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

I think we're live. So for our track today, we are rounding out the day with Avnet. First, I should introduce myself. I'm Melissa Fairbanks. I am the analog semi and IT supply chain analyst here at Raymond James. Welcome to the conference. We are really excited to have Ken Jacobson, CFO from Avnet with us today. We also have hiding in the audience, Lisa Mueller, who handles IR for the company. And it's been a pretty full day. Full room looks like, full day of meetings. So that's good. It's been an interesting time in analog semis and distribution, certainly recently. So Ken, if you would like to do just kind of a brief introduction of who Avnet is, I don't know if you need to do a safe harbor statement. And maybe give us kind of like some background on the company just to get us started.

Yes. Well, thanks, Melissa, for having us out here, and thanks, everyone, for your interest in Avnet. Avnet is a global value-added distributor. We connect the world's top technology manufacturers, primarily semiconductor and interconnected passive and electromechanical manufacturers to customers that use electronic components in everything they design and create. Our 2 areas of expertise at the center of the technology supply chain is design chain and design support, helping customers choose the right electronic components to make into their design and then supply chain. We've talked about a lot of supply chain since COVID times and the shortages and we're experts in supply chain. We've got global scale. We do business in over 140 countries worldwide, so we can help customers design or have supply chains anywhere in the world where they need it. And as of the last few years, the supply chain capabilities are becoming more and more important to making sure you can sustain your operations and have a resilient company.

Okay. Maybe go over the 2 separate businesses. You do have 2 separate reporting -- your reporting structure is 2 separate businesses. Talk about the difference between the components business and then Farnell.

Yes. So our first segment, Electronic Components business is what we refer to as a broadline distributor. So we've got a broad line card, and we're supporting primarily high-volume customers that are already in production. And so we're typical customers are the procurement groups of manufacturers, and that business is global, represented in Asia, which is roughly 50% of our business last quarter. The Americas is roughly 20%, and then Europe is roughly 30%. And so that business effectively supports production volumes, and we help customers design and support supply chains throughout the world. Our second segment is what we call the high service business called Farnell. That's one of speed and convenience, where you have design engineers and R&D activities going on that need small quantities, they need it overnight to finish their design and product. And with that, we yield a higher margin. So as the EC or Electronic Components business runs around 10% to 12% gross margin. The Farnell business runs closer to 30% gross margin, so definitely a premium there.

The mix makes a difference for sure. So I would like to kind of go over current trends because you guys do tend to follow the leader in terms of the semiconductor supply chain. Maybe go over some of what you're seeing by the geographic mix. Asia typically leads us out of a correction followed by North America and then Europe. That would be very helpful to kind of review that.

Sure. Maybe the first thing to point out is we're very diverse. So we've got a very robust line card, but no single supplier technology represents over 10% of our business and no customer represents over 4% or so of our business. So have a really good breadth of the market. Our key focus areas in terms of end markets would be industrial, transportation, aerospace and defense, networking and communication as well as some in the data center and consumer side. Really, this cycle, I would say the recovery starting in Asia, we've got 6 quarters in a row of recovery and growth in Asia. And that business now is at record revenue levels as of this last quarter. Now a little bit of that is driven by the data center and the AI phenomenon, but it's more broadly in terms of the recovery. And when we look at our Asia business, it's led by Taiwan roughly 40% of the business. And so a lot of strength in Taiwan. And then next biggest market would be China, followed by Southeast Asia and then Japan. And so what we've seen is broad-based recovery and the growth rates accelerating. Some of that is replenishment from the customer base because they've bled down inventories, but a lot of it is really the increase in broader demand. And so feeling really good about that. But just for color, our Asia business was 40% of our total business just 5 quarters ago, and now it's 50% because of that growth. While in the West, we just got back to growth in Europe this last quarter. Europe has been the slowest region. It's our most profitable region in terms of gross margin percentage as well as operating margin. That business is heavy in industrial for us, followed by transportation and then networking, comms. So we saw pretty significant declines. We're about 35% plus off peak revenue levels in Europe but got back to growth, roughly 1% year-over-year growth is last quarter and seeing traction there. And then the Americas is kind of somewhere in between -- had a couple of quarters in a row of growth, a little bit more robust in Europe but still closer to where Europe is at compared to Asia. And so what gives us some amount of confidence, but I would say, very encouraging signs that through all the regions, we're seeing robust book-to-bill ratios. We're seeing our backlog replenish over the past 4 quarters. We've been encouraging customers that give us visibility the more visibility we get, the more forecast we get, we can provide that information to our supplier partners. So they know what to load the fabs in making their semiconductor choices. So a lot of it's based on our visibility, we give them demand outlook. So we're seeing really good signs there in terms of backlog building back up again and getting some of the visibility we had pre-COVID. I would also point to, we called out this last quarter, a lot more mismatches. And so we're seeing the last few quarters, customers ordering within lead times. And what that means to us is customers have depleted some of their excess inventories and they're ready to buy product now, they're ready to replenish. But when they order within lead times, you're not necessarily able to get that product unless we have inventory on the shelves. And so what we saw this last quarter is now more signs of suppliers delivering product outside of lead times. If a stated lead time is 12 weeks, maybe the supplier is delivering in 15 or 16 weeks. And so that mismatch is creating an imbalance between supply and demand, which is good for us, but challenging for our customers if they want to make sure they keep their lines running. And so we continue to encourage customers to give us visibility, let us help with our supply chain capability as a pipeline product for you, so you can keep your lines running and avoid having shortages in certain areas.

Okay. Great. I'm sure that does help with the visibility longer term. Do you feel as though your customers, even the broad-based customers in Europe are now moving more toward real consumption rather than under shipping demand? I know for many quarters, the suppliers themselves were undershipping what true demand was. And so we didn't have a very good representation of what actual consumption was. Do you get a sense that this is still just shipping to consumption rather than inventory builds. I don't want to use the word stockpiling because that's a bad word. But just curious what you're kind of seeing from your customers there?

Yes. And maybe I'll start with our own inventory. I mean, I think it's important we're a distributor. So inventory is kind of the lifeblood of our business. And so we got to make sure we have the right inventory, and we've had our own challenges working down our inventory levels or getting rid of some of the areas of excess so we can invest in the areas of need. But clearly, in an environment where there's more demand with the short interval orders within lead times and then deliveries outside of lead times, if you're well positioned on inventory, you can capture more of the market. I would say the customers, in particular, Europe, but I think as a general statement, are in pretty good shape. I think it took a little longer to consume those excess inventory levels. But I would say, if anything, they're probably too leaned out on inventory. I think that's a broad statement. There's always some pockets of customers depending on your end market or vertical that might have some areas of excess. I think in general, we feel the customer inventories are healthy. And -- but we need to make sure we're getting the visibility to make sure they don't come up short. So what you're seeing right now is probably true demand. I think there's areas where things are getting tighter. And what you tend to see is customer behavior of wanting to order more to think if I order more than maybe I get in line or I get premium access, right? And I think we're trying to encourage responsibility is making sure that what you're ordering is what you really need for your near term so we can help spread those products that are high in demand across multiple customers.

So one of the questions that I get quite frequently, there's a little bit of a misunderstanding. And I think some of it was driven during COVID, during the supply chain crisis when we saw kind of an explosion in your revenue levels and then also the margin profile is how does pricing impact your margins? And rising costs that we're seeing on the component level, particularly I'm thinking, of course, in memory and storage. Are you able to just pass that through to your own customers? Or is there some kind of elasticity there?

Yes. I would say when we hit the peak of the shortages, we were seeing broad-based price increases, maybe even multiple times a year. And so at our peak, I'll use rough numbers, but we were maybe growing 30% in a given year, and we would attribute roughly 25% of that growth or 7.5% to pricing increases. And a typical scenario be a supplier announces a price increase, we tell our customers, there's a price increase coming, you might have some consumption of stuff you have on the shelves to be able to get in front of the price increase and then going forward, you're buying at the new price. And so on average, what we would do is pass those through. So we wouldn't make any more gross margin percentage necessarily, but we would still enjoy more gross profit dollars because of that growth. And so that helps us with our scale. If we had 30% growth, 7.5% of that or 25% coming from that growth, then we would create additional leverage in the model. And so we think that's likely to be the scenario going forward again, when there's opportunity when we have product on the shelves, we have opportunity to get a little bit more margin. It's okay to get paid the value we provide but at the same time, we understand if a customer is getting a 20% price increase, that's a lot to digest, right, but we still should be enjoying our same gross margin percentage in part because we're giving you terms on that, we're holding inventory at the higher price, right? So there is more value we are providing to. But I think what I would say, though, is the caution everyone is -- we are not anywhere near what we're seeing in that environment with broad-based price increase. I think we're hearing some anecdotes on increases, memory comes to mind as things have been announced, although some of those increases haven't taken effect. There's other price increases that we're aware of have been announced that are surrounding certain technologies or certain customer bases, but I would not say anything is broad-based. We're still early innings, but the indicators seem to be there if some pricing moves. A lot of that's driven by the input costs. You mentioned that before is we're seeing precious metals, gold, things with gold and okay, connectors with gold, hey, there's a price increase. [ Handle ] them on the passives. So there are true input costs that are rising that are leading to some of these talked about price increases.

I think when we get into periods of growth during the up cycle, typically, you kind of addressed a little bit of the working capital investment that you need to make in order to support that. I'm curious on the OpEx line, like your own internal costs. It seems as though we've got a little bit better leverage in the operating model than maybe in past "normal cycles" excluding the supply chain crisis. How much has automation, deploying AI within your own internal processes or internal efficiencies allowed you to capitalize on some of those -- like drive a little bit more leverage in the operating model as we get to return to growth?

I think we are focused. We brought in a Chief Digital Officer a little over a year ago with a lot of expertise, not only in e-commerce but also digital tools and solutions. And so we think about our to kind of value propositions of design chain and supply chain, there's a lot we can do with technology, 2/3 of our business is comprised of people and people costs. And so although in the warehouse, there's physical movement, you can always optimize there. I think as we look at our technical resources, we've got 2,000 technical engineers across the globe to help customers in design options, we can definitely use technology and digital tools and capabilities to help them be more efficient in supporting our customers in our design chain. And then the same thing is supply chain, customer service, all those kind of things, there's a lot we can use technology and the data we have to make better decisions and to support our customers better. So I'd still say we're early innings in terms of some of those use cases and capabilities, but we have a road map, we feel pretty good about that there is value to provide. And again, some of it's cost reduction, some of it's efficiency for the team, but it all should yield our ability to grow and not add a bunch of expense so we can drop more through to the bottom line. And I think we are -- feel well positioned with our OpEx right now to be able to have a couple of years of nice growth without having to add a lot of costs.

Okay. Great. That kind of leads us into a natural discussion about the margin targets. At your last investor meeting, which was a few years ago, you had set a target margin of getting operating margins above 5% sustainably. We were able to exceed that during the supply chain crisis. But I'm just curious, what are some of the market conditions or maybe product mix that we need to see in order to get that margin target sustainably?

I think...

Or above?

Yes. I think the targets necessarily haven't changed. Our EC business was above 5% for a few quarters. And our floor this time around is roughly 3%. So if you think about the last cycle coming out of it, we hit as low as 1.5% of that business. So I would say kind of the step-up in revenues and scale has allowed us to now have a new bottom of potentially 3% there, and we're on our way back to growth. I mean, I think again, growth in the West with the higher margins, the recovery of the West, I would almost say -- is going to help a lot because that's our higher-margin regions. But scale does matter in our business. And again, we can control the cost. So I think continuing to drive those initiatives to grow the business faster than the market. Focus on the value we provide to get a little bit more gross margin. Those are all levers that will help us. We didn't talk about Farnell much outside of the...

Oh, I was getting there.

So that will help a lot, too. Farnell business runs at 30 points of margin versus our EC business. So we've got some, I think, good tailwinds coming our way, and I think we're well positioned not only with our customers, but also with our supplier partners. But just this last quarter, we improved operating margin in the EC business by roughly 30 basis points. Our guidance for the March quarter implies another 30 basis point uplift so we're starting to see the traction as we start to recover in the West.

Okay. Great. I think I would like to talk about Farnell, talk about how there are synergies between that and the components business in terms of maybe serving as a funnel for longer-term opportunities. But certainly, that margin profile brings some opportunities for you as well. Discuss what's been going on there. I know that we had some disruption coming out of the supply chain crisis, maybe some inefficiencies and what you've been doing over the past year, 1.5 years, almost 2 years now in order to get the margin profile back up to where you want it.

Yes. Our Farnell business I think gives us a differentiator between our competition, that high service business. And again, the margins are very attractive. But I think what we're continuing to do is get our Farnell business closer to our core business. And I'll give you a couple of examples of that. Think about our core business, roughly 30% of that business is done through EMS contract manufacturing, and there's a long tail of the EMS customers as well as the big guys. And we're really underpenetrated in that customer base with Farnell. Although we've got great relationships in the core and Avnet's got -- there's not a lot of business not only for on-the-board components, but also the test and measurement, the maintenance and repair, all the things that an engineer would need to design products. And so we think there's more opportunity really just to continue to cross-sell with our existing customer base with Farnell. I think on the flip side, early identification for high-volume customers coming through Farnell. Farnell has got a much bigger customer base than our core business in the hundreds of thousands through their e-commerce platform, so continuing to identify leads and marketing leads and early in the process to shift those over to Avnet to be able to keep that business is good. And then going back to the Chief Digital Officer, one of the things we're focused on, we believe, within our control for the Farnell revenues is really just the e-commerce penetration. We're getting lots of website hits, lots of eyeballs coming to not only the Farnell, but also the Avnet properties. How do we convert more and capitalize more on making sure we're getting those converted to sales? And there's some things we can do in terms of the e-commerce proposition, some of the functionality of the site to help drive that conversion rate better, which then is additional growth for Farnell.

Is the mix of the product or the components meaningfully different between EC and the Farnell business?

I think in general, the types of products that are sold by Farnell, at least for on the board components are the same as the core business, although Farnell tends to focus on more SKUs in terms of if a supplier has a portfolio, let's say, of 10,000 SKUs, Farnell may support 9,000 of those SKUs, whereas the core business maybe only a couple of thousand as an example. Farnell, part of their value proposition is seeding the market with new product introductions and making sure we've got a broad selection of parts. So when an engineer goes, they can get anything they need from Farnell. There's a differentiator in Farnell's business in terms of they sell single board computers, test and measurement, maintenance and repair products that the core business really doesn't support and that's all for the benefit of here's everything an engineer needs at their design workbench to test their products. But from an on-the-board component perspective, we're very aligned in terms of line card and what we have there. And just for a little bit more color. When we talk about onboard component, that means a semiconductor or all the IP&E parts that are around the board. And so that's what we refer to as more of the Electronic Components, and that carries a higher margin for Farnell. So what you're seeing in Farnell's growth in some of those other areas, but the on-the-board components have been a little bit depressed and primarily because Farnell is mostly Europe but also heavy Americas business. And so as that market begins to recover, you'll start to see some tailwinds in Farnell's gross margin because of more sales of semiconductors and IP&E products. So that margin has stabilized and is a pretty good margin.

Great. You mentioned engineering and services a couple of times at different points in the discussion. Maybe if you could talk about how value-added services within either business are going to be accretive to margin longer term and kind of categorize what all you're able to provide for your customers?

Yes. I think from a -- I'll start with supply chain service, I think we're seeing more and more opportunity for customers coming to Avnet to support their supply chain needs. And a unique opportunity we're seeing, and we saw some of it coming out of the pandemic, and it's really the large OEMs that have complex supply chains, and they buy lots of parts. They have lots of partners that help with them with their manufacturing, but they don't actually have warehouses. They don't have even legal entity footprints to secure product where they need it. And so they'd bring someone like Avnet in to help provide supply chain services that could be procurement services. It could be warehouse and logistics, it could be buffer stock, and it could be kind of just-in-time delivery to their network of manufacturing partners. So we're seeing a lot more opportunity with the supply chain disruptions that come in and provide services. That's part of the available market or the TAM right now, but Avnet really hasn't played a part. Those are usually the direct customers of the supplier base. We're seeing more opportunities there to provide supply chain services and then we can take some of those solutions and provide it to our mass market customers and provide them more supply chain opportunities. So we like that. It's a higher gross margin. It's not really a top line mover but higher gross margin. And then our design capabilities, the more parts we can help customers select then we typically get a better cost from our manufacturing partners. And so there's a little bit higher gross margin there. So there's a few different things that we have in the portfolio to help drive gross margins. The last thing I'll talk about is Embedded and Embedded Solutions. We're seeing more and more customers eliminate time to market through choosing embedded boards and solutions, and we've got an embedded board in solutions business in -- based out of Europe that helps customers design custom boards or we have standard boards. And so we see that as a win-win-win where the suppliers can wrap more of their technologies within a single board. We can enjoy a higher margin because we own the design and then our customers get a quicker and cheaper overall solution. So we're seeing that business be a little depressed with what's going on in Europe because it's a heavy industrial health care base, but we're seeing some of that start to come back and the prospects over the next few years with the embedded space are good.

Great. Great. How much does trade and tariff navigation play into either your value-added services or even just the broader business. You touched on your locations in Asia, locations in Europe. You've got a pretty wide geographic footprint of just availability of warehouses, the distribution centers, even engineers globally. And so with a lot of the uncertainty in trade and tariffs, has this presented an opportunity for Avnet?

I mean I would say any supply chain disruptions, tariff included present opportunity, and I would maybe start with the positives before we get into some of the negatives. We have been able to adapt and pivot with some of these changes. And again, because we have operations in 140 different countries, we can move your supply chain where you need it. And you saw it back when -- there was a focus on China and China plus one. So we're seeing a lot of beneficiary here in Southeast Asia, markets like Malaysia, Vietnam, India. We're also seeing more nearshoring. Guadalajara, for example, is big for us. We're seeing a lot more companies move to Mexico. Although there was just disruption a couple of weeks ago in some of that, and we had to shut down the [ ware ]. So I do think you never know where your supply chain disruption is going to come. So our global scale and footprint and trying to invest ahead of the curve of where that next support spot will be important. And for the tariffs here, specifically in the U.S., we've been able to pivot our distribution center in Phoenix, Arizona is a free trade zone. So it allows us to mitigate tariff impacts until we know exactly where the product is going. And then Mexico has been another beneficiary there. So we try our best to mitigate where possible. But unfortunately, if you're going to be manufacturing here in the U.S. and use a product to produce in China, you're going to have to pay a tariff. And so we have to pass it through. We've been pretty transparent to our customers. It's been a lot of work for the team, the operations team for all the changes and you're kind of reacting to news reports real time. I think we've got at least some kind of process down.

That would be the negative.

And again, we've talked about price increase in the past, and I would say customers sometimes are easier to absorb a 20% pricing coming from supplier versus a 2% tariff pass-through. But we worked through it, and I think we're in a pretty good spot now, although we'll continue to monitor the situation. And just for more context, perhaps, our business overall, less than 2% of our revenues are from tariff billings -- from an Americas standpoint sorry, globally, it's less than 1%. So it's pretty insignificant in terms of the overall impact. So it's -- but that unlike the other pass-throughs, that's really truly a pass-through where we're -- whatever tariff we charge, we're charging the customer that as a moment of tax.

Okay. We've just got a few minutes left, so I want to open it up to see if there are any questions in the audience. Before I move on, I would be remiss we have the CFO sitting here. I need to ask them about capital allocation and some of your investment priorities. Typically, with the cyclical recovery, we touched on this a little bit earlier, requires a significant working capital investment to support the growth. But maybe talk about where your balance sheet is today, your current inventory levels. It seems as though we're supporting better revenue growth without driving that big spike in working capital investment.

Yes. From an inventory perspective, I would say we have at least the right amount of dollars. There's still some opportunity. We've been over the past several quarters kind of beneath the surface, although the balance sheet number might be one number, beneath the surface, there's been lots of changes in the composition of the inventory and getting some of the aged and excess inventory out and investing in inventory that's going to turn faster and that's needed. And there's still some work to do there, but I feel really good about the fact that we don't have to necessarily invest a lot of inventory dollars to continue to grow the business. Now we're going to need to invest in the right kinds of inventory and make sure we've got the right products on the shelf. But as lead times potentially extend as more demand from customers come within lead times, right? I think we're going to start turning the inventory faster. So from an enterprise perspective, we dipped below 90 days of inventory this last quarter. I think we got to 86 days. When you separate our businesses, the electronic components business should be running under 70 days of inventory. So still some runway to go there. But this last quarter, they were above -- or sorry, below 80 days in the EC business, and that's just a quicker turning. We're looking for 4 to 6 turns a year, so closer to 6. And then from the Farnell business, they do need to have more inventory. The proposition is one of inventory and having that breadth of SKUs. And so they're going to run closer to 200 days is our target for them. This last quarter, they were 220s. And so some room to go there in Farnell. But again, as they start to grow, they'll have more scale and start turning some products faster. So we feel good about the fact that we're not going to need a lot of cash necessarily to invest in inventory, although we'll continue to get the right kinds of inventory on the shelves. Where we're still going to need some working capital depending on the growth rates will be on the receivable side. Part of the value we provide to our customers is terms. And so as we grow, we'll have more in accounts receivable, but the cash conversion cycle overall should shorten in this next go around, at least for the foreseeable future here as we continue to grow. I think from a broader capital allocation standpoint, we want to return excess cash to shareholders. We've got a dividend that we've grown every year since we've implemented it. We've historically been aggressive on buybacks. Although right now, we're a little more focused on getting our leverage back into the 3-ish range. We're running just above 4. So we feel much more comfortable in the 3-ish range to be able to have the capital we need to invest in the business. But I think from our standpoint, we'll get that taken care of in the next few quarters and then get back to returning excess cash flow to shareholders. And again, CapEx is generally pretty sustainable between $100 million and $150 million a year.

Okay. All right. Maybe in the last few seconds, any closing remarks, anything that we didn't address today?

I do think that Avnet is really well positioned to get back into a growth cycle. We feel we're in a really good neighborhood in terms of the just the proliferation of electronics and everything we do continues to expand. So we see lots of opportunity with content, exciting areas like robotics, drones. There's lots of applications that we see just a continued amount of content growing. So we feel pretty good about the neighborhood we're in, and we're well positioned to capitalize on growth and return margins to historical levels.

Excellent. I would agree. Thank you very much, Ken. Appreciate it.

Thanks, Melissa. Thanks, everyone.

Thanks, everyone.