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

Greetings. I'm Matt Sheerin, senior analyst for technology supply chain, including components and the component distributors, including Avnet, Inc., one of the largest semiconductor distributors in the world. And representing the company today is CEO, Phil Gallagher; and Ken Jacobson, to my left, CFO. Welcome, gentlemen. Thank you.

This is just an open fireside chat. So we're going to start with some questions. So Phil, maybe the best way to start is just to kind of talk about recent earnings call in terms of your financials and your outlook. I know we're going through a bit of a cyclical downturn but some people are calling it for more of a soft landing. You're seeing strength across a lot of your businesses, including some of the industrial markets. So any overview you can give us would be great.

Yes, sure, Matt. Thanks. And I appreciate everybody being here or online or video, wherever you might be watching us from. So thanks for the opportunity. Yes. So we had a -- we closed our Q3 fiscal, right? That means in March we did the earnings call, I guess, roughly 4 weeks ago. We had a strong Q3 would beat guidance and consensus pretty well, which we're excited about. We guided the June quarter minus roughly, let's call it, 3% at the midpoint, which is pretty close to seasonality, maybe a point or 2 more, but -- and seasonality is a whole another thing, Matt, that -- I don't know what seasonality -- typical seasonality after COVID all we've been through, there's not been a lot of typical anything, frankly. So then we guided to June and we feel good with the guide. In our world, the West starts to pick back up. I'm sorry, this will come down a little bit. March is typically our biggest quarter in the Americas and Europe. Asia typically with the Chinese New Year and whatnot, it's a little softer, they'll start to come back or flatten out into June, then we'll see September, December increase. So we're really pleased with where we are, never comfortable. So we can talk about the market now. And you talked about mixed signals in the market. And I've been with Avnet for 41 years and been through a lot of cycles, and this one is -- certainly feels different than many. And we often talk about the nice slow increases like we call the Nike solution, like soft landings, an industry rarely sees that, and we didn't see this last time either. After COVID, everything went through the roof. We had the lead time issues, supply chain constraints. And now here we are with some kind of adjustment in the market. I, for one, think the adjustment is -- frankly, it's a good thing the way it's adjusting right now. Our book-to-bill have been below parity now for several quarters. It doesn't concern us. They were so far above, one to one, that, that wasn't real either. So I think we're leveling out from a realistic demand view standpoint. And if you look at the vertical, and this is what's really the interesting part versus if you compare it to '99 or 2000 or 2001 that you and I certainly lived through and we saw the big crash in the market. We were very -- as an industry, very top-heavy, very, very top heavy in comm, PC, the Y2K hit on telecom, when that went down, the industry took a pretty hard hit. Well, that business is still there. And although you might argue, mobile, some consumers a little softer right now. On the other side of the coin, the proliferation of electronics just looking around the room and around the conference itself, the amount of semi electric content and it's in so many different products. But the industrial segment, medical, defense aero, unfortunately, good or bad news, it's going to continue to stay strong. And of course, we talk about transportation. It's well beyond just automotive, which is still pretty strong, but the content going up quite a bit. it's transportation. I mean, it's trains, trucks, dump trucks, e-bikes, all chuck-full of semiconductor and interconnect pass electromechanical products. So that's kind of this counterbalance what we're seeing. So we're talking about some softening in consumer, PC, whatnot -- that will come back, by the way. But you still have this pretty decent pool on the balance of the market, which I think is helping us ease into a correction.

Looking at your customers' inventory positions, relative to your backlog, do you expect customers to just work down the inventory because obviously, it's above -- it's that record, highest pretty much everywhere, right?

Yes. So inventory is the topic of conversation, and certainly with Avnet as well, we would like to see our inventory down a little bit more than where it is, probably grew a little bit more than we wanted it to. As we spoke on the earnings call, like we're not overly concerned about it. The inventory is good inventory. It's fresh inventory. We're just managing -- Matt, to your point, our customers have a little bit more inventory than they want. So we're trying to work with our customers to see what do they need? When do they need it? Can we push it on them a little bit more? Probably, but that could become then a receivable issue. So we're just managing through it case by case. I believe, and I said this on the earnings call, and I think I'm right, time will tell. I think we're in an inventory correction mode. I think we're kind of living through it right now. I think it's -- if the demand in those verticals I just talked about stays just relatively good or even flat to where we've been in the last couple of years, I think we got a two to three quarter maybe into the early calendar 2024 inventory correction, and that it will take care of itself. But there's some burn off for sure. And all segments are feeling -- the suppliers, some of them have too much inventory, some of the EMS guys, ourselves. And then we get a look at the publicly held end customer inventories are a little bit higher too. But when I talk to these customers, they come in, they need some help with inventory. They might need some help in returns. And we're going to work with them. I mean our job -- a big part of our job, we've been around for 100 years, is -- we kind of play bank. I mean that's what we do. We're the middle guy. We're kind of the shock absorber for the industry. So whether it be inventory, backlog management, receivable, financing, we kind of play all those roles, and we're very comfortable doing that. But that's what we do. So that's why we're not afraid of it at all. We're kind of in a pretty darn good position.

It's just that not just but two- to three- quarter corrections as you see it.

I mean, that's what I see, and that's what I said in April to the earnings call, because customers will come in, they might have -- XYZ industrial customer, this is a real case, and I can't mention the customer's name. You would all know them. And in industrial. And they came in and need some help with inventory and maybe a little bit of help with receivables and so I am talking to them and their top person was in. And of course, and I shared with them, "Hey, we've got a little bit of inventory too." So you got to kind of remind them maybe we're in the same boat here, times 1,000 customers. And I said, we'll work and, we do 75% of their total business. So -- hey, we're a partner, right? That's what we do. But then I asked this, so how is your business going? And they're like, all our business is great. So again, the business is good. They just overbought, maybe too much of an insurance policy of products and they've got some short-term inventory issues, but their end business is still really good. And that's kind of the story that I'm hearing over and over again.

And I think this cycle is a little trickier because you still have some components with very extended lead times and most semis are still above their normal lead time range, which is, what, 12, 16 weeks or so. Now you're looking at what, 25, 30 weeks on an average?

And that's part of this -- again, no pun intend, it's mixed signals we're getting. So -- yes, now by the analysts, well inventory is all readily available. Well, no, it's not. In some products, yes, lead times are down quite a bit. And other products, however, [FGTs], high-end controllers, particularly anything tied into transportation or automotive, those lead times are still out there. Even if they've come in there's still -- you said they're still well beyond pre-COVID levels. And 80% of the semiconductors out there are still -- although lead times have come in, they're still above pre-COVID levels in January, February, March 2020. And same thing on the IP&E. It definitely have come down. But if you look at the chart, in total, in aggregate, they're still outside of where they were pre-COVID. So this is not a -- it's better, which is good, and that's part of why the suppliers are catching up in certain commodities. Thus, our inventory growing a bit because they're catching up, but there's others that are still long pole in the tent, you can't get the product.

Yes. And then just on the end markets, you've talked about industrial, medical, mil-aero, but some suppliers are talking about some slowdown in like factory automation, and some of those areas. Are you seeing any pockets of weakness there?

Not -- maybe flattening out, but not necessarily weakness. I mean, I think with what's happening in the whole industrial segment, that's a pretty broad segment as well, by the way, a lot of things -- it's about 30%, 35% of our total business is in that long tail and industrial customers. And -- yes, we're seeing some slowing in certain customers. But across the board, the pool is still -- I call it the pool, the demand pool is still pretty good. And I look at it like in our backlog, Matt. If I look at just our total backlog today versus a month ago versus a quarter ago versus a year ago, we're within any one of those months or quarters were within plus or minus 3% to 5%. So the backlog is still holding up, okay, which is interesting because we've had negative book-to-bill, but the backlog inside of 90 days is still pretty decent.

Okay. And then on pricing, we've all seen ASPs come up dramatically in the last couple of years, semis, IP&E. There's expectations of some pricing pressure, right? Are you seeing that at all or your pricing holding?

So far, pricing seems to be holding. Now let me clarify. And we still had in the first quarter -- first calendar quarter, we still had roughly 20 suppliers that will raise prices. Now customers are getting a little fatigued with the increase in prices, but we've been managing through that. I think you're still going to see some selective -- depending on the commodities or technologies, more price increases. But it's not going to be as ramping as it was over the last 2 years. As far as ASPs or average selling price holding, typically, Matt, as you well know, in years past, the market goes down and prices come down and whatnot, classic supply-demand curves. Right now, we're seeing pricing actually holding okay. Standard products, standard products defined as multi-sourced products, some of the passives, discrete, things along those lines, there's always going to be pricing fluctuations up or down. In the higher-end products, where all these CapEx investments were made, we're not seeing a lot of pricing pressure there at this point in time. Look, it can change, I'm just -- as I'm sitting here today, the high-end ASPs are holding up okay.

And if street pricing comes down and you've got lots of inventory, how does that -- do you get divided by the credits by the suppliers? And how does that work in terms of as you say, fresh good inventory and ASPs decline, how does that impact you?

At my Board meeting last week, they asked the same question. So we're pretty well price protected. So with the -- and I don't want to get into the ship and debit process because that's a three beer conversation trying to explain that. But basically, if the prices come down, the suppliers -- and we have backlog at a higher price -- again, we're shipping debit, we'll get a price debted down on that product. So that doesn't concern us too much.

And then also in terms of inventory obsolescence or need for write-downs or anything you don't see any of that?

Right now, we're -- we ask this guy to your left, right now, we're in good shape on reserves, and we're in good shape on aging.

Yes. And Ken, maybe you can just talk about the quality of your credit and your customers, you do have a lot of like smaller EMS guys that are obviously there. They're drowning on working capital requirements right now as their own inventory is up. How does that look?

Yes. I mean, I would say we've done really well. Even since the pandemic, had very few customers go under all of state of float. And I think that speaks to Phil's point about the end demand being good and they just need to finish their products to convert their cash collection cycle. So we've seen receivables, I think, let's say, on average, maybe like 10 days higher. In the December quarter, it came down a little bit. But the receivables really aren't bad, especially considering the inventories what's kind of causing some of that constraint, but the customers are paying. And if they're paying late, then we're trying to negotiate, do we get a premium or some interest on that as well as the inventory. So we're trying to work out where we'd get to a win-win. And I'd say, generally speaking, we've been pretty good about the collection side, and feel pretty good even today about even at the inventory levels, although we keep on working at it. One customer at a time. But clearly, we need to keep our customers afloat, so they continue to be for the next 20 years, right, a lot of these are long-term relationships.

Yes. You -- Ken has been really home. Our finance and credit team has done a great job. We went into COVID, first of all, protecting the balance sheet, as you recall, Matt, and then said, okay, we're going to figure -- there's going to be some customers that just aren't going to make it, particularly smaller ones, but -- weaker balance sheets and whatnot. And knock wood, we've not seen that to date. We've extended, again, as part, point bank, we're working with our customers. We've been around a long time. They've been good partners. But we're all involved, with some of the bigger ones, we're all involved. I'm personally involved in quite a few customers, working with their CEOs or CFOs directly and Ken's involved. Okay, how can we help them or their demands there. They just need -- they need a bridge, if you will, and how do we build that bridge? And then what do we get back for that, right? It's not all for free.

Yes. Okay. And one -- just on demand by region, North America and Europe seemed to be holding up very well. Asia has been -- I think it was down 10% year-on-year, obviously, more exposure to consumer, those kind of markets. Are you still seeing strength in the other regions?

Yes. The -- it's amazing. And the December and March quarter, Europe, which is our strongest region overall, okay, had record revenues and profits, which is kind of scratch-your-head with everything going on in Europe, or at least the perception of everything going on in Europe and the reality, the energy, the war, things along those lines. It's just such a very strong, diverse customer base, auto, transportation, and industrial segment, there's really a long tail. So Europe continues to be a strong performer for us. We're going to start to see some softening in Europe, I think, which is -- again, back to the conversation around seasonality. If you get into -- I think we would have a more typical summer season in Europe than we've had the last couple of years. So pricing a little bit of a slowing, but overall demand has been good in Europe. It's been very good here in the Americas. We've grown 30-plus % year-on-year in the Americas. Again, some of that is us gaining share back there we had lost a few years ago with some other issues we had. We're back really strong in the Americas and big time on offense. And against similar customer base, Europe had a little bit more exposure to the EMS guys, which is fine, we're good partners within Europe, but those two regions continue to be strong. And Asia is starting to starting to flatten out. We're not as exposed to China. We're pretty even in Asia, Matt. So we're between Southern Asia, China, Taiwan, Japan. And we think in the second half, we'll start to see that flattening out and starting to come back a bit.

Okay. And also, I didn't want to ask on your margins, which actually have been holding up very well. Your gross margin was 12.5% in the March quarter, that was flat year-over-year, while some competitors had seen that go down because of mix of business and also maybe more competitive pricing at the customer level. And you're not seeing that, and I know your operating margins have been above 4% and your -- I think your goal is to achieve that 4% level even in the downturn. So maybe you or Ken can talk to maybe the drivers of that?

I think, if you kind of take a step back and talk about pricing, all these pricing increases were going on, we were passing those pricing increases through kind of maintaining our gross margin. We weren't necessarily gouging customers, let's say, marketing objects as they are in high demand with the same concept that hate long term, need to kind of be fair with the customer. So you didn't really see an uplift in our gross margin as those pricing increases were happening. You saw an uplift in our operating margin because it helped our sales growth rate and things like that. So what we see is really a stable gross margin overall, and that's because of the pricing environment, but we also have high gross margin type of business opportunities, talk about demand creation, which is over 30% of our business. You talk about Farnell, who has very high gross margins and their growth rate is expected to be higher than ours, and we have some supply chain services as well. So a lot of higher gross margin opportunities that are out there. And our view is those will help offset general competitive pressures. So even though we're protected overall on prices, there might be competitive pressures that there always are of giving customers a better deal cutting a couple of points of margin. So we think we've got enough buffer in there with some of the higher margin opportunities to kind of maintain that gross margin. And then the reality is we've really been managing our OpEx and our investments really well, taking costs out to reinvest, and we don't see any huge uptick in cost. So as long as we kind of maintain that kind of $6 billion to $6.5 billion sales levels, we'll definitely be able to maintain a higher operating margin, really the sales growth over the last few years has given us a new baseline. And we feel pretty good even though there's uncertainty in the market and there may be some pockets that go down, there's a lot of opportunities we have. One is in Farnell with single-board computers. We know that's opportunities in the bank. We have opportunities in certain market shift in terms of market share with some [ tandem ] from suppliers, new wins of net new business to us, even if it's been part of the overall market. So those are things we have -- feels like they refer to them as gap fillers that help us stabilize that top line even if the market is kind of swinging a little bit. And that's why we feel pretty good about $6 billion kind of being afloat. As we see it today, as we see it over the next couple of quarters, we feel like the backlog is healthy, a lot of inventory to sell. And so that's kind of where those expectations came from.

So $6 billion sort of a base revenue and then 4% plus operating margin?

And if you think about last quarter, we were, call it, $6.5 billion, so that's almost a 10% cushion. Sales could go out of town 10%, would still be at $6 billion. And again, we have some of those gap fillers that we're expecting to kind of capitalize on over the next year to make up any kind of just overall softening of demand.

Got it. Okay. Any questions from anybody in the audience? No. Okay. Phil, I wanted to talk about the competitive environment and your position with suppliers and customers 3 or 4 years ago, you went through lots of changes. You had a couple of big suppliers move on. You took over as CEO 3 years ago. Since then, it looks like your supplier relationships have been very stable. And in fact, supply chains have changed dramatically in 3 years because of the pandemic. So more customers reaching out to distribution and suppliers adopting distribution more. And has this been, for lack of a better word, a good thing for you because customers really understand the role of distribution being key to their strategy?

Yes. Thanks, Matt. So -- great question. So -- we've always known the value that we bring from a supply chain expertise to the marketplace between the pandemic and the supply chain breakdowns in terms of Suez Canal, freezes buyers, it's even -- it's renewed, if you will. So customers and suppliers, both truly see the value that we bring to the market and our supply chain expertise being in the center of the technology supply chain. To be very direct, on your first part of your question, our supplier relationships, we feel really good about our supplier relationships. Again, never comfortable when you're in this role, right? We can't control who's buying who behind the scenes. But as of right now, we're #1 or #2 with our top 25 suppliers globally, okay? So we feel extremely good. We had a couple of mishaps a few years ago. That's way in the rearview mirror. By the way, all that revenue plus about 20% has been replaced, okay, and we're profitable. So we feel really good with the line card. And I don't want to start naming lines because then I'll miss one and I'll get in trouble, right? So there our line card is rock solid, and we're proud and thrilled with it. As far as customers go, it's really interesting. We have customers calling us or suppliers, by the way, that are being asked by customers to do certain things in their supply chains that the supplier might say, that's not our question -- that's not our core expertise, but we have a partner that can go do that for you. And actually, some suppliers have done joint marketing campaigns with us. And hey, we'll call on you from an engineering technology because it's Tier 1 customer. But a supply chain, that's not -- we're not very good at that. Avnet's our partner. So we've been actually brought into major Tier 1 OEMs, maybe one or two out of Detroit, some in Germany, where, so far are actually bringing us into those customers. And are now some of these are 18-month old engagement still in development because that's how complex -- because when you get involved in some of these supply chain engagements, you're integrated into those customers. And then we have other customers coming to us that maybe are in a medical industry and have been through a ton of acquisitions, like a lot of the medical guys have came to us recently and said, we need some help. We've lost visibility to our supply chains. We've got all these MRPs out there. Can you guys help us? And we're like, "Yes, sure." So these are customers that weren't there before. And then the next question is when things turn and supplies already, are they all going to go back to the old ways? I don't think so. I think there have been enough customers that are been snakebitten by not having a $0.20 or $0.50 microcontroller holding up a $500,000 dump truck or whatever it might be, that are going -- we were, they're going to stick to the supply chain engagements. And -- again, because once you're integrated, you're integrated, it's not like you just pull out anyway. I mean, you become part of their materials team almost, right? But I do think that's part of the challenge of what the industry saw in the last 3 years, I think there is so much lack of visibility to the supply chain, both up to the suppliers and down to where the real end demand was, the transparency just wasn't there. And our suppliers and our customers like the fact that we can build out these control towers, what we call them, where it gives visibility to the supplier knowing where their products are really going. And then it's the customer who might be outsourcing the 10 or 15 different EMS providers, can now see where their inventory is? Where do they need the product versus where they had too much product, that we help manage that for them. So it's actually been an exciting couple of years for us.

And that -- those Tier 1 engagements, so is that a consigned inventory model where you're basically getting a fee?

Yes and no. It depends on the model. Every -- I'll let Ken touch on that. But some of the really, really large ones, where there's a lot of working capital involved, we'll go back to the customer and say, "Hey, should we or the supplier, who should carry the inventory, and what's the model? " And -- it's a mix and match.

I mean, in general, their structure is more of a supply chain service than a buy and hold of inventory. The concept being it's really not our inventory. We may buy and hold title, even show in our balance sheet, but they really have the risk on the inventory. And we're really buying at their prices typically, right, because they've got negotiated price with the suppliers and things like that. So it's really meant to be more of a service. And going back to your gross margin question, it's services level gross margins. The assumption here is we have no inventory risk, right? We might physically hold the inventory, but we don't really have risk for it. They have to take it at some point. And if they don't take it, there's fees and penalties, right? I think the real million-dollar question now is with the cost of capital going up over the past few quarters, who buys that inventory really, and our push to the customers is you can have a much higher -- a cheaper cost of capital than us doing it, it's going to cost you more if we buy it. So you go ahead and buy the inventory, we'll hold it for you and work out how we do that. So it's a mixed bag. We can be flexible. That's part of the beauty of the services, we can be very flexible, but if we're going to hold it, we got to get paid for it, right? And not just our cost of capital, it's something on top of that. But those are conversations we're having ongoing. We have a few different models that help work it out. But it's definitely fast pace, and I agree with Phil that they're taking supply chains in their own hands, but they need a partner like Avnet. These OEMs aren't set up to hold inventory in 15 countries and across a bunch of different Tier 1 suppliers and things like that. So it's very complicated to set up that structure, but that's what we do. We've been doing business in 180 countries for several years. We've got the infrastructure. We've got the legal entities set up, the tax set up. So there's a lot of things that we have that we're already well ahead of the OEMs on so it's hard for any one customer to replicate that, especially with the scale we do it at.

How -- could you give us an idea of how large these engagements are? And how big that business is versus pre-pandemic?

It's hard to define it because it's net -- these are net treated now. So the revenues could be in the hundreds of millions, if you will, okay? But we're building out of the service level margin markets...

Okay. So like it's the gross profit?

Yes. So it's the GP. So I would say today, it's kind of like -- it's -- what we kind of point to supply chain as a service, what's nice about it is it starts to become an annuity. These aren't all new. Some of these -- there's a large, telecom guy in the beta, we've been doing this for 2 years or so, is just now expanding. But once you're in, that business is kind of builds up. So it's one engagement at a time, but it doesn't go away. It just kind of keeps growing. So this is one of the -- Ken pointed out that, I call it the gap fillers. I gave is just -- pure gross profit, it's really nice. And just it just turns every month in, month out. We just want to keep adding to it.

And are you working with the EMS providers in a similar way or more traditional?

More traditional, but in certain engagements where maybe it's a large supplier, and they have it direct, they want our help, we work with them. We're not -- no way we're competing with them. We definitely work with the Jabil, the Flex, et cetera. They're still more traditional, okay, in this environment, but I can see it being mixed moving forward.

Okay. And going back to the supply chain service, it's ramping, Matt, I would say, so I don't think you're seeing -- you're starting to see a little bit of impact in gross margin. But over the next couple of years, we see a robust pipeline, especially because it takes several months, if not years, to kind of fully ramp these things, pilot it, but we're starting to see some traction in terms of in the bottom line. But I think you see over the next couple of years, a lot of growth there, and we would expect at some point to start breaking those out once it becomes appropriate to size.

Okay. Great. And just last question on your balance sheet, capital allocation priorities. I know your interest expense has been rising. Your inventory has been up. What's the planned strategy in terms of capital allocation, Ken?

Yes. I think in general, I think interest expenses kind of peaked. And for some context, it's gone up, kind of threefold, if you will, from where it had been at a little bit more than that even. But the reality is as we work through inventory, we'll generate cash. And mostly, that cash will be used to pay down some higher interest debt. Our priority is continue to invest in the business, so whether that's OpEx or CapEx or even working capital, those are priorities. We've had pretty good success over the past few years by focusing on the business first. And so we'll do that. We do think the shares are attractive. They're are trading below, tangible book value, we think that's a very attractive. So as we generate cash, we'll look to pay down some debt, but also redeploy some into buybacks as well because we do see it's a good use of our cash. I think with M&A, I think we're always open to consider M&A, especially if it gives us a capability or customer base or product that we don't have today, but I think that's really not as much of a priority today, it's just really maintaining the organic growth strategy we've had. But we do see buybacks. And our dividend, we've been consistent there with the dividend, and expect to increase it here again in the next fiscal year, but really, we want to continue to return excess cash to shareholders as it comes available.

Okay. Great. Perfect. We're out of time. So thanks very much.

Thanks, Matt.

Thanks, Matt.

Appreciate it. Thanks a lot. Thanks everybody.