Arrow Electronics, Inc. Q4 FY2021 Earnings Call

Good day, and thank you for standing by. Welcome to the Arrow Electronics Fourth Quarter and Year-End 2021 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. Please be advised that today’s conference is being recorded. I would now like to hand the conference call over to your speaker today, Steve O’Brien. Please go ahead.

Thanks, April. With us on the call today are Mike Long, Chairman, President, and Chief Executive Officer; Sean Kerins, Chief Operating Officer; and Chris Stansbury, Senior Vice President and Chief Financial Officer. During this call, we’ll make forward-looking statements, including statements about our business outlook, strategies, and future financial results, which are based on our predictions and expectations as of today. Our actual results could differ materially due to a number of risks and uncertainties, including the risk factors in our most recent 10-K and 10-Q filings with the SEC. We undertake no obligation to update publicly or revise any of the forward-looking statements. As a reminder, some of the figures we will discuss today on today’s call are non-GAAP. We have reconciled those with the most directly comparable GAAP figures measures in our financial statements and earnings release. These non-GAAP measures are not intended to be a substitute for our GAAP results. You can access our earnings release at investor.arrow.com, along with the CFO commentary, the non-GAAP earnings reconciliation, and a replay of this call. We will begin with a few minutes of prepared remarks, which will then be followed by a question-and-answer period. I’ll now hand the call to our Chairman, President, and CEO, Mike Long.

Thanks, Steve. Thanks to all of you for joining us today. Before I get into our most recent results, I'd like to take a minute to reflect on the past year at Arrow. In today's environment, our focus on constantly evolving our business to better serve our customers is more important than ever. Our team has long recognized that the future of business will not look like the past. In order to win, we must both maximize our current business and embrace new avenues and sources of profitability. At Arrow, we continue to enhance the solutions and services we provide as the markets we serve change at an increasingly rapid pace. It is clear that our work is paying off. Our strong results demonstrate that we remain ahead of the curve supported by the best team in the industry. This year, our colleagues worked tirelessly to overcome the challenges caused by the lack of supply, in the face of an acute need for components and IP solutions. While our sales growth, profit, and operating income set all-time absolute records, our team's efficiency was also unmatched. We reached new benchmark levels on an individual employee basis for all three metrics. This increased efficiency was a direct result of our work over the last several years to assemble the most capable workforce possible, leveraging diverse skills, experiences, and backgrounds to best serve our customers across different regions and industries. Credibility and transparency continue to be the hallmarks of our business. Instances of severe supply chain bottlenecks have resulted in production slowdowns, but they also have enabled Arrow to showcase our unmatched experience, industry knowledge, products, and services to customers new and old. We understand the demand dynamics and are uniquely positioned to help our customers navigate today's challenges, including companies and industries who may be unaccustomed to shortages or supply restrictions. By helping to mitigate production risks and ensure a continuous stream of products to the market, Arrow deepens customer relationships and solidifies our position as a trusted partner. Moving to the most recent results, we continue to believe our investments in design engineering and supply chain services are bearing fruit. However, there is certainly an element of favorable pricing that benefits our margins. We have reason to believe that the overall industry pricing environment has structurally improved and could be better from cycle to cycle. From a structural perspective, consolidation is a key factor in pricing. In addition, we see only modest capacity additions coming online within the next couple of quarters, compared to the overwhelming demand. Longer-term, we recognize that there will be more challenging demand conditions at some point in the future, which will test the thesis. In this shortage environment, it’s paramount that we rethink how business in our industry is done to manage the dynamic nature of demand. Arrow has been working to address the potential for rising inventory levels in the electronics component industry, despite claims of unmet demand in the channel. Stocking higher-value inventory with greater design and engineering components contributed to record margins and returns on working capital and invested capital. That said, we know we must balance the competing near-term priority of keeping our cash cycle short with our long-term goal of maximizing economic returns. We're monitoring the quantities and types of our inventory closely and believe we're well-positioned to sell through our inventory and collect future cash on our working capital investments. Turning to enterprise computing solutions, close followers of our story recognize that sales and profit growth have become disassociated due to the accounting treatment of software services and cloud. We're pleased to deliver on our main focus, operating income growth for the full year. While supply chain issues continue to limit our ability to capitalize on strong demand, we saw postponed or realigned projects turn into available cloud-based resources. The flexibility of our business model has made us, in either case, well-positioned to remain engaged with customers and tailor our solutions to their needs. With enterprise computing solutions operating income on solid footing, we enter 2022 with excitement to serve our customers. Now more than ever, Arrow is unmatched in its services and support when compared to the competition. We're providing much-needed stability and experience to value-added resellers and managed service providers without distraction. In closing, I'd like to congratulate our team for delivering strong financial results and economic returns that we have been driving towards. In 2021, we have turned each potential challenge that came our way—from consolidation to cloud and to shortages—into opportunities and successes. While our industry continues to change over time, the fact remains that Arrow continues to improve and expand our business to the benefit of our customers, suppliers, and team. We look forward to continuing to build on this momentum. With that, I’ll now hand the call over to Chris to provide more details on results and our expectations.

Thanks, Mike. Fourth-quarter sales increased 8% year-over-year on a non-GAAP basis. The average euro-dollar exchange rate for the quarter was $1.14 to €1, below our forecasted expectation of $1.15 and below the $1.19 in the fourth quarter of 2020. Changes in foreign currencies understated sales growth by approximately $73 million year-over-year and had an approximately $58 million largely negative impact than we originally forecasted. Fourth-quarter gross margin of 13.3% returned to its highest level since Q1 of 2017. Gross margin improved year-over-year across global components in each of our operating regions and enterprise computing solutions in both regions. Operating expenses increased slightly as a percentage of sales during the fourth quarter but decreased as a percentage of gross profit. As a reminder, many of our value-added services and solutions can be independent from the sale of electronic components and therefore contribute more meaningfully to profit than to sales. Interest expense was slightly above our prior expectation, mainly attributable to higher interest rates on floating-rate debt and the issuance of $500 million of 2.95% 10-year notes. The proceeds were mainly used to meet the recent maturity of $350 million of 3.5% seven-year notes. Fourth-quarter tax rate was slightly below our expectations, primarily due to the timing of discrete tax items, and we also saw some favorability in regional profit mix. Our long-term target effective tax rate remains 23% to 25%. Turning to the balance sheet and cash flow, fourth-quarter operating cash flow was $28 million compared to the third quarter. Days sales outstanding (DSOs) and inventory days lengthened but were naturally offset by an increase in our payable days. As a result, our cash cycle, at approximately 54 days, was three days longer than the third quarter. As Mike mentioned earlier, with returns metrics such as return on invested capital and return on working capital at the highest levels in our modern history, we are being mindful of incremental working capital investments but also want to capitalize on the strong demand environment. 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 and was slightly lower than the third quarter. We returned approximately $250 million to shareholders for the third quarter in a row through our share repurchase plan. These were the largest single-quarter share repurchases in Arrow’s history, enabled by our strong profits and proactive working capital management. We repurchased $900 million worth of shares in 2021, by far the largest single year of repurchases in our history. We reduced diluted shares by approximately 8% over the course of the year. We remain committed to returning cash to shareholders by adding an additional $600 million to our authorization during December. As of right now, we have approximately $763 million remaining on our share repurchase authorization plan. We're confident that we are 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 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 published on our website this morning. Now turning to guidance. The midpoint of sales and EPS guidance implies all-time first-quarter records. The midpoint global component sales guidance would be an all-time record for any quarter. Our guidance reflects continued strong operating leverage for global components on a year-over-year basis, with profit growing several times faster than sales. Our forecast suggests enterprise computing solutions profit growth slightly year-over-year as reported, and at a somewhat higher rate year-over-year adjusted for currency. We estimated approximately $160 million headwind to sales and $0.10 headwind to EPS growth due to the strengthening US dollar, principally compared to the euro. Finally, please note the CFO commentary includes information on our fiscal calendar closing dates. Our 2022 quarter closing dates are mostly aligned with those of 2021. With that, I'll turn the call over to the operator for Q&A.

And your first question comes from Jim Suva with Citigroup.

It's a high-profile job, just a great opportunity. So this is a career thing, and that's why people on my team are just hush-hush. Yeah, we're meeting with Bruno Mars for dinner.

We have Jim, I think Jim's doing something else.

He'll call me and I'll call him. This is the real…

April, can you drop and move to the next caller?

Yes. Your next question is from Nikolay Todorov with Longbow Research.

Yeah, thanks. Hey, guys. Good afternoon, and congrats on great results. Mike, first, I want to start with a comment that you see reasons to believe that overall pricing is going to be better cycle over cycle. Do you have any type of framework that you've been thinking about? How do you think prices will evolve? Traditionally, obviously, they've been coming down cycle over cycle. But what do you see different and how do you see them evolving going forward?

Well, if you take this cycle compared to past cycles, past cycles were purely demand-driven. And then there was the expectation that you could get more efficient, thereby getting more product in. This cycle is a little different because you've got inflation hitting too, and that's raw material prices and prices for building semiconductors have gone up. So there is a structural change that's not expected to have those raw materials come down any time soon. The same thing we've seen now in transportation of those products all around the world—those prices are up at the same time, and again, not expected to come down. Some of that would come down with fuel costs, right? But you don't see any limiting factor right now other than it's likely to go up again before it comes down. So you have that, which means the price of the component itself is higher or the cost to manufacture is higher. I don't see that changing in the near term, and I certainly don't see that changing going from cycle to cycle here.

Okay, that's helpful. As a follow-up, I think you guys do a survey of your customers. Obviously, you're doing your due diligence and sometimes you've shared findings from that survey on the calls regarding customer inventory. And I think you touched on the call that you're monitoring the situation carefully, and despite that, there are some shortages. I heard that you said there are some signs that inventory is uneven. How do you characterize inventory downstream of your customers and what's the feedback on the surveys that you guys do each quarter on your customers?

Yeah. This is a highly interesting question because prices have gone up significantly in semiconductors, and that really started to hit in the fourth quarter and going into the first quarter, so customers’ inventory values are going up. Whatever they had traditionally in stock has probably gone up by somewhere between 10% and 20% now. They're reacting to the fact that they have more inventory dollars than they've ever had. In our situation here, actual units that we're getting from the manufacturers have gone down quarter-on-quarter, which is another reason to believe that the demand situation isn't going to fix itself any time soon. So you have customers that have a mix of products that may be skewed a bit, which is slowing their manufacturing time, but there's still a lot of hand-to-mouth. Inventory levels are up just like they're up here— you'll eventually ask us, but that inventory value is up while units are actually down.

Okay. Helpful. Last question for me and I'll go back in the queue. On the EPS, I think in the CFO commentary, there were notes that you're seeing increased customer engagement and order activity. What else can you share in terms of are you seeing upticks in activities on the hardware side? Is it a matter of supply chain improvements, or is that activity more so because, as you talked about, the supply chain constraints, more projects are moving to the cloud? How would that reflect on your ECS top line over the next couple of quarters? Thanks.

I'll be happy to take that question. Actually, if you look at our progress in ECS, I'll take you back to something Mike said about the way we treat reported sales. We've been pivoting our focus to the market for hybrid and multi-cloud for some time. That really is all about all things IT-as-a-service. That implies more software, more cloud, more services. That's not going to look as good as the reported sales line, but it's not going to show up nicely when we get to the operating margin line. I think you saw some of that in our Q4 results. We think it validates that we're in the right market space for our value-based selling motion. Frankly, we just need more scale. Some of the underlying indicators we're seeing from that business are encouraging. We might be a quarter or two away from seeing even more momentum. But if you look at the market headwinds, either supply chain or pandemic-related restrictions, I think they're ultimately transitory. So we're expecting to see even more improvement from that business across the course of 2022.

Your next question is from Melissa Fairbanks with Raymond James & Associates.

Hi, guys. Thanks very much. Just wondering if you could highlight any hot spots where maybe supply constraints worsened in the quarter. You did mention that unit volumes were down. Just wondering if there was one area in particular that was worse than the others or if you're—what we've heard is that some of the suppliers are kind of playing whac-a-mole, chasing constraints in one area from the other?

So, I like your analogy there, and unfortunately that fits. We don't have a lot of suppliers that we can say are up to date on everything. I think the golden screw piece you're talking about is different for every customer. Every customer has a shortage of product that's keeping them from producing something. It may or may not have overlap with other customers. The moral of the story is we're expediting more than we ever have. We are on the phone with suppliers more than we ever have been. Delinquencies continue, I even hate to say continue to rise, but our demand curves are very strong right now, and we don't see catching up all of 2022. I can tell you that because anything coming online is very modest compared to what's out there right now.

Okay, great. Thanks. Yeah, that's—we're kind of hearing the same thing across the board from your suppliers as well. Just wondering, what you said was that supply is not going to ease meaningfully or you're going to be in delinquencies through 2022. Is there any sort of baseline assumption that we should use for how much that's constraining your revenue upside? Or are there just too many moving parts to call that?

I think it's a lot of moving parts, and the reason is, for example, you might have seen a bit of a drop in Asia in the fourth quarter, which is typical seasonality for Asia. However, more products went into North America and Europe. Product is moving around based on demand, based on where the suppliers have constraints, and really attempting to keep everybody moving as far as their production goes. There's a lot of hand to mouth. There's a lot of work being done on behalf of the customers to make sure that they can continue to produce their products. Yes, we are constrained right now due to supply. You see our first quarter forecast, and that is purely a supply forecast still compared to a demand forecast. That's what we think. We're going to get enough supply to deliver those sales to you in the first quarter. When we start to see it free up, we obviously will acknowledge that and we'll go to more inventory control, but we're not seeing that at this point. The other thing I might highlight for our first quarter, the reason we could come out as strong as we did is that our inventories were up a little bit in some of the products that we were delinquent on. We'll be able to fulfill those needs. We have more confidence in our first quarter number forecast, being more accurate than I would say we have been for the last three or four.

Your next question is from Matt Sheerin with Stifel.

Hi, yes, thank you, and good afternoon. I wanted to just ask regarding the strength in the gross margin you're seeing on the component side, multiyear record. It looked like operating margin was the best number in 20-plus years. Obviously, as you said, you're benefiting from favorable pricing and also a mix with Asia down and the other regions up. My question is, how sustainable do you see that over the next two to three quarters? Like you're saying, basically it sounds like you're pretty much booked. You sound confident in the next couple of quarters. Can we expect elevated margins here for the near-term?

I think what you'll see is some hovering around—changes based on customer mix and product mix, Matt. I expect our gross margins to come down slightly in the first quarter just because of some mix issues. The fourth quarter was highly engineering, with a high level of engineered products that we were able to get back into the marketplace. We expect that to subside some to the first quarter and have a more level mix not only across the regions but also with product and customer base. We didn't have a lot of phone activity or high-level computing activity customers in the fourth quarter, and some of those have demand again going into the first quarter, but very little fluctuation over the next couple of quarters, Matt.

Okay, great. And just regarding the outlook for computing, it sounds like component constraint is an issue there. But in terms of outlook, what you're hearing from your reseller customers in terms of backlog of projects that need to be completed at customers. What's the outlook as you look through the rest of the year?

Yeah. I would—Sean can go into more detail. But in general, we're seeing higher demand now and higher demand for the services we’re providing. A lot of the slowdown is on the hardware side, which pushes those out. Sean, I’ll let you add some more color to that.

So that’s right, Matt. I think Mike captured it. Since sort of mid last year, we've seen lead times for most of our hardware businesses nearly double. That will probably be the case for a couple of quarters until the whole semiconductor supply situation starts to normalize. But the good news is our visibility to the pipeline for our channel partners and users is only improving, as they're giving us backlog with visibility much further out. That gives us pretty good confidence that demand remains strong. As some of the limitations to traditional data center business continue to abate, things will ultimately look up even more nicely.

Your next question is from Joe Quatrochi with Wells Fargo.

Yeah, thanks for taking the questions. I'm curious, your leverage remains at an all-time low. Given your commentary is very positive on the forward demand, how do we think about what the right level for leverage is in the context of where your shares are trading today and then your working capital needs and just the expectations of interest rates increasing this year?

If you look at the working capital since the beginning of this uptick in demand, we've had to put less working capital in per dollar sale than we ever have in the past. If you think, anytime you’ve had growth rates like we’ve had over the last two years, in the past, we wouldn’t have been able to cash flow. This time, we’re cash flowing on a higher basis than we have. Expect more of the same of what you’ve seen because there is no physical way to get ahead of the inventory demand and get enough inventory to catch up with that demand. Just the market itself keeps us from spending money on inventory where frankly, I'd love to have it. If all the inventory shortages come in at one time, this cycle is over, and we're just not going to see it. I don't think it's a concern, nor do I think it's going to increase for this year, 2022. Chris, do you want to add something?

I would just add, given that, Joe, we've been very aggressive, obviously, with the buybacks $900 million last year. At current valuations, it's safe to say that does not slow down.

Got it. That's helpful. And then just a question, we're starting to see the component shortages actually impact the guys who make the equipment to increase semiconductor capacity. How do you prioritize your customers? It seems like you're in a position where you could help kind of alleviate some of the supply issues by advocating for certain components to go to customers that could help increase semiconductor supply?

What I'm going to say is everybody is getting what they can hand to mouth to produce their equipment. Do I stop giving semiconductors to people that are making heart machines for people who are doing transplants? Do I stop giving semiconductors to other industries that are helping people? Do I shut down automotive? No. Everybody has to manage their inventory effectively in a cycle. As long as those people have put their orders in and are on a first-in, first-out basis, that's how they're being supported largely by the semiconductor manufacturers. We're not talking about one product here. We're talking about thousands of products, and millions of products in the case of the broader market. Everybody is feeling the pain equally here. I can’t say that we don’t lean in and try to get extra product for certain situations. But the nature of this demand environment is very challenging.

Your next question is from Toshiya Hari with Goldman Sachs & Company.

Hi, gentlemen. Thank you so much for taking the question, and congrats on the very strong results. I had one clarification question and then a follow-up. As my clarification question, just on inventory, I think, Mike, you mentioned that value was up but the volume was down on your balance sheet. Was that a quarter-over-quarter statement or a year-over-year, or was that both? And do you think you can build inventory in the current quarter?

That’s a statement for both, quarter-over-quarter and year-over-year. Our forecast is not anticipating us building inventory units.

Got it. Okay. Thank you.

No, I don’t think we can over the next couple of quarters, just to finish that thought.

Got it. Okay, very clear. I just wanted to get your thoughts on the competitive landscape. The higher tide, I suppose, is lifting all boats, and you guys are performing really well. As you think about your business longer-term, the competitive dynamics between distribution and direct is something that I wanted to ask about. TI in particular continues to talk about the advantages they see in going direct to their customers. They hosted a call earlier this morning, and you talked about TI.com and those kinds of things. I think your other suppliers are taking a much more balanced approach. I'm curious, from your perspective, how are you thinking about that dynamic between distribution and direct? More importantly, within the industry, what have you done over the past couple of years during the pandemic to better position the company as you come out of the pandemic? Thank you.

If you—there are a lot of questions in there. I'll try to hit them all and be as concise as I can. On the changing dynamics of distribution, I haven't seen a lot at this point with those changing dynamics. Individually, with different manufacturers, sure, they've changed their dynamics, but some have increased their participation in distribution. So as you said, I think there's a balance out there, and there will be for a long time. We've seen huge increases in our engineering business over the last two years now. In fact, we're seeing a marketable change in customers looking to redesign some old products to ensure that they can still manufacture with as many types of products as they can. So we're seeing that come into play. Also, our supply chain business is really way up. That includes arrangements we have with customers to either ship their products directly to them, handle freight only, or manage their inventory. Those types of activities are up too. The activity that is way up right now is finding shortage components for customers. I expect that this business will always be there for us, but it's heightened activity right now. Think more broadly about the digital changes we've made in the business for customers to come online and do some of their own designs, to set up supply chains over the web and in the cloud business in ECS. We've done a lot if I highlight that over the last couple of years. Those businesses are just starting to come online and expect to be high producers in the future. So it's not all about products.

Your next question is from William Stein with Truist Securities.

Great. Thanks for taking my question. Mike, I'm hoping you can talk about the timing of the impact of price increases from suppliers. When they announce that, does that affect your backlog, and does it affect your customers' backlog on to you at the same time? Or is there a timing difference that might allow you to capture a better margin today? Thank you.

So far, what we've seen is sort of immediate price increases. Those immediate price increases affect everything. That is due to the nature of increases that the suppliers have received in making their product. That has to be passed on because they're not going to take losses on what they're selling to get more product in the market. There's an immediacy of this that I've never seen before. Usually, they would say, 'We're going to do it over the next couple of quarters, and we're going to hit this family or that family.' It’s the first time we've seen it. The price increases are still coming from some manufacturers that are getting a late start on it. It's not over, and it's not going to go away. I guess that's the answer. It's more immediate than it's ever been. So now the opportunity to really raise your margin because of price increases is not the activity that's on your mind right now. This is a supply activity market.

Yeah, that's helpful. I wonder also, you touched on this for a moment earlier. You said there’s a business where you just take shortages. I'm not sure if I'm capturing all of the work because of that small explanation. But it was an interesting dynamic that you called out as a specific business. What I'm hoping you might address is the portion of revenue that you're doing in the components business that relates to established franchise agreements where there's price protection. That's probably not super relevant in this cycle, but those sorts of agreements versus more arm's length transactions where you might be able to eke out better margins. Can you remind us what the split is between those two types of businesses, and whether it's changed in the last year?

I probably misspoke—we're doing more of that activity now, not a specific business. We have groups of people that are trying to chase down a product or maybe where we sold something before and that customer isn't using it anymore, and we can divert that product to another customer, and then the transaction comes through us. The selling company sets the price, and the buying company decides whether they want it or not, so that does exist. I think the mix is the mix. If demand starts to get fulfilled, then that activity will go down too. But it will probably stay the same percentage of the business, even when the demand goes the other way because there's always a shortage. That activity still goes on, but I don’t see a structural change in that in the future; it just happens to be more prevalent right now due to the shortages. The sales are elevated, right? You've got both things going on at the same time. The current margins reflect the mix between US, Asia, Europe, and the same mix issues we've had before. Other than that, we shouldn't have any other changes over the next year.

Your next question is from Jim Suva with Citigroup.

Thank you. I have a long-term strategy question. You know, we've been through the China trade wars, COVID, power outages, and tsunamis, all these types of things. I was just wondering, Chris and Mike, are you having discussions with your suppliers or customers about adjusting the model less from just-in-time and more inventory, housing stuff longer-term? Even if it's a price to carry or consignment inventory, I'm just wondering what the next risk thing can navigate and if there are active discussions around that or just discussions that are different from prior cycles.

That's a great question, Jim, and it's something we think about every day. The answer is yes; of course, we're looking at housing situations for customers where they might pay by the month or the quarter. However, we need to get into the carrying costs and working capital. Those kinds of models will start to materialize in the future. Although I can tell you with high confidence that nobody would have carried enough inventory to solve this problem. They might have had a quarter's worth of inventory, which would protect them for one more quarter because nobody is going to put a year of inventory across the board of everything they need. Typically, our lead times aren't bad. Now, we actually have to build fabs to get more products out the door, and that's just a waiting game because demand is so high. What is it that I heard? Ten million less cars being built over the next couple of years—that's a lot of components and a lot to catch up on. The answer to your question is yes, Jim. That is nirvana. We're working on those models right now. Those will be introduced. But first and foremost, it's just getting more supply for our current customers.

Thank you for everyone for joining us today. If you have any questions, you can reach out to me. We appreciate your interest in Arrow Electronics, and have a nice day.

This concludes today's conference call. Thank you for participating. You may now disconnect.