Q2 2023 Arrow Electronics Inc Earnings Call
Hello, My name is Chris and I'll be your conference operator today at this time I'd like to welcome everyone to the Arrow Electronics second quarter 2023 earnings Conference call.
All lines have been placed on mute to prevent any background noise.
After the Speakers' remarks, there will be a question answer session.
If you'd like to ask a question. During this time simply press Star then the number one on your telephone keypad.
To withdraw your question. Please press star one again.
Anthony Bencivenga, Vice President Investor Relations you may begin.
Thank you Chris.
I'd like to welcome everyone to the Arrow Electronics second quarter 2023 earnings Conference call.
With me on the call today is our president and Chief Executive Officer, Sean Kerins.
And our Chief Financial Officer Raj alcohol.
During this call we will 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.
Actual results could differ materially due to a number of risks and uncertainties, including the risk factors described 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 result of new information or future events.
As a reminder, some of the figures we will discuss on today's call are non-GAAP measures, which are not intended to be a substitute for GAAP results. We've reconciled. These non-GAAP measures to the most directly comparable GAAP financial measures in this quarter's associated earnings release or Form 10-Q, you can access our earnings release at Investor.
<unk> Dot arrow Dot com, along with the CFO commentary the non-GAAP earnings reconciliation and a replay of this call. We've also posted a slide presentation to accompany our prepared remarks and encourage you to reference these slides during this webcast.
Following our prepared remarks today will be available to take your questions and now I will turn the call over to our president and CEO Sean carriers.
Thanks, Anthony and thank you all for joining us today I'd like to discuss our Q2 performance provide some color regarding the market overall, and then close with a couple of key thoughts.
We think about the future I will then turn things over to Raj for more detail on our financials as well as our outlook for Q3.
In the second quarter Aero delivered sales and earnings per share within our expected ranges.
Distant with the softer semiconductor market and a mixed information technology spending environment.
Our global team continues to deepen our relationships with our suppliers and.
An increase engagements with customers always with an emphasis on our value added offerings and capabilities. As a result, we believe we're well positioned to help our suppliers and customers navigate the current environment.
While positioning them for the many growth prospects that lie ahead.
Having said that we recognize we operate in a cyclical industry and we're currently managing through an inventory correction.
I can't say for certain how long this will last I can tell you that we've experienced these cycles before.
And fully understand what it takes to navigate them.
We've always been a resilient business and see times like these as opportunities to strengthen the company for the future.
To that end, we remain focused on our strategic priorities for excuse me accretive growth.
And exercising prudent cost management and working capital discipline.
And our global components business. There are a few dynamics currently at play.
Component lead times are coming down.
Seeing consistent improvement in average lead times for the past few quarters.
While they're not quite back to pre pandemic rates across the board there.
Has been substantial progress.
At the same time inventory.
Inventory levels throughout much of our customer base remain elevated consequently, while longer term electronics markets are expected to grow.
The total addressable market for semiconductors. According to multiple sources will clearly decline in 2023.
While it may take time to work through existing inventories, we are encouraged that in general and particularly in the west end.
End market demand appears to be fairly steady.
And in addition to improving lead times, we do see other indicators that speak to the underlying health of the business in Q2, the pricing environment was largely stable.
Our book to Bill rates still below parity continued to hold steady.
Our design related activity grew substantially.
And we're seeing continued adoption of our supply chain services offerings.
Now to take a look at each of our operating regions and a little more detail in Europe , we saw a slight sequential decline in revenue.
But that was better than normal seasonality and we achieved robust year over year growth from a resilient industrial market along with strength in automotive as well as aerospace and defense in the Americas, we experienced a sequential and year over year decline in revenue.
However performance was stronger when adjusted for the further decline we experienced in the shortage market.
We now believe to have largely normalized.
In addition, our focus on the market for interconnect.
And electromechanical devices is helping to offset a more challenging semiconductor operating environment.
And in Asia, while we experienced continued softness in the Chinese market across both verticals.
Did grow sequentially in the region with relative strength in sales from networking and communications infrastructure, along with modest improvement in parts of both the industrial and consumer segments.
Stability in our global components business remained above historic levels in the second quarter.
Given a fairly stable pricing environment. The sequential operating margin decline was mainly a function of regional mix.
And the decline in volume along with the associated impact to operating leverage we continue to believe our value added offerings, including demand creation design services and supply chain management are contributing to our structural margin health and remain committed to our long term profitability outlook.
For this business.
Now switching gears to our enterprise computing solutions business sales for the second quarter were down year on year.
Largely a function of mix as we saw relative strength in cloud software and services.
As customers migrate to <unk> solutions delivered on an as a service basis.
Operating income grew modestly year on year and was in line with our expectations. The favorable mix contributed to year over year operating margin improvement.
In Europe <unk>.
And for cyber security solutions and other infrastructure software remain healthy.
We were also pleased by the continued adoption of our hybrid cloud portfolio, which is enabled through our airless fear digital platform.
And in the Americas, we saw relative strength in the public sector.
To focus on expanding our customer base in the mid market and are seeing steady progress even against the backdrop of softer enterprise demand.
Now before I hand things over to Raj I'd like to offer just a couple of thoughts as we look to the future first I wanted to be clear I am very excited about the key markets in which we operate and believe the long term growth prospects are promising.
Consider just a few key trends the electrification and connectivity of everything.
The accelerated adoption of new technologies, such as electric vehicles, and renewable energy and artificial intelligence just to name a few.
The it space the growing relevance of hybrid and multi cloud solutions all delivered.
On an as a service basis and second.
The current market trajectories are challenging and a little bit uncertain, we're confident in our ability to generate cash in the near term provide.
Providing us the flexibility we need to serve our capital allocation priorities.
Effectively and with that I'll hand things over to Raj. Thanks, Sean.
Consolidated revenue for the second quarter was $8 5 billion.
Down 10% year over year.
Changes in foreign currencies had a negligible effect on revenue during the quarter by business Global components sales were $6 7 billion.
Within our expected range down 10% year over year.
Notably we had significant year on year growth in EMEA with strong performance in the industrial and automotive markets.
Enterprise Computing solutions sales were one 8 million also within our expected range and down 8% year over year.
Moving to other financial metrics for the quarter.
<unk> gross margin of 12, 5% was down 60 basis points year on year, principally due to reduced volumes and the component shortage market.
Partially offset by improved product and region mix in the enterprise computing solutions business as customers continue to shift from hardware solutions to software and cloud solutions.
non-GAAP operating expenses were $656 million a reduction from both last quarter and last year. We continue to look for further cost reduction opportunities in this environment.
non-GAAP operating income was $410 million or four 8% of sales with global components operating margin coming in at five 8% and enterprise computing solutions coming in at four 8%.
Interest and other expense was $85 million, which was better than expected due to lower average daily borrowings during the quarter.
non-GAAP effective tax rate of 23, 1% was in line with our expectations.
Diluted EPS on a non-GAAP basis for the second quarter was $4 37 in line with our expectations and based on a $57 4 million share count.
Now moving on to working capital.
Networking capital was up slightly from Q1 at $7 5 billion.
Accounts receivable are increasingly increased slightly from Q1 to $11 billion driving days of sales outstanding to $1 <unk> from 111 at the end of the first quarter accounts payable were flat sequentially at $9 billion, bringing.
Bringing days of payables to 111 from 104 last quarter.
Inventory decreased by about $75 million to $5 $5 billion with inventory turns remaining at five five turns.
With inventory down slightly and the changes in days payable offsetting days of sales, our resulting cash conversion cycle was roughly flat from last quarter at 74 days.
Cash flow used for operating activities in the second quarter was $127 million in conjunction with the cash generated in the first quarter on a year to date basis cash flow from operations was $97 million. We do continue to have confidence in our ability to generate positive cash flow.
Net debt for the second quarter was up slightly from Q1 at $3 9 billion and total liquidity stands at approximately $2 $1 billion, including our cash balance of $240 million, our balance sheet remains strong and provides us with ample financial flexibility.
Consistent with our priority of enhancing shareholder value we repurchase shares.
The amount of approximately $200 million during the first quarter during the second quarter.
At the end of the second quarter, our remaining stock repurchase authorization stands at approximately $824 million. Please.
Please keep in mind that the information that share. During this call is a high level summary of our financial results for more details regarding the business segment results. Please refer to the CFO commentary and the earnings presentation published on our website.
Now turning to Q3 guidance.
We expect sales for the third quarter to be between $7 78 billion and eight.
838 billion.
We expect global component sales to be between six and $6 4 billion.
Which at the midpoint is down 7% from prior quarter and reflects the currently elevated inventory levels across our customer base and continued softness in Asia.
We expect enterprise computing solutions sales to be between $1 78, and $1 98 billion.
Which at the midpoint represents a 4% decline year on year.
We are assuming a tax rate in the range of approximately 23% to 25% net interest expense in the range of $85 million to $90 million.
non-GAAP diluted earnings per share is expected to be between $3 $43 67 for an average diluted share count of 56 million shares.
We expect sequential decline in revenue and reduced operating leverage to be the primary drivers of the sequential decline in EPS.
We estimate changes in foreign currencies will benefit sales in Q3 by approximately $212 million.
And EPS by approximately <unk> <unk> compared to the prior year compared to the prior quarter, we estimate changes in foreign currencies will benefit sales.
$142 million and benefit EPS by <unk> <unk>.
I will now turn the call over to the operator for Q&A.
Thank you and as a reminder, if you would like to ask a question. Please press Star then one on your telephone keypad.
Our first question is from Matt Sheerin with Stifel. Your line is open.
Yes, Thank you and good afternoon, everyone.
Sean I would like to.
Just get a little bit more color on your guidance for the components.
In the September quarter, it looks like Youre guiding down roughly 15% year on year, 7% sequentially.
You did see you didn't you do normally see sequential growth in the Asia.
September .
And as we look at the numbers now.
Is that expectations.
For that growth, which would imply North America, and Europe down kind of mid teens sequentially does that makes sense.
Good morning, Matt.
I think those numbers would be a little bit extreme we are.
Guiding sub seasonal in Asia for the region.
We continue to see softness in China, that's probably not new news to anybody.
Just haven't quite seen the rebound yet.
The market expects.
But our our sequential decline in Europe , and the Americas, though sub seasonal.
Are not as significant as you suggest.
Those are mainly a function of just the elevated inventory levels that we see in the business.
Whereas the Asia, specifically Chinese.
<unk> or more a function of market.
But the the operating margin decline that you see in the guide is largely just a function of the shortfall in sales volume versus seasonality versus.
Much anything else as we do kind of assume continued pricing stability.
In Q3, much as we saw in Q2.
Got it and as we think about Q4.
Youre, not giving guidance for that but.
Would you expect this correction to play out through Q4, which would mean that the components would be down sequentially.
In Q4.
Well Youre right Matt.
We are only providing guidance for Q3, so I don't really want to speculate too much beyond that.
What I can say is that given our history with the cyclical nature of.
This business.
Our experience has been.
Historically that.
These kind of corrections take.
Two to three quarters to play out.
That would certainly seem consistent with the the inventory levels, we see in our business and our assessment of our firm backlog obviously.
A better demand environment could move things along more quickly.
Declining demand environment could slow things down, but that's been our our typical experienced historically.
And Thats kind of the best we can we can tell you about anything beyond the third quarter at this point, Okay fair enough and just lastly on Opex you've done a good job of.
Of taking cost down and it looks like it was down roughly $30 million or so sequentially on opex.
How should we think about opex on a dollars basis relative to where it was in the June quarter.
You mean for the third quarter, that's right yes.
Yeah look I think we will get the benefit of variable costs that will come down as the volume comes down so that part of it you should continue to see.
And then as.
I mentioned in my comments, we're always looking for further cost reduction opportunities.
Optimizing the business wherever we can.
Rebalancing, our workforce around the world and we've been looking at closing underutilized facilities, so that stuff doesn't show up right away, but it certainly does help over the longer term and so we're looking at that on an ongoing basis.
Okay very good thank you.
No.
The next question is from Melissa Fairbanks with Raymond James Your line is open.
Hi, guys, thanks very much.
Raj I had a question for you I just wanted to ask about the revolver and the interest expense I know you've been prioritizing the buybacks and that's driving a lot of accretion but.
But I was wondering how you're balancing that buyback against bringing down some of the debt in the near term.
Melissa we really think about it in the order of priorities of our capital priority. So we're always very much going to invest in the business to drive organic growth and expansion. That's the first priority.
We also as I mentioned before we're always looking at the right kind of inorganic opportunities that will fit within our strategy and then we use our excess cash or capacity to buyback stock.
If we feel that it's a good value and rehab.
Great value obviously.
The interest expense has been ticking up that's largely a function of rates.
The environment that we're in and that we're going to go through the next few quarters.
We would likely see more cash generation and so it gives us the opportunity to do all of those things as well as maybe even address.
Our debt level a level, but we are very much within our targeted credit rating ratios and so.
No concern from that standpoint.
Okay great.
And then maybe I always have to ask about inventories of course, it's great to see inventory dollars coming down.
I think you had said previously on our call that June quarter was probably going to we're going to start to see some normalization in the near term.
With under shipping demand and kind of excess inventories at the customer level.
You have kind of an updated view on when we could get.
Some of that working capital release.
So so Melissa I can give you a kind of a big picture on our inventory profile Youre right. We did see inventories come down in the quarter for the first time in several quarters Thats a good sign in this environment, we do expect them to come down even further in the third quarter.
It's interesting units were definitely down in the quarter.
A global basis.
Asp's largely held up.
Which does suggest inventory levels still reflect price increases.
They would have fallen even further part of that is the fact that many of our suppliers are pretty collaborative when it comes to.
Working with our customers as they look to reschedule.
Further production needs, but we think we're we think we're managing inventory well.
Like the quality of almost all of it. The only question is when it sells through given.
Given the environment, we're in but we do expect inventories to rotate down yet again in Q3.
Hence our confidence in cash generation in the near term as we look forward turns are not too far.
Out of line from what we would call historical norms.
In any of our our three big operating regions, Melissa I would say, they're each within <unk>.
<unk> Turner less of what you would expect when things finally reach steady state again.
Okay, Great. That's very helpful. Thanks very much.
Thank you Melissa.
The next question is from Joe <unk> with Wells Fargo. Your line is open.
Yes, thanks for taking the questions I wanted to kind of stick on the inventory dynamic some of your suppliers have talked about their distributor inventory still remains well below the kind of historical levels that they have.
Maintain previously so I guess, how do how should we think about that dynamic and then.
The ability to Navy.
Maintain pricing as being somewhat stable in that environment, just given the inventory.
Continue to be lean are also moving downward now.
Yeah, So Joe maybe just to step back and think about how these.
Corrections typically play out right as supply has improved and lead times have come down our suppliers have made decent progress addressing.
The enormous amount of delinquent demand.
It was in the market.
That typically gets solved for first with their larger OEM customers.
And in many cases, they are the ones that they tend to serve directly and then anywhere from two quarters or more later.
It starts to show up in the mass market customer base. They were basically further back in the queue. If you will which we tend to serve on their behalf. So.
The suppliers tend to see this whole phenomenon, a little bit better than a little bit sooner than we do.
But the pattern typically plays out the same in each case.
And we think that therefore, we got a little bit in front of us to work through.
The inventory build that we've experienced in the mid market, but it is headed in the right direction.
If you think about your pricing question Theres, a big difference between what plays out in the largest end of the market.
The large OEM customers versus the mass market, which is our primary focus.
The mass market as the place.
Our pricing and margins tend to hold up.
In a better over time that you might see in the and the largest sub accounts, but like I said, so far we've seen pretty good pricing stability.
And where we've been so far this year.
Got it that's helpful. And then just you referenced.
Typically these things take two to three quarters to play out.
In the context of your components EBIT margin has obviously been very strong over the last several quarters and you talked about the structural benefits there.
Put in place I mean, how do we think about those structural benefits coming into play now as demand starts to slow or do you think you can maintain components EBIT margin above 5%.
We do and I'll give you some perspective on this I mean, if you think about the up cycle that we all just experienced.
That preceded the environment, we're now in excuse me.
Probably the most significant disconnect between supply and demand.
Than we've seen in recent history in the industry certainly in all of my time.
Aero So a correction of some sort it was probably inevitable.
But if I go back to.
The last time that we would have seen.
Some kind of a cyclical correction that was 2019 pre pandemic and I could safely say that is EBIT with this guide or our margins are structurally better.
Then they were at that time.
We're a much more significant degree.
And such that even if we were to see further margin pressure down the road as inventory levels fully correct.
We know that some of that will cycle back just through sheer volume alone, which will help restore operating leverage and to your point, we have not lost sight of our value add priorities and growth opportunities around things like engineering and demand creation around things like supply chain and they can continue to.
Contributing to our structural margin strength. So we still for all those reasons, we still feel really good about our our longer term steady state outlook, we're basically not losing sight of of where we're headed even though the current environment is a little bit tough.
Got it thanks for that.
Yeah.
The next question is from <unk> Bhattacharya with Bank of America. Your line is open.
Hi, and thank you for taking my questions, Sean you talked about an inventory correction happening in the channel.
Could you give us a little bit more color on that are there specific types of semiconductors that have higher inventory in the channel and higher level question. How do you measure excess inventory like how do you know that there is something that is excess inventory in the channel and related to this is if the demand environment is weaker.
Using free cash flow generation in such an environment can be more can be higher than normal and would you use that higher cash flow for things like higher buybacks than you would have normally done. So if you can just give us your thoughts on inventory a little bit more color on inventory in the channel and your thoughts on free cash flow and uses of that.
Sure a couple of different questions in there. So maybe maybe we can break it down first I wanted to tell you that although our backlog has come down of late it's still multiples bigger than it was pre pandemic multiples and we still think roughly two thirds of it is firm.
And maybe 25% or more of it as delinquent so that alone tells us we still have fulfillment.
To execute upon.
Within our our inventory profile and we will.
But it also gives us confidence that.
Our guide is probably right where it needs to be.
The inventory build throughout our customer base, maybe less specific about certain technology sets and.
It's more about just the electronics market overall.
It's elevated and we know that because of our turns.
We know that because of.
The feedback we get from our customers.
And we certainly know that based on all of the close collaboration that we undertake with our suppliers.
All the time to kind of navigate this market. So again, we're probably a turn.
Or so off in each of our operating regions relative to what we would expect to see when things reach steady state.
But by and large.
Inventories are elevated to the extent they are across our customer base it slows down our.
Our ability to execute.
Execute on fulfillment.
And it will occur it's just a matter of.
The work our customers are doing to kind of realign their product their production schedules to solve for their end market demand.
With regard to what it all means in terms of free cash flow like I said in a correcting environment, we feel more confident about our ability to generate cash and maybe I'll, let raj talk a little bit about how we're thinking about what we do with that cash as we look forward in the near term yes.
Nice to speak with you again.
We're going to just continue to.
Managed care through our key priorities for capital.
We are investing in the business as I said and then.
Looking at inorganic opportunities, but certainly if we have more flexibility with cash.
I expect that will continue to buyback some stock and that's been accretive use of cash to last few years as you know.
And in a more.
More flush cash environment, we will certainly keep that as one of our key priorities so that that wont be off the table.
But we'll continue to evaluate against all those priorities.
Okay. Thanks for all the details there.
As my follow up if I can ask a question on ECS margins.
No.
The segment margins grew 40 bps sequentially on lower revenue.
How should we think about margins in that segment for fiscal <unk> is there any inventory correction happening on that side of the business.
And is it reasonable to think that even if the macro is weak the fiscal fourth quarter is typically the strongest quarter for that segment. Both from a revenue and margin standpoint, do you think that relative outperformance in the fourth quarter and maintained even in this environment. Thanks.
Sure thing roughly well again.
Probably not going to talk a lot about Q4 at this point because we're only guiding Q3 you are right Q4 is.
Very predictably the largest quarter of the year when you think about seasonality, but to your first question yes.
There really are any inventory.
<unk> in that business for us in fact.
This is working capital friendly for us because even in most places where we participated in hardware.
The model is more drop ship in nature.
We've always liked.
That piece of the model for us because again, it's working capital friendly.
I would say in our backlog has continued to build.
And that business is a function of all the kind of the multi period cloud and software subscriptions that we're helping the channel navigate and those things tend to get build out over time.
Piece of our business is growing which we think is good for the model.
Longer term, but theres no theres no barriers to.
Revenue or fulfillment as it relates to elevated backlog or inventory most of the supply chain challenges related to systems.
That business has evolved but normalized.
Okay. Thanks for all the details appreciate it.
Again, Thats star one if you'd like to ask a question. The next question is from William Stein with true Securities. Your line is open.
Great. Thanks for taking my questions.
Thanks.
A little late so I apologize if you might have addressed this already but I think in <unk>.
CFO commentary you talked about Tom.
Shortage market revenue and Im hoping you can just elaborate on your exposure to that part of the components market the impact it's having on your business today.
Terms of margins, especially in how you expect that to progress in the next few quarters.
Certainly so if you think about the the operating margin decline we saw in the second quarter will it was really a function of three things one part was regional mix.
And that was just due to the fact that we saw some sequential growth in Asia.
One part of it was just the normalization of our shortage market activity, which.
Typically it's been most prominent in the Americas.
Lead times have come in and supply and demand are yes.
Moving towards getting.
Better aligned the activity levels in that piece of the market.
Have declined pretty significantly we saw some further erosion of that activity in Q2.
That had some pressure on margins and then thirdly, and most substantially those strictly a function of the shortfall in volume overall.
Which put some pressure on operating leverage, but we think we'll that.
The upside and now the downside by way of period over period compares as it relates to our shortage market activity have largely normalized.
And that piece of the margin stress.
We get a lot simpler and less pronounced from here.
Yes.
That's helpful. I appreciate it one other.
Pardon me.
Inventory has been discussed a couple of times already but I just wanted to go at this a little bit different way.
So among the semi companies I cover most of them sort.
Sort of beat their chest about how they serve the channel of inventory through this whole last cycle and so.
While your inventories have increased there.
Very well protected.
A little bit difficult to reconcile these two data points, but.
I think the issue is that smaller companies, even some public ones I've spoken to you haven't been able to do a great job of.
Sort of managing this issue and so.
I've spoken to have told me about six months of inventory at.
At distribution I don't know, if you're experiencing that with any of your suppliers, but.
The real question gets to is I'm, hoping you can.
Talks through the consistency or on the other hand disparity.
Your inventory across technologies and suppliers that my guess is that it's very relevant.
Relative to what it usually is I'm, hoping you could sort of help us clarify this thank you.
Yes.
Yeah, sure and maybe just repeat a little bit of what I said earlier part of this is based on the pattern of how these corrections play out remember that.
Suppliers tend to solve for the larger customer demand, especially when it is delinquent as we saw it during.
During the last cycle before they solve for the mass market right. So we will typically see the inventory build later than they will.
Because the mass market customers were.
Further back in the queue, so that accounts for a little bit of a delta in timing and therefore, our experience now versus.
Their experience has been.
You're right in assuming that the inventory mix is not uniformly problematic for all suppliers in all technologies equally in all regions.
We are talking about this in the aggregate but.
I would say look most of our suppliers are pretty collaborative when it comes to meeting the.
The evolving production schedules of our customer base.
Work through their inventories.
As evidenced in the fact that our units came down pretty substantially in Q2, and we expect.
To see that again in Q3 and the.
The wildcard here is the fact that the asps are holding up so that's inflating inventories.
Beyond what they would look like otherwise, but if youre looking for.
One or two long poles in the 10.
To define this problem.
See you.
More generally across the portfolio.
There are some cases where suppliers.
Suppliers are different programs in place some are more favorable than others, but by and large.
We feel good about the handle we have on this.
Our ability to work both customers and suppliers to work through this as expeditiously as possible.
Given the broader market demand question.
Okay. Thank you.
Thank you.
We have no further questions at this time I will turn it over to Anthony Bencivenga for any closing remarks.
Okay. Thanks, again, Chris and thank you all for joining today's call. We look forward to meeting you at upcoming Investor events have a great day.
This concludes today's conference call you may now disconnect. Thank you.
Please wait the conference will begin shortly.
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