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

Perfect. So why don't we get started. I'm Joe Quatrochi, the component distribution analyst here at Wells Fargo. Excited to have the CEO of Arrow, Sean Kerins and as well as the CFO, Raj Agrawal. Thanks guys, for joining us.

Thanks for having us.

Great to be here.

So maybe to start, Sean, I know you've been with the company for a long time, newer to the CEO role, maybe start out with kind of help us understand what do you think is misunderstood or underappreciated most in the Arrow story by investors?

Sure, Joe, and thanks for having us. So when I think about the evolution of Arrow Electronics, I think there's 3 things that we probably should be talking more and more about. One is just the sheer size, scope, depth and reach of the company. If you think about it, we've got 22,000 employees throughout the world. Most of them wake up every day thinking about all of our suppliers and customers. We operate in 90 countries out of over 200 locations, more than 40 of which are pointed at our warehousing logistics and supply chain services capabilities. And we think all of that spells incredible reach and is increasingly appealing to our suppliers who are trying to get to the 4 corners of the world, but also now our multinational customers, especially given the geopolitical environment. And we don't say enough about all that. I think the second thing that comes to mind is just the extent of what I would call the value add that sits inside the Arrow portfolio, whether that's services in the realm of supply chain management or design services, where we actually augment, the design teams of large OEM customers for a fee basis or even what we do in our IT business to provision, manage and bill for cloud-related subscription services in the IT channel. Those are all becoming more relevant to our mix overall. The other part of that I talk about in the value-add space is just the sheer depth of our engineering capability. We've always leaned into the role and value of engineering especially at the field application engineering level because we believe the design in and demand creation margin opportunity and potential, especially in the mass market, has still got some really good runway in it. And we're fortunate to have thousands of engineers throughout the world, leading the charge on behalf of our suppliers every day. And then the last piece of our value add, I would point to is really our media and digital platforms. We don't talk often about those, but they play a really important role in attracting engineering and IT eyeballs to our line card, among other things, and our capabilities in a way that ultimately points to more lead gen and more demand gen, and that's kind of what we're therefore to help people grow. Lastly, you'll see this in the [ K ] every year, we've got 210,000 customers throughout the world, which means we have a lot of opportunity to sell things, not just to those customers, but to go expand the customer base overall. And it's a good indication of the reach that we represent on behalf of our suppliers. So I don't get a chance to talk about those things typically on an earnings call. So I appreciate you let me draw those out here for a couple of minutes today, Joe.

Yes, that's perfect. I mean, and I guess those things you listed, as you look over the next 3 to 5 years, what do you think is the biggest opportunity relative to -- for the company? And what are you maybe most excited about?

I think I'll talk a little bit more about the electronics piece of our business as it relates to this question. But I think if you look at the projections for the semiconductor industry, it wasn't long ago that the use cases for semiconductor technology were really limited to things like mobility and compute, right? The scope of the opportunity was somewhat narrow. Now look at the diversification of semiconductor technology. We talk about the electrification of everything. This technology is now being designed into every walk of life both residential and commercial, just about throughout every minute of our day. So I think the sheer diversity of demand alone will be a very healthy thing for the industry. I think most of the projections talk about an industry with a total TAM of maybe $600 billion right now, moving to $1 trillion by the end of the decade. We like that CAGR. We think that, that's something that we'll continue to invest in, and we're well positioned for. So the outlook is tremendous. I think if there's anything different in the way we look forward or think about our strategy as we look forward is that we want to focus even more deeply on the fewer things that are more accretive to that opportunity. So specifically, that starts with our engineering leadership for demand creation margin. It means more penetration of the market for interconnect, passive and electromechanical technology because that's such a good adjacency to the semiconductor technology. We think it means more investment and more sales capacity pointed at our value-add services, specifically design services in the engineering realm and then supply chain management. And then lastly, it also means that we continue to make steady progress in the IT transition to market for what I call all things IT-as-a-Service, which changes the structure of our ECS P&L over time, and it leads to more recurring revenue, more infrastructure software, more related services and more cloud, which we ultimately think is a good thing for the business model as well.

That's perfect. I mean -- and Raj, I think I asked you these questions last year when you were sitting here. You've been here a little bit longer now. I mean, anything you'd like to add to that in terms of just what you view as great opportunities for Arrow?

Yes. It's hard to believe that it's been a year already. It's gone by fast. I think Sean really covered most of the key points. The only other thing I would add is that we continue to be very cost focused. It's a discipline inside the company that certainly I've learned the company is very focused on. And and certainly really treating the working capital and the capital that's invested in the business very tightly and optimizing that at every turn that we get. So I think those are embedded disciplines within the company, which is good to see.

Perfect. Maybe shifting gears a little bit to the component side in the current kind of demand environment. Obviously, no 2 cycles or alike. But I guess, how do you think about the current downturn that we're in relative to prior couple of corrections? You talked about last earnings call -- last 2 earnings calls, 2 to 3 quarters kind of what a normal cycle is just kind of given where inventory at your customers are, your own inventory and just kind of demand, I guess, how do you -- how do you characterize the current cycle, where we are? And what should we be looking for in terms of those guideposts for a recovery?

Certainly. So I think you're right, all cycles are just a little bit different. This one, it turns out to have been a little bit more dramatic than maybe anything we've seen in recent history. And when you think about it, there was such a significant disconnect between supply and demand that some sort of a correction was probably inevitable. We see this one really being driven by supply finally catching up to a whole lot of delinquent demand. And as a consequence, we're right in the middle of the correction you speak of, where we're rescheduling a lot of orders, canceling fewer but working with our customers who gave us visibility to production schedules several quarters out as their demand patterns now change to work through the excess inventory as quickly as we can. I think the picture I was trying to draw, Joe, is that if you were to hold demand constant, and I would say we all understand that the Chinese economy, broadly speaking, is down. It's not immediately clear when it gets up back up on its feet in a more material way. Demand patterns in the West have held a little bit steadier. But if you took all that and said demand doesn't really change, and we're just dealing with managing the excess inventory alone, given what we see in our backlog and what our customers tell us about their production schedules. I think it is this quarter and next before we get a look at whether or not things start to normalize in the second quarter that being supply and demand starting to come more in sync, which means net new orders, it will be things that we can fill in the near term versus today, we don't get as many net new orders because we're still serving backlog that we received multiple months and quarters ago. So I still think, roughly, we're talking about the same time frame, just given what we've experienced historically. I think the wildcard is really the macro environment. If the macro economy were to accelerate for some reason, be it in China or elsewhere, I think things could move a little bit faster. I think if it were to get worse, I think things could take a little bit longer. I can tell you very confidently we've seen the movie before. We know how to navigate this. We keep our eye on the ball when it comes to cost. We keep the pressure on working capital discipline. At the same time, we don't lose sight of those accretive growth priorities I talked about so that we can emerge from this thing even stronger when the market does fully normalize, but I think we're in it for this quarter and next before we get a shot at seeing something that starts to look a little bit more normal in the spring quarter.

And I guess, typically, book-to-bill kind of that metric that investors are focused on. Is that still the right thing we should be looking at, just given kind of all the dynamics with supply chains and things and backlogs?

I think it's the simplest way to sort of aggregate where we really are in the correction. As you know, we've said our book-to-bills are below parity, but they have held steady. As I mentioned a few minutes ago, the -- managing through this has been more about rescheduling activity than it has been cancellations. So backlogs are not drying up. In fact, our backlog is still multiples bigger than it was pre-pandemic, pre the start of the good side of the cycle. So that gives us some confidence as we continue to validate those backlogs that we will work through this. We're helping to continue to bring down inventory again in Q4 and generate cash again in Q4, and we're reasonably confident we'll do that. So I think those are all healthy signs that the normal patterns that should play out through a correction are playing out, and we're managing it the right way to bring those conditions about.

You kind of touched a lot upon it, but regionally speaking, right, like Asia has been much weaker, right? Like component revenue, I think, from the peaks down close to like 25%, where the West, Americas and Europe are more down kind of teens range. I mean, is that kind of the path we should think about as being similar? Or how do you think about the mix differential? Because I think Asia is historically a little bit stronger, consumer electronics device related, how do you think about those kind of dynamics?

So I think the way these cycles tend to play out is the opportunity or in this case, the problem shows first in Asia, then it works it way to the U.S. and then eventually, it plays out in Europe. And so -- this is no different in that regard. We're experiencing the same sort of shift in demand patterns over time. I would say, again, demand patterns are holding up a little bit better in the West than they have been in China. Having said that, more recently, sequentially, we were only down slightly in our third quarter in Asia. And we've seen better activity levels of late, at least compared to more recent times. I think it's too early to call for a broader recovery in that market, but it could be that things are going to steadily improve there just a little bit while we work our way through the problem in the West. As you know, Joe, regional mix has a lot to do with our operating margins. And so when the West is strong relative to the East, that calls for one operating margin outlook and vice versa when Asia is a little bit healthier relative to the West. We're used to those dynamics and we'll be able to kind of track to our longer-term guidance as this plays out. But I think the 2 markets are a little bit different. And the big question is, when do we see the Chinese market look more attractive again? Or do we assume that it never really gets back to the sort of double-digit rates that the industry came to enjoy over many years, and we're in the middle of that assessment right now.

That makes sense. And just kind of inventory, obviously, you kind of touched upon it, I guess, why has Arrow's inventory been, call it, stickier than other cycles? I guess, how do we think about like that going forward? Like as maybe if we're finding somewhat signs of like things bottom at least in Asia and maybe we're working our way towards improved maybe demand looking in the second half of next year elsewhere like how do I think about like the inventory dynamic within Arrow and then your customers as well...

I assume when you say sticky, that's not a good thing, right? So look, the inventory, obviously, is key to our working capital performance. We're laser-focused on it. I think you get underneath our inventory mix in total, you'll find that the majority of it is what we would call proprietary. And that is the chipsets that we're involved in designing in at Board level are very bespoke for verticals and specific customers and specific use cases. And that gives us a degree of confidence in the relevance of what we carry over time, even if it takes a little bit longer for it to sell through. That certainly helps us from a gross margin perspective as well because it's indicative of our work to drive more design edge and design win activity so we can participate in demand creation revenues and margins. I think our inventories came down in Q2. As you know, they would have come down in Q3. Had we not made a more strategic decision related to a single opportunity. We do expect them to come down again in Q4 and we'll generate cash again in Q4, as I said. So we think the demand patterns are playing out as they should, and we're managing them properly. I don't worry about the overall health of the inventory from an obsolescence perspective. Raj and team do a good job of making sure that when it comes to things like shrink reserves, we're behaving as normal and normal methodologies would warrant. So we feel like we've got good visibility to where that sits. I think the incremental difference between maybe this cycle correction and others when it comes to inventory itself is a couple of things. One, we've been intentional about our commitment to the market for IP&E, which requires a different working capital commitment than semiconductor more broadly. Secondly, as we do more supply chain work for more customers on occasion, that does require inventory. We like the returns profiles of both of those motions. So we make those inventory decisions wisely, but you probably are seeing some incremental inventory in the overall mix as we work through the excess as a result of our strategy, right, which we know will pay off for us in the medium to longer term.

Yes. And maybe on that, Raj, one of the questions I get a lot is talking about protections in place and how to think about -- we can talk about pricing in a second. But just can you remind us of just the protections you have in place with your suppliers for inventory obsolescence and the changes in pricing?

Yes. I would say, and Sean is going to be more well versed in this area than I am. But from a price protection standpoint for some of the proprietary types of products that we sell, we have a fair amount of protection in place for the more commoditized products that we might sell. We sort of negotiate those prices in that market and not as well protected. But this space, as I've learned over the last year is really about long-term relationships and making sure that nobody is stuffed with a bad outcome, whether it's our customers or our suppliers with us. And so I think really everyone's goal here is to make sure that the outcome is right in nature. Having said all of that, we really just don't see any significant changes in the pricing environment at all. Not any significant price pressure in the market. And so there's not a big change or shift happening where price reductions have to take place in terms of that coming up. So I don't know, Sean, if you want to add anything more to that?

Yes. The only thing I would add is that we're fortunate to have a real good number of great supplier relationships. And by and large, our experience with them has been very collaborative through this cycle. So we've been able to manage the inbound as best as possible under the circumstances while the outbound demand patterns change in our customer base. Point being part of the inflation and the inventory itself is a function of price increases because units are down year-to-date for us on a full year basis year-on-year, which tells you part of that problem, if you will, or opportunity is a function of price. And if pricing holds up and it takes a little bit longer to sell, that's ultimately a good thing for the top line and the margin line. So we're optimistic that the price increases that the industry implemented over the past couple of years will largely remain intact just based on the underlying cost pressure that they're all grappling with.

I guess like maybe just double-clicking on that. I mean, this time it's different in terms of pricing, like how do you -- I guess, how do you think about it because I think at least from my seat, I would think about looking at maybe some of the foundries or some of the just like the as a proxy for them starting to maybe lower their wafer costs. Like is that what you look at in terms of as a proxy for thinking about component pricing? Or how do you -- what guide points do you look at for confidence in that pricing stability?

So I think you got to look at it through a couple of different lenses. One lens in the semiconductor suppliers are better experts at this than I am. But the cost of the product is not just about the fabrication process itself, right? It's the raw material, it's the packaging, it's the whole end-to-end supply chain. Many of those costs remain elevated, right? And so they have the cost pressure I referred to as an incentive to keep the prices where they got them. In addition to that, we all witnessed the uptick in capital investment, whether that's to diversify fabrication throughout the world or to move manufacturing to other parts of the world or some combination of both, those costs still have to be borne by the businesses over time. So I think they're rightly focused on making sure they can protect the margins as best as possible. However, the other vector will be the largest account or OEM space versus the mass market. Fortunately, the lion's share of our strategy is about the mass market where I think the price concessions aren't going to be as severe. The way that they get price savings or cost savings, if you will, is the redesign activity throughout their product line. So that tends to take some time, right? Certainly, in the high end of the market and as it relates to fulfillment volumes, I think you will see some price pressure over time as those big accounts renegotiate terms with the largest of their suppliers. I don't think we're entirely immune, but I also think that prices have a better chance of withstanding market dynamics than they would have been in prior cycles.

Okay. That's helpful. Maybe on the operating margin side, and you talk about the stability of components EBIT. Why is it sustainable for this cycle in terms of just kind of what you're seeing? And then you've also talked about some of the structural changes that you put in place in terms of just processes and things versus just pricing pass-through. So maybe talk about like how do you think about the structural benefits to EBIT versus pass-through of pricing or just higher revenue mix?

Yes. I mean, look, I think what we're seeing now is proof positive that margins are structurally higher than they were. We're about 100 basis points higher than we were in the last down cycle within our Components business. And it's because of all the things that Sean talked about earlier, the value-add areas that we're driving here. Obviously, pricing is a factor in there and then regional mix also is a factor. The last 2 years and even this year are abnormal in nature. The last 2 years, we went through the heights of the pandemic and the shortage market. Now we're sort of going through the cycle of correction. But when we do get back to a normalized market, to be determined when that's going to be. We still are confident that component margins will be in that 5.5% to 6% range because of all the things that we've been laying the foundations for. And as we look at optimizing the business, we're always looking to reinvest back in these growth areas, the things that are going to make a difference for us in the next few years. And that's going to be, again, supply chain services, demand creation, design services, and then just overall engineering capabilities that we're driving into the market. So we think that's why the margin profile of the business will continue to be quite strong in the future.

Okay. That's helpful. One of the things that I -- questions I get from investors is this year, I think we've seen pretty significantly China putting a focus on the semiconductor industry and trying to build their own industry. And obviously, because of the export restrictions, they're very focused on some of these mature markets that maybe overlap with some of your existing suppliers. So I guess like -- how do you think about China's increased focus on the semiconductor industry? Have you seen -- I think there's even some Chinese distributors. Have you seen increased competition? How do you think about that also just as a -- having margin implications as well?

So we went through a strategy exercise with our board in July, and we sort of stepped back and looked at the entire global landscape and looked at Asia, obviously, is a big part of that. Historically, we focused primarily on the Chinese market, and that served us well. We have a significant business in that market, and we fully intend to continue to compete in that market. Our strategy there has principally been about the industrial mass market in Mainland China. Said another way, we never leaned in too aggressively to what I would call the ODM Origin business out of Taiwan, which is primarily focused at the mobility in the compute space, where you tend to find higher volumes but lower margins and lower returns, right? That was largely intentional on our part. So now as we look at the go forward in Asia, I'd say 3 things. I'd say, one, longer term, we've got to think about opportunities in rest of Asia beyond China, and we are, and we've organized ourselves internally to kind of create that extra visibility to things beyond China that we want to think about down the road. Secondly, within China, there's a couple of different pieces to it that we benefit from. One is the multinational customer landscape that manufacture in China, right? And so some of that will stay. Some of that has moved. Some of that will move, and we're doing a really good job following the money, if you will, part of that will go to other parts of Southeast Asia. Part of that could go to Mexico. Part of that will go to Eastern Europe. We know what that looks like, and we'll stay close to those customers and their contract manufacturers. Then if you look at alongside that, the indigenous Chinese customer base, which to us is massive, right? That speaks to the heart of the industrial mass market, and we're talking about tens of thousands of customers that our suppliers really want us to help them go after. We still think there's demand creation opportunity for us that still makes sense. We still see potential in that play. Having said that, over time, if the market should start to trend to something that sounds a little bit more like China for China, well, we have and will continue to build out a China for China line card and a China for China strategy, so that we've got the right offerings to continue to compete in that market for the long term. So I think that will play out over time, not overnight. But we've thought about it in multiple threads. We don't just see it as 1 problem or 1 opportunity. It's ultimately going to be a good place for us, but the nature of it will change over time.

Do you see in China like some of the -- your distributor peers are like the native China distributor peers, is there much demand creation at this point by them? Or is it mostly just to kind of fulfillment?

From what I can tell, it's more about fulfillment than demand creation. And I say that just based on knowing what -- we know about what we do and where we play and who shows up. But I couldn't speak to their particular strategies in great detail. There are a good number of small local and regional distributors, there's only a short list of more substantial regional distributors and we know who they are, and we've competed against them for years.

Sure. Okay. Maybe shifting gears a little bit to the ECS business. Talk about just kind of your view for enterprise spending for '24. I mean I think '23 has been kind of an interesting year and the fact that like a lot of IT budgets maybe change mid part of the year, right, to kind of go after AI. So how do you think about '24?

Yes. I think the -- I think you're right. Over the course of the year, IT budgets in general became a little bit more conservative. I think in the larger enterprise space, what we've seen here in the back half is what I call more big deal scrutiny, which has slowed down a lot of traditional enterprise IT demand. That's been more evident in our North American business just based on our mix in this market. We found the mid-market to be a little more resilient, and that shows up in our European performance. It tends to be more of a mid-market economy and very representative of where we're also going in North America. We're just not as far along as we are in Europe. I think the outlook for next year is maybe incrementally better, Joe, but I don't think anybody is calling for a V-shape recovery. I think the talk is more of something more gradual, but we think we have an opportunity to grow in that business next year, certainly on the bottom line, if not the top.

Okay. What about like the acceleration in demand for AI-related hardware products? I mean, has that -- have you seen a benefit from that? Where does Arrow fit in that kind of equation?

So you can think of us as participating in the build-out of AI-related infrastructure, i.e., GPUs, primarily through our supply chain services offering, right, and enabling the bigger data centers and hyperscalers to establish AI-related infrastructure and capabilities. That continues to be a bright spot in the market overall. The good news, bad news is while we're participating in that, and it certainly benefits us on the operating margin line. It's not so big that if it were to change dramatically, that it would be overly disruptive to us in the near term. Obviously, what we want to see is the broader business normalize and recover more optimistically going forward. And we'll see when that happens, but I think the AI space is going to be good for the industry long term. And we're still in the early days of seeing its full potential play out in the enterprise and commercial realm would be my estimate.

Okay. Maybe just kind of to level set a little bit, but like the revenue dynamics within that business, right, has been continuing to kind of go through a transition, moving more to software that from a revenue standpoint, the growth is somewhat dampened because of the accounting. Like talk about just kind of how we think about like that product mix shift and like where are we in that transition in terms of trying to kind of -- like could we start to see like more accelerated growth just because of the mix within it has changed?

You're exactly right, and I hate to talk about accounting. I leave back to that guy over there. But -- we've been very intentional in our pivot to the market for IT-as-a-Service. That means more cloud-related solutions, be they hybrid or multi, more infrastructure software, and there's lots of good demand drivers for that. And then, obviously, related services for both, right? And it means that all those things are becoming a bigger piece of our total mix on a billings basis. By the way, the good news is as a subset of that mix shift, more and more of that is recurring in nature. And at the right time, we'll be able to kind of walk you through that in more detail. But what it means from a top line perspective because we account for that differently is the GP associated with that transaction is the sale. So it won't be a top line story. It will be a story about GP dollar growth, bottom line profit growth and ultimately a growing portfolio of recurring revenues from cloud solutions, from the transition from perpetual to subscription-based software licensing and then all the related services attached to those solutions, increasingly, we're trying to provision and manage on a digital basis. So it will take some time for us to get to the same place in North America that we enjoy in Europe. The good news is we know exactly what goodness looks like and it does require some incremental investment, but I think the future is bright, just given our size and scale in the IT market more broadly in the size of our installed base, we have a good shot of being very relevant in that space in the future.

That's helpful. I guess in that business as well, with that dynamic at play, how do you think about just kind of the trajectory of operating margins and where we could see that move over time?

So we had this conversation a little bit this morning. I would say historically, if you look at that business, we've operated in the 5-point realm. I think this year has been a little more challenging just given what's going on in the broader market, but that's not an unreasonable expectation moving forward. So we're confident, just given mix alone that we should be headed in that direction. And then obviously, if we benefit from a more vibrant market across all those categories in which we're really looking to drive the volume, then that certainly is going to make it very achievable.

I guess to get -- maybe see some improvement, is it more -- is it largely just volume? Or how does the mix -- you talked about a little bit of the mix, but like how do you get to kind of rank order, like what's going to be that driver that...

I'm really comfortable with where we're heading from a mix perspective. What we need now is more volume, really play out the GP dollar and OI dollar growth that I think that this model should yield. Again, we -- 2023 being a little bit of an anomaly. And hopefully, that's going to look better for us in the market overall next year.

Okay. Maybe in a couple of minutes we've got left. I'll pick on Raj a little bit. Talk to us about the working capital needs relative to free cash flow generation. I think if it does play out, the cycle is 2 to 3 quarters, and we start to see some kind of improvement mid part of the next year, is there a scenario where your working capital stays pretty elevated relative to kind of in the past cycles, you've seen a decent amount of free cash flow generation. Like how should we think about that?

Yes, I would say they're all connected. Our capital priorities are really going to be to continue to invest in the business and then we certainly look at M&A, although we've not done anything material for several years, we're going to be very disciplined there. And then we use our excess cash to buy back stock all with an investment-grade credit rating. The working capital and free cash flow sort of go hand in hand, we want to invest in the business. We know that we're going to generate cash in the next several quarters as we go through the cycle correction. Will working capital be elevated versus past cycles? Maybe because of some of those things that Sean talked about earlier with respect to the IP&E segment and demand creation and some other things there. But we know that this is not the right level of working capital for the size of the business that we have, given the cycle that we're going through and that we will generate cash and working capital levels should come down over the next several quarters, not going to stay where they are.

And maybe just sneak one last in and we're over time. But right amount of leverage relative to buying back stock given where interest rates are today?

Yes, it's all -- again, it's all connected. We want to manage with an investment-grade credit rating. So that's really our priority and we are flexible within that constraint to manage working capital where we need to. We'll certainly buy back stock as we have been the last several years, you can see our history. But we also understand as we go through this down cycle, we've got to make sure we're managing the debt levels appropriately, and that's certainly our focus as well.

Perfect. I think we're out of time. Thank you, both.

Thank you.

Thank you, Joe.

Thank you. Thanks.

Thanks, Joe. Good job.