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

Thank you, everyone. My name is Ruplu Bhattacharya. I'm with the IT hardware and electronics manufacturing services equity research team here at Bank of America. Thanks for coming to the third day of our Global Technology Conference. As part of my coverage, I also cover global distributors. And today, we're honored to have Avnet, which as you know, is one of the largest global distributors in the world. And from the management team, we have CFO, Ken Jacobson. Ken became CFO, I think, September of last year. And -- but he's been with Avnet since 2013. And prior to that, he was with First Solar. So he has more than 2 decades of experience. We're real happy to have you here, Ken.

Thanks, Ruplu.

Thanks for coming. We also have Joe Burke, who leads the Investor relations team at Avnet. But beyond that, he also is VP for Risk and Treasury. So Avnet is in good hands.

All right, folks. So we're going to get started. Ken, maybe I'll ask you a high-level question. Can you talk about demand trends by region and maybe by vertical? What are you seeing out there?

I think we just completed our third quarter, and it was a higher-than-expected quarter and how I'd characterize it as demand is still pretty good, especially in the vertical markets we serve, we're pretty diverse in terms of the end markets. So yes, we have some exposure to consumer, which is obviously down some exposure to the data center, but a lot of our business is really in the industrial space or the transportation space, which is automotive, but also think about things like e-bikes, golf carts, anything with wheels or anything that moves a lot of electronics and all those type of application. So we're seeing demand still remain pretty steady. It's muted a little bit, but it's still pretty good, it's not declining, it's still holding up. And I would say that's a broad-based statement across all regions. So -- although we're seeing some softness in China. And in those kind of verticals I just talked about, we're seeing continued strength in the Americas and EMEA. And in fact, EMEA had a record quarter last quarter, and they have a really, really broad-based customer set in the industrial space. And in the Americas, Aero and Defense, [ fortunately ], continues to be strong and probably will be for the foreseeable future just because due to geopolitical concerns. But generally, end demand is holding up pretty good. I know we'll get to the inventory question. But generally, it's been pretty good, and I would say, steady. So clearly, we're not seeing 20% year-over-year growth like we have seen over the past couple of years. But this last quarter, we grew 3% year-over-year in constant currency, just to give you some flavor.

Maybe just to dig on that a little bit deeper. You mentioned China is soft. I mean, can you just talk about what's happening there? Do you still have COVID-related costs or any disruptions happening there?

Yes. I would say it's less about COVID. I mean, I think we've continued to operate despite COVID and COVID, we had challenges when you couldn't ship product into a customer because they were shut down. But in general, I would say any costs we have are kind of steady state when it comes to that. But really, from an overall China demand, we're just seeing some general softness, not only on the consumer side, for example, but in general, there's some little bit of slowdown there. And Phil likes to refer this as there's kind of a wobbly environment, and that's been going on for the past couple of quarters, and that was reflected in our guidance for this next upcoming quarter, which was down 1% to down 6%, a lot of that is because of Asia still remaining a little bit softer than we expect, but we do kind of foresee a multi-quarter kind of correction. And so as we kind of enter into the new calendar year, we would expect some of that business in Asia, including China to start to kind of come back. And then clearly, consumer has been down for the past several quarters. At some point, those type of things are going to come back, right?

Right. Now you talked about demand holding up. So in terms of visibility, I mean, would you say that versus 90 days ago, has visibility improved or has it deteriorated? And when we think about forecast from customers, in general, like how long a forecast do you get from your customers? And has that changed over the years given all of the supply shortages, are customers giving you a longer dated forecast?

I mean I wouldn't say the visibility has changed. I would say the visibility we have is one we have a backlog, right? And that gives us a lot of comfort going out, let's say, 90 to up to 180 days, where we have true customer demand. We've got other indicators like our book-to-bill. We've got cancellation rates. And those are kind of factors we consider when we talk about visibility and clearly pretty good visibility 1 to 2 quarters out and a little bit less out there. But a lot of the visibility we were getting with the supply shortages where lead times were extended, so we were getting customer forecast even as far as 18 months because that's what they needed to give us so we could place orders because lead times may have been 75 weeks at the peak. So as lead times have come down and improved, the amount of forecast that we get from customers is lower, but there's still longer-term planning with both our suppliers and customers that give us visibility and clearly, some of the supply chain planning, which have given us some visibility as well. So in general, better visibility out to 1 to 2 quarters, but we do have some indicators, including new wins, for example, right? We know when those are going to onboard. And that's part of our belief that there's some new wins coming that we kind of see and gives us line of sight to some of that growth into the next fiscal year.

Got it. Got it. You talked about cancellation rates. I mean, how are they trending? What's the normal level of cancellation? And how is it trading versus normal?

I mean I think there's normally lots of cancellations, right, customers adjust their, let's say, forecast, MRPs. There's puts and takes, some pull-in, some push out. So I would say cancellation rates are within a normal range. I would also say book-to-bill, even though it's below parity, and that's across all regions, it has been pretty steady. It's been consistent for the past few quarters. And the backlog is pretty consistent. If you compare the backlog year-over-year against the last 30 days. I mean, it's been pretty within a tight range. So all those are positive indicators that kind of demand is, let's say, stable.

Okay. And you talked a little bit about backlog. I mean, how is that trending? And what's the normal level of backlog? And is it still extended for you?

Lead times?

Lead times?

Yes. So I mean backlog, I think, has been pretty steady and backlog really just represents the orders we need to ship that we know we need to ship when the product comes in. And that's been pretty steady across all regions. I would say from a lead time perspective, it's improved, but it's still elevated, especially when you think about power, some high-end micro-controllers. I mean those things are still pretty hard to get and they have a long pull in intent, and therefore, it's creating part of the situation with inventory in the broader ecosystem. But although lead times improved. I believe, 80% of semiconductors, for example, are still extended relative to pre-COVID levels. And so it's improved, but it's still takes much longer to get product than it did prior to the pandemic.

I see. What about lead times and passes? Are they extended as well.

Again, they're improving, but still most stuff in the IP&E space, Interconnect, Passive & Electromechanical, is still extended relative to COVID times. So it's more available, passes are available, but it's still longer lead times than we would like or that have been historical.

Ken, I want to talk about inventory because that's a concern that some clients have. Let's start with overall channel inventory. I mean what's your view on inventory in the overall ecosystem? Is it -- is there any excess inventory? And is there a cancel -- or a correction that's happening in the system?

So our view as of right now and as of our last third quarter when we had our earnings call in May was we're in the process of correcting, and we believe it's a multi-quarter inventory correction, some might call it a soft landing and correction is different than a downturn because in a correction, you still have got decent demand. And so what we see right now is, yes, elevated inventory levels, not only within the distribution channel, but also at our supplier partners with elevated inventory levels at our big customers, including EMS and also with the OEMs, right? So inventory levels are elevated. And part of that is lead times coming down, which has led to suppliers catching up on inventory levels and part of it is the fact that you still can't get all the parts you need to make your final builds. All those factors are contributing to, I would say, elevated inventory levels, I wouldn't say it's necessarily obsolete inventory, probably excess in terms of, it's going to take a couple of quarters to burn through the inventory, but it's really about -- everything is built up. So you need the kind of customer to be able to finish their builds and then consume new inventory, and that's kind of the situation. We call it slower turns, our inventory days have shot up close to 20 days, and that's really because inventory is turning slower than it was, still very new inventory. We know that customers have demand for it. And the analogy -- Phil likes to say as he talks to a customer, they need help with their inventory. They need help with receivables, right, because they're trying to get all the parts they need to finish their goods. We'll ask them a question, "Well, how is business." They say, "business is great, better than it's ever been." So that's the kind of consistent theme is the demand is still there, especially in the industrial base, which gives us comfort that it does take a little time to burn down the inventory, but it still needed inventory.

So maybe talk to us about pricing. If there's excess inventory at suppliers, if lead times are coming down, what are you seeing in terms of pricing from suppliers? Are suppliers still raising prices? And the next question I'm going to ask you is, if and when suppliers start to lower prices, how does that impact your P&L?

I think the word we'd like to use on pricing is stable. In January, we noted a handful of suppliers still raised prices, and the reason they raised prices input costs are higher, you think about at the fab, think about freight costs, all those things, labor costs, everything is up. So the actual cost to build the component is up. And that's what a lot of the price increases have been related to. From our perspective, we pass those on. So we haven't necessarily benefited on a gross margin perspective from all the pricing increases over the last couple of years, but we have benefited in terms of higher sales growth due to those price increases. And we attribute about 25% of our growth over the past couple of years due to pricing, the rest due to volume overall demand mix, things like that. So how we see it right now is because the underlying costs are still up, the pricing is relatively stable. From our viewpoint, clearly, as product becomes more available in, perhaps, as part of the way to get rid of some of the higher inventory levels, right, normal competitive pressures of us competing with our nearest competitors in terms of sometimes you go with price, you try to take share. You've got the normal dynamics of terms of our discounting price to get more customer business, but I think we've built into our expectations some level of normal competitive pressures, while we continue to focus on higher margin type of opportunities like demand creation, IP&E, Supply Chain as a Service and our Farnell business.

To the second part of the question, if prices -- should prices come down, we have mechanisms in place, good relationships with our suppliers and that there is a concept called ship and debit where we're able to go back to the supplier and say, "Hey, we've got a price for X. We'd like to sell it for Y", and they work with us to get the cost of sale back to we would want it to be. So good relationships with our suppliers, with most of them have that kind of mechanism in place that helps us on the downside.

So would you say that there's no inventory risk in terms of -- like it's not like you're buying inventory today and that becomes overpriced because suppliers lower their prices. Are you always protected in that case?

Yes. I would look at it a couple of ways. I think that Joe is right in terms of, if a supplier was to lower their price, their list price, for example, we would have protection for stuff we haven't sold because of the fact that we're still holding it. But on a broader statement, I guess, what I would say is our risk is more of having to hold inventory for longer to get rid of until demand comes there versus obsolescence risk. I mean clearly, first of all, semiconductor components, IP, they have a long shelf life, they don't go bad like food or something like that. But the idea would be, we'd bring less inventory in, sell through the inventory we have, right? And you might hold a little longer. And we're seeing a little bit of that now with the slower turns. But really, from a historical perspective, you go back until -- several years, it has been around for over 100 years, if you go back the past 25 years, never had any serious inventory exposure, inventory write-down, including 2000, 2001, we were able to get through it, just a matter of it takes time to correct, and that's why we call about multi-quarters to get through it. And so that's our view right now. And again, suppliers are being pretty good about not sending too much inventory away. What they're doing is catching up because lead times are coming in for demand that's been out there. They're not necessarily stuffing us on or loading us up with more inventory than we necessarily need.

I'm going to skip to a question that I thought I'd ask later. But because we're talking about inventory, would you say that your inventory is now elevated because some parts are just hard to get and you need to keep more inventory? And then how should we think about your working capital requirements over the next couple of quarters or maybe a year. Like when you think inventory normalizes and how does that impact your cash flows?

I guess I would characterize it as I don't see us having a lot of inventory now for, let's say, safety stock or supply chain resilience. I think that's a future opportunity where customers are going to want to hold more inventory to protect themselves. And the example we use is a $2 part holding up a $100,000 luxury vehicle. I mean automakers aren't going to let that happen again. And they rather hold 180 days of stock of $2 parts to avoid not selling the car. We see that as coming, but you're going to need to supply to kind of improve still in order that happen, to have that excess of the strategic buffer stock. What I would say we're seeing is a catch-up that customers were ordering inventory and they were hard to get parts and now as suppliers catch up with lead times, they might have had orders out for 52 weeks, lead times coming down to 26. So now they've maybe got a year worth of parts and they've kind of got to work through it, right, because they can't build a year's worth of -- in products in 2 months, 3 months, right? So what it is, is really they've got more than they need for their current production levels, but it's still needed in terms of the next 6 months, the next year that's kind of part of the correction. So -- and again, our inventory builds have been specific to certain technologies where lead times have come in and kind of built up a little bit as opposed to broad-based build of all suppliers, all inventory. It's been more pocketed for 5 or 6 suppliers, might make up 80% of the inventory build.

So the level of inventory, the dollar value is one thing, but I think what's more important to me is the turns, inventory turns, are they good? I mean are they normal or are they weak? I mean, how would you characterize inventory turns at this point in the cycle?

Yes. I think there, we can do better and we should be. So they're elevated -- I mean, I guess, they're lower than we'd like. Normally, we're in at least 4 to 6x type of basis. So our inventory days should be 70 days, we'll call it, and we're up to 83. So there's 10 to 15 days of reduction we should have there and that's all about turn. It does not -- I don't think the dollar amount of inventory is necessarily a concern. And as we continue to grow, that dollar amount may stay stable, but you're going to see the turns improve. And I guess if it's a stable demand environment, as we start turning it faster, then that would yield to excess cash flow generation.

Got it. Maybe I'll ask you one more question on inventory, and then I'll move on. Inventory on a dollar basis is up year-on-year. How much of that is because there are more pieces of inventory in your inventory versus the value of that inventory with -- the cost of the inventory has gone up year-on-year.

I think at a high level, similar to the sales growth being about 25% of our sales growth coming from higher prices, inventory levels will be generally about the same. So it's not all pricing. It's a lot of volume -- or mix, right? It could be a higher dollar MCU relative to a connector, and that's 15x the cost. So that's for illustrative purposes. So I mean, I think if the inventory is building really due to price, then you'd expect to see a higher sales growth when it's sold through. So I wouldn't say it's as much pricing, I'd say it's more volume or mix, causing some of the inventory build. And again, it's really just a matter of turning it. And we do think it's fresh. It's good. It's needed by the end customers. It's just a matter of it's turning a little slower due to the buildup of inventory on our end customers as well as the OEMs.

Got it. Okay. So let's move on. So 1 thing that keeps happening in the semiconductor space is that suppliers tend to merge, they tend to consolidate. In the past, I think you've been hurt somewhat because of that. How have you recovered from that? I mean how do you see -- and maybe as part of this question, I'll ask you, how is your share trending over the next -- are you gaining share in any region? Have you lost share, maybe you can just update us on that? And another thing is on your line card. Are you happy now with the strength of your line card? Or what's the trend there?

Yes, I'll start with the line card, Ruplu. We're very proud of the line card that we have. I mean we have supplier relationships that go back 40 or 50 years. And we can't control what happens within the consolidation in the industry. There's been times where we've won, there's been times when we lost some suppliers. But we're always looking at our line card, looking to fill gaps and areas where we need to. And we've done quite well. I mean, I think if we had a large disengagement back in 2019. We're an $18 billion company or a $25 billion company now. We've been able to make up for that. And one of the ways we do that is make sure that if we did have a loss, comp plans are not changed. Just tell the team, go out and get that business. And so again, we're very, very proud. We have a great line card, and that served us well in the past, and we expect that to continue on into the future.

Yes. I'd say from a market share perspective, we measure market share a few different ways. One is against our biggest competitor, how are we growing versus their growth? Well, 7 consecutive quarters of outgrowing them. When you think about our supplier partners, we're #1 or 2 in all of our big supplier partners. So to Joe's point, we love our supplier technologies we have. We've made up all the business of the lines we've lost. So if you really take that into consideration with our growth over the past 3 or 4 years, the growth rates are even higher when you say we made up $1.6 billion of business from a major analog supplier that we lost, so we feel pretty good. And I think part of that was really going back the last couple of years, our focus was getting back to basics. And part of basics with our business is really helping drive demand and supporting our supplier partners, right? We're an extension of their sales force. We're an extension of their customer base, and we're meant to cover the long tail of customers. And so how we win with our suppliers as we help increase their customer count, help increase their business, right? And then they want to give more business to us. And so our supply relationships are probably as strong as they've ever been. We're comfortable, never confident -- or I guess, confident, never comfortable, but we feel pretty good about there. And there's always potential consolidation in this industry. There always has been. And I think over time, we've won more than we've lost. We're really proud of our line card. So I think we're not scared of that. That's always been part of the industry, but we feel pretty good that we've got everything we need to serve our customers, and that's the important thing.

So maybe let's talk about revenue growth. I mean if I go back to the last Analyst Day, I think you gave medium-term revenue growth target of 5% to 8% CAGR. I mean, help us unpack that. How much of that is market growth versus you gaining share? How much of that is pricing? Why is 5% to 8% the right target? And then how should we think about revenue growth in the near term versus medium term?

Well, first of all, when we presented at Investor Day, we took trusted industry sources, and we took a look at our verticals and the demand as the industry sources forecasted and the good thing about our vertical businesses, we think we're focused on the right verticals, industrial, automotive, transportation and it's not just automotive anymore, as Ken mentioned before. It's golf carts, it's e-bikes, it's boats, it's -- you name it. And in addition, aerospace, military defense. So we think we're in right verticals. We do have some communications consumer business. That's a little sluggish right now, but that really factor into it. So as we looked at it, we saw that we're in the right markets with the right -- with the highest growth CAGRs over the next few years. And so that's how we got to that number. Now things will change based on macro, plus or minus. But we think we're in good position with the verticals that we serve.

Okay. And I think if we win more business like we have been, we'll be at the higher end of that range. And if we're kind of staying with the overall growth. And again, the content -- the electronic content and all things around us is just only continuing to expand. And that's kind of a lot of the proliferation of electronics, to think about electric vehicle or just a vehicle in general compared to 10 years ago, how much electronic content is in the build of materials now. And that's the trend we're going to see across industrial applications, talk about AI, 5G. I mean there's plenty of opportunities, a diverse set of opportunities to kind of fund that growth. And that's why our supplier partners are investing in capacity. I think longer term, if you look at the history of 5% has been a reasonable growth rate for semis, right, on a normalized basis. This past couple of years has been extreme growth, but mid-single digits has been a normal growth rate we've experienced in the past, clearly, when you normalize with the supplier losses.

Okay. So maybe let's talk about margins. I think one of the areas where you guys have done a phenomenal job is on the core business. If I remember, I think 2 years ago, the core business was at 2% operating margin. And last quarter, you reported 5%. So how much of that is sustainable? I mean, what are the drivers for improving margins further in the core business? And how should we think about that?

The biggest thing about our model, I think about the distribution model, is really creating operating leverage scale. And over the past couple of years, what we've done is improved our scale. And from our business perspective, we've got capacity in our warehouses. We may need to invest longer term for new warehouse capacity. We're going to invest in our people, 70% of our cost is people costs. So we're going to give raises and we're going to make sure we take care of our engineers and things like that. But the reality is, if we're growing 5%, we don't necessarily need to nearly add 5% of costs, right? And so the operating leverage, we can create in this model is significant. And so our view has been consistently if we just get back to taking our fair share of the market growth, we'll be able to continue to hold or expand margins. And I think the growth over the last few years has kind of led to a more steady revenue base and that revenue base that yields in operating margin. We're not planning to get to our expectations, which is really a 5%-plus long-term operating margin across all of Avnet through necessarily improving gross margin. We think we can hold gross margin because we've got a lot of higher gross margin opportunities, demand creation, where we help generate demands for parts for small- and medium-sized business for suppliers, that yields a 400 or 500 basis point better margin just a normal component sale. IP&E is about the same. We've got supply chain services, a lot of higher-margin opportunities that can offset just general competitive pressure on fulfillment-type margins. And then we'll continue to operate efficiently. When we do look at cost actions, we look to reinvest those dollars. So really just being very disciplined on cost and becoming more efficient in how we provide services to our supplier and customer partners allows us to kind of keep costs under control, and we've seen that over the past couple of years of very little cost increase, even though grow the business, 40%.

Yes. No, that makes sense. So if you're talking about margins, let's talk about your catalog business for now. Last year, margins were within your target range of 10% to 15%. Last quarter, it was down to 9%. Give us the lay of the land, what's happening with Farnell margins, what's impacting that? And when should we think that you can get back into the target range there?

Yes. Farnell is our high service business and so compared to, I'd say, we're like Costco or a grocery store or a Safeway. For now, it's like the 7/11, right? So you want to go in and buy a single Coca-Cola instead of buying a 24-pack and so we're able to yield a higher margin for that, especially for the speed and convenience they provide. So in that business, which is roughly 7% or 8% of our revenues, they did benefit a lot from the shortages and we're able to extract a higher gross margin for the components they did have. So what we're seeing right now in that business is a correction of their gross margins. They have about 3x of the gross margin of our core business, a little less than that, but we've seen that gross margin to have some pressure as well as just overall muted demand, and that's causing some pressure on the operating margin. There's also some investments we're making in that business specific to IT systems and warehouses because it is a higher margin business. Again, double-digit EBITDA versus our business that we are shooting for a 5% EBITDA, so 2x in the operating margin. So a little bit of OpEx there, and that's all kind of leading to a compressed operating margin, what we see over the next, let's say, a few quarters is some recovery of that operating margin, one, because of the fact that there's new business they have coming in, a new supplier line like ADI, National Instruments is another supplier that they're exclusive with. So they've got some new suppliers that have growth potential as well as single-board computers for Farnell businesses, it has about 10% of our business, historically been single-board computers. And single-board computers, just haven't been available because of the supply constraints and that backlog is robust, and we start to see that coming back online here in the next fiscal year. So going into the September quarter, we'd expect to see the single-board computers available, and therefore, the backlog starting to get filled that helps the growth rate. That helps the operating margins. So a combination of factors, but a lot of it is really the unwinding of the pricing premiums that they've experienced through the part shortages that's kind of putting pressure on their current operating margins.

Okay. And the time that we have left, I want to ask you a couple of more questions. Let's talk about capital allocation. How do you think about M&A? Would you lever up to do a larger M&A? I don't know if there are opportunities out there? How about like buybacks versus debt reduction. So just help us prioritize all of these.

I'll start. Our capital allocation is, first, to support the business. Where we are, we don't have a lot of capital expenditures for factories or distribution centers now, a lot of our cash goes into the working capital. That's what we've done. We couldn't had up until December of last year, double-digit year-over-year sales growth without having -- putting a lot of cash back in for the receivables and inventory that we needed. So to support the business: number one, we do pay a steady and increasing dividend over time, support the business means working capital, CapEx and things like that, the distribution centers and the systems. Working capital is important; then M&A, we'll take a look at M&A where as and when it makes sense for us. I mentioned the dividend, the buybacks. The thing that we have now is since we've had elevated levels as that burns off, we think we're sitting on a good amount of cash when that turns, and we'll be in a good position to look at our share repurchase because we think we're undervalued at this point in time.

So speaking of that, maybe I'm going to ask you the last question, which may be difficult to answer, but if you look at what's happened with Avnet, you've recovered from supplier consolidation, your revenue growth is good. You've got core operating margins at 5%. Farnell is 9%, which is still much better than the core. And yet, when I look at the stock, it's trading at just above tangible book value, why do you think that is? I mean what are investors missing? And why should they invest now in Avnet? So a couple of different questions, but I'd like to get your thoughts on that.

I mean, I think, again, we think it's a great value in the stock because we're trading well below book value. The thing we haven't talked about much is the countercyclical balance sheet. So let's say demand went down 10%. Our sales went down 10%, what that means is we're going to generate a lot of cash because our inventory levels will correct. We'll collect the receivables and therefore, we'll generate a lot of cash. And if you look at our history anytime, sales have gone down, we've been able to generate a lot of cash, which then gives us flexibility and capital allocation priorities. And typically, that's coming with a lower stock price. So if you look at our buybacks over the past 10 years, it's been pretty robust. I think the thing people are missing is: one, our execution is back. We've had some unforced errors over the past few years. You talked about that supplier loss. But if you really look at over the past 3 years, since Phil Gallagher took over as CEO, we've executed really well, and we've repaired our supplier relationships and really gotten back to the basics in terms of focus being on value-added distribution. Talked about it before, though, I mean, this is a really great neighborhood to be proliferation of electronics is here to stay. We've got the right line card to help us do it, and we've got the right end markets really where the growth is going to be. And so we're going to get through whatever this correction is in the worst case sales go down, we generate a lot of cash and then figure out what to do with that cash. But the reality is our position with electronic supply chain is critical, and it's a great neighborhood to be in. And so I think we're really poised for a lot of momentum going into the future even if there's some uncertain waters here over the next couple of quarters, we feel pretty good about and that's how I leave it.

Okay. No, that makes sense. So Ken, we've talked about a lot of different things. I really appreciate you taking the time to come here and wishing you great success over the next year.

Thanks, Ruplu.

Thank you. Thanks, Jacob and Ken.

Thank you. Thanks.