Arrow Electronics, Inc. (ARW) Q2 2014 Earnings Report, Transcript and Summary

Steven J O'Brien - Director of Investor Relations Michael J. Long - Chairman, Chief Executive Officer and President Paul J. Reilly - Chief Financial Officer, Executive Vice President of Finance & Operations and Interim Chief Accounting Officer Andrew S. Bryant - Chief Operating Officer of Global Components and Global Enterprise Computing Sean Kerins - President of Global Enterprise Computing Solutions Business

Jim Suva - Citigroup Inc, Research Division Brian G. Alexander - Raymond James & Associates, Inc., Research Division Shawn M. Harrison - Longbow Research LLC Mark Trevor Delaney - Goldman Sachs Group Inc., Research Division Matthew Sheerin - Stifel, Nicolaus & Company, Incorporated, Research Division William Stein - SunTrust Robinson Humphrey, Inc., Research Division Sherri Scribner - Deutsche Bank AG, Research Division Steven Bryant Fox - Cross Research LLC David Ryzhik - Brean Capital LLC, Research Division Amitabh Passi - UBS Investment Bank, Research Division Louis R. Miscioscia - CLSA Limited, Research Division

Good day, ladies and gentlemen, and welcome to the Arrow Electronics Incorporated Second Quarter 2014 Earnings Conference Call. My name is Jasmine, and I will be your operator 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 your host for today, Mr. Steven O'Brien, Director of Investor Relations. Please proceed, sir.

Thanks, Jasmine. Welcome to Arrow Electronics second quarter conference call. I'm Steve O'Brien, Director of Arrow's Investor Relations program. I'll be serving as the moderator on today's call. And 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, Chief Operating Officer, Global Components and Global Enterprise Computing Solutions; Eric Schuck, President, Global Components; and Sean Kerins, President, Global Enterprise Computing Solutions. By now, you should have all 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 CFO Commentary and the non-GAAP earnings reconciliation for the second quarter. Before I get started, I will 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. I will now hand the call over to our Chairman, President and CEO, Mike Long.

Thank you, Steve, and thanks to all of you for taking the time to join us today. We again executed well on our revenue, profitability and cash flow priorities in the second quarter, and we're pleased by the returns from our strategic growth investments. We're mindful of our position in the marketplace where we deal with a broad variety of technologies and touch upon an extensive number of customers and geographies. We continue to set aggressive financial targets and then to deliver on them. We're pleased to say we've done so again this quarter. We grew our global components business for the fourth straight quarter while the demand environment matched our expectations. Software and services continued to deliver good growth for our enterprise computing solutions business, and hardware recovered from the first quarter as we anticipated. Our consolidated sales were $5.7 billion, and diluted earnings per share were $1.43. Revenue and EPS came in above the midpoint of our guidance ranges, and we delivered strong leverage on our sales growth as operating income and diluted earnings per share advanced 17% and 20%, respectively. Year-over-year, operating margins were up over last year's second quarter in both businesses. Cash generation was again strong at $159 million. Return on working capital at a healthy 27%, advanced again year-over-year. Global components revenue was above our midpoint expectations. The overall market remains stable with lead times and cancellation rates within the normal ranges. Our sales of $3.6 billion advanced 5% year-over-year, highlighted by a fifth consecutive quarter of year-over-year growth in Europe. Book-to-bill remained positive at 1.04. Operating income grew 14% year-over-year, and the global components business has increased gross margins 2 quarters in a row and operating margins 4 quarters in a row on a year-over-year basis. Our global components business continues to bolster its leading value-added services by expanding design and engineering capabilities allowing us to deliver increasing value to both our customers and our suppliers. Enterprise computing solutions grew 10% year-over-year and were flat adjusted for acquisitions. Operating income grew 12%, and billings grew at a mid-single digit rate year-over-year adjusted for acquisitions. In enterprise computing solutions, we continue to move forward on our strategic transformation towards selling comprehensive solutions with a focus on the higher value segment targeted at the data center. Our comprehensive solutions addressed enterprise customers' entire needs, be they on-premise, in the cloud or a hybrid combination. Both global components and enterprise computing solutions are benefiting from the growing demands to generate and capture data from a proliferating variety of Internet-connected devices and security transmit, analyze and store that data. Paul will now provide an update of our financial results for the second quarter.

Thanks, Mike. Second quarter sales of $5.7 billion were above the midpoint of our guidance range. Adjusted for the impact of acquisitions and changes in foreign currencies, sales increased 1% year-over-year. Global components sales at $3.6 billion increased 5% year-over-year, above the midpoint of our guidance. For the fifth consecutive quarter, Europe had strong year-over-year sales growth. Europe sales in constant currency advanced 4% year-over-year with particularly strong results in Southern Europe. Sequentially, core sales in Europe were in line with traditional seasonality and our expectations. In the Americas, our sales were up 2% year-over-year. Americas' core sales were up 4% quarter-over-quarter within traditional seasonality. Sales in Asia grew 5% year-over-year and 8% quarter-over-quarter, in line with our expectations. Global components gross margin increased year-over-year, marking the second consecutive quarter of year-over-year increase. Global Components operating margin of 4.6% increased 40 basis points year-over-year. And our goal remains to deliver a 5% operating margin in 2014. Sales in our enterprise computing solutions business were $2.1 billion, well ahead of normal seasonality and in line with the midpoint of our expectations, driven by continued growth in our software and services businesses and by a rebound in our hardware-related business, following a spending pause during the first quarter. In the Americas, sales grew 34% quarter-over-quarter and grew 1% year-over-year. In Europe, sales grew 17% quarter-over-quarter. Europe sales in constant currency advanced 26% year-over-year, primarily due to the acquisition of Computerlinks. Adjusted for the impact of acquisitions, that's principally Computerlinks, sales declined 1% year-over-year in constant currency in Europe. In both the Americas and Europe year-over-year, growth in software and services were offset by a decline in proprietary service. We are pleased with the growing mix of high-margin software and services within enterprise computing solutions and believe profit growth is a far better measure of the market's uptake of our solutions. Enterprise computing solutions gross margin advanced year-over-year due to the more favorable mix of security infrastructure software as well as services. Operating income grew 20% year-over-year in the second quarter, and operating margin of 4.8% was up 40 basis points year-over-year. Our consolidated gross profit margin was 13.2%, up approximately 20 basis points year-over-year, principally due to both the margin improvement in our European components business and to more favorable mix within our ECS business. Gross margin declined sequentially by 70 basis points on a high end mix of ECS sales. Consolidated operating expenses increased 5% year-over-year on an absolute dollar basis. When adjusted for the impact of acquisitions and changes in foreign currency, operating expenses decreased 3% year-over-year. Operating income was $229 million, a 17% year-over-year increase. Operating margins advanced year-over-year as well, increasing by 40 basis points to 4%. Our effective tax rate for the quarter was 28%, net income was up 16% year-over-year to $144 million. Earnings per share were $1.43 on a diluted basis, toward the upper half of our guidance range and advanced 20% year-over-year. Cash generation from operating activities in the second quarter of 2014 was $159 million and $580 million on a trailing 12-month basis. Return on working capital for the second quarter was 27.2%, up nearly 300 basis points over last year. And return on invested capital was 10.5%, also up year-over-year. We repurchased $50 million of our stock in the second quarter of 2014, $125 million to the first half of this year. The Board of Directors authorized an additional $200 million of repurchases in May, and the current remaining authorization under our share repurchase programs stand at $226 million. Over the last 4 years, we have returned $1 billion to our shareholders in the form of share repurchases. Our capital priorities, funding organic growth, accretive M&A and returning excess cash to shareholders remains the same. This is a high-level summary of our financial results for the second quarter. For more detail regarding the business unit results, please refer to the CFO commentary published this morning. Now turning to guidance. We believe that total sales will be between $5.25 billion and $5.65 billion with global components sales between $3.55 billion and $3.75 billion, and then global enterprise computing solutions sales between $1.7 billion and $1.9 billion, all for the third quarter. We expect earnings per share on a diluted basis, excluding any charges, to be in the range of $1.26 to $1.38. Our guidance assumes an average tax rate in the range of 27% to 29%. Average diluted shares outstanding are expected to be 100 million shares, and the average U.S. dollar-to-euro exchange rate for the third quarter to be $1.35 to EUR 1.

Thank you, Paul. Jasmine, would you please open up the call to questions at this time.

[Operator Instructions] And your first question comes from the line of Jim Suva with Citi.

A quick question. It sounds like you're reiterating your confidence in the margin profile. The components businesses is about 5%. Can you just maybe help us walk through the visibility you have in that or the confidence? Because right now at 4.6%, it seems like a stretch, or was there something kind of pulling it down this quarter and help us understand that? And then my follow-up question would be on the SG&A outlook. You have a lot of different things entering SG&A. Some of them good, some of them headwinds, such as restructuring, ERP rollout and M&A. Can you give us a feel for SG&A and what we should expect?

I'll kind of take the differences, Jim, in the -- obviously, the seasonality of Q1 to Q2. When we said we were getting to the 5%, we also said last quarter it would not be linear. And we forecasted right about where we came in. We have made some investments in the business, good investments, towards the sales force. So some of that came online in the second quarter. We saw that. And as you did state, we did have an ERP conversion in Asia-Pac, although a little bit more de minimis than, I think, the investment we made on the sales line. We are doing some things structurally in the business, and I'll have Paul go through that in a minute, but here's basically the punchline we've seen. We see business pretty stable. We see the book-to-bill at 1.04, fairly stable. We've seen Europe really come on line since we did that conversion what has been 1 year ago and finishing up with Italy. We've seen continued improvements there in the profitability. North America, despite GDP being down, has really held their own and grown sales. And while we've seen a slowdown in the Asia market, we believe that it will continue to accelerate for us. And I might add, doing the conversion this quarter, it's the first time that we have done a conversion on a full business that has a run rate of around $4 billion. So think about -- we did the conversion last time in Europe in 3 steps. This is the first time we took the entire business and did a conversion. And we did that this quarter too. So we had more expense in our business of people participating in the Asia region. So hopefully, that gives you a little bit of an overview of the quarter-to-quarter swings that we saw. And Paul, maybe you want to add a little clarity to the expense line.

Sure, thanks, Mike. Just. Jim, one other point to -- around UNITY, which Mike mentioned. We end up with $5 million more of cost in Asia in Q2, principally all amortization because we turned it on there. As we've spoken about in the past, there's about a 6-month lag before we start to see measurable benefits from the new program. So while that's not going to be a step-up in Q3, that was a step-up in Q2. But we expect to see the benefits starting in Q4 and accelerate in beyond that. I would expect that SG&A will continue to trend up a bit in the third quarter for some investments we continue to make. Mike spoke about, spoken about the investments we're making in sales and marketing. The reality is we continue to believe we have still industry-leading results, whether an absolute operating income dollars and earnings per share, whether in operating income percent in terms of cash flow, which I think for the first half of this year, our cash flow was 120% of our GAAP net income, and our returns are up. So we're making a strategic decision to continue to invest in the business to get growth. And we think we can afford to do it. So we feel good about where we are. We think we're taking a measured approach to that. And we think that the payoff comes about 6 months after we make those investments. We'll begin to see some payoff from investments we made in the first half of this year, late in Q3 and definitely through Q4. And we'll continue to pay some investments as we go forward.

And the trend up on SG&A, do you mean quarter-over-quarter or year-over-year?

Well, the year-over-year, we were down actually in Q2 by, I think, 3%, if you exclude the FX impact and the Computerlinks acquisition. Keeping in mind though that also means that we absorb the extra $5 million of amortization tied to the ERP rollout. So I'd expect that year-over-year, our expense levels would be down in that 1% to 3% range also as we continue to move forward.

And your next question comes from the line of Brian Alexander with Raymond James. Brian G. Alexander - Raymond James & Associates, Inc., Research Division: I just wanted to confirm. Are you still targeting the 5% in the components business for the full year? Because it would seem to imply you'd have to hit like 5.25 in the second half to get there. So I wasn't sure if you were endorsing that for the full year because the investments that you're talking about in ERP and sales headcount, if they don't really begin to pay off until the end of the year, I'm just trying to understand where you get that incremental leverage from for the back half.

Brian, we think that if you take a look at the third quarter forecast, you'll see improvements there, and we would expect the fourth quarter to tick up again. So we're, at this point, feeling like we're still in that game to deliver on that, and we've put the investment in early. We actually saw some sales uplift this quarter from it. And if the market continues to hold, and we can continue to see that uplift, we do believe we can get there, Brian. Brian G. Alexander - Raymond James & Associates, Inc., Research Division: Okay. And then maybe just a bigger picture question about the cycle. Just curious, do you subscribe to the view that this is the new normal for the components business where cycles are flatter and less volatile and lead times should remain relatively short? And if so, is that an optimal condition for your business? Maybe just talk about the impact that flatter cycles might have on your value proposition, your margin profile and ultimately, the returns on capital that you're looking to achieve.

I think it's interesting you'd say that, Brian. We've always said that a flatter cycle is a tougher business for us to manage. It is also less exciting at times, and that is both good and bad. So in some instances, it takes a little drama out of it for us. I still believe that we'll see some swings at certain periods of time based on technologies that take off in wireless and other types of verticals where the manufacturers would then turn their attention. I'm still a believer that if we did see in the industry a 10% increase in sale across the board for everybody, you would probably be in an allocation mode, and we'd be right back at the tough to get inventory levels, customers panicking and ordering. Right now, there has been a good balance. And I think you could take a look at the last couple of years. We've been relatively successful within that balance. And I, for one, would actually welcome less swings, and I would welcome more predictability because I think it's under that scenario, you can invest easier in things like engineering that we were doing and see and measure your payback better than when you get these swings. That's sort of a byproduct of a soft environment, but I also -- or a flat environment. But being in this business for 30 years, and you guys looking at this business for an awful long time, we just haven't seen that type of thing over the years. And despite the fact that it's been like that, nobody is boasting about their world's economy. The U.S., the GDP wasn't anywhere exciting in the first quarter. Europe, by all stretch of the imagination, has been sort of a flat semiconductor market, even though we've kind of improved our position there, or some would say, take it back after our conversion. And we've seen some growth in Asia-Pac. But I don't think we've seen everything hit on all cylinders. And when we do, I think it's going to be an entirely different scenario than what we see right now.

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

I wanted to delve in the ECS on 2 different areas. Number one, just the healthy 40 basis point margin expansion year-over-year. Wondering if that can continue through the end of this calendar year. And then second, just wanted to get, I guess, an update on how you see the demand environment playing out in the second half, particularly for storage and server products given the fact that there was a pause in the first quarter, whether there's risk of that happening again and maybe just whether you see growth rates stable right now or the potential to accelerate.

Yes, as far as we see on the EPS side, our business now, compared to what it was years ago when it was primarily service -- servers, is really prepared now to service customers on-premise and off premise, as we've said before, through the cloud or any hybrid combination. So we're in a much better position long term than we were when we were primarily servers. The server headwinds are the piece that you see slowing offset by really securities software and storage, which has not been spectacular, but I wouldn't argue over something not being spectacular these days. In the near term, we expect to be right within our seasonality, and we expect that we'll still see a decent fourth quarter. I can maybe have Andy go a little bit into the cloud strategy and why we think that we're positioned pretty well, and maybe that will help address the second half of your question.

Shawn, it's Andy. Let me pick up, Mike, first on your opening. When you look at our performance for the quarter, we did it in an environment where proprietary server continues to be down year-over-year significantly. So we've really transformed the business, Shawn, and Software and Services are not at their highest percentage of our total since I've been here at Arrow. It jumped again year-on-year, the percentage of software and services. And that's driving our OI higher. It's also driving our returns on working capital higher because there's less visible inventory. And then to the second part of your question, and Mike's comment about the cloud. I'm sitting here with Sean Kerins, who now runs the business worldwide, and we're always looking at the pipeline. And there is some growing in the pipeline for server and storage that we think is building for the second half. There's a roll out of some new products from one of our big suppliers in the proprietary area. So we expect to see that installed base migrate, and there's a big change in server 2003 that's underway. So I would just say we're optimistic for the second half that we will see some demand pick up on the hardware side. And then finally, the cloud were well positioned on-prem or off-prem with our tool, ArrowSphere. And you probably noted our recent signing with Softlayer, an IBM company, VMware and others. So we've got a great mix there in the cloud. And again, in summary, we think the second half is stable and maybe firming up a bit.

That's good. And just to focus in on the margin side of it. Margins grew 40 basis points year-over-year in the second quarters. Is that type of growth rate in the margin profile sustainable through the rest of the year?

Shawn, it's Paul Reilly, so we were up 20 bps, I think in Q1, 40 in Q2, right? So when you look at it, on average, we're up 30 basis points over last year. So we don't necessarily look quarter-to-quarter. But we would expect our operating income margin in the business to be up year-over-year as we go forward. It's lots of different dynamics quarter by quarter. But so actually, our expectation to operating income percent will continue to trend up for the rest of the year.

Okay. Just a brief follow-up. 1.04 book-to-bill. If I look back last time you had a book-to-bill ratio, I think, in the second quarter this high was 2010, yet the world's still kind of moving sideways. Maybe if you could help me figure out what a 1.04 book-to-bill means relative to what we've seen in the past 3 years?

Well, what we've seen is an uptick in the backlog, and then you've seen an uptick in the inventory to support that backlog. But you did see the inventory grow. But if you take a look at the turns of that inventory, they remained about the same. We are expecting the business to continue to grow. And you saw growth rates from the first to the second quarter. And then you've seen our third quarter forecast. We're still relatively bullish on the business. The book-to-bill is still showing strength and diversity for us, which is something we like to see where it's spread out amongst the regions themselves, and no one place totally overpowering the other. So all in all, for us, it's a good, strong business. The backlog is there. And we think that we're poised to deliver the third quarter and then onto the fourth quarter, we can get another quarter of that book-to-bill. That's really going to project out the fourth quarter estimates that we think we're going to come forward for you guys. And it's all good news at this point.

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

My first question is on the same lines around the inventory levels and the component cycle. I think inventory dollars quarter-to-quarter came up about $200 million. I think at the midpoint of your revenue guidance for the third quarter, component sales will be up $80 million to $100 million quarter-to-quarter. So maybe just talk a little bit about to what extent you're starting to procure inventory for shipments in the fourth quarter? And if there's any areas that you're seeing some lead time extension?

Mark, it's Paul. So when we look at inventory management, our inventory turns are about flat with last year in Global Components. So we try not to feel good about the inventory levels. With that said, there's 2 other factors to consider. One is a traditional seasonality-type trend. We actually accept or take inventory in, in the month of June for Europe because there's extended holiday periods and distribution centers don't have as many people on hand to receive inventory that we hope to ship in the month of September. So we may not have seen that last year because the European economy was weaker, but our European business is showing really good growth. So really what has happened is you've added a little bit more inventory to support that higher level of sales in Europe. So the seasonal trend happened to happen this year, it didn't happen last year because the European business was weaker. I don't think that's an indication at all of the overall recovery or pace of recovery in the global components business. The other thing I would point to is keep in mind that we did do the Unity roll out in Asia. As Mike mentioned earlier, it was for a whole region. Something very different, best one we've ever done so far, but very different from what we've done in the past. And our team rightfully so, in Asia, took a prudent approach to inventory management. That meant, they had more inventory on hand than they normally would have had to make sure there are no stock-outs. The bottom line is we expect to sell that inventory out over the next quarter or 2. So I kind of look at that and I would say don't jump to the conclusion that we've added 10% uplift around numbers in inventory sequentially because we think there's an impending cycle change with an acceleration in the market or there's going to be extension of lead times. I think some of it is the normal seasonality that Europe's getting back to more normalcy, from things around community rollout. You may not have noticed that as much in the past because we did 1/3 of a region in each of the previous roll outs, so it's less likely to have a bigger inventory -- noticeable inventory impact. So I would just wouldn't forecast that out to be anything other than hey, we're managing, one, the region. It's turning around from a sales point of view. And two, more so around a prudent approach to inventory for a bigger region like Asia.

I appreciative the perspective on that, Paul. For a follow-up question, I'm hoping to talk a little bit on the Ultra Source part of your business. I don't think that's come up recently. Can you just talk a little bit about what you're seeing from a sales and a pricing perspective in the Ultra Source components business?

Yes. Mark, the one thing I would say is probably I'm not going to talk about pricing because everyone knows Ultra Source is really dependent upon a single supplier, and we don't like to talk about single suppliers. With that said, I would say that sales were up good in Q2 at a good rate over 10%. So we feel very good about that. We don't see anything really that's upsetting in the marketplace right now around the trend that's going to dramatically change up or down.

And your next question comes from the line of Matt Sheerin with Stifel. Matthew Sheerin - Stifel, Nicolaus & Company, Incorporated, Research Division: Just wanted to go back to the question and issue of the margin expansion and components that 5% target. It seems, given that the seasonality of the mix of the business typically works against you in the back half of a calendar year, particularly in December with Europe down, Asia flat to up. So it would seem that the mix on the gross margin side would work against you. So I'm trying to help understand how we get to the 5%-plus margin in the seasonally softer mix of business?

Matt, it's Paul. So -- understand the basics of what you all described. The reality is we've been investing in sales people, and we think there's a 6-month lag between when they come on board and they really get full speed as far as the selling of it. The contribution margin from their sales is anywhere from 10% to 12% depending upon -- that's in global components in general, and it could be higher in North America or in Europe and lower in Asia. So the reality is that we're looking to outgrow the market because we have more feet on the street, more sales people being more effective, tied more closely together with our investments in field application engineers, which also drive a differentiated margin. So when we think about it, we think we have a chance to drive more sales, more GP dollars. And of course, attached to that, we'll not go up meaningfully as we move forward for the second half of the year. Matthew Sheerin - Stifel, Nicolaus & Company, Incorporated, Research Division: Okay, that's fair. And in the design, in terms of the FAEs, are you starting -- I know Mike, last quarter, I think you talked about seeing an acceleration in terms of design activity and design wins. Is that still playing out, is that a good indicator going forward?

Yes, design wins is always a good indicator. And I think where we are in the design activity right now is up about 2% year-over-year. And the first half was around 104,000 design registrations, to give you an idea. I mean that's the magnitude of the numbers that we measure and the productivity from our engineering group. Once an engineer gets on board, it does takes them 4 to 6 months to get designs that are going to produce anything. And as you know, a portion of those don't produce. But we have definitely seen a correlation since I think we introduced that to you in 2009 between design wins, margin and improvement in the business. And while 2% doesn't necessarily say it's going to be a barn burner, 2% does say it's growing and that's the important thing. To go back to where Brian brought up before, yes, a little bit slower growth environment, but we are seeing the growth, we are seeing the firming in the margin, and we are seeing the business come in. And I think that's just the environment we're in. So I don't see it as an alarming trend right now. And I think with more engineers, we'll actually be able to skew that number more in our favor. And that's what we were really attempting to do with some of the investments. Matthew Sheerin - Stifel, Nicolaus & Company, Incorporated, Research Division: Okay. And then just switching to the computing segment where you haven't -- you're not seeing a lot of organic growth. And I understand that talking about these product cycles coming later in the year, which are encouraging. But have you seen any negative impact from some of the channel changes with suppliers, particularly the IBM program, giving some product to Ingram and Tech Data? Have you seen any share issues yet or any issues with that move?

We have seen absolutely nothing from the IBM change, Matt. In fact, I'm not sure the other guys have booked $1,000 at this point. With very much that de minimis to us, I can't imagine why somebody would want to put a bunch of engineering work into what has been a dying technology. But that, for some reason, we have to keep talking about it, I guess, to make everybody happy. Seriously, the proprietary server business has been declining for years. It being open, we don't see a big impact. We don't see it driving to anything different. And obviously, from our results, we haven't been hurt by it.

Matt, if I could just add some color around your observation about not much organic growth. And you're right, we're looking at it on an accounting constant basis. The reality is that we're now selling -- our billings were up 5% year-over-year, x acquisitions, right, billings. Remember, we kind of talked about the fact that the accounting for certain software sales is on a net basis. We only recognize the GP as revenue. And kind of so we are seeing organic grow, we're just replacing with different products. And in fact, the really proof in the pudding is the 20% uplift year-over-year and operating income dollars in the global ECS business. So look, I understand there's a lot of moving parts in all of our businesses. But we look at it and say, "Gosh darn, that's pretty good growth year-over-year, 5%." When you consider it's Europe and North America, the economies are not tearing it up right now.

Matt, just a couple of numbers for you just to help you. Proprietary servers year-over-year are down about 17%. That's why I'm really ho-hum on the IBM changes. There's really just not that much there that's worth going after. But our services business and software business is up 11% and 15%, respectively, towards that number. And that just highlights what Paul has said. We've really made a move over the last several years to change the complexion of this business. And that's also driven some of our margin activity higher, too. And we think that, that's positive. And we think that we know how to transition a business of this size. That, coupled with some of the new products and services that we can offer around the cloud, we really think we're in for a good transition. And we're following where the market is going, and we think that's going to pay off in the future for us. So hopefully, that helps a little. Matthew Sheerin - Stifel, Nicolaus & Company, Incorporated, Research Division: That's very helpful. Just a number on the server, the services and software as a percentage of your sales. Did you break that out?

I'll have to have the guys get it to you afterward. I don't have it here at my hands, but you'll see, it's a growing number.

And your next question comes from the line of William Stein with SunTrust Robinson Humphrey.

I'd love to hear about maybe a little more detail on the breakup in the systems business. It's done very well in the last few quarters despite all the fears around IBM and also the transition to the cloud. And again, you've done well in this segment of the business. I'm wondering if you can perhaps, give us some idea as to the breakout by product grouping and how it might have changed in the last couple of years. That may be a bit putting you on the spot too much. But any color you can give us in terms of quantifying that shift away from hardware, in particular, proprietary servers to software and services will be helpful.

This is Andy. I'll start -- let's start with the cloud. I think the one thing we know today about the cloud is, it's not an either/or decision. People aren't just saying I'm going to cloud, I'm leaving the on-premise behind. It's very much a blend of on-premise, off premise, and we've been very strong in both those bases. We've built out our ecosystem to serve both those bases, whether it be on-prem, off-prem or hybrid. And so, I think as you look at some of the recent results of cloud sales around the market, things aren't maybe going quite as fast as everybody thought. And we stayed very focused on our data center line card, and I think it reflects in our performance. When you go to the software services line, both of those areas are growing double digit, as Paul highlighted. And particularly, Computerlinks has been a home run. By any stretch of the imagination around that strategy, Computerlinks brought us new capability, new reach. And if you look at our European performance, we had record sales, record operating income and record operating income percent in Europe. So that's a big validation of that strategy that's paid off. And so when you look even deeper below that, security is growing at 9% worldwide for us. That's a pro forma number. That's taking into consideration the acquisition of Computerlinks. So I'll just kind of sum it up by saying, we've moved the portfolio nicely to software and services. Within software, it's security, it's infrastructure, virtualization. All 3 of those areas are growing quite nicely for us, and that's how you see the performance actually getting better while the server market's been soft.

And any comment on enterprise switching? I forget your presence in that market.

Switching?

Yes, enterprise switching.

Well, we still represent some people like Juniper and Brocade in that space. Actually, our networking business has been growing quite rapidly from a smaller number. And so that's been a very strong segment for us.

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

I just wanted to ask again about the ECS segment. I think you've said that there was some improvement in the hardware business. I know that the proprietary business has been declining. But can you give us some sense of which pieces of the hardware business are improving and what parts you're most excited about for the second half?

Sure. We saw the industry-standard servers. Sherri, go up on the quarter. We saw a 9% increase in EMEA. And year-over-year, that's up about 2%. And as we've said, we saw declines in both Europe and North America around proprietary servers.

I would just add, Mike, networking up 5%, which is also included in our hardware calculation.

Okay, great. And then just thinking about the margin profile with the shift to more software and services. Understanding that you're recognizing the gross profit and the revenue line. Would you expect that your profitability and your operating margins to continue to improve in that segment as the business mix shifts?

We just put in a new president of that business, and we wouldn't have done it if we didn't think it could continue to improve, Sherri. So yes, we absolutely believe that he'll take what he has and make it better.

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

A couple of quick questions. First on the ECS profit growth. You mentioned the 20% year-over-year. Can you just sort of remind us what that growth would have been excluding the acquisition? And then I have a follow-up.

Growth on ECS.

I think it was at the 12% range.

Okay, great. And then looking at just -- there's been a lot of discussion on this already. But going back to some of your prepared remarks about solution sales, targeting the data center. Is there any more color you can provide in terms of how you're attacking that market? How it's affecting? Is it too early to sort of talk about maybe how it's affecting the financials and what kind of investment rates we could see in the future there?

Yes, I'll give you a couple of things. In the beginning, we announced Softlayer, an agreement that we do with IBM. And then the rollout of our vCloud Hybrid Service with VMware. And then we have a relationship with Microsoft to enable staff positioning. Overall, we've got several different SKUs, especially if you get involved with our ArrowSphere program, which maybe, Sean, why don't you just add to that a little bit around ArrowSphere. And that will give you a view that it's really a comprehensive program, not only product-line specific, but one that is important and affects our resellers right along with it.

Sure, Mike, I'll be happy to. ArrowSphere is a proprietary platform that we've invested in over the past couple of years. And it's a place where all of those cloud-based solutions SKUs that we've been signing as part of our new ecosystem reside. And what it does is it enables the existing channel as well as our emerging channel, involving MSPs and other new resellers, if you will, sometimes referred to as born in the cloud. It really helps them adopt those SKUs as they try and serve their customers' needs, be they on-premise, off premise or some combination of the 2. And what it does is it helps simplify all the associated provision, billing and contract management on behalf of those partners. As a service-recurring revenue, it's a little bit trickier to manage it, this is a tool set that really makes it easier for those sellers to move in that direction.

Steve, it's Andy. If I could add an additional comment to your question around how we are changing and attacking the data center. We have 2 big plays right now that are driving it. Security has become the biggest concern of most CIOs and big data, and of course, our storage offering and analytics has become the driver of the data center. So I would just go back and point to the moves we've made with Computerlinks and how we've grown our storage business. It's really becoming the lead as we go into the data center. And then as Sean outlined, cloud is also growing as well.

That's very helpful. And then if I could just sneak a very quick one in Paul. Looking at where the inventories are today in dollars and given sort of some of the growth prospects that we look for, for the second half of the year. I'm not sure if I should think about inventories in absolute dollars coming down before the end of the year, maybe generating a little bit of cash or staying at these levels. Is there an easy way to think about that?

Right, it's a good question. So I would say that our expectation would be that depending upon the pace by which we're able to exit some of that excess inventory in Asia, we'll see some of variability in the cash flow, but that's quarter-by-quarter. Over the next 6 months, I don't expect us to see a dramatic change, negative change in how we're managing our cash. I think as I mentioned earlier, first half of this year, our cash flow from operations is 120% of our GAAP net income. Our target's like 70%. So we continue for the second or third year a row to outperform that. I expect us to be very healthy in the second half of the year. And we worry quarter-by-quarter, but we look at bigger chunks, so I don't think there'll be any negative impact on cash as we work through the end of the year.

And your next question comes from the line of Ananda Baruah with Brean Capital.

David Ryzhik here for Ananda Baruah. Just going back to software and services. Is the strength concentrated in a particular region, or is it more broad based? And would September Q guidance assume double-digit growth for both of those segments as well?

This is Mike. I only heard the first part of your question. What we've really seen in the services piece is North America's a little bit ahead of Europe in growth. Europe's around 7% on the services side. And on the software side, Europe is actually leading North America by the same kind of few percentages as you saw services the other way. So the good thing about what we're seeing is that the business is learning from each other, region to region. And that's really allowing us to grow our sales exponentially because they're sharing best practices between them and they're following suit very good. So it's not 1 region that's leading the task of the transformation of the business, but it's actually both regions. And we've been real satisfied with the work they're doing together to make sure that Arrow, as a whole, is benefiting by this.

And does September quarter guidance assume double-digit growth for software and services?

Well, I think we're in normal seasonality, right, Paul?

Yes, so he's talking about year-over-year. You're right, the same pace of growth that we saw really in Q2 or the first half of the year, we would expect to continue in the third quarter.

And one last one, just a general commentary on enterprise storage, any color on traditional versus emerging would be helpful.

So this is Sean Kerins here. It's a good question because storage has been a high growth segment for us for a great deal of time. We have seen it slow somewhat, I think the market is taking it's time to evaluate the emergence of certain new technologies that includes flash, that includes converged and hyper converged. And even things like software define. But in general, we have seen pipelines and activity levels improve for storage. And so we think as we look at the full second half, we're fairly optimistic.

And your next question comes from the line of Amitabh Passi with UBS.

I had a question and then a couple of quick clarifications. On the question, I guess, Mike, for you, the year end. You have given all the discussion around cloud and your focus on software and services. Given some of the trends that we are seeing with alternative forms of storage, whether that be flash, riser, white box, switching, alternatives by host of private and public companies, are these other hardware categories also an area of interest for you within the context of cloud, or do you think you'll sort of increasingly shift your focus more in software and services?

No, they're definitely an interest to us. Storage has been a business around here for a good number of years. And being in the components business, we have absolutely no fears of a technology change. In fact, we had to change the entire computer business to make it what it is today from just a storage house. And I think that we fully understand storage. We understand where it's going, we understand who the players are. We have had some lines we have signed to make sure that we'll participate in that growth. And we're really going to be ready for it in all fronts. I think you'll see it happen slower rather than faster. And I think it will be a migration just like we typically see around technology. But we're really not concerned about it.

Okay. And then Paul, just a couple of quick clarifications for you. On the global components operating margin, can you clarify, is it 5% for the full year, or do you think you'll hit 5% exiting the year? And then just your free cash flow. I think last quarter, you said $300 million to $400 million is the target for the full year. Is that still on track?

Right. So just for clarity on the 5% goal. Our CEO has set the target of 5% operating income in our global components business for the full year. And then the number that you have for cash flow is still what we anticipate being able to deliver for this full year.

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

Another question on the ECS side. Could you mention how well you're doing on the converged system front in the sense that, that seems to be getting a lot of traction than the ones that you are partnering with in the space? And then a couple more.

Thanks, Lou. Good question. Sean Kerins again. So the converged infrastructure market segment has been quite promising for us. I don't want to talk about too many suppliers specifically, but suffice to say, we represent all of the solutions that you hear most about in the market. And we continue to see above-average growth in that segment as compared to storage in general and certainly as compared to servers. And I think it will continue to serve us well in the future as data centers migrate from traditional stand-alone servers and storage to things that are more integrated.

Okay. You mentioned that there's going to be a major rollout in the second half on the proprietary line. Are you getting any feedback from clients so far that demand for that is going to show a material rebound from a very, very weak first half and I guess maybe in a very weak 12 months?

Lou, it's Andy. What we typically have there is an installed base of customers who look at price and performance. And as you know, the new server's been announced. I would only comment that the quote activity is very active and the pipelines are building. But it's hard to put our thumb around that one or put our hands around what it's going to mean by the end of the year.

Okay. And then final question's on the gross margin line. When you look back to last year, it was, I guess, maybe more flattish on a quarter-to-quarter-to-quarter basis. This year, very strong gross margin in the March quarter, down quarter-to-quarter. I guess, is that now more typical? And then what can you tell us about, I guess, the September and December quarters from a gross margin standpoint?

Is that for Arrow? Are you talking about the ECS business?

No, that's for the company, in general. The 13.85 to 13.12, which is up materially first quarter year-over-year, but then only up modestly second quarter year-over-year.

Right, well, I think there's a couple of things happening, right? We're looking at mix here and we look at Arrow Electronics, Inc. for the consolidated results, and we really manage the company based upon the segments and the geographies. So I'll go back and talk a bit about in our prepared remarks, we said that for the second quarter in a row we show an uplift in GP percent in the Global Components segment. That's a positive that we see happening. You may recall that we saw under this extended economic malaise, if you will, more pricing pressure than we had seen in the past. That always was our belief it would come back. So we're seeing some of that uplift. We're also seeing some of the impact of the change in the product mix in the ECS business where we have more software, which carries because it's on a net basis, certain segments of it, and positive impact on GP. So right now, if Europe -- and then finally we had Europe, right? Europe components, which was really a very integral part of our business, which had a 3-year rollout in UNITY, but even more impactful was the fact that the economies are so weak there. So we have a lot of different dynamics right now that are impacting GPP and driving it upward, and of course, the change in mix for the overall enterprise. So we would expect to see GPP continue to improve on a year-over-year basis. There'll be some quarters when it will be stronger, and some quarters when it will be weaker. But it will still be an improvement year-over-year. And that's really what we're focused on.

We have no further questions. I would now like to turn the call over to Mr. Steve O'Brien for closing remarks.

Thank you, Jasmine. If you have any questions about the information presented today, feel free to contact me. Thank you for your interest in Arrow Electronics, and have a nice day.

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