Avnet, Inc. (AVT) Earnings Call Transcript & Summary

Okay. Thank you, everyone. We're going to get started. I'm Matt Sheerin, senior analyst at Stifel. And with us this afternoon is Avnet, Inc., one of the world's largest distributors of semiconductors, electronic components and other devices. Representing the company is Tom Liguori, the CFO; and Joe Burke, VP, Treasury Risk and Investor Relations. Thank you, gentlemen, and welcome.

Thank you.

So let's start off, Tom, with the summary of your Investor Day. You had your Analyst Day just this week on Monday in New York. And you set some longer term or medium term, if you will, targets in terms of revenue growth, margins, returns, cash flow? And when do you just bring up to speed on those metrics?

Sure. And thank you, Matt. Thanks for having us. We've had a number of really enjoyable meetings today. So it's great to be here, and it's great to see Stifel doing well and taking over the whole hotel again. And a lot of -- you can't say enough about it. So we had our Investor Day on Monday, we hadn't had 1 in 4 years. So it was time to really get out and the world has changed a lot. And we were happy to report that if you looked at what we said 4 years ago, we executed to what we said pretty much. But going forward, think of Avnet as we're a leader in electronic components and semi distribution. And as you all know, that is now everywhere. It's in your home, your office, your car. And we started off with just talking about the growth rates of the markets we serve. And we're predominantly in industrial, auto, medical, defense, and we showed some third-party market projections. And if you look at where we play, we should have a top line market growth of about 5% per year over the next 3 years. All of our targets for the next, we said 3 to 4 years, 4 years has -- stuff always happens in the middle. So we see our markets growing about 5% a year. From an operating margin, today, we're -- the last 12 months, we're at a 4% operating margin. And we think over 3 to 4 years, we can get to 5% or higher. And we do that mainly by continuing to invest in our higher-margin businesses. And just briefly on that, you probably know Avnet has high-volume, global distributor, distribution centers around the world, when you need thousands, we can deliver thousands. We also have a Farnell business, which is a company we acquired 5 years ago. And Farnell is about when you need 30 parts and you need them tomorrow. And it's a B2B e-commerce, you go online and you get your parts. And they currently operate at a 15% operating margin, and we like to say it's like a 10% to 15% through the cycle. But we're making a lot of investments in Farnell. We have made a lot of investments, broadening the inventory, SKUs, improving the e-commerce system. So that's one growth area. The second is embedded, which is like chip on the board connectivity. It has a software component. These are things all of our customers and suppliers are looking for. And we see growing that to about a $1 billion business and a 10% operating margin. And then we also -- we don't talk a lot about our IP&E business, which is interconnect passive electronic components, which is like connectors, passives, that's a high-growth area for us. And we'd like to get those 3 businesses to about half of our gross profit dollars. Today, they're about 40%. And we think with investments, we can do that. And by getting more of our business in the higher margin, we should be at about a 5% operating margin. From a cash perspective, we said we should be able -- we generate cash in up markets and in down markets. We should be able to generate $1.5 billion to $2 billion of cash over the next 3 to 4 years. About half of that would be used internally, which is for growth in distribution centers, improving our systems, maintenance, things of that nature. But the shareholder return portion is very, very important to you and it's very important to us to deliver that. And we spend a lot of time on taking our dividend up to a certain level. We've increased our dividend about 25% over the last 5 or 6 quarters. And we plan to make one more step increase. And then the goal is have it a steady, reliable dividend with annual increases through the cycle. But the last part is on our buybacks. And to be very upfront about that. Today, when we look at M&A opportunities, we think they're fully valued. When we look at our share price, well, we're trading at about a 7x PE. Historically, we trade at a 9 to 12. So when we look at cash usage, we think buying back our own shares is actually very good investment today. So we announced a larger buyback program, new share authorization of $600 million, which is about 13% of our market cap, and we fully intend to do that over 3 years or sooner. Part of it will be like a systematic buyback and part of it will be opportunistic. So we think all of those put together is a good place for investors to take a look at Avnet and consider it as part of your portfolio.

Okay. Just on the margin targets, which appear reasonable. I guess one counter to that is that your margins were strong. They rebounded very sharply in the last few quarters. You're also in probably 1 of the strongest demand cycles that we've seen or demand and supply imbalance. And your gross margins are up 150 to 200 basis points in a matter of a few quarters. So the question is, how much of you -- are you overearning now? And when we're back to normal 10- to 12-week lead times instead of 50 weeks when clients will pay whatever they need, whatever ever they have to, what does the model look like?

Yes. So the targets we laid out with the growth and the operating margins, there are 2 big assumptions, right? One is that demand and supply come back into a more normalized balance and that is normalized pricing, and that's really important. We didn't build our targets based on where we are today. We said there will be some -- there may be some moderation in pricing. We try to be very transparent with you and with the investors on this. During our earnings call, we'll say what are our margins with and without the year-over-year price increases. So for instance, Farnell is about a 15% operating margin today. And the reason Farnell benefits from pricing is it's an e-commerce. It's an online order. So when market prices change, they change in the system and when somebody goes on, they're paying current prices as opposed to our core distribution where it's more backlog, open purchase order, contract pricing. But because of that, Farnell does benefit from -- we're trying not to say what did you call it, what type of -- overearning, we try not to say it's overearning. We try to say is benefiting from pricing. We're benefiting from pricing, Matt. So the 15%, if you took out all of the price increase, it's 12.7%. And we think of Farnell as like a 10% to 15% operating margin through the cycle. But when we've set our targets, we base them off a mid-cycle base.

And what about the core business obviously is benefiting as well, right?

Yes, but to a much different extent. So the core business passes on. Think of it like if a supplier cost goes up 5%, we will pass on 5%. So there is some revenue benefit and there's a smaller gross profit dollar benefit. The reason why it's a one for one, it's a few. One is, well, these are long-term customers, and we're going to have them -- we had them 10 years ago, and we're going have them 10 years from the future, and we're not trying to take advantage of this. There's also supplier agreements where it helps protect us and them in a down market and in up market. So when the market goes up, we pass on price increases. And when -- if the market went down, we kind of get the suppliers work with us to insulate us on that side. So on the core business, it's much less of an effect, on the Farnell, there's clearly no effect.

Okay. Okay. Great. I do want to just ask about your thoughts on the current supply-demand environment. We're still hearing from many companies out of the March quarter earnings and even April quarter earnings that their component constraints are hurting sales, hurting the ability to get parts. You've got the COVID lockdowns extending in Shanghai. Most people are saying it hasn't eased as quickly as they expected. So how do things stand in terms of your perspective on supply right now and lead times?

Things are still very tight, and it doesn't seem like things will change in the near term, like through the rest of the year. So what we look at is our backlog or book-to-bill that's still extremely healthy. We look at things like cancellation rates because that's usually a preview of when things are softening, and there's no change in our cancellation rates. From a supplier perspective, we continue to see price increases. As we speak today, we have 4 or 5 of the top 10, 15 suppliers doing another round of price increases of 10% plus. So things remain very tight. It's -- in a way, the environment benefits us long term. Because what you're finding is, if you think about the last 3 years, right, we went through a pandemic, lockdowns, tariffs, now shortages, and if you're a stand-alone company, it's very hard to manage all of that and get supply. So we've traditionally always been in like the middle market as customers, we're seeing increasingly larger companies, companies that haven't done business with us in the past, do business with us. And the reason is, we are -- we have scale, we can aggregate demand. We have distribution centers around the world. We have billions of dollars of inventory. And we have different routes to get skew from part Place A to Place B, so we can manage through that better. So that tends to help us. And right now -- and if you listen to our Investor Day, we had a panel discussion with some of our customers and suppliers. And that's what they all said, distribution is needed now more than ever. Joe...

I would say that's right, Tom. And just to expand on that. One of the things that we did talk about are supply chain opportunities. And today, the stress and strain on supply chains whether their supply chains are broken or they're in crisis is one of the topics that we covered. And as Tom mentioned, we had, for example, one customer as a panel who wasn't a customer of ours a year ago. And today, they're a very big customer because they didn't even have visibility in their own supply chain. Maybe they had products of certain partners over in Europe, some in Asia, and they didn't have the visibility. So we're able to come in and help them build control towers and visibility into their supply chain. And we're seeing great opportunities there, and we look for that to continue. And that's business that's going to be more enduring and stick around because just in time just hasn't worked. And we see that as great opportunities for us in the future.

Yes. I want to get back to the supply chain as a service model that you have and the opportunities there. But first, I want to just follow up the question on supply and lead times on inventory. Your inventories are very lean, and I know Phil Gallagher, the other day said and [Indiscernible] said the same thing. If we could get more inventory, we would, everything you sell, you pretty much -- I think you buy, you sell pretty much immediately. But if you look at a lot of the customer bases, the OEMs, the EMS guys, they're up 50%, 60%, 70% year-on-year. There seems to be an imbalance somewhat of parts while they're waiting for the so-called golden screw. What are you seeing? And is there a concern that at some point that all those are correct? Or are customers taking a different tack where the new normal is just a more elevated buffer of inventory?

Yes. Many customers -- its an excellent point, Matt. I mean they have more inventory. A lot of it is more like work in process. And the reason is there -- we had an investor today that said you just brought an Escalade and it got delivered without a chip for the heated seats. And I think they came to see us to see if I could get him the chip for his new Escalade. But the point being, that's what's happening, right, in factories. They're building products. He was a very nice gentlemen, so I'm just joking. But it's a true story. People are -- EMS companies, anybody, they're building a product to the point they can but they're missing parts and they can't ship it. So when you look at their inventory, it's very large, some of the numbers that you see in front in terms of days inventory. So we think what will happen is it'll come a time when if it's an auto manufacturer, maybe an auto specific chip where that will flush through. Our inventories as Phil said, if we had more inventory, we'd have more revenue, that's very clear. And we're not concerned about it. We're -- because of the pandemic, we have an inventory meeting every other week with Phil, myself, Joe and each of the business presidents and it's just on inventory, and we did it out of a need for a different need. But now it's out of making sure that we know what's on order, what's coming in and being able to manage through it. So I think we're in good shape. It's always hard to predict the future, Matt. But a lot of the customer inventory is work in process waiting for that final part.

Okay. That makes sense. Yes. Good question.

I didn't really hear that whole thing.

So I can repeat. Basically -- the orders are you seeing sort of one-off orders for those hard-to-get parts versus traditional customers saying we need our own material and obviously, are you helping them?

Well. Yes. So I want to be clear, so yes, obviously, right? People go any place to get a part. And we're mindful. We don't take advantage of it from repricing. I mean what you may be alluding to, there are nice term as independent distributors, i.e., brokers that today, you'll hear a lot of horror stories about a $50 part going for $800 because somebody needs 10 of them. We heard a story 3 weeks ago where is a company that had a lot of work in process, missing a few parts. They couldn't find this chip any place. Guess what it was used in a washing machine and they went out and they bought 10 washing machines to be able to ship through millions of dollars of parts. So I mean that's the world we're living in today. It's quite severe. Some of our suppliers talk about being sold out through calendar year 2023. So things can change, but that's -- it's just pretty severe.

I guess just a follow-up to that is, are you seeing more customers because customers who used to, let's say, the EMS guys who buy most of their product direct. But now they've got distribution has product, and they're your best friend today. What happens tomorrow when lead times are normal, and they can get credit pricing on a direct basis?

We actually see them coming to us and spending 8 months working on a supply chain management agreement to service -- to take over their supply chain. So it's more longer term. I think what we do see is people that usually go through Avnet Core, maybe they go on to Farnell because if they need -- if they can find 2 parts on Farnell, they'll buy it on Farnell. And they'll go to every online distributor to try to fulfill.

So there's not a concern that some of those customers will leave when demand gets suffice?

I think the larger ones are probably here to stay because it's been multiple shocks, and it's never been so severe. And in things like auto, they didn't -- historically didn't have to spend a lot of time on their electronic supply chain because they didn't have a lot of semis in it. And today, just the opposite. So I think some of the larger ones they're actually spending months with us to work out like how we're going to do it. It's not like a one-off buy. Sure. Will there be some that go back to normal pattern? Yes, but there's -- people have people are going beyond just in time to secure their supply chains.

Okay. Question? [indiscernible].

I think it puts a lot of stress on the people at Avnet. Every day, it is expediting parts. I will say this, compared to 2 or 3 years ago, our revenues were up like 20%, and our head count is actually down by 5% or 6%. So people are working hard, but a lot of the efficiency improvements that have been made have worked. And we're fortunate that we put them in place.

I do want to talk about the supply chain as a service model. And maybe talk us through that and how that contributes to the gross margin expansion of the business?

Sure. As I said before, when just in time isn't working, we have customers and some suppliers asking us to come in and help them get through these supply chain issues. And there's no one single explanation for how the model works. These models where previously, it might have worked because of low cost of capital, people are going to hold inventory. Well, maybe customers coming to us, they don't want to hold inventory. We'll figure out a way to work out with them, who pays for that inventory. But the way it does work is you get the throughput through gross profit dollars, not necessarily through a sale and a cost of sale. So supply chain as a service will work differently. Sometimes we're earning a fee. And it all depends. These are primarily financial models, as we said. And these financial models will definitely increase our gross profit dollars. And it depends on who's going to -- each situation is different. We tailor it specifically to the needs of the customer, and it could be working capital light or it could be we have the working capital on our books. But in each case, we're trying to make it work out. So it definitely is accretive for Avnet. And it's a win for the customer, too, and they end up in a better place than they were when the supply chain from their perspective was working.

How is that different than I know you've had different businesses, Avnet Velocity and others where you did very big supply chain engagements in Asia on behalf of suppliers, but then you walked away from a lot of that business because there was low margin didn't meet your returns goals right? So how different is the model today versus a few years ago?

Well, it has its roots in United Velocity, okay? So we've continued to do it. And it wasn't all in Asia. So we used to do a lot of handsets, the mobile phone business, and that's what we kind of deemphasized. But the Velocity model is something that was always a piece of our revenue. And now that is what -- when I talk about companies that have never worked with those before spending months working out how to manage their supply chain and to use Joe's term, their control tower, that's where the roots of it come from. These are -- the way to think about this is it's a long lead time to get a contract signed, but then it's very sticky for years to come, and it almost acts like a recurring revenue. And these are named companies though they don't want us to mention their name because they don't want us to mention who is managing their supply chain. And that's their business. So we want to be very respectful. But they're Fortune 100 companies. So these are -- these are things that are going to benefit Avnet for years to come.

Okay. Great. Any other questions? Yes, go ahead, Brad. Yes, I'll repeat that. So the question is on our relationship with suppliers and actually this is one of the questions that on my list here is the supplier relationships, and we've seen some major semiconductor suppliers take their demand creation, meaning designing in parts that customers direct away from distribution. And at the same time, you've lost some key big suppliers in the last 3 to 4 years for various reasons. So the question is the importance to the supplier community distribution versus them going direct particularly as they get bigger, they've got a much larger portfolio, and they've got thousands of their own FAEs?

Yes. I'd break it into 2 questions. Like really, the crux of yours is, we're managing a supply chain, not one commodity for that large company, okay? So we are managing multiple suppliers to get to multiple plants and we're running and doing the routing and the distribution for that. So that's this little -- that's what I think the gentleman in the back is bringing on. The thing about like Texas Instruments, they went direct, right? So one way to go direct is reduce your suppliers, have people go direct, and that's what they wanted to do. We can honestly say nobody else is talking to us about that. And I think it's because, first of all, it takes a lot of time to be able to build the systems and the warehouses, it takes a lot of capital. Most semi suppliers just are not interested in investing capital in that, they want to invest their capital into R&D and next product, next generation, and that's why they come to us because we're the ones with the engineers that are going out to companies and working with their design engineers to get their parts, their next-generation chips into the next-generation product lines. Does that make sense?

Yes.

It's really because first of all, we wanted to do smaller tuck-in M&A to further enhance Farnell, our embedded business, some of our IP&E business. And there's opportunities available, and we continue to talk with people. Today, everybody is feeling very good about their own business and having a very healthy valuations. And we just think it's probably not the best time to be putting a big foot forward on that. And at the same time, our shares we're at a below historical multiple, and -- so therefore, we concentrate on that. And at some point, right, our multiple will come back and perhaps M&A will be less expensive and then we'll shift it. But either way, it's going to be EPS accretive.

And just on M&A, given that Avnet Narrow have largely consolidated most of the industry, there are some specialists, IP&E specialists, some fragmentation in Europe. But is there really a big M&A opportunity? Or are there complementary industries, whether it be industrial markets or others where you might take your model and move to those?

Yes. Like take Farnell as an example. There are -- first of all, some regions in Europe and in Asia and even in the Americas, where it might help. There's companies, independent companies that we brought them in, that would benefit Farnell, their select product lines. One of the things at Investor Day Chris Breslin, our President of Farnell talked about was, well, Farnell sells more than just semis and capacitors and connectors. They also sell material repair MRO type equipment. They also sell test equipment. If you think about MRO, it's kind of the same thing in that. My machine broke down, I need a part tomorrow. I'm going to go online and order and Farnell can get it to them tomorrow. And therefore, you get a good margin on it because it's a need. So one of the things Chris is going to do, we always talk about expanding what he has in inventory, well, he's going to expand the MRO, but there may be opportunities, smaller M&A opportunities to expand that. So that's the type of M&A, we're looking at Matt.

Okay. It looks like we have like a few seconds left. Any other things that I haven't brought up or any other last thoughts on the company and why people should be getting involved here?

Just -- it's being -- it's participating in the proliferation of semiconductors in more and more different products. It's a time for distribution to do very well because people's supply chains are broken and they need help. We have a shift to higher-margin businesses. And we think we have a good cash generation model where we generate cash in positive times and in negative times. And therefore, we have a healthy shareholder return program going forward. And thanks for the time and coming, Matt. Thank you again for having us. And Stifel always puts on a great show.

Okay, thank you, Tom. Thanks.