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

Okay. All right. Thanks, everyone, for joining us on day 3 of our 2024 Global Technology Conference. My name is Ruplu Bhattacharya, and I'm a Director with the equity research team at Bank of America, covering IT hardware and electronics manufacturing services companies. Today, we have one of the largest distributors in the world, Avnet here, and we're honored to have CFO, Ken Jacobson, here with us. Ken has a lot of industry experience. He joined the company in 2013, and he was appointed CFO in 2022. But even prior to that, he's worked at other companies like First Solar and he's been at PwC. So lots of experience here. We also have Joe Burke, Vice President of Treasury and Investor Relations with us. So we hope to have a great discussion. So Ken and Joe, thanks for being here today.

Thanks for having us.

Thank you.

Maybe, Ken, I want to start with a high-level question. Just talk about the macro environment. If you can talk about what you're seeing from a regional basis, North America, Asia, Europe, what are the demand trends like. The same question on a vertical basis and market basis, what are you seeing?

Yes, maybe I'll start with the regional kind of view. And we've really been down in Asia and China for the past several quarters. So I think we're seeing signs of stabilization there. We're not overly weighted to China. We're about 10% of our business is China, but we have a big business in Taiwan and Japan and then the rest of South Asia, so we're saying we're seeing pretty good signs coming out of the Lunar New Year of stabilization, still underlying weaker demand, but we're not seeing it get worse, and we're actually seeing a little bit of sequential growth that was implied in our June quarterly guidance. As we kind of shift to the West, Europe has been kind of our strongest region, even as this past December still hit record numbers. So now we're seeing a little bit of fallout of demand coming out of Europe and then seeing kind of double-digit declines here implied in our guidance and then kind of similar in the Americas. So starting to see the demand soften in the West. From a vertical standpoint, clearly, defense is still holding up pretty well. Our Americas business has a decent sized defense business. Europe is smaller, but we're seeing some traction there with things that are going on, unfortunately, in the world. And industrial is really our strongest market overall, including in the West, and we are starting to see that soften a little bit. And then transportation is another big market globally, and that's softer but still holding up relatively well. So it's kind of mixed across the globe, but some of the markets that were strongest even as this past December, starting to soften a little bit, but generally still there's demand and we see some of that softness being from inventory corrections and excess inventories at our customers with some of it being driven by underlying demand declines.

Got it. In this environment, how long a forecast do you get from your customers? And overall visibility, based on those forecasts, do you think that visibility is better than what you had 90 days ago?

Yes. I would say visibility is more of the same. We'll talk about lead times a little bit, as lead times have come down. Customers are giving less firm orders if you can get stuff in 13 weeks, right, they tend to order in those time frames. So we're seeing less longer-term visibility when lead times are pushed out over a year. We had a lot more -- but what we are seeing is the fact that lead times are stable and we see normal level of cancellations. In our business, we're always having some level of push out, pull ins and tweaks there with the day-to-day forecast. But I think in general, our backlog is down year-over-year, but the level of visibility is consistent, but that backlog being down is some byproduct of lead times coming in, and then the softer demand, so you would expect some decline in backlog, right? But that also is helping the book-to-bill as we start to see more of those coming in. As the billings go down, you start to see that as a driver for some of the uplift in the book-to-bill.

Got it. So since you talked about book-to-bill, can you talk about how book-to-bill is trending across different regions?

Yes, I would say it's -- I talked about Asia kind of stabilizing. So we're seeing it trending up higher in Asia, still not a parity but getting closer there, still softer in the West. But we are seeing, for example, as semi stabilized, that's starting to improve, but we are seeing IPD, book-to-bills, getting near parity which is consistent with what we're seeing in terms of IP&E being pretty stable market and start to see some demand increases there.

Right. Ken, you talked about China. What is the game plan for China? And do you see your revenues, your investments in China increasing? And overall, at a higher level, can you talk about where your investments and where your focus is on a regional basis, where do you think there's maximum growth for the company?

I think we're talking about China specifically. I would say, a few years back, we were underinvested there. And so we've been intentional about China investment or broader base demand there. Transportation is a really strong market, but also just the mass market there in China. Seen a lot of opportunities in some of the renewable kind of spaces, so solar, wind, some of those types of things. So we do see it as an important market. I think we're happy that it's not overly concentrated for us. Again, 10% of total revenues and roughly 25% to 30% of Asia revenues. So we see that as a long-term market, even though there's some softness there. I think one market we have definitely continued to invest in is Japan. It's a very fragmented market, right now the global players have a significant presence there, but we see that as a good market. It's got a little bit higher margins in China as well than, let's say, Taiwan or Southeast Asia. But Japan is another market that we see is very good and our business there is performing well. So some more opportunity there. And Taiwan has just always been kind of our strength in Asia. And we're seeing that see signs of starting to recover, and that's about 40% of our Asia business is out of Taiwan. And so that's getting healthier, and we're optimistic we start to see some growth there in the near term.

Got it. I'm going to come back to Europe when we talk about Farnell. Maybe that's a better time to talk about that. Let's -- you also mentioned backlog. What is the normal level of how many months of backlog do you typically have? And how is that running and do you think there's any double ordering happening at this point?

I mean I think backlog in many ways is a byproduct of lead times. And so although we have customer forecasts, and we do a lot of demand planning and supply chain type forecasts, we typically don't get backlog until customers need to order the product. So I'd say the trends with backlog are generally normal as it relates to lead times, getting into the overall picture, I would say we are seeing pretty normal trends in terms of what was happening is as lead times extended, customers are having to place orders and Avnet was having to place orders and kind of be stuck with those orders. We call them non-cancelable, nonreturnable. And so there's a lot more restrictions on when you placed orders that you couldn't cancel it even if your demand changed. We're seeing a lot of softening of normalization of those kind of trends. So we feel very good about the ordering patterns and the kind of the rules of ordering with our supplier partners are kind of back to normal. We always have some level of noncancellations. You're 30 days out from when you need to take an order, suppliers aren't going to let you cancel because they've already built the product. So that would be normal levels. And we were saying we're kind of behind or through all of the kind of strict terms and conditions that were in place. I still think there's opportunity to build up buffer stocks and we'll talk about supply chain services, but there is still some need for customers to build up safety stock and things like that to make sure they get protected if things start to tighten up or if natural disasters happens or another pandemic that they're kind of protected with critical parts. So there's still opportunities there, and there's still some things going on between suppliers and OEMs to kind of strengthen that assurance of supply.

Just on cancellation rates, is there -- what is the normal level of cancellation? Is there a certain percent that is normal and that you typically try and keep that under?

Our rule of thumb is, in any given day, you have a 25% change in your overall ordering between pushouts, pull-ins, cancellations. What I would say is cancellations still remain normal. Some cancellations are good because when we know there's not underlying demand. We're going to adjust the backlog accordingly. So some of the cancellations we've seen in the past, let's say, 6 months have been our own doing to make sure we've got the appropriate picture of what inventory is coming in. But I would say, oftentimes, stuff changes with our customers in terms of demand, timing, but we don't see any unusual patterns and cancellations right now that would be of a concern that would indicate anything more than what we're seeing is just some softness due to overall demand plus the elevated inventory levels of customers.

Got it. Ken, what investors are looking for in this space is to time the upturn, there's an inventory correction that has impacted this market. How do you see that trending? I mean how many more quarters of inventory correction do you see happening?

I would say we still have some work to do. That's one area where we're disappointed that we haven't been able to convert the excess inventory into cash. A lot of times, with Avnet, one of our benefits is the countercyclical balance sheet. So as demand starts to go down, you start to burn off receivables and inventory and generate a lot of cash, and we had a good cash flow quarter last quarter, but it's been slower than we would have liked it to have been. What I would say it's still going to take a few quarters to work through some of these things, customer inventories are still elevated. So that impacts our ability to get through some of our inventory, but at the same time, we think the inflows coming in for the suppliers are very well controlled and not creating additional headwinds there. But as the underlying demand environment has declined, right, that's causing more time. But I think our commentary was couple of quarters ago, mid-2024 would be where we start to see some uptick there. I think we're thinking more now in the late 2024 is where we start to see kind of the inflection point. But we'll continue to monitor it. And again, our view is we'll continue to make progress on inventory this quarter and the next quarter. And so I think it's going to take a few quarters, but we see progress coming and the situation is getting better each quarter.

Got it. Maybe I want to talk about pricing. What are you seeing from suppliers in terms of pricing on both the passive side as well as on the semiconductor side? And are people -- are suppliers still raising prices in this environment?

I wouldn't say we've seen a lot of pricing increases. I would say we see pretty stable ASPs, in particular on the high-end semi side. But in general, pricing is pretty stable. And remember, the reason prices went up, for the most part, was input costs are up, right? The cost to fabricate the semiconductors, the freight cost, all the labor costs, all those costs are up. So a lot of those price increases coming were pass-ons or pass-throughs or price -- actual hard costs. We see it pretty stable right now, although we would argue in commodity type areas where there's lots of different alternatives. Those tend to have more pricing discretion in terms of ASPs, but the more proprietary type products, ASPs are holding up pretty well. And I think where we'd see more pressure on potentially pricing is more of the competitive nature is demand is down a little bit. We've done a good job from our perspective, taking share over the last several quarters. So, there's a dynamic competitive environment out there as demand goes down, trying to fill volume. And so we could see some normal competitive pressures. We've always had that in our business and we try to counter that with more higher-margin type of opportunities and sales to kind of counterbalance sometimes normal pressures on competitive. But ASPs will be stable, but maybe competitive pressures will have a little bit of pressure on overall pricing.

Okay? And if suppliers were to take down pricing, I mean, an investor concern has always been like what impact that's going to have on the P&L. So what are your thoughts on that? Like what happens when suppliers take down prices?

Yes, I think if we go back a couple of years on the pricing increase started to happen. Our approach to that was we need to pass those on because obviously, we can't absorb those costs as a low-margin distributor, but at the same time, we were looking to take advantage of our customers with the long term in mind. So we really just passed on those price increases. Something went up $1, we would pass on $1 plus our normal markup. And so we think that worked pretty well from us, and we had success passing all those on. I think right now in the environment, customers have pricing fatigue, right? If you get 2, 3, 4 price increases, you're kind of ready to not have price increases. So think a lot of that's behind us. I think on the flip side, if pricing start to come down, I think we'd be protected in terms of the overall margin would stay pretty stable, but you clearly have less revenue if prices went down $1, that will be $1 less of revenue, but in general, we don't have exposure to our inventory for the most part because we've got price protections and things like that. So the inventory we would correct down to the now market price, if you will, and then we would work with the customer accordingly. So we'd see that as some potential negative leverage if that was to occur in a broad base, but in general, wouldn't impact gross margins significantly.

Got it. You also mentioned that you've gained share. Couple of years ago, you had some supplier consolidation that impacted revenues. But I think for the most part, you guys have done a good job coming out of that. So where are you gaining share and which regions? And how is the line card trending? I mean, have you added more suppliers? Are you happy with the progress you've made?

I would say we're very happy with our supplier line card. We've got a lot of the greatest technologies out there. And so very pleased with our line card. We're always looking to refine it or improve it where customers have needs but feel very good about our line card and our line card is one of the reasons that we were able to outgrow maybe some of the other competition there. What I would say is although we did lose some suppliers in the past, that kind of got us focused on profitable growth. And so our analog business today is actually larger than it was at the time we had a couple of the big analog guys that we lost. And so we feel pretty good about our recovery and that we solidified a lot of relationships with other suppliers on our line cards and now are #1 with those suppliers versus maybe being #2 or #3 in the past. So -- we feel we have a very strong line card to go to market with. And our focus really has been back to the basics of profitable growth, serving our customers, being efficient at those operations. So we were able to grow the top line without growing the expenses very much and that created the operating leverage that you see today. And we think we can sustain that through this cycle and then start to expand when we get back to grow, start to kind of create that operating leverage again, kind of maintain the negative leverage now but get back to growth and expanding operating margins as the growth comes back.

Got it. So maybe this is a good segue to talk about the segments. I remember the Analyst Day, which was I think in 2022, you gave an overall revenue target of 5% to 8%. Obviously, the world has kind of changed over the ensuing years. But how should we think about revenue growth in the medium term and in the long term? How are you thinking about growth now?

I think we think about it the same in terms of as we get through this down cycle when the up cycle recovers, we think that somewhere in the mid-single digits growth up to, let's say, 8% is the right CAGR. A lot of that is based on -- you have to remember that we're very diversified in terms of our end markets we served. And when you think about our strength in industrial, our strength in transportation, our strength in defense, those are the markets that are expected to grow faster than, let's say, the normal market. And so that gives us comfort that we're in the right areas where the demand is going to go. A lot of this is the secular trend as well of the proliferation of electronics and you think about compared to 10 years ago, how much electronics are in everyday products we use, including our own vehicles, we see that trend continuing, especially in the industrial space. And so we think we're in the right neighborhoods, similar to some of our EMS partners and that's the kind of same size growth there they're expecting as well. So we feel we're pretty balanced there. And obviously, we have to wait for the market to correct, but it's really the focus on those key verticals that have the most use of electronic components that we're seeing coming in there.

Yes, that makes sense. Just talking on margins, the core business margins last quarter, I think, were 4.1%. So I think I asked you this on the earnings call, but I'm going to ask it again, like what needs to happen to keep core operating margins above 4%. And when you think about the drivers of margins, like what -- can you help us think about the impact of pricing versus revenue growth versus FX versus other -- are there cost measures you can take? Just talk about how you're thinking about core operating margins.

I think in our EC business, we're right around the 4% operating margin last quarter and I think our guidance implies slightly below 4%, but there's still depending on how things shake out this quarter still to be at 4%. So I'd say we kind of need stable revenue levels at the current levels, and that's -- right now, the total corporation is about $5.3 billion to $5.4 billion. So we do need revenue stabilization because of the fact that there is good leverage on the upside but also negative leverage on the downside. We feel pretty good about gross margins being at least stable. There's lots of opportunities we have in terms of demand creation, IP&E, Farnell, you mentioned, which we'll get into a little bit more. Supply Chain as a Service embedded. Those are all higher gross margin type of product sales we have that can kind of overall help the gross margin. But at the same time, we talked about those competitive pressures that may be out there, but we feel pretty good about some higher-margin opportunities balancing out overall gross margins. We did announce some level of cost actions this past quarter, and part of that is really just some things we need to do to be more efficient on the OpEx side, but we also aren't afraid to invest in OpEx. And I think in past cycles, unfortunately, we may have overcorrected as the demand started to go down, we decided let's go take costs out. And we think long term, the better approach is going to be hold the line on the OpEx and be prepared and well positioned to take advantage when the recovery comes. And I would say in past cycles, we might not have taken full advantage of the recovery. And I think our view and especially supported by Phil Gallagher, the CEO as well as all of our executive leaders is let's be smart about this one around. And instead of saving $0.10 or $0.15 of EPS in the short term, we're going to have to pay a lot of severance. We're going to have to do things that really on a cash basis or a ROI don't make sense. So let's pull the line on expenses, do the right things like we have done over the past several years in terms of managing expense closely, but look to the bottom line. And I think on the flip side there, part of our profitability as interest expense is up. I think there's opportunities as we generate cash, we can start to pay down some debt as well as return cash to shareholders, and that will help overall EPS and things like that. But really, the path, I think, is keeping efficient operations and making sure that we're ready to capitalize on the growth.

Got it. Just staying on the core EC business for a bit. Talk to us about demand creation. I mean, is this a higher margin business for you? I mean what's this differential in margins between a demand creation opportunity versus a regular opportunity? And then, I mean, what exactly -- like what type of customers take -- or what type of suppliers take benefit of your demand creation?

Yes. So I think at our basic premise as a company, our job is to grow customer account and grow sales for our supplier partners. And we're kind of an extension of their sales force as a distributor. But when we help generate those leads or that demand, they're willing to pay us a higher margin. So a lot of our sweet spot in terms of customer is small- and medium-sized customers that may have some engineering and product development, but don't have the full suite of development that a large OEM may have. And so we can help supplement their internal resources and help them with product selection, product design. And when we do that, and we have a supplier's part put into a board, then the supplier pays us a little bit more margin. So on average, we get 400 more basis points for demand creation sale then it would be just a normal fulfillment sale, where we help influence the design. And so suppliers like it because of the fact that we're out there generating more demand for them and helping them. Customers like it because we're adding value to them that we're supplementing their technical resources. So it really gets us in strong both on the supplier and the customer side. But we do enjoy a higher margin. So we are focused on growing that as a percentage of the business. And what I would say in the shortage markets is what was happening is people were focused on redesigns. What parts are available. Let me redesign my product and get something in there. Now we're focused on new designs that products are more available. So that is a positive sign that we're working with customers, a lot of new designs versus chasing parts and getting to those next revs of their products.

Got it. Maybe let's segue into Farnell. So talk to us about what's happening in the catalog business. You talked about high margins at Farnell. I remember like they used to be double-digit margins there. So how do we get from the 4% back to double digits? Or are we going to get there? So just talk to us what are the issues facing Farnell? And how do you see margins?

And Farnell is our high service or catalog distribution business. And the best analogy I have for those aren't familiar with it is you think about if you go to the gas station or 7-11 or [indiscernible] you want to buy a coke, you're going to pay $2 for a bottle of coke. You go to the grocery store and buy a 12 pack or 24 pack, you're going to get them for $1 apiece, right? And that's the kind of the model that's high service, quick and convenient. And Farnell did expand their operating margins in the shortage market because they had parts available, everyone was chasing the parts, and so they were able to generate more demand, along with their competition. And typically, that comes with a premium because they were having more dynamic pricing. So they benefit a lot from the shortage market in terms of not only top line sales, but also gross margin. So when we knew that they were kind of over-earning a little bit there. And so what's happened of late as product became more available is Farnell has a kind of double whammy margins have normalized because of the fact that semiconductors are more available. So therefore, pricing has kind of stabilized on that side of the business, but also the demand for semiconductors in the high service has come down because of the availability and more of the broad line. So some of the benefits of volume they were getting in the down market have kind of subsided. So those 2 factors have kind of really compressed gross margin. So although Farnell's sales have generally been holding up through the past several quarters, what's happened is their mix has become more negative. So it's really been a gross margin story. So we've taken certain actions to restructure that business. But the main premise of the restructuring would be to try to really bring the Farnell business closer into Avnet. One thing that we have that others don't have is the large scale and scope of Avnet that we can leverage for Farnell into our customer base and really help accelerate some of their sales. So we're getting back to bringing Farnell closer to Avnet to try to drive some more synergies there. And we think those restructuring actions are really just a byproduct of that. We're still very excited about Farnell and their opportunities. Again, their gross margin is roughly 3x Avnet's average gross margin. So you can kind of see the size of that. So a little bit of growth there goes a long way in terms of driving bottom line. So our near-term goal as we get through our fiscal '25 is to kind of exit fiscal '25, somewhere in the 80% plus operating margin range, but our midterm goal is they need to return to double-digit operating margins. And that's going to be through a combination of growth and other initiatives to bring them closer to Avnet. So we feel very good about it, although it's not going to happen overnight, but we -- they've been at double-digit operating margins. Their competition at double-digit operating margin. So we feel there's no reason that they won't return there with some of the changes we made.

Farnell has benefited from summer sales. What type of investments do you still need to make in Farnell, like do you need to hire more engineers or do you need more CapEx into that business? So how do you see spending on Farnell trending?

I mean right now, we talked about the OpEx reduction, but there are still areas we want to invest in Farnell. I mean we have invested in Farnell in terms of inventory, in terms of warehousing, in terms of e-commerce capabilities. So I would say more marketing and other type of e-commerce capabilities is an area of investment, really looking for the right tools to help drive demand there. And over time, warehouse footprint and things like that would make sense. So what I would say, though, is I don't think it's something incremental outside the normal expectations of CapEx and investment that we've had. So there's nothing magic given that we're investing in IT systems or their e-commerce capabilities, it's nothing that would be unusual relative to our kind of normal $100 million to $120 million a year in CapEx.

Got it. Talk to us about your inventory expectations for cash conversion cycle free cash flow?

Yes, it's elevated and so it's been a drag on cash flow. It was what I would say. And so I think we are making progress. Again, I talked about the input costs or the input of inventory coming down. And we're working to reduce the excess level, start to turn the inventory faster. So I think we're making good progress. The progress is mixed depending on the region, doing a little bit better in the West than in Asia, but still making progress. So we see what we did this last quarter, and we would continue to say we're going to have a streak of quarter after quarter of reductions there, and that will benefit cash and -- so I still think it's going to take a few quarters to get through, but I think we're on the right path, and the team is definitely focused on it. So that's one of our #1 focus is to generate more cash from inventory.

Got it. Can you talk about supply chain services? How do you see revenues from that?

Supply Chain Services, this is where we would step in, let's say, the normal relationship would be a supplier sells directly to OEM and the supply chains are getting more complex and OEMs are demanding more resilience in their supply chain, someone like Avnet can step in and help facilitate warehousing services, logistic services, broad supply chain visibility to all your partners. A lot of times, these OEMs use a lot of different partners, and they can have visibility to what's at one partner, but not all the partners. So we really can aggregate and give more control towers across their supply chains to understand what inventory they have, what inventory they need and kind of the overall scope of their supply chain situation. So we're seeing lots of opportunities to partner with our suppliers and OEMs to step into those supply chains. And that's what we call Supply Chain as a Service because the inventory model is a little different in terms of we might be holding the inventory, but it's not our inventory. We're not taking the risk on the inventory. We also have discretion with the pricing in terms of the pricings that are negotiated between the OEM and the supplier, but we get a fee for service for moving the product, holding the product in some of the visibility we give. So we view it as a high-margin opportunity. We see it as a good growth engine, although when you talk about services revenue on a $25 billion plus revenue basis, it's hard to move the needle in terms of revenue, but we see it as a stabilizing force for our gross margin. And we see that these issues that happened during the pandemic and a lot of the supply chain disruptions that happened really brought people back to see the value that someone like Avnet can provide. And so we're seeing lots of opportunities coming out. That's kind of the silver lining of everything that happened is people now value supply chains. They talked about it all the time and someone like Avnet, especially for OEMs that have not traditionally used a lot of semiconductors or electronic components, right? We have the expertise there to help them in their supply chain. So we're very excited about the future prospects, although it's scaling slower than we'd like, we're still seeing the opportunities there.

Got it. So we have about a minute left. I want to talk about your thoughts on an issue, which is shares have for the longest time traded at tangible book value. And now over the last month, I think they were up 17%, and you're still at book value. So what are your thoughts on that? I mean how do you see receivables? Are there any asset write-downs that you're expecting? So what is the market missing? And what would you say about -- do tell investors why this is a good time to invest.

Yes. Thanks. I'll take that, Ruplu. I think the market is starting to appreciate. That's why you'll see that I appreciate the value of Avnet brings. When you talk about the receivables, you talk about the assets that we have, like inventory. We reserve very well for our receivables. They've done a great job in keeping sure that even as we get inventory down, receivables have come down, that's one thing to note in the Q3 that just closed. So again, we've been -- Lisa and I have been talking to a lot of investors. We're screening very well being under book value, and it's looking like there's been a renewed appreciation for where we are in the cycle at this point in time and that if the market starts moving up -- if and when it starts moving up again, we're very well positioned to take advantage and bring those net revenue leverage down to the bottom line.

Great. So we've touched on a lot of different things. I've got a lot of questions, but we're out of time. So -- so Ken, and Joe, thank you for coming. Really appreciate all the details.

Thank you.