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

All right. Perfect. Well, I think we can go ahead and get started. I'm Joe Quatrochi, the semiconductor analyst for Wells Fargo. Excited to have Bill Austen, President and Interim CEO of Arrow Electronics. Thanks for joining us.

Thanks for having us.

So maybe to start, just kind of set the stage for the discussion what do you think like investors maybe don't appreciate about the Arrow story, and then we can kind of get into maybe a few other things that are kind of going on with the company right now.

Sure. Sure. So what don't investors understand about the Arrow story. Let's just back up. The company is 90 years old. So I think investors need to understand the legacy of the company, the history of the company. You just don't wake up 1 day at 90 years old, you've got to earn your way there. And I honestly believe that Arrow has earned its way through up cycles, down cycles, sideway cycles to be the global brand that it is today, to have the global reach that it has today and to have the employee base that it has today that I think investors might miss that. We have tremendous employees that have a long history with the company that have a long history in the industry that really understand what makes it go. But if you look at where we are today and the work that's been going on at Arrow over the last few years on cost down, productivity, getting the model in a different position if you think through that and if you're a believer in the cycle that takes place in this industry and the cycle is at the bottom, Arrow has done a tremendous amount of work over the last few years to position itself. So as that cycle comes back, the business is really going to outperform. And that outperformance based on where today's stock price is -- it's -- the company is way undervalued, and the stock price is undervalued. And with the work that's gone into the model to create leverage, nothing but upside.

That's helpful. So you're in the interim CEO position now, right? Kind of maybe walk us through where we're at in finding a permanent replacement for the CEO, the time line, what are you looking for in that person as well?

Sure. So I've been in the interim role for about 7 weeks. I've been on the Board for 5 years, so it's not like I'm a foreigner to the company and that the company is -- the leadership team, I know them well, they know me well. As far as the CEO search goes, we put a search committee together at the Board level of which I'm a part of. We have now selected a search firm, and we are starting to gather several resumes from the industry, just to see what's available and to see what kind of characteristics people might have. We put a characteristic list together of -- the CEO characteristics we'd like to have in the company. And we want to make sure that the incoming person understands the legacy, understands we're 90 years old, understands the dynamic in the industry, is a humble individual, we're not looking for a chest beater, and understands how the management team has been put together, how the strategy has been put together and the Board has been involved in that strategy development for the past several years. We've been involved in the bringing up of the leadership team over the last several years. And lastly, a key characteristic that we're looking for is someone that has operational expertise and experience. Arrow is a big sales company, a big distribution company but we really want someone that bring in some operational expertise and operational chops to the company. Not that it doesn't exist but to continue the daily cadence of hitting metrics, driving metrics and performing to expectations.

Okay. That's helpful. Maybe in addition to obviously helping with that search, I mean, on an interim basis of running the company, what have been your areas of like strategic focus?

Yes. So as I said, the Board, myself, we've all been involved in putting the strategy and helping the leadership team coalesce around the strategy, which looks at how do we margin up the company, how are we going to create margin not just from the standpoint of taking cost out, taking cost out, taking costs out, we have to be good there. There aren't any companies today that perform well that aren't always focused on productivity and cost out. We're going to continue to do that. But the next phase is how do we get growth? What are we going to do to get growth? And if you talk to the IR folks, they'll tell you we can get all the growth you want. Well, time out, slow down, take a breath, let's make sure we get the right growth. So the focus and the attention has been on shifting the mindset from constant cost out and head down in the weeds to driving growth but growth that contains the right kind of margin. And when I say the right kind of margin, if you look at how we have started to differentiate business. We're big in semiconductor, obviously, that's part of the core, if you will. But other pieces of the business that the strategy contains is services. Okay, if you think about 1 piece of that would be Arrow Intelligent Solutions, that is a business within Arrow that builds very unique pieces of appliance, that brings software and components together to build an appliance and I say an appliance, a component, a device that would be think about high mix, low margin -- No, not low margin, high mix, low volume, sorry, high mix low volume in that 150 units. So we've recently done some work for some shipbuilders that they wanted to have different kinds of GPS tracking devices. So we built 150 of these units incorporated software into it, and then it gets installed, onboard a ship, we've done some things like that. So think about low volume, 150, 100 units, but high mix. Each 1 wants purple, 1 wants green, 1 wants blue. And these bring together components, software into an appliance, and it carries a higher margin profile. That's a piece of the strategy that we're pushing on. Another piece of the strategy that you've heard us talk about is on the service side, engineering services. We use our engineering folks that we have and whether it's eInfochips or whether it's silicon experts to offset engineers within our customers pool of engineers to help them design and create and develop their next product. And we might do that for a quarter. We might do that for 6 months or they might sign us on for a year, to be an offset to their engineering talent. Another piece of our service business is supply chain services, where we're pushing on and leading the management team to go out and get more of these contracts, supply chain services is we take on the supply chain operation for some of our customers. Now I'll give you an example, think about hyperscaler, right? Just -- hyperscaler buys $5 billion worth of GPUs because they're going to put in a 500-megawatt data center in Indonesia, we will provision, buy, relocate, store, house and then move to the customer's site when they want it. So we'll put in a distribution center somewhere in region where our customer is going to be finally building out, and we will bring in their materials keeping in our -- keep them in a distribution center and then provision them out to the site when required. Now you don't see a lot of that on the revenue line because it's a fee-based model, we get paid a fee to do that. And those fees are in excess of 2x what our fees would be in the semiconductor side of the business. The Arrow Intelligence Solution is the same thing. Margins are 2x what they would be in the semi side of the business. So trying to create more of a mix around services and ECS would be the other piece is what I'm pushing on what the leadership team is pushing on and what we're getting focused on as we move into '26.

That's helpful. Maybe also kind of like as you take a more day-to-day role from relative to being on the Board, I mean, has there been things that -- about Arrow that have surprised you that you thought was a good decision when you're out of the Board, but then when you're kind of more day-to-day is maybe your opinion changed at all?

So I got this question earlier at the one-on-ones. What really you've seen is different? And what I said was blue jeans I mean, I've been retired for 5 years. And when I'm up to work, I want to work like this, but I've seen a lot of folks coming in blue jeans, so guess what, I'm wearing blue jeans to work now, which I think is really great, okay? But to answer your question more specifically, Joe, the focus on cost within the business and cost out and productivity and heads down internally focused over the last couple of years is, I guess, if I step back from my Board role, and I said, Geez, I didn't realize that it was hands in and eyes in. And I think right now, what we're trying to do is we want to maintain that rigor on the productivity and cost out, but we got to get hands and eyes out focused on how we drive in volume and the right volume. So that -- and those have been my conversations. I have a conversation with our Chairman every couple of weeks, what's going on, how you're doing, is your head still in a good spot, that kind of thing. And those are the conversations that he and I have.

Okay. That's helpful. Maybe shift gears a little bit, kind of looking at the demand side, can you talk about just the trends that you're seeing within the global components business? Maybe any color about geography or vertical markets?

Yes. Yes, absolutely. Look, let's start in the East because that's where components has come back first and the quickest, if you will. So if you look at the East, and I'm talking to Asia Pacific, the components volumes have come back -- have been back strongly in that region of the world but to the big accounts where you have a lot of volume, but lower margins. And that's across the market segments in Asia Pacific, probably the largest would be transportation that has come back the quickest. Then if you move West you go to EMEA. It has -- EMEA has been a weak in the components business across pretty much all of the verticals with the exception of aerospace and defense, and you can imagine why. We've had good growth there, transportation is flat. If you look now where we're at in EMEA, industrials are starting to sprout some green shoots in the industrial space. Compute and communications has been reasonably solid in EMEA but the big driver, transportation has been flat. And industrials are now just starting to tick up. And if you come back, you keep coming further west in North America. We're seeing now the industrial markets, what we would call the mass market, so the mass market is coming back in North America, not strongly, but gradually. And if you listen to our third quarter call, that's the terminology we're using is, we're using gradual recovery, but we are seeing a gradual recovery. And if you look at North America, transportation has got some growth. Aerospace and defense now is flat. Compute, communications networking has got growth and now we're starting to see industrials. And we term industrials as the mass market, if you will, and that's the industrial base within the United States. And we would term those customers as a customer that buys $3 million or less of components. So think of companies like Carrier, Whirlpool, Honeywell, companies like that, that are -- we're now starting to see them pick up a bit, but -- and then if you look forward a touch from where we -- our third quarter call, what we were saying is that we're now at above parity with book-to-bills in all regions, which is -- that's the first time in a while that we could say that. So as I said -- as I started out this conversation around if you believe that there's a turn coming and all the cycles bottom and then come back up, we're in a great position to go after the gradual comeback.

So you think that -- I mean, do you think about, obviously, like visibility is difficult, but as you think about just kind of '26, and like how do you think about like your kind of initial expectation is, you think it's still more gradual? Or maybe we start to kind of see interest rates come down, you got to get maybe a little macro help less uncertainty. Is that...

I'm a real firm believer in the gradual recovery, okay? I'm firmly parked in that spot. And you know what? If I'm wrong, it's okay.

Okay. Okay. Sticking with global components, you talked earlier about like value-added services and things. Where do those exactly kind of fit? I mean I think the hard thing for investors is you look at the reporting segments, and it's hard to kind of see those things. You see global components. You think semis, IP&E, right? But how do we think about just where those value-added services fit? And then maybe just touch again on kind of the margin structure there?

Yes. to us, they fit in global components, okay? And as I said, they don't drive the revenue line but they drive the profit line. And we've been on this journey of trying to shift mix to services for maybe a year. So it's not like it's all falling through, but it certainly is helping the bottom line. And as we get more traction which our plan's for '26, are going to measure, monitor and track that traction into the business units with rigor, we'll know where -- we and you will know that we're executing on those because we should see our OI line go up.

Okay. You talked about kind of like the things that you're focused for '26, I mean, what -- what do you think are the steps to accelerate that business? Is it just more headcount? Is it just kind of educating customers? Like how do we think about like what can really kind of pour some fuel on that fire to accelerate the services?

I'll give you my perspective, and I'll be very honest. It's focused within the company. It's just focusing and measuring those items. My point around part of the CEO search is a CEO that has some operational background. Raj, our CFO has got great operational background, okay? He understands and he knows how -- what moves the needles. But the CEO has got to be a partner to that. The CEO has got to be part and parcel driving the business unit leaders to measure, monitor, track those things that are going to move the needle. And in the past, moving the needle was always getting more sales. okay? That's not necessarily the case today. Let's go get the right sales that have the right -- that contain the right margins and let's go push on services and set the organization up and we are in such a way that services can be stood up, measured, monitored, tracked.

Okay. What would you be sitting here next year at this time? Hopefully, as you...

Joe I'm telling you, I'm not going to be sitting here next year this time.

What would you view as like measured success, right? And like...

We've talked about it. As you think out and maybe not next year, but we should be getting back to margin levels that were prepandemic. There's no reason for the business not to be able to do that. Just in my mind and in the mind of the leadership team, that's doable. It isn't going to be next quarter, next 2 quarters, but that's the trend line.

Okay. Maybe we'll shift over to the ECS business. Maybe first start just kind of the value that, that brings to Arrow and why it makes sense for that to still be part of the business with the components, a little bit different. But same philosophy a bit...

There you go, you hit it. It's a distribution business, right? Is it -- does it completely mesh and tie the components? No, it doesn't have to. It helps us differentiate from the other guys, which I think is extremely important, okay, to have a differentiated model that sets us apart from other pure distis. We distribute on the ECS side of the business. But if you look at where our business is headed and where the market for that business is headed, that's a better way to look at it. Technology software with what we are presenting to the marketplace is anticipated to grow 10% to 15% over the course of the next 5 years. And we're good at it. We have a great brand within ECS with -- and it was kind of founded and put together, I don't know, say founded, but it was put together very successfully in Europe. And we've done a great job in Europe. We've now taken the European model and brought it to United States. And the fellow that ran Europe now runs our global ECS business, and he's taken the same philosophies, same tools, same strategies to the U.S. with ECS. The next phase is which we've embarked on already as we call Beyond Distribution. Beyond Distribution, is where we feel this software selling is headed. And it's -- what's happening is that software providers want to do what they do best. They want to develop and create software and modify their existing platforms of software. They don't want to have feet on the street selling to the mass market, they want to sell for the Big 10 directly. And then everybody else, I got to get my brand out there. I got to get my software out there. They're coming to -- we've gone to them and said, we'll be your exclusive seller in this region of the world, this is an interesting opportunity. We pay them a fixed fee. We pay the software guy a fixed fee, and then we have the right to sell those software packages into the mass market in that region of the world. If our fixed fee is $10, and we sell $12, we keep $2. If we sell $13, we keep $3. So it's a fee-based model, and it has the opportunity to really upsize our margins. And we started in Europe. We've been successful with it in Europe. We brought it to the United States, and now we're doing it in the U.S. as well. And we think that this is the direction that, that segment is headed, and we like it. That's the other thing. We like it. We don't want to sell it. We don't want to get rid of it. We want to continue to drive it. We have great leadership. We have a great brand recognition, and it brings us financial stability to the balance sheet when one is down, the other is up, when that one's down, the other one is up. So it helps us flatten out the ups and downs within the financials.

Okay. That's helpful. I mean I guess, like maybe spend another second on just kind of the components aspect of you talked about earlier, just kind of like being able to come out with like more unique solutions for customers of doing small volume but very specific tailored solutions to your customers' needs. I mean -- are there more opportunities like that? And do you need to like change your line card on the ECS side to support some of that? Or like how do we think about like that dynamic?

That's a good question, and I haven't been asked that question before, and I'm not sure I've thought through it.

Not to put you on the spot.

No, that's okay. That's okay. I mean that's what this is about, right? I think if we -- yes, yes, the answer is yes. As we broaden out the line card on the ECS side of the house. And what allows us to do that is a platform we have called ArrowSphere, which is a very unique platform that it's interesting because now that you asked that question, we have suppliers coming to us saying, we want to be on your ArrowSphere platform. So that indirectly answered your question, which I think makes a whole lot of sense. So yes, the answer would be yes. We would like to continue to fill out that line card on ECS, and we're going to do it through ArrowSphere.

Okay. That's helpful. I guess like maybe shift gears a little bit like think about like the margin outlook, right, a gradual recovery, and it seems like maybe you guys are making some investments and things along the way to try and kind of reaccelerate growth. How do we think about just like total company like margin structure near term? And then where do you think you kind of talked about it a little bit ago, but where do you think it could go if you look out 18, 24 months?

Yes. Well, like I said, we'll be -- this is -- sorry, this is me. I won't be here in 18 to 24 months, so I'm going to talk for the next person, we're going to be on the trend to get back to pre-pandemic levels. That's where we're headed. And we're going to measure and track it and hold people accountable to make those things happen. That's the operational rigor that we got to instill.

Yes. Okay. Can you talk about just kind of views on capital allocation priorities, M&A.

Yes. Our capital allocation priorities haven't changed. They're the same that they have been organic growth, one: M&A, two; and return capital to shareholders through share buyback. And all of those are going to have an eye on what's got the highest return for the shareholder in terms of how is it -- are we ahead of our ROIC targets in any of those 3 categories. Now I know the question might be, you didn't buy any shares back in Q3, right? And we've been buying back at a $50 million quarter clip which is insignificant from the standpoint. If you miss a quarter, you can always make it up. You shouldn't read anything into the fact that we didn't buy any shares back in Q3, just -- we just didn't. So we've got to make sure that we maintain our investment grade rating and we didn't want to put any of that in danger but don't read anything into the fact that we didn't buy shares back in Q3.

Okay. Maybe on M&A, you guys have talked about potential opportunities like that might present itself. I mean if you think about you as looking to maybe further consolidate like this pretty -- can be fragmented distribution market. Is that something that you're interested in? Or how I guess what do you think about what's the right M&A like strategy?

Yes. So I'm a firm believer and I've said this to the team and the Board, we're just not going to buy something to add bulk, okay? That's not what we're going to do. That's my view, my words a waste of capital. But if there's -- if there are things that we could buy that add to the -- what we're doing from a strategic perspective and margin up the company, those are the things that we're going to go do. They have to be accretive, we're just not going to go buy to buy because we can. We're going to buy things that make sense that fit the strategy and are accretive both to ROIC and EPS, obviously. So things like things in the space of the other areas that we're pushing on within the company to expand margins IP&E, okay. We've got nice growth around all regions in the IP&E space. So IP&E would be an area that we would want to -- that makes sense from an M&A perspective. But just adding another distributor to consolidate in our view, doesn't make sense.

Okay. Okay. That's helpful. Maybe just as we think about free cash flow and just kind of working capital management, I mean, you talked about a gradual recovery of demand. How do you think about that from like an inventory level and what Arrow has, and if there is a gradual recovery, how much inventory do you need to add? Or do you need to add inventory?

We'll obviously need to add it in certain places, but as -- as revenue increases, we'll see our inventories come down. I think you need to think about working capital and we're into what, mid-20s today. And I think we used to be somewhere in the upper teens I don't know if we'll ever get back to the upper teens or middle teens, I should say, but we should certainly be able to drive it down from where we are today. So it's another area that the business needs to get a bit more rigor around and tied to some metrics and some incentives.

Okay. Okay. I think that's a perfect place to leave it. Thank you for joining us.

Thank you.