Arrow Electronics, Inc. Q3 FY2021 Earnings Call

Good day. And thank you for standing by. Welcome to the Arrow Electronics Third Quarter 2021 Earnings Conference Call. Please be advised that today's conference is being recorded. I would now like to hand the conference call over to your speaker today, Mr. Steven O'Brien. Please go ahead, sir.

Thank you, Steve. And thanks all of you for joining us today. Before I touch on the supply chain topic, specifically the current imbalance between supply and demand in the electronics component market, I'd like to focus on the theme we've been discussing over the last few years: Arrow’s ability to create even in challenging market conditions. Our customers and suppliers recognize the value we bring as our team achieved all-time records in gross profit, operating income, and earnings per share during the third quarter. Arrow's investment in design, engineering, and supply chain solutions have delivered unmatched performance that makes us a leader in our industry. Through those investments, we have established a continuous cycle of growth that enables more customers to manage manufacturing and bring compelling new products to market sooner. It also helps our suppliers embed their designs in the next generation of electronically rich products. This continuous cycle ultimately leads to new product innovation, closer ties with customers and suppliers, and better outcomes for all. Our emphasis on inventory and working capital investments, as well as our key competitive differentiators of industry knowledge, media properties, and experience have made us well positioned to help customers drive their business advantages. These low-risk, near-term investments are helping our customers secure manufacturing in increasingly unpredictable conditions. Moving to the financials. The trajectory of the global components business was positive during the third quarter. Our global components business capitalized on continued strong demand in all regions, with sales up 25% year-over-year. Sales were above the midpoint of our expectation for six quarters in a row, just like last quarter with a struggle to secure additional inventory to meet strong demand. Based on the data we collect in our market intelligence, it's increasingly clear that supply will remain short of demand through the better part of 2022. Instances of severe supply chain bottlenecks have increased, leading to widely reported production slowdowns in certain industries. During the quarter, we saw robust demand from sectors such as transportation, industrial, communications, computing, and data networking. Our demand strength across all regions and multiple end markets more than offset any one customer’s or set of customers’ challenges, and as a result, our global component sales of $6.6 billion set an all-time record for Arrow and we were slightly ahead of last quarter. In terms of profitability, we achieved significant growth along with exceptional operating leverage during the quarter. Notably, operating income from our global components increased by more than three times the rate of sales. We continue to provide customers with value-added supply chain services that utilize our global ERP capability and unique level of inventory insight. Our digital platform is also helping customers manage component supply and safeguard their manufacturing processes. As a result, the revenue contribution from design and engineering activities increased within our mix during the third quarter. Turning to enterprise computing solutions, sales were within the range of our expectation. However, supply chain issues limited our ability to capitalize on strong demand. We saw projects postponed during the third quarter due to an inability to secure IT hardware products. This also led to missed software sales that would have been associated with those specific hardware refreshes. It's not surprising that the same component shortages impacting global components are affecting global ECS right now. It's a supply, not a demand issue. It's important to note that near-term postponements due to product availability may not result in one-for-one catch-up in future quarters, and customers have immediate needs to run mission-critical applications and workloads in a secure manner and limited ability to stretch existing infrastructure. Any bottlenecks are therefore accelerating the utilization of cloud-based compute and storage. Good news for Arrow is that we have the leading cloud enablement tool ArrowSphere ready and able to help our VAR and NSP customers meter, monitor, and bill cloud right away. In closing, I'd like to acknowledge our team for consistently delivering for our customers and suppliers that faced some of the most acute and protracted product shortages and shortfalls we've ever seen. We are building trust with our customers during these tough times, and that certainly includes times where demand outstrips supply by a wide margin. By delivering for customers right now, we're securing strong, mutually beneficial, multi-year relationships for the future. With that, I'll now hand the call over to Chris to provide more details on our third quarter results and our expectations for the fourth quarter.

Thanks, Mike. Third quarter sales increased 17% year-over-year on a non-GAAP basis, and the average euro-dollar exchange rate for the quarter was $1.18 to €1, which was roughly in line with our forecasted expectations. Changes in foreign currency benefited sales growth by approximately $55 million year-over-year. Third quarter gross margin of 12.6% returned to its highest level since Q2 2018. Gross margin improved year-over-year in global components in each of our operating regions. Operating expense increased slightly as a percentage of sales during the third quarter, but decreased as a percentage of gross profit. As a reminder, many of our value-added services and solutions can be independent of the sale of electronic components and therefore contribute more meaningfully to profit from sales. Interest expense was in line with our prior expectations. While the third quarter tax rate was slightly below our expectation, that was due primarily to the timing of a discrete tax item, and we also saw some favorability in regional profit mix. As we have been saying on prior calls, for the full year 2021, we expect our effective tax rate to be near the low end of our long-term range of 23% to 25%. Turning to the balance sheet and cash flow, third quarter operating cash flow was $114 million. Compared to the second quarter, DSOs and inventory days lengthened, but were naturally offset by an increase in our payable days. As a result, our cash cycle of approximately 51 days was effectively the same as last quarter. Our liquidity position is the best in the history of our company and continues to improve. Leverage as measured by total or net debt to EBITDA is at its lowest level in over 10 years. We returned approximately $250 million to shareholders during the third quarter through our share repurchase plan. This matched last quarter as being the largest single quarter of share repurchases in Arrow’s history, enabled by our strong profits and proactive working capital management. We remain committed to returning cash to shareholders with approximately $413 million remaining under our share repurchase authorization plan. We're confident that we're repurchasing shares below their intrinsic value based on increasing return on invested capital and return on working capital. Please keep in mind that the information I've shared during this call is a high-level summary of our financial results. For more detail regarding the business segment results, please refer to the CFO commentary that we published on our website this morning. Now turning to guidance, the midpoint of sales and EPS guidance imply all-time full-year records for 2021. Our forecast implies a strong seasonal increase in enterprise computing solutions sales and profits. However, both businesses continue to face supply constraints that are limiting our ability to make the most of the strong customer demand. Our guidance reflects continued strong performance in operating leverage for global components on a year-over-year basis, and for global enterprise computing solutions, profitability levels to be substantially accretive to consolidated financial performance. Finally, as we discussed last quarter, please note that CFO commentary includes information on our fiscal calendar closing dates for 2021. In 2021, the fourth quarter began on October 3 compared to September 27 in 2020. This makes this year's fourth quarter about one week shorter than the prior year fourth quarter. Full-year comparisons are not affected as our fiscal full-year ends on December 31 as always. With that, I'll turn the call over to the operator for Q&A.

Yes, thank you, and good afternoon. Thanks for all the details so far. I just wanted to ask about the nice margin upside that you saw in components. I think that was the highest number I can remember in quite some time at 5.9%. How much of that was driven by favorable pricing versus that mix? Obviously, you saw strength in Europe and in North America, so mix versus pricing versus the pickup in design and in demand creation that you talked about, Mike.

Yes, Matt, thanks. By the way, thanks for noticing. I didn't have to bring up the 5% thing again this quarter. What we're seeing right now is probably about half of that profit increase, I'd say half to a third, somewhere in there being structural. In other words, driven by services, some of the supply chain activities, those types of things, design, group that we've been selling for some time as the mix goes to North America and Europe, that's largely where those services have been. The good news is they were growing before COVID, they grew during COVID, and they continue to grow right now, so that means more customers for us. The other two pieces are really mix as you suggested and then secondly, pricing increases that we're seeing from the manufacturers. With some of that price increase, that's also why you see increased inventory, not necessarily more units, but increased price on the inventory that we have. By the way, the price increases are just rolling through. They're not done by any stretch of the imagination at this point in time. So, we fully expect that to go on all the way through 2022 and possibly beyond. But right now, I'm prepared to say that it looks like next year is going to be healthy in all cases and possibly help out with a softer landing.

Okay, thanks for that. And then on the computing side, you talked about some of the challenges, especially the component constraints, but it looks like your growth rate, if you look at some of the large VARs in the infrastructure market and other areas, they looked like they're growing faster than your business. I know there are some netted down revenues, some moving parts there. But how do you think you're positioned to maybe start growing and reaccelerating growth in that business again?

Yes, so let me give you a little more clarity on that. Obviously, we saw growth in Europe, which was as expected. The other thing is we saw growth really in the core business as the VARs, everything you saw in North America, where it was notably soft with more in the public sector business and those deals came up shorter term. As a result, they are harder to supply product to, and that's really where the vast majority of the shortages were. And then if you remember, computing in the fourth quarter is usually the governmental budget flush. So, part of our guidance is based on what we think we'll get for supply. It is clearly not a demand problem. So, the good news there is sort of the core customer base is growing, the notable slowdown for us within public sector, and by the way, that was the majority of it. I'd love to, Matt, but I don't think today is the day.

Hi, can you hear me?

Yes.

Hi, great, thanks for taking my question. Mike, I'm wondering if you can talk to us about the effect of the preferred supply program that one of your suppliers has installed. We learned last night that there is another vaguely similar supplier that put one of these programs in where they're demanding very long non-cancelable, non-reschedulable orders. What sort of visibility is that dynamic introducing into your business and maybe you can touch on book-to-bill and lead times while you're at it? Thank you.

I mean any time a customer will give you more visibility, I'll start with this: it's a good thing. Given the long-term nature of the supply-demand imbalance here, the more information we have from a customer, the better we can help them. So, I'll put those two things out there first. This sort of contractual arrangement with the supplier allows you to secure supply over the next three years, let's say. Yes, then you're going to share your forecast, and the supplier is going to commit to a percentage of your production capacity that you think you need. They're not going to allow you to stock it and put it on the shelves and not ship it or not manufacture with it, but it opens a different type of dialogue. So, personally, I like these arrangements for that reason. If you're sort of an old-line customer that you've used to getting your shortages fixed by demanding it or calling up and asking somebody for a favor and then yelling at them, those customers are not likely to get their products. It comes down to this: if you want to fix the supply chain, it has to involve better visibility, longer-term commitments, and you can't just continue to whip the supply chain and think you're going to get products. There is no real one industry anymore that wields the power to come in and push anybody around in today's electronics marketplace. So, it will require more information, more visibility, and as a result, we can expect better results for everyone over the next couple of years because this situation isn't going to disappear soon.

Yes, the things clear. I appreciate that. One other, if I can. You know the pricing dynamics that you can deploy to perhaps enhance your margin are sometimes a bit mysterious because we know there is a big part of your business that's done on these ship-and-debit dynamics that are sort of built for a deflationary ASP sort of industry which it's not today. So, when prices are rising, are you able to pass along more than the price increases, or is that only in a relatively narrow set of cases where you're more purchasing components at arm's length transactions? Maybe you can help explain this dynamic to us to understand that part of the enhanced margins. Thank you.

Yes, well, I believe there is a structural change going on in the industry. In the old days when you had, what we used to call allocation, it was because there was a temporary shortage of products, and you raised your prices. But when the market changed, they would come right back to where they were. There is no more year-over-year cost reduction on parts like there used to be. Raw materials are up for the suppliers, transportation is up for not only for the suppliers but for us too, handling and labor costs are up as you've seen those types of things. So, we are experiencing a structural change in the business that hasn't seen an inflationary impact for probably ten years, maybe a little longer. These costs are real, these costs are permanent, and we will charge for them, and that's a little different than what we've seen in the past. I don't expect the pricing to reduce. In fact, we have some suppliers telling us right now prices are set to go up another 20%. If that's the case, you'll see things happen again. Therefore, it's very important for us at Arrow to have our back-office systems in order, have to be low cost for the customer, and to have average transportation routes be the quickest, easiest, and shortest for the customers to help keep the prices down. As far as pricing going away, there has been a big change in technology, and that's not going to come back.

Thanks, Mike.

Hi guys. Thank you so much for taking the question and congrats on the strong execution. I had two as well. My first question is on customer behavior in the marketplace. One of your larger analog companies on their earnings call talked about customers being a little bit more selective with their expedites this quarter versus three months ago, six months ago. Three months ago, six months ago customers were pulling really hard across a very broad number of device types. But more recently they have become a little bit more selective. Are you seeing similar behavior from your customers, or is it pretty much pulling hard across everything at this point?

Yes. So, I'm not going to limit it to analog as analog is only a portion of the market and it doesn't tell the story. The truth is, I had five friends a year ago and I've got about 20,000 now. People I didn't even know are calling into the office. Now we are seeing an increased number of expedites, but those expedites are being used more to how can we help the customer over the long term and just through one month shortage that occurs and how can we help them lay out a manufacturing schedule they can make sense for all the parts on their bill of materials. So, these expedite calls are not for one part; they're really for all parts that we're supplying that customer so they can get into manufacturing. So, they each take longer, and there is better information with flows. But as I said, we probably saw more significant or, what I would say, emergency shortages over this quarter than we've seen since this started.

Interesting. Thank you. And then as my quick follow-up. Wanted to ask about market share in components. If we take sort of the midpoint of your December quarter revenue guide, I think your components business is going to be up 27%, 28% year-over-year in calendar 2021. You're clearly outperforming your nearest peer. Obviously, they had some unique idiosyncratic headwinds this year, but even excluding that I feel like you guys are outperforming against them and also the broader industry you've got idiosyncratic tailwinds and then sort of ADI maximum dynamic going forward and just being the company you are, you probably have better access to supply vis-à-vis some of your smaller peers. So, I guess the question is, how should we think about your ability to continue to outperform from a growth standpoint into 2022 and beyond? Thank you.

Well, thanks for that. Those are nice accolades, but we still have to get up and fight the battle every single day that we're here and show the customers that it's worth it for them to place their orders with Arrow. I would say that our ability will increase as customers continue to come to our engineering services and utilize our supply chain services that exist other than just the parts today. Selling parts is very important to Arrow, but you are expected to be low-cost and get parts from A and B on time; all of that are table stakes today. But the ability to affect the customer and help a customer with their design to make sure they're getting their products out and that they are low-cost is becoming increasingly important to us and our profit levels. So, as long as we continue to push that and stay in that end of the business, this cycle will be repetitive for us, and we believe we've been fortunate. We believe our strategy has worked. It's taken a long time to get here, but now we just have to continue to drive these new businesses that we've built inside the company.

Thank you. And I would be remiss if I simply don't congratulate you on a great profitability and that's just really remarkable. With that complement though, some people will say is this the new norm, or are you getting some extra boost from some of the shortages, and how should we think about that because the profitability is truly remarkable? I know you put a lot of effort into it. So maybe if you can just kind of talk about the sustainability of the profit margins? Thank you.

Yes. Thanks, Jim. We did not come out and raise our longer-term targets yet. We're still sorting through the benefit of our services, the sales that have a higher profit level at the bottom of the sales and also our supply chain solutions business, which has a higher profit level at the bottom than components parts do, and then, of course, our long-term engineering where we actually do engineering for customers, that continues to grow. What we're seeing is or what we believe is those will continue to grow into the future even if products incrementally abate. So, we're becoming increasingly positive that we will surpass the long-term bottom-line number we gave you guys of 5% in the components business in the future, but we're still evaluating the data for 2022 to see what the growth looks like. But certainly, I can tell you right now, 2022 is looking a lot like today. So, hopefully that gives you enough information, and we'll be looking at the rest of the business over the year and where the growth rates are panning out before we make that commitment.

Hi, thank you for taking my questions. My first question is on inventory. Some component companies have talked about some level of inventory build, maybe in automotive at the OEMs and in industrial in the distribution channel. So, when you look at the supply chain, are you seeing any level of inventory build? And specifically with respect to your inventory, it looks like it was up 5% sequentially. So, Chris, are you happy? Do you think that this is a good level of inventory, or would you like to – do you think you need to build more inventory as we go forward, and how would that impact the free cash flow?

Yes, this is Mike. I'm going to take this and then let Chris respond. A portion of our inventory this quarter is from price increases, which has made the inventory a little bit more valuable. So that has a piece to it. Secondly, I think you brought up transportation or automotive. That would be fantastic if they could build some inventory because then they can build some cars. They are trying – the automotive manufacturers are trying to build 10 million more cars next year than this year. So, clearly, they need inventory to do that. They are not going to pull the trigger and start building cars until they can get to sort of an assured supply chain to where they know they're going to get product. So that's what you're dealing with today. The good news, in my opinion, is whatever they get, they're going to manufacture, so that's going to help. We are largely seeing that in most sectors that are growing this year. If the industry is only supplying 80% of what the market wants, there is a 20% extra growth rate in there; they can be utilized today how sustainable those growth rates are over time. Therefore, I don't think just looking at inventory is a viable indicator for what the future is going to hold because there are many moving parts. Even with our inventory, some of that is when inventory hits at the end of the quarter and it couldn't get out the door. So, that is a trigger that should cause for some questions to be asked, but it is right now no means an indicator that the market is slowing because I can tell you our book-to-bill for the quarter remains high, demand is strong, and we expect that to continue throughout 2022.

And I would just weigh in and say to the question on our inventory levels. Again, I wouldn't spend a lot of time looking at the dollar value of inventory. I'd really encourage you to focus on the cash conversion cycle. Inventory levels will rise as the business grows. Working capital levels will rise as the business grows. The key for us is being able to manage the days it takes to convert that into cash. The other thing that you'll see this quarter is we do have some positive margin gains because of geographic mix, and we know that inventory turns a little slower in the West than it does in Asia, and that's got a margin benefit to it as well. So, you've got to take all those variables into play, but our key focus in terms of how we're running the business day-to-day is laser-focused on the cash conversion cycle.

Got it. Thanks for the details there. I appreciate that. Just for my follow-up, Chris, if I can ask you. Can you remind us of your capital allocation priorities? In this environment, are you looking at any potential M&A and how should we think about prioritizing debt reduction versus share buybacks? Thanks.

Yes, this is Mike. I'll answer it just so there is no question for anybody here or for you guys. Remember, our number one priority is to invest in our business to grow, our number two is M&A, and our number three is to return cash to shareholders. As you can see right now, we're doing a fair amount of returning to shareholders through our buybacks, and we would expect that to continue for a while.

Yes, thanks for taking the question. I was curious as we look into 2022 and I take your comments, Mike, thinking about the components margin and the strong pricing that I guess is expected to continue next year, is there any reason that we should view this quarter's results from an operating margin perspective as an upper limit, or could we continue to kind of increase that given the mix dynamic on a quarterly basis just – or is there some level of fixed maybe investment that you need to make as your run rate?

Yes, let me answer it such that I say whatever it is not enough for me. So, I'll start there. This is sort of one quarter—we're still sorting out. Remember, we had some mix changes, so mix does have an impact. Not only does mix by region have an impact, but also, mix from our services sales can influence it. So, if all things stay equal, I would tell you it would be equal, but we're one quarter into this, and what I can tell you is I'm very positive about what the future looks like, but I'm not ready to tell you that we're going to be going way north of this number going into next year.

Yes, Joe, I think if you look at our business historically, it's about a third hardware, about a third software, and about a third services, and that bounces around a bit quarter-to-quarter, but year-to-year it holds relatively constant. We generate a variety of returns across that portfolio. Now I'd like to say not all hardware is bad and not all software is good, and as we pivot to all things cloud and all things IT-as-a-Service, you're going to see our mix change. But the supply chain constraints we're seeing now are probably double the lead times than we saw at the start of the year. So, this will be a headwind for a little time, and obviously that will create some downward pressure on the top line. But just to give you another way to think about that, I don't believe the market has returned to pre-pandemic levels when considering enterprise IT. However, we are seeing signs of renewed activity in the data center; the proof points for that being the strength of our storage business year-to-date, which is up in the high single digits. The second thing I would add is we've now seen our backlog at record levels, and a good piece of that is associated with things that will land in the traditional data center, so all hardware will be a bit of a challenge in the short run. I don't think it will persist indefinitely.

Got it. That's helpful. Thank you.

Yes, thank you, and congratulations on the results. Mike, you mentioned that half of the component margin increase this quarter is structural. My question is what the benchmark for that structural upside is. Is it based on the 5% target you discussed a quarter or two ago? Additionally, how much of the component margin increase is attributed to the supply chain services agreement you mentioned that are generating higher margins?

Yes, I'm not going to break out the differences between the services and the supply chain services. But what I can tell you is, yes, the upside over 5% has been significantly impacted by those sales.

Okay. And as a follow-up question, you touched upon price increases. We similarly in our work have heard about acceleration in price increases, particularly in high-end SMEs. Can you talk about how much of your portfolio is experiencing price increases and what is the magnitude of realized price increases, as I’m assuming you're referencing less price is also going up by 20%, which, I think, could be different from what the realized prices are?

Yes, actually I'm going to have the guy answer that a little bit, so I'm going to ask David West to give you an answer on that because he has been shepherding these price increases through the system, and he didn't have much here to start with, you've got less now, so you'll get to hear it.

Yes. We've seen price increases for more than 100 suppliers, and we expect that to continue through 2022.

Yes, Nick, I mean the key thing that impacts our view on buying back stock, obviously the starting point is its value. If you look at the way we're trading today, I think we're roughly eight times forward, so the stock is cheap on that basis. It's a good buy versus the intrinsic value. So that's point one. Point two is, while cash flow is an important variable there, so is our leverage, and unquestionably we're getting to a point where cash generation moderates somewhat because of the need to invest in working capital for growth. However, given the state of the balance sheet, we've got a lot of room while maintaining our commitment to investment grade to buy back stock. So, to Mike's point earlier, I think that's what you should expect from us.

Got it. Thanks, guys. Good luck.

Thank you for joining us today. If you have any questions, feel free to reach out to me, this is Steve O'Brien. And thank you for your interest in Arrow Electronics. Have a nice day.

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