艾睿電子 (ARW) 2006 Q2 法說會逐字稿

Good morning. At this time, I would like to welcome everyone to the Arrow Electronics second quarter earnings call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (OPERATOR INSTRUCTIONS). Thank you. [Ms. Weaver], you may begin your conference.

Thank you. Good morning everyone and welcome to the Arrow Electronics second quarter conference call. I am [Sabrina Weaver], Arrow's Director of Investor Relations, and I will be serving as the moderator on this morning's call. Today's call is also available via webcast. To access this webcast or future webcasts, please visit our investor relations website at www.Arrow.com/investor and click on the webcast icon.

With us on the call today are Bill Mitchell, Chairman, President and Chief Executive Officer; Paul Reilly, Senior Vice President and Chief Financial Officer; Ed Coleman, President, Arrow Enterprise Computing Solutions; Mike Long, President, Arrow North America and Asia-Pacific components; and Jan Salsgiver, Executive Vice President, Arrow EMEASA and Vice President, Supplier Marketing.

By now, you should have all received a copy of our earnings release. If not, you can access a release on the investor relations section of our website at Arrow.com. Before we get started, I would like to review Arrow's Safe Harbor statement. Some of the comments to be made on this morning's call may include forward-looking statements, including statements address addressing future financial results that 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 several minutes of prepared remarks which will then be followed by a question-and-answer period. As a reminder to members of the press, you're in a listen-only mode on this call, but please a free to contact us after today's call with any questions you may have. At this time, I would like to introduce our Chairman, President, and CEO, Bill Mitchell.

Thanks, Sabrina and thanks to all of you for taking the time to join us this morning. Our earnings performance this past quarter was just terrific and I'm really pleased by the results we were able to post. Our initiatives to outgrow the markets, coupled with our ability to take advantage of favorable market conditions, enabled us to post record second-quarter sales and the highest quarterly level of sales and earnings since 2000.

As I would like to point out, we continue to manage our business for consistent performance and continuous improvement. And in doing so, that enables us to outperform the market regardless of the market conditions we are in. Although the data isn't fully available yet, we're confident that we gained share in all of our components businesses. In North American Components, daily run rates rose for the fifth consecutive quarter increasing sales to level not seen since the first quarter of 2001, while achieving strong gains in operating income.

Sales in Europe matched the highest level of quarterly sales in Company history while achieving almost 60% growth in operating income year-over-year. Asia again achieved record sales and made significant improvements in profitability. In the overall market, leadtimes remained at the higher end of normal, and I would emphasize normal ranges this quarter, with some spot shortages in some commodity products due to constraints in back end packaging and test.

Book-to-bill ratios were between 1 and 1.1 while cancellation rates remained low and pricing was generally stable. Our enterprise computing business continued to demonstrate solid profitability and returns. Growth was driven by strong performance in storage, industry standard servers and our European enterprise business offset by weakness in the broad proprietary server market and software in North America.

On our next slide, I would like to review some key second quarter financial highlights with you. We came in at the high-end of our revenue forecast and exceeded our expectations for earnings while continuing to deliver a strong return on invested capital. We posted our 14th consecutive quarter of year-over-year sales growth with an increased 24% or 14% on a pro forma basis, including DNS and Ultra Source in prior period results, to reach sales of $3.44 billion.

Earnings per share reached record levels excluding the tech bubble period at $0.77 per share, excluding certain charges and including the impact of option expenses.

Continued focus on carefully controlling our cost base resulted in a reduction of operating expenses as a percentage of sales to a six-year low, driving an increase in operating income of 35% and an operating margin increase of 40 basis points year-over-year. We generated a return on invested capital in excess of our cost of capital for the 10th consecutive quarter. Our return on invested capital was 12%, its highest second quarter level in 10 years.

In summary, we continue to outperform the market and remain our industry's clear leader in operating performance and return on invested capital. We once again had an excellent quarter as our ongoing initiatives and favorable conditions in the components markets led to an increased market share and consistently improving margin profile.

As we look ahead, we expect markets will remain rational and disciplined in all of the regions in which we operate. We expect the components market to return to more normal, stable conditions in the third quarter and that's a very healthy environment for us in which to operate. We will continue to show consistent, steady improvement across all measures independent of market conditions. Paul Reilly will now give you a more detailed view of the second quarter and then Mike, Jan, and Ed will discuss their businesses' performance in greater detail and I'll come back for a summary at the end.

Thanks, Bill. As reflected in our earnings release, there are a number of items that impact the comparability of our results with those in the trailing quarter in the second quarter of last year. I will review our results excluding these items to give you a better sense of our operating results. As always, the operating information we provide to you can be used as a compliment to our GAAP numbers. For a complete reconciliation between our GAAP and non-GAAP results, please refer to our earnings release or the earnings reconciliation slide at the end of the webcast presentation.

Sales for the second quarter were $3.4 billion, an increase of 8% sequentially and 24% year-over-year. Pro forma for the impact of acquisitions, we grew sales by 14% over last year. Sales in our worldwide components business were $2.8 billion, an increase of 6% sequentially and 27% year-over-year. Pro forma for the acquisition of Ultra Source, sales increased a very strong 20% year-over-year.

Each of our component businesses around the world achieved sequential growth and impressive year-over-year increases in sales and operating income. Worldwide components operating margin increased 30 basis point sequentially and 60 basis points year-over-year. As we push forward with our ongoing initiatives, particularly in Europe and the Asia-Pacific regions, we continue to make great progress in achieving the targets set out in our timeless business model.

Worldwide computer products sales were $680 million. That's up 17% sequentially and up 14% year-over-year. Pro forma for the acquisition of DNS, sales in our enterprise computing solutions business declined by 2% over last year. Our solid performance in storage, which increased by 24% year-over-year, was offset by continued weakness in the broad proprietary server markets and software in North America. In our computer products business remained solidly profitable with industry-leading margins and strong returns in working capital.

Our consolidated gross profit margin remained flat sequentially at 15.3%. During the quarter, we saw increasing margins at our core small and medium-sized components customers which were offset by the change in mix. The acquisitions of DNS and Ultra Source accounted for the entire decline in gross profit percent when compared to Q2 of 2005.

Operating expenses as a percentage of sales were 10.4%, a decrease of 10 basis points with the first quarter and down 110 basis points from last year. This quarter represents the 14th consecutive quarter of year-over-year declines in operating expenses as a percentage of sales and is at its lowest level in six years. WE continue to be very proud of our consistent progress with initiatives to drive operational excellence further into our business.

Operating income was $166.3 million, an increase of 10% sequentially and 35% year-over-year, again demonstrating our success in growing earnings faster than sales. Our operating margin was up 10 basis points with the first quarter and up 40 basis points from last year. Excluding the DNS and Ultra Source acquisitions, our operating margin increased by 60 basis points.

Our effective tax rate for the quarter was 33.7% and for modeling purposes, you should assume that our tax rate for the remainder of 2006 will be approximately 34%.

Net income at $94.7 million was up 13% sequentially and 45% from last year. Earnings per share was $0.78 and $0.77 on a basic and diluted basis respectively, excluding certain charges but including option expense. Earnings per share on a diluted basis increased by over 40% compared to last year's second quarter.

Inventory has always been and will continue to be the lifeblood of our business. As a partner to the supply chain, we continue to be focused on having the right product at the right time for our customers. This quarter, to assist our customers through the transition of becoming compliant with environmental regulations issued by EU, we built additional buffer stock around RoHS products. In addition, in Asia Pacific, we built inventory to position ourselves for the onset of the peak season in the second half of the year.

While our decision to invest inventory resulted in the use of $98 million of operating cash flow this quarter, we achieved a strong return on working capital, increased inventory returns year-over-year and reached our highest second quarter return on working capital in 10 years. ROIC was 12%, the 10th consecutive quarter which our return on invested capital exceeded our cost of capital, and our ratio of working capital sales of 18.7% remains near historically low levels.

Our balance sheet remains very strong with net debt below $1 billion in net debt to cap at 26%. We will now discuss the results of each business unit for the second quarter. First up will be Mike Long, who will discuss our components businesses in North America and Asia Pacific.

Thanks, Paul. In North American Components, we continue to experience broad based strength during across all business segments this quarter. We also achieved our fifth consecutive quarterly increase in daily run rates, and preliminary market data indicate that we also gained market share. Sales reach the second highest level for a second quarter in Company history at $1.2 billion, increasing 6% over last quarter and even stronger increase of 17% over last year.

Specifically, sales in our passive electromechanical and connector segments achieved strong gains for the quarter as our growth initiatives continue to take hold. We again demonstrated the tremendous leverage in our business model by driving operating expenses as a percentage of sales down 150 basis point year-over-year, which led to operating income growth of approximately 30% and represents the sixth sequential increase in operating income. In addition, return on working capital increased 12% year-over-year.

With respect to current trends in the market, leadtimes have remained at the high end normal with some spot shortages in commodity products due to back end packaging and test constraints. Our bookings remained strong for the quarter with particular strength in the small, mid-sized customers while cancellation rates also continue to be within normal range. Lastly, our quarterly customer survey of over 300 of our customers indicated that well over half of our customer base felt they had appropriate levels of inventory heading into the third quarter. In summary, this was another great quarter for us in components in North America.

We move on to Asia-Pac, we again achieved record results with increasing sales 7% sequentially and 75% over last year's $569 million. Sales on a pro forma basis, adjusting for the Ultra Source acquisition, increased by a strong 25%, significantly outperforming the overall market. We experienced year-over-year growth in all regions, and the China and (indiscernible) region performed exceptionally well compared to last year. Continued focus on our higher margin passive electromechanical and connector products resulted in another strong quarter with the year-over-year sales in these products increasing approximately 40%.

Our operating performance improved substantially in the second quarter. Operating income more than doubled sequentially as we pushed forward with our efforts around profitable growth and operating efficiencies. We're excited about these results and can see a clear path into achieving our targeted levels of profitability for the region. From a working capital perspective, we have made a conscious decision to invest in inventory to position ourselves for the onset of the peak season in the second half of the year. We were still able to deliver an increase in return on working capital.

The market remained generally stable and order patterns stayed strong. While leadtimes continue to extend, this is not unusual as we head into the seasonally stronger second half, and levels remain at the upper end of normal. Pricing overall was stable with some increases from our PEMCO suppliers. In summary, we had a great quarter as we focus on generating profitable growth. With the infrastructure we built over the last two years, we stand well positioned to continue to gain market share and outperform the market. We look forward to achieving our goal of being the clear number one in Asia.

Thanks Mike and congratulations to both North America and Asia for terrific performance. Jan, let's turn to you because you had a terrific performance in Europe too.

Thank you, Bill. In the European region we also had an excellent quarter. Early market data indicate that we gained share with sales of $980 million, an increase of 3% sequentially on fewer shipping days and 18% year-over-year. This represents our highest second quarter sales ever and matches our level of sales in the first quarter of 2001, the highest quarterly sales in the quarter Company history.

Components were the driver, with sales up 5% sequentially and 22% year-over-year. A portion of the strength in sales of our core components was related to customers replenishing their inventories with RoHS compliant products. A higher mix of core components this quarter, coupled with ongoing strengthen our broad small to medium-sized customer base and our discipline throughout the business, drove continued strength in our gross margins. Sequentially, margins increased 70 basis points and 10 basis points year-over-year.

Our initiatives around growth and operating efficiencies continued to show results as we grew operating income 16% sequentially and 59% year-over-year. That's earnings growth of over five times sales growth sequentially and over three times sales growth compared to last year. We also delivered an increase in return on working capital despite our building RoHS related buffer stock to support our customers through the transition in becoming compliant with environmental regulations issued by the EU.

From a leadtime and pricing perspective, Europe was similar to the other regions with both being stable for most products. Leadtimes continue at the upper end of normal and book-to-bill remained positive. While pricing for semiconductors was stable, we did see some selected price increases in PEMCO products. In summary, we had a great quarter and we continue to focus on driving results by both investing in new markets and enhancing our existing strong, local presence with more consistent and disciplined processes on our way to one Europe.

Thanks Jan. Let's turn it over to Ed Coleman to discuss our enterprise computing solutions business.

Thank you Bill. Our enterprise computing solutions business achieved sales of $625 million, an increase of 22% sequentially and an increase of 18% year-over-year. Sales on a pro forma basis, adjusting for the DNS acquisition, decreased 2% year-over-year. We saw strength in the storage arena as well as solid performance in industry standard [service]. Our enterprise business in Europe performed very well again this quarter based on strength in DNS security, virtualization, and access software based solutions which comprised about a third of their revenue.

Our sales performance was impacted on a year-over-year basis [and] continued softness in proprietary servers, the loss of a large reseller customer at the end of 2005, as well as weakness in software sales in North America. Enterprise Computing Solutions again delivered solid profitability, decreasing operating expenses as a percentage of sales by 90 basis points which led to a 32% increase in operating income quarter over quarter. Disciplined focus on profitable growth along with efficient asset management also resulted in sequential increases in return on working capital.

In summary, ECS continues to have industry-leading margins and returns with significant opportunities in high-growth areas such as storage, services, software, and industry standard servers. We remain focused on providing value to our VARs and to working with our manufacturers and software partners to recruit, enable, and grow their value added channels.

Thanks Ed. Overall and in summary, we had a very strong quarter and we once again delivered results ahead of the overall market. We continued to manage the Company for steady consistent growth and continued to execute on the goals we set out to achieve, and I would just like to continue to emphasize the steady and consistent performance in the way we're trying to manage the Company.

And that shows up that we have consistently grow faster, grown sales faster than the market; 10 consecutive quarters of year-over-year market share growth in our components businesses. Our ongoing strategy is to drive efficiencies into all parts of our business, resulting in our ability to growth year-over-year earnings faster than sales for 13 of the last 14 quarters. And we significantly improved our financial performance, advancing our return on invested capital from 4.9% to 12% in the last three years while consistently generating a return on invested capital well in excess of our cost of capital for 10 consecutive quarters.

And that is how we're managing the Company -- consistent steady performance, consistent improvements.

Looking forward, we expect the components markets to return to more normal, steady conditions in the third quarter after having experienced an increase in demand over the last few quarters. Based on the information known to us today, we anticipate traditional seasonality for our businesses next quarter as markets remain rational and disciplined in all of the regions in which we operate.

In Asia Pacific, we expect to see uptake in demand in preparation for the typical holiday build. Both Europe, because of its extended holiday period, and Enterprise Computing Solutions due to its typical third-quarter seasonality, are expected to see a normal drop-off in activity levels. In North American Components, we expect normal seasonality coupled with fewer shipping days. We believe this will result in sales between $3.275 billion and $3.425 billion for the upcoming quarter.

We anticipate worldwide component sales between $2.67 billion in $2.77 billion and sales for worldwide computer products to be between $605 million and $655 million. Earnings per share on a diluted basis, including $0.02 relating to the expensing of stock options and excluding any charges, are expected to be in the range of $0.68 to $0.72 per share. Excluding the impact of expensing stock options, earnings per share for the third quarter are expected to increase between 35 and 42% from last year's third quarter.

We expect to continue to outperform the market and to move along the path of consistent execution towards achieving our timeless business model targets independent of market conditions. More progress lies ahead as we remain disciplined and focused on executing on the fundamentals of our business strategy -- growth, operational excellence, financial stability, and shared leadership. And we see a clear path to continuous improvement on all of the measures by which we run our business.

Thanks, Bill. I would like to open up the call to questions at this time.

(OPERATOR INSTRUCTIONS). Matt Sheerin, Thomas Weisel Partners.

Thank you and good morning. I'd like to delve into the inventory issue a bit, because I think if there's one area of concern from investors, it's that number that was up -- it looks like it's up in inventory days for the fourth quarter in a row. And if you could, just break down as much as you can how much of that sequential increase from last quarter is RoHS related, how much of it is buffer stock. And then also, what gives you confidence in visibility going into the end of the year that it's wise to build that buffer stock now, because I think were hearing from a number of suppliers a little bit of a more cautious tone about demand as we get into the end of the year?

Paul, why don't you take that one?

Thanks for the question. In fact, it's something that we focus on quite a bit. We want to make sure that we can service our customers, make sure we can meet their demands. And you know, there's not a single market that is consistent in how the inventory works, so when we look at the metrics, we're still performing well. We're performing better each year-over-year. We really had, when you look at it, our inventory turns are up. We had our second -- our highest second-quarter return on working capital in 10 years. As we talked about, it's the lifeblood of what we do. We want to make sure we can assist our customers.

We have customers transitioning to become compliant with environmental regulations, and we built buffer stock around RoHS. We know that the second half will be more robust in Asia-Pac than where it is for the first half and we positioned ourselves there also.

When you look at inventory turns, don't forget also there's an impact for foreign exchange. Interestingly, when you look at it, quarter end exchange rates are higher in Q2 than they were in Q1 or last year, yet when you look at the average rate which you use for the income statement, it actually was flat. It's pretty amazing. So that has an impact also, which obviously distorts inventory days or inventory turns, so we feel really good about where we are at inventory right now. There are always going to be times when there's increases to service customers and there will be time to take advantage of the marketplace and we've been pretty consistent in that.

Can you give us a percentage of the RoHS related buffer that you're building? Just give us an idea, and once that works through over the next couple of quarters as customers get comfortable with their inventory there, would expect that -- your turns to increase?

Yes, when I look at it, it's interesting as we complete the RoHS initiative if you will in Europe, we'll see a transition to other parts of the world -- for two reasons. One is manufactures in Asia-Pac or North America need to be RoHS compliant for products they are shipping into the European marketplace. So we'll see that expand in those regions also, as well as those regions began to focus more on their own local requirements around the green initiatives, so it's tough to say exactly how it's going to go piece by piece.

We would expect inventory turns to continue to improve year-over-year, and that's really what we're focusing on. Just one other point as a point of clarity, when you talked about the increase in inventory turns for consecutive quarters, actually decrease, don't forget that the fourth quarter is a bit distorted by the fact that we have a very heavily weighted computer products business which has a very low investment in inventory.

And then just lastly on RoHS before I go computer question, what kind of -- are you getting paid from customers for holding that inventory and do you have any liability there?

I'll take these first -- the second question first, which is no real change to our liability profile with our inventory, so you know that from our franchise agreements we have price protection and stock rotation and obsolescence clauses, all which mean that this does not increase our risk of this point in time. It may impact timing of cash flow, but not potential risk in inventory as we go forward, so not an issue there for us as we look at it.

I might ask Jan to comment a little bit on what she sees in Europe. In general, I think it's fair to say we are very pleased with what we have done in the RoHS transition. We like were we are in terms of inventory and I think we're well positioned. But Jan you might want to give a little more flavor to them since I suspect this is a topic of some interest.

It certainly is, Bill. I think we talked on the last couple of calls that we took a very proactive approach to communicating with our customers and to helping make sure that they were being as aggressive as they needed to be in order to meet the July 1st deadline. So we were very busy profiling inventory, preparing our customers for the change and preparing our own inventory so that we would be making our own transition.

And those activities are going on around the world as well. We feel very good about how we ended this quarter and there are some customers who are continuing to transition in the third quarter, but I would say the majority within Europe are done. As Paul said earlier, we do in fact see that different regions are adopting at different levels, and so it is one of those that's just going to take to little bit more time to work through.

And I think we view it as a real opportunity for us. We're in very good positioned. We profiled the inventory carefully as Paul said. We don't believe we've increase the risk profile of our inventory at all. What we do think is that we have positioned ourselves very well for both the continuing transition in Europe as well as the oncoming transition probably first in Asia and then in North America. And we see that as a big opportunity that we can provide service that not all companies are going to be able to offer. We have done the data. We have done the work. We have the inventory, and that's a very nice opportunity for us going forward.

Okay great. And if I can just ask a quick question to Ed on the computer side, it looks like you mentioned weakness in the proprietary servers, and you came in overall a lot lower than we had expected or your previous guidance, so trying to get a sense of that. Is that just a secular trend that you're seeing continuing? Is it sort of a onetime event? And how are you positioning Arrow's computing business now to basically change with the times and change with those trends?

Ed Coleman, could you take that one on?

I would happy to. If you go back to the first quarter, our performance was weaker than we had expected. And while there were indications of market softness in Q1, we viewed it at the time as somewhat of an aberration and thought we could have performed better with better execution. And we forecasted second quarter accordingly.

And while I believe we executed well this quarter against the market, it's become clear there is a real a continuing market softness that has revealed itself as more than just a short-term issue. Primarily around the proprietary servers in Q2, we certainly saw greater softness than we expected in proprietary servers, particularly at the high-end. As a result, we're focusing on the higher growth areas. We certainly want to maintain our position in proprietary servers in their traditional market. But we're focusing on higher growth areas such as storage, services, and industry standard servers as well as software based solutions to adapt to the market forces (inaudible) driver of growth in the future.

Okay. Thanks a lot.

Brian Alexander, Raymond James.

Thanks. Good morning. Bill, your comments in your outlook for the components segment to seem to be a little bit more cautious than kind of what you suggested in all the regional commentary, so just trying to tie that together and figure out how much is your new caution, if you will, due to daily run rates that you see in your business or feedback from customers versus broader macro concerns and just an overall weak stock market?

Brian, thanks for bringing that up because if I am coming across as being cautious, then I said it wrong. Here's what we're really seeing. We had some really solid demand in the first two quarters of this year, which was really higher than we expected. What we're seeing is that we are, in all of our businesses, that we are -- we have continued growth ahead of us. It's more normal. It's more rational. It's more disciplined. It's the market we've seen and that's a good environment for us.

And again, the third quarter is one where we see some seasonality. We certainly see some seasonality in Europe. We see some seasonality in our enterprise computing business. There's a bit of seasonality in North America and, of course, Asia is quite strong because of its beginning to build for the holiday season.

But we see continued growth in the marketplace as -- not as substantial as we saw in the first two quarters, but still good, solid growth, rational, disciplined markets and we're well positioned to continue to outperform [them]. And so we see no signs of a downturn in front of us at all, which is what some -- there has certainly been some concern expressed in the -- in lots of quarters about whether or not we are looking at a downturn. We don't see it.

Great. And then just a quick follow-up on your EPS guidance for the September quarter. If you kind of tie that back to your revenue guidance, it looks like you are expecting blended operating margin to decline a bit sequentially. Can you talk a little bit more about what's causing that decline? It seems like your overall mix between components and enterprise solutions should actually work in your favor from a profitability standpoint. So if you could kind of dig beneath those segments and help us understand if more of this is coming, for example, from the computer side or if there is anticipated margin pressure within any of the [GOs] in the component segment. Thanks.

It's Paul. The single biggest driving factor about the change in the margin is the fact that will see, as a percentage of mix, less European business which has a higher operating margin, and more Asia Pacific business which has a lower operating margin. And that's pretty consistent with what you would see historically in normal times where because of the extended holiday period really in southern Europe and especially in Italy, it impacts the mix and therefore the margin more than anything else.

So if we look, just to clarify, if we looked at the individual geographies within your components segment, we should not expect any real change in profitability quarter to quarter.

We're sure we would see that in Europe because it would have less component sales in Europe, so you would see a drop-off to a certain extent because of the fact that were getting less [GP] dollars, but no more than we would normally see in the third quarter.

Right. Okay. Thanks Paul.

Michael Walker, Credit Suisse.

Thanks. Paul, just back on the inventory question, I am wondering if I can ask it a little bit more directly. In terms of Q3, it looks like you're guiding overall sales down in the midpoint about 3% sequentially. Just given what you said about RoHS, although with the Europe deadline for RoHS been passed now and seasonality in Asia on the inventory front, do you expect inventory dollars to be down sequentially in line with sales or would you expect them to continue to run slightly ahead of sales?

When we look at the inventory, normally I'll say without worrying about issues around RoHS, that type of thing, the inventory at the end of the quarter really is what we're profiling for sales in the coming quarter. So we would expect to see that -- a stronger Q4 as we move out of the seasonally slow period in Europe, we could see the European business go up. We expect to see strength also in -- seasonal strength in North American Components, so it would be dependent as we move forward as to what we think the fourth quarter is going to be like for us to adjust inventory either up or down.

Although by that equation, you would have expected inventory then to be down sequentially in June since revenues are down.

Correct with the exception that we made a conscious decision to invest to be able to help our customers should they have disruption because of RoHS.

Okay, so looking out two quarters -- and I know you don't generally like to do that, but would it be fair to assume inventories might be able to see their first downtick in sometime in the December quarter?

Well then we would have to look in see what the business activity level is going to be like in the first quarter. And if we think about what we normally see, I'm talking about normal markets, we see Q1 being historically the strongest European business, pretty strong in North America also, but you would see a bit of the drop-off in Asia Pacific because of the extended Chinese New Year. So I'm not just talking about we normally see from a seasonality point of view. We'll have to obviously make decisions based upon with the market is going to be like either moving into Q4 into Q1.

Okay, and one last question on the inventory front. Is it fair to say that the inventory movement quarter to quarter is generally reflective of what's going on in the component side or have there been any kind of sharp fluctuations on the computer side?

I would say that generally it's more tied to components, though we do -- should recognize that our European computer products business is a little bit different than our North American business, and they have a little bit more investment in inventory in the DNS business than we do in the ECS business in North America.

Okay. And then second set of questions is on margins in the computer business. You've talked in the past about getting to 5.5 to 5.7% as kind of a year-end '07 targeted operating margin in the computer business. You had been running ahead of that. You're now running pretty well below that. I am wondering if that's still an applicable target range and what it's going to take to be able to get there.

Yes, were not changing our timeless business model goals for this business. In fact, when you go back and look historically, Michael, in you're absolutely right; we were ahead of it. We also said had that OEM business that we -- from a reporting point of view because we changed the way we run that business, moved it out of computer products to components. So that's a bit of a distortion when we compare to historical levels.

We're not changing our goal. We believe we can deliver on that. Ed believes he can deliver on that and we will push for that.

Also the one thing to keep in mind is that our fourth quarter is historically our strongest, so that kind of distorts six months results where we are today versus our timeless business model, which is a full year measure of success from a P&L and from a returns point of view.

Okay. My last question is on cash flow and from the perspective of the timeless business model, what's happened with receivables and with inventories has been that free cash flow has gone negative now for two quarters in a row after being positive for the prior six quarters. It feels like in this period of growth, you're starting to kind of revert to the countercyclical cash flow model. Is there something that's being put in place that could enable you to swing those cash flows back to positive even with growth continuing?

Yes. Two comments to that, Michael. One is in addition to having the operating income targets, we have a return on invested capital target, and we hit 12% this quarter in the face of negative cash flow. Keep in mind we've said we would deliver 12.5% in terms of invested capital by the end of 2007, and we're pretty close to it at 12%. So we recognize that while cash flow was negative for us for the second quarter in a row, we feel very good about our ability to drive that return on invested capital to a higher number.

In addition, we've said we would be cash positive throughout the cycle. I absolutely believe that there is more that we can do to be more efficient and more effective in how we manage inventory. As CFO, I get to say that. Guys like Jan and Ed and Mike have to execute on that. But we absolutely believe we can get there, and we think we will.

You have to also recognize that in periods of spikes in growth, that may mean that ability to really generate cash may be impacted. You are absolutely right. It's not just inventories, it's on the receivables side. Where we have more sales we have more receivables, and we manage that also. We do, though, fully expect that if we were to see some type of in the future, a downturn, we would expect to see the same type of balance sheet performance we've seen in the past which is generating a substantially more amount of cash flow.

Michael, this is Bill. One thing again to remember, we remain committed to the goals that we stated, that is consistent improvement. And one of those measures that we follow very carefully is the amount of working capital as a percent of sales, and we're committed to continuing to drive that down. That's -- that doesn't necessarily happen every quarter, quarter after quarter. It depends on the market conditions we are in, but over the long-term trend it's going to continue to go down. As we continue to drive that down, we get more cash positive and that's a good thing for us. And we remain absolutely committed to those goals and we remain absolutely committed to the consistent improvement in that performance of over sustained periods of time.

Thanks a lot.

Thomas Dinges, J.P. Morgan.

Good morning folks. A quick one for Paul on the income statement. Help me kind of walk through the operating expenses on the SG&A side. They were up about 6% sequentially in total dollars which was slightly below the overall increase that you guys saw in sales. Was this more a function of you're still expecting real strength in the computer products business and obviously didn't get as much revenue out of the model as you were expecting? Or was there some incremental hiring there as well? And kind of what's the expectation in dollar terms for the line as we move forward? And I have a quick follow-up for Ed.

Okay, on the expense dollars, first off, there are a few things that are outside of our control, which is surprising I know. But stock option expense was up over $2 million compared to the first quarter. In addition, our longer-term incentive program which is tied to generating returns for our shareholders was also up about $2 million. That's because of a change in our stock price. That's a function of change in stock price. So that's part of the increase; one is that the accounting rules and how it impacts us and one is just the change in stock price. So that's a little bit something that we can't control day-to-day.

We have said, Tom, that we would be making investments in the business, and we're not just looking for quarter to quarter, but we really believe over the long-term we are making the right investment to outgrow the market. And in fact, we talked about this last year and this year, we're making some investments in sales and marketing to grow ourselves faster than the market. And we see the proof in the pudding because our marketshare is up again as well as our profitability, so it's not is getting market share, but it's profitable growth we're seeing at this point in time.

Okay, and then Ed, if you could help us a little better dissect the shortfall relative to what you guys were expecting in terms of just percentage-wise, how much was actually related to you guys were thinking you would have a much stronger second quarter of the year in proprietary products, how much was related to shortfall because you could not get contracts signed on North American software? And how much of this is just a little bit of cannibalization, perhaps because industry standards, especially from one of your largest vendors there, have generally been pretty positive for most of the other suppliers this quarter? Any color that you can provide there relative to a fairly significant shortfall would be helpful.

The biggest secular changes, the ones that you mentioned -- the whole shift in proprietary servers -- industry standards servers. And the vast majority of our service business -- server business historically has been proprietary space. So we have a growing business and a fast-growing business in the industry standards side of things. Clearly that's just a curve that creates some tension in the system.

On the proprietary server business in particular, we were expecting to see a lot more strength in the high-end than proprietary server business, which would be consistent with our historic results that we were expecting in Q2 and we just didn't see the high-end servers getting placed this quarter. So that was the biggest part of it. It had some supply chain issues, some of which were RoHS related. But I would say the fundamental secular issue that we're dealing with is this trend from proprietary to industry standard.

At the same time, there are some good growth areas for us as well in the storage area, and we think we're -- have a lot of upside in our software business as we emulate the DNS software solution model more broadly across the business.

Just lastly on that supply chain issue, how much do you -- do you know how much possible revenue was left on the table at the end of the quarter and how much of that might have still been sitting in inventory?

No, I can't comment on that.

Okay. Thank you.

One thing I would remind you is that I recognize that we came up short of our outlook, but we did have very strong sequential growth of about 22% this quarter, which is stronger than normal.

Bernie Mahon, Morgan Stanley.

Question for you on the inventory. What is the number of days of inventory that you have over in Asia right now? And how does that compare historically the last couple of years?

Okay Bernie, you're going to have to bear with me for a moment as I look to the details I have, so just bear with me for moment. Actually, our inventory turns are up in the second quarter. We look turns, at not days. And our inventory turns are up compared to Q2 of 2005 back to 2003.

Do have numbers you could give me for that?

We usually don't give out individual breakdowns of assets by region. So I can tell you that we're up about 15% in inventory turns Q2 this year compared to last year. And it looks pretty consistent; 2005 was 16% ahead of 2004.

That's helpful. (multiple speakers)

In terms of our Asian model, our Asian model assumes that we have higher turns in Asia than we do have in some other parts of the world. So you can guess yourself what happened, but there's some -- that is good news. As Mike was pointing out, we had strong performance in Asia as we -- the investments that we made over the last few years, which are people inventory, systems, etc., are beginning to generate similar returns for us both in terms of profitability as well as returns on working capital. And returns are working capital is driven heavily by our inventory turns, which as Paul says are up 15% year-over-year. So it's a good news story for us and Asia.

No, definitely. And how -- where's the book-to-bill in Asia exiting June?

Book-to-bills remained positive in all parts of our world. Book-to-bill in Asia is a little less indicative of the business that we have out there because so much of that business is really book shipped business. So whereas book-to-bill is a very important indicator for us in North America and in Europe, it's less so in Asia just because of the nature of that business, which tends to be a very heavy percentage of book it today, ship it tomorrow, so it really doesn't show up in the book-to-bill ratio.

That makes sense. And then just finally, on the inventory, is there any kind of parts that you build more of in the quarter because [of] say the PEMCO products, or is it proprietary semiconductors or commodity semiconductors? Is there any way you can look at the inventory build that way?

Bernie, it's Bill. I'll take a shot at that one. In general, no. Again, you have to break it down and get very granular by market, by geography, by technology -- really by customers and profile what each of them needs. And we do spend a lot of time on that to make sure that we do have the right amount of inventory in there, but there is certainly nothing that we would see in there that would stand out that would be a special spike or anything. We're trying to manage the business to the demands that we see.

Can even break it out between the PEMCO products versus semiconductors or is that too granular?

Bernie, we do track that information internally, but we don't publish that information. So I don't have it with me, but something that we do watch. It's interesting. We have obviously very different inventory turns targets for PEMCO versus semi, and then we breakdown even further. So we do manage it that way, but I don't have the data with me.

One thing, Bernie, we would note, is that we have been gaining market share in both PEMCO and semiconductors on both sides of the business we have been doing -- making strong market share gains. As Mike noted in his remarks, we had a specific -- a very especially strong quarter in PEMCO in Asia as we're beginning to make some real inroads into a very powerful market for us.

Steven Fox, Merrill Lynch.

Good morning. Can you give us the specific dollar amounts related to RoHS in the inventories?

Steve, we're not going to disclose that information because we think it's competitive data for us and in fact, it's an advantage for us.

Okay fair enough. And related to that, does that imply though that with a combination of RoHS and the weaker proprietary servers, that Q4 could have less seasonal strength because you're borrowing a little bit -- you borrowed a little bit during the first nine months of this year?

I'm asking Ed to try to direct the question on proprietary.

Yes, I don't think it's going to have a weakening impact on the back end of the year.

So off of the base you set in the summer, you think you could still see typical sequential improvements in Q4?

Absolutely.

Okay.

I feel the same way about the potential impact from a RoHS point of view, Steve. I don't see it as being something that's going to necessarily impact our ability to grow seasonally in the fourth quarter. In fact, it may be something more around how we utilize cash. We may need to invest in less inventory if we sell out to RoHS components or if there is returns or that type of thing.

Okay. And then just one question on Asia relative to the margins, how close are you within your targeted range? It sounds like profits have taken a big jump recently. Can you give us a sense of where we are versus that type of goal?

Steve, it's Bill. We are on track to do what we said we would deliver, which is to get to our timeless business model goals by the end of 2007. And we're beginning to reap the results of the investments that we've been making all along in all the elements of our business. So we are on track.

As we've said pretty consistently, the timeless business model in Asia has a lower operating margin, a higher asset velocity, a lower net tax. So the overall bottom line is not diluted to earnings relative to earnings in other parts of the world and it's not dilutive to our return on invested capital. We're now starting to turn the corner as we've gotten critical mass and as we're beginning to generate some of the returns off of the investments that we made, so we're right on track to meet our targets at the end of 2007 as planned.

Fair enough. And if I could just retort on that real quick, in terms of the inventory improvements in Asia, it sounds like you're not getting the type of turns that you would have liked if you were investing ahead of demand. Shouldn't we still be seeing the same inventory turns or are talking that is something that we have to look at on a smoothed over basis, say over like a four quarter period?

I think you have to look at it on a smoothed over basis. I'll let Paul answer that one.

Absolutely right, as well as the fact that -- don't forget that we were investing in inventory much more aggressively in the past to fund the growth of the business. We talked about our funding for that business, the investments being in inventory and in people, so we're coming off of a lower base and getting now closer to our targets, but not at our targets yet.

[Gene Rowan], Banc of America Securities.

Can you give a little bit of guidance on what you expect in terms of share buybacks, maybe debt redemption, also what your long-term ratings targets are?

Sure. What we can talk about is the fact that we have a maturity coming up again early 2007. We fully expect to be able to meet that requirement with the cash on hand, so no issue around that. Around stock buyback, we have approval from the Board to do up to $100 million. We haven't done anything on that yet. That's really a matching off, if you will, of option exercise. So we'll take the proceeds from options exercised and use that to buy back equity in the marketplace.

We actually go through a pretty detailed review with our Board of Directors twice a year where we look at our capital structure, not only today but he where we thing the future will take us, and we have a pretty good discussion around the types of items you're talking about. And as our strategy changes we'll let you know about it, but right now we are definitely focused on maintaining our mid-tier investment-grade rating.

Carter Shoop, Deutsche Bank.

Thanks. You guys are talking a lot about market share gains in the quarter. I was wondering if you guys could try to quantify that by region. Do you have any sense on how much share you actually took?

We do and we don't disclose that. That's another thing we think is proprietary to us. It has been strong across all regions. We have shown share gains in all regions and we're very pleased with that. But again -- we have done it with a consistent methodology, so we're -- we know that we are consistent and we're very confident that we're gaining share. We don't disclose how much or specifically in which region. Exactly the same thing -- it is a proprietary advantage to us to know where it is and what is getting us there.

It's proprietary to know what it is -- -- isn't that public information you guys subscribe to?

In terms of -- well, in terms of the exact number what I am talking about would be the exact number of -- the number of points that we gained and where it is. That would be something that we wouldn't disclose, I don't think we ever have disclosed it.

No, Carter, we haven't. In fact, there's not a service out there are a data point that we can go to and get the data. In fact, we have to do that data region by region collecting the facts from a series of information points. And in fact, the important aspect for us is that we keep it consistent. We're not changing our methodology, but in fact being very consistent in how we define it and how we go forward.

So there is not a public number out there like marketshare for automobiles, as an example in (indiscernible) distribution.

Okay. You guys also made some comments about a small and medium type businesses being particularly strong in North America and Europe. How are the larger enterprises there, both on the OEM side and the [EMS] side?

Mike, do you want to comment on that?

Yes, we're still seeing strength in the larger customer base. As we had indicated, all segments are doing well. It is particular to note that we have been expanding the account base in the small to medium-sized business, so we are seeing a more stable environment from those customers than we have in the past.

Okay. Two more quick ones here. On computing, do you have a percentage of revenue from proprietary servers and software that you can provide us? Roughly?

We don't disclose that information. That's, once again, competitive so we're not going to disclose that type of data.

Last question for you. On PEMCO, could you talk about where you saw the price increases and also comment on your ability to pass along those price increases in the quarter?

Pretty much any product that uses metal, we're starting to see some price increases. And yes, we have been passing those increases onto the customer base as they come. It may come in the form of a metal [adder] and we do adjust the margins based on that.

I would just point out the fact that our core customer base did see an improvement in gross profit, so we were not able to pass over -- and we grew so much in PEMCO if we were not able to pass the price increases along, we would have seen a decline in gross profit percent.

Okay. Great. And then was that [any of the] inventory build in Asia related to anticipated price increases going forward into 3Q? Or was that again primarily just for volume?

No, nothing around anticipated price increases. A lot of our businesses is price protected and ship and debit transactions are pretty common in our business. So it's less about trying to [pay] price increases and in fact better control over the pricing that we give to customers.

Do you guys have pricing contracts in place for PEMCO? Is that -- you guys are kind of exposed to those price (indiscernible) though?

The contractual terms we have from suppliers in components is generally the same, whether it's PEMCO or computer -- or semiconductor.

Great, thanks.

[Josh Golden], J.P. Morgan.

Good morning. Real quickly I want to touch on a question that was brought up earlier. When was the last time that management has sat down with the rating agencies to discuss the dramatic improvements that have been made to the balance sheet? Just -- I am questioning sort of -- I don't understand why you are still rated below investment-grade at Fitch, and I certainly do not understand why you are rated low triple B by Moody's and S&P. And have you met with them and what are they looking for from you?

Josh, you're my type of guy and we would like you to join us for every one of the meetings that we have with the rating agencies. In fact, we gave them a preview to our earning performance for the second quarter, and they were happy and pleased it. Where they are, where their heads are at this point in time it's tough for me to say; not sure what goes on behind the doors at their place. We are just driving the Company forward, focused really on ensuring we have the right capital structure and ensuring that we stick to our capital structure strategies and move forward.

Let me ask you this question about capital structure. You're down into the mid to lower 30%-something debt to cap. A lot of the other technologies type oriented companies have very low debt to cap type levels. Are there further ambitions to lower that?

Josh, what we have said is that we want to be a mid-tier investment-grade rated Company. We think that works for all of our stakeholders, so that would be our shareholders. That would work for our lenders. That would give us enough the flexibility going forward to be able to access the market if we needed to or wanted to. We have found that those types of companies -- those rated companies in technology have really unlimited access to capital at a reasonable price, and in fact, usually enjoy a higher multiple for shareholders. So we feel comfortable with being a mid-tier investment-grade rated Company.

Okay. Good luck to you. Thank you.

Ladies and gentlemen, we have reached the end of the allotted time for questions and answers. Ms. Weaver, are there any closing remarks?

Yes. Thank you Jody. Before ending today's call, for those participating in today's webcast, we will quickly scroll through the slides referenced in our webcast that contain a reconciliation between GAAP and adjusted results. This reconciliation is also included in our earnings release. Both the release and this presentational will be available on our webcast at www.Arrow.com/investor. I would like to thank all of you for taking this time to participate in our call this morning. If you have any questions about the information presented today, please will free to contact Paul or myself. Thank you and have a nice day.

Thank you. This concludes today's Arrow Electronics second quarter earnings call. You may now disconnect.