Arrow Electronics, Inc. (ARW) Q3 2013 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Arrow Electronics, Inc., Third Quarter Earnings Conference Call. My name is Patrick and I will be your coordinator for today. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes. I would now like to turn the conference over to Mr. Greg Hanson, Vice President and Treasurer. Please proceed, sir.

Thank you, Patrick. Good afternoon, and welcome to the Arrow Electronics Third Quarter Conference Call. I'm Greg Hanson, Vice President and Treasurer of Arrow. I will be serving as the moderator on today's call. If you'd 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 of Global ECS; Peter Kong, President of Global Components. By now, you should all have received the copy of our earnings release. If not, you can access our release on the Investor Relations section of our website, along with the CFO commentary and the non-GAAP earnings reconciliation for the third quarter. Before we get started, I'd like to review Arrow's Safe Harbor statement. Some of the comments 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'd like to introduce our Chairman, President and CEO, Mike Long.

Thanks, Greg, and thanks to all of you for taking the time to join us today. Arrow, once again, had a strong quarter with year-over-year sales and diluted earnings per share up 2% and 8%, respectively. Revenue of $5 billion and non-GAAP diluted earnings per share of $1.18 were both in line with guidance. Our businesses executed well. Operating margins were up quarter-over-quarter and year-over-year with good returns on invested capital and cash flow generation. While executing well on the short-term, we continue to advance our long-term strategy deploying capital to both organic growth initiatives and acquisitions. We're investing in several sales initiatives, focused on further expanding our solution selling to the small and medium account base. Finally, we've made excellent progress on our annualized $75 million productivity initiatives and expect to exceed the targeted savings by the end of 2013. As you saw, we closed Computerlinks acquisition just 2 days ago. This acquisition advances our matrix strategy in Europe. It gives us a stronger presence in the large German market and access to fast-growing products. We believe we provide the most comprehensive solutions to our customers in both Europe and North America. We'll continue to deploy capital to accelerate our strategy of providing full-service, value-added services to our customer. Turning to global components, we view the overall market as stable. The conversations with our industry partners indicate that the supply chain continues to be tightly managed and lead times unchanged. Our sales of $3.5 billion were in line with seasonality and expectations. Book-to-bill, which was the highest third quarter level in 3 years, was near parity. Sales advanced year-over-year in the Americas and Europe, and were flat in Asia. Our core growth margins expanded quarter-over-quarter, both in Europe and Asia, and modestly down in the Americas. Operating income also improved year-over-year. In our enterprise computing solutions, we also see a stable market. Our North American business saw growth in storage, services and software. In Europe, results were modestly below our expectations due to a pushout of activity in the U.K. Both regions were also somewhat affected by the early quarter end cut off when compared to several of our suppliers. We estimate the impact to be somewhere between $50 million and $70 million. ECS margins in the third quarter were 4%, advancing year-over-year. Our strategic transformation towards a comprehensive selling solution with focus on high-growth, high-margin products continues to provide good results. Looking to the fourth quarter, we're not expecting to see a meaningful change in the macro economy. Currently, our view is we would expect to see sales in line with traditional seasonality in the fourth quarter, in both segments of our business. We continue to pursue a balanced approach to maximize our performance in the short term without sacrificing our long-term goals. Paul will now provide an update on our financial results for the third quarter.

Thanks, Mike. Third quarter sales of $5 billion were in line with our expectations and guidance. Adjusted for the impact of acquisitions and changes in foreign currencies, sales were flat year-over-year. In global components, sales of $3.5 billion increased 3% year-over-year and were in line with our expectations. In the Americas, our sales were up 2% year-over-year, and in the core sales business in Americas, we were flat quarter-over-quarter, which is in line with traditional seasonality. In Europe, sales in constant currency advanced 4% year-over-year. Sequentially, core sales in Europe increased 1%, which is at the high end of traditional seasonality. Sales in Asia were flat year-over-year. Core sales in Asia Pacific grew 7% year-over-year and were flat quarter-over-quarter. The sales comparison in Asia is somewhat negatively affected by our decision to exit our customer engagement that did not meet our financial hurdles. Sales in our enterprise computing solutions business were $1.6 billion, also in line with our expectations. In the Americas, sales grew 3% year-over-year, were down 14% sequentially. In Europe, sales in constant currency fell 14% year-over-year and 26% sequentially. Sales were below our traditional seasonality. As Mike mentioned, we saw a pushout of sales in the U.K. and as was expected, there was an impact due to our quarter end cutoff, which was earlier than several of our suppliers. The silver lining of the difference in the third quarter cutoff is that we are off to a good start in the fourth quarter. Our consolidated gross profit margin was 13.3%, an increase of 30 basis points quarter-over-quarter as core margins advanced in global components and ECS. Year-over-year, gross margins were virtually flat. Operating expenses were essentially flat year-over-year on an absolute dollar basis. And adjusted for the impact of acquisitions and changes in foreign currency, operating expense dollars declined 2% year-over-year and were 20 basis points lower as a percentage of sales as our efficiency initiatives more than offset our investments for future growth. Operating income was $194 million. Both operating income dollars and margins advanced year-over-year, and that's the first time we've seen that in 7 quarters. Revenue growth, stabilizing gross margins and our efficiency efforts all contributed to this improvement. Global components operating margin of 4.9% was at its highest quarterly level since the second quarter of 2012. Operating margin increased 10 basis points year-over-year and 60 basis points sequentially, well ahead of traditional seasonal trends as our higher mix of sales in Europe, stronger gross margins and the benefits of our productivity initiatives improved results. Global enterprise computing solutions operating margins were up 30 basis points year-over-year to 4%. Our effective tax rate for the quarter was 29.4%, which is a little higher than our traditional range and cost us $0.01 versus our guidance. We expect to move back to the 27%, 29% range in the fourth quarter. Net income was $120 million, and earnings per share were $1.19 -- and $1.18 on a basic and diluted basis respectively, up 8% year-over-year. Cash generation from operating activities in the third quarter was $81 million and $423 million on a trailing 12-month basis, once again exceeding our targeted level of 70% of GAAP net income. Return on working capital for the third quarter was 23.5% and return on invested capital was 9.6%, well ahead of our weighted average cost of capital. While we did not repurchase any shares in the third quarter as capital was directed towards our acquisitions, please keep in mind this aligns well with our strategy of allocating capital first for our strategic growth initiatives, then to M&A, then finally, to return excess cash to shareholders. Year-to-date, we have repurchased nearly $300 million of our equity. This is a high-level summary of our financial results for the third quarter. For more detail regarding the business unit results, please refer to the CFO commentary published this morning. Now turning to guidance. As Mike mentioned, we are not expecting to see a meaningful change in the macro environment in the fourth quarter. We believe that total sales will be between $5.6 billion and $6 billion, with global components sales between $3.2 million and $3.4 billion, and global enterprise computing solutions sales between $2.4 billion and $2.6 billion. We expect earnings per share on a diluted basis, excluding any charges to be in the range of $1.56 to $1.68. Our guidance assumes an average tax rate in the range of 27% to 29%. Average diluted shares outstanding are expected to be 102.5 million and the average U.S. dollars to euro exchange rate for the fourth quarter to be $1.37 to 1.

Thank you, Paul. Patrick, at this time, please open the line to questions.

[Operator Instructions] And gentlemen, your first question comes from the line of Amitabh Passi with UBS.

Paul, just a question for you. On the fourth quarter outlook, can you give us some sense of how you're thinking about the contribution from Computerlinks, and then how should we be thinking about gross margin and OpEx?

Sure. So let me work in reverse order. When you compare it to the third quarter, we would expect that seasonal trends, much stronger global ECS business, would result in a downward move on gross profit. Not meaningful, but you'd see, 10, 20, 30 basis points downward. That also would result in a downward trend in the operating expense to sales ratio. So that when you look at it, operating income percent should be up both over the third quarter and over the fourth quarter of 2012. We'll have the Computerlinks acquisition in our results for 2 months this quarter. And as our previously published information, it said, it's immediately accretive upon closing to our results. So we would expect that the impact would be -- I'm going to put a round number out there, about $0.06 in the quarter, maybe a little bit more, a little bit less, as we get to understand the pace and activity of that business. But we feel good about it being immediately accretive in the first quarter that we owned them.

Okay. Again, we'll double check our numbers, but it looks like we have to assume operating margins going up to like the mid-4% range just to get to your EPS target. And that just seem like a pretty strong sequential uptick, and I want to confirm if we're kind of on the right track there?

It sounds directionally correct.

Okay. And then just a quick one for you guys, on the component side, what needs to happen for you to get back to, say, the 5% plus range, is it simply a function of the macro environment, developed market? I mean any color you can give us in terms of, a, how the business is trending, and b, what you would need to get to that 5% plus operating margin target?

Sure. We're actually in pretty good shape. As you saw, we were at 4.9% for the quarter. And our core margins did expand quarter-on-quarter. They're both up in Europe and Asia, and modestly down in the Americas. Certainly, if we had some better market conditions that would drive volumes, we would go right past that right now. And although we see somewhat of a lag there, we're going to continue to drive our gross margins which should get us back into that range. We've made really great progress with that business. And without the -- if we don't get the market improvements that we're expecting, we are seeing benefits in Europe right now on the European implementation, coupled with some of our efficiency programs. So we're pretty sure that we can improve that business back to those margins that we had put in our timeless business model.

Your next question comes from the line of Paramveer Singh with Stifel, Nicolaus. Paramveer Singh - Stifel, Nicolaus & Co., Inc., Research Division: This is a Param Singh on for Matt Sheerin. First of all, I want to get a little color on your component side. You heard that some of the Asia OEMs have weakened a little bit and how does this compares to your guidance especially as it relates to MediaTek? And how able to those quarter-to-date? Then I have a follow-up.

Sure, I can talk to you about that. Sales in the third quarter in Asia for us were somewhat negatively affected, as we decided to exit a customer engagement that was not meeting and we didn't think was going to meet our financial hurdles. We did seek growth in other areas, including our vertical markets where both lighting and transportation were up quarter-over-quarter. We expect, actually, in the fourth quarter that the Asia sales will be right at the midpoint of seasonality. Book-to-bill is running strong for total Asia. And the core business itself is above 1. So most of the indicators we have out of Asia is looking pretty good. Paramveer Singh - Stifel, Nicolaus & Co., Inc., Research Division: I was actually looking, I want to know what the book-to-bill overall was to the component segment. And for my follow-up, on the computing side, I know you had that 1 day or 2 days off and the sales were recovered in December quarter. But have you guys seen any impact from the shutdown of -- and I know some of the OEMs have guided slightly differently than the distributors have. And do you think there is a disconnect?

Well, I think, as we said before, the day shutdown for us was somewhere $50 million to $70 million. The October rates are already up over that where we would normally see going forward. So the truth is when you look at the guidance and the seasonality, it will all follow that 1 day we view as that was our main impact on the ECS side.

And on the book-to-bill, just as a reminder for the third quarter, we were at 0.99, which is the highest third quarter book-to-bill we've had in 3 years in the components business. And we're above 1 in the month of October.

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

I was hoping you guys could elaborate a bit more on the Computerlinks acquisition. Yes, maybe first, if you can talk about how the margins of Computerlinks are relative to the rest of the ECS business?

Sure. Mark, it's Andy Bryant. So Computerlinks margins are pretty much at par with our ECS business today. We may see a little bit of an uptick in our European performance because of their mix around network security. They have operations in the Americas, that will be about at par. So in general, their value add and our data center value add are very much matched up pretty closely.

That's helpful. For my follow-up, I just wanted to talk on Computerlinks. Paul, I think you said $0.06 of quarterly accretion. The price [indiscernible] that you guys had put on in the past, I think it's that kind of $0.20 to $0.24 for the full year. And you guys get yourself a partial quarter for the fourth quarter of this year. So it's $0.06 on a run-rate basis when you have it fully integrated for a full quarter as -- or is $0.06 the benefit that you expect you get this year?

$0.06 is what we'll deliver for the month of October and -- I'm sorry, November and December this year, Mark. So there's -- any synergies that will happen are further out, obviously driven by things like regulatory requirements which take longer. So any expense synergies are further out in the year, but the $0.06 is for 2 months. Keep in mind, this business is similar to what we do in our North American business and our European business. So it's more heavily weighted to Q4 being the best quarter, if you will, with the summer quarter being the softest quarter.

Your next question comes from the line of Shawn Harrison with Longbow Research.

This is Chris Dankert calling in for Shawn. So you guys said that you're expecting the cost savings program to exceed targets in the December quarter. I was wondering if you could just say what you're targeting now and what the incremental is for the December quarter?

Sure. So what we gave was $75 million and right now, we're looking to be substantially higher than that by the end of the fourth quarter. We had a lot of items that came up for us where we're able to reposition in our business. And that will cause that $75 million number to be exceeded.

All right, great. I guess, also with -- I might have missed it if you already addressed it earlier. But with the announcement by Avnet on the dividend, I guess where does the dividend rank as far as your outlay of cash?

Our deployment of capital is to invest in initial sales initiatives. It is to then proceed with M&A. And it is then to return to the shareholders. So far this year, we've returned over $300 million to the shareholders. And I think Paul can probably give you a number over the last couple of years. So we're quite comfortable with where we are in our capital deployment at this point.

Right, just as a retrospective look. We've returned over $1 billion of capital to investors over the last 5 years.

Okay, great. And then, sorry, just kind of coming back to restructuring. Can you just remind us where you're at now on a dollar basis?

I guess, maybe what we can do is take it off-line if you're just trying to understand what the incremental impact would be in the fourth quarter. I'm happy to take that off-line and try to figure that out and help you out. But from a modeling point of view, maybe Greg can help you with that, Chris.

[Operator Instructions] Your next question comes from the line of Brian Alexander with Raymond James. Brian G. Alexander - Raymond James & Associates, Inc., Research Division: Paul, can you just talk about the nature of this engagement you alluded to in the Asia components business? Just what changed in the relationship and what's the significance from a revenue perspective, and what does that do to your Asia profitability with that out of the bottle?

Right. So the nature of the relationship was that when we first entered it, it was an engagement that was going to be much larger, much more impactful. In the end, it didn't really grow and get to enough size and scale where we could get our hurdles on operating income or return on working capital. So the run rate was about $30 million per quarter. So we'll drop about $120 million engagement on an annualized basis that we've had for about 9 months. And it has an impact that obviously, as you would imagine, because it had low margins and low returns, it will increase the core business performance in Asia-Pac. If I pro forma and go back to Q2 and take that roughly $30 million run rate out and adjust for the whole engagement, we're still up in GP percent on a sequential basis in the core business, and the operating income percent is still up meaningfully on a sequential basis. So while it certainly impacts the margins, it doesn't really distort the real performance, which is meaningful uplift in operating income dollars and percent on an apples-to-apples like basis. Brian G. Alexander - Raymond James & Associates, Inc., Research Division: Great. And then just a follow-up. If you'd normalize for Computerlinks and for the timing of the cutoff, the $75 million, I think you referenced earlier, I don't have my model in front of me. But what would that equate to in terms of normalized sequential growth per year in December guidance for ECS if we were to adjust for both of those, what is kind of a midpoint of your guidance assuming sequentially?

You're right. Brian, I think I could put it this way. In Europe, we would be above the midpoint of traditional sequential performance, the midpoint to upper end. And then I have to look at in North America, we'd be below the low end to midpoint.

Your next question comes from the line of Steven Fox with Cross Research.

Just 2 questions for me. I was just curious if there's any change in sort of your design win activity on the component side that would signal any changes in economic environment? And then secondly, just again following up on the disengagement in Asia. I mean, is there any broader statement to be made about your ability to win sort of acceptable high volume business going forward or do you think this was more one-off? And if it is a one-off, can you sort of go through some of the -- any other specifics that would be around that?

I think the -- I would call it a one-off. But as does happen, basically customer commits and commits certain volumes to get a certain price which requires a certain amount of inventory to be held for them, and the volumes don’t come in and the ratios don't work. And at that point, we made a decision to exit. I think it was a pure business decision on a deal. It doesn't impact anything or the ability to capture future deals. That's just one that was fairly tight and ultimately did not pan out so we made that decision to exit. I think any time where our capital deployed in a deal becomes more than the value we're getting out of that deal, we would make the same decision tomorrow. So for that one, I don't have any problem with. As far as the design activity goes, we're seeing designs, registrations up about 4% right now, or I should say a little over 4% for the third quarter. And Europe, actually being the leader, they were up the most during the third quarter, and we've seen a higher growth of activity there. Asia, we saw as up. In North America, we're seeing relatively flat. So hopefully, that gives you an idea of where we're seeing the mix come now.

Great. And then very quick follow-up. I just want to make sure I'm clear. Relative to the government shutdown and its impact on your North American business, are you saying it had an impact or too early to tell? Just want to clarify that.

Well, I think we did see an impact a little bit in the first part of October, in both sort of the core and the specialty businesses. But we're only actually expecting that to impact timing for us within the quarter. And remember, this only affects our North America business. So we don't expect it to be that big. And in fact, in our guidance, we really account for that. But we're not expecting that to be something we hang our hat on in the fourth quarter.

Your next question comes from the line of Lou Miscioscia with CLSA.

If we take out the acquisition in ECS, it looks like that business on a year-over-year basis is still flat for the second quarter. Whereas obviously, in March and June, you guys had a very nice year-over-year gains. I guess, maybe could you just remind us as to why that business decides to go back to the macro. I mean, obviously you had some 1 year or 2 of really great results there.

Lou, can I ask a point of clarity, did you say Q4 or Q3 versus Q3?

Q4. The guidance for Q4 for ECS.

Now, we think we'll still see some growth both in the North American VAD business in the fourth quarter. It may be a bit more modest, but we still think there'll be growth there. And in the European business, on a Euro basis, we'll be flattish to marginally up. So I think we really don't need to take a stop and think about it. North America economy is a little bit better than Europe, so we'll see a bit of an uplift there. And being flat and probably was a little bit weaker economy in Europe was pretty good.

Okay. Well, maybe then just compare that to the results you had over the last few quarters, where you're up many quarters in double digits. Is it just that you had some really good wins, they had it in but then they grandfathered?

I give you my view which is that, there's a change in mix also that goes on, right? Andy was just telling us this and reminding us just earlier today that in the fourth quarter, we see a bit more in the way of software sales. Software sales come at net revenue, not gross revenue in certain instances. So that while we may sell service, which come in gross revenue in Q2, which give you a bigger uplift, if you expand quickly, the net revenue part of our business software and some services, it doesn't get the same uplift in revenues, but the billings uplift would be stronger than what I just talked about in revenues.

Okay, great. And then maybe just on a similar topic but slightly different. Flash arrays, either all flash or hybrids are starting to come to market. Some those companies are coming public. You mentioned in your CFO comments that you guys are doing well in storage. Maybe you could give us a couple of lines as to whether you're also participating in this and is that where you're getting the majority of the storage growth from?

Lou, it's Andy. So, yes, we have signed several of the new players in that market, and you know who those players are. We're participating with one of our bigger supplier partners in that market, IBM. And as you can see, storage was still a double-digit growth for us in the summer quarter at 11.2%. So it's all a part of our strategy to continue to add to the line card what we think are the emerging technologies that serve the data center. And so we're very much on top of that.

And do you think that was most of your growth in the storage or did most of the lines grow in storage?

The growth right now, I think, Lou, is still coming from traditional disk. I mean, I think, you're seeing some change over there as you mentioned. But now the growth is coming from the traditional side.

At this time, I'm showing there are no additional questions in queue. I would now like to turn the call back over to Mr. Greg Hanson. Actually, I apologize, I do see that we have one additional question. It comes from the line of Scott Craig with Bank of America Merrill Lynch.

Paul, I was wondering if you could give us the book-to-bill numbers on a regional basis? And then, Mike, with regards to walking away from that business in Asia, I know you guys consistently look at business like that and are always evaluating it. But do you see other opportunities where you are looking at some similar businesses, either in components or in ECS where you can improve the profitability as it relates to getting into the ranges that you've put out there for your business models?

Yes, look, we do this all the time, whether it's with an acquisition, whether it's with a customer or even if it's a supplier that falls out. There are certain requirements that we have in-house. There are certain things that we need to do or certain levels that we need to be out to deploy our capital. And if we're tying a lot of capital up in a deal that is taking away from capital, we need to employ in a deal that is going to produce acceptable results, well then that would be a bad thing. So we strive to not make that happen, and we are going to pretty much stick to our guns of how we deploy capital and the profitability required in-house. It's a way we've managed the business. We've managed the business that way for a long time. It just so happens, I think we have a deal here that we probably exited at a time when you guys are watching the sales growth closer than maybe normal. As far as the book-to-bills, the book-to-bill, we're seeing North America is at 1, or it's above 1, I should say right now. The book-to-bill in Europe that we're seeing is above 1, and Asia is at 0.99 right now.

Your next question comes from the line of Sherri Scribner with Deutsche Bank.

This is [indiscernible] here. I'm calling on behalf of Sherri Scribner. So the question is just with regards to trends in ECS, which seem to be a bit lower than expected. Perhaps, you can shed some more detail on servers as well, and then I have a follow-up question.

Sure. We saw year-over-year change in industry standard servers were up about 10%. And having said that, we've seen proprietary servers continue their decline. And that was in the mid-20 range. Services we've still seen as being up at 12%. Software still up, storage still up, and networking is up meaningfully for the quarter. It's a slow server quarter, which is typical. But as we have been seeing over the last few years, proprietary servers are continuing to get hard -- hit hard just like they've been hit hard all year long. My guess is if there would have been one more day in the quarter, we probably wouldn't even be having this question. But that's pretty much how it's spelled given where our cutoffs were.

Okay, great. And the follow-up is just, how much government exposure do you have?

It's Andy. So first of all, again, the government exposure, we're talking about our North American ECS VAD business only. It's in the high-single digits as it relates to our forecast and already half of that has been booked and will ship. So the exposure is not that big. And we anticipate, through the balance of November and December, that the orders that we're pushed out due to the shutdown will come in. So as Mike mentioned, we don't see it as a significant risk.

We have a follow-up question from the line of Lou Miscioscia with CLSA.

Andy, I guess one more time with ECS. I know you described the business as stable. But any additional type of color or comments we could get at as certain folks or CIOs decide what to do with it and small-medium business decide what to do with their IT budgets as they close out the year?

Yes. So just maybe adding to Mike's comments because Mike took you through the segments. It's very clear that we're executing to our strategy to play more in the software and services part of the market, and Computerlinks is going to add network security, one of the fastest-growing segments in the market. So we're well positioned. And even with the decline in the server business, you see our operating margins hitting record levels for summer quarter at 4%. So there's really, from my perspective, no change to our strategy and our execution, it's going well. And I think CIOs, top of mind is going to be security, network security. And top of mind, it's going to be perhaps Software-as-a-Service in the cloud, and we're well positioned to capitalize on both.

I think just to kind of highlight that a little bit. IDC predicted growth of somewhere around 3.8% in 2014. And they are somewhere at 4.5% for 2014. And the Gartner numbers are a little lower than that, I think, they're around 3.6% or 3.7%, something like that. So that would indicate to me that we're still seeing a stable market. We've shown that we can outgrow that market over the last few years, especially with the changes we're making in it. So we're pretty comfortable that the market's relatively stable. And we're pretty comfortable that we're performing very well within that marketplace.

There are no remaining questions at this time. I would now like to turn the call back over to Mr. Greg Hanson for closing remarks.

Thank you, Patrick. If you have any questions about the information presented today, please feel free to contact me. Thank you, and have a nice day.

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a great day.