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

All right. I think we're live.

I think we are.

All right. Good morning, everyone. Welcome to day 2 of the Raymond James Tech Conference. I'm Melissa Fairbanks from the supply chain and semiconductors teams here at Raymond James. We're thrilled to have the team from Arrow joining us this morning. Today, we've got Chris Stansbury, CFO; and Steve O'Brien from IR. Just some housekeeping, if anyone has any questions for the team, there's a button in the upper right corner of your screen that allows you to submit questions live. I'll do my best to get to all of them. And with that, we'll kick it off. To start, maybe, Chris, if you could provide just a brief overview of the company, some background, evolution of the business, 2 primary report segments. And I think you've got some directions for the safe harbor statement as well.

Yes. Thanks, Melissa. Yes, so for the safe harbor, you can all go into investor.arrow.com, and you can read our safe harbor statement. So I won't belabor that. But Arrow really is -- to your point, it's got 2 big business segments, and we are a global provider of technology products and solutions. We've got over $30 billion in sales. I think we'll be close to $34 billion this year, depending on how the quarter goes. About 20,000 employees, 85 countries we do business in and about 200,000 customers. And we sell electronic components, but we also sell a lot of IT software and hardware. And all of that is across hundreds of suppliers so that we can design, engineer market, sell, deliver, managed credit on behalf of our customers -- for our customers on behalf of our suppliers. So it's a big business. It's a complex business, but it's been going well.

Great. Could you maybe review some of like your major product categories, some of your suppliers? There's obviously been a lot of consolidation on the supplier base. You've been a beneficiary of some of that, of course. How has the supplier customer geographic mix changed in recent years?

Yes. It's -- it really is. There's a lot of change in the space. There's obviously been a lot of supplier consolidation. But just to ground everybody, global components is about 3/4 of the total sales, and about 25% is our enterprise computing solutions business. In components, 45% of that is Asia, and that's been growing faster over time. Obviously, it was the first into COVID, first out of COVID. So we saw some growth in that segment really over the last year, 1.5 years. About 30% is Americas and the balance, about 25% is Europe. Whereas in ECS, it's about 60% Americas, 40% in Europe. We really don't have a big business in Asia. What we've been doing really over the last few years is focusing our investments on the things that our customers need to solve problems. So heavy investments in engineering to help our customers with design. We've also invested heavily in other service capabilities around supply chain management. And really what's happened, as the landscape has changed, as more and more suppliers as they see the growth, the differentiated growth that we're driving because of our focus on customers and their needs. As suppliers consolidate and the suppliers are considering using one global partner, Arrows has generally been a beneficiary of that because of those differentiated capabilities.

This kind of leads us into some of your competitive advantages, your commitment to ECS, focus on geographic exposure. Clearly, scale is an advantage as well, geographic distribution, suppliers, logos, SKUs. Can you maybe talk about some of the strategy? I guess, some of your peers have chosen to exit the ECS business or how do you think...

It's interesting. Yes, it's interesting. It's something that we obviously evaluate from a shareholder value perspective on an ongoing basis. But I think where Arrow is positioned is different than where the competitive set is positioned. So there's some very good broadline distribution players that are selling really, I would say, a wider breadth of product, a lot of commodity products, laptops, tablets, smartphones, printers, toner, commodity servers in addition to application software and things like that. Arrow's focus is really on the core of the data center and edge of network environments and complex, multi-cloud or hybrid cloud environments. So really, as we're working with our VAR partners, they're relying on Arrow to help develop those complex solutions for the end customer. And so we've done very well in that space. We've held that space for a long time. And as the business has evolved, we've added on other capabilities like ArrowSphere, which is really the online enablement and deployment of product. It was started in Europe, where customer reach is more challenging. And it's done very well. In fact, Gartner just looked at that asset as well as others in that space, and ArrowSphere was ranked right at the top. So we continue to perform well in that space, and it's a good business for us. I would say the other important part of that business, frankly, is -- and it's I think one of the reasons why you've seen so much activity from the private equity players in that space is cash generation. And so the cash generation from the ECS business has really allowed Arrow to invest as heavily as it has in the components business, and that has been a big differentiator for us as we've continued to make the investments that I talked about. So it's really a strong relationship between the 2. There is some supplier crossover as well. And so for the time being, it's a business that we love and it's a business that we think adds a lot of value to Arrow.

Okay. Right now, you mentioned it's a split of roughly 3 quarters, 1 quarter. How do you view that split going forward? Do you expect ECS to grow faster as you kind of invest in that business? Or is it just the whole -- the business as a whole is going to grow in proportion?

It's interesting because part of the issue here -- And it's certainly not -- it's not the full impact. But the way that we account for revenue -- the way we have to account for revenue in ECS does mute sales growth, right? So as there's more and more software on a license basis, you get software renewals, you have a lot of the cloud product. And that -- the accounting rules tell us that we have to book that under something called agency accounting. And in effect, what that means is that we're -- our revenue is effectively gross profit. And so it has the impact of muting sales, but it has the offsetting impact of increasing margins, right? So that business, I think there is a very strong growth scenario coming out of COVID. A lot of customers had projects lined up going into COVID that were put on hold. Those projects, in large part, require us to be on-premise, whether that's in the core of the data center or an edge of network environment. And that work hasn't been done. In addition to that, since COVID began almost 2 years ago, there is additional backlog coming into the system of work that customers want to do. So backlog in that business is very strong. It's very high. And I really think it's a function right now of being able to get back on-premise. And then to a lesser degree, because hardware is not a big piece of that business, but certainly not the majority, but we do need the current shortage environment to clear up a bit as well because while servers aren't the core of what we do, they're only about 10% of what we do. The reality is when we're going in and solving a solution, inevitably, a server upgrade is going to be required. So those 2 things need to happen, but I think we're close and there's definite demand there.

Well, we're definitely going to get into some of the supply and demand dynamics. But first, I want to just kind of address maybe some quick comments on kind of unusual in the space. You provide a lot of detail by geography, broken down within each business segment. And I think that provides a lot of visibility into some of the geographic trends, some of the demand trends that you're seeing. How do you think about each of these subsegments? Are there -- does the mix impact your cash generation? Does the mix impact margins? Are there areas where you see room for improvement or maybe are trying to grow faster than others? You could just...

It's a great question, Melissa, because each geography does have its own nuance. I mean what we're doing geography to geography is very consistent, and that's what our suppliers look to us to do. But if you look at the West, you're going to see higher margins than Asia, but you're also going to see a higher tax rate and slower turning inventory, right? So when you get to a return level, the differences are much more narrow. And so that's something that we pay a lot of attention to. We know that at the end of the day we can talk margins, we can talk balance sheet investment, we can talk cash generation. But ultimately, the metric that matters the most, if you can only choose one, is our return on invested capital. And so that's how we look for opportunities. That's how we make decisions across geographies, and that's really how we manage the business. And I think that's really begun to show with the ROIC levels that we're delivering right now in the 16% to 17% range. I think in time, as we grow more services and we bring new lines of business on top of what has historically been that core distribution business, you'll hear us talk more and more about those things. They've got to get a little bigger, but I think that's additional information that will becoming transparent to investors in time.

Are you seeing any changes in your geographic mix just in direct response to what's been going on with COVID and maybe some geopolitical issues shifting?

Yes.

How fluid are your operations or your suppliers' operations as certain regions going to lockdown or have been in lockdown and then open up again?

Yes, that's really an important part of what we do. So to the first part of your question, the business definitely has seen more growth in Asia for many years now versus the West. That got exacerbated in COVID because Asia was first in, first out, and that's why you see 45% mix in the components business today. What we're seeing near term is as the West recovers is -- and I know that's tenable, right? It depends on what we see on the news. But we saw the Americas and EMEA grow at roughly 2x Asia in Q3. And in the near term, we would expect that to continue. So I think there's going to be a bit of a rebalancing in the short term. In the long term, I think Asia will continue to be the stronger growth vehicle. And typically, we're going to grow at a multiple of GDP because of the electronification of everything. So it really is more tied to GDP and where we are. Now to your point on flexibility, I think that was best exhibited when tariffs came into play, right? So we had a lot of suppliers that moved production China to other locations, and we're able to help them quickly and seamlessly make that transfer because of our global footprint. And so as customers and suppliers shift things around the globe, and sadly, I do think that's the way of the world, and I think that's what -- that's the environment is certainly going to be operating into the rest of my career, right? I think we're heading back to more nationalistic tendencies and whatnot. The reality is that adds complexity and we do complexity well. And I think that's a value that suppliers and customers will be looking to us to help manage.

Okay. Maybe going back to some of your earlier comments on return on invested capital. You've had some really strong improvements over recent quarters. Some of that may have been driven by some pricing and maybe demand and supply dynamics. But where are you now? Where do you hope to get -- I assume you kind of manage toward a target over the course of the cycle? And then how do you think you stack up versus some peers? And maybe what gives you an advantage there?

Yes. Again, a really good question. I think one of the things that we've been trying to message over the last few years is that we are different, right? We have made significant investments in engineering, in digital, in customer acquisition tools, which are largely digital, 80 web properties around the world. We own things like e-times, EDN, big reference libraries. And all of those things are really designed to draw customers into Arrow, and that's worked well for us. eInfochips, a very high-end engineering firm in Asia. And now our Supply Chain as a Service business. So we are different, and I think the results show it. I don't think we need to really beat that to death. I think that -- so the way we're managed is we do need to obviously grow the gap between our weighted average cost of capital and our ROIC. That's part of management compensation. But really, my focus and the broader focus of the management team here is we want ROIC to increase. We don't have a target in mind.

Okay.

But I can tell you that all the things that we're doing in the core business and on the services side are with that in mind, because we know that's what moves the multiple. The big question that's out there today is how much of that ROIC can stick through the cycle, right? I mean that's -- and the stock today, to be clear, isn't being rewarded for that, right? If you look at broader distribution in other industries, industrial goods, food, et cetera, you're going to see a forward multiple that looks pretty much the same as the ROIC. It's almost a one-to-one relationship. Steve has done quite a bit of work on that. And so we're well below that right now. And the big question is not our ability to generate cash. We've checked that box in the last couple of years. It's really Arrow's ability to maintain the margins. And I think there's a lot of skepticism around the current pricing environment. So in Q3, what we told investors is, if you look at the year-over-year increase in margin, at that point, roughly 1/3 of it was pricing. 1/3 of it was mix, which deals with kind of that Asia/West thing kind of coming back a little bit and 1/3 of it was structural. And the structural piece is really those higher-margin activities that I've talked about. The interesting thing is, as we go forward, those structural things will continue to grow as a percentage of the total in terms of their impact on our profit, on our margins. And that will be a strong tailwind to ROIC. The mix will ebb and flow, but we've been able to manage that. And even as Asia got to be in a couple of quarters over 50% of global components, the impact of that geo mix shift wasn't fully seen in our margins because of those services businesses. So it speaks to the fact that they're growing well. The interesting one to me, and this is just an intellectual debate, is pricing, because our pricing is passed through from the suppliers. And there's been a lot of discussion with suppliers that's -- in the investment community about the fact that given the tens of billions of dollars that they've invested in capacity, they are going to hold price increases at some level coming out of this cycle. So if they do that, our prices will remain high. We're not going to unilaterally lower prices while suppliers keep prices up. That's not a recipe for success in our business. So to the extent that you believe that at least in part, those price increases will stick, then that will be true for Arrow as well. And so that remains to be seen, but we feel good about what that looks like going forward.

Yes. For what it's worth, what we've heard almost unilaterally across your supplier base is that these pricing increases are expected to be structural and long term in nature. And at some point, we returned to kind of normal annual price declines but never get back to like this floor that we were in about a year ago?

And I think that's right. So look, we're not -- and certainly, I'm not sitting here saying that all of this is going to stick. But what I am definitely saying is we don't see this going back to where it was. And that's a very good thing for our margin profile and for our returns.

Certainly. Certainly. So this kind of leads us into the macro discussion. It doesn't seem to be a normal semi cycle for any number of reasons, of course. But kind of share your view of the state of the industry. Do you have any sort of visibility longer term to the extent that your suppliers are starting to sign long-term agreements with some of their customers, with some of their distribution partners? Does this change the way that your suppliers are using you in the supply chain? And does this change the way maybe some of your conversations with your end market customers are going?

Yes. It's an interesting time, and I love it, right, because no 2 days are the same. It's definitely not boring, right? But if you look at the shifts, I mean, what's -- what's very interesting to me about this cycle versus the last big cycle, right, which is now many, many years ago, 10 years ago. There's almost an inversion in the industry, right? So 10 years ago, when we had a big cyclical swing, you had a lot of suppliers and many of them had their own manufacturing facilities. But you had very few customers because the concentration of consumption was around a few industries. Today, you've got far fewer suppliers, much more consolidation, many of them using outsourced manufacturing, and you've got a customer base that's exploding. So it's almost a direct inverse to what it was. And so what that means is that in previous cycles, and I think it's what drove the cycles, is you had a lot of suppliers adding capacity to focus on a few verticals, and you would end up with oversupply and big fluctuations in supply/demand and therefore pricing, whereas today, the additions of capacity are far more rational. And there's a lot more places for product to go, and that's only going to grow. So big picture for Arrow, that's a very good place to be. There's a lot of tailwinds for growth. Really the only headwind has been the fact that it's been a deflationary pricing environment. And with that, at least solidifying at some level, that takes that negative away. So as we look at backlog, to your question, typically, we see out a couple of quarters. Right now, we're seeing out well beyond that. We're not seeing cancellation rates rise. We're not seeing customers push out orders in a meaningful way. We are getting some pushback of, "Hey, I can't get everything I need, so I want to defer a quarter." And we'll let a customer do that, but not beyond that. And in time, I would expect our visibility to come back down to a couple of quarters. But right now, customers want their place in line. Suppliers want to know, we want to know, so that demand signal is strong. On the customer side, there is definite changes in the air. And I think the traditional motion of us engineering for small and medium-sized business, that remains the same. And what was very encouraging through COVID is we saw record levels of design activity. And that was a strong, strong indicator that, unlike the financial crisis, these companies were going to survive and they were thinking about the future. What's interesting is that we've won a lot of those designs, but we're actually not shipping against them yet because customers are saying, "I'm going to hold until I know I can get all the products." So I think there's actually another margin tailwind that can help offset any moderation in price because that is yet to enter the mix. And then the last piece is the supply chain side. So there's a lot of big, multinational customers whom we don't sell product to and won't sell product to because they buy direct from the suppliers. But they're now facing a scenario where they want to carry more inventory in their system to protect themselves against shortages, and they can't do it. It's complicated. They're buying from hundreds of suppliers. They're trying to get product to a dozen factories around the world to make hundreds of different products. And so inevitably, they're getting the wrong product to the wrong place at the wrong time. And so to stick Arrow in the middle and to have us help them manage with that is a big value. It's a small price to pay, and for us, it's very margin accretive. So I think that as the world continues to evolve, it's more good than bad for Arrow, for sure.

All right. So to that end, how much visibility do you have into your end customer inventory levels? And are there any tools that you can use or any metrics that you look at to maybe kind of monitor for double ordering? To the extent that, obviously, no one can really shift to double orders but yet, but...

Yes. I would tell you, it's a little trickier in today's environment because so much is in shortage. I know if you go back to 2018 when we had an MLCC shortage, we could use data analytics to spot when customers were trying to build inventory and maybe arbitrage the market. Because if they typically order a basket of goods and that basket looked a little out of whack, we could do something with it. Today's environment is hard because they need everything, and they need everything because -- let's not forget, we had a great year. The industry had a great year in 2018. We went into a down cycle in '19. Everybody brought inventory down, we brought inventory down we went into COVID, everybody brought inventory down again. And so we're -- our customer base was looking at record low levels of inventory coming out of COVID, not that we're out of COVID, but certainly going into recovery. And so we don't believe -- and the reason I'm saying this is we're not seeing cancellation rates rise. We do a customer sentiment survey on inventory in the Americas, and we're not seeing people say, "I've got too much inventory or that move in a big way." So I think we're getting closer to being in balance. I can tell you, certainly from an Arrow perspective, we would like to have another $300 million or $400 million of inventory just for availability versus where we are today. But -- so I don't think we're there yet. As we start to see more customer request to push out receipts a quarter or we see cancellation rates rise, that will be a signal, but we're not there right now.

Okay. Okay. Do you -- this may or may not be a fair question for you because it's -- I imagine your customers are going to be the ones dictating it. But do you think we will ever return to just-in-time kind of inventory management with enough...

That's a good Vegas bet, right? Yes, I would say -- Yes, I don't think -- I think for the customers that we serve, they were never really just in time, right? They carry a little bit of inventory. The reality is one of the big values that we bring -- that distribution brings to the small and medium-sized customer base is for the supplier and for the customer, we help finance the supply chain, right? We extend -- Typically, we're extending credit, say, 30 days beyond the credit that we're granted from suppliers, and that's an important part of what we do. And so for customers to take big, big positions on inventory, requires an investment that they're willing to carry on their balance sheet. So over time, as things rebalance, I really don't think you're going to see a big shift for that reason. Now I do think, back to the supply chain business, you're going to see big multinationals automotive, right, who was used to receiving inventory in semiconductor chips 2 hours before they got plugged into a car. All right, that's going to change. They have the financial resources, the cost of not having that product far outweighs the investment, but they're going to need help managing. And I think that's where the opportunity is.

Excellent. Excellent. Okay. We're closing in on time, but I do want to address capital allocation. What are your priorities for investment in the business, shareholder returns kind of talk to that, please?

Yes. So our capital allocation priorities are, first and foremost, organic growth. And we've done a lot of that. That's the engineering. That's the digital acquisitions. It's the supply chain business. You'll continue to see us -- it's working capital as we take on new suppliers. You'll see us continue to do that. That is the cheapest way to drive growth and the best return. And frankly, that's led to share shift. So it's working, and we'll continue to do that. The second would be accretive M&A. And there's -- today, there's not a lot of that out there. The distribution business has largely been consolidated. What's still out there is either not for sale or is very expensive, right? And so not all that attractive. Over time, you might see us do something that -- in that space that bolsters a service. There's nothing on the table right now, so I'm certainly not signaling that. But eInfochips was an example of that.

Okay.

And then the last is return the remaining cash to shareholders through buyback. And again, with the valuation differential that I talked about earlier, and by the way, this isn't just our math, we use our banking partners to help us get a view on that we share with the Board. We're aggressive buyers of our stock. We think that a 9x, sometimes sub-9x forward PE is low, given the differentiation we've driven in returns outlook that we have. So until things normalize, we're going to be buying stock.

Okay. Great. So kind of digging in on some of the organic growth. Obviously, the industry itself, just in this very strong demand environment, is going to help drive a lot of that and you've put a lot of the pieces in place. Going forward, is there a need potentially to kind of aggressively pursue new logos or aggressively pursue new suppliers? Or do you think you can kind of just build on -- like I've heard some suppliers use the term land and expand, where you've got good relationships in place and just kind of growing as they grow?

Our -- it's interesting. I would say our focus is not about trying to go lock up a supplier, our focus is really on driving differentiated growth and with all the capabilities that I talked about. And what's happened is because of that, the suppliers are approaching us. So it's -- and they're saying, "Hey, I want to be part of that." Because as time goes on, suppliers are looking less and less to extract margin from the channel, right? There's not -- that's been done. It's really about differentiated growth. So if we continue that focus and we don't take our eye off of that, I think that bodes well for us. So I think that's going to be the focus. It's really going to be on making sure we've got the right engineering balance, the right capabilities. We just did a major, major investment that's now up and running in EMEA on warehousing, a huge capacity expansion and heavy automation. So a lot of the building blocks are there, it's really about executing in the marketplace, and I think the rest will come.

Okay. I've got one quick question about the CHIPS Act and potential for you to benefit from that. If we do see greater level of investment on the supplier base in more Western or the Americas, do you have the existing infrastructure in place to support that? Or is this something that you would work with your suppliers to kind of grow in to service those same...

I would say where the product is made is less important to us. I mean, obviously, there can be some benefits around tariffs for our customers, which takes some administrative headaches off of our plate. And we'll certainly help suppliers, as I said earlier, move that around. But I would say, from an infrastructure standpoint, I just referenced EMEA, we're in good shape, and so we can do that equally and we'll certainly be part of making that seamless for our supplier partners.

Okay. Just in the last few minutes, I think one way that I like to close out the discussion, one, if there's anything that we haven't addressed yet in the conversation today? And then just in closing, what's the key message you want investors to focus on moving into 2022 and beyond? And maybe across the cycle, any ideas that you think are misunderstood about the company?

Yes, thank you for asking that. The big thing -- we've really addressed it. I think the big thing is we are different. I think that's been proven. We don't take that for granted. We're aggressive. We sing for our dinner every day, and we're going to continue to do so. And we're going to continue to make those organic investments. I think the big thing is there is a disconnect in the marketplace today. If you believe suppliers are going to keep prices up and are making investment decisions on the supplier side based on that, then the assumption just simply can't be that Arrow is going to be doing something completely opposite to what the suppliers are doing. It's just not possible. So that's probably the big near-term message, but the proof will be in the results. And again, I don't think we're going back to the margin levels we were pre-COVID. And I think there's a lot in our favor even outside of pricing as it relates to the growth in the services business. So I think you're going to see, going forward, continued strong ROIC performance out of Arrow. And hopefully, that's a multiple expansion opportunity for all involved.

Okay. Great. Well, I think we are close to time. So at that, if you've got nothing else to add, I don't see any other questions coming through. So we'll leave that for all the breakout sessions, but thank you very much, gentlemen. Thanks for joining us.

Yes. Thanks, Melissa. Appreciate it.

Have a good afternoon. Thanks.

Yes. You, too. Bye.