you think back a few years ago, there was a lot of share shift that required us to invest in working capital ahead of the EBITDA coming our way. And so we need the flexibility to do that. So in the near term, would we take that leverage up significantly to buy back shares? No, because then it doesn't leave us with much gunpowder. We need to have the gunpowder. But to be very clear, there's -- I see no need to be paying down debt further. We're very comfortable with where we are. We've got a nice term cycle on the debt that we have and some very attractive pricing. So we feel good about where we are right now.

Got it. We're almost out of time. You have a couple of minutes. I have a couple of questions got e-mailed to me from investors, so I'll try to sneak them in. So the question is, how can you grow the demand creation side of the business? Do customers come to you? Or do you proactively seek out design opportunities? So I mean, just your thoughts on demand creation?

Yes. So there's a number of ways that we can get to customers. So typically, customers do come to us. They go-to-market and say, I want ideas from Arrow and Arrow's competitors, and I'm going to pick one and award it. Now the way that we tend to do better in that environment is we have some unique tools through our digital properties. We've got about 80, 90 web properties around the world, where customers are looking for information, it could be media properties, EE Times, EDN, DataSheets.com, that kind of thing. And so as they're out there looking for information, we're going to go introduce ourselves to them. And so that's another way that we can get in that maybe the customer isn't going to the broader market. So that's one vehicle we have. And then at the other end of the spectrum, we have a company in India called Einfochips, about 2,000, very high end engineers that can do everything from writing software and if necessary, even chip design for a bespoke industrial IoT solution. And in that case, we tend to be sought out. But part of it is us introducing ourselves to those bigger Tier 1 customers who would see value in that kind of an engagement, and that's something that we continue to do as well. So I would say at both ends, there's still opportunities for Arrow to do more, and we're very focused on that.

Got it. Maybe just in a couple of minutes that we have, just the other question is, can you talk about your investments in Aerosphere? How has that contributed towards your revenues? And do you see that as a growing part of your business?

Yes. Aerosphere is definitely a growing part of our business. And that product, if you will, that platform originated in Europe. Our European team saw the need over there to reach a very distributed customer base and they saw that quite a few years ago. It continues to evolve. It has migrated West. And yes, it will continue to be, and I talk about roughly $100 million in Capex. A portion of that is continued investment in Aerosphere to continue to expand its capabilities. But it's a really powerful platform for us in EMEA. There's a lot of cloud product that is sold through that platform. And in some cases, it sits on mobile networks, where Arrow is also earning a portion of the data usage back. So it takes us to other places where we can sell product. The VAR is still a critical part of that because the VAR will service the customer locally, but it is a great way to reach more and more customers on a -- that are very fragmented otherwise.

Great. Right. So we're out of time. I think we've covered a lot of different aspects of the business. So Chris, thank you so much for joining us today. Really appreciate it. And for all the investors who joined us today, if you have follow-up questions, please let us know. We'll pass it on to Chris, and we'll try and get the answers. Thank you, again. And last thing is, if you liked our work, please do vote for us in II. So thanks again, Chris. Thank you. Appreciate it.

Thanks a lot.

All right. Thank you. Bye-bye.

Bye.