Arrow Electronics, Inc. (ARW) Earnings Call Transcript & Summary

Good morning, everyone. Thanks for joining Citi's Virtual Tech Conference today. My name is Tim Yang, and I cover tech distributor sector at Citi. I also support senior analyst, Jim Suva, on tech supply chain coverage. For this session, we are pleased to have Arrow's CFO, Chris Stansbury; and Head of IR, Steve O'Brien, joining us to share their insights about Arrow and the industry. As a background information, Arrow is the largest semiconductor distributor globally and is the fourth largest IT distribution company in America with their ECS business. Before we start our Q&A, we have a few housekeeping items. Arrow Electronics asks that you please refer to their Investor Relation website for their recent SEC filings as well as Reg FD and the safe harbor statements. There are Citi research disclosures associated with this session for you to review. All clients subject to MIFID II are reminded that they need to have research agreements in place and contact Citi salesperson if you have any questions. We will go through the questions that we prepared for this event. And if there's additional time, you can ask a question by e-mailing me at tim.yang@citi.com. With that, I would like to hand over to Chris for a brief overview of Arrow, and then we'll start our Q&A. Chris?

Great. Thanks, Tim. Thanks, everybody, for joining today. I know we're all kind of settling into doing these conferences by video. It's a little different not being in New York with everyone in September. This is usually the big kickoff for the final push through the end of the year. I would say that we're relatively pleased with where the business sits today, given where we are with COVID. I think the fact that the industry had gone -- on the components side had gone through an inventory correction prior to COVID hitting, that benefited us. Customers are sitting on lean inventory. So as we navigated our way through COVID, we are -- we're in better shape than we otherwise would have been and certainly, coming out of it, that puts us in great shape. We're very pleased with the resiliency of the business, the fact that despite sales being suppressed, we're generating respectable profits and very respectable cash flow. We are able to be buying back stock, and we announced an expansion of that last quarter, and that's also very encouraging. So again, great to be here and look forward to some good Q&A, Tim.

Great. Chris, I think you just mentioned the COVID is definitely very uncertain, like for global macro environment. Can you maybe just talk about the demand trends in the near term? And how this change as we enter into 2020 as COVID spread globally?

Yes. It's -- I mean, really the way COVID impacted the world is what we saw in our demand patterns, right? So Asia was impacted much earlier in the year. And then obviously, we saw EMEA and North America follow. And since, we've started to see Asia recover. And our Asian business is very strong. We had a record quarter last quarter. And obviously, in the near term, it became a much bigger piece of our mix. And so when you look at our margin performance, particularly given the size of Asia, I think it's very respectable. As we go from here, I think we're continuing to see that strength in Asia continue. Third quarter is always the most challenging quarter of the year in Asia just because of the summer holiday period, but I would say that the business is performing as expected. And in North America, it's early yet, but I think there's some signs that we're starting to see some level of recovery in the North American business. And then for ECS, we obviously had very strong performance in Q1 and then into Q2 for remote work product. And the capabilities that we've built over the last number of years that allow us to remotely deploy product to customers had really given us an advantage. A lot of our VAR partners asked customers to use Arrow as the deployment vehicle because of our ability to execute rapidly. So we positioned ourselves well there. So I think what really remains to be seen is how do the economies of the world outside of Asia recover in Q3 and Q4. We're definitely seeing activity pick up as factories are turning back on. But ultimately, that will be -- that success will be dictated by how much returns in consumer spending.

Got you. It sounds like the near-term demand is actually improving. How do you think the pandemic has shaped the underlying driver for the growth outlook for your end market in the medium term, like 2 to 3 years from this year?

Yes. It's a really good question, and it's a big question, right, because it's not just about where does growth come, but how do people operate. And one of the things that has amazed me and certainly my peers at Arrow is when you think about the way Arrow has traditionally done business, it's very much a face-to-face business, right? You're -- you've got sales teams that are visiting customers. You've got engineers that are doing the same thing. And with COVID, it forced us into a situation where overnight, we had to work online. And the fact that it's gone as well as it has, I think, is a strong indicator that maybe the world was ready for it sooner than a lot of my generation thought. When you think about Arrow now being over 60% millennial and younger, that population is used to transacting online. It's what they grew up doing. And so this is a very natural motion for them, and the same is true for engineering. So I think we will see a return to some level of face-to-face, but I don't think it's going all the way back to where it was. And I think what we're seeing is more rapid design and more rapid closure of issues when people aren't stuck on planes, trains and automobiles, they're actually working effectively online. So we'll see where it goes, but I think we're going to probably end up in a bit of a hybrid environment when we're done.

Interesting. So given the hybrid environment you just mentioned, can you maybe just share with us how has your company actually changed the business practice to enable like more efficient operations with this -- the hybrid environment?

Yes. So really, like most companies, right, we're not allowing our offices closed for a period of time. It moved depending on what was happening in different hotspots around the world. And we went entirely to online engagements with our customers. And we definitely saw the sales impact in Q1, right? Q2 was less severe, and our guidance for Q3 improves again. So I think that the fact that we've been able to not just sell but also collect, I mean, I think about my world as CFO, our percent current on accounts receivable is at record levels, record highs. So people are paying us faster than they were 6 months ago. And I think that speaks to the dedication of our teams, but it also speaks to the importance of Arrow to our customers, and they need us when growth returns. And so we bode well in these kind of environments. So we've been very nimble. I think that has worked well for us, and we've got to continue to do that as we go forward.

Can you maybe just share with us that your demand creation and maybe just the project in the ECS business that you are doing -- apparently, like you are doing this probably remotely. Can you maybe just share with us the feedback from customers? And how do you improve your operational side just to drive growth or drive the business in those 2 segments?

Yes. So on the component side, we've been very, very focused at doing a couple of things. One is continuing to add just sheer numbers of engineers. And we actually announced in Q2 that we were embarking on additional hiring of engineers that's taking place today. And that's really setting us up for future growth. The other thing that we've done in components is make sure that our ability to execute from small to large engineering engagements is efficient. So it's not just numbers of engineers. It's also how you engage in that engineering discussion. And at the very lowest end, the most simple end of design, maybe a small inventor, we can do stuff through our digital properties through an Arrow pipe where we can share designs. And that's really where that capability started. But now that's being utilized on bigger, more complex engagements. And at the other end, you've got something like eInfochips, where they can do very, very complex designs and prototyping for IoT ecosystems, right? So it's devices. It's the connectivity. It's the compute environment. It's the software that's proprietary that sits on those devices. And that business has continued to succeed, where customers typically would want us face-to-face, but they don't want the innovation to stop. And so they've been open to us engineering with them online as well. In the ECS space, we've made a number of investments over the years in a platform, which is called ArrowSphere. And that allows us to provision and deploy software and cloud services. The heavy focus was really on our VARs to act as MSPs, but that's continuing to grow. We're seeing telecoms in Europe using that platform to enable the sale of, for example, cloud product because they want that consumed on their networks. And so that capability, as the world was shifting in that direction, actually, was a huge, huge benefit to us when we had to start deploying more remote work products. So that's really -- some of it's some smart investments, some of it's luck in terms of the things that we've done to grow our digital presence in previous years, but it definitely has set us up well for the current environment and I think go forward.

Great. That's impressive. Maybe we can dig into the ECS part later. But just back to the component business, I think the book-to-bill was above 1 last quarter. Can you maybe just give us an update on the book-to-bill by region and then by vertical?

Yes. We don't really do it by region or vertical, but what I will tell you is that when we talked about book-to-bill at the end of the quarter, we said that in total, we were roughly at parity with Asia, a bit above in North America, close in Europe sub. And it's not uncommon for Europe to be below 1 in the third quarter simply because of the summer holiday season. So as I look at where we are as we're progressing through the quarter, I would say those trends are continuing and no surprises, steady as she goes.

Right. I probably need to learn from people in Europe that are -- where to go for the summer vacation time, but...

It's not a lie. I was teasing my team because I said I am assuming that with COVID that once people are done with COVID, they won't be going on vacation. And it was met with laughter at the other end of the phone. So they said, "No, no, we will be going on vacation."

So yes, that's interesting. So TI share shift has been a very big topic in the distribution space. I think the U.S. distribution channel only for fulfillment business. My question here is that if you are gaining shares, which I assume is the case, how soon the transition would be? Is it 1 year, 2 years or maybe several years?

So again, we don't -- for any of our suppliers because we've got a lot of very important supplier partners, we don't like to talk about specifics. What I would say, though, is that in this case, TI has been very clear as to their plans. And the fact that, that transition would be done by the end of the year, and I expect that, that will be the case. I think what we're seeing is very consistent with what's been communicated by TI in previous announcements.

Got you. Okay. Can you maybe just talk about your component revenue mix in fulfillment demand and demand creation and the supply chain? Obviously, this could change with the transition within TI, but if you can provide some color on that mix, that would be great.

Yes. So typically, what -- Mike Long, actually, a couple of years ago on an earnings call said that roughly 35% of our components business should have a design win margin attached to it. And that's a goal. We're obviously well below that right now. And we were seeing steady increases before the inventory correction, which was clearly visible in our GP margin performance. In the current environment, obviously, that's subdued. That's the bad news. The good news is that when you look at what drives that and you look at the metrics that -- in the commentary that we've shared about record levels of design activity, that is a really good precursor to what I expect to come. So coming out of this, we should see -- there's a lot of puts and takes in the gross margin line. Let me talk about gross margin and operating income margin. From a gross margin standpoint, we, near term, have some region mix headwinds as Asia is stronger than the rest of the world. We obviously have some supply shift that's fulfillment only. That's a headwind. But the tailwinds we have are this pent-up demand on all these designs that we're doing today, which will help. And we've also got a lot more business that we're doing where we're helping suppliers and customers with large complex global supply chains and using the backbone of our ERP to help manage that. And that's a very high-margin business for us because think of that as a consulting kind of engagement, where we're helping with the flow of product and getting paid a fee to do that. So that puts us in a position, I think, for actually gross margin improvement despite some of those bigger headwinds that I mentioned. At the operating income line, it really starts to flow. Because as soon as we get even just the smallest amount of growth, you will see us drive operating income leverage. And then a number of our businesses are very light on OpEx. The more fulfillment we do, it's lighter on OpEx. The more supply chain engagements we do, it's lighter on OpEx. And so we expect that on the components side, we'll get back to 5% pretty quickly coming out of COVID with just a little bit of volume growth.

Interesting. So a quick follow-up on the margin side. I think your component margin is [ expected to ] decline on a year-over-year basis for September quarter. Chris, you mentioned that normally, in the normal -- normally, like you're in the trough of the cycle, like probably your margin year-over-year decline probably lasts probably like 4 to 5 quarters. But if we include the September quarter, that will be the seventh quarter of year-over-year margin decline, which is similar to a financial crisis. How would you compare like this cycle versus financial crisis? And also, maybe just you touched on the recovery of the 5% margin side. How should we think about that 5% like the time line for you to achieve that 5%?

Yes. It's a very good question. I mean I think what we're seeing right now is just, to your point, it's not like the financial crisis, and it's really 2 things attached to each other, right? There was the inventory correction and then COVID immediately followed. So it's really kind of an abnormal time that we're all navigating through. That said, as we look to Q4, it's really going to depend on, I think, on end-market demand, right? We're seeing factories turn back on. We're seeing companies start to order product. But ultimately, that has to get bought. And consumers have to buy cars and washing machines and a whole host of other things before we can feel good that things are going to return. So unless -- I'm certainly unconvinced that there's any kind of a V-shaped recovery. I think that's behind us. I think we're going to see a slower return to growth, and we're going to have some bumpiness in that, I think. As it relates to how quickly do we get back to 5%, tough to say because we've never really sat here before. But I do think, even just a low to a moderate amount of growth, we could get back there pretty quickly. A few quarters, 3 or 4 quarters would be, I think, reasonable.

3 to 4 quarters. Do we need to see higher revenue for margin expansion on a year-on-year basis? Or does not necessarily given that you have done some cost savings? And maybe next year, you have easy comp and then we can see some margin stabilization on a year-over-year basis.

Yes. I don't think we need volume growth, but let's just call it what it is, right? Eventually, we get into Q1, Q2 next year, we start to lap some pretty easy numbers. So even if we -- with the low volume growth showed some margin improvement, I don't think we'd be celebrating that too much because we're still -- even though we like the way we're performing in the current environment, nobody likes where our margins are today as a long-term focus. So -- but yes, I think we can -- given all the things that I've talked about, we can show margin improvement as we go forward from here, even with flattish kind of growth trends. Now that will be limited. I don't think that's something that could go on for years, but I also don't think we're going to be in this for years. I think we're going to be at some point next year, starting to see a return to growth.

Got it. With the TI shift, obviously, that's the fulfillment business is lower gross margins. But would you say that given you already have some TI business in the portfolio, the operating margins would not be dilutive in general compared to you adding more fulfillment business, which is naturally a margin headwind for you guys?

That's right. I mean this is -- we've said that our focus here really is on driving incremental returns. And so as we look at -- even suppliers who want to do a fulfillment model that's very OpEx light, depending on what that looks like, in this case, consigned inventory, right, so the working capital investment is less. Then the key for us is whatever business we take, we have to be driving a respectable return and improved returns for our shareholders, and that's what we're doing.

And 35% demand creation as a percent -- as a portion of your total component business still the target given that the TI transition. Is that right?

Absolutely. Because if you look at what we've done is we -- as I said, we continue to add engineers. We announced we were adding more even in the current environment. So I don't think there's any reason for us to think that, that would slow down. It's a space that right now we own. And we're going to continue to maintain that lead by continuing to invest in those capabilities. So I think that's still a good goal. And while we don't disclose that, we're well below that right now. And you're seeing that in the margin. So that's the bad news, but the inverse of that is obviously good news as we get back to growth.