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

We're going to get started here. Good morning. I'm Matt Sheerin here. I'm the senior analyst here at Stifel, and we're happy to have Arrow Electronics, one of the largest semiconductor and component distributors in the world and major IT enterprise-focused distributor as well. Welcoming here is the CFO, Raj Agrawal, who's been at the company for about 18 months now. I think Raj.

You're right? Yes.

Welcome. Raj is going to go through a quick couple of slides just to set the tone in terms of where the company is and the direction, and then we'll go into Q&A. Raj?

That's great. Thanks. Good morning, everyone. Great to be here today. And Matt, thanks for having us, and it's nice to meet you in person finally, and look forward to our discussion. I'm going to say a few words about the company and then get into discussion as appropriate. If we can go to the presentation, [ just visit on ]. Arrow Electronics is a company with a rich 90-year history. And we are now a global provider of components as well as enterprise computing solutions to a number of different end markets and geographies all around the world. We have over 20,000 employees. We are in more than 200 locations and almost 40 different distribution centers around the world, and we serve over 80 countries. At the very basic level, we are a technology -- we connect our technology suppliers to the mass market manufacturers and enterprise organizations that have a need for technology and our solutions. We also have added on value-added services over the last few years, which has allowed us to improve the overall margin profile of the business. And you can see some of the summary stats on this page. If you go to the next page, as we look at the 2 different business areas, global components, we are the channel. We are providing at a very basic level, semiconductor components and IP&E or interconnect passes and electromechanical devices to different parts of the world and to a lot of different end markets. We operate in every single region, APAC, North America, EMEA and in global ECS, enterprise computing solutions, we enable the channel. So we're taking a number of different technologies from our suppliers around software and hardware, and enabling our thousands and thousands of channel partners to get to a number of different end markets. We operate in ECS in North America as well as in EMEA. And then we serve a number of different end markets throughout our organization, whether it's industrial, transportation, medical, aerospace and defense and data center. There's no single customer that's more than 2% of our overall revenues. And so we're quite well diversified from a customer standpoint. If you go to the next page. Looking at a little bit more on global components. The foundation of this business is all around the global scale and scope that we have, right? So we are distributing semiconductor and IP&E components all over the world through 180 sales offices, 40 different distribution and value added centers. And we have a global reach with hundreds of suppliers going to tens of thousands of customers all over the world. And because of this global capability, we really are the distributor of choice in the market. We've layered on, as I mentioned, a number of different value-added services, which includes the thousands of engineers that we have in our business that are doing demand creation, activities, designing, components into printed circuit boards, all the way to more sophisticated, complete product designs for which we get paid a fee. And then supply chain services offering that's taking the global capabilities of our organization and the global scale that I spoke about and delivering that for the benefit of large OEMs that may have a need for us to manage their component supply chains. And it's different from our normal fulfillment process. We are earning a fee for that service that we're providing and that is gaining more traction. Overall, we believe that with the electronification of the space that we're in, this -- the backdrop -- market backdrop will have good drill for the foreseeable future, and that bodes well for our business as well. And then if you look at the next page, global enterprise computing solutions, we are taking a number of different technologies from suppliers, whether it's software or hardware oriented, and providing solutions to our value-added resellers or managed service providers or middle market partners to get to the end market customers that they serve. And we are typically operating in a more complex area of the enterprise IT market. So that means that we will likely be more involved in a solution sale than just a device delivery sale, and that's really where the business is going. We also provide training and certification programs and systems engineering capabilities. And all of this is supported by our ArrowSphere digital distribution platform, which allows us to get to the middle market and allows us to provide the cloud services and allows our channel partners to manage their hybrid and multi-cloud environments in a much more efficient way for their -- to run their entire businesses. So that's a little bit about Arrow Electronics. Sorry for the slide snap through, but we'll get into Q&A.

That's on us, not you. Thank you for that introduction. I'll start off with some questions. And if anybody from the audience has, you can certainly raise your hand. We'll start with the component business, your biggest business. And obviously, going through a really interesting cycle here in the last 4 years. You've had 5 quarters in a row of year-over-year declines. I think you were down 28%. You're guiding 28% down year-over-year. But you also talked about signs that we are close to the bottom in terms of your book-to-bill getting a little bit toward positive or parity. So could you talk about what you're seeing in terms of demand and maybe by region, if there are differences there?

Sure. Yes. It's hard to call the inflection point in our business. In our global components business, we are -- we have guided in the second quarter to be down 8% quarter-over-quarter, which is similar to what we saw in the first quarter, down about 8%. We believe that we're getting closer to the bottom of the cycle. Hard to say exactly when that's going to take place, the inflection point, but as we -- as you mentioned, we look at a number of key indicators, whether it's book-to-bill ratios that have been improving in the last 3 quarters in a row. Our backlog levels have been coming down, which -- they're still above the pre-pandemic highs, but lower in the last 3 quarters, and that's probably more in line with normalized lead times. Cancellation activity has also stabilized, and we have seen inventory levels throughout the ecosystem, including our own inventory levels coming down. So that tells us that we're closer to the bottom than we were a few quarters ago. There are obviously soft spots in the business still, but it's going in the right [indiscernible] from other players in the market as well.

Yes. And the guidance for June suggests that you're below seasonal, and that's because your customers are still working down inventory, right?

Yes.

Are you getting a sense and do you know like a different types of customers in terms of inventory levels and are we talking a quarter or so when you get back to a more normal order patterns? Or is it going to take longer? Or it really depends on end markets or customers?

It really depends on end markets and customers. There are differences in different vertical segments that we're serving. Industrial continues to have a higher level of inventory, and that's going to take some time for you to work through. And -- but it is going in the right direction, Matt. And hard for us to say we -- the cycle has lasted a little bit longer than anyone expected, the correction has. And so it's hard for us to say exactly when that's going to inflect, but it is going in the right place.

Got it. And then ASPs or pricing seems to have been holding up very well. And maybe that's because demand is still weak. And as volumes come back, maybe we'll see pricing pressure. But what's your take on that in terms of ASPs? And then not just what you're seeing from your suppliers, but obviously out there, you're competing with your big competitor, but also smaller competitors in terms of pricing dynamics, could you share that?

Yes. Yes, I would say, overall, the pricing environment continues to remain relatively stable, whether it's the transactional pricing to customers or even on the supplier side, we haven't seen any significant changes in the pricing environment. I would say that even though inflation isn't necessarily as high as it has been, and prices are necessarily going up as much as they were. They're certainly not going in the downward direction in any significant way. It still costs money to design, develop, distribute the products all over the world, and that's really what we see in our business. Hard to say how long that's going to last, but we don't see any price pressure in any material way that's sort of driving it down. At some point, things will normalize, but we don't really see a big functional step down in terms of pricing at this stage.

Okay. Great. And then below the top line, your margins in components have been well above 5% for several quarters. And I mean you had record margins through the cycle, right? And -- but now there, it looks like you're guiding below 5%. You're below 5% in the March quarter. How should we think about margins? Is it really just a function of volumes coming back or other factors?

Yes. I would say, we are operating today at structurally higher margins than we have been. I would say that if you look at the last down cycle, we're still about 100 basis points above the last down cycle in our components business. And that's a reflection of some of the value-added areas, the services that we're providing, whether it's the IP&E focus or the supply chain services offering or demand creation and engineering services. All of those things have helped to drive higher structural margins. I do believe that today, the margins are lower because of the volume reductions that we've had. And so as we get that growth back, as we start to see the growth, we will start to see more margin expansion. The other thing I would just add, Matt, is that we have also been focused on reducing costs in the business, things that we can control. And so although we'll invest some of that money back into the business, we also believe that, that will help to drive more leverage on the bottom line as we get the revenue growth. And we continue to believe that components margins can be in the 5.5% to 6% range on a longer-term basis in a more normalized environment.

And could you maybe expand on the cost cutting? Has there been some headcount reductions? Where are you cutting? Obviously, you probably don't want to cut sales folks, the technical experts that you have. So where are some of those cuts coming?

Yes, you're right. We want to protect the front line as much as possible. We also want to protect our engineering resources because those are the things that are going to make a difference when the business does turn around. We have looked at -- like everyone else, we're looking at facility closures, consolidating. Our corporate headquarters has been a part of it because I talked about the number of facilities we have. If we're not getting people coming into the office, we're going to sort of consolidate that. That's just one example. We also have continued to evaluate rebalancing our workforce in different parts of the world and leveraging more of our shared services capabilities. And I think that's going to continue to be a theme for us. We're always looking at cost takeout to optimize the business. We know that some of the costs will come back in as we start to grow again, but we -- some of those will be more permanent in nature as well. And again, it's a focus on the things that we can control while we're going through this correction process.

Okay. Great. I wanted to ask a bigger picture question regarding the semiconductor suppliers. And some of your biggest suppliers have changed or transitioned their channel strategy. Some are going more direct to customers, your biggest customer, your biggest supplier, sorry, TI. And then others have talked about moving more demand creation to -- on a direct basis, your biggest customer or your supplier and then talk about other suppliers. So how should we think about your relationship with suppliers, particularly if we see more semiconductor industry consolidation and the role that Arrow plays from demand creation. Meaning, you're going in getting design wins and then you're getting a higher margin versus just fulfillment. And then the third part of that is the supply chain services that you're doing, which is different but really focusing on the supplier relationships. I know there's a concern from investors that only a couple are really moving on a direct basis around distribution, but there's concern that others will. So what's your take on that? And how is Arrow strengthening the relationships with suppliers?

Yes. I think it's a great question. I don't see it as a big trend. The -- what you described. Most of our conversations with our supplier base across the board is about how we can grow the business better with them, how do we drive more volume with them. And that's going to be around some of the value-added areas that we're always focused on. We play a very important role for the supplier base, which is to get to the mass market manufacturers and mass market enterprises that have a need for this technology, and that's a role that we're always going to play. So we're getting more suppliers coming to us. Obviously, things will ebb and flow in the market, but this is not a new phenomenon. And I would also say that there's no single supplier that's more than 10% of our revenues. We're very well diversified. We have lots of good things that are in the hopper in terms of where we think the business will go. And our focus and drive every single day is really about how do we drive the long-term growth in this market in the next few years. And I'm confident that we'll get to a good place with better revenue growth, good margin expansion. And we always look at the resources that we have tied up with suppliers. That's really important to us. It's important to suppliers as well if we dedicate some engineering resources to them. And it's really also the right reasons. And we were just in our Boston office yesterday as we came in the afternoon and they described a lot of great things that are happening in the business and how they're engaging with customers on the demand creation side, which ultimately leads to more relationships with our suppliers and better margins. So that's really our focus. You also mentioned that the supply chain services, I can certainly describe that we'll get more...

Yes. I would love to delve more into that.

Yes. It's really an interesting offering for us. Supply -- our traditional fulfillment model is to buy inventory for suppliers, hold it on our balance sheet, and we negotiate prices and we sell it to the end customers that we have and we're earning a spread on that product. With the supply chain services offering, it's a very different activity. We are earning a fee for the services that we're providing to the large OEM ultimately. So we're sort of stepping into the middle of a relationship that an OEM already has with the supplier. We are not negotiating pricing of that product or anything of that sort. We are simply handling the supply chain for components of that end customer. That's taken on a higher level of importance as we went through the [ shortage ] experience in the last couple of years. And so we will take down that inventory. It's not on our balance sheet, it's a relatively light working capital business. We'll have accounts payable and accounts receivable associated with it on the behalf of the customer. And we'll get that product to the customer whenever they want, right? And how ever they want it in which ever plant or facility they want it, and they're paying us a fee for that service, that's how we earn our money. So it's not going to be as impactful from a revenue standpoint, but it's going to be more impactful from a margin and a profit standpoint. And so that's why we like it. It has gained some good traction there. Some of our largest customers are the hyperscalers, for example, where we're managing their component supply chains. And so these are the kinds of things that our team is very focused on.

Could you give us an idea of the size of that? And I know from a gross profit standpoint, it's lower because of the fee that you talked about. But in terms of like the volume of inventory that you end up, not selling but distributing to that customer. We're talking about like a couple of billion dollars kind of a revenue pass-through, if you will.

Yes. Well, it's a sizable -- there is sizable volumes behind it. We have not actually quantified specifics behind it. Our goal is really to go get more market share right now and go tie up those relationships wherever we can. We think it is really important to our customers. And as we -- as I described the global capabilities we have, that's really what the customers are trying to leverage. Those 40 distribution centers that we have and our people that have the expertise and the know-how and the knowledge, that's really what they're paying for. I see this continuing to be an important contributor to the profit line. And we are certainly with our 40 distribution centers, we're handling a lot of volume for all of our partners, including in this part of the offering.

And do the suppliers care one way or the other in terms of working with those OEM customers? Are they involved in all of that?

Not necessarily, but I think it's really -- we're not taking over that relationship to the supplier and the customer. We're just helping to sort of facilitate the delivery of that product. So the suppliers are still winning in that equation, so are the customers and we're providing a value-added service to the customer.

Got it. Okay. Great. I wanted to talk about inventory. Obviously, your inventory and everyone else was very bloated through the cycle. But you've worked down over $1 billion of inventory in the last couple of quarters, pretty significantly. And that's obviously a help to your free cash flow as well. So how are inventory levels tracking? I think even last quarter, you said you're probably not going to see a big cut here, right? Where you may be where you are, but you're -- in terms of inventory days, you're higher than you were pre-pandemic. And I guess the question is, is that -- do you want -- is that comfortable for you or customers want you to carry more inventory? Or is there more to do?

Yes. I mean you're right, we did reduce inventory in the last couple of quarters by over $1 billion. Inventory actually on an absolute basis is the lowest it's been in a couple of years. So we've brought inventory levels down quite a bit. And that was the reason why we indicated that you shouldn't expect the same kind of change in the next couple of quarters because we do want to be well positioned in the role that we play is to make sure that we have enough inventory on hand to be able to drive the growth. So as the business turns and as we get more growth opportunities, we certainly want to support that with the inventory in that regard. The turns metrics are very important. It's driven in large part by where the top line is and where the overall business is. So that will correct itself naturally as we start to grow back out of this. And so having said all of that, we're always trying to optimize the working capital, right? We want to reduce working capital, wherever possible, agnostic any cycle correction. So we always -- we have an effort underway inside the company to keep looking at ways of optimizing our working capital because there are always places where you can be a little bit more efficient regardless of the cycle that you're in.

Okay. Do we've any questions from the audience? Anyone have anything? No? Okay. Well, we haven't spent any time on your computing business, ECS. Can you update us on demand trends there? I know that there's been basically sluggish IT spending, right, more cautious, elongated sales cycles, much more scrutiny from customers. What are you seeing in that business?

Yes. I would say that we're seeing some pockets of relative strength, but it's compute or business applications or for infrastructure. But generally, I would say that we sort of have 2 tails in our business. We've got the European business that in the first quarter did have good billings growth. It had good GP dollar growth as well, and that was offset by the North American business, and that continues to be in transition. They are a little bit different from each other, and that's really where our strategy is going. You've got the European business that is further along in the cloud journey and IT-as-a-service type offerings, and that has allowed us to be more middle market focused as well. The North American business has historically been more focused on the larger enterprise IT part of the segment as well as a little bit more hardware focused. So it has had a more challenging time. And -- but that business is in transition right now as we speak. We've got the ArrowSphere digital distribution platform. That's going to allow the North American business to get more access to the middle market and really scale up that middle market faster than you might be able to otherwise do with our distribution capabilities there. And so I think that's really the formula for us on how that business can sort of correct itself. We also did assign a new leader recently. His name is Eric Nowak. He is a veteran of the business for more than 20 years. He actually ran our European ECS business prior to being assigned the global responsibility. So I'm not saying that he walks on water everywhere, but I think he can certainly help us to turn this business around. And he's hit the ground running and he's got the right mindset. It doesn't necessarily mean that there's a big change or shift in strategy. It does mean, though, that we've got to execute and deliver these things and we've got the right tools to be able to do this.

Are there certain product lines or franchise agreements that you have in Europe that you don't have in North America? And that you -- are there any efforts to add [indiscernible].

Certainly, there will be more efforts to expand the line card, if you will, from the supplier side. We want to make sure that we're well positioned there. I think we have some good capabilities there already, but we'll continue the expansion there. And the trick really for the North American transition will be this ArrowSphere digital platform and what it allows our middle market partners to ultimately do in distributing and managing their own businesses.

So in other words, you're trying to take share from some of the bigger players -- some of the bigger broadline players like the SYNNEX and Ingram Micro.

Sure. I mean, yes, we're going to try to -- we got to turn the business around. We've got to position it well, and then we'll certainly try to go after more market.

And if you look at the top line, your top line hasn't really grown in a few years, partly because of the netted down...

Yes, exactly.

We understand that. But even operating profits haven't really grown much, and I guess...

It's really -- you really look at EMEA, which is a different story. It has grown billings. It has grown profit dollars. North America is sort of the opposite story. But we're in the process of correcting that. And with Eric's leadership, I think we'll get to the right place.

Okay. Good enough. And then I wanted to just talk about -- we talked about inventory reduction, free cash flow. You've been -- the company has -- I think you bought back 25% or 30% of the stock in the last 3 or 4 years. I'm very aggressive there. But your interest expense has also risen dramatically, obviously, with the working capital. What's the priority? Are you going to try to bring down your short-term borrowings or do more buybacks? What's the capital allocation strategy?

Yes. Capital allocation strategy is quite simple. We want to invest in the business to drive organic growth and expansion. That's our #1 priority, whether it's working capital or CapEx. CapEx has generally been less than $100 million. So it's not a significant allocation, it can vary from any -- in any given year. Obviously, but the -- we always look at M&A opportunities as another area. We've done a -- in the first quarter, we did a small tuck-in acquisition in the engineering space to give us more engineering resources. So that's a key use of capital wherever we see the right fit. And then we'll buy back stock with our excess capacity, excess cash flow. That's all wrapped with an investment-grade credit rating. So we want to make sure that we're going through the low points of the cycle, which we are right now that we have put more towards debt paydown to get the credit ratios where they need to be, but we'll get back to growth at some point. And interest expense, I would say, Matt, has been trending down. We guided to about $75 million of interest expense in the quarter. That's down from $80 million or so n the first quarter and down from last year. So it's probably going in the right direction.

Okay. We're out of time, but thank you very much. Appreciate it.

Thank you. Matt. Thanks for having us.