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

This is Melissa Fairbanks, again. I am the analog semiconductors and IT supply chain analyst here at Raymond James. We are thrilled to have the guys from Avnet here. So today, we've got Ken Jacobson, CFO; and then Joe Burke from Treasury, and he also handles some IR. I think you might have some just brief introductory comments, but we'll just jump right into Q&A.

Sure. I'll start. So good morning, everyone, and thanks for joining us today, and thanks for your interest in Avnet. Just a little bit about Avnet. We're -- as some of you may know, if you don't, we're -- we serve an important point in the technology supply chain. We connect the technology at the many manufacturers of electronic components to the ever-evolving needs of large OEMs, contract manufacturers, large corporations around the world. And we do this through a great global footprint. Our business, scale and scope is a key to the business. And we are able to reach shipment to 140 countries around the world. We have 250 office locations. We have 15,000 employees around the world, and we have engineers that help our customers design new and ever-changing applications into their production needs. So we haven't been doing this for a while. This isn't new to us. We've been in the business since 1921. So we've been in this game for over 102 years.

Excellent. Great. So I definitely want to focus more on the longer-term kind of dynamics of the business. But I think it would be helpful to review some of the more recent trends or near term, what you saw in the December quarter, what you're seeing in March. I know a lot of investors kind of use you as a channel check for a lack of a better term. But you've got bird's eye view into a very broad-based supplier base and customer base, so I think that would be helpful to review.

Sure. Our second quarter, which ends in December, it was largely as expected. Sales were down year-over-year, approximately 7% or 8%. We saw all regions contributing to that. Asia was down about 10%. The Americas down roughly 6% and EMEA down around 8%. But underlying demand still was holding up pretty good. We started to see some weakness in the industrial segment, specifically in Europe but markets like aerospace and defense in the Americas as well as transportation. Overall, we define automotive as broader than automotive because of all the applications and golf carts, e-bikes, trucks, all kinds of things have electronics going to besides just autos. That demand was holding up pretty good still. So mixed across our end markets, our guidance for the third quarter, which is the March quarter, was roughly down 7% or 8% as well from the December quarter and largely more of the same demand environment. That's below seasonal for us. Typically, in the March quarter, we would see growth in the west followed by shrinking in Asia due to the Lunar New Year. So we saw the shrinking from Lunar New Year, but we also saw seasonal declines or declines in the west versus growth. So clearly, the impact of the broader demand is starting to impact the west where that was generally holding up over the past several quarters. So still think the underlying demand is still reasonable, clearly working on the inventory. I'm sure we'll get some questions on the inventory. But we generally feel really good about our position with our supplier partners. Our customers, even though kind of demand is down, really well positioned to capitalize on the secular growth we see in the semiconductor industry here over the next few years. And to remind everyone, we're very diversified. So we don't have any real concentration of end markets. Industrial is our biggest. It's the long tail. It's very broad-based. Transportation is very big for us, aerospace defense. We also can participate in consumer and communications kind of markets, but I think about industrial, transportation, and aero defense being roughly 50% of our business.

So we've seen across our supplier base kind of a rolling correction going on over the past couple of years. Obviously, consumer PC was among the first to recover; more recently, industrial because it's so broad based. We've seen a couple of waves of correction and now maybe a little bit of a correction in the auto space. Are you seeing the same trends that a lot of your suppliers are also seeing in those end markets?

It's interesting because it's hard to triangulate us versus what any one of our suppliers says. Every supplier is different. Some are saying transportation is great for them and they see the good outlook. Others are saying it's down 20% plus. So I do think we are a snapshot of the broader semiconductor industry. We have a very, very line card. So I think about all the top semiconductor companies we typically participate in selling their products. So very broad-based. But every company is a little different and every company's inventory or customers' inventory situation is a little different. Different suppliers have different timing when they started to soften some of their stances on required purchases and as lead times came in and things like that. So everyone is a little bit different position there. So I think that's why you're seeing the mixed results. But in general, I'd say we're generally seeing what they're seeing, but it's not any one end market that sticks out. But we're clearly seeing benefits on softening of the policies, the lead times coming in. The inventory inputs are coming down for sure. Now it's working through the end inventory with our customers.

So I guess, a year ago, when we were sitting up here, we were still kind of in the middle of some supply chain crisis, where some of the supply was -- we saw some easing a year ago, but there was a lot of tight supply. Maybe just briefly discuss what you're seeing in terms of broad-based supply availability, your ability to shift to customer demand, and what those trends are looking like.

I would say lead times have come down. As a result, inventory has now started to come in a little bit more. And as a result, we're working our best to get that inventory out to the customers. Customers have ordered it, perhaps not ready for it now. But we -- it's still -- inventory is there, but the lead times have come down, but they're still above the pre-pandemic levels, I would say. So that's important to note. And I'd say just lead times are pretty stable right now, still elevated relative to pre-pandemic levels. We don't necessarily see that changing in the near term, but clearly more predictable of when you order a product, when you'll get it, and some of these really extended lead times. We don't see a lot of products that have -- there are still some parts that are hard to come by that we're still chasing a little bit. But I think that's maybe back to a more normal level. You always had some of that in the past year.

I love the CEO, Phil Gallagher. He is the term you serve as the shock absorber for the industry. You kind of are in between the suppliers and your customers, and I think that's like the perfect description. So moving on to something like the longer-term trends. Maybe talk about your margin targets, how you think about return on investment capital, where you expect the model. First, I think it would be helpful to say where you were because this industry has definitely kind of become a far more sustainable, far more predictable generator of returns, but discuss where you're kind of heading and what's going to drive that?

Yeah. I mean I think the current snapshot is, broadly speaking, we're a 4% operating margin business. We've got pockets of our business that can run double-digit operating margins. And the core business is a little bit north of 4%. The trailing 12 months is like 4.3%, just to give you some context. And so a lot of the claim to fame with our business is scale. As a distributor, we can really leverage top line growth to expand operating income and operating income percent. And that's what we've seen over the past few years. We had a couple of unforced errors. But if you look at the kind of growth from FY '19 to this last year, normalized for some of the loss of business we had, it's pretty robust double-digit growth. And some of that was attributed to pricing of the ASP inflation we attributed in fiscal '21 and '22. About 25% of our growth was attributed to ASP inflation because of the input costs going up, but the rest was just organic growth. And so we feel that's the good road map for the next 5 years of scale the top line, compete well for business, and then manage our operations effectively like we have been able to do. We don't have to add costs every time we grow the top line, and so we can kind of continue to create operating leverage. And so we think about our model being mid-single-digit growth when the kind of market recovers and stable gross margins. There's going to be puts and takes on our gross margin. We've got higher gross margin type opportunities. We'll talk about it a little bit later, but there's clearly going to be competitive pressures on margin like there always is, whether it's our competition or whether it's broader industry kind of pressures on gross margin. But I think we can keep a stable gross margin and we keep an effective cost base, continue to focus on execution, operational efficiencies, digital tools and capabilities. So we think longer term, we can get a 5% operating margin and kind of go from there with our Farnell business running greater than 10% operating margin. Return on invested capital should be in the mid-to-high teens with a return on working capital higher than that.

I would just add that. As we think about the opportunities for us, the markets that we serve, the way we look at it, excluding certain types of memory product, DRAM, things like that, it's roughly at $500 for FY -- for calendar year '24, it's roughly $533 billion total addressable market. We think there's plenty of opportunity for us and others as well. But where we are today, we look at some of the growth in the end markets that we serve, notably, industrial, transportation and defense. And these are some of the highest CAGRs that you see out the next 3 to 4 years of mid-to-high single digits. So we feel good about our ability to grow that, to scale up, and to get the benefits that Ken mentioned of leverage as we grow.

And then going to your capital allocation priorities, I mean, I think we are definitely interested in returning more cash to shareholders. We have a dividend that's been growing. Our CapEx is pretty manageable relative to the free cash flow we should generate. So we have a lot of cash trapped on the balance sheet in the form of inventory that we're working down. But absent that, we've generated cash flow in the past, expect to generate in the future with those kind of growth rates, and that should deliver lots of excess capital to buy back shares. We're currently trading at below tangible book value, 20% below book value. So we definitely feel it's an attractive share price and we're going to put some capital into share repurchases as we start to generate free cash flow in the next upcoming quarters.

Excellent. Excellent. That's what we all want to hear. I'm just curious. Do you think the past few years, this whole supply chain disruption that we went through over the past few years, has it permanently changed the way that distributors are used just from a fundamental standpoint? Are your customers looking at distribution a little bit differently? Are your suppliers looking at distribution a little bit differently? And do you think some of these changes are going to stick?

Well, we think there's a new appreciation or renewed appreciation for the value distribution brings to supply chains. And that's been our expertise for 100 years. And supply chain became front and center with the shortages and all different reasons that it was caused by. But we would say a lot of the major OEMs and overall, all of our customers really are thinking about how they can improve their supply chains, how they make it more resilient. We kind of talk about everyone was a just-in-time kind of inventory model, and we're learning that maybe that's not the best approach. Some critical parts you need to have sufficient buffer stock to make sure you can keep production going in times of natural disasters or blockages in canals or COVID, whatever it is. So we're actually seeing a renewed appreciation for what we bring to the technology supply chain. But I'll say it's actually -- a silver lining as a lot of business opportunities. One thing we talk about is we'll call it supply chain as a service, and that's where we step in. We step in to help facilitate supply chains, think about major OEM that's buying components directly from a supplier. They got short in this environment. They don't want that to happen again. So they bring someone like Avnet in to help them make sure they get that assurance of supply. We take the parts from the supplier, get it to all their Tier 1s that need it, give them visibility, optimize, but also have the buffer stock. So those are opportunities where we weren't talking to OEMs like that. That was typically direct business with the suppliers. But we're seeing ourselves being able to get in and provide kind of a logistics as a service or supply chain services offering for them, where they still own that relationship with the end supplier but we help optimize their supply chain and make sure they don't get caught short again. So we've actually seen that as a silver lining. That would be business on top of, let's say, the normal core business we have. Supply chain has always been things we do, implant stores, MRP planning and forecasting, right? We've always been helping in those kind of services, but this is a new customer base that we see as a great opportunity that we're really focused on making sure shortages don't happen again for them.

So I love that we've been talking about the Supply-Chain-as-a-Service business offering for a couple of quarters because you've kind of seen this acceleration with large customers coming in and requesting it. Longer term, do you see -- is this something with some of your existing customers or as we get to more electrification, more complexity, more electric components or electronic components in things that we never -- I always use, my favorite example is like a lazy boy. Are you seeing opportunities longer term for customers that maybe never used to have to procure electronic components? And is this a place where you can grow longer term to that business?

I think the short answer is the things we're providing for these, let's think about major OEMs, we can scale for our smaller customer base, right, maybe a little bit different model. It may not be a service model, but it may be similar types of things we provide. I guess what I would say is, yes, part of the lesson learned is a lot of these companies that weren't used to dealing with components, electronics, right? Think about non-technology companies. I'll use an automaker as an example. Well, they knew about steel. They knew about leather. They mastered those commodities, right? But semiconductors, they didn't know too much about. So they're educating themselves. We're finding that we can add value to that education part and just understanding that overall environment. So we're seeing a lot of opportunities but we see in nontraditional OEMs that haven't typically dealt with electronics or maybe only been deal with them for the past 10 years, let's say, versus technology companies have always been dealt with electronics. So we are seeing those as a great opportunity for a customer base, but it's not limited to those types of customers. But they're definitely in the sweet spot where they're trying to educate themselves, and someone like Avnet can really help them redesign their supply chain for components and understand. Even when we come to the capacity expansions that are happening, a lot of that's cutting edge nodes. Some of these companies that may be in the medical space or the defense space, they don't want to design in those cutting-edge parts. They need to keep the same designs so they don't have to do redesigns. So there's some supply chain nuances that happen with some of the higher node technologies that may become short into the future because capacity is not going into those type of applications.

So while we're kind of on this track of margin-accretive businesses, I'd love to talk about the programming business because I think this is something that is kind of unique to Avnet just in terms of getting the registrations. You own more of the supply chain, and obviously, that becomes margin accretive. So I think in the past, we've talked double-digit margins for that business. I don't want to put words in your mouth, but...

We don't really quote what the margins are, but it definitely is part of the value proposition that we provide to our customers. Examples are, we do have 6 programming centers around the world. We're programming millions of chips around the world for customers who want to buy chips from us, but they want some software on it. So we're happy to take that software, load it up on a school reel, and just ship it out to them so that goes right into their production. So again, programming is another one of those things that we've been doing for a long time, and it does add some -- how should I say -- I want to say, stickiness to the business, but we're very nimble with that business. We can take designs of a program and just anywhere around the world have prototypes delivered back to the customer today and then have it programmed on a school anywhere around the world, basically in the major regions that we deal in. So it's a very good business for us.

Any other margin accretive kind of initiatives that you're investing in in the near term? I know you've got a lot of opportunity...

The one I'd mention that we've talked about a little bit but it's beginning to kind of ramp would be we call our embedded business. So think about embedded boards and displays kind of full solutions. So instead of just selling components, we're actually selling boards. A lot of those boards are boards that Avnet designs or works with our customers to design, so it's kind of our IP. And so that tends to be more of a solution sale but tends to come with a lot higher margin. And then when you think about if we've got that design, then the business kind of lasts longer. So that -- we acquired a company back in 2013, '14 called MSC, a Munich-based or a Germany-based company, and they've got a lot of capabilities for embedded boards and displays. And we also partner with third parties that create embedded boards in display. So we kind of have our internal brands but also third-party brands. And so we're seeing a lot of customers who want to go to the whole solution versus, let's say, designing their own boards. It's really let's go and design a whole board. So we're seeing a lot of opportunity there, and that's 2x type gross margin than our typical core business. So we find that very attractive and should be a double-digit operating margin type of business. So that's another one we have. And then we haven't talked much about Farnell, which you'll get into, but Farnell is our -- our high-service business. And they're more of a speed and convenience type of distributor, small quantities for engineers. And they've got a pretty broad SKU count base, but they also generated gross margin 2.5x Avnet's gross margin. So really focusing on growing those businesses, which again helped to keep our overall gross margin stable, hopefully grow, but at least keep it stable while we're getting the profitable growth on the top line.

And through the cycle.

Through the cycle.

Is really important. I want to pause here. If anyone has any questions here?

Could you talk about thinking for levels of higher -- a higher [indiscernible] -- if that's true, I think question one is, where are your inventory levels relative to that? You said [indiscernible]. And then the second piece is whatever that new normal is and the higher variant cost, you can make all those or that is customer satisfactory?

Yes. A couple of questions there. I think what we said was lead times are still extended from pre-COVID. Inventory levels are clearly greater than pre-COVID as well. I guess what I'd say is our inventory levels are elevated. We believe that's more of a byproduct of excess inventory or a lot of inventory on the customer side of things, right? So they need less replenishment as a broad statement than what they normally need because they're sitting on whatever many weeks of inventory. Now the demand softness that we've seen over the past couple of quarters is kind of compounding that a little bit. But the really, the issue got created a little bit with the lead times coming down. If I had a 52-week lead time, I guess, by definition, I need 52 weeks of parts before I get replenished to be able to build. And as lead times came down, people still had those longer times, and our customers can only make so much product, right? If they've got 6 weeks of inventory, by definition, it takes some 6 weeks to build that if they were going full steam ahead. So what we're seeing is, clearly, more inventory than we need or our customers' needs, and we're in kind of a hand-to-hand kind of combat to kind of get the customers to take it, right? Phil you'd say, we expect our customers to be responsible, right, in their role in some of the supply chain things, and we're having some difficult conversations with customers that may not want the product. But going back to your point, it's not free for us to sit on it. So we have those conversations as the customers want to potentially push out. How do we get paid more margin? Is there a working capital cost for us? I wish we could say we're successful in all those discussions, but we do our best. But I think as we look to the more medium term to longer term, clearly, the dynamic during COVID was the cost of capital going up. Our interest expenses almost tripled. Clearly, that's a drag on EPS and earnings, but we're focused on getting the inventory levels corrected. And then the secondary step after that is to have those conversations. If a customer wants 60-day terms, Melissa mentioned, we're the shock absorber. We want to give you 60-day terms. We want to hold 4 weeks inventory for you. But the cost of doing that, I need more margin or you need to have less terms, either way. So those conversations are ongoing, but we're trying to get the inventory corrected first before we start having some of those conversations. And I think customers get it. Our team is definitely being more educated on working capital, the cost of capital, all those things. So it's definitely front and center when we have our internal discussions with the teams. Easier said than done to affect that, but we definitely think in order to get those returns that we want, we need to make sure we're getting the proper margin. So that is being ingrained in our team. And I think with our general health of our business over the past few years relative to, let's say, FY '19 or FY '20, we're in a much better position to make sure we're being disciplined as we look at new business, right? We're not chasing business. We want to make sure it's the proper returns, it's the proper margin right for us. And we tell the team it's okay to say no sometimes, right? If someone else wants to give those terms that don't make the proper return, that's on them. We can make sure we're getting paid properly. But clearly, there's plenty of work to do on the inventory side, and we've underdelivered on that aspect. One of the benefits to our business is what we've heard as a countercyclical balance sheet. As sales start to go down, we start to burn off working capital in the term of receivables and inventory, and the inventory hasn't moved. The AR is coming down nicely and we're doing good on the collections there, but the inventory hasn't corrected like it should at this point in the cycle. So that's what we're focused on.

And I think it's important to note though, you've had a couple of unique instances, either acquiring a portfolio of products that we're going end of life, opportunistic supply that you brought into inventory that you're carrying that -- over time, that becomes margin accretive as well. And so it's not exactly like a one-to-one like we would normally see a typical cycle.

Yes. I think if you look at the past couple of quarters, inventory has increased both quarters but our messaging has been kind of the core business inventory, the inventory that everyone's worried about, lead times, and customer access and all those things, that's been stable. So it hasn't gone down like it should, but it's not going up. The reasons for the inventory increase were specific to some opportunistic deals with suppliers and/or our supply chain service growth and the inventory for that business. So it's different than the broader dynamic and that's what we tried to explain. But optically, inventory is up the past couple of quarters, even though our view it's stable and working on getting it down, right? So why we're disappointed, it should be down versus stable, but at least stable is better than up in the core business.

Yes. No, I think you've done a really job of explaining the distinction there. And I think it is kind of unique versus past cycle. Any other questions before we move on? Okay. All right. We'll keep going. So you touched on capital allocation. Obviously, the buyback is the only for you. In terms of internal investment, either investing more in programming, investing more in the supply chain as a service, opportunities for automation -- I think you have a new facility in Germany that is among your most automated and highly advanced facilities. How do you balance between internal investment versus just kind of keeping you with the normal kind of fulfillment business.

I'd just say, in general, we're not a capital-intensive business like an EMS company or a semiconductor manufacturer. How we look at it is a lot of our investment is the working capital, right? The working capital is the intensity. But from a CapEx perspective, think about a normalized $100 million plus or minus $20 million a year. Our big investments for CapEx would be distribution centers, which is kind of the lifeblood of getting product in and out and getting it to our customers, and IT systems to make us better, whether it should operate more globally or to have digital tools and capabilities to make our employees more efficient. So that's where we really invest in terms of CapEx. We've had a big investment in a warehouse in Berenberg, Germany, outside of Leipzig, which is going to give us additional capacity for the future growth we expect in the Europe market. Europe is one of our strongest performing businesses. And so this gives us the long runway to be able to support the growth we see there. But that's few and far between. It's not like we have to build a new warehouse every couple of years with the growth, but we're always looking 3, 5 years out, where do we need capacity. So you'll see CapEx for warehouses. You'll see some IT type of investments, but I think we're still within that -- fitting within that average range. And then really, OpEx is where we make investments, right? We talk about technical resources. We talk about capability. So we want to invest in our people.

Just to throw that in there.

Yes. I mean, I think, again, we may not participate in a lot of those servers and things like that, but we do participate in a lot of our supplier partners have technologies that sell into the AI makers, right? And so we do see it as just another secular trend in terms of -- we talked about transportation being a big growth area, EVs, and things like that. AI would just be another vertical market that we see being meaningful to the broader semiconductor growth. And internally, we see that as being a tool to make us more efficient, better at what we do. We want to scale our business by adding all people that helps our technical resources to be more efficient if we can give them tools like AI to help them make design decisions and kind of get more coverage for each individual technical resource. So we want to continue to invest in feet on the street, growing our capabilities. We talked about the embedded business. So we'll invest some OpEx. A lot of times, we'll try to repurpose it and take OpEx out of one area where we are overinvested and move it to areas we want to invest in. We're very disciplined in our OpEx, but that's where we see a lot of the investments going. And again, it should be ratable over the years. So it's not going to constrain us from some of the other return to shareholders, things we want to do.

I just got a couple of minutes left, maybe 1 quick one. Are there any -- in terms of M&A, are there opportunities or technologies or capabilities that you're looking to invest in that maybe you might be able to find it externally rather than investing internally on that?

I guess my 2 cents would be -- I mean, I think there's a transaction in our space that was announced recently. And so our industry is generally consolidated when we think about distribution in the '90s and 2000s. Avnet did 114 acquisitions and kind of rolled up the industry. There's a few big players out there, but there's always IP&E businesses, interconnect, passive, electromechanical, that's a higher margin. It's all the components around the semiconductor on a board. There are some markets that we're underpenetrated in that we might be interested in. But I think it's really -- we probably want to prioritize organic growth, investing in our business, buying back shares than any kind of transformative M&A. We are always listening. So we just don't see that being key over the next several years that M&A is going to be a big part of -- we never say never, but that's just not in our wheelhouse right now. We think we want to go get share through more organic means and probably more investment OpEx than M&A.

Great. I think -- one question. Yes.

Just on the capital allocation, is there specific of target leverage number maybe [indiscernible].

Yes. I think I'd say where we're at right now is we've had the appetite. We've got $230 million left on our authorization, which gives us plenty of runway. We're focused on not borrowing to buy back. Our constraint has really been because we haven't generated positive cash flow for the past few quarters. We haven't been active in buybacks. Once we generated positive cash flow, we'll put some of that positive cash flow back into buybacks. So we feel good about our leverage and we're about 2.6x. Anything under 3, we feel pretty good about. It's more a byproduct of not wanting to borrow additional money to do buybacks in the near term. But we see line of sight to positive cash flows to be able to get back and to use that authorization.

Excellent. I think that's it for time. We'll head downstairs for the breakout session. Anyone has any more questions? Thanks very much.