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

Okay. Good afternoon, everyone. Welcome to the afternoon session of the Stifel Cross Sector Insight Conference. I'm Matt Sheerin, Senior Analyst. I cover stocks across the technology supply chain, including the biggest component distributors. And we have Avnet with us this afternoon. Representing the company is a long-time CEO, Phil Gallagher; and Ken Jacobson, CFO. Welcome.

Thanks, Matt.

I thought, Phil, it might be good just to give a quick, for those not familiar or have not visited the story in a while, sort of a quick review of Avnet. And also, you've been CEO now for 4 years. Interesting time to be CEO, right, 4 years. But your metrics are better comparatively in terms of [indiscernible] where you were last trough, margins are higher. So talk about that journey in the last 4 years. How are you positioned going forward?

Sure. Thanks, Matt, and thanks, everyone, for your time today. So Avnet, yes, I've been with Avnet for 42 years, minus the 18-month sabbatical in there. And Avnet as a company was founded here in New York City. We've been around for about 103 years at this point in time. Had always been and e-technology supply chain. And today, what we are [indiscernible] to say, we're in a centered technology supply chain. We're distributor of electronic components [indiscernible], semiconductor supplier and many of you familiar with, interconnect [indiscernible] to mechanical suppliers. And we service 100,000 plus customers around the world, roughly $24 billion to $25 billion in revenue, with about 35%, 40% of that in Asia, 30% in Europe, and the balance here in the Americas. We ship products into 140-plus countries around the world, and really manage supply chains from I'd like to say, from a design chain, food supply chain. So basically, our products are almost any product that you're using or see that has technology, as some of our orders -- some of our semiconductors, suppliers and their interconnect past mechanical suppliers in those products. So glad to answer any other further detailed questions on that. And we're listening on the NASDAQ. Yes, Matt. So yes, I was interim starting in August 2020. So it's almost 4 years now. It's hard to believe, and became permanent from global sales operations to this role. I would say what we've really done, thanks for the compliment. I think what -- we got back to fundamentals and basics. And I think every company goes through these different journeys and these different vectors. And I think we were starting to chase some shiny objects, frankly, getting outside of our core, and our core is value distribution, okay? And we're proud of that. And what we did is we got back to some of the basics and the fundamentals -- to put a percentage on it, we said, we need to get 85% operationally sound. Okay, and 15%, we'll continue to work on strategy and new and different things. And most critical where we had some speed bumps prior was in the supplier side. So we really got our arms around our supplier relationships. And today, I'm really proud to say the relationships are as good as they've ever been. In our business, it's really -- I simply. There's 3 pillars. There's suppliers. I call that street. You got customers. We take our suppliers value propositions, we bundle those down from a demand-and supply chain services to our customers, and the middle is our employees. And we work on the culture and the employee engagement is that people feel that they're going to play good. But that's -- fundamentally, that's basically what we've done.

Okay. Great. Great starting point. So let's go to the near-term trends. We're, obviously, in the throes of the bottom of the cycle, it's been a very long cycle. And your revenues declined or component revenue year-over-year for about 3 quarters in a row now. Clearly, Europe has been lagging where you had growth there, even the last half of last year, I think. And I know you've talked about book-to-bill is getting a little positive signs that were bottoming. But just talk us through the fundamentals and maybe by region or end market, particularly inventories any pulse that you have in terms of inventories at customers?

Yes. So I think I go back to a little bit the last 2, 3 years, has almost some precedented growth as well, right? So it's just the sooner later, you're going to have that correction, and we're in that now. And it's -- again, it's not our first time, not our first rodeo, we'll manage through this. And good news about our businesses is were countercyclical. So things get softer, we'll reduce inventory, we'll generate cash and support our dividend, our share buybacks and reduce debt. When you look at the market, I'm optimistic that we're bouncing on the bottom, maybe a quarter or 2. Would've said, "Yes, probably coming out of June and in December, we'll start to see a recovery." And I think that's probably not the thing. I don't think it's going down much more. You still look first 4 years ago, the industry is still up quite a bit. But we think it's going to bounce on the bottom. And as we get into the end of calendar '24 into '25, we'll start seeing that increase again. And we'll continue to bring inventories down. And as you said, there's definitely more inventory out there than that anybody needs, but we're working that down and had nice progress in that last quarter. We'll see more progress this quarter with positive cash generation. When you look at it, and Ken can jump in here -- but we look at it by region, it is or some different colors here. You've got -- so if you let start with Asia, Prince Yun, our leader in Asia. We believe we've hit bottom in Asia, okay? We believe Asia is going to start to show growth through the calendar year, which is really good news. December quarter, typically, you see that growth in Asia. And then because in typical cycles, that starts to spread then across the West. Europe, to your point, it's only 3 quarters but we have record numbers in Europe. So multiple quarters back-to-back of all-time record numbers in Europe, which was phenomenal. We're excited about that, given all the situations going on in Europe between wars and the oil and energy and whatnot. Very resilient. So now we're starting to see that correction. And Europe is really heavy in a good way and strong in industrial. So we're just starting to see that industrial market start to soften up a little bit. As we said, more inventory than probably needed in the end customers and in the channel, and we'll have to burn that off. Also very strong on transportation and automotive market, and our position in the Central is extremely good. So we're gaining share. I mean we can't control the size of the market. We only control how well we compete in the market, and that's what we focus on in all regions, frankly, and globally. And the Americas is kind of somewhere in between. The Americas has come down as well. Again, heavy industrial. And in the Americas, we have really strong verticals in defense aerospace. And unfortunately, what's going on in the world of that market is strong today. It's forecasted to stay strong. And we've increased our industrial penetration in automotive as well. So it's really -- again, -- now we always go back and talk about 2000 in the big market in 2000, 2001. I just don't feel that at this time. I think the diversity and the applications of technology are so much broader than they were in 20 years ago, that's going to help us bounce on the bottom and start seeing this thing come back. And through the cycle, kind of to your first question. We just -- why we feel like we're in a good case? We're been managing expenses in the up cycle. So we're very careful to manage the corporate expenses, stay lean, drive the drop-through so that we're positioned well through the market as it bounces back. We're positioned to get some really good drop with any kind of lift in the market. Yes. Ken, you want to?

Yes. I just say we're encouraged about the signs in Asia. Usually these down cycles start in Asia and work their right to the west. And in fact, we expect sequential growth in Asia in the June quarter, which is implied in our guidance, and then kind of continue from there, we think is positive. And maybe a couple more quarters to go through in Europe and the Americas.

Yes. And aside in Asia, I'm sure some of the -- they're heavy in like consumer and some of there's datacom markets and it looks like they're coming off the bottom well. But do you get a sense in terms of like the inventory work down, you talked about industrial in Europe and any other pockets where there's more work could be done. And others where you're actually seeing companies sort of back to normal order patterns?

It's a mixed bag. So first, when we talk about inventory, I mean, it's important -- it's not all the inventory, right? So we talked about over inventory. It's not all SKUs. It's not all commodities. It's certain. I would say it's a kind of Pareto, 80-20. There's probably a handful of suppliers and products that are more inventory than we need. There's others in discretes, capacities, interconnect. The inventory is really just fine. As far as -- and we're starting to see, I should add, that in addition to Asia is starting to come back, we're seeing increase in bookings in the IP&E space, in the interconnect pass electromechanical space, which is encouraging. They didn't go as high as a semi, they didn't go as low, so it's much more steady. So that's also another positive sign that things are looking like they're going to be getting better again as we come out of the calendar year into 2025. As far as visibility into the end customers' inventory. That's a difficult one. I mean what we see, we don't have visibility into other inventories. But what we do see is they're ordering cycles and are -- because we take in 1,000-plus forecast from customers around the world on a regular basis, whether it be EDI, API, we'll take a [ fax ] [indiscernible]. But what we're seeing is just that continuous decline or flattening of their needs, which just tells you that they've got more inventory in finished goods and more raw goods that have been sort of that they're still burning off. And now that lead times have come down, still a little above pre-COVID levels, but very manageable. And there's more inventory out there. The customers are not giving us as much visibility. So we're back into that again. So they're not giving visibility. Our suppliers want the visibility because they want to know what to build in the factories, they're hitting us up for. We're hitting the customers [indiscernible]. Everybody is trying to just tap and brace on inventory, which could be an issue down the road if they're not planning appropriately. You could swing back the other way.

Yes, I was going to get to that. But it looks like one difference in this cycle is that not only are your customers have too much component inventory but their channels -- their industrial channels, there's too much finished goods that they're working. The EMS guys are a perfect example, right? They're all guiding down because their customers have too much in their end. But back to your question, I mean, your comment about customers not giving you visibility. When lead times are short, they'll just order what they need. But I guess the question is, are we going to run into a problem again in a year from now? The economy, we've got some of these end markets, 5 or 6 end markets start to recover. Are we going to get into a shortage situation? And how are you talking to customers about we want to manage to have more inventory this cycle than last, which 4 years ago, everyone was saying, "Oh, we're always going to be owning lots of inventory." But now they're like particularly with interest rates right -- and the cost of capital in your own interest expense, obviously, is balloon. But your profits are up. But so that's the question. Will we get into another problem? I mean, of course, for you, that's a good news, bad news. The good news is you've seen profits and then the other side of that is ugly, right?

As we seen last year, I think, and the CEO is the Chief Expedite Officer, right? Got a call from every customer around the world trying to get products, and phone hasn't been ringing as much right now, but I'm not going to speculate. But Matt, we built brands all the time. This is what happens. Everybody puts the brakes on, inventory is available, lead times are in and look at what happened post doing COVID, right? I mean all the verticals have swung back at the same time. Nobody was ready for it, and we ended up with the shortages that everybody talked about for a long time. You're right, it's a good news. It could -- sometimes that's a silver lining for us. But it could be painful for the customers. So that's why we're important. And they just give us the backlog, give us the pipeline so we -- or give us a visibility so we can plan the pipeline with the suppliers. And we're starting to see some of it. I don't want -- it's not [indiscernible]. So book-to-bills are improving modestly, which is good news. I mentioned the IP&E, which is good news. So we'll just see how that goes over the next 90 days.

Okay. And then I wanted to talk -- you talked about one of the issues that Avnet had 4, 5 years ago. We said some of your major semi -- well, 2, at least, a couple move to either a more direct model or consolidating their distribution channels. And there was concern that I get from investors and maybe that's why your stock still trades at a low multiple where others have rerated the concern that semiconductor suppliers, as they continue to consolidate, we're going to move more direct, particularly demand creation, where you get a better margin rate than fulfillment. I don't know, you've given lots of reasons why that may not happen in terms of that trend. But I'd love to take your -- get your take on that.

Yes. So there's a couple of guys, you mentioned [indiscernible], let's call it in the analog space and one guy in particular down in the South. But obviously, one comment actually, it was an analog, so I won't name the suppliers, but our analog business today is actually larger than it was when we had them. So we've replaced that business. We've gained share in other suppliers and inside customers to replace that business. That's just a comment there. So I think we're -- our balance and mix today is frankly better than it was then. We don't have any one supplier greater than 5% or 10% of our total revenue. Another customer greater than 5%. So we're very diversified. Matt, only I can answer that today, that's how suppliers are thinking. I meet with our top supplier of CEOs and global sales leaders on a regular basis. And I feel as confident, never comfortable. But I feel confident today as ever about our supplier relationships. They're leaning in more. I mean we give them to scale and the leverage in the marketplace and the reach that them, themselves cannot get or cannot get efficiently, that they can through us. Our demand creation numbers, where we do the design registration [indiscernible] and get design wins from the suppliers or are up. Our demand creation revenue is in the 30% to 35% of our total revenue. So I don't see that today. Again, we're never -- again, never get comfortable, but certainly confident that our relationships with the suppliers is as good as any. And those conversations aren't on the table right now.

I would just add, I think we feel really good about our line card. And we have certain technologies that our competition doesn't have. And we're happy with those lines. And I think what we're really seeing, especially with all the supply chain disruptions and the availability of the product is we're actually seeing many suppliers really look at rationalizing their direct customer base versus not. So we're seeing just as many opportunities of taking some direct customers on, either through supply chain services or actually just taking them on as a core customer versus customer shifting direct to suppliers. So with all the expectations customers have in terms of buffer stock visibility and things like that, I mean that's just more in our sweet spot than it is for our suppliers. And so they're really helping us to grow our business with some of those shifts.

It's really good. Thanks, Dan. Actually, we're very pleased with our current line card lineup. I mean I don't want to get into names because that I'll miss one, but our top suppliers, we're #1 or 2 with -- on a global basis. To Ken's point, they're starting to actually move more business to us in the supply chain services arena from the call that -- so TAM, direct to [ DTAM ]. So actually, we're very comfortable with the line card always watching out for what could happen in the future, though.

Okay. That's a good segue to my next question, which is on supply chain or distribution as a service and your competitors have been talking about this, too, where you're actually providing the services. But you don't take titles to the inventory, right? So there's a balance sheet difference there. And both Arrow and Avnet have been talking about that opportunity. Could you talk about that business model, maybe different business models within that? How that impacts your top line and your balance sheet, et cetera?

Let me start, and I'm going to turn it over to Ken because it's much more financial modeling, okay, than it is anything. So when we talk about supply chain services for the investors, I have to break it into a couple. We've been doing supply chain. That is what we do for living, right? So we've been doing that forever. And there is traditional value-added supply chain. We are taking customers' forecasts, we manage that pipeline. We do aggregation. We ship it, point-of-sales. We actually ship in and build it. We have on-site implant stores. We call them with manned implant stores. Some of our customers will have upwards of 15 to 20 people on site, managing the inventory, managing the pipelines. Consignments, [ compounds ], et cetera. That has been -- that's our core supply chain services, right? So from years ago, the great [indiscernible] you would know. That was where I started. There's now another element of supply chain as a service, where it's working capital-light, okay? We're zero in some cases, where it just becomes a fee-based service that we're managing, and it's throughput to us, and we just build out GP, but I'll let Ken get much. This is not sold through the traditional sales force. These are definitely supply chain architects, Celanese has a completely finance model and treasury [indiscernible] Joe here.

A lot of what we're talking about here is volume that already exists in the TAM. This is usually a business that suppliers are doing directly with large OEMs. So we use a great example during the part. Shortage crisis was automotive and automaker couldn't get a $2 part, and that $2 part was holding up $100,000 luxury vehicle. These automakers are ingraining their minds. We're never going to let that happen again. So someone like Avnet can step in and help them secure a buffer stock, have visibility to their broader supply chains because you think about a large automaker, how complicated their supply chain is, in terms of the number of Tier 1s or other contract manufacturers making everything and assembling it everywhere, right? So giving them that visibility to the products or the most critical products, right, doing BOM health assessments and things like that. So we're really just helping and supplementing that direct relationships by physically holding the product. Getting it where it needs to be, when it needs to be there, giving visibility. And in some cases, holding working capital for a fee as well because it's all fee-based. So we look at it as the risk of inventory doesn't lie with us. The pricing is negotiated directly between the OEM, and the supplier for the component pricing, but we're negotiating service fees to warehouse, provide logistics services as well as working capital, if that's part of the solution. And a lot of times, we're talking about very large engagements. So usually, there needs to be a solution for the working capital. So a lot of these OEMs are cash flush. So we encourage them to use their own capital to the model. And we have various different models, we can provide the capital that could be third parties involved, or the OEM provides the capital, which gives them the cheapest cost. Either way, we are working through the volumes and giving visibility. And it just gives us even more scale, and it's a service fee, so it's not going to move the top line, but you'll see it in the gross margin. And clearly, then the return on working capital as well. But again, it's still smaller. We're seeing a lot more opportunities coming out of the pandemic and the supply chain disruptions. But it's still starting to grow in scale but with a $25 billion-plus top line business. It's hard to deal necessarily on gross margin. We think it's one of our stabilizing forces now.

Yes. It was one of the silver linings coming out of supply. Supply chains broke down, a lot of these OEMs, they toss everything over the wall, they outsource and the they're like, "Wow, where's our parts?" And not only -- we're are downstream. And now we're giving them -- we call a control tower, they actually have visibility to upstream the suppliers, downstream to customers, really positive.

Can you give us a size of that business? I know it's hard because it's -- you get a fee. But are we talking about like 20 major OEM customers or dozens or how big? And can you tell whether it's moved the needle in terms of your gross margin or operating margin, like -- or is that hard?

Yes. What I'd say, historically, it's been -- always been a part of our business, with some of the -- let's say, the technology type OEMs that have more advanced supply chains when it comes to semiconductors and things of that nature. I guess what I would say is right now, if you look at our inventory report on the balance sheet, roughly 10% of that inventory is earmarked or as part of supply chain as a service-type of engagements. And it does benefit if you did took this out, you'd have a lower gross margin across the board. But I would say it's not super meaningful or material right now, relative to the gross profit dollars. But we see a trajectory where you have 3x-type growth in this area relative to the core.

It's in the customer. It's in the dozens at this point in time. And it kind of builds like an annuity. But once you're in, it just cranks. And then you had another one, it's just like not mailbox income because we're doing a lot of work for it, but it just comes in every month, every quarter. And some of these -- a few of them have been around for a long time, and everybody here would know them, very common companies up in Cupertino that we've been doing. And now we're just -- the pandemic and what broke down is just accelerated it with the [indiscernible]. So the throughput is -- it's pretty sizable.

But some of the programs, you are buying the inventory and carrying it, right, and others, you're not. Are you getting compensated? That [indiscernible] still a lot of inventory you're carrying.

Yes. I think I would say there's no free working capital. I mean, again, in our normal model, we get a margin for whether it's demand creation fulfillment. There's usually working capital terms built in here, here. It's all fee-for-service, so there's working capital involved. It's going to be charged for and charged through. So it's very little -- fill goes into financial modeling because it's very kind of depending on what service you want. Here's the price kind of thing. And obviously, with the cost of capital, you mentioned there, working capital is the most expensive part of that solution. But what we are doing in the meantime is [ whittling ] down our overall interest expenses and inventory comes down and trying to provide more flexible solutions on the working capital side for these type of engagements. Usually, we try to match terms what we buy with the supplier, we give to the customer. And then depending on how much inventory you need, right, either getting the cash upfront or figuring out how much we want to finance for that.

Yes. Yes. And I'd like to talk about the inventory. Can you -- you're still above where you want to be. You're, obviously, financing that. Your interest expense has been up. I know some of that reasons why it's still high is because of those engagements, but the supply chain game -- so how should we think about the inventory, what it looks like over the next few quarters?

I think, what I would say is this cycle, the difference is one of the things that Avnet provides a benefit for is the countercyclical balance sheet. So as sales go down and the market goes down, we burn off inventory, then collect receivables. And so you have a lot of cash flow generated in the kind of the down markets. And this has been slower to generate that cash than in past cycles, and it's disappointing. But I think we made good progress the last couple of quarters, and we anticipate just continued progress. So we wish it was happening overnight, but there's still lots of ongoing conversation with customers about taking inventory we have on hand that they ordered. But it's good progress in terms of starting to get the inventory down and the cash flow generated. So it's going to take a few more quarters to continue to whittle that down. But I think we just expect to see continued progress. And the good news is on the inflow side of things, it's very well controlled, right? I think all of the supplier partners and even the customers, I think everyone is working collaboratively together to try to get it. Sometimes, they're tough conversations. But I think in general, kind of everyone understands that the sooner we get through this, the sooner we can get back to growth, increasing customer accounts, right? And that's the name of the game is the secular trends are exciting, but we've got to get through the correction and support customers to get through their inventory levels as well.

And as you generate cash over the next few quarters, what's the allocation? Are you looking to bring down the short-term borrowings so the interest expense comes down, stock buybacks? What's the priority?

Yes, I think a combination there. I mean, obviously, our leverage is going up a little bit because of the fact that EBITDA is down. But we look at it as we want to be opportunistic. Our shares are trading below book value, so we want to continue to support the buyback over the last 2 years. We've roughly accumulated 10% of our outstanding shares going from $100 million to $90 million as we exit this year. But we still think paying down debt and having that capacity and lowering the interest expense is appropriate. So we expect to see that as well. Although again, just like getting inventory down, it's going to be hard to get interest expense down to historical levels. But we think we can keep whittling away and that will be accretive and create a tailwind for us [indiscernible] -- yes, and supporting the dividend, we have annual dividend of about 2.5% yield depending on the share price.

Any questions, anyone? I'd like to talk about your Farnell distribution business, which focuses on design engineers, they buy small volumes. That's a business that you bought a few years ago. You've had financial targets of look, I think, in the teens in terms of operating margin. You've hit that a few times, but not consistently. So -- and I know you're going through a restructuring there. So can you talk about that?

For sure. And investors get the number pretty transparent. We're disappointed where we are with Farnell right now. We did get up in the 15% -- almost 15% operating margin in the peak. And if things correct that they just corrected and the deceleration was -- a negative drop was pretty significant. So we're doing restructuring at Farnell. I just want to make it really -- we love the property. And it was a one-time 6% of our sales and 26% of our operating income, that's the margins that they deliver. So our objective is to get that back in the double-digit, okay, operating margins and get it back somewhere between 10% and 15%. So the restructuring we announced that, taken some expense out somewhere between $40 million and $60 million. That's underway. And then we had a separate strategy session where we're actually bringing it. Won't keep it separate, Matt, but we're going to leverage more of the Avnet Inc., where they have not been leveraging that, and we had some management changes of recent. So we'll be announcing a new leader here shortly. In the interim, we've had 2 of our best leaders in Europe managing that for me over t he last...

So you're doing a search right now?

Well, we got -- we're very close. Absolutely very close. So we'll remain a separate entity. We're going to be aligning closer to the Avnet core and leverage what the Avnet core can bring to Farnell. And then what Farnell as an e-commerce digital business can bring to Avnet. So really excited what we're looking for is incremental gains. So as you know, they closed out a 4% operating margin. We're going to get to 4%, back to 5% to 6% to 8%. And we think going out fiscal '25, starts in July. Fourth quarter fiscal '25, we'll be back closer to the double digit, probably in the 8% operating range as a model.

That's based on CapEx cost and the expectation that you're going to grow again?

Yes.

Okay. A couple of minutes left and we haven't talked about AI. And what's the play for other than the fact that, you obviously, you're selling it to everything. And are you doing things with hyperscalers? Are you doing -- working with the big hardware OEMs?

Yes, directly and indirect. I mean, AI is definitely an opportunity for everybody as is 5G and what's going on in power, et cetera. We don't obviously play directly in there, but we do through the associated sale. So anywhere -- some of those big chips go, they need more power. They need more analog, and we've been getting some actually phenomenal opportunities in some of that space. And you have heard a lot, as I said earlier, our industrial customer base is extremely strong, okay? A lot of those-- I don't want to name names, a lot of those industrial customers are selling in the data center that in the hyperscalers, right? So we're getting it not only in selling products and down the road services but we're getting through our traditional customer base, that's benefiting from the growth in AI. So definitely an opportunity for us. No question, I think, for everybody. And then when it ends up driving more applications on the edge, okay, we got the right MPU suppliers, MCU suppliers, where from the edge in, we'll benefit from.

Okay. Okay. I think we're out of time, but thank you very much Phil. And thank you, Ken.

Thanks, Matt.

Thank you.