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

Hello, everyone, and thanks so much for joining us here virtually at the Citi Global Technology Conference, where we have over 200 technology companies that we're hosting. I want to lay out a few housekeeping items. First of all, this is the fireside chat with Arrow Electronics, stock ticker ARW. Before we get into our interactive discussion, I wanted to mention that media and press are not allowed on this. If you are media or press, please disconnect immediately. Also, investors who are subject to MiFID II, please ensure you have those applicable agreements in place. Also, there are disclosures associated with this, both on your login as well as Citi Velocity as well has been disseminated for this conference. And I want to point you specifically to Arrow Electronics. On their investor relations website where they have lots of information that is useful, it also includes a safe harbor, the risks and the forward-looking statements and very -- other SEC filings such as 10-Ks and 10-Qs. I want to mention also that joining us on this call is Chris Stansbury. He is the chief financial officer or CFO or Arrow Electronics and I have actually known him for many, many years. So Chris, it is simply great to have you here. And I want to let you know that we laid out a few questions ahead of time that we prepped with you. But for investors on the line, if they want to hit the submit question, please do so. And I will then compile those questions, if we have time at the end. So they are all kind of grouped together subject wise, but I won't disclose the identity of those who are asking. But Chris, thanks so much for joining us here and I'll tell you, your company and the industry and where you're on the supply chain, has probably never been more fascinating in the dynamic than now. So can you maybe give us a little bit update about, where you're sitting. Whether there will be shortages, the bottlenecks and things like that?

Yes, Jim, great to be here. Thanks for having us again, and always appreciate these chats. Really and not surprisingly, what you'll hear from us is really what you're hearing across the industry, which is the shortages are real. I think they're here to stay for a while. Through the first half of the year, we and I think the supplier community, we're able to smooth out some of the bumps, even though there were shortages because of inventory. But nobody is really sitting on any inventory right now. So it's more hand to mouth. And like what we're hearing more broadly, I think this is going to continue into next year, certainly into midyear and maybe beyond.

It is pretty interesting. Has it gotten worse, better stabilized from where you sit, you see -- I mean, you have hundreds and hundreds of suppliers and customers, if not thousands, is it getting better or worse or stable?

Yes, good question. I'd say it's stable, but we're feeling more of the pain right now with our customers and our suppliers because, like I said, in the first half, there was some inventory where we could smooth out some of the bumps, not all of them. But now that we're through that inventory, the analogy I've been using with folks is there's no more shock absorbers on the car. So you can feel every bump in the road right now..

Yes. It is pretty interesting. And it also comes at a time where we had trade wars and then a ship gets stuck in a canal and can't transport. And then COVID hits us and you're right in the middle of all this.

Yes. No, it really is interesting when you think about how the industry has changed because last time the industry had a big shortage scenario that was across the board, the landscape look differently, right? The number of end markets that we're using these components and connectors is far fewer -- was far fewer than it is today. And there were many more suppliers, and that's obviously consolidated. So it's almost like the market has inverted to where we've got more centralized supply, more decentralized demand, which I think ultimately is good for suppliers and distributors over the long run because more -- that broader demand is across industries, and I think that will continue to grow. But to your point, we've had pandemic. We've had geopolitical tensions. And I think that certainly the tensions continue. So the complexity of the supply chain in all of this has just exploded. And I think a lot of customers are looking at what they're going to do going forward from an inventory standpoint because of that complexity. We've got to start thinking about the world a little differently now.

Yes, it's quite dynamic. Your book-to-bill has been above 1 for a while. Demand is strong. But yet your inventory popped up, and we talk about all these shortages. So how can you help me bridge the difference of inventory balloons up? And not only you but your other North America competitor balloon -- had inventory balloon up too. Help me bridge the -- there are shortage, shortages, I can't meet demand and inventories have risen?

For us, and I think this is across the board, again, it's all about timing. As I said, we feel all the bumps right now. And so that literally was some late receipts in the quarter of inventory that went right back out early in Q3. So our ability to see everything we're going to get, when we're going to get when we're going to get it is a little muted right now just given how strained the entire supply chain is. And that's what it was. It was just -- again, our balance sheet is a quarter end measure, not a kind of through the quarter measure. And the reality is we'd love to have more inventory than we do right now on a sustained basis, and it's just -- we're not able to do that right now. So that was just a blip.

So it sounds like, again, I think you know I'm a CPA that the way they counted it was a one snapshot in time, and it looked like a balloon or a blip. But then immediately once you got it scanned into inventory, your people were putting it in packages to kind of go out, but the snapshot captured it all kind of in.

That's exactly right. Yes, the inbound receipt has taken place. And by the time we got into the first couple of days of the following quarter, it was gone. So yes.

Okay. So one shouldn't extrapolate that all of a sudden you're sitting on a boatload of inventory and things have materially changed.

No. Definitely not.

Okay. Book-to-bill over 1. Companies have kind of stopped giving out the 1.08, 1.12. Can you talk about your book-to-bill? Is it just you're building in a little bit of conservatism in case people are trying to get more on to their shelves?

Yes. I mean the book-to-bill numbers, the backlog numbers, we've really done the same. We're not talking much about it because they don't mean much. I mean if you think about traditional movement of goods through our business in a non-shortage environment. We're seeing demand for 4 products 1 to 2 quarters out. Right now, we're seeing well beyond that. And part of that is self-inflicted, right? It's the suppliers and Arrow going to customers saying, "Hey, give us a good demand signal further into the future, get your place in line. And in the more of a demand signal, you can give us the better we're going to be able to meet those orders down the road." So we don't put a lot of weight on that. What I will say is that we're not really seeing booking patterns change right now. So customers haven't slowed down. They put their orders further out. They continue to kick them out that far. Nobody is really adjusting their orders. So that's another reason why we think the demand environment is going to be strong for some time.

And what about cancellation rate? Have they changed at all?

No. Very, very little in that regard. And we also -- Jim, you may recall, we do a -- in North America in components, we do a sentiment survey of our customers around their inventory levels. And it's literally one question, how do you feel about your inventory levels? And the response is too much, too little or we're good, and we're seeing record levels at the tails of that. So record high responses and I don't have enough record low responses in I've got too much and that remains very strong. And design activity remains very strong. We're either above or near record levels in design registration. So the demand environment really showed us some positive signs through COVID because of that design activity, but that has not slowed down as we're starting to recover economically.

So your survey, you mentioned is showing like not enough inventory that people don't feel confident enough. That's what you mean is. Okay.

Yes, they would like their own inventory levels to be higher, as a matter of fact what we want to say.

Are there pockets of inventory that are in excess? And the reason I asked that is like 2 years ago, the big shortage was CPUs. And now we don't talk about CPUs as much. We talk about power management or display driver is the shortage. I'm just kind of wondering about are there some pockets of extra inventory or some pockets of specific products you want to mention that just you can't get enough hands on?

Yes, it's a really good point, Jim, because the other one I'll throw out there is 3 years ago was MLCCs, right? That's what we talked about, right? And so right now, it's across the board. Now there's varying levels, right? It depends on which space -- which specific space within the technology stack you're looking at. But I would say, across the board, we are seeing lead times extended. Sometimes it's only 20%. But in other cases, it's 100% in terms of those lead time extensions.

Okay. Let's talk about operating margins. During the past few quarters and historically, the margins right now are looking good. Are they sustainable? Or some people say, "Oh, are the distributors over earning right now?

Yes. I was talking to somebody in one of the breakouts earlier. And we've been on a journey, as you know, now for many years to kind of come to customers and suppliers with new growth mechanisms, new services that create incremental demand and ultimately margin for Arrow. And we've proven a lot. We've proven that we could consolidate a lot of supply, we could still generate a lot of cash, which we've done. The one thing I wish we had proven because I believe strongly that we are going to prove it, that we have proven before this market shortage was the resiliency of the margins because we do believe it's there. The reality is, though, there's truth in the statement you make. There's no question that in an environment like we're in today, there is market pricing that will create higher margin opportunities that won't be permanent. But that is not everything that's going on inside of Arrow. So suppliers are raising prices. Suppliers have been very, very clear that they'd like to see a lot of that stick coming out of this. We'll see if that can take place or not. And the investments that are being made in new supply really aren't next-gen technology. So I think we might see Moore's law slow a little bit here, which could benefit us in terms of pricing. But separately, the things that are in our control, services to help customers manage their supply chain where we get paid a management fee to do that. Services like doing light touch manufacturing, integration activities are growing, the engineering services that we do. So we feel strongly that our ability to earn that 5% margin in components on an ongoing basis is there. Obviously, we've got some other tailwinds right now. But coming out of this, we feel good about our ability to do that.

And can you remind investors of your inventory, most of its more -- I don't know if the right word is discrete products that aren't highly volatile in pricing like memory chips. If you think about DRAM, where the memory prices can skyrocket up or plummet down pretty quickly, is my memory still correct on that? You're not a big memory holder where if pricing changed, you could be a little more riskier than some of your other products?

That's right. And I think memory is roughly 10% of what we do. So it's in there. It's meaningful. But we're not really in the business of arbitraging the market because if you think about it, our inventory profile needs to very closely match the order activity from customers. And when a supplier makes a price increase, they're going to give us 60 days to change pricing in our system or whatever that time frame is because it's complex to do so. We're not in the business of trying to gouge our customers if we see a market opportunity. Because that ultimately comes back to bite us over the long run. We're here to help them with their supplies. So we don't think that's the right approach. Now separately, we can help our customers who are short, trying to find parts that we may not have in inventory. And in that situation, that is more of a market dynamic. But that's a very small piece of what we do.

Yes. Well, there are a lot of smaller distributors. There's typically in the world 3 huge giant gorilla ones or goliath ones. Arrow, Avnet and World Peace. How do you gain share in a world of kind of an oligopoly or a concentration of 3 big goliaths?

Our view of the world is that by being very customer focused and having tools to acquire customers at a faster rate than our competitors can. And that's a lot of our digital tools and whatnot that we've talked about in the past. Then we can drive differentiated growth for our suppliers. And if we're doing that and we're doing -- and we're continuing to invest, and we're continuing to innovate and we can give our suppliers differentiated growth. And that's how we win. So we haven't let up. We've -- even during COVID, we were adding engineering capabilities, and we've continued to do so. And you'll continue to see us make those investments to drive future growth.

And then in the past few years, there's been some pretty meaningful distributor chip supplier relationships that have shifted. And in fact, Arrow Electronics has been on the positive or beneficiary side of that. Can you walk us through -- some people say, "Oh, it's just a bake-off based upon lowest price." Can you walk us through about why would a chip company change its distribution or go to market? And is it based upon price? Or is there a lot more behind it?

There is a lot more behind it. I mean, again, each distributor has their own strategy. And obviously will only speak to ours, but focusing on that differentiated growth really has brought a supplier value that, that others have not been able to bring. And so ultimately, that benefited Arrow because of the capabilities that we have. So it's easy to say it's pricing. But when you look at the growth in engineers, the investment that we made in over 50 multi-language digital properties around the world. To find the customer who was looking for help before anybody else found that customer. Guess what those customers are sticky when you show up, and that leads to design win. And so continued investments in those kinds of capabilities, supply chain management, as I mentioned. All of those things bring capabilities that very few others have in our space. And in part, that's because of the power of our global ERP, where we have, on one ERP, seamless visibility from beginning to end. And particularly in a world where you've got geopolitical tensions that is of increasing value to our supplier community as well. So we're not going to lift up on the accelerator in terms of investing organically in our business to be differentiated, and hopefully, that will continue to put us in a good position.

Chris, many companies, including yourself, are talking about higher value actions or activities for sales growth, whether it be a shift to services, a shift -- value-added consulting or engineering. What is Avnet Electronics doing and some examples that investors can actually grasp about higher value actions?

So sorry, what is Arrow doing?

Yes.

Yes. So for us, it's really, I would say, on the core business, it's the continued investments in engineers. It's investments in those digital properties that -- it's an analogy you've heard me use before and I'm sure some of the people on the call will have heard, it's like fishing with a net rather than a hook. The ocean is full of fish. If you think about the continued fragmentation of the customer base and the number of people consuming semiconductor and other electronic components today, the ability to get to those customers is critical. So I think we've got some proprietary things that no one else has. We own media companies. We own reference libraries. In all of those things, our properties were customers access, and we can find them before they find one of our competitors or vice versa. The eInfochips, very high-end engineering, 30 worlds first last year in terms of bringing big new inventions to market. So those things are real. The ERP was over 10-year many hundreds of millions of dollar investment that's in the rearview mirror now, but we continue to find value in that data and in our ability to manage complexity that customers are now increasingly willing to pay for. No one on the planet has Arrow's ERP, that is proving to be a competitive advantage. So that is a motion that we'll continue. We'll continue to invest. And again, I feel good about where we go from here.

And Chris, as Chief Financial Officer, you're also in charge of your company's capital allocation framework, uses of cash where the investments go. Can you walk us through about where you're focused on that capital allocation? And importantly, has it changed kind of versus pre-COVID during-COVID and someday post COVID?

Great question. It hasn't changed. I mean really, where the money goes, changes over time just because of where the balance sheet sits or where M&A opportunities are, but the priorities don't change. So our #1 objective is to invest organically in the business, and that's things like engineers, that's things like ERPs, right, that I've just mentioned, and we'll continue to do that. I would say that the big, big investments we've largely already absorbed. So that's good. And we do that because that's where the highest return is, right? It's close to home. We know what we're doing in that space. The second would be accretive M&A. And as you know, this space has largely consolidated. There's not much M&A left in the landscape today. Certainly not big stuff. And what is big is expensive today and not for sale. So not a lot going on there. And then the third is to return what's left to shareholders through buybacks. We did, in that third bucket, have to balance off going into COVID, getting our debt levels back down, right? Obviously, when we look at debt leverage, it's a trailing 12-month measure, and knowing that EBITDA declines would be a risk, we paid down debt quite a bit. But we've stayed true to throughout that continuing to buy back stock. And we bought back a lot over the last couple of years, and we'll continue to do that because I think debt levels are where they need to be right now.

I got an investor question that's quite interesting. They said, Jim, can you ask Chris why investing in engineers is so important, especially if Texas Instruments and Analog Devices and Microchip and all of them have their engineers designing the chips? And then you've got Ford, GM, Apple and all the OEM companies with their engineers why are engineers for your company so important? Maybe give some examples of what actually an engineer does at Arrow Electronics?

Yes, a really good question. So all the examples that you just mentioned there, Jim, really are in the Tier 1 space, where we don't buy sell. So we're not selling directly to Mercedes or Ford or Microsoft. But we could be selling deeper into those Tiers -- Tier 2, Tier 3 customers who might be in the case of automotive making a NAV system or an electronic seat, airbags, whatever it is. And so with the explosion of the use of electronics in every aspect of our lives. A lot of companies, smaller companies have to be very focused on where they're spending their money. So they may have engineers that are working on the IP, but on the lower level stuff, they may bring us in because it's less expensive to have Arrow do it than having an engineer to it on site. They're also looking in many cases for kind of best-in-class board assembly, which may or may not have chips from all the same supplier on it, right? So they're looking for a specific solution, and we will give them the best solution for their needs. So it's about the ability to scale engineering services efficiently, but it's also about giving something to the customer that is really focused on what they're trying to do. So I'd say high level, that's what it is. But increasingly, because of the change of -- increasingly change of pace and complexity in the world of electronics. It's really hard for the customer size that we focus on to stay abreast of everything. So it may be pieces that they do, but they just can't do all of it. And we're able to spread that cost across multiple customers. So it makes more sense.

So if like a Jim Suva small company designs I lost my cat or dog tag but I'm not smart enough to do all the engineering, that's where Arrow Electronics would come in and help me make it weather-proof, harsh resistant, put some wireless and battery connectivity into it.

Absolutely.

How do you get paid then?

So in that case -- in multiple ways. The traditional way is when we do those designs, we will register those with the suppliers that pay us the higher margin for those designs. And over the life of that board assembly, we'll get paid 300 to 400 basis points higher GP. In the case of a supplier who doesn't want us designing in, that's okay, too. if they just want us to do fulfillment, we'll do fulfillment. And that's a model that we can do very efficiently and earn very good returns on because it's a lower OpEx model. But back to the engineering. In some cases, I'll give you the complete opposite end of the spectrum. We have a company called eInfochips that we bought over 3 years ago, and that's over 2,000 engineers in India who are working with Fortune 100 clients, I think, I mentioned earlier. Last year, they helped bring to market 30 worlds first. And these are very complex solutions often in the industrial IoT space for a specific customer. And in that case, the customer will write us very large checks to do that complex engineering, which can include software and everything else. So it's -- it literally depends on whether it's a, to your point, a dog or cat tag or whether it's industrial IoT, we can scale the engineering depending on the size of the engagement.

And at the inception of the relationship you talk about the terms or expectations of fulfilling through you versus just the design and things like that, right?

That's right. And it is a structural industry thing where when a customer says, "All right, I'm going to go to market and ask for ask for distributors to bid on board assemblies", they'll be very specific about, okay, I need the board to do the following things, right? And we may give them 4 or 5 different options. But when we give those to the customer, those are all registered with the suppliers represented on those boards. If one of those designs is selected by the customer, then the suppliers know that and all of the volume associated with that board going forward over the life of that product have to be purchased through Arrow.

Okay. No, that's good to know. It's quite interesting. When we take a look back past COVID, past the trade wars past the ships that are getting stuck in canals and things, do you think there's going to be a shift of a benefit and need for distributors actually to systematically hold more inventory because I don't know when the next shock will be? But it seems like there's going to be something. And who knows what it is, if it's COVID-22, COVID-23, who knows what? What's your thoughts about that?

It's a really good question, Jim, because the issue is this. One of the values that we bring to our customers in this smaller to medium-sized space is we're a bank, right? We extend more credit to our customers and the suppliers extend to us. So that's a value to both the customer and to the supplier because we're moving more product as a result. The issue is, is we've got to earn a return on all of that as well. And so I don't think big picture, I don't think suppliers or distributors are going to be eager to carry a lot more inventory because that's got risks associated with it as well. I do think you will see suppliers derisk some of the locations as to where that product is made because of geopolitical tension. I do think that the additions of capacity make real-time availability improvements that help correct some of this. But I -- in my own view, and I'll talk about Tier 1 separately, in my own view, the customer base that we sell to needs us to do that financing piece of their business. They're not going to want to hold the inventory. And if they want us to hold it, it's going to come at a cost. So ultimately, I don't think that leads to big seismic shifts. And at the end of the day, the suppliers and Arrow don't want a lot of inventory in a system because that just means cycles are more prolonged, up and down, right? I do think that the Tier 1 customers, the customers that buy direct from suppliers and will continue to buy direct from suppliers need to think about it very differently than they have. They do have financial resources. And they do need to adjust just-in-time manufacturing systems to ones that maybe aren't just in time. I think the world of globalization and low barriers to entry across markets is a thing of the past. Unfortunately, I don't think it's coming back. And so that will necessitate more inventory being held in those Fortune 100 and they could need help managing that and that could be an opportunity.

Chris, I had asked a question about shipping costs. FedEx, UPS, DHL, a container from Hong Kong or Taiwan to San Francisco or LA, or even an airplane, the shipping costs have gone up. Do you absorb those? Or do you line item when you ship Jim Suva, 150 MLCCs and there's just a line item for shipping costs? And I see that it went from $12 to $18. How should we think about shipping costs?

Yes, we will pass those through. That is a direct pass-through to the customer. It's really interesting because in today's environment, we get a lot of phone calls saying, "What can you do to help me? I really need more. " We're not getting phone calls saying this pricing is ridiculous. They just -- the conversation is not about price, whether it's on the raw component or whether it's on shipping today. It's about just please get me product. And they're, in turn, passing it through their end customer?

Last question. Can you ask Chris, Jim, about when he puts his orders into the chip companies and all of his customers, meaning Arrow's customers want more product, like you just said, and you're putting in your orders to your various customers, when do you think we're going to start to see a better equilibrium or supply demand? It seems like so far from all the companies yesterday, it's not going to be this calendar year.

It's definitely not this calendar year, Jim. And I think what we're hearing is that we'll start to see capacity drip in and I use that term intentionally. It's not going to be a faucet turning on. It's going to be a drip, and that's going to take place over next year. So the earliest that I think we see that and Mike Long, our CEO, mentioned this in Q&A in Q2 call, was probably midyear next year, but we're hearing more and more about this maybe going into 2023 at this point just because of where demand is. And again, I think a good indicator is when you have the automotive suppliers announcing they're going to shut down production for a few weeks at a time, I think, that speaks to just how tight things are right now.

Yes. And every time you have a COVID shutdown or a containment or have to reduce the numbers of work hours or electricity or water or power outages that happen, it probably pushes things back further.

Yes. So I think this is the normal for a little while. And so I saw the head of our global components business this morning in a break. And I said dancing for parts today and he just chuckled, then he said you know it. So that's where we are right now.

And can you maybe spend this time we have a big audience here, Chris. To answer any questions that you traditionally have been getting a lot of to maybe educate investors or clear up any misunderstandings that you get asked a lot about because there's just so many people connected here.

Yes. I would say we'll often get into conversations about when does the cash come versus when does the margin come? And I think we've proven with all the consolidation and the share that we've taken in the market, our ability to generate cash. I think $1.6 billion over the last couple of years. So this is a cash-generating machine, particularly in softer times. And we're seeing strong cash gen now because we can't build inventory up as much as we'd like. But when we can do that, it's not seismic. I mean we're looking at maybe $300 million, $400 million of inventory that we'd like to have for this kind of level of business we have today. And so I would really encourage everybody to focus on where we go forward on returns. There will always be noise, what's going on in GP good and bad, what's going on in OI good and bad? What's going on with working capital? And ultimately, it comes down to returns. And I really do believe that as we move forward, there's a lot going in our favor from just broad demand to the capabilities that we have, where you will see Arrow generate, I think, some very positive good returns over time.

And Chris, as CFO was the 1 or 2 things you want to leave investors with about why they should be buying Arrow ARW stock today or this week.

Yes. Even if you take the pessimistic view that earnings are inflated because of the pricing environment or whatnot, I'm looking at the ticker today at $113. Arrow is a very inexpensive stock today on any measure. So you can look at forward earnings, you can discount that for the current environment somewhat. But when you think about just the broader demand environment, the stock is cheap right now.

I personally want to thank the Chief Financial Officer, Chris Stansbury, and his team for helping us today put us all together as well as all the investors who've connected, and we sincerely hope that next time we do this, it will be live and in person in front of everybody in a big room as we get together personally. Hopefully, that will be the case. Chris, thank you so much for your time today.

Yes. Thanks, Jim. Great being with you.