安富利 (AVT) 2007 Q1 法說會逐字稿

Our presentation will now begin. I would now like to turn the floor over to Vince Keenan, Avnet's Vice President and Director of Investor Relations. Thank you, Mr. Keenan. You may begin.

Good afternoon and welcome to Avnet's first quarter fiscal 2007 corporate update. If you are listening by telephone today, and have not accessed the slides that accompany this presentation, please go to our website, www.ir.avnet.com, and click on the icon announcing today's event.

In addition to disclosing financial results that are determined in accordance with generally Accepted Accounting Principles, or GAAP, the Company also discloses nonGAAP results of operations that excludes certain items. Reconciliation of the Company's analysis of results to GAAP, can be found on the Form 8K, filed with the SEC today, and several of the slides in this presentation, and on Avnet's Investor Relations website.

As we provide the highlights for our first quarter fiscal year 2007, please note that we have excluded certain items from the current and prior period, in the accompanying slides, in order to facilitate comparison with current periods. These items include restructuring, integration, and other charges resulting primarily from the Memec acquisition, as well as the loss from a sale of some noncore business assets and debt extinguishment cost.

Before we get started with the presentation from Avnet management, would I like to review Avnet's Safe Harbor statement. This presentation contains certain forward-looking statements, which are statements addressing future financial and operating results of Avnet.

Listed on this slide are several factors that could cause actual results to differ materially from those described in the forward-looking statements. More detailed information about these and other factors is set forth in Avnet's filings with the SEC. In just a few moments, Roy Vallee, Avnet's Chairman and CEO, will provide Avnet's first quarter fiscal year 2007 highlights. Following Roy, Ray Sadowski, Chief Financial Officer of Avnet, will review the Company's financial performance during the quarter. At the conclusion of Ray's remarks, Roy will wrap up with additional comments on second quarter guidance, after which a Q&A will follow.

Also here today to take any questions you may have related to Avnet's business operations is Rick Hamada, Avnet's Chief Operating Officer, and who is also acting President of TS, and Harley Feldberg, President of Electronics Marketing.

With that, let me introduce Mr. Roy Vallee, to discuss Avnet's first quarter fiscal year 2007 business highlights.

Thank you, Vince. Hello, everyone. Thank you all for taking time to be with us and for your interest in Avnet.

Turning to the highlights for the first quarter of fiscal 2007, we can start with the top line, with a better than expected performance from Electronics Marketing, and a rebound in microprocessor sales at Technology Solutions, revenue grew 14.2% on a year-over-year basis, and 1.4% on a sequential basis, when adjusted to exclude the impact of divestitures made last fiscal year.

On a reported basis, revenue grew 11.6% year-over-year, and 1% sequentially, to $3.65 billion. We are excited about the growth rate at Electronics Marketing, and encouraged with the performance at Technology Solutions, where the year-over-year growth rate reaccelerated after two quarters of slowing growth.

Shifting our focus to profitability. You can see that operating income grew 6 times faster than revenue on a year-over-year basis, excluding restructuring and other charges in last year's first quarter. Operating income including stock-based compensation and amortization of intangibles increased by 72%, to $145 million, and operating income margin increased 139 basis points to 4%.

This is the second quarter in a row where pro forma operating income margin grew more than 100 basis points year-on-year, and it represents the third consecutive quarter where it grew at both operating groups across all three regions. This enterprise performance demonstrates the leverage in our operating model. The consistency across the businesses is a result of our value-based management principles permeating our global organization.

The next highlight is not so much a quarterly highlight as it is the result of a multi-year effort to strengthen our balance sheet. Over the past few years we have been focused on reducing debt and interest expense, which when combined with our improving profitability has had a meaningful impact on our credit statistics.

As a result of that improvement, Moody's upgraded Avnet's debt ratings to BA1 from BA2 during the quarter. While this rating is still one notch below investment grade, we are focused on maintaining our coverage and leverage ratios at investment grade levels, which should be reflected in future ratings.

At S&P which maintained Avnet at an investment grade rating of BBB-, our outlook was upgraded from neglective to stable, as a result of our improved credit statistics. Subsequent to these actions, we took advantage of market conditions to refinance our high-interest debt with new 10-year notes. Ray will cover the details of these transactions later in the call.

The key take away I'd like to leave with you with, is that our effective interest rate is the lowest it has been in many years, and the majority of our long-term debt now has extended maturities. Our current capital structure has us well-positioned to fund future organic growth, as well as strategic acquisition opportunities.

Electronics Marketing started off the new fiscal year right where it left off at the end of fiscal 2006, by continuing its string of impressive year-over-year improvement across all key financial metrics. In the first quarter of fiscal 2007, EM grew pro forma revenue $356 million to 2.44 billion, a 17.1% increase over the year ago quarter. Not only is this the highest year-over-year organic growth rate in two years, it also represents the fourth consecutive quarter that EM has delivered double digit year-over-year organic revenue growth, including Memec's revenues from the prior quarters, and excluding the impact of divestitures.

EM continues to translate revenue growth into meaningful operating margin expansion. In the September quarter, EM grew operating income year-over-year more than 5 times faster than revenue, to $125.6 million. Operating income margin of 5.2% was 185 basis points higher than the first quarter of fiscal 2006, and represents the third straight quarter that EM has produced operating income margin of over 5%.

With the added scale and scope of Memec and a continued focus on operational excellence, Electronics Marketing is well-positioned to continue growing faster than the market, and expanding operating margin, as we progress towards our goal of 5.5% or greater.

From a returns perspective, Electronics Marketing had another solid performance with return on working capital increasing from 14.8% in the first quarter of fiscal 2006, to 23.6% in the current quarter. While the increase in operating margin had a lot to do with this improvement, EM also realized that year-over-year increase in working capital velocity, which led to a near 3 day reduction in the cash cycle.

In the first quarter of fiscal 2007, EM revenue of 2.44 billion, was down 0.5% sequentially on a reported basis, and flat if you adjust for the divestitures mentioned earlier. This performance, which we would characterize as a little better than normal seasonality, exceeded our expectations on strength in both the EMEA and Asia regions. On a year-over-year basis, EM revenue was up 15.4% on a reported basis, and 17.1% on a pro forma basis, with all three regions accelerating their rate of organic growth.

At a regional level, growth was led by our Asia region, where revenue was up 7.8% sequentially, and 27% as compared with the first quarter of fiscal 2006. This is the highest year-over-year growth rate in two years including Memec's historical sales on a pro forma basis, and when combined with double digit growth in the last three quarters, produces a trailing 12-month growth rate of over 23% for our Asia region.

In the EMEA region, EM continued its four-quarter streak of accelerating year-over-year growth rates, with growth of 15.8% on a reported basis, and pro forma growth of 21.4%.

The Americas region grew 8% as compared with the September quarter of fiscal 2006. We exited Q1 with a book to bill ratio slightly below 1 in all three regions. During the quarter, lead times came in for some products, however, Average Selling Prices remain stable, and cancellation rates remain normal.

The decline in bookings was driven primarily by normal, seasonal trends, accentuated by cautious inventory management at most customers, and notably large EMS companies serving the communications end markets. Looking forward, we expect normal seasonal trends of slightly down revenue for EM in the December quarter, and we expect our inventory to be down slightly as well, maintaining inventory turns at a high level.

Turning highlights to Technology Solutions. Let's start with the reacceleration of year-over-year revenue growth rate. As you may recall, TS's string of double-digit year-over-year revenue growth began to slow in the second quarter of fiscal 2006.

Revenue as reported in the first quarter of fiscal '07 grew 4.8% on a year-over-year basis, but when you adjust for the divestiture of our Avnet Enterprise Solutions business in the third quarter of fiscal 2006, pro forma revenue grew 8.9%, as compared with the first quarter of fiscal '06. While a rebound in microprocessor sales drove the sequential increase, the year-over-year growth was driven by sales of enterprise computing products, embedded systems, and displays.

While we can't control the rate of growth in our end markets, we can manage our profitability. And at Technology Solutions, we have delivered consistency of performance. With TS exceeding our targets for operating margin and returns on capital, we are focused on profitable growth, and opportunities to expand our products, services, and geographies.

In the September quarter, TS operating income of $39 million, grew 20% as compared with the year ago quarter, and operating income margin increased another 41 basis points to 3.2%. This represents the 13th consecutive quarter that Technology Solutions increased operating income, and operating income margin on a year-over-year basis.

Finally, I would like to recognize the fine job our team at ACC, or Avnet Computing Components, did in the September quarter. As a reminder, ACC is focused on selling micro processors, memory, and other products, primarily to white box manufacturers around the world. Although one of the smaller businesses within TS, they got a lot of attention last quarter, when excess inventory and a well publicized price cut in microprocessors, drove an approximate 45% sequential decline in our microprocessor sales. This quarter revenue at ACC grew 57% sequentially, which brought their profitability right back to our long-term targets.

In the September quarter, Technology Solutions sales were $1.21 billion, up 4.2% sequentially, and 4.8% year-over-year on an as-reported basis. As I mentioned earlier, the sequential growth was driven primarily by a 57% increase in microprocessor sales, and our regions with the highest content of ACC sales reflect that performance. So on a sequential basis, Asia and EMEA revenue were up 49% and 12% respectively, while the Americas region was down 1%.

The decline in the Americas was driven by the normal seasonal trend at Avnet Partner Solutions, where revenue was down an expected 3%. TS year-over-year growth rate was led by the EMEA region, which was up 13.8% while the Americas was up 7.9% pro forma.

Asia, which for Avnet is over 80% microprocessors, was down 2% year-over-year, as the significant sequential increase in sales, did not quite reach the peak sales experienced in the first quarter of fiscal 2006 there. Looking at the December quarter, we expect TS sales to rise sharply, in-line with normal seasonality.

So now I would like to turn the commentary over to Ray Sadowski, Avnet's Chief Financial Officer. Ray?

Thank you, Roy. Hello, everyone. Let's begin with an overview of our operating results for the first quarter of fiscal 2007. This slide shows a year-over-year comparison with a dollar and percent change in the highlighted columns on the right.

Please note that we have included a GAAP net income at the bottom of the slide to account for the debt extinguishment costs, and two other items recorded from the current quarter. In the September quarter, reported sales of $3.65 billion, were 11.6% higher than in the year ago quarter.

Gross profit of 468.4 million, was up $45.2 million as compared with the first quarter of fiscal 2006, while gross profit margin declined slightly by 10 basis points year-over-year to 12.8% in the first quarter fiscal 2007. Year-over-year decline in gross profit margin was due primarily to the regional mix shift at Asia grew from 25.5% of EM revenue in the year ago quarter, to over 28% in the current quarter.

Operating expenses of 323.4 million, were down 15.4 million, or 4.5% year-over-year, excluding restructuring and integration charges in last year's first quarter, due primarily to a full year of operating expense synergies from the Memec acquisition being realized in the current quarter. Operating expenses were also down at TS year-over-year, primarily due to the reduction in operating expenses, related to the divestiture of [Avnet] Enterprise Solutions in fiscal 2006.

In addition, both operating groups are benefiting from ongoing operational excellence initiatives. The 338.8 million of expenses in the prior year first quarter shown here, exclude $13.8 million of restructuring and integration costs.

Operating income of $145 million, was up more than 71% as compared with the first quarter fiscal 2006, excluding certain charges from last year, and operating income margin improved 139 basis points to 3.97%. Above the operating income line, interest expense declined by approximately 6%, due to our lower effective interest rate as a result of our refinancing activities. Taxes increased $20.8 million, due to a combination of an increase in pre-tax income, and a higher effective tax rate in the current fiscal year.

The tax rate increased from 33% in the first quarter fiscal 2006, to 33.5% in the current year first quarter, due primarily to the change in the geographic mix of profits. We currently estimate our effective tax rate will be between 33 and 35% for the remainder of fiscal 2007. Net income excluding certain charges increased $40.2 million, or 96%, to 82.2 million driving diluted earnings per share to $0.56 per share in the September quarter, as compare to $0.29 per share in the year ago quarter.

On a GAAP basis, our results for the first quarter fiscal 2007 including debt extinguishment charge of 27.4 million, and an income tax audit provision of $3.4 million, related to our operations in Europe, partially offset by the recovery of a previously reserved nontrade receivable of $2.8 million, that is included in other income. The net impact of these items was to decrease pretax income, net income, and diluted earnings per share by 24.5, 18.1 million, and $0.12 cents per share respectively. After taking these items into account, our GAAP net income was $64.1 million, or $0.44 per diluted share, as compared with net income of $24.9 million, or $0.17 per diluted share in the prior year first quarter.

This next slide looks at the key productivity metric of expense to gross profit dollars over past 3 years. The bar represents the individual quarters, while the trend line depicts the performance over a trailing 12-month period at the end of each quarter. On a trailing 12-month basis, our ratio of expense to GP dollars declined from 78.3% at the end of last year's September quarter, to 70.2% in the current quarter, and has improved significantly during the last three years.

As you can see on the slide, the rate of improvement started to accelerate after the first quarter fiscal 2006, as we began to realize the operating expense savings from the integration of Memec. The over 800 basis points declined since last year is further proof of the scale and scope advantages of the Memec acquisition. On a sequential basis, the operating expense to gross profit ratio worsened by 55 basis points from the June to the September quarter.

This sequential degradation was due to the decline in gross profit dollars, driven by a geographic mix shift to Asia at EM, and a product shift to microprocessors at Technology Solutions. In Electronics Marketing, the expense to gross profit ratio improved more than 1000 basis points from the year ago quarter, while at Technology Solutions the expense to gross profit ratio improved 543 basis points on a year-over-year basis. We expect our continued focus on productivity and operational excellence to drive meaningful improvements and efficiency, as we drive towards our long-term business model.

Similar to the expense to gross profit slide, and a trailing 12-month trend line to this slide, which portrays quarterly operating income margin over the past 3 years. Once again, the very positive impact of the Memec acquisition is clearly visible as the 12-month operating income margin improved from 2.84% in the first quarter of fiscal 2006, to 3.85% in the first quarter of 2007. While EM had a greater impact on this performance as a result of the integration, of integrating a $2.3 billion acquisition, TS also had a meaningful positive impact on operating income, despite facing slower growth in their end markets.

With a more streamlined expense structure, and a continued focus on operational excellence initiatives, we are poised to continue to build on this operating leverage in the current fiscal year. In the current quarter, operating income margin of 3.97%, improved 139 basis points on a year-over-year basis, with both operating groups contributing to this performance. At EM, operating income margin of 5.16%, improved 185 basis points, and Technology Solutions operating income margin of 3.2%, improved 41 basis points as compared with the year ago quarter.

On a sequential basis, operating income margin declined 23 basis points. At EM, operating income margin declined 35 basis points sequentially, due primarily to the revenue shift to Asia previously mentioned. While TS's operating income margin declined 24 basis points sequentially, due to the Partner Solutions Group seasonally softer September quarter.

On this graph, we have shown return of capital employed, which is a key metric to Avnet, and how we drive our business since the adoption of our values-based management initiatives over 5 years ago. As is evident on the slide, during the last 3 years, we have made significant progress toward our stated goal of 12.5%, from 3.1% at the end of September 2003, our trailing 12-month return of capital has increased by a factor of more than 3, to 9.9% in the current September quarter. While Memec has had a lot to do with last year's improvement, the 3-year trend is all about our focus on profitable growth, and improving asset velocity at both operating groups.

On a year-over-year basis, the September return on capital increased 311 basis points to 9.5%. With the recent promotion of Rick Hamada to Chief Operating Officer, one of his key areas of focus is to continue to look for opportunities to capitalize on Avnet's scale and scope advantages, to accelerate improvements in both margins and return metrics. We continue to focus on achieving our long term financial metrics within our stated timeframe.

During the September quarter, we completed a Public Offering of $300 million principal amount of 6.625% notes due in 2016, and elected to redeem all of our outstanding 9.75% notes due in February 2008. As a result, we recorded a debt extinguishment charge of 27.4 million pre-tax, 16.5 million after tax, or $0.11 per share on a diluted basis, consisting of the premium paid to the holders of the 9.75 notes, the costs related to termination of the interest rate swaps, and the write-off of certain deferred financing costs. This refinancing activity was essentially neutral from an economic perspective, as the debt extinguishment charge is approximately equal to the net interest reduction for the remaining life of the 9.75% notes.

The settlement of the redemption of the 9.75 notes occurred subsequent to the end of the first quarter. As a result, both the new 6.625% notes, and the remaining portion of the 9.75 notes were outstanding at the end of the first quarter of fiscal 2007. We will retire the remaining 8% notes when they mature in November 2006 using our available liquidity.

As noted on this slide, we represent our debt structure as if the redemption of the 9.75 notes took place by the end of the September quarter. Our pro forma debt would have been 1.286 billion, and our debt to total capital would have been 30.6%. This refinancing was made possible as a result of our multi-year strategy to increase return on capital, and improve our credit statistics.

As you can see on this slide, over the last 5 years we have reduced our leverage ratio, or debt to EBITDA from 10.1 to 2.1, while increasing our interest coverage from 1.4 to 6.1. We believe that our current capital structure will allow us to maintain our coverage and leverage statistics, at what we believe are investment grade levels, while funding future growth and acquisitions.

The net effect of all of the financing activities that took place during and just after the September quarter, will be to reduce effective, our effective interest rate from roughly 6.5% in fiscal 2006, to approximately 5% based on our current blend of debt and short-term rates.

Going forward, we expect to reduce annual interest expense from the second half of fiscal 2006 run rate, by roughly $20 million pretax, or $12 million after tax, or roughly $0.08 per share on a diluted basis, by the time we retire the remaining 8% notes due next month.

Now let me turn it back over to Roy, who will provide our outlook and guidance for the December quarter. Roy?

Okay. Thanks, Ray.

Looking forward to Avnet's second quarter fiscal year 2007, management expects sales at EM to be in the range of 2.33 billion to 2.43 billion, and anticipates sales for TS to be in the range of 1.5 to 1.6 billion. Therefore, Avnet's consolidated sales should be in the range of 3.83 to $4.03 billion for second quarter fiscal 2007 ending on December 30, 2006.

Management expects the second quarter earnings to be in the range of $0.58 to $0.64 per share, including approximately $0.02 per share, related to the expensing of stock-based compensation. We continue to expect the impact of stock-based compensation to be approximately $0.02 per share, in each of the remaining fiscal year 2007 quarters, for a full-year impact of roughly $0.09 per share.

With that, let's open the lines up for Q&A. Operator?

Thank you. Ladies and gentlemen, we will now be conducting a question and answer session. [OPERATOR INSTRUCTIONS]

Our first question comes from the line of Brian Alexander with Raymond James. Please proceed with your question.

Yes, just a couple questions. Can you guys talk again about the sequential operating margin decline you saw in the September quarter in EM? I thought I heard you say it was primarily due to the shift in Asia, Ray, but it didn't look like the shift was that dramatic. I am just wondering if by geography, if you could just walk us through qualitatively, how the margins progressed quarter over quarter? Then I have a follow-up.

Brian, are you asking us sequentially or year-over-year?

Sequentially from 5.5 to 5.16 about a 35 basis point decline. I'm just wondering was all of that truly due to mix shift to Asia, or was there margin pressures that you saw in other parts of the world?

Essentially the margin in the Americas was virtually flat, being down about 5 or 6 basis points whereas in the EMEA region, and it looks like our margin was down about 50 basis points on a sequential basis.

That's Op margin, right?

Op margin.

So Brian, the gross margin in EMEA was also essentially flat. America and EMEA gross margins were virtually flat sequential.

Then your December guidance overall looks like you are assuming, you know, blended operating margins to be roughly flat sequentially, despite what will be a seasonal shift toward the Technology Solutions business, which is lower margin, and also probably more of a shift to Asia within EM, so could you just kind of walk through what's behind your thinking about the margins by segment, and what is going to be able to keep them flat despite those shifts?

So Brian, it's Roy. If you look back in history, Q2 for Technology Solutions is always the highest op margin quarter of the year because of the leverage we get with the revenue bump. And if you look back at last year, I think you see an Op margin that was close to 3.7%. Getting pretty close to the enterprise level Op margins, okay?

Okay.

So TS performs almost in-line with Avnet Inc's Op margins for that particular quarter. And the rest of it is essentially a flattish Op margin for Electronics Marketing, coupled with some additional benefits in the form of interest expense, Ray, is down sequential.

That's correct.

And stock-based compensation is also slightly lower sequential.

Yes.

Great. Last question, Roy in your comments you mentioned some inventory adjustments taking place, and it sounded like that was pretty broad based, although you did point out some of the large EMS customers in the telecom segment, maybe a little more adjustment there. Just trying to get a sense for, you know, when you saw this start to take place, and your best guess as to how long you think this adjustment needs to take place?

Okay. So let me, I will make some high-level comments, and then I'll ask Harley if he'd like to add anything. Brian, actually it feels to me like we have been talking about this for a couple of quarters already.

And the sense that I have is that book to bill ratios peaked in the March quarter timeframe, and book to bills started softening in the April/May timeframe, and were definitely lower June quarter versus the March quarter. What we have seen in the September quarter is sort of an extension of that. Revenues holding up pretty nicely, in fact, my perspective is they are slightly better than seasonal, when you adjust for the divestiture that we made, and the bookings have been weakening for a couple of quarters now.

My sense is that in general, inventories in the supply chain are being well managed, and the reason we are seeing this book to bill adjustment despite relatively good revenue, is that companies who did accumulate more inventory than is actually now needed, they are taking aggressive actions to get their inventories back down in relatively short timeframes.

So given all of that, I think from the standpoint of inventory balance, we are likely to enter calendar '07 in reasonably good shape as a supply chain. The only disclaimer I would put on that of course, is macro economic conditions and any potential changes to demand, but overall I think this is a very mild correction that is roughly two-thirds complete.

Harley, would you like to add anything to that?

Sure Roy, thank you. Hi, Brian. I think the additional color I would add as we have often talked in the past, we in essence manage two different material flows. One would be for what I would loosely call our core business, which in essence held up quite nicely through the summer. Actually as Roy said, a bit better than seasonal. And our inventory in support of those customers, that group of customers globally, is in real good shape.

Aging is in real good shape. So we feel real good about that. Where we indeed started to see a softening as Roy said, most dramatically around June, would be in those customers I would loosely call, large global customers whereby, we traditionally fill a supply chain role. And that customer set did show some slowing through the summer period, so the real question, and I assume the genesis of your point, is what do we believe will happen at that set?

And obviously as Roy said, I can't predict what I would say to you is, we are in very, very close contact and engagement with those customers, many of which actually we service through some of the larger CMs. And they appear to believe that their increase, that we all experience together, will show us some relief going to the end of the calendar year. So we feel good that we will see some improvement in that, but again, it is hard to predict for those large customers.

Thanks a lot.

You are welcome.

Our next question comes from the line of Matt Sheerin with Thomas Weisel. Please proceed with your question.

Yes, thanks. Just to follow up on Brian's question, is it possible, Roy, that given EMS being conservative with inventories toward the end of the year, and perhaps some big OEM customers, that you could see less than seasonality, because you are basically guiding for seasonal trends in your components business, but could we see a little worse than that this year? Most of your semi suppliers that you sell for are looking at, you know, seasonally or worse than seasonal trends right now?

Yes. Matt, hi. It's a really good question. And I think of course the answer has to be, it could happen, but I want to come back and emphasize something Harley said. Remember for our suppliers, the vast majority of their business is in that Tier 1 account base, that traditionally direct market.

And for distributors like Avnet, the majority of our business is in the mid-Tier account base. In the mid-Tier, we have not seen anything like the inventory accumulation that we have seen at the Tier 1 EMS. So we are seeing, of course we are affected by the macro industry conditions, but we are seeing a different segment of the market that feels healthier, than say, just the top tier dealing with the largest communications companies in the world.

Okay. Great. Then just looking at your operating model now. You have done a great job of taking costs out. Looks like gross margin is seasonal, but it doesn't look like you are going to get a lot of upside there, so what should we be thinking about in terms of a slower growth rate environment for your operating margins in your leverage going forward?

So I think we are going to stick with the story we've been telling, which is, you know, that we think the market we serve, when you combine EM and TS, we have got a market that's growing at about 7% annually, and we have been growing substantially faster than that, as you know. And the midpoint of our guidance for the current quarter is right around that 7% range, including this inventory adjustment that we are talking about within Electronics Marketing. We are still not at our enterprise return on capital goal yet, however.

So the kind of leverage we are looking to build into the Company is to ensure that of our gross profit dollar growth, more than half is falling to operating income, and therefore of course, less than half is going back into the business to refuel, and to support that growth. So we are still looking to grow operating income at a rate that, you know, is at least 2 times gross profit dollar growth.

Okay, great. Just one quick last question. Back to the demand environment with lead times coming in and book to bill at or below 1, particularly for the suppliers, would you expect to see a return to normalized price erosion going into '07? Are you getting any indication of that at all?

So again I'll make a macro comment, and ask Harley if he'd like to add, Matt. My personal belief is that ASP erosion, of course, is a function of mix, I think for the industry we are seeing ASPs influenced by the growth of consumer, as opposed to the traditional business applications for electronic components.

But setting that aside for a minute, and thinking about the ASPs, say that we enjoy and the medical instrument sector as an example, I think that that ASP is driven primarily by capacity utilization. If our suppliers are getting reasonably good capacity utilization, so think about numbers like 85 to 90% utilization, their incentive or their motivation to lower prices is limited. You know, when utilization rates get too low, obviously, they work on lowering price to better utilize that fixed asset.

Right now, we are seeing cap utilization rates that are hovering in the 90% range, with leading edge technology being well above that, still up in the mid-90s. And in return, we are seeing product lead times that, while they have come in a little bit, I would still describe them as fairly extended. Harley, I think 8 to 10 is sort of a common lead time metric. So given those lead times, Matt, and that capacity utilization, I don't think there is much motivation in the industry yet, for the suppliers to move on Average Selling Prices.

Hi, Matt. This is Harley. I would add an additional comment that I am always reluctant to make statements, which we always do by the way, that ASPs are stable, lead times are stable. Although factually correct, what always, my challenge with those statements is always that they are a gigantic averaging process.

So when we look across the breadth of our product offering and commodity offering, indeed, the gigantic averaging would say that lead times have come in a bit, but indeed, what you see when you look deeper, is that some have gone out, some have come in.

And the reality is our job is to manage that overall process. My point in all that is that I don't see anything that tells me that we are going to be awash in inventory looking for a home, because of the modest lead time reduction that we saw over the last fiscal period.

Okay, great. Thank you.

You are welcome.

Our next question comes from the line of Jim Suva with Citigroup. Please proceed with your question.

Hi this is Kim Duncan in for Jim Suva. Just a question on the tax rate. Wondering why it is so high, when so much of your sales is in international locations?

Well, the sales are, the profits are at international locations, but keep in mind the European tax rate on average runs between, you know, 38 to 39%, and here in the U.S. it runs 40%.

So if you look at the bulk of Avnet's profits around the world it is still heavily weighted from a dollar perspective, more in the Americas and in Europe, and again a combined rate for both of those places in the 38, 39% rate.

Okay that is helpful. Can you talk about your acquisition strategy, and what you look for in an acquisition, maybe an update on your pipeline of opportunities?

So, Kim this is Roy. So a couple of things, you know. One, we have done a lot of M&A and of course, we have built up a competency there. I think we've demonstrated that last year through the Memec transaction, as well as a small number of smaller deals.

Based on the secular growth rate of the industry, and our rising return on capital, our cash flow profile has improved substantially, and we see ourselves as a cash flow generator. So as a result of that, we would expect to continue to do M&A. As far as sort of offensive targets, we would like our Technology Solutions business to expand into more geographies in Europe. We would also like to expand that business in Asia PAC, and for Electronics Marketing, we have a small presence in Japan which is a large market, and so we would love to expand there.

So our offensive strategies would be along those lines. And then I guess what I would say is a reactionary strategy would be, opportunities to consolidate provided that we feel comfortable with the culture, the integration strategy, and of course the economics associated with that consolidation. If we could meet our return on capital targets in a consolidating acquisition, in fact for that matter for all acquisitions, you will find us engaged in both types.

Great. Thanks very much.

You are welcome.

Our next question comes from the line of Carter Shoop with Deutsche Bank. Please proceed with your question.

Hey, guys. Could we talk a little bit about the linearity in the quarter in regards to orders, and also the cancellations? Did we see them start to pick up at all towards the end of the September quarter, or were they pretty consistent throughout?

Harley, do you want to take that?

I'm sorry, Carter, what was before cancellations? Linearity.

I'm sorry, linearity in the quarter for both orders and cancellations?

Well, cancellations showed no appreciable change from the previous couple quarters, so that looks to be very much under control. No change there of any significance. As far as linearity, I'm not sure what you are referring to.

Think about your book to bill by month, did the book to bill by month change from July to August to September?

I see. Really difficult one, Carter because of seasonality in the west. So if you look year-on-year, it was pretty consistent with what we have traditionally seen when you incorporate what typically happens in Europe, and to a somewhat lesser degree in America.

Yes, Carter, at a higher level, Harley's obviously a lot closer than I am. I don't think we could say that we entered the quarter or left the quarter stronger or weaker. There was no pronounced trend that came through the quarter. It was pretty consistent.

Okay. You did deliver better than expected results, so the components division actually came in above expectations. So still, given that, you are saying that overall cancellations and orders was pretty steady?

Yes. Keep in mind when we gave our guidance, we said that EMEA had pleasantly surprised us with the month of July already, and we thought, of course, August is the big test over there, with southern Europe pretty much going on holiday. And to our surprise, Europe sort of hung in there all quarter long, so July turned out not to be an aberration. It turned out to be, you know, a trend.

Then as Harley was referencing on seasonality in Asia, you know July is typically an okay month, but the real seasonal power starts to come in August and September, and so that was not visible at the time we gave our guidance last quarter, but it did in fact, come in, and I think we would have expected, you know, Asia to be up in the high-teens for year-on-year growth as they had been in the prior couple of quarters and they ended up, you know, more like 23.

Okay.

So we just got more strength out of Europe and Asia. America came in almost exactly as we would have expected.

Okay. Looking at inventory, Arrow reported last night or yesterday their inventory turns improved almost 15% sequentially. Your guys inventory turns on a quarter-over-quarter basis were actually flattish. Any reason why we are not seeing more improvement here, given the fact that lead times are contracting?

Yes. Again, I'll make a macro comment, and then Harley, I'll ask you to add some color. Carter, what happens, you know, if we take just as an example the large EMS companies serving the communications end markets.

So they receive forecasts from their customers, which in turn causes the EMS companies to send us a pipeline. We receive that pipeline, and we in turn react to it for the devices that we are responsible for managing. One of two things then happens. Either the demand from the end customer occurs, and we get pull triggers and the product flows through the supply chain, or the end customers demand pattern doesn't materialize. The forecast turns out to be too aggressive, in which case we have an inventory build.

So in a period where there's either an over forecast, or the same effect occurs with a reduction in lead time from our supply base, and in either case, what happens short term is an inventory accumulation. And I think the question you are asking is, so then once that adjustment is made, shouldn't the inventory then decline, and the answer is yes, and that's what we expect to have happen this quarter.

Carter, I don't know that I would have anything to add to that, other than the fact that I obviously don't have any specific knowledge as to what would occur, what did occur relative to any of our competitors on their inventory performance for the September quarter, as I didn't in the June quarter, either.

Carter, if I could add one more point. I would encourage all of us to obviously focus on inventory because it's a very important metric, but also keep an eye on total working capital, because there's a balance between inventory and payables, and then again between inventory and receivables. So the real issue is managing that overall working capital bucket.

Sure. Last question on inventories. Could you talk a little bit about your inventory right now, in regards to leaded versus unleaded products, and how that changed sequentially?

Yes, hi, Carter. This is Harley again. Overall, we feel we are in pretty good shape. I would say candidly that we work through some issues over the summer, primarily in America, where as you are probably aware, the adoption to lead free is moving at a rate obviously significantly less than in Europe. So we work through a number of those issues, and I think we have got that in pretty good shape.

As far as percentages of inventory, I don't have that at my fingertips.

But it certainly would have shifted, right, Harley from, we continue to acquire more compliant material as we sell off the older materials, Carter. So it's clearly shifting, but we would have to do a lot of work to give you the actual statistics.

Great. Thanks a lot.

You are welcome.

Ladies and gentlemen, [OPERATOR INSTRUCTIONS] Our next question comes from the line of Jason Gursky with J.P. Morgan. Please proceed with your question.

Thanks. Good morning, guys. You guys did a great job of explaining the sequential decline in gross margins with, you know, TS becoming a bit more of the overall revenue picture here. As we look on a year-on-year basis, EM is actually a little bit higher, about 200 basis points higher this year than it was last year as a percent of the total.

I understand that you went through a transition with one of your vendors, from more of a design end to product fulfillment. I was wondering if you could just help us understand when that transition started, and whether we are looking at, you know, true comps here, and if it was fully baked into last September's quarter, that transition had already happened. Maybe you could just shed some light then a bit on the year-on-year gross margin decline, and the sources of it?

Yes. So Jason, at EM gross margin year-on-year declined by about 20 basis points. And the answer to your question about that supplier is it started in Q1 of last year. It had its biggest impact in Q2 in our results, and then by Q3 it had normalized out, and our gross margin decline actually stopped. And for the last three quarters, Electronics Marketing gross margins have been very stable.

Okay. So the 20 basis points year-on-year then is more related to the transition with this vendor, or are there any other particulars that you could walk us through?

I would say that vendor coupled with the regional shift.

Okay. Okay that's helpful.

Sure.

And then Ray, on the balance sheet, just kind of walk us through a few of the moving parts as we progress through the year here, and maybe just remind us a bit on what your targets are for this year on DSOs and, I guess inventory is a bit of a moving target for you, but DSOs and Days Payable, and how we ought to be thinking about cash flow, as we walk through the rest of this year?

Okay. I think overall, obviously, a big part of our cash flow and our DSOs is driven by the mix of business, as we have talked about. And at this point in time, we don't see anything dramatically changing.

EM right now from a velocity perspective is near record levels in overall velocity, as well as with inventory turns. We would expect that to continue. Same thing with TS, which overall from a working capital perspective again continues to improve. So we don't see any major change one way or another from an overall days perspective.

As a result, you know, if you look out through the balance of the fiscal year, although it's very hard to predict on any individual quarter, because again we do have $2.4 billion worth of working capital, and 1 or 2 days worth of working capital adds up to a lot of dollars very, very quickly, so it's difficult to predict what cash flow is going to be on a quarter-by-quarter basis. Especially this December quarter whereas you are probably aware, heavily back end loaded towards our TS business. Depending upon how that business runs through the last, you know, month of the quarter, last week of the quarter, will have a pretty big impact on our cash flow for that particular quarter.

But if we look at an annualized basis, we are looking for a positive cash flow for the year. Exact magnitude is very, very hard to predict at this particular in time, but I would expect it to be in the $150 million range, or thereabouts, maybe a little higher than that but again, depends upon growth of business. As we exit each quarter and as we exit the year quite frankly.

Okay, then any changes to the view on CapEx for the year?

CapEx, do not really see any significant changes from where we are now. It's running a little bit higher than what it's been in prior years, as we make some important investments, but for the year, we have about $14 million in the quarter, and don't really see a big change from that. It'll tweak up maybe a couple million dollars per quarter going our for the balance of the year. I think our forecast has us around $60 million or thereabouts in CapEx for the year.

Okay, great. Thank you, guys.

You are welcome.

Our next question comes from the line of Richard Keiser with Sanford Bernstein. Please proceed with your question.

Hi. I just wanted a quick clarification on product category strength. You mentioned I guess in the release that there was some strength in storage and software. Then in your comments, you said that the year-over-year growth was driven I think by some different categories. I don't know if it was just an oversight, but could you just provide kind of maybe what kind of the key drivers were on the product level, and then perhaps some weaker products in the quarter?

Okay, Rick, you want to take that?

Sure. Good afternoon. Thanks for the question on TS. As always, the reference I think in the script had to do with storage solutions overall, which were up year-on-year in the high teens. From an overall aggregate perspective, the breakout on the commodities for TS were Hardware at 73%, Software at 18, Services at 9, and the growth rates and again with the adjustment for the divestiture of the AES business on an 8.9 aggregate growth rate, proforma the Hardware was up about 8%, Software up about 10, and Services up about 14.

Okay. And the strength you saw on software, where was that driven by, or what was it driven by?

It was primarily the middleware tool set from our major server and storage OEMs.

Great. Thank you very much.

You are welcome.

Our next question comes from the line of Harry Blount with Lehman Brothers. Please proceed with your question.

Thanks, guys. Really just a couple quick clarifications hopefully. One is the $0.08 that you expect to save on the interest refinancing. Is that supposed to be getting in the December quarter? Did I hear that correctly?

A significant piece of it will be in the December quarter. We do have a maturity that is due in November of '06. So really the full benefit of that you will see in the March quarter, but you should still see a fairly sizable reduction in the December quarter. Right now, order of magnitude, I would say we have interest expense in this most recent quarter of $22 million thereabouts. We would expect it to be down in the, let's say, $19 million range sequentially.

Okay. And then on the depreciation side, given your comments on CapEx, your depreciation is down, 2 or $3 million year-over-year, to about 13 and change here a quarter. Is that essentially where you expect it to bottom out on a normalized basis?

At this point, I think the answer to that is yes. I don't see it going much lower on a go forward basis. It will start to move up a little bit as we go through the balance of the year.

Okay. All right, great. Thanks.

You are welcome.

Our next question comes from the line of Kevin Sarsany with Next Generation Research. Please proceed with your question.

Thank you. You got my company name right. Appreciate it. How much of TS is made up of micro processors? The mix?

Yes, hi, Kevin. Rick, you got that at your fingertips?

Yes, let me do just a quick division overall here. I'm going to guess 15%. I'm doing the quick math.

Okay. Whether is that included, hardware, software or services?

I put that in Hardware. 14% you can run with.

Okay. Thank you. I guess it sounds like, Roy, you are talking about we are in the two-thirds through what sounds like an inventory correction. Is that correct?

Well, I don't profess to know for sure, Kevin, but that's the sense that I have, yes.

Okay. So why were revenues at the highest level they have been in 2 years, and then why do you think it's going to drop off year-over-year in EM next quarter?

So what we are saying is going to drop off is the rate of growth, but not the revenue themselves. We're looking for a normal seasonal quarter in the December quarter.

Did last year's second quarter, with as that outsized for some reason?

Yes. If you remember, we closed the Memec deal in the first quarter.

Right.

And they had pulled some revenue up into the June quarter.

Right, 40 million.

Correct. So the Q1 number in a manner of speaking was understated by 40, so therefore the Q1 to Q2 growth rate was overstated.

Okay. Interesting. And I guess, a couple comments here, you know, you guys have always talked about inventory being the life blood of your business. It is what you provide with other things around it. Now, and you have continually drop down your inventory days, maybe not as much this quarter, but I mean, how far can that go, and isn't there some type of relationship to lead times? I mean, maybe back of the envelope, maybe I don't do it as well as you guys do it, but you know, if you are at 50 days in inventory days, and lead times are 8 to 10 weeks, let's say 9 weeks, that's 60-odd days. Isn't there a gap there? I mean, or am I just making it too simple?

Let me give you two answers, Kevin. Answers to both of your questions. First of all in the context, or category of where we go from here, if you looked at the inventory as being steady state, all other things being equal, I would tell you that we have done 90% of the heavy lifting. You are probably never going to hear us say that there is no more opportunity to improve, because we're sort of committed to continuous improvement at a cultural level.

But do you want to improve?

I think that improvement in the context of, can we get more inventory out without having a negative impact on sales, sure.

Okay.

I would like to do that from a return on shareholder capital perspective. But let's just say we're 90% of the way done there, okay, you still have issues like the shift from the west into the east, where we have a lower margin/higher velocity profile, and we also have another shift that's been going on for many years, which is a shift from transaction-based distribution to integrated supply chains. And the integrated supply chains have a higher inventory velocity profile.

So as our mix of business shifts more to Asia, and more to supply chain, there is always the opportunity to further improve our asset velocity. And then regarding lead time, you are right on point, but there is a subtlety. When lead times are expanding, with an ING on the end, then yes it is common for our inventory to rise in support of that. Now typically, revenues are rising too, so there is a dynamic there, but typically the inventory does go up.

If inventories are at a high level but they are stable, on a sequential basis, you should see relatively stable inventory velocity from us as well. So it's when the lead times are changing, that our inventory profile has to change, but once it stabilizes even if it's at a higher level, we can still deliver our productivity metrics.

Do you think we are at a stable level?

They are actually contracting slightly, which means that we should actually be able to lower inventory and increase turns and, you know, as Ray was commenting earlier, this asset is huge, so it's difficult any given quarter to nail the projection, but our expectation going into this quarter, is that we will lower inventory and increase turns.

Okay. And my last question and it's a little bit of a softball here, is if you have been going through this so-called correction since March/April, looking at your slide 14, 15, 16, back in 2004, all those metrics during that last inventory correction, and a little bit of demand, all kind of stopped progressing in a positive way. We have not seen that. Is that to come, or are you guys getting to be that good?

Well, first of all, I would seriously give a lot of credit to the organization. There is a lot of people whose daily and day-to-day actions drive those numbers, and we have been continuing to drive this value-based management principle throughout the organization. And our people and our processes and our systems are in fact better, and they will be better two years from now, than they are today. So I give that a lot of credit.

But I also would have to tell you that in all fairness, this correction cycle is substantially less severe than the '04 cycle. The run-up in '04 was steep, and then the correction was steep. This has been a gradual increase in growth, and the correction is gradual because there is not a lot of excesses out there.

And do you expect this type of correction to kind of pervade going forward barring, you know, big dropoff in demand and big capacity in wafer fabrication growth? I mean, is this the kind of cycle you foresee on an ongoing basis?

As a matter of fact, it is.

Okay. Thank you.

Gentlemen, there are no further questions in the queue. Do you have any closing remarks?

Yes, Vince.

Yes. As we conclude today's quarterly analyst call, we will now scroll through the slide mentioned at the beginning of our webcast, that contains the nonGAAP to GAAP reconciliation of results, presented during our presentation, along with a further description of certain charges that are excluded from our nonGAAP results.

This entire slide presentation, including our GAAP financial reconciliations, can be accessed in downloadable PDF format at our website.

We would like to thank you for participation in our quarterly update today. If you have any questions or feedback regarding the material presented today, please contact the Avnet Investor Relations department by phone or e-mail. Thank you.

Thanks, everybody.

Ladies and gentlemen, this does conclude today's teleconference. Thank you for your participation. You may disconnect your lines at this time.