Avnet Inc (AVT) Q3 2023 Earnings Call Transcript

Welcome to the Avnet Third Quarter Fiscal Year 2023 Earnings Conference Call. And I would now like to turn the floor over to Joe Burke, Vice President of Treasury and Investor Relations for Avnet. Thank you, sir. You may begin.

Thank you, operator. Earlier this afternoon, Avnet released financial results for the third quarter of fiscal year 2023. The release is available on the Investor Relations section of the company's website. A copy of the slide presentation that will accompany today's remarks can be found via the link in the earnings release as well as on the IR section of Avnet's website. Some of the information contained in the news release and on this conference call contain forward-looking statements that involve risks, uncertainties, and assumptions that are difficult to predict. Such forward-looking statements are not a guarantee of performance, and the company's actual results could differ materially from those contained in such statements. Several factors that could cause or contribute to such differences are described in detail in Avnet's most recent Form 10-Q and 10-K and subsequent filings with the SEC. These forward-looking statements speak only as of the date of this presentation, and the company undertakes no obligation to publicly update any forward-looking statements or supply new information regarding the circumstances after the date of this presentation. Today's call will be led by Phil Gallagher, Avnet's CEO; and Ken Jacobson, Avnet's CFO. With that, let me turn the call over to Phil Gallagher. Phil?

Thank you, Joe, and thank you, everyone, for joining us on our third quarter fiscal year 2023 earnings conference call. I am pleased to share that we delivered another quarter of solid financial results, which exceeded the top end of our sales and earnings guidance. More importantly, we achieved these results despite the market uncertainty and macro headwinds affecting certain areas of our business. In the quarter, we grew sales 3% year-over-year in constant currency, and we delivered adjusted earnings per share of $2, which is our fifth consecutive quarter of adjusted earnings per share of $2 or greater. We continue to manage our operations with a sharp focus on efficiency. That, coupled with a stronger-than-expected performance in Europe and the Americas, enabled us to achieve a 5% operating margin in our Electronic Components business and a 4.8% operating margin for Avnet overall. During the quarter, we saw sales growth in the Americas and EMEA regions, offset by a sales decline in Asia. The decline in Asia was due to the expected seasonal impact from the Lunar New Year holiday and from an overall slowdown in demand in certain Asian markets. From an overall demand perspective, in the quarter, we saw continued strength in key vertical segments, most notably, industrial, transportation and defense aerospace. Demand signals continue to realign globally, resulting in lead times trending down on several component categories. However, we continue to see constraints and shortages on other products such as high-end MCUs, power, and MOSFETs. Lead times for these constrained categories have improved but more modestly than other categories. Overall, semi lead times are above pre-pandemic levels, and IPD lead times are modestly above pre-pandemic levels. The pricing environment remained stable during the quarter. At the beginning of the quarter, we still saw a handful of suppliers raise prices, primarily due to the higher input costs for the components. As a result of the current demand and lead time conditions, our book-to-bill ratio remains below parity in all regions at levels similar to last quarter, and our backlog remained relatively consistent with the end of last quarter. Inventory levels remain elevated across the supply chain and our inventory increased in the third quarter as well. Our customers' inventory levels are elevated due to a combination of softer demand in certain areas and overall market conditions as it relates to component availability. They continue to seek certain key constrained parts that are needed to complete their end products. As a result, we are managing through adjustments to our backlog. While cancellation rates are up, they are still within our normal range. We remain confident in the quality of our inventory and are working to improve turnover and ensure the inventory on hand is aligned to the near-term sales outlook. So with that, let me turn to the highlights for our business. Our Electronic Components business sales grew 4% year-over-year in constant currency, which led to EC delivering a 5% operating income margin. Our targeted margin is above 5%, so we are pleased that EC achieved this milestone this quarter as it demonstrates our ability to continue to drive operating leverage as we focus on top line sales growth. I am particularly pleased with the Americas team delivering another solid quarter of sales and operating income. Our Americas business delivered the highest level of operating income margin in the past several years. The EMEA region delivered its second consecutive record sales quarter, and our Asia business was able to maintain their operating margin despite the seasonally lower sales. Asia has been impacted by reduced demand in verticals like consumer and communications. We saw overall softness in key markets like China leading to quarter-over-quarter sales declines, which we expect to continue for at least the next two quarters. We achieved another quarter of record revenue and gross profit dollars for demand creation, further proof of the value we provide to our customers and supplier partners despite the mixed market conditions. Demand creation and customer expansion remain critical to us as well as our supplier partners. Just a few weeks ago, I was able to meet with leaders of three of our top ten suppliers. One of the first things I wanted to discuss was demand creation and how Avnet can continue to help them grow their sales and increase their customer accounts. The success of our engineering teams and the digital design tools have been key to improving our margins, particularly in the Americas and EMEA regions. Roughly one-third of our revenues come from demand creation. And this strategic priority is one of the elements that should enable us to achieve our higher margin goals in the medium term. Now let's turn to our Farnell business. Farnell's sales increased 9% sequentially and 1% year-over-year in constant currency. Farnell's operating margins held steady sequentially at 9% during the quarter and were down year-over-year primarily due to the expected unwinding of pricing premiums as certain components become more available. Overall, Farnell continues to be our highest margin business, and we expect the operating margin to expand as supply constraints on single-board computing devices ease in the first half of our fiscal 2024. To be clear, there continues to be a healthy backlog for single-board computers, and when the semi-electronic components become more available to complete their production, we expect to begin to realize improved sales as we move into the September quarter. We have made substantial investments in Farnell's inventory offerings over the past three years and plan to make additional investments where we see the potential for accelerated growth and a solid return. Our Farnell inventories have increased nearly 50% in the past year as Farnell has expanded its line card, replenished inventory levels, and continued to focus on both on-the-board and off-the-board growth opportunities. Farnell's e-commerce business mix continues to improve with 56% of Farnell's total sales and 74% of total orders placed through their e-commerce platform. We remain excited about Farnell and continue to see an opportunity to leverage Farnell's and Electronic Components' unique and synergistic collaboration, which is a key differentiator for Avnet. Our near-term milestone is driving Farnell to over $2 billion of annual sales at double-digit operating margins. While we are pleased with the sales and earnings results for our third quarter, we are closely monitoring market conditions and the impact of component lead times on our backlog and inventory levels as products become more available. We also continue to manage through the impact of inflation and higher interest rates on our overall business, which we have successfully done over the past few quarters. In the same way that demand outstripped supply over the past two years, supplier product has begun to exceed overall demand. Our current view, supported by our supply chain industry tracking metrics, is that we are experiencing an inventory correction that will take a few quarters to play out. As we manage through this correction phase, we will continue to work with both our supplier partners and customers to regulate incoming orders and prioritize getting the right inventory levels to support sales and improve our turns. Although the market correction is underway, we are not overly concentrated to any supplier end market. We continue to believe that due to our balanced line card, combined with the diverse end markets we serve, we are well positioned to outperform the overall components market and gain market share and expand operating margins when market conditions normalize. With that, I'll turn it over to Ken to dive deeper into our third quarter results.

Thank you, Phil. Good afternoon, everyone, and thank you for your interest in Avnet. With another quarter of year-over-year sales and operating income growth, we believe our third quarter financial performance demonstrates further progress toward achieving our medium-term financial targets, led by the 5% operating income margin achieved in our Electronic Components business. Our sales for the quarter were $6.5 billion, modestly higher year-over-year and exceeding the top end of our guidance range. In constant currency, sales growth was 3% year-over-year. On a sequential basis, sales were down 5% in constant currency, which is lower than our historical seasonal trend of sequential sales growth. Sales grew year-over-year, led by EMEA with nearly 10% growth and the Americas with 5% growth. This sales growth was offset by a decline in Asia of 10%. In constant currency, year-over-year sales grew 15% in EMEA, 5% in the Americas, and declined 8% in Asia. From an operating group perspective, Electronic Component sales grew 1% year-over-year or 4% in constant currency. Quarter-over-quarter, Electronic Component sales were 6% lower in constant currency. Farnell sales declined 3% year-over-year, but were up 1% from the prior year in constant currency and 9% higher sequentially in constant currency. Excluding sales of single-board computers, Farnell sales grew 2% year-over-year in constant currency. For the third quarter, gross margin of 12.5% improved 79 basis points quarter-over-quarter and was relatively flat year-over-year. The sequential improvement in gross margin was primarily due to higher gross margins across all of our regions and from the seasonal shift in sales mix from Asia to the Western regions experienced every third quarter. We continue to maintain discipline around SG&A expenses as adjusted operating expenses were $497 million for the quarter, down 2% year-over-year and up 3% sequentially. Foreign currency negatively impacted operating expenses by $12 million in the third quarter compared to the second quarter. As a percentage of gross profit dollars, adjusted operating expenses were 61% in the quarter, 138 basis points lower than a year ago and 41 basis points lower than last quarter. For the third quarter, we reported record adjusted operating income of $315 million, which increased 4% year-over-year and grew more than 2x greater than sales in constant currency. This is the ninth consecutive quarter of operating income growth exceeding our sales growth by more than 2x. Our adjusted operating margin was 4.8% in the third quarter, which improved 15 basis points year-over-year and improved 36 basis points quarter-over-quarter. By operating group, Electronic Components operating income was $305 million, up 15% year-over-year. EC operating margin was 5%, up 64 basis points year-over-year and up 34 basis points quarter-over-quarter. All three EC regions saw year-over-year operating margin expansion, led by our EC Americas business, which expanded operating margin by more than 80 basis points. Farnell operating income was $41 million, down 41% year-over-year. Farnell operating margin was 9% in the quarter, down 589 basis points year-over-year but held steady quarter-over-quarter. Farnell operating margin continued to be impacted by the expected unwinding of pricing premiums experienced due to component shortages and from unfavorable changes in foreign currency exchange rates. During the quarter, the Farnell operating margin was also impacted by certain nonrecurring expenses recognized in the quarter. Farnell continues to be the highest margin business within Avnet, and overall operating margins continue to benefit from our focus on their growth and continued investment in their inventory, systems, and distribution centers. We expect Farnell operating margins to remain at similar levels for the fourth quarter of fiscal 2023, with improvements in operating margin beginning when certain components impacting the completion of single-board computers become more available. Turning to expenses below operating income. Third quarter interest expense of $72 million increased by $46 million year-over-year and $13 million quarter-over-quarter, primarily due to a combination of increases in interest rates and from higher average borrowings to support working capital increases. This increase in interest expense negatively impacted adjusted diluted earnings per share by $0.37 year-over-year. Our adjusted effective income tax rate was 24.5% in the quarter. Adjusted diluted earnings per share were $2 for the quarter, which decreased 7% year-over-year but were flat quarter-over-quarter. Differences in foreign currency exchange rates negatively impacted adjusted diluted earnings per share by $0.09 year-over-year. Turning to the balance sheet and liquidity. During the quarter, working capital increased by $232 million, including a $381 million increase in inventories. Foreign currency negatively impacted the increases in working capital by $62 million overall, of which $45 million impacted inventory. As a result of this working capital increase, working capital days were 96 days for the quarter, which increased 12 days quarter-over-quarter. Our inventory days increased by approximately 9 days and our receivable days increased by approximately 2 days quarter-over-quarter. Our inventories grew during the quarter, and as Phil mentioned in his remarks, this is consistent with the broader trend across the supply chain and our customers. The quality and freshness of our inventory continue to be good. Consistent with last quarter, inventory turnover slowed in the third quarter as customers requested rescheduling of product shipments continued as customers managed through their own inventory and production timing challenges. Our return on working capital continues to be more than 2x greater than our cost of capital, however. In the third quarter, we generated $18 million of cash from operations, and we expect to generate positive cash flow from operations in the fourth quarter. Our debt decreased by approximately $80 million. We ended the quarter with a gross leverage of 2.3x, which was an improvement from the second quarter. At quarter end, we had approximately $750 million of available committed borrowing capacity, and our teams continue to work on selling inventory on hand and collecting receivables to provide additional liquidity. With regard to our capital allocation, in the near term, we continue to prioritize the needs of our business, including working capital and capital expenditures. During the third quarter, cash used for capital expenditures was $26 million. For the long term, we remain committed to our roadmap of delivering a reliable and increasing dividend and share repurchases to increase our shareholder value when we believe our shares are undervalued by the market, which continued to be the case in the third quarter. In the third quarter, we paid our quarterly dividend of $0.29 per share or $27 million. We have $319 million left on our current share repurchase authorization as we enter the fourth quarter. Book value per share improved to approximately $50 a share or a sequential increase of approximately $2 a share due primarily to our strong earnings for the quarter. Turning to guidance. For the fourth quarter of fiscal 2023, we are guiding sales in the range of $6.1 billion to $6.4 billion and adjusted diluted earnings per share in the range of $1.60 to $1.70. Our fourth quarter guidance is based on current market conditions and implies a sequential sales decline of 1% to 6%. This guidance assumes below traditional seasonality in sales across all regions. This guidance also assumes similar interest expense compared to the third quarter, an effective tax rate of between 22% and 26% and 93 million shares outstanding on a diluted basis. In closing, I want to thank our team for delivering another solid quarter of year-over-year operating income growth and margin expansion. Our team continues to deliver great results while demonstrating our value to our customer and supplier partners. With that, I will turn it back over to the operator to open it up for questions.

Our first question comes from Ruplu Bhattacharya with Bank of America.

Phil, last quarter you anticipated that in the third quarter, revenues from both Europe and the Americas would remain flat or slightly decline sequentially, but they actually increased. What factors contributed to this better-than-expected performance, and which products or sectors performed better than you anticipated? Additionally, how do you assess the current demand environment compared to three months ago? Do you believe the end markets are showing strength or weakness? Could you also address the pricing environment? As lead times decrease, have you noticed any shifts in pricing?

Thank you, Ruplu. I appreciate that. We'll begin with Europe and the Americas. It's not just one specific area; there are a few we've mentioned. Automotive and transportation are performing very well in our sector, which includes e-bikes, cars, trucks, and everything else related to transportation, alongside the industrial market. The industrial sector has been stronger than we had expected a quarter ago. Additionally, in the Americas, the defense and aerospace sectors have been quite positive for us. Overall, it's a diverse range across the regions, which is encouraging. Regarding pricing trends, we are currently maintaining our position. At the start of the quarter, several suppliers increased prices by about 15% to 20%, which remains uncertain as it pertains to specific technologies rather than the entire market, since input costs are still a factor. However, the pricing environment appears to be relatively stable at this moment. As for the demand environment, we are anticipating some typical seasonality during this quarter. Overall, I would describe it as steady. There is some inventory and buildup across various verticals, but for now, it seems to be holding steady, which aligns with the guidance we provided for our June quarter. It's indeed a mixed situation out there, Ruplu.

Thank you for the details, Phil. I’d like to ask Ken about inventory. It appears that inventory increased by 8% sequentially. Was there a timing issue you mentioned? When considering inventory, working capital, and free cash flow, what is your near-term target for the cash conversion cycle? Additionally, how should we view free cash flow moving forward?

Yes, I believe that with the inventory increase, our working capital is higher than we would prefer. Our goal is to reduce it back into the 80s, specifically the low 80s. This situation is partly due to timing; we received some items at the end of the quarter, but much of it was received during the quarter and could not be shipped out. There isn't a single cause for this. Approximately 10% is due to foreign currency, another 10% relates to Farnell, and the remaining 80% is largely from the EC business across all regions. Looking ahead to the next quarter, we anticipate that inventory levels will remain stable. However, we still expect it will take a couple of quarters to effectively manage the elevated inventory levels.

Got it. And Ken, if I can squeeze one more in real quick. So the core components margins, even on sequentially $200 million lower revenues, it grew to 5%, so 30 basis points sequentially. So in present performance, can you help us break that down to how much was because of mix versus volumes versus pricing? And as we think about this going forward, I mean, do you think that this level is sustainable or at what revenue levels can this margin level of 5% be sustainable?

Yes. I think we need to have in the mid-$6 billion to make the 5% sustainable. I will say, as we kind of look out there, we don't really foresee sales in any quarter dropping below $6 billion or really operating margin dropping below 4% as we currently see it. But getting into the current quarter, we did have a favorable mix. So about half and half, half of it was a more favorable mix than we thought. But I would point out for EMEA and Americas, it was still below normal seasonal growth. So although we did better than expected in those regions, coming out of the December quarter, it was still lower in terms of growth rates than we'd expect to see in a normal environment. And the rest was a little bit better margin in each of those regions. So they did drive a better mix. We talked about demand creation. So it's all those things we've been talking about helped to contribute to a little bit higher gross margin in all the regions as well.

And the next question comes from the line of Melissa Fairbanks with Raymond James.

Congrats on the great quarter and guide. Really nice progress on the margins. It's really good to see in this kind of an environment. I know you're probably tired of talking about it, but I'd like to dig on the inventory levels. Thanks for providing the color on FX impact. I'm curious if price inflation is also impacting the new inventory you're bringing in? You've seen continued price increases in the past quarter. We've heard a few suppliers so far this quarter signal that more price increases are coming. And then separately, there are a number of suppliers that have been holding inventory back from the channel, including in distribution. As the supply continues to ease, we expect these suppliers to begin releasing more inventory. Is there a potential for your inventory levels to continue to rise as this happens?

Melissa, I'll address the first part. I would say that pricing is certainly affecting both our sales growth and inventory levels, but the impact is less pronounced than it was a few quarters ago. In terms of the inventory increase, I believe around 80% of it is attributable to the core business, and I would estimate that no more than 25% is due to pricing, which is reflected in our sales growth as well. Regarding the possibility of inventory levels rising, that is a potential scenario we are trying to manage. Inventory rose more than we anticipated this quarter. However, if certain suppliers begin supplying us with more inventory due to our demand or orders, we are addressing the few suppliers that contributed to the increase this quarter. It's all part of the ongoing dynamics of inventory management.

Yes. Thanks, Ken. And Melissa, this is Phil. Thanks for the comments and the questions. On the inventory, I want to reemphasize, it's fresh inventory. It's good inventory. It's not aging. And getting to a few constraints, there's a handful of concentrations where the inventory has really grown. So it's not across the board, right? So it's not every line or every technology. So it's really, I would say, the classic case there with the concentration in a handful. And then the other thing is we're balancing the customers' requirements. Kind of going back to the previous, how do we see demand and it depends on the vertical, but we're managing the customers, how much can they take? Maybe they might have a little bit too much inventory. So we're trying to manage being in that center technology supply chain, the suppliers and the customers and what the real needs are. And we're in for the long haul with these customers. So where they maybe can't take it this quarter, how can they take it next quarter and then maybe we have to extend a little bit of accounts receivable as you heard went out a little bit as well. It's all kind of hand-to-hand combat on every one of these deals.

Okay. Great. That's super helpful. Maybe just one really quick follow-up, this might be for Ken. So this is definitely not 'normal' cycle because of some of these supply constraints and changing behavior of holding more inventory on the supplier side. Does this potentially change the normal countercyclical pattern of the working capital release in your model?

I guess, I wouldn't say we see it that way. I think it could take a few more quarters to get that flow going, right? Because typically, that normal seasonality would be sales go down, so therefore my inventory goes down and I collect the receivables from those higher sales, and that's what creates the cash. That still holds true, but the inventory hasn't gone down, right? We look at more cash when we got this quarter, next quarter, but the key is going to be getting the inventory down to actually create that larger countercyclical effect. So we don't believe it's changed. We have not seen the inventory whereas you've seen in other cycles, the inventory goes down a couple of quarters after the sales go down.

And the next question comes from the line of Matt Sheerin with Stifel.

Yes, Phil, I think you mentioned that you anticipate the inventory correction will take a few quarters. It appears that you are behind some of your suppliers since your business is clearly holding up. You are among the few semiconductor companies that are still showing year-on-year growth. It seems like you are just beginning this process. Regarding your visibility on how long it will take, do you expect sequential changes or trends that are less than seasonal, at least for the rest of the fiscal year or calendar year?

Yes, thanks, Matt. First of all, the typical seasonal trends have been disrupted, making it difficult to provide a clear outlook. Our guidance reflects this situation. Based on our backlog, inventory, and revenue forecasts, I estimate that we will experience a burn off over the next two to three quarters. This cycle is quite different from what we’ve encountered before, and we’re seeing many mixed signals. For instance, while some sectors like PC consumer are declining, others such as industrial and automotive remain steady or have even improved. This mix of signals is challenging, but we believe the demand reflected in our forecasts, based on customer feedback, supports a two to three quarter cycle. I see this more as a correction than a typical cycle.

Got it. And in terms of your own inventory build, is that a function of suppliers maybe shipping ahead of their lead times because of their own maybe seeing cancellations from other customers and then you seeing cancellations and pushouts from customers and that's why sort of it's piling up, if you will?

I don't think the suppliers are shipping early. They are catching up because lead times are improving, which means they are aligning with the original delivery dates. It's important to note that they are not shipping anything ahead of schedule. Products are not arriving quarters sooner, and while they may be recovering quickly, we cannot pass that on to customers. Even if they fail to meet their targets, they cannot produce everything in a short timeframe, so they have to adjust their manufacturing plans. Everyone's situation is unique, but I do not believe suppliers have the intention or are actually shipping early right now. We are not observing that trend.

Got it. And I know you're guiding revenues down roughly 4% sequentially. Would you expect all regions to be down sequentially?

Yes. I think normally Asia would see a small increase after the Lunar New Year, but the increase is less than we would like. EMEA and the Americas are expected to decline, making the overall mix less favorable than in the third quarter, with the revenue around $6.25 billion.

And that's typical in the West, Matt. Europe and America coming down from the March quarter typically are one of the largest quarters.

Okay. And just lastly on that interest expense, which is up obviously significantly year-over-year, and you're still guiding to that $70 million level or so. I would think that that would be a priority for you in terms of your balance sheet to try to work down those short-term borrowings. Is there a plan there?

Yes. Matt, I mean, I think that's the priority as cash gets generated, we pay down the debt, and I think we've kind of hit the plateau there with the peak there, the $70 million. But yes, we got to work that down as well. And clearly, you can see the headwind that's created with the EPS, right? Our EPS would be a lot more robust hadn't we had that additional expense to fund the working capital.

Our next question comes from Joe Quatrochi with Wells Fargo.

Yes. My first one, I wanted to ask about the change in collections that you're seeing. I think you talked about that last quarter and maybe referenced it again this quarter. I guess, are you seeing that spread to additional customers? And then kind of coupled with that, were there any sort of change in customer behavior, just given kind of some of the banking issues that we've seen across several of the regional banks?

Thank you, Joe. I believe the overall quality of our receivables and their aging has improved slightly since the end of December. The fluctuations we saw in December were largely due to our customers' year-end processes. Generally, payment terms may be extended a bit, but we are successfully collecting payments. We are not currently facing any immediate risks from customer bankruptcies, which is also relevant to our inventory situation. We feel optimistic about our collections and our collaborative efforts with customers. Regarding the banking environment, we commend our treasury team for successfully closing a debt deal just before some recent disturbances, which enhanced our liquidity. We appreciate having secured financing ahead of the noise. Some of our customers have been affected by issues within certain regional banks, but overall, we have not experienced a notable impact.

Yes, I would like to add that accounts receivable are strategic for us. We are actively working with our customers, so there are no real surprises regarding accounts receivable. As we receive inventory, if customers cannot take it right now, we will hold a bit more inventory or potentially extend the receivables. These discussions are conducted one-on-one with our customers because we are committed for the long term and want to support them. I have been very proud of the credit and collections team; they have done an exceptional job so far.

Got it. And then just as a quick follow-up, and I apologize if I missed it. You said that total book-to-bill was relatively the same as last quarter. Did that change at all really by region?

Not really. It's below parity, Joe, and some of the negative book-to-bill is due to us moving backlog as well. We're adjusting where suppliers are allowing us to be, and if some of the NCNRs receive some relief, we're managing that too. Some of this is self-inflicted for the right reasons, as suppliers understand what the real pipeline is. We want to check in with our customers and ask if they need the product or not. Much of it is on us. Additionally, we're not seeing as many cancellations; the cancellation rates are generally within our expected range of 25% to 30%. We are seeing some pushouts, which isn’t necessarily a bad thing, but customers are still hesitant to cancel their backlog, which is interesting.

Everyone, there are no further questions at this time. I'd now like to turn the floor back over to Phil Gallagher for any closing comments.

Yes. Let me just thank everyone for attending today's earnings call and look forward to speaking to you again at our fourth quarter fiscal earnings report in August. Have a great day. Thanks.

And ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation, and have a great day.