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

Good afternoon, everyone. Before we get started, if you are a member of the press or media, please disconnect at this time. This is a restricted line. Any unauthorized party in this meeting or any unauthorized use of the information communicated in this meeting is subject to prosecution to the fullest extent of the law. Any unauthorized person, including the media that is on the line at this time, please disconnect. Please note, today's call is being recorded.

Great. So I'm Joe Quatrochi, the components distribution analyst here at Wells Fargo. I'm happy to welcome Arrow Electronics' CFO, Chris Stansbury; as well as Steve O'Brien, VP of IR. [Operator Instructions] And before we get started, Steve has a quick safe harbor to go through. Steve?

Steve, are you going to read the safe harbor? Maybe he can't hear us. We can say that the Safe Harbor Statement is available on the Investor Relations page at Arrow, Joe. So I think if people refer to that, that's probably acceptable.

Okay. That's perfect. So thanks for...

Chris, can you hear me?

Yes, now we can hear you, Steve. Sorry. Go ahead, Joe. Just go ahead. Sorry about that.

Okay. Yes. So no worries. So maybe let's just start on the component side. Obviously, that's a big topic of discussion for investors right now given what's going on with supply shortages. Can you remind us how do we think about Arrow's forward visibility? Maybe talk about the confidence that you have going into 2022 that things continue to be kind of supply running short of demand.

Yes. So we typically have good order book visibility out a couple of quarters, and that's kind of in a normal operating environment. Obviously, in this kind of an environment, it's out well beyond that. I'd say it's probably closer to a year. So the things that we watch are our cancellation rates changing or those order patterns in those outer months and quarters changing, and we really haven't seen any changes there. Cancellation rates are not rising. We're not seeing a lot of customer request to, say, shift orders. Eventually, that will come and we'll watch for it. But at this point, that extension is really driven in part by us and in part by the suppliers who are telling customers, look, you guys got to give us a good demand signal given the constraints, and therefore, customers are trying to keep their place in line by ordering well into the future.

Yes. And I guess maybe on -- how do you think about -- or maybe how has demand disruption been kind of a dynamic in past cycles? And I guess is this cycle somewhat different because you have that kind of visibility in the lead times? I mean I think when you think about some of the maybe IT hardware names or things like that are buying components, you can see like their purchase commitments have really exploded that they report in their filings and things that we've seen over the last several quarters.

Yes. It's -- I think there is a big difference, right, this shortage environment versus what we saw 10 years ago now. And I think structurally, the industry is just in a very different place, right? You've got fewer suppliers, more of whom are using outsourced manufacturing. So the additions of capacity, I think, are more rational. And I think we're seeing that. We're not seeing a rush to the gates where we're going to end up with this massive overcapacity. But I think the other piece of it is on the consumption side. You used to have very centralized verticals where a lot of the consumption took place. And now it's very dispersed. So it's almost an inversion of the market. We had very decentralized supply and centralized consumption a decade ago, and it's almost the opposite today. And I think that ultimately, I think, sets the industry up well coming out of this because the demand is going to continue to be a tailwind. You're going to continue to see the electronification of everything. And the additions of supply, I think, are more rational. So we'll continue to watch it. That has to obviously play itself out. But certainly, given what we're hearing from suppliers about wanting to maintain prices to earn a return on the investments they're making in capacity, I think that's all very good news for us.

Yes. And I guess on the pricing, I mean, is it more mostly a function that when you think about the stability of pricing into next year? And I think you guys have even talked about maybe potentially seeing another round of price increases from your suppliers that you, of course, look to pass on. Is that structural difference a function of them adding capacity that they have to think about the higher cost structure where a lot of these chips are being made on, call it, 28-nanometer and above that have been traditionally produced over the last several years at fully depreciated assets that now that has to flow through the cost model? Is that the way we should be thinking about that?

I think that's definitely a component of it. And we know that input costs are rising, right, for the suppliers. We're in an inflationary environment. So everything that they use and need is going up in cost. And to your point, they're now making big capital commitments that ultimately have to be depreciated, and they've got to earn a return on capital associated with those. So that, I think, bodes well for more price stability, if you will. And Arrow makes a margin on a cost, right? And so to the extent that the suppliers are raising prices, that's our cost. So -- and that's -- you see that flowing through the model today. So look, we're not going to sit here and say that current price levels are going to hold exactly where they are. I'm sure there's going to be some level of moderation. But I think our current view and expectation is that we're not going back to where we were. And I think a lot of suppliers are using similar language. And again, that's -- if that holds, that's very good news for us.

Yes. And so maybe thinking about that, right, in terms of -- maybe first remind us when your supplier comes to you and says, pick your number, right, if prices are going up 10% or 20%, whatever, how long does that take for you to then pass through to the customer? Is that a quarter? Or is that more or less instantaneously? Just how do we think about that?

We basically are given a signal from the suppliers in advance so that we can get pricing in the system updated. It is a very manually intensive process because you're going through and adjusting customer by customer and product by product. So it does take a little while. But generally speaking, by the time it hits us, we're able to pass it through to the customer. The suppliers generally give us ample warning so that we're ready to go.

That makes sense. And maybe with that basis, right, when we think about -- I think a lot of the questions I've been getting over the last couple of quarters is, well, the inventory, at least, the dollar amount, right, in the distribution channel, it seems to be somewhat kind of creeping up over the last 2 quarters on a sequential basis. So I guess when we think about the inventory increase that you guys have seen, how much more -- how much should I relate that more to -- I think you guys use like an average cost basis for your inventory. How much do I attribute that more to price increases versus actual increases in maybe the number of goods?

Yes. I would say that what you're really seeing right now is almost entirely driven by pricing. We're not really seeing units rise in inventory yet. And I don't -- based off of, again, everything that we're hearing, I think we're more of the expectation that, that's -- we're not even going to see the beginnings of that until maybe Q2 next year. It's just probably more like second half. So I think we're kind of going to be in this environment for a little while.

Okay. That's helpful. And so when you think about -- maybe kind of go back to the demand side, obviously, we're seeing very broad-based demand, and you guys are reporting a pretty impressive revenue numbers that are really more based on what you can get from -- in terms of supply. So I guess when we think about the demand that you could theoretically fulfill, I mean, how do we think about Arrow's capacity utilization or demand fulfillment capabilities and maybe some of the investments you guys have made there? Are we close to -- need to make more? Or how do we -- how should we think about that?

We've been making investments all along the way, and we'll continue to -- I'll tell you, I guess, there's a few things, right? There's the human side and then there's the more fixed infrastructure side. I'd say on the latter, we're in very good shape. We actually just quietly brought online a major capacity expansion in EMEA on the warehousing side, lots of automation and efficiency there. And that went live, I guess, a couple of months ago now. On the human side, we have continued to add engineers. We've seen record levels of engineered designs. I think what's encouraging is that we're actually getting design wins, and we're not actually shipping yet against those wins because in many cases, the customer said, "I'm going to wait to launch my product because I can't get the entire bill of material." And so there's designs that have been won and products that are ready to go to market. But as the supply side strengthens and we don't have those shortages, you'll start to see more of that margin flow through the business as well. So I think there's actually some pent-up good news once the supply and demand situation corrects itself.

That's a good point. And I guess when you think about like those design wins, I mean, how -- is that becoming kind of a pretty big problem for your customers? Or how do we -- is it maybe more broad-based than, I guess, you would have expected in terms of like bringing on new design wins to market?

I think the demand for the engineering services is very, very strong, right? So we're seeing lots of requests to engineer a new product. People are still innovating. And I think in some cases, customers are trying to hedge their bets and having alternate designs for shortage situations in the future. So all that's beneficial to us. And it's not just in any 1 vertical. It's really across the board in broader industrial, which is where we -- where our sweet spot is. So I think the bigger part of it is that all these record registrations and wins, we're not shipping as much as we could be. And when that flows, we'll see the margin lift.

Yes. No, that's helpful. And kind of staying on maybe some more where Arrow really tries to add value. I think some of the things that you've talked about over the last couple of quarters and it makes a lot of sense is given the supply chain disruptions, given the shortages, maybe can you talk about some of the different services that maybe investors are less familiar with in terms of supply chain services, things like that. How sticky are those revenue kind of, I guess, streams? And then how do you think about adding new customers to these services? And then once things maybe normalize, that those customer is sticking around and still using those services?

Yes. I mean Arrow has got a lot of capabilities that really have built on our core distribution businesses. And services around supply chain would include things like dealing with a customer base that is bigger than what we typically deal with, but not in a buy-sell relationship, more in a inventory, distribution and management relationship. And so I don't want to get too deep into it. But the reality is that with the shortage environment, there's a lot of very large Tier 1 type customers who are kind of waking up to today's world in reality that they're going to have to carry more inventory and that the management of semiconductor and PEMCO inventory is highly complex. If you're a big industrial customer and you are using materials from hundreds of suppliers and you want to get them to dozens of locations and it's not the same in every location, that's really complicated stuff, right? So we have a global ERP. No one else has the capabilities we have in that regard. And that's of interest where people would come in and ask us to sit in the middle and manage the flow from their direct buy relationship with the supplier. So that's a business that continues to have interest. I think the current environment bolsters that and is only increasing that level of interest. I would say that the sales cycles on those engagements are very long because they're complex. There's obviously a lot of risk involved for the customers. They want to make sure everything is working and in good order. But when it's done because of all that, they tend to be very sticky. And so that's one thing. We also have tools that we've acquired as part of our digital expansion a few years ago, which give customers great visibility into how to manage things like shortages and tariffs and just other visibility tools. So think of it as a basket of services around supply chain management that customers can either cherry pick or buy the full suite, if you will. And we'll continue to build capabilities in that area. So really, you're going to have this core distribution business that everything is built on. We'll continue the motions around engineering, like we've talked about. eInfochips, our premier kind of engineering service in India, I think, had something like 40 world's firsts last year in terms of major inventions. That will all continue. But in the new economy that's very reliant on electronic components, I think there's this other opportunity as well for us.

And those types of engagements, maybe 2 questions, some follow-up questions on that. Those types of engagements are sold as -- is it a contract? Or is it subscription or something like that type of, I guess, pricing mechanism?

It depends. Yes, it depends. In terms of like our access to our database, which is the world's most comprehensive database on silicon, that's more subscription-based and license-based. If it's a physical engagement where we're physically touching inventory and moving it, that's contractually based, and those contracts have different terms. But again, they're very long selling cycles. Think 18 to 24 months. There's often IT requirements. There's a lot of stuff that goes into it. There's tax and treasury issues. So once that's up and running and running well, they tend to be sticky, very sticky.

Yes. Yes. That makes sense. I mean, I guess, I assume that you've kind of seen customers maybe use a piece of that, that could be a shorter sales cycle, just given the dynamics of the industry right now that now are kind of maybe double-clicking on what the possibilities that you could actually offer like the, I guess, the visibility or the potential that you've seen just given over the last 18 months from the pandemic and everything that's come with that maybe has opened the eyes of some customers that otherwise wouldn't have considered Arrow as managing the supply chain. Is that a fair statement?

I think that's fair. Yes, it's definitely fair. I don't think that it accelerates the selling cycle. I think what it does do is it's -- if you look at the funnel, there's more going into the funnel at a faster rate than there was a year ago.

Yes, yes, yes. Okay. And maybe on the component side, you guys have seen a pretty remarkable increase in your profitability. Maybe talk about the sustainability of components EBIT. I know you guys aren't ready to maybe give kind of a new long-term target. But how do we think about, I guess, the sustainability of that given a thought of kind of maybe sustainable pricing, sustainable higher -- net higher revenue run rate? How do we think about that?

Yes. So on the Q3 call, we talked about the margin increase year-over-year really being 3 buckets, and they were about evenly split. One bucket was mix. And as you know, Joe, really over the last 18 to 24 months, just given the way COVID hit the world and the way the world recovered, we had a sizable mix shift to Asia, right? And we're able to manage that mix headwind, if you will, very well. But now that's come back a bit. So in Q3, we saw both the Americas and EMEA grow, I think, at 33%, and Asia grew at half that. So that for the near term anyway is good mix that helps us. About 1/3 is structural. And that talks to things like the engineering services. It talks to the supply chain services. That's here to stay. And I think you'll continue to see more demand from customers in that regard. And that's a very good tailwind. The third bucket is pricing, right? And the question on pricing is how much of that will stay. And the reality is we don't know. But again, based off of our earlier conversation, our belief, based off of everything the suppliers are saying, so we're not really saying anything inconsistent from where they are, is that a lot of that is going to stick around, right? A good chunk of that. So if all that is true, then I think you will see us in time raise our margin expectations for that business. I think right now, it's too early because we've got to let that play out. But when you look at the way the stock trades today, it's basically trading under the assumption that we won't be able to maintain pricing. That's kind of built into that forward PE. And what's really interesting is that the market that is layering that assumption on Arrow is also making an assumption around suppliers that they will be able to maintain pricing. So to the extent that suppliers maintain pricing, guess what, we're not going to lower prices. So that's -- so the point is the market is skeptical. We understand that. And it has to be proven out. But based just what everybody is saying, I think we're in good shape.

Yes. No, that makes sense. Okay. Maybe let's shift gears a little bit, talk about the ECS business. Maybe first, just give us a little quick kind of overview. Remind us of like the mix of that revenue. I think there's also kind of a little bit of an accounting nuance that kind of dampens the revenue growth there as you kind of continue to move to software. Maybe give us a quick kind of review on that business.

Sure. So the accounting nuance, just to get that out of the way, is that whenever we are selling things like a lot of our cloud revenue or license renewal, a lot of that revenue is subject to agency accounting. And under agency accounting, you basically report the sales line at effectively what is gross profit. So it has 2 effects. It has the effect of as you have more and more mix shifting that way, especially as we're going to more and more ratable revenue, you end up with a dampening in the sales growth and you end up with a stronger margin. Overall, that business today, the way we really talk about it is only about a 1/4 of that business is hardware, and the balance is software and services. And when you look at the software, it's not really application software. It's more the software that drives the data centers. And that's one of the reasons why that business was so resilient during COVID because we were able to deploy and distribute at scale a lot of remote work software that enable people to work remotely. So it's -- that's been very effective for us. The business -- it's almost a tale of 2 businesses. In EMEA, the business continues to grow very well. And there's a couple of things that I think have benefited that business over time. The first is the way suppliers went to market is they were far more distributed in Europe country by country. And by default, as things consolidated, we ended up with a much wider distribution of supplier base in EMEA than we have in the Americas. And I think that's a real benefit given all the new tech. The second is we developed in EMEA a tool called ArrowSphere, which is really an online deployment vehicle for a lot of product, cloud-based software and whatnot. And it's being used today by, for example, mobile carriers in Europe to deploy product over their networks. Both of those philosophies, right, widening the supplier base as well as more heavily using ArrowSphere is taking place in the Americas. We're starting to see some good results there. So it will just take some time. But there was also a survey, I think Gartner did it, about the various products that exist out there from us and our competitors, and ArrowSphere is at the top of the list. So it's a very desirable tool for not just customers, but also our VARs who can use ArrowSphere to act as a managed service provider and do all the contract administration, metering, billing for cloud-based product for their customers. So I think we've got the tools that we need. It's really about execution, largely in the Americas. And again, I think we're on the right path there.

Yes. And I think in the last quarter, you talked about seeing some issues with component shortages and things kind of impacting your ability to ship. I mean, I guess, how do we think about that in terms of -- is there a risk to more demand disruption in that or potential switching to just try to get tools -- or I'm sorry, equipment on the floor of data centers? Or I guess how do we think about that?

Yes. I think in the near term, it's issues that we're just going to have to deal with, and we'll feel them as they come. That's the bad news. The good news is that -- I mean, let's just look at the reality of the world, right? Data centers have not had a lot of attention in the last 2 years, and they need attention. So the backlog that we're looking at in that business is very, very strong. It's a different kind of backlog and components backlog where customers are trying to keep their place in line. These are customers saying, "No, I need work done in my data centers." And so as soon as we can get the equipment, we're going to be in there. The -- I think the other thing that we're hearing is that the big equipment suppliers that we rely on for that product, look, they're going to get fed the semiconductor product they need pretty quickly in terms of the food chain, right? And so ultimately, we think that this is short-lived, but it's something we're going to have to deal with for a few quarters, and then it'll loosen up. So we'll continue to try to guide as tightly as we can. But the good news is the backlog is there, and I think that demand is going to stay very strong for a while.

Yes. And to be clear, you're meaning more on-premise data centers rather than cloud data centers?

Correct. A lot of what we do is a combination of on-prem, private cloud, public cloud and the integration of those things together. So it's those more complex engagements where we really focus and we shine. And so being in the data center is definitely part of that.

Right. Right. Yes. Because that kind of leads to my next question. You talked about the equipment shortages or availability driving people to adopt cloud faster. I'm curious how do we think about the size of your cloud business today? And just remind us what -- are you across all -- using all kind of the major 3 cloud providers? Or where does your portfolio kind of fit?

Yes. We have -- in terms of public cloud, we have a broad swath of the public guys. And again, I don't know that we've said that it's forcing a shift to more public. I think a lot of the businesses that we support are still -- they have a few different things they've got to be concerned about. Moving everything to public cloud isn't necessarily cost effective, number one, right, if they don't have the scale. Number two, there's still concerns around security and whatnot. And there are some things that they want to keep a little closer to home. And that's why we tend to end up in these hybrid environments. And we think that is the way of the future. So it's -- where there is a need for public cloud, we're able to deploy that and integrate it and do that very effectively for customers. But there is that other element as well that's important to that.

That's perfect. And maybe just one final question I'll slip in before we have to go. Arrow has been aggressively buying back their stock the last couple of quarters. Obviously, I think you guys have been in a good percentage of the daily volume relative to the normal. Talk about the metrics that you look at. And maybe on that, kind of where do you think investors most undervalue the Arrow story? What do you think investors are missing the most?

Yes. We have been heavy buyers of the stock, and it really gets back to the point I made earlier. I mean we're trading at a [ 4p of 9 ], sub-9 right now. We've got an ROIC today of 16%, 17%. And those 2 things just don't equal each other. So we think that's a strong buying opportunity. We've obviously got the support of the board. We use our external banking partners to evaluate all that as well. Where I think the market is undervaluing us, and it's a big disconnect, I mentioned it earlier is, you cannot have an environment where suppliers are going to raise their prices and Arrow is going to lower their prices. There's a fundamental disconnect in the market because the supplier's price is Arrow's cost. And so if -- you can't be looking at a supplier base and saying, we're going to put strong valuations on them because they're all saying they're going to raise prices and hold prices and at the same time, assume that the prices that Arrow passes along to its customers are going to fall. And so that's the big disconnect. Again, the cycle has to prove itself out, but we believe we will, and that's why we're buying at the rate we're buying.

That's perfect. Well, with that, I think we're out of time. Thanks for joining us.

Thanks a lot, Joe.