艾睿電子 (ARW) 2006 Q3 法說會逐字稿

At this time, I would like to welcome everyone to the Arrow Electronics third-quarter earnings conference call. [OPERATOR INSTRUCTIONS] Thank you. Mr. Birns, you may begin your conference.

Thank you, good morning, everyone, and welcome to the Arrow Electronics third-quarter conference call. I am Ira Birns, Arrow's Vice President and Treasurer and I will be serving as the moderator on this morning's call. Today's call is available via webcast. To access this webcast or any future webcast, please visit our Investor Relations website at www.arrow.com\investor and click on the webcast icon. With us on the call today are Bill Mitchell, Chairman, President, and Chief Executive Officer; Paul Reilly, Senior Vice President and Chief Financial Officer; Mike Long, Senior Vice President, Arrow Global Components; and Cathy Morris, acting President, Arrow Enterprise Computing Solutions.

By now you all should have received a copy of our earnings release. If not, you can access our 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 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 any members of the press, you are in a listen-only mode on this call but please feel 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, Ira, and thanks to all of you for taking time to join us on this very, very busy earnings release day. Arrow continues to perform well, and we again delivered outstanding results in what is traditionally a seasonally weak quarter.

Our initiatives to outgrow the markets we serve enabled us to post the highest level of third-quarter sales and earnings in six years, and as I have said many times, Arrow is about growth and it's about execution, and we continue to manage our business for consistent performance and for continuous improvement. This focus enables us to outperform the market and enables us to outperform the market regardless of the market conditions we operate in.

In our components world as I pointed out on our last call, the first half of the year was unusually strong, and we expected the second half to reflect more normal seasonality. That has proven to be the case thus far. The North America and European components markets remain stable, and Asia continued to experience strong growth, up 20% year-over-year pro forma for the acquisition of Ultra Source.

Based upon preliminary data for the third quarter, we believe we once again gained share in all of our components businesses. Book-to-bill ratios remain positive in all three regions. Lead times improved slightly while remaining in normal ranges. And cancellation rates remained low.

On our enterprise computing side, that business experienced year-over-year growth that exceeded 7% pro forma for the acquisition of DNS. That was driven by strong performance in storage and industry standard servers in North America, and by software in our European enterprise business, DNS.

On the next slide, I would like to review some key third-quarter financial highlights with you. Consolidated sales were $3.45 billion, representing the highest level of sales for a third quarter in company history. Earnings per share were $0.71 a share, excluding certain charges and including the impact of option expense. That's an increase of 37% year-over-year.

Our continuous efforts to improve operating efficiencies resulted in a reduction of operating expense as a percentage of sales to a six-year low, driving an increase in operating income of nearly 30% and an operating margin increase of 50 basis points year-over-year, once again excluding the impact of DNS and Ultra Source acquisitions. While inventory turns remained at record levels for a third quarter, we continued to provide best-in-class service levels to our customers. Our return on invested capital was 10.6% for the quarter, and that represented record performance for a third-quarter and more than twice our return on invested capital in 2003.

Before I turn things over to Paul, I would like to take a moment to welcome the newest member of the Arrow team, Philippe Combes, Philippe recently joined us as the new President of Arrow Europe reporting to Mike Long. Philippe previously served as Executive Vice President of Operations and Financial Services for GemPlus International and has significant International experience in both Europe and Asia. Philippe will enable us to further accelerate our strategies in this region driving Arrow Europe, Middle East, Africa, and South America to the next levels of success.

I would also like to welcome Cathy Morris who is with us today on this call, our new acting President of Arrow Enterprise Computing Solutions. Kathy has extensive experience in the ECS business, knows our customers and suppliers very, very well. Her role in further developing our strategic initiatives and her extensive operating experience will ensure the continued success of our enterprise computing business.

And so in summary, we once again delivered outstanding results this quarter as we continue to take advantage of opportunities in the marketplaces we serve around the world. As always, I am extraordinarily proud of the performance of all the Arrow people around the world. Our theme is continuous improvement driven by consistent execution on all of our initiatives.

And this has enabled us to outgrow the market and to deliver greater value to our shareholders through strong year-over-year growth in revenues and profitability. We remain the clear industry leader in operating income, operating margin, and return on invested capital, and I have every confidence of our ability to continue in that role. Paul will now give you a more detailed review of the third quarter, and then Mike and Cathy will discuss their business's performance in greater detail.

Thanks, Bill. As reflected in our earnings release, there are a number items that impact the comparability of our results with those in the trailing quarter and the third quarter of last year. I will review our results, excluding these items, to give you a better sense of our operating performance. As always, the operating information we provide to you should be used as a complement 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 third quarter were $3.45 billion, up 27% year-over-year and flat sequentially in what is seasonally a weaker quarter. Pro forma for the impact of acquisitions we grew sales by 17% over last year. Sales in our worldwide components business were $2.8 billion, an increase of 29% year-over-year and 1% sequentially.

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 significant year-over-year growth and impressive year-over-year increases in sales and operating income. Excluding the Ultra Source acquisition, worldwide components operating margins increased 50 basis points year-over-year.

Worldwide computer products sales were $661 million, that's up 22% year-over-year and down 3% sequentially, which compares favorably to historical decline in the seasonally weak quarter. Pro forma for the acquisition of DNS, worldwide computer product sales increased 6% over last year.

Growth was driven by strong performance in storage, with year-over-year growth exceeding 20%, as well as industry standard service in North America, and security and infrastructure software in our European enterprise business. Our consolidated gross profit margin was 14.7%. The entire decline of 80 basis points year-over-year was driven by a change in our mix as a result of the DNS and Ultra Source acquisition.

Sequentially, we declined 60 basis points. The sequential decline was impacted by our lower mix of European components revenue due to the extended summer holiday period in Europe. Operating expenses as a percentage of sales were 10.2%, a decrease of 90 basis points year-over-year and 20 basis points from last quarter.

Excluding the impact of DNS and Ultra Source, operating expenses as a percentage of sales were down 50 basis points year-over-year. This is the result of our continued focus on driving operating efficiencies throughout our business. This quarter represents the 15th consecutive quarter of year-over-year declines in operating expenses as a percentage of sales and the lowest level in six years. Our CPI initiatives, as well as our focus on driving operational excellence further into our business continues to pay off.

Operating income was $154.3 million, that's up 30% year-over-year, once again demonstrating our ability to grow earnings faster than sales. Our operating margin was up 10 basis points from last year, but excluding the DNS and Ultra Source acquisition, our operating margin increased by 50 basis points year-over-year.

Our effective tax rate for the quarter was 32.9%, but for modeling purposes you should assume that our tax rate for the fourth quarter will approximate 33.5%. Net income was $87 million, up 36% from last year and down 8% sequentially. Earnings per share were $0.71 on a basic and diluted basis including option expense. Earnings per share on a diluted basis, excluding the impact of option expense, increased by 37% when compared to last year's third quarter. Our outstanding operating performance in a seasonally weak quarter allowed us to achieve our highest third-quarter return on working capital in nine years, excluding the Tech Bubble period.

Return invested capital was 10.6%. More than twice our return in 2003 and the 11th consecutive quarter which our return on invested capital exceeded our cost to capital. Our ratios of working capital sales and inventory turns both remain near record third-quarter levels. We did used $36 million of operating cash in the third quarter. This was impacted by our transition to a new financial system during the third quarter in North America.

In order to ensure a smooth transition, we paid our suppliers somewhat earlier than normal near the end of the quarter negatively impacting our cash flow. We fully expect to be cash flow positive in the fourth quarter. Our balance sheet remains very strong in liquid with net debt near a 10-year low and net debt to cap at 27%. We will now discuss the results of our business units for the third quarter. First Mike Long will discuss our global components business.

Thank you, Paul. On a worldwide basis, the components markets continue to act rationally and order patterns remain strong. Preliminary data indicates that we again gained market share across all of our regions. Lead times in pricing remain stable, cancelation rates remain low, and our level of inventory appears appropriate to meet our customers' needs around the world. Book-to-bill ratios remain in the 1 to 1.1 range in all three regions of the world.

In North America, we continued to experience broad-based strength across most business segments this quarter. We also achieved our sixth consecutive quarterly increase in daily run rates for our small and medium-sized customers, and preliminary market data at this point in time indicates that we also gained market share. Sales reached the second highest level for a third quarter in company history at 1.2 billion, up 14% year on year and down 3% sequentially.

Specifically, sales in our passive, electromechanical, and connector segment again achieved strong year-over-year gains as our growth initiatives continue to take hold. Operating income grew 4% year-over-year, representing the 11th consecutive year-over-year increase in operating income. Our bookings remain strong for the quarter, with particular strength in the small, mid-sized customers. Our quarterly customer survey of over 300 of our customers indicated the majority of our customers feel they had appropriate levels of inventory heading to the fourth quarter. In summary, this was another great quarter for us in North America.

In the European region, we also had an excellent quarter. Sales were 974 million, up 26% year-over-year, and flat sequentially in what is traditionally a down quarter. This represents our highest level of sales for a third quarter in company history. Our initiatives around growth and operating efficiencies continue to show results.

As we grew operating income by 77% year-over-year, that's three times the rate of sales growth compared to last year. Our operating margin increased 180 basis points year-over-year, a, and we also delivered a 43% year-over-year increase in return on working capital, reaching the highest return on working capital for any third quarter in company history, excluding the Tech Bubble period.

In Asia, sales for the third quarter once again reached a new record level at $655 million, up 70% year-over-year and 15% sequentially. Sales on a pro forma basis adjusting for the Ultra Source acquisition, increased by a strong 20%, year-over-year significantly outperforming the overall market. We experienced year-over-year growth in all regions with China leading the pack in the [ASION] region and Ultra Source also performing well.

Continued focus on our higher margin passive electromechanical and connector products resulted in another record quarter with year-over-year sales in these products increasing by more than 50%. We are excited about the significant progress we have made thus far and see a clear path to achieving our targeted levels of profitability for the region. From a working capital perspective, inventory turns reached a record level for the region.

In summary, we had an excellent quarter as we continued focusing on generating profitable growth. We continue to make significant strides towards reaching our goal of being the clear number one in Asia as we are in both North America and Europe. Bill.

Thanks, Mike, nice quarter. Cathy Morris will now comment on our Enterprise Computing Solutions business. Cathy.

Thank you, Bill. As you know we traditionally experience a seasonal decline in the third quarter which historically is our weakest quarter. Sales increased 26% year-over-year to 594 million representing our 11th consecutive quarter of year-over-year growth. Sales on a pro forma basis, adjusting for the DNS acquisition increased 7% year-over-year.

We saw continued strength in storage and industry standard servers in North America, and security and infrastructure software at DNS in Europe. Despite the weakness in the proprietary server market, our North American operating margin is only down 20 basis points year-over-year. We recently announced the acquisition of Alternative Technology, a $300 million provider of security and virtualization software.

This is further evidence of our strategy to expand the breadth of other enterprise Computing Solutions business. This expansion of our existing software business will strengthen our position in this high growth segment and will provide us with meaningful cross-selling opportunities. In summary, we remain focused on our strategy of selling total solutions to our customers, while expanding the products and services we offer.

The acquisition of DNS in Europe and Alternative Tech in the U.S. are evidence of our efforts to expand the breadth of our product offerings, as well as our geographic depth of our business. We have delivered industry-leading margins and returns, with significant opportunities to increase our presence in high-growth areas such as storage, services, and software. We remain focused on providing value to our VARs and working with our manufacturers and software partners to continue growing their value-added channels.

Thanks, Cathy. And another nice quarter from our Enterprise Computing Solutions group. Let me just summarize and close. We again had a terrific quarter. We had our highest levels of third-quarter sales, earnings and returns since the bubble year of 2000. Each of our components businesses posted strong year-over-year gains in sales and operating income.

Our enterprise computing business in North America posted solid gains in sales while maintaining industry best profitability. We continue to outperform the market. And the changes we've made to our operating model have focused on clear, consistent goals and clear, consistent improvement allow us to manage the Company for steady and consistent and profitable growth.

I am really proud of the way the Company has operated. We have consistently grown sales faster than the market, 11 consecutive quarters of year-over-year market share gain in our components world. Our ongoing strategies to derive efficiencies in all parts of our business resulted in our ability to grow year-over-year earnings faster than sales, 14 of the last 15 quarters. We have significantly improved our financial performance, advancing our return on invested capital from 5.1 to 10.6% in the last three years, and while consistently generating a return on invested capital well in excess of our cost of capital for 11 consecutive quarters. This is the way we are running the Company now is for that clear and consistent improvement and clear consistent performance. And I would, again, like to thank the entire Arrow team for again delivering another outstanding quarter.

As we look ahead and we look to the fourth quarter, we expect the worldwide components market to remain generally stable and rational, driven by our core small and medium sized customer base. Growth is expected to slow somewhat from the accelerated rates we experienced in North America and Europe during the first half of 2006.

This is primarily due to large customer segment, which continues to hold some excess inventory. We expect continued growth in storage, security, and infrastructure software and industry standard servers, but we also expect the secular trend and the seasonal growth in our enterprise business to be tempered by continued weakness in the proprietary server market.

We believe that total fourth-quarter sales will be between 3.425 and $3.625 billion, with worldwide component sales between 2.675 and $2.8 billion and worldwide computer product sales between 750 and $825 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 $0.71 to $0.75 per share. Excluding the impact of expensing stock options, earnings per share for the fourth quarter are expected to increase 16 to 22% from last year's fourth quarter.

Thanks, Bill. Please open up the call to questions at this time. Thanks.

Thank you, sir. [OPERATOR INSTRUCTIONS] Your first question comes from the line of Brian Alexander of Raymond James.

Thanks. Good afternoon. Just -- you obviously had a big sequential drawdown in inventory relative to last quarter, and I just wanted to get a sense for -- if you could talk about geographies, where you saw that inventory drawdown and if you can dive into some of the segments where you saw the inventory reduction, I assume most of that was on the component side?

Hey, Brian. It's Paul. When we look at the decline in inventory, first we also have to keep in mind that inventory turns were flat with last year's third quarter at 6.6 turns. We did drive the inventory down but to a more normal level.

You may recall that we were a bit over inventory at the end of the first quarter. The way I look at it is if you were to strip out the impact of foreign exchange, as well as the impact of the over inventory position we may have had at the end of the second quarter because of RoHS, et cetera, we were down about 4% in components revenue from the June time period.

Inventory.

Okay. Given your revenue guidance for the next quarter, what would be your expectation about inventory in Q4?

Yes, Brian, when you look at it, we feel pretty good right now where our inventory is. Lead times are right in the midpoint of normal to maybe a little bit shorter than that. So we don't feel there is as much pressure on us to hold more inventory now, nor do we feel that will change going into the beginning of the first quarter of next year. So feel pretty comfortable where we are. This is just consistent with what our goals are of driving our returns on inventory up higher.

Just the last question, longer term, just give us an update on sort of your confidence in your operating margin target for the component segment of I think 5.7 to 7% given what you just reported at 5.3% and the fact that it seems like we are seeing moderating growth. Is that still something that you think is achievable by the end of next year? Thanks.

Yes, we really do, Brian. It's Bill, and the reason we believe that is that we are continuing to see the investments that we have made in Asia start to pay off. We continue to see the continuous process improvement efforts that we have throughout the Company, continue to pay off. And so we remain very confident that we can reach the operating targets that we've shown to you and all the members of the industry for the last year or so. We will absolutely be there by the end of next year.

It's interesting, Brian, just as a follow-up to that, if we strip out the impact of Ultra Source, our operating income margins for components actually was in the range that you just quoted. So we would actually be there already. As Bill said we have initiatives in place to make sure we drive the entire company forward on that basis.

Okay. Thanks a lot.

Your next question comes from the line of Michael Walker of Credit Suisse.

Thank you. My question -- first question is on gross margins. I know you target operating margins, but there's been a steady sort of decline the last four years in a row in the gross margin front, and I know as long as you can take down expenses that it's okay for the operating margin line, but I think sometimes investors fear that if that line continues to go down there will be a point where you really can't take any more costs out and operating margins are to hit a ceiling. So I am wondering if you are able to tell us that gross margins can stabilize, or if that is kind of a long-term trend that we need to be modeling into '07.

Michael, it's Paul. Let me try to answer that a couple of different ways. First off, the entire decline that we saw year-over-year is simply a change in mix, where we have more of low margin business, both from DNS, which is computer products, as well as from Ultra Source which is in Asia-Pac, as you know, both have a inherently lower margin as well as a lower cost basis. That is the first thing.

The second thing is that we have gone back and looked at the actual change in our, what I'll call our core customer business, small to medium-sized components customers in Europe and North America, and generally we are flat both sequentially and year on year. And in fact, if you go back and look at the last 10-plus years, the actual decline in that customer base is really less than 100 basis points.

So we are not really seeing a dramatic change in the margins for our core customer base. What is changing is our mix, whether it is more Asia-Pac, whether it is more computer products, which really is, I think, distorts a little bit the trends that are going on in our business.

Mike, let me follow-up with that, because I think it is a really important question, a really important point that you make. You -- we do have to get underneath the numbers. The areas where we have the lower gross margin which would be in our computer products and some of our Asian businesses also in fact have a lower cost to serve and have operating margins which are exactly where we would expect them to be for the rest of the business.

So we can show if we show growth in those areas in excess of what we are seeing in the rest of the Corporation. What in fact you will see is a decline in an operating margin as the mix shift -- or not the operating margin, in the gross margin as the mix shifts, but an increase in the operating margin.

And I know that's -- that's some puzzling, but that is in fact the way the math works and that is the way the business is working. So those are accretive to us and strongly accretive and those are two areas, both in computer products and in Asia that we absolutely want to grow. If we do that, you will continue to see gross margins go down and operating margins go up.

Okay. My second question is just on the outlook on the component side. You are telling us, I think, that the semi part of the business will be tracking flat to maybe down a little bit. In the December quarter, I think, Bill, at the tail end of your comments, you said that some large customers still seem to have some excess inventories, and I interpreted, Paul, your answer to the first question to mean we could see inventories down again in the fourth quarter. Putting this all together, is there little risk on the demand environment here that you're referring to? Or is this an inventory adjustment to the supply chain?

Well, let me take a first shot at that and then I will ask Mike for an additional comment. What we saw in terms of inventory in the system, as Paul said, we are about where we want it to be. We see our customers saying they are where they want it to be with one exception, and that is the large customers, particularly the EMS customers have reported that they have grown some inventory and have a little more inventory than they would like to have.

That is not anything that hasn't been well reported on. The suppliers built, by and large, a bit of inventory versus the -- in the quarter. Again, we are sitting where we want to sit. We've pulled ourselves back from where -- having a little bit of excess in the second quarter.

We think we are well-positioned for the markets that we see in the -- coming forward, and as I say in the customer space, everybody seems to say we have got about what we want with the exception of the large customers that may have -- be slightly over inventoried. And the suppliers are heading into their seasonally strong quarter, and we are about where we want to be with vis-a-vis with them. Mike, anything you want to add to that?

Yes. I would only add that I agree with the inventory levels and the large customers, but one of the strengths of our business is the diverse nature of our customer base and to also the breadth of the industries that we cover. And serving so many different industries, industrial, medical, military, and aerospace gives us a little bit more stability at that small customer level than in nontraditional markets, and that's how we'll continue to drive the business. And expanding those accounts base helps us with the fluctuations of the large account base.

Great, thanks a lot.

[OPERATOR INSTRUCTIONS] Your next question comes from the line of Matt Sheerin of Thomas Weisel Partners.

Thanks. Just want to follow-up on Mike's question regarding large customers. Are you -- are you seeing a lower book-to-bill from that customer segment than your small and medium-sized customers?

Matt, it is Bill. Normally we don't disclose that in terms of breaking that down in detail. What we have said is that we have -- the book-to-bills have remained in the 1, the 1 to 1.1 in the overall through all of the -- the customers that we serve.

Okay. Well, other than reading what we all read about inventory levels, are you getting any indication from the big EMS customers that they are looking to be more cautious in the fourth quarter? And may put the brakes on orders earlier than they normally do?

They are always trying to adjust their inventories relative to the demands that they see, and we service them to what they -- to what they are seeing. Mike, you may want to comment a little bit on that in terms of what your view would be.

Thanks, Bill. The -- Matt, it's a little bit spotty in the large EMS customers as you know. There are some programs that are continuing on while others drop off and then also some different types of products moving in, and I think what Bill said is exactly right. We have seen the book-to-bills that he had indicated to you across all of our customer base, and having said that, there has been some ups and downs with some of the larger ones, but nothing at this point in time where I would say we see a consistent trend that would tell us for sure that anything is happening dramatic in the fourth quarter.

Okay. Great. And then on Europe, you said it was -- revenue was flat quarter-quarter which is better than seasonal, and I think we've had better-than-seasonal strength for two to three quarters now. How much of that do you think is RoHS related? I know it is hard to tell, and do you think that we will start to see slower growth going forward as Europe adjusts to the new -- that new environment?

Matt, it is Bill. In terms of what we have seen in RoHS, we clearly saw some increase in the first half of the year that was related to RoHS. It was also clearly not all of the increase that we saw, that there was a strong demand. Some of that did carry over into the third quarter as the transition -- as we had expected was not a -- a light switch type of cut-over. It was more of a transition.

We see that transition continuing a bit, going forward, although it is basically behind us. Europe is back to a more normal and more rational kind of outlook going forward. It's at a higher level. So what we saw was that Europe had a very strong first half. Some fueled by RoHS, some fueled by genuine increases in demand as the European economies for our types of products that did well, and it's gone back to a more rational and stable kind of environment, but at higher levels. All in all that's good news for us

Okay. Just a quick question for you, Paul, on the tax rate. What did you say the expectations for tax rate in December was?

33.5%.

33.5, thanks a lot.

[OPERATOR INSTRUCTIONS] Your next question comes from Jim Suva of Citigroup.

Great, thank you and congratulations. Quick question regarding your operating margins of 4.5% in September. Comparing that back to September of last year they were around 4.4% if my math is correct, yet I want to better understand -- sales were up almost 28% year-over-year, and I understand that you had some acquisitions and stuff, but can you help us understand why we didn't see a little bit more leverage on your operating margin line?

Yes, Jim, thanks for the question. Let's first take the acquisitions out of the mix. In fact our operating income percent would be up some 50 basis points instead of the 10 as reported. We did actually in our other businesses have very strong performance, good performance as we have committed to in the past. What is happening is we have added two businesses that have a lower mix, not in Q3 of last year.

Jim, we acquired a company called Ultra Source in Taiwan mid-December of last year, a company called DNS which is in Europe in computer products right at the end of December, December 31, last year. So they were not in the fourth quarter either. So the comparison to last year is a bit tough to make because of the acquisitions since we have a different mix.

Great.

Over the long term we think these are great opportunities for us.

Right. On that same topic. When we look at the acquisition that is coming on line for -- I believe it is the December quarter for Alternative Technology, should we expect a similar type of impact on the operating margins? Or what type of accretion, and what type of financial impacts should we be looking at?

Jim, first off, we think we will be closing that acquisition at the end of November, so we will only have one month of operating results, which we are really have a minimal impact on the fourth quarter. We do think that the accretion next year will be in that $0.02 to $0.04 range.

Okay. In your outlook for sales do you have one month of sales built in for your outlook for the fourth quarter?

Yes we do.

Great, thank you.

There are no further questions at this time. Mr. Birns do you have any closing remarks.

Yes, thank you. Before ending today's call for those participating in today's webcast that contain a reconciliation between GAAP and adjusted results. This reconciliation is also included in our earnings release.

Both the release and this presentation will be available on our website at www.arrow.com\investor. I would like to thank all of you for taking the time to participate in our call this morning. If you have any questions about the information presented today, please feel free to contact Paul or myself. Thank you and have a nice day.

Ladies and gentlemen, this concludes today's conference call. You may now disconnect.