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

So I'm Melissa Fairbanks. Thanks for joining us on the first day of our annual conference here for I -- cover Analog Semis and IT Supply Chain. So kicking off my track here at the conference. We are thrilled to have Arrow back again. We've got Sean Kerins, President and CEO. And also in the audience, we've got Brad Windbigler, who is Treasurer and IR. Thanks for coming back again, Sean. You've had a very eventful weekend i think.

Yes, I have. Thanks for having me. Melissa, good to be here.

Great, great. For those of you that don't know, Arrow is one of the sponsors of a couple of IndyCar teams. So -- they had a fun weekend in St. Pete. Can't complain about the weather.

It was a very good weekend. Lots of suppliers and customers joined us. The team didn't do so well, but that's okay.

That's all right. That's all right. Great. Great. So for those that are less familiar with Arrow today, Sean, maybe could you provide a brief overview of the company, the two different segments, reportable segments?

Sure. So let me -- maybe the best way to do this because I'm sure some of you are closer to technology than others. But basically, you can think of Arrow Electronics as sitting in the middle of a pretty -- pretty massive ecosystem. We work on behalf of the electronic component industry and the enterprise IT industry. And we really sit in the middle of all of those suppliers and ultimately, all the customers that will consume their technology over time. So in that way, we're very much a platform-based business model. So we connect thousands of suppliers with hundreds and thousands of customers, right? And our job is to kind of do everything we can to help them get their products to market. That could involve design-in at the Printed Circuit Board level or beyond, that could involve configuration of data center technology, that could involve integration and build to get bespoke products to market. It certainly involves warehousing and logistics and all the great work our teams do with all of our supply chain assets throughout the world. But again, we represent thousands of suppliers and help them get product to market for hundreds of thousands of customers in the electronic components in the enterprise IT space. As you know, from the math, the Electronic Components business is roughly $20 billion in size. Our Enterprise IT business is roughly $8 billion in size. And for our Enterprise IT business, we actually enable a pretty significant channel of resellers, solution providers, managed services providers, cloud services providers. There's a whole host of names that describe the independent channel. And in that way, we enable this massive off-payroll sales force. We think of it as off-payroll sales force. And the more of those customers that we can enable, to go sell on behalf of their suppliers, the better we do. In our Electronic Components business, we are the channel. Most of our suppliers basically hire us to represent them and call on the mass market, which is tens of thousands of customers that they don't call on themselves. And in doing that, we point our sales force and our field application engineers at all of those OEMs throughout the world to help design-in the technologies that we represent. So one is a $20 billion segment. The other is an 8 [sic] $8 billion. We'll get into this a little bit because I'm sure you'll ask me about our Enterprise IT business. But funny enough, if you look at our Enterprise IT business on a gross billings basis, it's $19.5 billion. So if you look at it in terms of real point-of-sale activity, these two businesses are very similar in size. It's simply a function of just the way we account for software and services as a function of agency accounting that makes it look a little bit smaller, but it is still a substantial business for us as well.

Okay. Great. We're going to dig into that one in a little bit. But I'd like to start with because this is a generalist conference. I'd like to start with kind of a longer-term view. You just gave us a great overview of the company. But maybe talk about where you've been? And where you're going? In terms of the target model, how things have evolved. And then, of course, we're going to get into how ECS, the Electronics IT business sits in within that model.

Well -- Arrow has been around since 1935.

I love that.

We opened up a small store on Radio Row in New York City, and we were in the industry in its very early days, helping university professors and hobbyists start to exploit markets for things like transistor radios. So we've been basically involved with electronics since the advent of the industry, and we've helped shepherd the evolution in every turn of the crank that has come its way since. So now we're a global player with global reach and supply chain assets throughout the world to help connect our suppliers and those customers. And beyond fulfillment alone, our journey to the future, as you describe it, is really more about the value add that we can bring to bear alongside our core business. So in addition to all the supply chain fulfillment work we do, throughout the world. We're now in the Engineering Services business. That's a great way for us to serve large OEM customers very differently. We're now in the Supply Chain Management business, where we serve large OEMs on an outsourced Supply Chain Management basis, if you will. And we still continue to drive into new segments. The latest foray for us is to really penetrate the market for interconnect passive and electromechanical technology more deeply. You can think of that like you're walking in the customer, and you don't want to walk past all the nickels and dimes just to pick up all the dollar bills. So when you're in the same account, why not do more on behalf of that customer and capture more of that electronic design. So our future, I think, will very much be in the value-add space, Melissa. I think we'll continue to look for reinvestment opportunities that move us even further into the higher-margin services business. Like Engineering Services, like Supply Chain Management and maybe a few other offerings beyond. And the same thing is happening in our Enterprise IT business where we grew up as a hardware distributor in the enterprise data center to now a company that basically 2/3 of our mix is in the cloud, hybrid cloud and managed services space, where we represent all the Enterprise IT suppliers that you might recognize on behalf of all of our channel partners, and that is a much more recurring offering in nature. The recurring piece of our mix is now over 30% of our total volume.

So that's the IT-as-a-Service?

That's IT-as-a-Service. And we like where that business is going as well, and we're going to continue to point it at in a more accretive ends of the Enterprise IT spectrum.

Okay. Great. How much in terms of hitting maybe your own internal margin goals longer term? How much is tied to revenue cycles? We're all very familiar with how semiconductor cycles go, even though this most recent cycle is a little bit unusual -- to say the least. But then also ECS has a little bit of a different investment cycle going on. So in terms of getting to some of these growing the margin accretive businesses, how much is tied to, we need to wait for a volume recovery? Or how much of it is just purely structural?

That's a great question. So if I start with our Electronic Components business. Those of you that have followed the space closely, full well that we're still in a pretty significant cyclical correction. The upside in 2021 and '22 during the pandemic-driven shortage market era was pretty generous to all of us, and we probably could have expected it would be equally challenging on the downside. That correction is, as you know, been longer and deeper than we had expected, but we do think we're at the bottom, and we do see recovery in the future. I know you're going to ask me when?

Give me an exact date. I mean, come on, Sean.

I think -- look, I think the inventory levels are finally starting to normalize. That's not universally true, but the inventory levels throughout the ecosystem are finally, starting to creep down to more normal levels, and that's improving the visibility that we're seeing from our OEM customer base. Again, on behalf of all those suppliers for whom we carry inventory. And I think that's going to lend itself to a modest uptick throughout the year. What is less certain is really the economic catalyst for better demand overall. We are well established in the industrial sector, in the automotive sector, in the aerospace and defense markets, especially in the West and to a lesser degree, markets like medical equipment, renewable energy and consumer devices. And we're always looking to -- look to the next vertical that will drive the growth for us in the future. It's not apparent that there's a big economic catalyst for demand in some of these markets. Markets like automotive are challenged, especially in the West. But we do think the piece of the correction that's been largely a function of excess inventory is coming to an end, and we would expect to see improving activity levels throughout the year. As you know, we haven't guided that way on a full year basis because this environment is so uncertain. But we are expecting things to get a little bit better from here. And -- that is also because we did a pretty good job last year really lining up to serve our large multinational customers pretty well. They have awarded us with incremental business that will start to fold into the business this year. We've been active on the line card development front, meaning build new supplier relationships, new suppliers, we get new customers, which in turn, we get new suppliers, sort of the lifeblood of a successful distributor. We were very active in the last 12-plus months on that front. We'll start to see some of those volumes fold-in over the course of the year. So even beyond what the market is going to offer us. We've really been determined to take matters into our own hands as well. So I think we're well positioned there. I think the trick will be to your question, above and beyond the sort of cyclical dynamics in our core business, how fast can we go with Engineering Services? How fast can we go with Supply Chain Management? How fast can we further penetrate the market for IP&E? Which you know is accretive to the semiconductor segment. Those are all the things that are influencing the way we think about how fast we invest in organic growth. But those would be our organic growth priorities. And we think ultimately keep us on a path that says, we exit from this thing a little bit healthier than the way in which we entered it. And that's been our goal throughout this cycle. On the Enterprise IT side of our business, we're not so big that we represent the market in total. So a lot of the improvements and the trajectory that we're now starting to enjoy in that business has largely been a function of what we've done and what we're doing differently versus the way the market itself is playing out. "So that's a business where we said, 'We have a really successful go-to-market model in Europe,' which is largely a mid-market economy." We've got a healthy line card, all pointed at cloud and software based on how they grew up. And we were well out in front of the move for cloud adoption in the channel with the help of our digital platform to sort of lead the European market in that capacity. And last year, I put the leader of our European business in charge of our Global business so that we can replicate that same model in North America, and we've made a number of changes in that business to kind of do just that. We like the momentum that we're now seeing in our North American business for Enterprise IT, which we call Global ECS. And there's been some publicly reported wins that have come our way with the likes of VMware, with the likes of Citrix in support of what they see us doing. So we feel good about the trajectory for that business, not just in this particular quarter, but for this year. And again, we think because we're not the market in total, we can influence our outcomes...

There are opportunities and upside...

Regardless of where the overall market ends up on a sort of CAGR basis.

Sure. I think that's a key differentiator between Arrow and maybe some of the other bigger guys globally is, is that ECS business.

I think so, too. In fact, we sometimes get viewed as a semiconductor distributor alone, and it frustrates me a little bit, because I believe that there are other assets in the portfolio that we need to properly describe and frankly, get credit for from a valuation perspective. And so if you paid attention to our Q4 earnings call, I did talk a little bit more about our Enterprise IT business for that reason. I think it will be a better contributor to the Arrow Inc, story in 2025 than it was in the past couple of years.

Yes. It's definitely something that's underappreciated. And so I think having more focus on it, talking more about it is definitely going to be helpful. Now you did mention this correction has been a little bit more prolonged than a year ago, we were sitting here and we thought, well, maybe things are starting to stabilize and then not so much. You have announced some restructuring recently. And I think a lot of it has been underway. Maybe talk about you -- entered the supply chain crisis with a very lean organization, and very efficient. And where are some of the areas that maybe some of this restructuring has been targeted? If you're willing to.

Yes. No absolutely. It's a good question. Well, as most of you might know, a market environment like this really gives you the opportunity to make changes that you wouldn't necessarily have the time to make when the market's a little bit healthier. So we did just that. And I would say it's a combination of multiple things, Melissa. On one front, it was just good old-fashioned portfolio housekeeping. We had some smaller underperforming or diluted businesses that weren't really in-keeping with our strategic priorities. None of those were overly material in size or scope, but it was the right time to take care of those and we did. We certainly had a couple of pockets of the organization where given the depth of the correction we had to do some rightsizing. That was mainly from a management overhead and back office perspective. And that makes perfect sense given the duration of this correction. But obviously, we feel like that helped put some of those businesses in better shape for the future. And then -- and this is what I would call the ongoing piece. We have always been in the business of redeploying OpEx from places where it's less effective to places where it can be more effective given our strategic priorities. So I can give you an example of that. As you might imagine, a distributor of our scale, we execute millions and millions of transactions a year in support of all of our suppliers and customers. And so managing that transactional workload more effectively, applying more tools and technology to help automate some of those processes, is a way for us to free up capacity that we can then redeploy to more salespeople, more field application engineers, right. More if you will, front office capacity to help us grow, especially in the areas that we would say are really critical to the accretive trajectory we want to be on. More IP&E, more demand creation and more of our value-added services in our global components mix. In the same thing in our Enterprise IT business, more cloud, hybrid cloud or I should say, all things IT-as-a-Service, which is recurring in nature and ultimately accretive to that mix as well. So this idea of not just taking costs out and dropping it to the bottom line. But in fact, redeploying and reinvesting it, consistent with our growth priorities is exactly where we want to be. And that's a motion I've told my team it's not going away, even though they all want it to stop. Because that's a sign of a really healthy company, and that's where we're going to continue to go.

And I think it's important to point out this isn't just reactive to -- this isn't just, we're in a downturn and then it's reactive. This is part of an ongoing process?

It absolutely would be ongoing. Yes, even when we see more normal market volumes again and growth patterns, again, we have opportunities for what I call the enduring productivity gains that are available to us throughout the portfolio and having a sustained initiative at going after them. Again, not to take that to the bottom line necessarily, but to redeploy it in ways that we think will be more accretive.

So that kind of leads into what are we seeing in the current, maybe a shorter-term view. It might be helpful to review. Obviously, you have a very -- you touch a very long tail of customers, a very broad-based customer and supplier base across a number of end markets. Maybe review what you saw in the December quarter and then what the March quarter outlook is kind of assuming? Because not everything is terrible.

Yes. No, no, you're exactly right. It's easy to get distracted. And I don't want to do that. But first to -- there's a distinction I want to make about, where our suppliers play versus where we play. Because one of the questions I get for both operating segments is 'hey, are you at risk of your suppliers taking your customers direct?" And the reality is, in the very largest of accounts, right, in our Electronic Components business that's large OEMs, right, or an Enterprise IT, that's a large enterprise companies, big banks and so forth. It's very true that our suppliers are much more directly involved in serving those relationships. Where they hire us to give them reach and scale and where they make our rewards most attractive is in the mid- and mass markets. That's the tens of thousands of customers they're not going to get to on their own. And so we've pointed our models to our go-to-market models in both businesses exactly to those pieces and parts of the market. And we think that, that's resonating for our suppliers and in turn it puts us right in front of customers who value our offerings and capabilities the most. So the point of what's happening right now? I would say in Q4, we were fortunate to over-deliver the guidance we set. We may have been a little bit cautious on the electronic components front, just given all the uncertainty and all the guides that surrounded us, right, both from a supplier and competitor perspective. Visibility hasn't been as good as we'd like it to be. It turned out we overachieved our own expectations in Asia. We overachieved our own expectations in North America. And we did better than we had projected with our value-added offerings, which helped from an operating margin perspective as well. I think as we look to Q1 in that business, again, most of the guys in our space were down sequentially. We thought that we were for better or for worse in good company. We've seen a guide or two late, that's a little more encouraging. Like I said, I don't think we're out of the woods. We guided to something -- it was down sequentially, but less so than in Q4. And I would just say, so far so good, in the first quarter relative to our expectations. Again, I think what we're starting to see is improving visibility as a result of inventory levels that are finally depleting enough to warrant the mass market customer base to start to show us, what their production requirements are going to look like well beyond just the next 90 days. And that's an important indicator for a player like us in terms of our long-term confidence. So we'll have to see what the broader economic outlook tells us. And then in our Enterprise IT business, we had an even better quarter than we anticipated in that business as well. That unlike our Components business is a very annual in nature. So you want to look at that business on a year-over-year basis each quarter, not a quarter-on-quarter basis. But as you know Melissa, Q4 in the enterprise IT world is the biggest of the year, and we had an even bigger uptick than we expected. And it played out for us in the more valuable pieces of our mix, where we can add the most value from a provisioning management support perspective when it comes to all these cloud environments that we use our digital platform to help manage. The outlook for that business is sort of typical seasonality in Q1, even though we don't typically talk about seasonality in that business. And I would say, so far so good for us in both markets, Europe and North America. So we think we're doing the right things, which is helping, and we're also seeing a little bit of renewed activity in the traditional data center in part, because you've had some old sweaty assets on a lot of these shop floors for some time that are in need of an upgrade. But also, I think CIOs are now starting to look at what will the long-term implications be for how they embrace AI, as an influence over their data center footprint as well, and that's stimulating some renewed activity levels. I think if you look more broadly at some of the players in the server storage and networking space, you'll see comments and data points that kind of reinforce that. So we're optimistic about the outlook for that business as a result.

Great. So I have to -- I know we don't like to look at a 90-day snapshot. But almost looking at a 7-day snapshot now. I have to ask about tariffs and some of the trade implications. One, how does that impact your business? Is that just pass-through? Two, have you seen any pull-forward activity ahead of potentially some tariffs? And then the third aspect, and you can kind of wrap this all into one. But third aspect, how easy is it for you to move inventories from one geography to another to maybe address your customers needs?

Got it. Okay. That's a great question. So let me come back to that last and maybe start with your middle question.

I'll try to remember it.

Yes. Well, tactically, as part of our Q4 result in our Q1 guide, we did get the question that said,"Did you see any pull-forward activity in preparation for tariffs"? And our answer was we saw nothing material, where that would have been most likely was in China. For better or for worse, we're already in the business of managing tariffs on Chinese goods in our business. So we had those processes in place since 5 years ago or 4 years ago whenever they were first implemented. And so we're simply tuning up that process and that muscle memory now for additional volumes. And we know what that looks like, and we know how to execute, and we're not, in general, not worried about our ability to pass all that on. I think broadly speaking, because this has been such a dynamic in some ways, uncertain environment. I don't think the industry broadly knows exactly how this will settle out yet. We're all in the same boat. And I think, therefore, customers like it or not, we'll have to live with the reality that we're all passing this on and that will exactly be our posture. I think -- I'm hopeful that there's still some negotiating going on relative to Canada and Mexico, even though we're one day away from when some of these things become official. But we're already in place ready to go. We'll manage that as carefully as we can. The point -- you make a great point about, you asked a great question about our ability to move inventory throughout the world. So what I'd like to remind people of, is that in a world of uncertainty and tariffs being imposed not just in one direction, but also in reciprocity. Large OEMs and the people that manufacture for them are all rethinking the configuration of their supply chains, meaning what do they do where? Well, a company that has -- the reach and scale that we have and the supply chain assets that we have throughout the world and the well-established processes around warehousing and logistics, not to mention tariff management. We're in a great position to help do that. And so we try and turn these conversations from how do we contain the tariff exposure and pass it on to how can we help you reconfigure your supply chains for the long haul? And I don't think you'll see people make dramatic moves in the short term because everybody is still trying to figure out how this all settles out. But it is [indiscernible] conversation to help them think through the best way for them to set up their business models.

Excellent. Now we're quickly running out of time, which is unbelievable, but I just want to be sure, are there any questions in the audience? Okay. Great. I definitely want to touch on capital allocation. You have been very active in buying back shares and maybe just remind me, remind all of us what are your priorities for cash use? I know that you've talked about reallocating some of the OpEx to areas where you see it's going to be more efficient, some growth areas, but maybe talk about the priorities for the cash use?

Absolutely. So well, first of all, they haven't changed. Priority one, and this isn't even a priority, but it's a given. We are guided by debt ratios and ensuring that we do the right things to maintain our credit rating such as it is. I think everybody knows what that dynamic looks like. But beyond that, our three priorities haven't changed. The first is to really invest in a healthy organic growth strategy, and I'll come back and talk more about the principles of that organic growth strategy. The second is to think about, especially the more accretive aspects of our growth strategy and look for independent assets that we can bring in from an M&A perspective to help augment, complement and accelerate those pieces of our strategy. So we're always actively exploring -- who we might be interested in, what might be in play, and I can talk to the priorities for that focus. And then barring that, though, as you know, M&A can be a little unpredictable. We're all about returning cash to shareholders. Brad can give you a chapter inverse on, what our history has been over the past multiple years on that front. I think we've returned maybe $0.25 billion to shareholders last year. It was probably $0.75 billion the year before that. Obviously, with the correction in play, we weren't able to buy back at the same rate last year as we did the year before. But our appetite, and our priorities for capital haven't changed. So just in commenting about the organic growth priorities because people say, what does that really mean? There's really three facets to it. One is to, make sure that we're scaling our core business for earnings growth and reinvestment capacity that helps us redeploy. The other is to accelerate the growth of our value-added offerings namely things like Engineering Services and Supply Chain Management. And then the third is really leverage our platform, right, for both top line synergies, and that really means cross-selling, right, and walking more customers into the rest of the Arrow portfolio as best we can and then enduring productivity gains, so that we create that flywheel for reinvestment as well. Those organic priorities are really clear across the company, and both segments know exactly what those three pillars look like for them. And then beyond that, it's all about making good use of cash, right? And hopefully, one day finding the ability to earn a better multiple, right, that would ultimately come...

That would be great.

The longer-term investment thesis.

That would be great. So amazingly, we are out of time. We do have a breakout session downstairs, in case anyone has some follow-up questions, and you can dig in a little more deeply on some of these topics. Thank you very much Sean.

Absolutely. Thank you so much, Melissa. Appreciate it. Thanks everybody.