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

Great. So let's go and get started. I'm Joe Quatrochi, the semi cap and component distribution analyst here at Wells Fargo. Really happy to have the Arrow team here, Raj Agrawal, the CFO; and Ric as well from the accounting team setting in for the meeting. Maybe, Raj, to start, since you recently just joined the company, maybe talk to us about what do you think investors are maybe misunderstanding or underappreciating about the Arrow story and what attracted you to the [indiscernible] you're in now?

Yes. Joe, first of all, thanks for having us here. It's great to be here with you. I know we're on the tail end of the conference here. But look, I think my initial impressions about the company are that it's a very well-run company. It's very disciplined from a capital deployment standpoint. In almost every single conversation we have, it is about the return on working capital, return on invested capital and what are we going to get for the money. I think that's really a good discipline that exists in the company and that's a refreshing to see. From my perspective, the company has great long-term growth prospects. As we look out the next few years, I would say both organically and inorganically as well. I know we've sort of stepped away from the inorganic part in the last few years, but I think that will be a little bit more of a focus for us as we go forward. And then I would say that the margin profile is something I hear a lot about within the company in terms of what investors have said to us, I don't see the margins going back to where they were pre-pandemic. We have not stepped out and said what the new margins will look like in more of a steady state. But certainly, there have been some things that have changed structurally, which we can talk about. But what attracts me to the company is that look, it's a well-run company. I like the people that I met. I like the organization. It's in my hometown. So that was a bit easier as well from a transition standpoint, and I think the company does have great growth prospects ahead of it.

That's perfect. And so maybe as we kind of segue into -- obviously, the big topic of debate right now is kind of where we are in the cycle. Maybe talk to us a little bit about when the company guided for kind of the seasonal sequential decline in the components business looking into the December quarter. How do we think about where your views are for the current cycle? Talk to us about like your visibility into customer demand. Some of those metrics that investors are very focused on?

Yes, it's a great question, and we think about it every single day. In terms of the outlook that we gave for the fourth quarter, we we'll see more of the same of what we saw in the third quarter, which is a softer Asia business. We saw a relatively good strength in the Western markets. We also saw our shortage part of our business that continued to sort of ease off, which is not too surprising at this stage as supply chain constraints have eased a bit. So we are seeing more normalization, but we continue to have extended lead times. Our backlog continues to be very strong. So there's still demand out there. And a lot of the inventory levels that we have are really being driven by price, not necessarily by unit availability. So that's why we think that there will be continued good demand certainly in certain parts of our business in the component side in Asia is likely to continue to be slower, and we're going to likely see the shortage part of the business continue to soften over the next several quarters.

Maybe you kind of talked about inventory being more a function of price. I guess, how do you think about capacity that's being brought online for your suppliers to maybe increase kind of units inventory? And then how do you think about the stability of pricing? Are you still seeing your suppliers increase prices? Or is maybe that's kind of stopped?

It hasn't stopped, but it's probably leveled off a bit. So we've seen some price increases, but it's probably leveled off from where it has been the last couple of years. However, we don't see it turning around anytime soon based on what we've seen in our business. So there seems to be a level of stability right now in the pricing environment because of the long lead times, the strong backlog. There's still tightness in the market, if you will, and that's likely to keep the pricing level stable or at least for the short term. It's hard to say longer term what's going to happen there, but it certainly hasn't turned the corner yet.

Okay. The book-to-bill I think, reached Perry this past quarter for the first time in quite a long time, like pretty much prior to the pandemic. How do you think about that? Is that healthy? Or just given that they were so extended in terms of lead times? Or is that the metric that you think investors should really be watching for the kind of the turn in the cycle, so to speak?

Yes, I'll give you my impressions and maybe, Rick, if you want to add to it. I don't think that's the only metric that we look at. Certainly, that indicates that things are normalizing a bit. But again, we have extended lead times. Backlog continues to be quite strong. So it's not as if things are going to fall off a cliff just because the book-to-bill ratio is normalizing. So it's just 1 of the metrics we look at, and it's just indicative of everything else that we see in the market. Rick, if you want to add anything else?

Yes. No, I think it's just important to think of it as 1 metric, and overall demand remains pretty healthy. Supply is still short of that demand. That's not the case in every single instance, but overall demand still is strong and Raj talked a little bit about Asia softening, but the West is still very strong. Lead times still well beyond anything we would have ever called normal a couple of years ago. So even though they're stabilizing. They're not really coming down back to normal levels yet. So the backlog is still out there reflective of that -- those lead times. We do a lot of work to validate backlog with our customers. So we feel like we have good backlog against good inventory this is more of a moderation than anything else.

That's helpful. Maybe switching gears a little bit on the component side. One of the things that you guys have talked about is just the growing number of customers that are leveraging your kind of wider spread supply chain management, just given all the disruptions we've seen. Can you talk about like the investments that you guys have made over the last few years to really differentiate that business from your competitors? And then talk about like the stickiness of that business as we kind of -- as supply chains may be normalized over the next several quarters?

Yes. We have invested in our engineering capabilities. We have design services. We have supply chain services, all these things is what I would bucket as value-added services in the business. And these things do create more sticky relationships with both suppliers and customers and they're also quite margin accretive to the rest of the business, and that's the part of the margin that is likely to stick longer term because that's sort of an area of the business that is a strategic for us. We're going to continue to push those value-added services. We think it's very valuable to differentiate ourselves from other providers in the distribution space. And I think that continues to be some of the investment that we've made historically. And so that's going to continue to be a focus for us.

That's helpful. Kind of sticking on the higher value-added services. Your design activity continues to be really strong. And so how do you think about that as kind of a leading indicator for revenue growth as you look out over the next few quarters? And then what's driving that? Is it new products? New customers? Just maybe help us understand that dynamic.

Look, it's -- I think it can be a leading indicator. It's not -- it's less about the revenue increment, it's more about the profitability that it provides because it is margin accretive. So it creates more stickiness in the revenue profile and maybe there's a little bit of a revenue increment, but it's really about the bottom line that it helps to drive. And maybe, Rick, I'll give it to you for more of the color around who is using those services.

Yes. And I think back to the question of why has it become a leading indicator. It's because the designs that we help customers today are revenue today, it's several quarters down the road before those products actually go to market. So that's an investment in our customers, it's investment in our suppliers to create that new demand. It's a win-win-win. But we don't see the benefit of that right now. It's quarters down the road. And so I think the more design activity we have, the better we can feel about the long-term outlook. Doesn't necessarily do much for, hey, how does Q4 look like just because design wins are still strong. It's more about the longer term. And so we continue to invest heavily in this space. And it really is about helping mostly the smaller customers really with their engineering because of our product expertise, we can help them find solutions that maybe they wouldn't have been able to help find themselves and we're helping those suppliers sign new business that they maybe wouldn't have found themselves as well.

That's helpful. One of the things I think obviously during the pandemic and the demand increase that we've seen in your Asia business has gotten significantly larger than it has been in the past and even as a mix of kind of the revenue even though we've seen some weakness maybe over the last couple of quarters. But what about the design activity in Asia? Are you seeing kind of green shoot opportunities that those kind of higher margin type of opportunities are more common than maybe in the years past?

I think the value-added services opportunity is global in nature. So it really is throughout all of our 3 component regions, including Asia, the margin profile is lower in Asia than it is in other parts of our business, but it continues to give us incremental opportunity there. And that really is a focus for us globally, not just in any particular region.

Okay. That's helpful. And just kind of sticking on the component side for a little bit more. You talked a little bit about the stability in terms of the profitability. I guess maybe help us understand -- the question that I continue to get from investors, right, is why is this time different from a cycle perspective in terms of profitability? What are the -- I guess, sustainable drivers for that profitability relative to many past cycles?

On the margin?

Yes.

Yes. The margin -- look, we've tried to articulate that it's really 3 or 4 pieces. And many of them are structural in nature that will stick with the business. Some are more transitory, the structural pieces we talked a little bit about the design services, the engineering services, supply chain services. These things are likely to stick and we're going to continue to push in that direction. We also are benefiting from the overall pricing environment that we're in. And as we talked earlier, that pricing change, we don't see that changing in the near term. And so there's likely a piece of that will stick with us longer term. And then there's overall product mix and geographic mix as we've seen benefits in all 3 regions from a structural standpoint. And then the shortage part of the market is sort of the headwind or the negative aspect of that, that will continue to sort of go away over the next few quarters. But if you were to take all those pieces together, the structural pieces are likely to be larger than the part that's going to go away over time. And again, I don't see us going back to pre-pandemic levels. The other way I would just think about your question is just a sort of different approach given where our EPS level is today. And if you compare it to 5 years ago, there are 3 components that have sort of driven the over the last 5 years. So you've got 1/3 of that lift is related to revenue. Another 1/3 is related to margin improvement. And then the last 1/3 is related to share buyback, right? So the share buyback, you might even argue that, that is permanent in nature because we've reduced the shares outstanding. So that piece of the EPS lift is going to stick. And then you have to sort of make some assumptions around what portion of the revenue lift is going to stick. And I would argue it's going to be a large portion of it. And then what portion of the margin lift will stick. And I would also argue that's going to be a large portion of it. So you can sort of back into what is a base level of EPS in the business in various different scenarios and you get to a place where it really shows that the stock is significantly undervalued based on that kind of a view. So just gives you another way of looking at the business.

That's helpful. Maybe shifting gears a little bit and talk about the ECS business. Talk to us about the backlog that you're seeing for that business. Obviously, from a hardware perspective, the supply chain dynamics have been limiting in terms of sales and things like that. But I guess how do we think about the sustainability of the backlog versus demand destruction as you kind of maybe macro is kind of slowing as you look into next year, what's your kind of outlook for that business?

Let me give it to Rick to maybe address that.

Yes. I don't -- I mean, we feel pretty good about the backlog. I mean there -- our sense is that there is pent-up demand here that hasn't really been fulfilled in part because of some of the shortages you mentioned. We don't think that's going away. I think what we're seeing is more of like projects delayed versus they're not going to happen. So it's not really about destruction of demand at all. I think it's just a matter of when can we see sort of that leasing of that backlog, see the supply come through so we can really help our customers with what they need.

That's helpful. In terms of going your visibility looking into '23 in terms of the kind of IT budgets and spending, do you still see that being healthy?

Yes. I mean we think it sets up well. Obviously, we still have some work to do as we kind of look ahead to '23 and what sort of guidance we want to give on that. But we do still feel good about the overall health of the businesses we have in the regions we're in. And so I think it sets up for a good year.

Okay. Got it. One of the things that I think you guys have been doing for several years, right, is trying to transition this business to be more software-centric. So maybe can you give us kind of an update of where -- what inning are we in, in terms of that transition to that starting to be the biggest driver of revenue because there's also kind of an accounting dynamic there that maybe makes the revenue growth a little bit more muted than otherwise would be for other parts of the business. So just maybe help us understand like where we are in that transition?

Yes. I don't know what inning I'd say it's in, but there's definitely some innings left in this game. I think we're going to continue to -- and I guess what I would also say is I don't know that it's necessarily us driving it. It's really a combination of what customers are looking for as well as what suppliers are selling, and we're there to help out really all around. But I do think that transition is going to continue to happen, you're going to see more software, but you're also going to see more things transition to subscription, more of the as-a-service model. And so definitely a lot of time left in this game. And you're right about the accounting impact. A lot of what more transitioning teams ends up coming through. We talk about being a sort of an agency accounting basis or treatment. And so you don't see the necessarily the revenue growth that comes with that, that's why we do focus more on profitability in this business, we really want to grow the OI because regardless of whether we're selling a piece of hardware or we're selling a cloud solution or as a service, we can still drive profitability off that, even if the top line isn't necessarily what you would intuitively expect.

Got it. And on the profitability side, I mean, how do you think about, I guess, the -- as you move to that more software-centric selling, do we kind of find like a baseline EBIT level on a quarterly -- Obviously, fourth quarter is usually more given selling cycles and things in budget flush. But how do you think about, I guess, like are we finding like a baseline of EBIT kind of that we feel comfortable with kind of going forward with that business?

In terms of percentage or in a number absolute?

Probably more absolute, right?

Yes. Well, I mean I think we have a lot of growth upside from here. It's been relatively stagnant for a couple of years now. But I think as we position ourselves with sort of this transition and some of the capabilities we've invested in, we do think there's opportunity for growth. And -- so I do think it's -- over the long haul, this is going to be a growth opportunity.

Okay. Got it. The cloud business that you guys have been the resellers of cloud. But maybe help us understand, I don't -- that's a question that I get from investors a lot is how large is that business for you? What kind of -- where do we see that going in terms of obviously, cloud is a very pervasive in IT infrastructures now, but if we don't hear you guys talk a ton about that. So maybe any details that you can share there?

Yes. No, you're right. We haven't quantified that, put any numbers there. But what I would say is that it is still very important for us, and it is definitely a growth area for us. It I think maybe since last time anybody talked about any specific numbers. We have seen that grow, and it will continue. We're very much a player in this space, and we continue to invest in our capabilities around it. So I think you're going to hopefully hear us talk more and more about it as we move forward.

Okay. Got it. Maybe shifting gears a little bit. Let's kind of talk about working capital management, how you're approaching that, given where we're at in the cycle? And just you talked about inventory is not really increasing on a unit perspective, but on a dollar basis, which is mix and pricing, how should we think about cash flow over the next few quarters?

Well, the -- I think it just depends on what sort of -- how the business is doing overall. We generally, in times of growth, we're going to continue to invest in inventory levels, and we have been sequentially investing a little bit less each quarter just given the trajectory of the business. We're a countercyclical business. So to the extent that it does slow down at some point in time, we're going to get a significant influx of cash, like we always do, and that gives us the flexibility to do what we're doing right now. We've been investing in inventory and working capital, and we've been buying back our stock. And so we're sort of operating within the constraints of what we have, but we have a tremendous amount of flexibility still as a company, given where we are.

Got it. And I guess maybe as a follow-up to that, I mean, how do you balance in stock repurchase? Obviously, you talked about viewing that the stock at the current level is a very attractive return on investment versus maybe having dry powder for as things do slow I think still expectations right now are that the cycle would be maybe relatively short-lived from a nonconsumer semi demand perspective? How do you balance those 2 kind of dynamics? And then there's also -- you do a lot of kind of financing and things like that, that can kind of offset those. So how do we balance that? And especially the interest rate environment we're in?

Yes. Look, I think it's somewhere of the same. We -- generally, we're trying to operate within our credit rating that we currently have, which is a BBB- level overall. So that gives us a lot of flexibility from a leverage ratio standpoint to continue to do what we're doing, which is to invest in the business to drive organic growth. We will look at acquisitions as they come along, and we have enough capacity to do tuck-in type acquisitions that will fit within the strategy. And then lastly, we'll use our excess capacity to buy back stock especially when it's trading at the levels it is, which we think is a good value and a great value actually. And so we've continued to buy back a lot of stock. But we know that if and when the business turns around or it turns down for some period of time, the dynamics of the cash flow will -- the business that we have will generate cash on its own. And so I think we're quite flexible in terms of our financial flexibility and gives us a lot of capacity to do a lot of things that we're doing right now. So we'll go move up and down with the cycles as they come along.

Yes. In terms of M&A, I mean, that like you said earlier, it hasn't been a part of the aero story for a while. Your strategy is kind of maybe pulling that in, talk us through that. And what type of capabilities would you be looking to maybe add on to the platform that you don't have today? Or what are -- what excites you from an M&A perspective?

Yes. Look, I don't think we're going to become an M&A machine, right, but we'll certainly be more focused on that than we were in the last few years where we've gotten away from some of the M&A activity. And I think our -- 1 of our key areas of focus will be on the value-added services. So we have some capabilities, but we don't necessarily have them across the globe, right? We have them in certain markets, not in every single region. So we want to think about -- more about engineering services, design services, supply chain services, these are all the value-added services that we're providing today in certain pieces and parts, but doing that on a more global level is where we'd like to go, and it's a strategic focus for us.

That's helpful. Maybe as we kind of maybe going out, a couple of minutes left. But as you think about the next 3 to 5 years with the company, the industry, what do you think is maybe the biggest opportunity for Arrow that's maybe smaller -- small today as you look forward?

Yes. It's really these value-added services, which are -- we're doing a lot of good things there, but we can do a lot more. We do want to -- we're going to continue to be very good at what we do in our day job, which is distribution all over the world. we want to continue to become more and more relevant to all the partners that we have, both suppliers and customers and that's by filling in the gaps on other engineering and design capabilities and things that are -- that our customers and/or suppliers are not really able to do or things that they find valuable for someone like us to do, and that's how we can differentiate ourselves from the competition as well. So I think it will be an evolution to the strategy that we have today, but it will be just sort of more of an evolution, not really a revolution to what we have -- what we've done historically.

And maybe on that point, talk about you're somewhat unique in the fact that you have the ECS business as well as the components business, your closest competitor had similar kind of overlap and got out of the systems distribution business or software distribution business. How does that differentiate your offerings to customers? And maybe just talk about like the synergies between those 2 divisions.

Yes. Look, I think the synergies are probably less between them, but it's really about the working capital benefits that we get with the ECS business and also maybe it's a little bit countercyclical to some of the other things that we see in the component side. So it gives us a little bit of diversification, right, in terms of how we're going to market and the kinds of services that we offer. And so that's why we like that business. I can't speak for what Avnet went through, and I wasn't even around then. But I don't know, Rick, if you want to add anything to that as well?

Certainly not about their decisions around that, but I mean like Raj, he said there are some things that we really like about having both. And I do think it differentiates and it just gives us a different perspective on technology as a whole, right? We're not limiting ourselves just in the component space, but we can also look at the computing, a lot of it, a lot of big players are in that space and just gives us an understanding of what those suppliers want, gives us a really broad view on the entire world that we don't necessarily think anyone else has right now.

Perfect. Maybe I don't know if there's anything that I should have been asking you that you want to cover or highlight, but I think that seems like a great place to leave it for today.

Yes. No, we appreciate the opportunity, Joe, and thanks for having us here, and look forward to doing it again soon.

Sounds great. Thank you very much.

Thank you.