Good day, and thank you for standing by. Welcome to the Arrow Electronics Second Quarter 2021 Earnings Conference Call. [Operator Instructions]. I would now like to hand the conference over to your speaker today, Steve O'Brien. Thank you. Please go ahead.

Thanks, Stephanie, and welcome once again to Arrow Electronics Second Quarter 2021 Earnings Conference Call. With us on the call today are Mike Long, Chairman, President and Chief Executive Officer; Sean Kerins, Chief Operating Officer; and Chris Stansbury, Senior Vice President and Chief Financial Officer. During this call, we will make forward-looking statements, including statements about our business outlook strategies and future financial results, which are based on predictions and expectations as of today. Our actual results could differ materially due to a number of risks and uncertainties, including the risks factors in our most recent 10-K and 10-Q filings with the SEC. We undertake no obligation to update publicly or revise any of the forward-looking statements. As a reminder, some of the figures we will discuss on today's call are non-GAAP. We have reconciled those to the most recent directly comparable GAAP financial measures in our earnings release. These non-GAAP measures are not intended to be a substitute for our GAAP results. You can access our earnings release at investor.arrow.com along with the CFO commentary, the non-GAAP earnings reconciliation and a replay of this call. We will begin with a few minutes of prepared remarks, which will then be followed by a question-and-answer period. I'll now hand the call to our Chairman, President and CEO, Mike Long.

Thanks, Steve, and thanks to all of you for joining us today. Over the last few quarterly reports, I've shared with you the growing momentum behind our business. Even as we navigated the pandemic, we maintain staffing. We continue to identify efficiencies to fund greater investments in design, engineering and supply chain services. I'm pleased to report that this momentum is yielding results. We achieved all-time record sales, gross profit and earnings per share, not just for the second quarter, but for any quarter in Arrow's history. In our industry, maintaining a leadership position requires constant evolution. At Arrow, we strive to be our customers' trusted source for solutions to their manufacturing and information technology challenges. We always seek new ways to help their businesses be more successful. To do so, we must consistently expand and enhance our service offerings in the areas of engineering, design for manufacturing, supply chain management and secure workload management. And we've made great progress on these fronts. Arrow is now operating from a position of strength. The opportunity for our business has never been greater. In the current environment, it's rare to find a company or industry that's not facing challenges from a supply chain perspective. We're ideally positioned to help customers address those challenges by leveraging our unmatched databases of design, electronic components information from our media properties. Beyond information, we see the companies around the globe are rethinking their approaches to component procurement. Just-in-time deliveries have become a high-risk, low-return strategy. Customers are seeking reliability, and we can work with them to create a more stable and a more secure stream of parts that benefits our suppliers as well. As a result, we've expanded our customer base, and are engaging with new companies who are in the past had not considered Arrow…

Thanks, Mike. Second quarter sales increased 25% year-over-year on a non-GAAP basis. The average euro-dollar exchange rate for the quarter was $1.21 to EUR 1 compared to the rate of $1.18 we had used for forecasting. The slightly stronger euro benefited sales growth by approximately $69 million more than we anticipated. Interest expense was slightly lower than we expected, but a slightly higher-than-expected effective tax rate offset any impacts to the bottom line. For the full year 2021, we continue to expect our effective tax rate to be near the low end of our long-term range of 23% to 25%. Turning to the balance sheet and cash flow. Second quarter operating cash flow was $281 million despite substantial inventory demand to fund growth. Over the last 5-, 10- and 15-year period, cash flow from operations has consistently averaged 90% of non-GAAP net income. But on a year-to-year basis, cash flow has an inverse relationship to sales growth. Our cash cycle of approximately 50 days improved by 6 days compared to last year. This improvement significantly aided cash flow performance in the face of working capital demands. Our liquidity position is the best in the history of our company and continues to improve. Leverage, as measured by debt-to-EBITDA is the lowest level in nearly 10 years. We returned approximately $250 million to shareholders during the second quarter through our share repurchase plan and this was the largest single quarter of share repurchases in our history and was enabled by our strong profits and proactive working capital management. We remain committed to returning cash to shareholders and recently expanded the operation by $600 million. The total authorization under our plan is approximately $663 million and we're confident that we're purchasing shares below their intrinsic value based on the increasing return on invested…

[Operator Instructions]. Your first question comes from the line of Joe Quatrochi with Wells Fargo.

Congrats on the results. I was curious, last quarter, I think you talked about being hand to mouth in terms of anything that you could get in from an inventory perspective to be right out the door. I was wondering if you could talk about the sequential increase we saw in inventory relative to the demand commentary you gave in the backlog commentary.

Yes. Thanks for the question. I think you hit right at the court of what everybody is wondering. Clearly, book-to-bills are still strong. Backlog has grown significantly again in the quarter. Inventory, while you saw up, I have to tell you, a moment in time, if you would have seen the same inventory on Monday, it would have looked significantly different. We are still a bit of hand to mouth. However, we've been able to try to manage our customers' expectations along with our suppliers, so everybody knows what's coming. Our third quarter guidance is purely guidance based off of what we think we can get in inventory. I can tell you right now, it'd be a very simple equation. It could be $1 billion bigger if I got the inventory. So the demand is not the issue at this point in time, supply is the issue. But I would say there's more visibility into supply now than there was last quarter or the quarter before. And hopefully, we'll be able to keep everybody's expectations in check. And hopefully, we can get out of this sometime next year. But as I said in my remarks, I don't see it anytime sooner.

And then just as a follow-up for Chris. Just kind of curious on the gross - kind of implied gross margin for the September quarter. How should we think about the mix and the pricing? It seems like that can be pretty strong going into the September quarter?

Yes. I mean I think, again, we got to be careful about looking at points in time. The way we're looking at it, if we look at our Q2 performance, we're basically back to the gross margin levels in the components business that we were at before we went into the cyclical downturn in late 2019. So Q2 '19 to Q2 '21, gross margins are pretty flat. So I think what you're really seeing in the business is a return to those historical levels, but at much higher sales and gross profit dollar levels, which is driving operating leverage down through OI margin. So as you go to Q3, to specifically answer your question, we just really see that trend continuing given the current environment, and we'll continue to drive strong leverage - operating leverage as we go forward.

Your next question is from Matt Sheerin with Stifel.

I just wanted to follow up on the previous question, that's regarding the gross margin and also just the pricing environment. And you looks like the mix certainly helped geographically with Europe growing year-over-year and really strong sequential growth in North America. But I would imagine that you're in a pretty beneficial position in terms of pricing, where you're not battling your competitors for orders. So how much of that is helping? And how sustainable do you see that?

Thanks, Matt. I think if you remember the last couple of quarters we had talked about, the design win business being off some, the engineering business being off some. And the ancillary business is in here where customers were focused on just getting product, not really driving more designs. We've had record design wins for the quarter. It's hard to find a business in-house that is not producing these days. So that helps a lot. The mix is sort of coming back, as Chris said, to pre decline levels. And I think that's really what you're seeing, Matt, other than something special because of demand. These contracts sort of roll off and roll on over the course of the year, so there's not a lot of room for a huge uptick in pricing. We do have suppliers that raise their prices. That gives us more gross profit dollars, which is a benefit. And we've seen that from a few of our suppliers, but it has not been widely done at this point, although we do expect price increases over the balance of the next year. And I don't think there's any way to stop that given the raw materials that are coming in. So price increases are real, they're for a real reason more than just the demand piece. But on the second side of this, Matt, customers are being held more accountable for their forecast than ever. And I think that's going to be good for the industry going forward - in the supply chain going forward. So I would say expect most of it to stick. And I'll leave it at that for right now.

Okay. And just on the similar other side, we've been hearing from several suppliers and customers, that customers are reconfiguring boards and designs to accommodate the constraints to replace parts with others. Are you involved in that at all with customers? I would imagine your FAEs are working with customers there? And do you see that as a positive or negative for Arrow?

I call it overtime right now, which is a positive. Any time our engineers are working over time, that's more money for Arrow, and we like that. And not to be too flip about it, but our design services business is working at scale right now helping customers find new products. I will put a caution on that. We see most of the work continuing to be new designs for the future. There's not a lot of mileage short term in trying to redesign a board to find another product because the product you're looking for is on allocation, too. And so I don't want you to think for a minute that, that work is the primary driver of the engineering business because, frankly, it's not. And when you look at the component lead times, there's not much that's available in 12 weeks right now.

Your next question comes from Ruplu Bhattacharya with Bank of America.

Congrats on the quarter. Is there a way to quantify what the impact was of component shortages on your revenues? Like, how much more could you have shipped either in components or an ECS if you had all the parts that you'd do it?

Well, I thought you heard me before, but give us $1 billion, we'll ship $1 billion. Give us $1.5 billion, we'll ship $1.5 billion. After that, I'd probably have to look at my notes and do some math to see if it's more, but it is a lot of product that we could ship.

Okay. I appreciate that. And then maybe just on the margins on the component side. You had a strong 50 basis points operating margin improvement, and you're above 5% now. I guess, on the guide for the September quarter, you're guiding for $100 million or so lower revenue at the midpoint. But do you think you can maintain the higher margins? I mean what - is there a way to quantify how much of that 50 bps mix versus FX versus higher volumes? And how should we think about margins going forward? Any thoughts would be appreciated.

I think you'll see like margins going forward. That's what we were sort of have in our model. And by the way, I had a bet with the guy that no one would notice we were over 5% on the bottom line. So thank you for that. It's - as I said, we're getting back to sort of the pre-pandemic levels, in the pre-downturn levels, where we did have the company leverage both from a scale point of view to produce right around that 5% range. And it's good to see even after going through a downturn and coming back up out of the downturn that we could get there. But we are expecting to stay right there for now.

Congrats on the quarter.

Thanks.

Your next question comes from Nikolay Todorov with Longbow Research.

Congrats on strong results. I want to first clarify the comments around component supply. You were able to get upside inventory in the second quarter. But judging based on your guidance, it sounds like you're going to face incremental constraints in getting inventory in the third quarter. So is supply getting worse? What are some of the drivers of that? You also talked about improving visibility. So it sounds like there's some silver lining of getting better, but maybe that's more in the fourth quarter or beyond that? So just a clarification on that.

Well, I think the qualification was I thought it would get better towards mid next year. That was qualification. I didn't expect it to get better in the short term. But if you look at the guidance, it would suggest we think we're going to get the same amount of product that we kind of ended up with last quarter. And it would be great if something else happened in the quarter, and it very well could. But our job here is to give you the very best that we see at the time that we're on this call, and I think we did that. I would hope we would get some upside, but you have everything we think we're actually going to get right now.

Okay. And then on the operating margin on the component side, getting to the 5%, obviously, much earlier than anticipated. Can you talk about the structural versus the cyclical components and impacts on operating margin? And as we think about - you mentioned component pricing is kind of an uptrend for the - at least in the medium term for the next couple of quarters, should we anticipate for you to see incremental uptick in component margins as pricing flows through and drive leverage?

Yes. If we see the growth - as we see growth, yes, I think you'll see some. The business operates to a certain level of the business, where all of your costs get based upon your mix. And if you're down in one area, your costs are a little higher, you feel that. Once the corporation gets to a certain breakeven size, everything becomes kind of a fixed cost after that. And I can have Chris detail that for you a little more when I finish. But when you have that fixed cost coupled with a little bit of margin improvement, that's exactly what you're seeing in the leverage, and we expect that to continue. Chris, do you want to add to that?

Yes. Nick, just to put it in perspective, going back to the comment I made earlier on where we were pre the cyclical downturn in '19 and pre-COVID and where we are today. So ROI margin has grown by 120 basis points. That's entirely OpEx as a percentage of sales. It's entirely operating leverage. The gross margin is effectively flat. And so back to Mike's point, there's a lot of puts and takes that go on in the mix of the business, but this is an operating leverage model. And the more that we can drive in terms of sales on GP on OpEx efficiently, that's what really drives the OI margin where it is. So that's the big picture.

Got it. Very helpful. If I can sneak one more. Free cash flow generation, very strong given the environment. Chris, it sounds like you got the right formula for working capital management. Maybe can you talk about the structural nature of free cash flow in a strong growing demand environment. Is this the new normal for Arrow to have positive free cash flow in this environment?

Yes. I wouldn't go so far to say it's the new normal. I mean the reality is back to Mike's comments on if we had more, we'd ship more. Ideally, if you were to take the current baseline of sales, we have a few hundred million more of inventory than we have today. Not crazy amounts higher, but we definitely have more inventory. And typically, in a window like of growth like we're going through now, you would see those additions coming in. But because of the supply constraints, it's a little tougher. So that will normalize over time. But that said, I think we can continue to manage our collections and our payables very tightly as well as those inventory turns and we will. And that has been a focus over the last 12 months. We generated over $700 million in cash, and it will continue to be a focus.

Your next question comes from Jim Suva with Citigroup Investments.

A lot of the commentary so far was focused on components, which is absolutely fair. Can you talk more about ECS? We're hearing about a lot of corporate enterprise demand, yet it seemed like this quarter, I'm not saying it was bad, but it was a little bit softer than I think what some people were expecting or maybe it was just lack of availability. Can you talk about ECS a little bit?

I'll give you an override. What we're seeing, Jim, is sort of a bit in our customer base of a retreat from work to home and migration to more complex data center issues that we had prior to the downturn or prior to the pandemic, which clearly changed the trajectory of this business and every other IT business out there. So we do have some supply constraints that are very real in that, plus the change of how the business is moving is happening at a pretty good clip, and it takes longer to close those more complex deals, they're longer to service those deals than just setting up work from home, somebody's home office. So that's sort of the structural change we've seen. I'll have Sean add to that a little bit and tell you what you sort of expect you'll see over the next quarter or two, which should catch up to this.

Yes. Jim, to Mike's point, if you look at kind of our performance in the second quarter, on a relative basis, we actually saw a pretty good strength across the hardware portfolio. Proprietary server, storage, networking. I take that as a good sign of kind of renewed activity levels in the traditional data center. I don't think that's all the way back yet. I think we're still looking for that to get back to more predictable levels, but I take that as a good sign. Mike is right, I think we saw at least a pause as it relates to some of our work and learn from home offerings and then the associated security. I think that's transitory, if you will. I think security is still a really good market to be in. I think it's a big piece of our mix, and we're going to continue to invest in that space, and that's going to be promising for some time to come. I think that as we look to Q3 and beyond, we are wrestling a little bit with the downstream impacts of the chip shortage in our systems business. I think we saw a rotation out of Q2 into Q3. I think we'll see something of a similar mix to out of Q3 into Q4. But activity levels, we do fully expect to pick up. Backlog is strong. We're now getting more visibility to more demand from end users to channel partners for multiple quarters, not just 60 to 90 days. So that's a good sign. So I think the overall direction of the market is promising but steady and somewhat mixed. I think we're headed for better days.

Great. And then my follow-up question, maybe it's better for Chris. I noticed your inventory went up. Mike said if he had another x amount of revenues, he could have easily sold it and X plus Y, you could have sold that to and maybe even more. When you mentioned a point in time for inventory, was that literally like a truck showed up the day of your inventory count and you didn't have time to completely unpack it. And if it had been like 3 days earlier, it would have been out the door? Or how should I think about those comments?

That's exactly right. We've been doing this for too long, Jim. We did have some inventory show up in the last 2 days in the quarter that immediately shipped out in Q3. So it's definitely, you do not want to read into, things are improving and supply is starting to free up. It was just a big shipment that happened to land on the day that it landed.

Congratulations.

Thanks, James.

There are no additional questions at this time. I would like to turn it back over to Steve O'Brien for closing remarks.

Thanks, Stephanie. Thank you all for joining us today. If you have any questions about the information presented, feel free to reach out to me. Thank you for your interest in Arrow Electronics, and have a nice day.

Thank you. This concludes today's conference call. You may now disconnect.