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

Winding down here in Orlando. Welcome to the conference. I am Melissa Fairbanks. I cover analog semis and IT supply chain. Before I get to introducing the Arrow team, we do have the team here from Arrow. I just want to point out there is no breakout session after. So if you have questions, we're going to give you a chance to ask questions here in the presentation towards the end. So anyway, from Arrow Electronics, we're really excited to have Bill Austen, interim CEO, and I hate saying interim, but...

It's okay. I'm going back to retirement.

Good for you. Good for you. We do have in the audience, we've got Raj Agrawal, the CFO; and then, of course, from Investor Relations, we've got Michael Nelson and Nate Troscinski. So we have the whole team here. And I would like to start off, Bill. I think if we could do kind of a general overview or an introduction to Arrow, that would be great.

Sure, sure. So for those of you that know Arrow, thanks for coming. And for those who don't know, Arrow, hopefully, we'll be able to share some insights with you today. So Arrow is a 90-year-old company, a large electronic component distributor. We've been in business, like I say, for 90 years. We've celebrated our 90th year this past year, rang the bell -- closing bell at the NYSE with the team, which was kind of a fun event. But we have been -- had long-standing relationships with our suppliers and our customers. Some of our suppliers have been with us over 50 years, and we've been with them for over 50 years. But we deal in a very large and growing space of electrical components, semiconductors, IP&E, value-added services and technology solutions from a software perspective. So it's a very large market that we address. We are the largest global components distributor in the world. And we have a diversified business model, okay, one of which is on the hardware side, which would be components. And on the software side, we distribute infrastructure-type components. About 75% of the ECS business is hardware. And -- 25% is hardware and 75% is software. So about a $30 billion business revenue-wise. And we really like the fact that we're a diversified business because it allows us to kind of level out our earnings through the ups and down cycles that we confront on a year-in year-out basis. Great business team, a great business model. We're global in what we do. And we see ourselves right now today as an extremely value-driven company in the sense of we are undervalued.

I knew that was going to come up.

So if you are a value investor, we are right down the center of your fairway. If you love stock price today and where -- if you believe that the semiconductor cycle normally turns, we're in the early innings of that turn. We see a gradual recovery that we've embarked on. For the last few years, our business team has been focused on reducing costs, both on the fixed side and on the variable side. So our fixed costs are down about 10% over the last few years and our variable cost, which is primarily made up of variable selling costs is also down a touch even though we've grown revenue. So if you believe the semiconductor cycle is turning, we are extremely undervalued because if you look at our fourth quarter, we had a wonderful fourth quarter on the heels of a good third quarter, and we're approaching this year right now with -- our backlog is increasing. We have better visibility in the backlog, the best visibility we've had in quite some time. And when I say visibility, stretching out. We see backlog now filling in into the third quarter. Book-to-bills in all 3 regions around the world are greater than 1:1, and they haven't been at these levels for the past 3, 4, 5 quarters. So we see things turning. We see that it's real demand that's being created. It's not just price. It actually is volume-related demand. So we're in the early stages of a cyclical turn in semiconductors and we are extremely well positioned because we've created a tremendous amount of leverage in the P&L. So as we bring in more revenue, that revenue falls to operating income. So we feel real good about where we're at and where we're going.

He just wrote my note for me. I think it would shock you to know that Bill comes from a manufacturing background, not sales.

Yes. [indiscernible]. People would have called me years ago a knuckle dragger I came out of the operating side of the companies that I've worked for.

I do want to address just very briefly what's the time line and the profile for the CEO transition because I know you're anxious to get back into retirement. The CEO transition, the search has been ongoing and just want a quick update on that?

Sure. So I stepped into the role on September 16. We started a search in earnest probably 4, 5 weeks later. We put a search committee together at the Board level. We've engaged with a headhunting firm. We've had a tremendous number of resumes that we've reviewed. We have a criteria that is somewhat exacting, if you will, from the sense of we want somebody that's got a set of operating capabilities and skills. We're a company made up of really good salespeople and good commercial people. We want the new CEO to have that skill set, but not to be over-indexed there. We want the new CEO to be more indexed on the operating side of things. And that's the criteria we've put out. We're down to a small number of finalists, which will go through the normal background checks, normal interviews with the Board and presentations that they'll make to the Board, and we feel we'll have a decision sometime within the next 4 to 6 months.

Okay. Great. Now that we have that out of the way, we do need to talk about the cycle. So I'd like to know like how would you characterize the demand trends? You did mention we are in the early innings of a cyclical recovery. It's not exactly a "normal" cyclical recovery, but we're getting there for sure. But I'd like to discuss some of the demand trends within the components business, either across geography or end market?

Yes. Let's take them all.

Go for it.

Yes. So the East, Asia, normally is the first one to go into a down cycle on the first one to come out of a down cycle. We've had growing volumes across several verticals in Asia for the past several quarters. which, if you looked at our results from Q2 of last year, Q1 of last year, you'd see that our margins were depressed. Why? Because we were geographic -- poor geographic mix. Asia was stronger than was EMEA, than was North American markets, okay? So we had a lot of growth in Asia, but it's at lower margin as it is across every -- most industries. So now fast forward, you get to Q3, we start to see green shoots coming up in EMEA and in North America. Fast forward to Q4 of last year, those green shoots are actually turning into some plants and they're starting to grow. You get into Q1 of this year and our vertical markets in transportation -- let's take -- I'll go transportation last. Aerospace and Defense, very nice volume growth in aerospace and defense, both in EMEA and in North America. Our industrial markets, which we -- you'll hear us term on our call and in our discussions, the mass market. Okay, what the heck the mass market? The mass market is what I would term as the big middle. It's industrialized U.S., it's industrialized Europe. Those companies that buy less than $2 million of components we term as mass market customers, okay? So who are they? Honeywell, Johnson Controls, Lutron, Whirlpool, General Electric Medical systems. Those kinds of customers make up what we call the big middle or the mass market. They are coming back, okay? They are actually seeing their order book filling in. They're now starting to order, and we're getting very nice growth rates -- we're seeing good growth rates from those types of customers, both in EMEA and in North America. Asia is still growing quite strongly, even though we went through the Chinese New Year, we see Asia continuing to do well, okay? More so on the compute side of things, okay? So AI-related...

Not surprisingly.

Storage and compute there. But we're seeing industrial Europe and Industrial North America come back. Transportation in North America is coming back. We've got a nice order load from -- in the transportation sector. And when I talk about transportation, I'm really talking the automotives, but we deal with the Tier 1s and the Tier 2s. So it's not like a Ford or General Motors, but we're dealing with all those Tier 1 and Tier 2 suppliers. And we're actually now starting to see some growth in transportation in Europe. So that's a good sign. Not big, but a good sign all the same. So we feel really good about where we're at right now. And we believe, as I said earlier, we're at the early stages of the cyclical turn in semis, which then cascades into IP&E, into our value-added services and to everything else we do.

We'll get to that next.

Okay, but my point is that we've created real leverage in the P&L. So this revenue that comes in, we get better margin out of it, which is what we've been saying we were going to do, and now we're actually seeing that hit the P&L.

I think it's also important to note, there's no single customer that's more than 2% of revenue?

Correct, right.

Did I -- I got that right?

No single customer more than 2%...

So very broad-based, very well diversified, and...

Absolutely. And no supplier more than 8%.

Wow. Okay. Great. So in terms of the geographic footprint -- Raj gave you the thumbs up. In terms of the geographic footprint, obviously, you do have operations worldwide globally. What's your China exposure specifically? We do get asked about that quite a bit.

Yes. We look at more than China, we look at Asia Pacific. And it's less than 10% of the overall revenue, Asia Pacific.

Okay. Is there any risk -- again, unfortunately, this has come up more recently, is there any risk to your exposure in Mexico?

No. We have a big distribution center there in Guadalajara. We have a -- our back office center is there in Guadalajara. We were down for one day. We were down -- after the issue that they had, we were down on Monday. We kept everybody out. We kept everybody home. We located everybody. They all responded. Everybody was fine. And we were back in the distribution center on Tuesday.

That's amazing.

But -- and we kept our back-office folks working virtually from home that whole week. So all good.

Okay. Great. All right. I had to check that box. So the next most popular question, what's the impact of supplier price increases on your model? And I'm thinking specifically related to like memory or storage, in particular, but we have heard pricing has been relatively stable across the supplier base. But how does that flow through your business model?

That's exactly what happens. It flows through. We pass it right through, where we have contract. Where we don't have contract, we get as much in the market as we can.

Okay. All right. All right. Is there any impact of the memory shortages on your demand recently? Or do you see that -- are your customers starting to worry about potential shortages on the memory side of things?

I think that obviously, people are going to worry they got to make products. They've got to ship, right? There's always that fear out there. We have not had a major issue that, okay? We've gotten everything we needed. We've been able to push it through. We've been able to get it to the people that need it. But I will say that from a salesperson's perspective, there's a bunch of things salespeople do, right? One of which is they go get sales. They talk to customers, get orders, bring in orders. In some cases, right now, some of those sales folks are turning into expeditors, which is another part of a salesperson's job, right, is to pound out, "Hey, you got to get this. I need this. I got to have this, got to get this." So some of our sales folks are flipping the switch to become an expeditor which says that things are getting tight, we're getting worried, and we just want to make sure that, that cadence of pounding on the supplier is there.

Okay. All right. All right. So moving on, that leads into my next question. How does Arrow actually help your customers? Is it the salesperson's responsibility? Or does Arrow have systems in place to help your customers or also the suppliers navigate some of the trade and tariffs situation?

The tariffs have been -- I don't want to say it's a nonevent, but it's been much less of an event than people think it has been on us. Stuff comes into the U.S., we pass the tariff on. There's a lot -- it's easy for me to say that. Okay. It's really easy for me to say that. There's hundreds of people in our inside sales organization that are paddling like crazy under the water to make sure that those tariffs are not an impact on our business. From a revenue standpoint, last year was probably 1%. Tariff was about 1% in our revenue. So -- but there's a whole lot of people working really hard to make it that way.

How easily are you able to kind of flex either your warehousing supply or your ability to service your customers from one geography to another. Have you seen a lot of that kind of activity?

Yes. We see that a lot. We see that a lot. Guadalajara is a free trade zone. It's somewhat easy for us. So there's been a lot of movement that's gone from some warehouse facilities in the United States down to Guad. We've had to ramp up the employee population in Guad. We had to get them trained. We've had people from other warehouse facilities go down to Guad to help the locals get trained up quickly so that we could meet the demands. We've moved some shipments out of -- from North America to Venlo. But yes, there's -- it's a chessboard, maybe Chinese checkerboard would be a better way to say it, but this stuff is moving around all the time. And we've got an incredibly flexible organization that's dealing with it.

Okay. I think it's important to note, this is something that you've dealt with through the history of the company, I mean that's not how...

90 years old, man. You don't get there by not working hard.

All right. Now we can move on to the talk about the value-added services because I think that, that is an important, obviously, being able to work with your suppliers, working with your customers directly, moving that -- like actually moving the components through your system is one thing, but let's talk about how you're adding value to servicing those customers.

Perfect. So we're more than a distributor, and that's the point that hopefully some of you take away here from here today, is that we've had this thing called value-added services. And one of the components of value-added services is what we call supply chain services, in which we actually will go in and manage the supply chain of electronic components for a customer, okay? So think of a large user of electronic components, think of Volkswagen. They make cars all over the world. They source components from all over the world. They put subassemblies together from all over the world. We will manage that supply chain for them. And what we end up doing is we have systems in place that -- people ask me what we're good at, and I say it's -- we're good at managing complexity because that supply chain to get what you need -- what Volkswagen needs when they need it, where they need it, is really difficult. We have systems in place to do that. And we have been able to -- it's a fee model. It's not a revenue model. We don't -- you won't see revenue on the top line from this, but you see a lot of leverage to the OI, to the operating income because we get paid a fee to do this. And we do this for very large customers. We do it for all the hyperscalers and what they're trying to do today with their GPUs, moving them all around the world. We take that on for them. And it might be that we put a warehouse in, okay, in a location that's going to be within earshot of where they're going to build a data center. So we'll do that, and we will manage their movement in and out of electronic components for the build of that data center. And we do this for the largest of large customers. It's not for everybody. It's a sale that gets made at the CEO and CFO level because what we're doing is we're displacing their internal systems that they're not built to do, and we've got systems that are built to do just that. So it's part of our core competency, but not theirs. So we take that on and we get paid a fee to do that. That's one piece of it. The other would be demand creation. Everybody talks about demand creation. I know that it's out there. We have engineers. We have a lot of engineers that work with end customers that may not have a large engineering organization or the expertise within an engineering organization to design a new product. So we'll help them do that. We have one customer, for instance, we have 150 engineers that work for that customer every day and have been for the last several years, helping them design their next iteration of electronic product. When we design that product, product A, B, C, we then register that product A, B, C with the supplier so that the supplier knows that we're the guys that created it and all of that then flows -- all of the material then flows through Arrow to the end customer, okay? The other thing that we've done here on demand creation is we've just launched and we are launching, you'll see it out in the press here in the not-too-distant future, what we call digital test drive. The way that our field application engineers work with customers is, I'm a field application engineer, I go to your site and you say, "I'm trying to build this thing." Okay, great. What is it going to take? In the past, what it took was 10 of these, 12 of those, 14 of these, 17 of these, we put them in a box and we ship them to the customer. And they would go into their lab and try to make this thing on a work bench, right, in a lab. They blow up half the components and ask for more. And then they get a -- they'd have a field -- application engineer to come in and help them refine that. Well, what we've done with that now is we've put that into a virtual model, not only for design, but for test. So they can actually virtually test that device online and have an FAE work remotely with them, so that they can actually build out that product. No more hardware gets exchanged, no more stuff gets broken or blown up in the shop. And it speeds the design of that product and get it to the market a whole lot quicker than it did in the past. So we're just rolling that out. It's called digital test drive and it's going to be out in the next several weeks, you'll see it.

Fantastic.

And then the last item, I know I'm going long winded here.

No, please.

Is our integration services, what we call intelligent solutions. And we actually build -- think of this as building high mix, low-volume appliances for a customer, a specific type of rack -- storage rack, a specific type of compute rack. Well, they only want 72 of them. Well, you're not going to get a Flex or somebody else to do that. So we take that on. And not only do we build out the hardware side of it, but we'll integrate the software into it and completely test it for whatever their test criteria is, 72 hours, 114 hours, whatever it happens to be, we will do that testing in our facility for them. And that's been a really quickly growing piece of our business, and we're -- the business unit that leads this thing up is looking for more space. They're looking for more test capacity, more megawatts are required in the facility. So it's really a [ neat ] thing. And just real quick, what are these things? We did a job for Philips Medical, where we built these appliances, which is actually a very, very high resolution camera that get taken into operating suites so that there can be 5 doctors 3 states away or 4 states away watching the surgery and advising the operating team on what to do next. So it's really kind of cool stuff that we do.

I think it's safe to assume that's probably margin accretive?

That would be margin accretive. Yes. More of those.

All of the value-added services. Have you ever quantified how much -- you mentioned -- some of the -- like the supply chain services, you don't see that on the revenue line, but it does flow through to the OI. Have you ever quantified how big collectively those value-added services are?

So just from a needle perspective, we've moved our -- the contribution to income from value-added services from 20% to 30% in the last couple of years. And if you think about the -- what the margin level is because everybody asked that question, well, how much margin are these things? It's somewhere in the range of 2x or greater than what our gross profits would be on the normal side of the business. So that's why we're pushing on it because it makes sense.

For sure, for sure. I think we do need to actually move on to ECS and talk a little bit about the ECS business. I think that's an area where I get a lot of questions, understanding how ECS fits in with the global components business, but...

It's complementary. It's more so a fit to the overall company of -- the overall Arrow Inc. So ECS, for those who don't know, it's -- we distribute software, okay? 25% of what we do is hardware, 75% is software. But we're dealing -- it's a different animal altogether. It's not hardware components and things. But it's countercyclical to what happens in the semi side or the component side. So it helps us stabilize our earnings over the longer term. And we really like that business because it is margin accretive, okay? It's got greater margins than those components. And it -- we do some things in that business that we don't do on the component side of things. Like, for instance, one of the new things that we're out in the market with is what we call beyond distribution. Beyond distribution is where we will work with an infrastructure software provider, big guys. They don't want to have feet on the street, okay? They want to take their OpEx and bring it internal to develop more infrastructure software. So they will outsource their commercial arm to us. And we've done this with a couple of guys now. And they do that because we have reach, we have capability, we have scale in parts of the world that they may not, nor will they want to go hire people to go sell in that part of the world. So we take on the direct sales motion to the market in that area. And it's on -- it's for a fee. We pay them a fixed fee for the right to do this, and they're multiyear contracts. And every dollar we make above that fixed fee, we keep, okay? Now it works to flip way, too. If we don't meet that fee, we take it as a hit. We've been successful with this thus far. Several hundred million dollars of billings last year, and we're ramping the model up. And we see it as a -- the fellow that runs this piece of the business, Eric Nowak, he's been in this game for a long time. He sees this is the next evolution of software distribution.

Okay. All right. And it does have the ability to kind of like smooth out, whereas the components business is always going to be highly cyclical, and then you get the margin cyclicality associated with that. The ECS business kind of helps to smooth that out a little bit, correct?

Absolutely, you bet. One thing I'll mention here is because everybody -- the questions that we get around this are, wow, we keep reading and all these people talking about AI is going to eat software. Software is going to go away and AI is going to create the next this and that. There's 2 elements here, alright? There's technology software in structure, okay, networking, compute, security, okay, that your core companies layer into your organizations. And then there's all the applications: Salesforce, ServiceNow, all the applications. AI is going to start to bite at the applications, but we really don't see them biting into the technology or the infrastructure side of software. And here's why. Because what's happening, the guys that develop the infrastructure software, the enterprise software, they're incorporating AI agents into their platforms, okay? They're going to talk to the AI agents that get built into all these applications, and they'll communicate, okay? But as more and more of this takes place, more and more of it goes to the cloud. So as your companies put more and more in the cloud, what do you need? You need more storage, you just need more network, you need more compute and you need more security. Where does that come from? It comes from the technology side of software, not the application side of software. So that's why we feel that we're in a good spot because we're on the technology side of the software, not the application side.

Okay. All right. We are quickly running out of time. It's hard to believe, but I just want to check to see are there any questions in the audience? Oh, here we go.

I guess just you kind of characterize versioning fairly broad-based recovery growth in that geographies. Is there anywhere that you think is still softer than you'd like it to be or that you don't see necessarily a recovery happening, like what's....

Question about the recovery and if there are any areas of softness, I just wanted to...

Yes, these guys might shoot me, but I'll tell you, no. The place that would be the least amount of growth right now, but it's still little green shoots is automotive in Europe. Everything else is really starting to track, and we call it a gradual recovery. It's a gradual quickly -- a quick gradual recovery.

[indiscernible].

I'm not saying that.

Can you talk about the [indiscernible]. Do you worry that, obviously, with the first starting, you could provide that value added service. But as AI gets smarter, do you worry that that could be disintermediated by the companies themselves as opposed to you doing that for them. As we start to do that some and that gets loaded into the intelligence, would they really -- could you disintermediate yourself?

It's a good question. And the way we think through that is that these appliances that we are building, that we're putting together for these companies requires an incredible amount of testing, and it's real live physical testing. It's not a test that you're going to perform with some AI injected into it. It's a physical let it run for the next 5 days and see what burns up kind of test. So I'm not sure that we would get disintermediated that way because we put -- we've invested in a substantial test facility. And that test facility is now just -- it's requiring more and more megawatts to test some of these appliances. I hope I answered your question.

We are amazingly out of time. Bill, I feel like we could sit here and talk for hours. Didn't even get to talk about margins.

They're going up.

I would ask for a closing commentary, but I think I know exactly what you would say.

You do.

Undervalued and...

We're a good buy.

Thank you so much for being here, guys. Really appreciate it. Yes. Thanks very much. Have a good afternoon, everyone.

Thanks, folks.