Arrow Electronics, Inc. (ARW) Q1 2013 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Arrow Electronics, Inc. First Quarter Earnings Conference Call. My name is Shaquana, and I will be your coordinator for today. [Operator Instructions] I would now like to turn the presentation over to your host for today's call, Ms. Greer Aviv. Please proceed, ma'am.

Thank you, Shaquana. Good afternoon, everyone, and welcome to the Arrow Electronics First Quarter Conference Call. I am Greer Aviv, Senior Manager of Arrow's Investor Relations program, and I will be serving as the moderator on today's call. If you would like to access today's call via webcast, please visit our Investor Relations website at www.arrow.com/investor and click on the webcast icon. With us on the call today are Mike Long, Chairman, President and Chief Executive Officer; Paul Reilly, Executive Vice President, Finance and Operations, and Chief Financial Officer; Andy Bryant, President, Global ECS; and Peter Kong, President, Global Components. By now, you all should have received a copy of our earnings release. If not, you can access our release on the Investor Relations section of our website, along with the first quarter CFO commentary that should be used as a complement to the earnings press release. You can access a copy of our earnings reconciliation for the first quarter in our press release or on the Investor Relations section of our website. Before we get started, I would like to review Arrow's Safe Harbor Statement. Some of the comments to be made on today's call may include forward-looking statements, including statements addressing future financial results. These statements are subject to a number of risks and uncertainties that could cause actual results or facts to differ materially from such statements for a variety of reasons. Detailed information about these risks is included in Arrow's SEC filings. We will begin with a few minutes of prepared remarks, which will then be followed by a question-and-answer period. As a reminder to members of the press, you are in a listen-only mode on this call, but please feel free to contact us after today's call with any questions you may have. At this time, I would like to introduce our Chairman, President and CEO, Mike Long.

Thank you, Greer, and thanks to all of you for taking the time to join us today. We performed well in what remained challenging markets in the first quarter. Our consolidated sales were in excess of $4.8 billion, and diluted earnings per share were $0.89. Revenue was in line with the midpoint of our guidance, while EPS came in above that midpoint. Our strong performance over the past 3 years in our enterprise computing solutions segment continued into 2013. This business continues to post leading industry performance, and sales reached the first quarter level, increasing 8% year-over-year. This also represented the 13th consecutive quarter of organic growth for the ECS organization. On a global basis, storage, software and services continued to grow at a healthy rate year-over-year as customers focused on productivity and efficiency enhancements for their organizations. We also had a solid year-over-year growth in industry-standard servers. In the Americas, sales growth was above normal seasonality in the core value-added distribution business, with a stronger-than-expected close to the quarter. In Europe, as expected, sales were modestly below normal seasonality, as the European economies further weakened in the first quarter. For 2013, Gartner expects global IT spending to increase 4% year-over-year on a constant-currency basis, with faster growth rates expected in the subsegment of enterprise, software and IT services, which now make up 50% of ECS's annual billings. Over the last few years, we've successfully transformed our ECS business into a much stronger, more diversified organization with an expanded geographic reach, and we've increased exposure to fastest-growing products and services and a more robust customer and supplier base. We expect the momentum we've created over the past 3 years to continue into the future. In our global components segment, we executed well in a market that continues to be impacted by the weak macroeconomic environment. The year-over-year sales decline of 5% was in line with our expectations. And in the Americas, market conditions weakened as economic uncertainty persisted in the first quarter. Customers maintained a conscious -- or a cautious stance. In the region, sales in the core business declined 5% over year (sic) [year-over-year]. On a like basis adjusted for Ericsson [ph], sales in Europe declined 5% on a local-currency basis as economic conditions worsened over the last 9 months. On a positive note, the core business in Europe experienced normal seasonal growth on a sequential basis. Our Asia-Pac business saw double-digit year-over-year growth, driven by strength in the core business which increased a very healthy 14%. Book-to-bill was above 1 globally, with all regions reported positive ratios. Leading indicators, including cancellation rates and lead times, remain in line with normal historical averages. As we look forward, global GDP growth was recently revised downward, with the International Monetary Fund now expecting growth of only 3.3% in 2013, as the world's economic outlook has worsened over the last 3 months. Much of that expected growth should come back in the second half of 2013. We continue to expect to outgrow the markets we serve. Our global teams remain committed to driving increased profitable market share in all the markets we serve, while providing the highest possible level of service to our customers. In summary, we had a solid first quarter, and once again, successfully navigated through the choppy macroeconomic environments around the globe. We continue to remain focused on our long-term goals of growing sales faster than the market, growing profits faster than sales, and generating positive cash flow and generating returns in excess of our cost of capital. Our global scale and financial strength are clear competitive advantages and serve to further differentiate our industry-leading position. Paul will now provide an update on our financial results for the first quarter.

Thanks, Mike. First quarter sales of $4.8 billion, as Mike said, were in line with our expectations. Adjusted for the impact of acquisitions and foreign currency changes, sales declined 3% year-over-year. In global components, sales declined 5% year-over-year as the double-digit growth in Asia was offset by revenue declines in the Americas and Europe. Adjusted for the impact of acquisitions and foreign currency changes, sales in global components were down 6% year-over-year. Sales in global ECS increased 8% year-over-year, with strong double-digit growth in Europe, as well as increases in the Americas. Adjusted for the impact of acquisitions and foreign currency, sales increased 2% year-over-year in global ECS. Our consolidated gross profit margin was 13.2%, a decrease of 70 basis points year-over-year. And adjusted for the impact of acquisitions and foreign currency, gross profit margins decreased the same 70 basis points year-over-year. That decrease is due to ongoing pricing pressure in the global components segment, as well as a change in product and geographic mix. Gross margins improved seasonally on a sequential basis. Operating expenses are flat year-over-year on an absolute dollar basis. Adjusted for the impact of acquisitions and foreign currency changes, operating expense dollars declined 4% year-over-year and were flat as a percentage of sales. To assist you with your analysis, acquisitions added approximately $10 million to operating expenses this quarter. We committed to delivering on $40 million in annual expense reductions in February 2013. And now, with a more thorough review of our processes and productivity enhancement opportunities driven by new systems, as an example, the ERP implementation throughout the European components regions, we will be able to exceed that commitment and reduce cost by more than $75 million on an annual basis. Most importantly, we will be able to deliver on this increased target while still selectively investing in the businesses where we believe we can benefit over the longer term by increasing our opportunities in high-growth markets, better leveraging our global scale and further diversifying our revenue streams. Operating income was $159.2 million. And operating income as a percentage of sales was down 70 basis points year-over-year as reported and as adjusted for the impact of acquisitions. Adjusted for the impact of acquisitions, global ECS operating income as a percentage of sales was up 10 basis points year-over-year, as expansion in the Americas was partially offset by a modest decline in the European region due to changes in product mix. In global components, adjusted for the impact of acquisitions, the operating margin declined 100 basis points year-over-year due in part to geographic mix as Asia-Pacific growth continues to outpace the other regions, as well as weakness in the more profitable regions of Europe and the Americas. Our effective tax rate for the quarter was 27%. And for the remainder of the year, we expect the effective tax rate to be between 27% and 29%. Net income was $96 million for the quarter. And earnings per share were $0.91 and $0.89 on a basic and diluted basis, respectively. Cash used for operating activities in the first quarter was $179 million. There were a combination of factors, which impacted our performance here. With that said, we expect cash flow to be positive in the second quarter, and we expect to achieve our stated cash goal of converting 70% of GAAP net income into cash in 2013. Return on working capital for the first quarter was 19.4% and return on invested capital at 8.1% was again ahead of WACC. In the first quarter, we repurchased 2.4 million shares of Arrow's stock for $98 million. Since the end of the first quarter, we have also repurchased almost $14 million of our stock, leaving us with $186 million remaining on our most recent repurchase authorization to fund future share buybacks. Since the beginning of 2007, we have returned more than $910 million to shareholders in the form of stock repurchases. This is a high-level summary of our financial results for the first quarter. For more detail regarding the business unit results, please refer to the CFO commentary published this morning. As we look to the second quarter, we believe that total sales will be between $4.9 billion and $5.3 billion, with global components sales between $3.15 billion and $3.35 billion, and global enterprise computing solutions sales between $1.75 billion and $1.95 billion. As a result of this outlook, we expect earnings per share on diluted basis, excluding any charges, to be in the range of $0.95 per share to $1.07 per share. Our guidance assumes an average tax rate in the range of 27% to 29%. Average diluted shares outstanding are expected to be 107.1 million, and the average euro to U.S. dollar exchange rate for the second quarter to be 1.30 to 1.

Thank you, Paul. Please open up the call to questions at this time.

[Operator Instructions] Your first question comes from the line of Shawn Harrison representing Longbow Research.

This question just goes back to the update, and I guess, restructuring your cost reduction program. When would you expect to realize those full synergies? And maybe just a little bit more detail in terms of where you're seeing the cost savings come from.

Sure, Shawn. So here's how we kind of look at what's going to happen for the rest of the year. We expect a $5 million to $10 million impact in Q2. That $5 million to $10 million will increase from, let's say, $10 million to $18 million in Q3, and right around $20 million in Q4. So that's kind of how we see it happening. So the way we're measuring this is we're saying we're assuming no real change. This is not a forecast or guidance. This is just how we're measuring it in the business from Q4 2012, and what we expect would happen with our expense load in the fourth quarter of 2013. Obviously, there'll be variable costs as the business goes up or down that will impact this, but it's how we're tracking it at this point in time. Areas that we're looking at? Well look, we're in the process right now of moving the Coronado [ph] warehouse, that's our last PDC, stand-alone PDC, in Europe in the European components business. We're moving all that inventory over the next few quarters into the Venlo warehouse. So we'll shut down 1 warehouse and we'll get better productivity out of our Venlo warehouse. So that's a real productivity enhancement we're going out of the unity or what we call unity ERP rollout. We're looking at other areas where we can focus on real estate, where we can focus on, a, what's the process that we're following; and where can we redirect efforts elsewhere to accelerate performance. So I would say it's spread out over both businesses and in headquarters, though as we said last quarter, most of it's targeted towards global ECS. It's not in any particular region, it's not in any particular business, but this is something we're good at. And we're able to spend some more time staring at it and thinking about how we go to the marketplace, and that's how we got to the $75 million.

Okay, very helpful. And I guess, Mike, as a follow-up, book-to-bill has now been good for a little while. They're above parity in all regions now. Could you see anything in your bookings that would -- through here, I guess, the end of April, that would make you a little bit more positive in terms of longer-term bookings beyond 90 days or anything in that book-to-bill that we'd take away as kind of a positive sign, other than things just kind of incrementally nudging forward?

What I would say is that the first half of the year seems to be that incremental nudge, as you've stated, and it's been the one that's been eluding us. There's a few positive things that I think have an impact is that the bookings are showing homes going into the second half of the year. So we think that our customers are starting to see some strengths in the second half in their production facilities. And I view that as some good news. Because what we're not seeing is the short-term backlog increase, but the longer-term backlog is where those bookings seem to be going. As far as other positive notes, I think our design -- when our design registrations activity is up about 16% year-over-year, that is future designs that will go into production. So we've seen that increase continue, but yet strengthen again this quarter. And that usually bodes well for 4 to 6 months out. So all in all, in the prepared comments, I noted that most of the growth would come in the second half of the year, and I think we still believe that.

Your next question comes from the line of Matt Sheerin representing Stifel. Matthew Sheerin - Stifel, Nicolaus & Co., Inc., Research Division: So Mike, on the components business where margins have been under pressure for the reasons you talked about, are you continuing to see pricing pressure here even in the last quarter? Because given some of the cuts and given the mix of business where you saw a nice sequential increase in Europe, I would have expected your operating margin to be up more significantly than it was from the December quarter. So is it still a mix issue? Is it the type of business or maybe more fulfillment business, more pricing pressure? What are the reasons for that?

Yes. I think what we did see was a small tick up sequentially from Q4 on the growth margin or the gross margins into Q1. Let's remember one thing, I'll come back to Europe. In general, we had a large increase in Asia-Pac, which was a negative effect for us on the margin although it's improving in Asia-Pac. We're seeing the margins at this point start to stabilize and trend up on the future bookings. But we're still dealing with sort of the book shift in the fulfillment business that's been happening for the last several quarters. In Europe, Matt, if you remember, some of the productivity enhancements we're looking at, we've been converting the computer system in Europe. So we've been carrying some additional cost in that marketplace. And remember, during the year last year, we were kind of hamstrung from being able to do any big productivity enhancements because all of our focus was on getting that computer system right, getting it converted, getting everybody up on the same system. And that has now been accomplished, and that's how we were able to come through with some of the additional productivity enhancements that we just -- that Paul just outlined for you. So going forward, I think we're in a pretty good position. I think, our goal is to continue to march back to that 5%. And if we get some market uplift, Matt, I think we'll be back there towards the end of the year. Matthew Sheerin - Stifel, Nicolaus & Co., Inc., Research Division: And in terms of your outlook for components, it looks like it's just a little bit below seasonal. Are you expecting those conditions similar in all regions? Or is North America still going to be softer than that? Or are you seeing more stability there?

Well, actually, our -- what we're looking at right now is that in the second quarter, we expect the core Americas components business to be at the mid to the high end of seasonality. We've seen some strength there. We actually see some strength coming in, in Europe and expect them to also be at the sort of trending towards the high end of their seasonality. So I would say, Matt, overall, our seasonality would be right in there. And seasonally adjusted, I think, we had a fairly strong December quarter, and the second quarter is looking better than the first. So all of that -- if you take historical factors, that kind of fits right in with what's going on and what's gone on past in the market. Matthew Sheerin - Stifel, Nicolaus & Co., Inc., Research Division: And just my last question. Regarding that ERP rollout, it sounds like you're done in Europe. So what's left to do on the components side with the ERP rollout?

Well, the ERP rollout as we go forward, we still -- while the good news is we have Asia-Pac on 1 system today, that's still left to convert, and we're still left to convert North America. And we will come out with a schedule for you guys of what that looks like going forward. But all in all, we've been pretty pleased with the rollout. We haven't had major customer disruption. We carried a little extra inventory last quarter in Europe, which impacted cash flow, but we had that warehouse we were shutting down. We wanted to make sure we gave good service, Matt. And that's sort of the trade-off, I guess. There's some little nits of expense to make sure that happens, and we'll continue that going into those 2 businesses when we roll out the schedule.

Your next question comes from the line of Jim Suva representing Citigroup.

I have 2 questions. One of them is just a clarification. I got a little bit confused with the moving parts with the SG&A outlook. If you can maybe just let us know kind of a dollar outlook of what we should be expecting for kind of next quarter, because it seems like there's a lot of moving parts. And then my other question is, you mentioned servers, storage and software were up year-over-year. Can you help us quantify a little bit about that? And are we seeing some deceleration in that up year-over-year from the past few quarters due to the macro environment? Or any potential, looking forward, acceleration you should have seen [ph], because those 3 look like really the big drivers.

Sure, Jim. Well, Paul's getting some of the cost stuff for you there. We actually saw about a percent change in industry-standard servers on the quarter year-over-year, 11%, roughly, in proprietary. Services was up strong at about 13%. We saw about a 5% in software and about 6% in storage. In general, the -- what we've been seeing in this business is a consistent desire by the customers to have a complete solution, and that's starting to play out. I think the good news that we saw was that there was actually some life in that proprietary segment for us. It's been a long time coming. But the declines have, as you know, have gone down with sort of the maturity of that product. I would still expect things to kind of hang in there for the year. Gartner was talking about something like a 4% growth in the business. But if you really think about some of the data center products like services and storage, that growth outlook is still pretty good for the year. Andy, you want to elaborate any more around what you saw with the proprietary systems and the industry-standard systems?

Sure, Mike, thanks. And I think, Mike, you were actually looking at the EMEA numbers. Industry standard was up 6% year-on-year globally. Storage, up 12%; virtualization, up 7%. And software, in general, Jim, so you know, when we talk software, it's mostly virtualization and middleware, was up 10% year-over-year. So while the server market remained sluggish, and as Mike mentioned, proprietary showed some signs of life, but it was still down year-over-year significantly. The fact that we strategically have diversified our portfolio and we continue to put the numbers up that we're putting up says that our strategy is working. So as Mike commented, different parts of the market are forecasted to grow at different rates, but we're pretty pleased with how we have the business positioned.

Great. And then on the SG&A side?

Sure, Jim. So if you look at Q1 non-GAAP, it was about $483 million of operating expense SG&A. Obviously, there will be an uplift in Andy's business, the seasonal uplift which will drive more variable costs and will take some costs out in the range of $5 million to $10 million. So you can work that math depending upon what your assumption is for the net increase in revenues. And then to be on the conservative side, that will get at least $5 million out, but we are shooting for $10 million. I have full confidence we'll accelerate the reductions as we go throughout the rest of the year.

Your next question comes from the line of Brian Alexander representing Raymond James. Brian G. Alexander - Raymond James & Associates, Inc., Research Division: Andy, can I just go back to the [indiscernible] growth rates? If I look at the CFO commentary [indiscernible] and industry-standard servers [indiscernible] it seems like everything else grows double digits. But your overall [indiscernible] revenue was up 2% pro forma and 8% overall. So I don't know if those are pro forma growth rates or total growth rates, but I was just trying to reconcile the overall difference [indiscernible] 2% [indiscernible].

So Brian, you're really breaking up pretty bad there. But I think what I heard you ask was our overall growth rates, 2% and 8%. Brian G. Alexander - Raymond James & Associates, Inc., Research Division: Yes, sorry. Is that better? Basically, the question is, it looks like every major category was up either high-single digits or double digits, yet, the overall computing business was up 7.5% and 2% pro forma. So I guess, what I was just trying to understand is, to reconcile that in which areas of the business might not have grown as fast, to get you down to a 2% pro forma growth rate.

Okay. We certainly saw security slow down, as noted. The growth went even with year-over-year. And as you know, Brian, with software, it's always a question of how much of our software business is new license versus renewal and the way in which we report that. Unified communication's dropped off year-over-year, so again -- and proprietary, as mentioned already, was down 26%. But the mix drove, as you referenced, 8% as reported, 2% pro forma x FX. Brian G. Alexander - Raymond James & Associates, Inc., Research Division: Got it. And then Paul, just on cash flow, you reiterated your expectation that it would be roughly 70% of net income for the year after the first quarter being negative 1 79 [ph], and you said Q2 should be positive. My question is which quarters would be significantly positive and above net income to get you to that full year rate?

Sure. So let me first identify 2 -- and Mike alluded to 1 already, but 2 of the items that drove the biggest piece of our negative cash flow. As you mentioned, we're moving the Coronado [ph] warehouse to our Venlo warehouse, shutting down Coronado [ph]. We bought extra inventory to ensure we would have no disruption to customer service. Let's call that round numbers $40 million of excess -- extra inventory at the end of Q1. We're not worried about that from a valuation point of view, with price protection, et cetera, so that's a timing issue. Some of that'll come out in Q2, some of that'll come out in Q3. The bigger item, ironically, is that in moving to the Venlo warehouse, with the increase in volumes, there has been an increase in the VAT receivable, the V-A-T receivable, from the Dutch government. We had been assured we would get a big payment the last week of the quarter, and that didn't happen. In the first 10 days of April, we collected round numbers about $125 million of the VAT receivable. So we'll see that Q2 should be better than Q1 and probably ahead of that 70% target. We already got a good head start on it. We got roughly $125 million in the -- a large piece of which probably should have been in Q1, if not the whole thing. So we'll get a little bit of acceleration of cash in Q2 around this. And then we'll have to track the seasonality, et cetera, beyond that. But as I say, for us it's 2 identical -- identifiable items that really we're able to point our finger at. In fact, when look at working capital year-over-year on a gross billing basis, we only saw about a 1 day slip. And it's hard to really say that's good or bad. It's just it happened, and we'll catch up on that also.

Your next question comes from the line of Mark Delaney representing Goldman Sachs.

I was hoping first, Mike, if you wouldn't mind elaborating a little bit on the linearity of your business throughout the quarter for both computing and components.

Well, the linearity for the first quarter of the business, is that what you're asking?

Correct.

Well, we saw things, of course, strengthen the last month of the quarter. And in fact, that's where we saw the billings or the bookings start to come in, too. It was interesting because when we had gone through the first quarter, we weren't quite seeing the same rates, but we did see them significantly pick up in the April time frame. That's why we were comforted that there was some consistency with it. Also, remember that earlier in the year, you have the Chinese New Year. And during that time, we don't have the same booking rates before that new year ends, and so China also starts to strengthen after that happens. And that's really a significant event for China. But for the most part, everything came in toward the end of the quarter.

For my follow-up question, I understand you guys wouldn't want to comment on any unannounced deals. But can you just remind us what the business today for distribution of equities like servers, some of the value proposition that you bring to set, if there is any change in who owns those businesses, why Arrow would make sense to use it as a distribution partner? And then related to that, if there's any agreements with your resellers such that they would still be required to use Arrow for at least a set period of time.

Andy, you want to comment on the reseller fees?

Sure. So I want to make sure I understand the question. Are you talking in regards to the overall server market or the UNIX proprietary market?

I was talking more on the standard server part.

I'm sorry?

I was talking more on standard servers.

Oh, on standard server, okay. On the industry-standard server, I mean, we believe we're very well positioned today regardless of the changes that might occur in the market. I mean, there's a couple rumors out there that are best asked of those suppliers, what's going to happen. But we're very strong in blade [ph] and we're very strong in enterprise server with Intel architecture, and you may have just seen our recent announcement with Lenovo around our EAD business. So in general, our value there is still a midrange-data-center value. We're very comfortable with our offering, and I think the growth in our business of 6% for the quarter kind of validates what we're doing.

[Operator Instructions] Your next question comes from the line of the Louis Miscioscia representing CLSA.

Andy, when you look at the strong growth you have, how much can you attribute to just, I guess, end-market organic growth? And maybe how much can you contribute to what you've done recently in adding some new OEM customers?

Well, as you know, the market, Lou, is growing slowly. I think a lot of it is due to our strategy, which Mike and I have talked a lot about. We call it our matrix strategy of expanding with new suppliers or taking the ones that we have in countries in Europe and expanding that relationship into new countries in Europe. And with 13 quarters in a row of organic growth, clearly, the building out of our line card is a tailwind there. The overall market is tough. I think we're gaining some share as well. So I would attribute most of it, though, to our expansion of the line card.

Okay, that's helpful. And then switching over to a different topic. When you look at Amazon's web services and also Rackspace, they seem to be growing very quickly and a lot of that seems to be coming from small-medium business. When you talk to number of your different VARs, are they seeing any sales shift over and processing shifting over from selling hardware with your VARs to the cloud?

What we see, Lou, in the Amazon offerings today and the Rackspace offerings is there's still a lot of basic things that are being outsourced. I think, if you look into companies like Rackspace, there's still -- a tremendous amount of that is web hosting. A lot of Amazon is Software-as-a-Service and what I would call a commodity space like e-mail. But I haven't seen a significant change in the way hardware is getting procured, or I haven't seen a big movement of off-premises server and storage. That's still a pretty robust area for us, and we still think that the hybrid private cloud is really driving our business today. And we don't see that slowing down.

At this time, there are no further questions. I would like to turn the call back over to Ms. Aviv for closing remarks.

Thank you, Shaquana. If you have any questions about the information presented today, please feel free to contact Paul or myself. Thank you, and have a nice day.

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect, and have a great day.