Sunshine Seeds
Investment summary
My recommendation for Arrow Electronics (NYSE:ARW) is a buy rating. The trough of this cycle seems to be reaching its end, and several leading indicators are pointing to this fact: book-to-bill ratio reaching parity, billings and gross profit dollars growing in EMEA, and sequential growth touching subprime levels. ARW should be well-positioned to ride on this next upcycle, as it has done a great job tightening its inventory position.
Business Overview
ARW distributes electronic components and computer products. The products that ARW distributes have a wide range, ranging from circuit protection to connectors, semiconductors, thermal management, etc. The customers that ARW targets come from various industries as well, from OEMs to commercial customers. Segment-wise, ARW reports in two segments: Global Components (GC) (75% of total revenue) and Enterprise Computing Solutions (ECS) (25% of total revenue). Geography wise, ARW has a pretty mix of revenue from the world, with ~37% from the Americas, 35% from EMEA, and ~28% from APAC.
Scale is a big competitive advantage.
ARW’s biggest advantage comes from its scale, which enables it to hold a wide range and deep depth of SKUs. Specifically, I meant the ability to hold thousands of SKUs across various product lines. In order to do this, the business needs to have: (1) sufficient financial resources (need capital to afford to load up on inventories); and (2) visibility into demand for each of these thousands of SKUs so that one can better plan how much inventory to hold.
For ARW, given its ~$30 billion revenue size, it has sufficient financial capacity to fund these inventory purchases, and importantly, it is able to hold more SKUs because it has enough demand visibility. For the smaller player, they are unable to compete because: (1) they have less capital; and, more importantly, (2) the lack of demand visibility means that they are not able to carry as much as SKUs—most likely just focusing on the mainstream SKUs that have high demand in the market. In addition, given the scale that ARW has, it has strong buyer bargaining power against suppliers, making it a lower-cost supplier than sub-scale players.
As such, large organizations that are looking for a lot of parts over a long period of time are likely to work with ARW, as they know ARW is able to supply what they need at a lower cost.
Demand stabilizing
ARW reported its 1Q24 results at the start of May. Revenue fell by 12% sequentially and 21% annually to $6.92 billion, which was 2% below consensus. By segment, GC saw revenue of $5.19 billion, down 8% sequentially and 24% annually, and ECS saw revenue of $1.73 billion, down 22% sequentially and 8% annually. Gross margin fell by 10bps sequentially to 12.5%, which led to a weak operating EPS of $2.41 (down ~40% sequentially and 48% annually).
From the reported figures, it seems like that business continues to perform poorly. However, I believe there are leading indicators that point to demand stabilization. Management highlighted trends that are positive for the consumer end-market in Asia, the demand for aerospace and defense in Europe, and the transportation industry in the Americas. In my opinion, these comments show that demand is beginning to stabilize as the company deals with the cyclical slowdown. Other more convincing leading indicators that ARW is nearing the end of this cyclical trough are:
The book-to-bill ratio has continued to improve since 3Q23, now reaching parity. EMEA billings and gross profit dollars grew on a y/y basis.
Furthermore, looking at ARW’s historical revenue cycle, I gained more confidence that the trough is near. Over the past few quarters, ARW has seen its largest deceleration in y/y growth for the past decade, and the last time this happened was during subprime. After the subprime crisis, y/y growth surged to significantly higher levels. From a q/q growth perspective, this also marks the longest and most consistent (direction is 1 way down, unlike the past with sharp spikes upwards) deceleration since the subprime crisis. Each time the sequential growth rate dips below -10%, the following periods’ y/y growth has been strong.
Redfox Capital Ideas
Solid inventory management
In a cyclical downcycle, we can see the quality of management execution scales, and ARW did not disappoint. Management has made significant progress on working down inventory, as seen from the decline in inventory dollars from near $6 billion in 3Q23 to below $5 billion in 1Q24, and management guided for another sequential decline in 2Q24. This is clearly very positive for ARW on two fronts:
This frees up cash for ARW to continue returning capital to shareholders. ARW bought back shares every single quarter over the past decade, even during downcycles. This lifts the pressure on gross margin, as ARW need not continue to provide discounts to clear inventory. I also note here that ARW has done a much better job in this cycle relative to the past, as the trough gross margin is higher than the past 2, implying a higher base for gross margin to expand from in the upcoming cycle (refer to the chart below).
Redfox Capital Ideas
Valuation
Redfox Capital Ideas
I model ARW using a forward PE approach, and using my assumptions, I believe ARW is worth ~$168 today. I believe the trough of this cycle is going to be in FY24, and ARW expects to see growth acceleration in FY25 and FY26. I took on a conservative view that FY24 will see growth decline by a larger magnitude than FY24, given that 2Q24 is guided to see further sequential slowdowns at the midpoint. For my recovery growth expectations, I do not expect the same strength as what happened after the subprime crisis, given that the factors driving this cycle are different (a high-rate environment vs. a financial shock previously). I forecast this recovery pace to be of a 50% smaller magnitude, to be conservative. Historically, ARW net margins have generally trended between 2 and 3%, and given the higher gross margin base, I see a high chance for ARW to achieve a 3% net margin as growth recovers. In my valuation expectation, I used the ARW historical average of 9x forward PE as my assumption. However, I note that valuation could trend higher since ARW will be in a growth cycle.
Risk
Arrow’s forward visibility remains limited, particularly with the ongoing compression in lead times, which are now closer to pre-pandemic levels. As such, management forward-looking statements may not be a good gauge of which part of the cycle we are in today. For all we know, we are still in a downward trend. The global recession is a major macro-risk that should be considered as well. A further slowdown in global economic growth will put further pressure on demand.
Conclusion
My view for ARW is a buy rating despite the ongoing cyclical downturn. While the company’s recent earnings report showed a decline in revenue and margins, leading indicators suggest the industry trough is nearing its end. ARW’s strong inventory management further strengthens its position, freeing up cash and reducing pressure on margins. Given the potential for growth acceleration in the coming years, I give a buy rating.
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