Good day, and welcome to Arrow Electronics Third Quarter 2022 Earnings Conference Call. Please note, today's conference is being recorded. [Operator Instructions] Thank you. At this time, I would like to turn the conference over to Rick Seidlitz. Mr. Seidlitz, you may begin your conference.

Thank you. Good day, and welcome to the Arrow Electronics' Third Quarter 2022 Earnings Conference Call. With us on the call today are Sean Kerins, President and Chief Executive Officer; and Raj Agrawal, Senior Vice President and Chief Financial Officer. During this call, we'll make forward-looking statements, including statements about our business outlook, strategies, future financial results, which are based on our predictions and expectations as of today. Our actual results could differ materially due to a number of risks and uncertainties, including the risk 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 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. Following our prepared remarks today, we will be available to take your questions. I will now hand the call to our President and CEO, Sean Kerins.

Thanks, Rick, and thanks to all of you for joining us today. Before I discuss our most recent results, I'd like to share some thoughts about my first full quarter as the CEO of Arrow Electronics. You know, I spent much of this time meeting with suppliers and customers who continue to validate the essential role we play in their success. I've also had the chance to engage our leadership team to review our strategic priorities, explore opportunities for accelerated growth and begin the process of refining our road map for the years to come. I look forward to sharing more about this with you over the coming quarters. Three months ago, I expressed how excited and confident I am about the future of the company. Today, I am even more motivated to lead this great company on a journey to realize its full potential as well as the noble purpose we fulfill in the process. I'm also very pleased today to be joined by our new CFO, Raj Agrawal. Raj will be a key contributor towards helping us focus our resources and investments for growth, leveraging the totality of Arrow's capabilities to extend our market leadership and advancing stakeholder engagement through our finance and other support teams throughout the world. I believe his strong financial acumen and business experience make him the ideal executive to lead our finance and accounting team and be an instrumental part of driving the continued growth and success of Arrow. Now turning to our results. I'm delighted to report that this was our best third quarter ever, with sales growth of 14% year-over-year on a constant currency basis. This is a function of strong performance by both our global components business and our global enterprise computing solutions business as well. The dedication and focused…

Thanks, Sean, and thank you for the warm welcome to Arrow. A few moments ago, Sean shared his excitement and confidence about the future of Arrow. I share his enthusiasm, and I'm extremely grateful for the opportunity to join the company and help it realize its full potential. I am impressed with the strong talent level in the organization, the deep business expertise and significant opportunities for long-term growth throughout the business. I look forward to engaging more deeply with shareholders, employees and partners over the coming months. Turning to our results. Third quarter sales grew by 9% versus prior year or 14% on a constant currency basis. Changes in foreign currencies impacted sales growth by approximately $380 million year-over-year, which was slightly more than our expectation of $350 million. Sequentially, the business declined by 2%, primarily due to currency impacts. The average euro-dollar exchange rate for the quarter was $1.01 to EUR 1 compared to our previous expectation of $1.02 to EUR 1. Third quarter gross margin of 12.8% was up 20 basis points year-over-year driven by higher margins in both global components and global enterprise computing solutions. Gross margin declined 30 basis points sequentially due to the normalization of our shortage market activities discussed earlier. Operating expenses as a percent of sales were 7.3%, down 50 basis points year-over-year. Interest and other expense totaled $51 million, above our prior expectation of $46 million due to higher rates on floating rate debt and higher borrowings. The effective tax rate for the quarter was 23.5%, in line with prior expectation and the target long-term range of 23% to 25%. Turning to cash flow and the balance sheet. Our third quarter operating cash flow was $141 million. Our cash cycle of approximately 63 days increased 3 days from the second quarter…

[Operator Instructions] Your first question comes from the line of Matt Sheerin with Stifel.

Just my first question, Sean, I'm just hoping you can provide a little bit more color on the bookings and the backlog within the components business. You said it sounds like book-to-bill is around 1. If you could clarify that. And in terms of the pushouts you're seeing, what are the reasons? We're hearing from others that there's an imbalance and customers are waiting for other parts. Is it that or other issues in there? Are there any specific markets where you're seeing more of that versus others?

Sure, Matt. Thank you. Happy to do some of that. So you're right. Our book-to-bill rates have normalized. We're at parity. That's for sure. As we said, demand in China is a little more challenging than it is in the West. I think the demand trends in the West are more broad-based and appear to be holding up certainly in the fourth quarter. I think if you look at our backlogs, our backlogs are still at all-time highs. They came down from its most recent high in Q2, but just a little bit. One thing our teams continue to do a great job of is working with customers and suppliers to validate and revalidate that backlog on a constant basis. So it's still well beyond historical levels. Maybe 25% or more of our backlog is what we would call delinquent. We think that through all the validation work that we do, that a good chunk of the backlog is firm versus forecasted, which gives us some confidence in our outlook, certainly for Q4. You asked about pushouts. We're seeing some pushouts. That's been mainly in China. But as I said earlier, almost no cancellation activity. To the extent that customers are looking to push out orders, it has more to do with them thinking about their production requirements for the long term. Demand patterns have not dropped precipitously, except for maybe in segments that are closely related to consumer technologies.

Okay. And then as a follow-up, just on the margins. It looks like based on your guidance, gross margins are going to be roughly flat quarter-on-quarter. So down 50 basis points year-on-year. I imagine part of that is due to the softness you're seeing in that shortage services business. I think that's called Converge. Are there any other reasons for that? Is it mix issues or anything else?

So Matt, if you look at the margin compression we saw in Q3, and some of which we'll see in Q4, you're right, it's primarily a function of just the normalization we're starting to see in the market and the softness in the shortage-related services that we provide. It's probably good to go back and just remind everybody what we talked about when we described the drivers for our operating margin expansion over the past several quarters. We said it was one part mix, both region and technology; it was one part pricing; but it was also one part structural. And what gives me confidence about the future is, while shortage-related services are one part of our structural value add, the reality is we've invested for lots of other capabilities as well. We continue to see the benefits of our engineering investments to capture design win margins. I think as I said in the script, our demand-creation revenue mix improved, both sequentially and year-on-year. And that, I think, still has runway in it for many years to come. Our supply chain capabilities are now helping us serve our customers in different and value-adding ways. For example, we're now finding ourselves with a viable role in the automotive industry in a more direct capacity than we would have ever imagined in the past. So when I look longer term, yes, we'll see some margin compression as it relates to shortage. But there's a lot of other structural investments that we've made to the model, which I think point us to sustainable returns.

Your next question comes from the line of Melissa Fairbanks with Raymond James & Associates.

I was just wondering, you had mentioned that on the inventory increase, a lot of the increase was largely related to pricing. I was just wondering, in general, what are you seeing in terms of pricing across the portfolio, either from the suppliers? How much of that is maybe providing a tailwind to revenue or operating profit? And then secondarily, as your inventory -- you are investing in inventory at kind of higher prices. Is there a risk that as kind of supply starts to normalize maybe as we go into next year, some of the pricing that you're able to pass along also normalizes?

Sure. I think I can easily speak to both of those questions. So if we tackle kind of pricing first, just so you have some broader context, price increases did drive the bulk of our year-over-year revenue growth. We have seen price increases kind of abate in terms of number and frequency, but they've not disappeared altogether. And what we were able to kind of monitor in the third quarter is that we still have been able to pass on price increases and haven't yet seen any real erosion. Unless demand were to drop precipitously, I think prices are going to remain fairly stable, especially in the technology sets still with longer lead times. If we go back to inventory and kind of look at it overall, we were actually pleased that it only creeped up maybe 4% quarter-on-quarter. I think that was the number. That was progressively less than we saw in Q2 and Q1 and so forth. So I think that you're right. The increase you see in inventory is almost entirely due to price increases. Our units were still down sequentially and year-over-year. But I'd say, we also feel pretty good about the quality of the inventory on hand. It's relatively current. And I'm not really concerned that we won't sell through it, given the size of the backlog that we still see in front of us and again, given the work we do to continue to validate its veracity.

Great. That's extremely helpful. Maybe just one quick follow-up on lead times. Are there any product sets or categories where lead times are still extended beyond normal ranges? Or is the supply starting to improve kind of across the board?

It's a mixed bag, Melissa. There are certain technology sets, things like memory and CPU where we've seen lead times come in somewhat, but there's still a great number of categories that for which lead times remain extended, and so for which we still carry significant backlog. And that sort of gives some support to my point that I don't think prices are necessarily coming down anytime soon. Lead times will continue to come in as supply normalizes, but I think that's going to play out over multiple quarters. And I think the overall demand in the market is still in excess of our ability to supply it. And so I think we're going to watch this play out quarter-to-quarter, but I feel pretty good about where we sit today with our Q4 outlook.

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

I have 2 for Sean, and if I can sneak one for Raj, that will be great. Sean, I wanted to ask you first on components. It looks like from the prepared remarks, you saw year-over-year revenue decline in Asia, which seems to be a somewhat weaker performance than one of your main competitors. So can you talk a little bit about what impacted your revenues in Asia? And did you see any share shifts in that region? And as we look into the December quarter, should we expect Asia to be a stronger -- to be stronger in the December quarter?

So what we saw in Asia in the third quarter, Ruplu, was largely a function of the macro headwinds and COVID-related lockdowns that we experienced in China. They were a little stronger and a little more persistent than we saw in Q2. We did also see a rotation of some level of supply from the East to the West, which bent a portion of our delinquent backlog, and that market went unserved. But I think the important point to kind of move to maybe at a higher level, Ruplu, is to think about our strategy. We've been very intentional with our strategy in Asia and especially China to focus on the industrial mass market, where we continue to see really healthy returns for our investments, and then to a much lesser degree, the higher volume, lower return segments like mobility and compute. So as I look at that market, I think at some point, the economic headwinds will diminish, and the economy will again improve. I wish I could tell you exactly when that will be, but I'm confident it will happen. Given our focus on the mass market, given the breadth of our line card, given the substantial size of our customer base, I really like our position in the Asia market for the long term.

Okay. One more for you. In the ECS segment, in the Americas, you talked about muted growth due to supply chain constraints. So maybe can you talk about which parts were short? And what was the impact on your sales from not having those parts?

So if you go back a little bit, Ruplu, our business in North America has always been a little bit more weighted to infrastructure as compared to our business in Europe, which is a little bit more weighted to software and cloud. So our backlog in that business is also at all-time highs. And therefore, if you kind of map that to our regional mix, North America carries a disproportionate amount of it. Some of the progress we did make in the quarter was a function of backlog relief, but the backlog levels are still high. I don't think that's going to improve in the near term. It tends to follow improvements in the semiconductor supply chain by a good couple of quarters, but we will get benefit from that backlog over time. And that's why the kind of the top line in North America may be not as robust as what we saw in Europe. As we look forward, I think, again, we're continuing to make progress with software, cloud and other aspects of our sort of IT-as-a-Service strategy. And I think the momentum will continue to look better for us in North America over time.

Okay. Raj, one question for you. Nice to have you on board.

Yes. Thank you.

Can you -- I was just wondering if you can talk about your thoughts on 2 things. One is on the free cash flow expectation, the working capital. How should we think about cash conversion cycle trending over the next couple of quarters and then free cash flow for the year? And then also, just in general, your capital allocation priorities. I mean, as you choose between buybacks or further delevering or M&A, I mean, just your thoughts on how you prioritize those different choices.

Yes. Absolutely. On the -- let me take the second one first, the capital priorities. Our primary -- our priorities really are to invest in the business. As you've seen in our -- over the last couple of years, we've invested a lot in our working capital, and that continues to be our #1 priority to drive organic growth and expansion. And then although we've not been too active on the M&A front the last couple of years, we continue to evaluate M&A opportunities, and that could be a use of cash. And then lastly, we use our excess cash flow over time. And I say over time because this business does go in cycles to buy back our stock, to the extent that we see it being attractive. And we see our stock at this stage being quite attractive as an investment, and so that's why we've been buying back our stock. When we think about free cash flow and working capital, we continue to have significant opportunity for more leverage as we need it. So we've continued to invest in the inventory. As you've seen, the inventory balances have gone up over the last year or so. And we have -- as Sean said, we have a strong backlog and strong demand for the inventory balances that we have. And so we feel good that we can clean out that inventory over time and really drive good cash flow in the business. So I don't really see any issues with the business. And we have plenty of capital capacity in the business today to certainly invest more in the inventory and also to buy back more stock, and that's really our strategy as we go forward.

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

You'd mentioned some order pushouts, you said geographically in China. Any sense on end market or end product like, I don't know, industrial or surveillance or anything like that for end market?

Yes. It's been more a function of consumer-related sectors. We did see a little bit of that bleed into, say, light industrial and parts of transportation in the quarter. But again, our teams still have a significant backlog. And even as they reschedule certain parts of it, we still end up with near-term demand that is a challenge to satisfy. But I would say the pushouts have not been broad-based, and they're far less significant in the West. And again, cancellations have been really de minimis.

And then just a couple of modeling things. Should we kind of anticipate inventory to sustain at these levels or be working down a little bit? I know it seems like pricing is starting to change a little bit and lead times are. But anything on inventory as we look at it? I mean I don't view it as a bad investment, but I'm just wondering about, since it's been building a lot through ASPs, how would you kind of be thinking about inventory looking ahead?

I'm glad you said that, Jim, because I kind of like the returns that we posted with the working capital in Q3 as well, and not to make light of it. We obviously watch this very carefully. We take pride in the fact that we know how to walk the fine line between our returns as well as both supplier and customer satisfaction. We don't anticipate significant increases as this cycle plays out. Remember, in the aggregate, we still have less supply than we have demand to go satisfy. So -- and as Raj points out, and as I said earlier, it's pretty current inventory. And as you've seen through many cycles, I'm sure we've got great confidence in our ability to sell through it, at which point, we start to generate lots of cash. So I think we're managing that about as effectively as we can give how complicated this market has been when it comes to trying to satisfy customers with scarce supply.

Okay. And then yesterday, the Fed raised interest rates. Can you help us understand what we should kind of be thinking about for interest rates for your company? And I assume it would include the actions from yesterday, but if you can just help us with that.

Yes. Jim, this is Raj. Our interest rate expense -- our interest expense has been going up, as you've seen in the third quarter. And then we also guided to even more interest expense in the fourth quarter, and that's largely related to the short-term rates going up over the last -- over this year actually, because the Fed has raised from almost nothing to high 3s now in terms of the Fed funds rate. And our debt balance is about 50 -- has been about 50-50 floating and fixed. And so that's why we're seeing the negative impact to the interest expense. But it's quite manageable. It's still accretive for us to continue to do all the things that we've been doing, including buying back stocks. So we're going to -- we'll sort of manage through it. And as this business goes through its various cycles, we'll get cash influx at some point in time, which will help us pay down some of the short-term debt.

I will now turn the call over to Rick Seidlitz for any closing remarks.

All right. Thank you for your interest in Arrow Electronics, and have a nice day. Thank you for participating. You may disconnect at this time.