Q3 2022 Arrow Electronics Inc Earnings Call

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Good day and welcome to Arrow Electronics third quarter 2022 earnings Conference call. Please note today's conference is being recorded.

Lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer session. If you would like to ask a question. During this time simply press star followed by the number one on your telephone keypad. If you would like to withdraw your question Press Star followed by the number one again.

At this time I would like to turn the conference over to Rick <unk>. Mr. <unk> you may begin your conference.

Okay. Thank you.

Good day and welcome to the Arrow Electronics third quarter 2022 earnings Conference call.

With us on the call today are Sean Kerins, President and Chief Executive Officer, Raj <unk>, Senior Vice President and Chief Financial Officer.

During this call, we'll make forward looking statements, including statements about our business outlook strategies 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 on today's call are non-GAAP , we have reconciled those to the most directly comparable GAAP financial measures in our 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 Dot Com, along with the CFO commentary the non-GAAP earnings record.

Filiation and a replay of this call.

Following our prepared remarks today, we will be available to take your questions I will now hand, the call to our president and CEO Sean Kerins.

Thanks, Rick and thanks to all of you for joining us today.

Before I discuss our most recent results I'd like to share some thoughts about my first full quarter as the CEO of Arrow electronics.

You know I spent much of this time meeting with suppliers and customers who continue to validate the essential role we play in their success.

I've also had the chance to engage our leadership team to review our strategic priorities.

Floor opportunities for accelerated growth and begin the process of refining our roadmap for the years to come I look forward to sharing more about this with you over the coming quarters.

Three months ago, I expressed how excited and confident I am about the future of the company today.

Today, I am even more motivated to lead this great company on a journey to realize its full potential as well as the noble purpose, we fulfill on the process.

I'm also very pleased today to be joined by our new CFO Raj Agarwal Raj will be a key contributor towards helping us focus our resources and investments for growth.

<unk>, the totality of arrows capabilities to extend our market leadership.

And advancing stakeholder engagement to our finance and other support teams throughout the World I believe his strong financial acumen and business experience make him the ideal executive to lead our finance and accounting team and be an instrumental part of driving the continued growth and success of arrow.

Now turning to our results I'm delighted to report that this was our best third quarter ever with sales growth of 14% year over year on a constant currency basis.

This is a function of strong performance by both our global components business and our global Enterprise computing solutions business as well the dedication and focused execution by our team helped us deliver strong quarterly sales gross profit operating income and earnings per share.

While market conditions remain challenging they also provide ample opportunities for us to showcase our commitment to the success of our customers and suppliers.

In our global components business demand for electronic components and associated design engineering and supply chain services generally remain healthy on a constant currency basis sales grew 15% versus prior year.

<unk> have returned to a normalized rate following the exceptionally high levels, we have experienced since late 2020.

Yet despite bookings coming off all time highs, we still carry a significant open backlog.

While we are seeing some orders pushed out we are not seeing cancellations to any material degree lead.

Lead times, while relatively stable since prior quarter remain extended for the majority of products, we sell while supply is improving modestly it is still a sufficient to support the delinquent backlog, which has built over many quarters. Therefore customer services support remain our top priorities and our teams continue to work tire.

Fleet to support the deliveries needed by our customers.

Both the Americas, and EMEA regions produced year over year growth rates in excess of 20%.

As both regions experienced robust demand across most end markets and industries in particular transportation industrial.

In aerospace.

The business in both regions remains very healthy due in part to our ongoing investments in design and engineering capabilities, which have generated growth and demand creation revenue and.

In the Americas, we did see some softness in our shortage market services as bookings normalize and supply begins to improve.

This was the primary driver to the sequential sales decline in the Americas as well as the margin compression for the global components business overall.

Sales in our Asia region declined due to weakening demand in several end markets along with supply chain constraints as fewer parts were allocated to the region how.

However, overall backlog in the region remains healthy as we benefit from servicing a variety of industries and providing products from a diverse group of suppliers. We are not overly concentrated in any one piece of the market.

Again in this challenging environment, we continue to work with our suppliers to secure parts for their most critical customer needs.

In our enterprise computing solutions business sales for the third quarter were above the midpoint of our guidance as demand for more complex enterprise. It content was healthy in both regions on a constant currency basis sales grew 10% versus prior year fueled by growth in both regions while supply constraints.

A challenge we are starting to see some benefit from our historically high backlog, we continue to see strength in cloud software and enterprise it infrastructure and are well positioned for the transition to.

Service.

In EMEA, we experienced strong growth in all of our markets and technologies in the Americas. Our growth came primarily from strength in compute storage and data intelligence, we continue to measure.

This business on operating profit growth and we are pleased to report 9% growth in operating income on a year over year basis. We believe the prospects for this business will continue to improve across the balance of 2022 and into 2023.

Now before handing over the call I do want to reiterate that our backlog remained strong and pointed out that our design win activities are at record levels. While there are indications that supply demand imbalances will moderate over the coming quarters I am confident that our capabilities are unmatched and then we are uniquely positioned to help our customers.

Suppliers navigate the road ahead with that I will now hand, the call over to Raj to provide more details on our results and our go forward expectations. Thanks, Sean and thank you for the warm welcome to Arrow, a few moments ago, Shawn shared his excitement and confidence about the future of Arrow rideshare isn't.

The hasnt been an extremely grateful for the opportunity to join the company and help it realize its full potential.

Impressed with the strong talent level in the organization.

These business expertise and significant opportunities for long term growth throughout the business.

I look forward to engaging more deeply with shareholders employees and partners over the coming months.

Turning to our results.

Third quarter sales grew by 9% versus prior year or 14% on a constant currency basis.

Changes in foreign currencies impacted sales growth by approximately $380 million year over year, which was slightly more than our expectation of $350 million.

Sequentially the business declined by 2%, primarily due to currency impacts.

The average Euro dollar exchange rate for the quarter was $1 one to one euro compared to our previous expectation of $1 two tier one euro.

Third quarter gross margin of 12, 8% was up 20 basis points year over year, driven by higher margins in both global components and global Enterprise computing solutions.

Gross margin declined 30 basis points sequentially due to the normalization of our shortage market activities discussed earlier.

Operating expenses as a percent of sales were seven 3% down 50 basis points year over year.

Interest and other expense totaled $51 million above our prior expectation of $46 million due to higher rates on floating rate debt and higher borrowings the.

The effective tax rate for the quarter was 23, 5% in line with prior expectation and the target long term range of 23% to 25%.

Turning to cash flow and the balance sheet.

Our third quarter operating cash flow was $141 million.

Our cash cycle of approximately 63 days increased three days from the second quarter and 12 days year over year, primarily due to inventory increases which are largely related to pricing.

We have continued to make inventory investments to support customer demand and backlog and generated strong returns in the process. Our return on invested capital and return on working capital remained near all time highs.

At the end of the quarter net debt totaled $3 $5 billion in total liquidity stands at over $2 3 billion, including cash of $334 million. Our liquidity remains in one of the strongest positions. We have had in recent periods.

Our strong financial position and flexible balance sheet positioned us to maintain our commitment to returning cash to shareholders due to repurchase of $259 million of shares during the quarter.

At the end of the third quarter, our remaining repurchase authorization stands at $629 million.

Please keep in mind that the information I've shared during the call today is a high level summary of our financial results for more detail regarding the business segment results. Please refer to the CFO commentary, which we published on our website. This morning.

Note that the CFO commentary includes information on our fiscal calendar closing dates.

Now turning to guidance.

Mid point sales and EPS guidance implied records for the fourth quarter.

Our guidance reflects normal seasonality and a continuation of the current market conditions, which we have discussed.

Midpoint global component sales reflects an expected growth rate of 4% compared to prior year and 9% on a constant currency basis.

Our forecast suggests enterprise computing solution sales will decline, 2% year over year, but grow 5% on a constant currency basis.

We estimate that the strengthening of the U S dollar compared principally to the Euro will result in a reduction to sales.

Growth of $420 million and EPS growth of 25 cents.

Compared to the prior quarter, we estimate that the impact will be $100 million to sales and seven sensitive Etfs.

I will now turn the call over to the operator for Q&A.

At this time I would like to remind everyone in order to ask a question. Please press Star then the number one on your telephone keypad, we'll pause for just a moment to compile the Q&A roster.

Okay.

Your first question comes from the line of Matt Sheerin with Stifel.

Thank you.

Hello, everyone. Good afternoon.

Just my first question Shaun.

Hoping you can.

Provide a little bit more color on.

On the bookings.

The backlog within the components business.

You said it sounds like book to Bill is around 1%.

If you could clarify that and in terms of the push outs youre seeing.

What are the reasons, we're hearing from some others that.

There is an imbalance and customers are waiting for other parts.

Is it that or other issues and are there any specific markets, where you're seeing more of that versus others.

Sure Matt.

Happy to do some of that so.

You are right our book to Bill rates have normalized we're at parity.

That's for sure.

As we said demand in China is a little more challenging than it is in the west.

Thank the demand trends in the west are more broad based.

Peer to be holding up certainly in the fourth quarter.

I think if you look at our backlogs our backlogs are still at.

All time highs they came down from.

Its most recent high in Q2, but just a little bit one thing our teams continue to do a great job of is working with customers and suppliers to validate and re validate that backlog on a constant basis.

So it's still well beyond historical levels, maybe 25% or more of our backlog is what we would call delinquent.

We think that through all the validation work that we do.

Is that a good chunk of the backlog is firm versus forecasted.

It gives us some confidence in our outlook.

Certainly for Q4, you asked about push outs.

We're seeing some push outs that's been mainly in China.

But as I said earlier almost no cancellation activity.

To the extent that customers are looking to push out orders. It has more to do with them thinking about their production requirements for the long term.

Demand patterns have not.

Dropped precipitously, except for maybe in segments that are closely related to consumer technologies.

Okay. Thanks for that and then.

As a follow up just on the on the margins it looks like based on your guidance gross margins are going to be roughly flat quarter on quarter, So down 50 basis points year on year.

Imagine part of that is due to the softness you're seeing in that.

Shortage services.

So I think thats called converge.

Are there any other reasons for that is it mix issues or anything else.

So Matt if you look at the margin compression, we saw in Q3, and some of which we'll see in Q4, you're right. It's primarily a function of just.

Just the normalization, we're starting to see in the market and the <unk>.

Softness in the shortage related services that we provide.

It's probably good to go back and just remind everybody.

What we talked about when we described the drivers for our operating margin expansion over the past several quarters. We said it was one part mix.

Both region and technology is one part pricing, but it was also one part structural and what gives me confidence about the future is.

While shortage related services are one part of our structural value add the reality is we've invested for lots of other capabilities as well.

We continue to see the benefits of our engineering investments to capture design win margins.

I think as I said in the script, our demand creation revenue mix improved both sequentially and year on year and that's I think still has runway units for for many years to come.

Our supply chain capabilities are now helping us serve our customers.

And different and value adding ways.

For example, we are now finding ourselves with a viable role in the automotive industry.

In a more direct capacity than we would have ever imagined in the past.

So when I look longer term.

Yes, we will see some margin compression as it relates to shortage, but theres a lot of other structural.

The investments that we've made to the model, which I think point us to.

Sustainable returns.

Okay that was very helpful. Thank you very much.

Your next question comes from the line of Melissa Fairbanks with Raymond James and Associates.

Hi, guys.

Thats.

Hello, good good thanks.

I was just wondering you had mentioned that on the inventory increase a lot of the increase was largely related to pricing.

Was just wondering in general what are you seeing in terms of pricing across the portfolio either from the suppliers.

How much of that is maybe providing a tailwind to revenue or operating profit.

And then secondarily as your inventory you are investing in inventory kind of higher prices is there a risk because it does kind of supply starts to normalize maybe as we go into next year some of the pricing that youre able to pass along.

Also normalizes.

Hi, Melissa.

Sure I think I can easily speak to both of those questions. So if we tackle kind of pricing first just so you have some broader context.

Price increases did drive the bulk of our year over year revenue growth.

We have seen price increases kind of abate in terms of number and frequency, but they've not disappeared altogether.

And what we were able to kind of monitor in the third quarter is that we still have been able to pass on price increases and haven't yet seen any real erosion.

Unless demand were to drop precipitously.

Prices are going to remain fairly stable, especially in.

The technology sets.

Still with longer lead times.

If we go back to inventory and kind of look at it overall, we were actually pleased that it only creeped up maybe 4% quarter on quarter I think that was the number that was progressively less than we saw in Q2 and Q1 and so forth. So.

I think that Youre right.

The increase you see inventory is almost entirely due to price increases are units were still down sequentially and year over year, but I'd say, we also feel pretty good about the quality of the inventory on hand.

It's relatively current.

And I am not real concern that we won't sell through it given the size of the backlog.

That we still see in front of us and again given the work we do to continue to validate.

Its ferocity.

Great. Thanks, Thats extremely helpful. Maybe.

Maybe just one quick follow up on lead times are there any product sets or categories.

Where lead times are still extended beyond normal ranges or or is the supply starting to improve kind of across the board.

It's a mixed bag Melissa.

There are certain technology sets.

Things like memory, and CPU, where we've seen lead times come in somewhat but there's still a great number of categories that for which lead times remain extended.

And so for which we still carry.

Significant backlog in.

That's sort of give some support to my point that I don't think prices are necessarily coming down anytime soon.

Lead times, we will continue to come in as.

As supply normalizes, but I think that's going to play out over over multiple quarters and I think the.

Overall demand in the market is still in excess of.

Our ability to supply it and so I think we're going to watch this play out quarter to quarter, but I feel pretty good about where we sit today with our Q4 outlook.

Excellent. Thanks, very much that's all for me.

Your next question comes from the line of <unk> <unk> with Bank of America.

Thank you for taking my questions.

I have two for Sean if I can sneak one for you Raj so that would be great.

Sean I wanted to ask you first on components.

It looks like from the prepared remarks.

The year over year revenue decline in Asia, which seems to be somewhat weaker performance in one of your main competitors. So can you talk a little bit about what impacted your revenues in Asia and did you see any share shifts in that region and as we look into the December quarter should we expect Asia to be a stronger ship to be stronger in <unk>.

December quarter.

So what we saw in <unk>.

In the third quarter flu was was largely a function of the macro headwinds.

Covid related lockdowns that we experienced in China, they were a little stronger and a little more persistent.

Then we saw in Q2, we did also see a rotation of some level of supply from the east to the west.

Which meant a portion of our delinquent backlog in that market went unserved.

But I think the important point to kind of move to maybe at a higher level group fluids to think about our strategy. We've been very intentional with our strategy in Asia, and especially China to focus on the industrial and mass market, where we continue to see really healthy returns for our investments and then to a much lesser degree.

The higher volume lower return segments like mobility and compute.

So as I look at that market.

At some point the the economic headwinds will.

We will diminish.

And the economy will again improve I wish I could tell you exactly when that will be but I am confident it will happen.

Given our focus on the mass market given the breadth of our line card given the.

The substantial size of our customer base.

I really like our position in the Asia market for the long term.

Okay. Thanks for the details there Sean one more for you in the ECS segment in the Americas, you talked about muted growth due to supply chain constraints. So maybe can you talk about which parts are were short and what was the impact on your sales from from not having those parts.

So if you go back a little bit through flu our business in North America has always been a little bit more weighted to infrastructure as compared to our business in Europe , which is a little bit more weighted to software and cloud so.

Our backlog in that business is also at all time highs.

And therefore, if you kind of map that to our regional mix North America carries a disproportionate amount of it some of the progress we did make in the quarter was the function of backlog relief, but the backlog levels are still high.

I don't think thats going to improve.

In the near term.

It tends to follow improvements in the semiconductor supply chain.

By a good couple of quarters.

But we will get benefit from that that backlog over time and Thats why the.

The top line in North America, maybe not as robust as what we saw in Europe .

As we look forward I think again, we're continuing to make progress with.

Software and cloud.

And other aspects of our.

Sort of as.

As a service strategy and I think the momentum will continue.

Continue to look better for us in North America over time.

Okay. Thanks, Thanks for the details there Sean I appreciate it.

Roger One question for you nice to have you on board yes.

Thank you.

I was just wondering if you can talk about your thoughts on two things one is <unk>.

On the free cash flow expectation the working capital.

Should we think about cash conversion cycle trending over the next couple of quarters, and then free cash flow for the year and then also just in general your capital allocation priorities I mean as you.

Choose between buybacks or further delevering, our M&A I mean, just your thoughts on how you prioritize those different choices.

Yes, absolutely.

Let me take the second one first the capital priorities.

Our primary.

<unk> really are to invest in the business.

We expanded our.

Over the last couple of years, we've invested a lot in our working capital and that continues to be our number one priority to drive organic growth and expansion.

And then.

Though we have not been too active on the M&A front. The last couple of years, we continue to evaluate M&A opportunities and that could be a use of cash and then.

And then lastly, we use our excess cash flow over time, and I say over time, because this business does go in cycles to buyback our stock to the extent that we see as being attractive and we see our stock at this stage given quite attractive as an investment and so that's why we've been buying back our stock.

When we think about free cash flow and working capital.

We continue to have a significant opportunity for more leverage as we need it.

So we've continued to invest in the inventory as you've seen our inventory balance has gone up over the last year or so.

And we have.

We.

Sean said we have.

A.

Strong backlog and strong demand for the inventory balances that we have and so we feel good that we can clean up that inventory over time.

And really drive good cash flow in the business. So I don't really see any issues with the business and we have plenty of capital capacity in the business today.

There are certainly invest more in the inventory and also to <unk>.

Back more stock and Thats really our strategy as we go forward.

Okay. Thank you for all the details really appreciate it.

And your next question comes from the line of Jim Suva with Citigroup.

Thank you very much.

You had mentioned some order push outs, you said geographically in China any sense on end market or end product like <unk>.

Industrial our surveil gains or anything like that for end markets.

Hi, Jim Yeah, it's been more of a function of consumer related sectors.

Did see a little bit of that bleed into say light industrial.

And parts of transportation in the quarter.

But again, our teams still have a significant backlog and even as they reschedule certain parts of it we still end up with near term demand.

That is a challenge to satisfy but I would say the push outs have not been broad based.

And therefore less significant in the west.

And again, okay installations have been really de Minimis.

And then just a couple of modeling things should we kind of anticipate inventory to.

Sustained at these levels it would be working down a little bit I know it seems like pricing is starting to change a little bit and lead times are but anything on inventory as we look at it I mean, I don't view it as a bad investment, but I'm just wondering about since it's been building a lot through asp's, how would you kind of be thinking about inventory looking ahead.

I'm glad you said that Jim because that kind of like the returns that we posted with the working capital in Q3.

As well and not to make light of it we obviously watch this very carefully.

We take pride in the fact that we know how to walk the fine line between.

Our returns as well as both supplier and customer satisfaction, we don't anticipate significant increases as this cycle plays out remember in the aggregate, we still have less supply than we have demand to satisfy so and as Raj pointed out.

And as I said earlier, it's pretty current inventory and as you've seen through many cycles I'm sure.

We've got great confidence in our ability to sell through it at which point, we start to generate lots of cash. So I think we're managing that.

That as effectively as we can given how complicated.

This market has been when it comes to trying to satisfy customers with scarce supply.

Okay, and then yesterday the fed raised interest rates can you help us understand what we should kind of be thinking about for interest rates for your company and I assume it would include the actions from yesterday you can just help us with that thank you.

Yes, Jim this is Raj.

Yeah, our interest rate expense, our interest expense has been going up as you've seen in the third quarter and then we also have guided to.

EBIT margin expected in the fourth quarter, and that's largely related to that short term rates going up over the last over this year actually because the fed has raised from almost nothing to high threes now in terms of the fed funds rate and our debt balance is about 50 has been about 50, 50 floating and fixed and so that's why we are seeing.

Still accretive for us to continue to do all the things that we've been doing including buying back stock. So.

We will sort of manage through it and as this business grows through its various cycles will get cash influx at some point in time, which will help us pay down some of the short term debt.

Thank you so much for the details.

I will now turn the call over to Rick <unk> for any closing remarks.

Alright. Thank you for your interest in Arrow electronics and have a nice day.

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