安富利 (AVT) 2010 Q1 法說會逐字稿

I would now like to turn the floor over to Vince Keenan, Avnet's Vice President of Investor Relations.

Good afternoon and welcome to Avnet's first quarter fiscal year 2010 corporate update. If you are listening to 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. As we provide the highlights for our first quarter fiscal 2010, please note that we have excluded impairment charges and restructuring, integration and other items from the current and prior year periods in the accompanying presentation and slides. When discussing pro forma sales or organic growth, prior periods are adjusted to include acquisitions. And finally, when addressing working capital, it is defined as accounts receivable plus inventory, less accounts payable.

Before we get started with the presentation from Avnet management, I would 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 2010 highlights. Following Roy, Ray Sadowski, Chief Financial Officer of Avnet, will review the Company's financial performance during the quarter and provide second quarter fiscal 2010 guidance. At the conclusion of Ray's remarks, Roy will wrap up with closing comments, after which a Q&A will follow. Since we have added a few new analysts to our coverage universe, I would ask that you limit yourself to one question, and if we have time at the end of the call, we will take any follow-up questions.

Also here today to take any questions you may have related to Avnet's business operations are Rick Hamada, Avnet's Chief Operating Officer, Harley Feldberg, President of Electronics Marketing and Phil Gallagher, President, Technology Solutions. With that, let me introduce Mr. Roy Vallee to discuss Avnet's first quarter fiscal 2010 business highlights.

Thank you all for taking the time to be us and for your interest in Avnet. For the September quarter, our revenue exceeded expectations at both operating groups, which suggests that the business environment is improving in our end markets.

As we have previously mentioned, due to our 52, 53 week fiscal calendar, our results for the just-completed first quarter of fiscal 2010 include a 14th week as compared with the typical 13 weeks. Since there is no way to precisely quantify the impact of that extra week, we simply have taken the average of the first and last weeks of the quarter, to develop an estimate of what revenues would have been in a normal quarter. Using that methodology, we estimate that the extra week accounted for approximately $400 million of revenue at the Enterprise level, with about $250 million attributable to Technology Solutions, and $150 million for Electronics Marketing.

Even after adjusting for the extra week of revenue, both operating groups delivered sequential growth that was better than normal seasonality for a September quarter and our year-over-year rate of decline improved. And Avnet improved from a trough of down 25% year-over-year on a pro forma basis in the June quarter, to down 15% in the September quarter, again, excluding that extra week of revenue. Since the downturn hit us with full force in the December 2008 quarter, our year-over-year rate of sales decline had been worsening. This is the first quarter that we've seen an improvement in this metric, and we believe this is further evidence that the technology markets we serve bottomed in the June quarter.

Across the supply chain, and at Avnet specifically, inventories seem well aligned to the current levels of demand. It is difficult to ascertain how much of this quarter's growth was due to supply chain adjustments, and how much was due to growth in end demand. However, based primarily on our performance at tech solutions, it does appear that end demand is improving gradually. Although the rate of decline in gross profit margin slowed materially from the June quarter, it declined sequentially, primarily driven by the mix shift to Asia where both operating groups have a business model characterized by lower profit margins, offset by higher asset velocity and lower taxes.

For the September quarter, our Enterprise revenue in the Asia region grew over 23% sequentially and 11% year-over-year. As Asia has been less impacted by the global downturn, the region has grown from 18% of Avnet's total sales to 25% in just the last three quarters. Gross profit margin also declined sequentially in the EM EMEA region, where similar to the third quarter at EM America, we experienced a decline due to a variety of late cycle, market-driven pressures. We are encouraged by the fact that this prior quarter decline in the Americas reversed this quarter, as EM Americas posted a 63 basis point sequential improvement. Since EM EMEA bottomed after the Americas, we expect to see gross profit margin improvement in Europe in the coming quarters, as inventories stabilize and demand begins to improve. The sequential increase in volume and higher productivity at both operating groups drove an improvement in profitability across the Enterprise.

Each region at both groups delivered a meaningful increase in operating profit margin from the June quarter. The only exception was TS Asia where we continue to follow our plan to increase investment in our organic growth initiatives. As a result of this performance, EPS in the September quarter excluding charges, exceeded expectations and grew 38% sequentially to $0.44. This is our best quarter so far in calendar 2009, and we expect to continue to grow profits faster than revenue due to the operating leverage we have built into our business model. The combination of better than normal seasonality, and the 14th week, contributed to record working capital velocity in the September quarter.

The Avnet team around the globe did an excellent job as they were able to support approximately $590 million of sequential revenue growth with just $67 million of incremental working capital. While the shift to Asia accounts for some of this improvement, working capital velocity did improve in the Western regions at both operating groups. Return on working capital improved for a second consecutive quarter, and is up 588 basis points since it bottomed in the March quarter. This performance is further evidence that we can improve returns and shareholder value as our end markets recover, while managing the mix shift to Asia.

Now let's turn to the operating groups. In the first quarter of fiscal 2010, Electronics Marketing sales exceeded expectations and after adjusting for the extra week, were above normal seasonality in all three regions. Similar to last quarter, Asia had the strongest sequential growth, while both the Americas and EMEA regions had an improvement in their rate of year-over-year revenue decline. After adjusting for the extra week and acquisitions, revenue declined roughly 21% over the year-ago quarter as compared with the 27% decline in the June quarter. While revenue is still well below year-ago levels, we are encouraged by the sequential progress as well as strong incoming orders.

For the quarter just ended, EM's book-to-bill ratio was over 1.1 to 1 with all three regions exhibiting strong bookings. As a result of the double-digit sequential revenue growth and cost reduction initiatives completed in prior quarters, EM's operating income increased 42.5% from the June quarter to $81.4 million. And operating income margin increased 65 basis points to 3.3%. In Asia, operating income increased more than 80% sequentially, and return on working capital was up both sequentially and year-over-year and in line with our long-term goal.

In the Americas and EMEA regions, where the impact of cost reductions drove an improvement in productivity metrics, operating income grew 40% and 28% respectively. Even though the improvement this quarter was an important turning point for EM, we're not satisfied with this level of profitability and expect continued progress as growth ensues, particularly in the industrial markets in the Western regions.

Turning to the balance sheet, working capital velocity at EM set a record for the second quarter in a row. For the September quarter, EM inventory was up $72.5 million in delivered dollars, and $55 million in constant dollars. Inventory turns improved 14% over the June quarter to a record 6.7 times. This impressive performance by the global EM team is an ongoing reflection of our VBM culture and the focus we have maintained on managing working capital. The improvement in operating income margin, combined with higher working capital velocity, drove EM's ROWC higher by 548 basis points sequentially to the best level since last December when we were negatively impacted by the downturn.

In the September quarter, Technology Solutions exceeded its revenue expectations and delivered better than normal seasonality when you exclude the impact of the extra week. Growth was strongest in the Asia region, where investments we've made in organic growth drove sequential revenue up 18% and year-over-year growth up 60%. While TS year-over-year growth rates remain negative excluding the extra week, in both the Americas and EMEA regions they were down less than the prior quarter which could indicate that customers are beginning to increase investments in IT. At a product level, servers, software and microprocessors were our fastest growing categories. Operating income increased 24.8% sequentially, to $51.4 million, and operating income margin improved 16 basis points to 2.7%. At a regional level, operating income margin was up 24 basis points sequentially in both the Americas and EMEA, while Asia was down slightly as we continue to invest in organic growth.

Just this month, we announced the acquisition of a controlling interest in the Vanda group. Founded in 1982, Vanda is a leading IT solutions and services provider, covering major cities in China, Hong Kong and Macao. With over 600 employees delivering systems and solutions, incorporating hardware, software and services from major vendors including IBM, Cisco and Sun Microsystems. TS Asia will enhance its competitive position in the region and be positioned to address new opportunities for growth in this critical IT market.

In the September quarter, diligent working capital management, combined with double-digit sequential revenue growth, drove a significant improvement in working capital velocity. The combination of improved profitability and faster working capital velocity drove a 986 basis point sequential improvement in return on working capital, which for the September quarter was at the highest level in the last seven quarters. Of particular note, TS Global ROWC has been above our 30% hurdle rate for the past two quarters. Since we first saw weakness in our server business back in March of 2008, Technology Solutions has been on a recovery program that included aligning resources with end market demand, investing in new solutions practices, and integrating acquisitions.

It is very gratifying to see that while we have not yet experienced a meaningful recovery in end demand, our return metrics are approaching levels comparable to the quarters prior to March 2008. As market demand improves and the benefit of our value creating M&A gains traction, we expect to deliver higher margins and returns in pursuit of our long-range goals. Now I'd like to turn the commentary over to Ray Sadowski, Avnet's Chief Financial Officer. Ray?

Thank you, Roy and hello everyone. Let's start with a review of Electronics Marketing. In the first quarter fiscal 2010, Electronics Marketing's revenue of $2.44 billion was down 9.8% year-over-year on a reported basis and down 8% adjusted to exclude the impact of changes in foreign currency exchange rates. Pro forma revenue after adjusting for the impact of acquisitions and foreign currency exchange rates, was down 13.2% year-over-year.

Sales in the Americas region were down 20.5% on a reported basis. In the EMEA region, sales were down 10.6% on a reported basis over the prior year quarter, and down 4.4% after adjusting for the impact of changes in foreign currency exchange rates. On a pro forma basis, EMEA sales were down 21.8% year-over-year, and after adjusting for the impact in changes in foreign currency, sales were down 16.4%. And finally, for EM Asia's region, sales were up 3% as compared with the prior year, and down 1.3% on a pro forma basis. On a sequential basis, EM sales were up 14.6%, which includes the extra week of sales, estimated at roughly $150 million.

Excluding the extra week, EM sales were up approximately 6% sequentially, above our normal seasonality, and on a year-over-year basis EM revenue declined approximately 16%. In the September quarter, Technology Solutions sales of $1.92 billion were up 6.9% year-over-year on a reported basis and 10.5% adjusted to exclude the impact of changes in foreign currency exchange rates. Pro forma revenue after adjusting for the impact of acquisitions was also up 6.9% year-over-year as there was only one small acquisition in the Asia region, slightly impacting the pro forma sales number.

At our regional level, revenue in the Americas was up 9.2% on a reported basis year-over-year. In EMEA, revenue was down 9% over the prior year quarter in reported dollars, and flat when you exclude the impact of changes in foreign currency exchange rates. Sales in the Asia region were up 71.4% as compared with the year-ago quarter, and were up 70.5% on a pro forma basis driven primarily by the investments we have made to drive organic growth. TS sales grew sequentially roughly 17%, [including] (corrected by company after the call) an estimated $250 million of sales attributable to the extra week. Excluding the extra week of sales, TS was still above our normal seasonality with an increase of approximately 2% sequentially. Excluding the extra week of sales on a year-over-year basis, Technology Solutions sales declined approximately 7%.

Now let's look at the Enterprise results for the first quarter fiscal year 2010 as compared with the prior year. The September quarter financial results improved in comparison to recent quarters, which is an indication that the effect of the global economic slowdown on end demand may be beginning to improve. However, the September results remain below our prior year first quarter. For the September quarter, Avnet sales of $4.36 billion were down 3.1% in reported dollars, and essentially flat in constant dollars as compared with the year-ago quarter. On a pro forma basis, revenue was down 6.5% over the year-ago quarter. On a sequential basis, the September quarter sales increased 15.7% with both operating groups delivering double-digit sequential growth.

Excluding the extra week, estimated to be approximately $400 million, sales increased 4.6% sequentially. Gross profit of $499.7 million was down $84.5 million or 14.5% as compared with a first quarter of fiscal 2009 due to the decline in revenue and gross profit margin mentioned earlier. Gross profit margin of 11.5% declined 153 basis points year-over-year, primarily due to regional mix and lower margins at EM America and EM EMEA. For the December quarter, we expect to see an improvement in gross profit margin for EM while at TS we expect gross profit margins to be flat or slightly up. Therefore, at the Enterprise level, we expect gross profit margin to remain roughly flat sequentially due to business mix as technology solutions ends the calendar year with their normal increase in revenue for the December quarter.

Operating expenses [excluding] (corrected by company after the call) charges were $392.6 million, down $27.1 million or 6.4% year-over-year, and down almost 10% after adjusting for the impact of foreign currency and expenses associated with companies acquired in fiscal 2009. On a sequential basis, operating expenses increased $35.1 million, or 9.8%. However, excluding the impact of foreign currency, operating expenses were up $25.7 million or 7.2%. As part of our year end earnings call in August, we communicated that operating expenses would be up roughly $20 million sequentially, due to the extra week of expenses in the quarter and increased stock compensation, offset slightly by incremental cost reductions.

Excluding the impact of foreign currency, our operating expenses came in roughly $5 million higher than forecast, with revenue coming in approximately $450 million above the midpoint of our guidance. In terms of the status of our cost reduction efforts, previous announced restructuring actions totaling $225 million annualized were substantially complete as of the end of our September quarter. Since the announcement of our first cost reduction actions in March of 2008, total operating expenses excluding certain charges have gone from roughly $450 million per quarter, that is $400 million as initially reported, adjusted to include the impact of acquisitions and currencies, to approximately $380 million per quarter if you exclude the impact of currency, acquisitions and the extra week of expense in the first quarter, thereby exceeding our announced reductions of $225 million of expenses, and $40 million of synergies.

Looking forward to our December quarter, and into the next calendar year, operating expenses will be impacted by foreign currency exchange rates, acquisitions, and incremental sales volume. As always, one of our key productivity metrics that we use to manage our business is operating expenses as a percent of gross profit. For the September quarter, we improved this key metric by 217 basis points sequentially and we expect to see additional improvement as we continue to benefit from our operating leverage as growth resumes.

Operating income excluding charges was $107.1 million, down 34.9% as compared with the prior year quarter, with both operating groups contributing to the decline. For EM, operating income declined 41.3% to $81.4 million, and operating income margin of 3.3% was down 179 basis points from the prior year quarter. Although the cost reduction actions at EM provided the expected benefit to operating expenses, the year-over-year decline in gross profit margins in the more profitable America and EMEA regions was a significant factor in the year-over-year decline in EM's operating income. Technology Solutions operating income of $51.4 million was essentially flat year-over-year. Even though the TS gross profit margin declined, operating income margin was down only 17 basis points over the prior year first quarter due to the benefits of the cost reduction actions.

Operating income margin at the Enterprise level improved sequentially by 20 basis points due to the improving business environment and the impact of cost reduction actions offset by business mix. This was the first sequential improvement in five quarters, providing us with another indication that we're past the trough and we expect additional improvement to operating income margins as we move forward. Below the operating income line, interest expense for the September quarter was $15.3 million, down $1.6 million or 9.4% from interest expense of $16.9 million in the prior year quarter. Excluding the retrospective application.

Primarily this decline in interest was due to the retirement of Avnet's $300 million of convertible notes that were put to us in March of 2009. On a sequential basis, interest expense was up approximately $700,000, primarily due to the extra week in the quarter. The other income expense line was income of $2.9 million in the current year quarter, as compared with $600,000 of expense in the prior year first quarter. The year-over-year swing was primarily due to foreign currency gains, as compared with losses in the prior year first quarter, and some additional interest income. The effective tax rate on income excluding charges was 29% in the current year first quarter, as compared with 30.8% in the prior year quarter, due to more income from lower tax rate jurisdictions. Our tax guidance for the remainder of fiscal year 2010 is between 29% and 32%.

Net income excluding charges was $67.2 million, or $0.44 per share. GAAP net income was $50.9 million or $0.33 per share for the first quarter of fiscal 2010. During the quarter, we generated $6.2 million of cash from operations, which compares with a usage of $5.3 million in the prior year first quarter. On a trailing 12 month basis through the September quarter, we generated cash flow from operations of $1.1 billion due to our continuing efforts on working capital management. As a result, we further strengthened our balance sheet and improved our liquidity position. We continue to focus on managing working capital velocity which improves significantly both year-over-year, and sequentially to record levels.

Working capital declined $869 million year-over-year, or 28.9% while sales declined 3.1%. Resulting in a 172 basis point improvement in working capital velocity to a record of 7.6 times. Some of the year-over-year improvement in working capital velocity is due to the growth in Asia and the increase in TS revenue as a percentage of the total Enterprise. As both TS and our Asia businesses have higher working capital velocity and somewhat lower operating income margins than the rest of our business. It appears that revenues are beginning to improve and working capital velocity is at an appropriate level for both operating groups, so we do not expect to continue to generate the same levels of cash from operating activities as was generated over the past four quarters.

In the September quarter, return on working capital of 18.7% improved 399 basis points sequentially, while our net days were down almost two days as compared with the June quarter. At Technology Solutions, even though working capital increased 9% sequentially, both working capital velocity and net days improved as a result of the double-digit revenue growth and capital management of accounts receivable and inventory. At Technology Solutions, DSOs were down 2.7 days and working capital velocity improved 24% from the June quarter. At EM, net days decreased 2.6 days sequentially, and working capital velocity set a record for the second quarter in a row. This impressive performance at both operating groups drove a 986 basis points, and 548 basis point sequential basis point improvement for ROWC for TS and EM respectively. Return on total capital deployed. Due to improvement in return on working capital and the impact of the goodwill impairment charge recorded in fiscal 2009.

On a trailing 12 month basis, return on capital employed was 8.7%. Despite the turbulent year in our financial results, we have been able to maintain our investment grade credit statistics and have the healthiest balance sheet in years, reflecting our strong financial position. On a trailing 12 month basis, debt to EBITDA was 2.0, and EBITDA coverage was 8.0. We exited the quarter with $987 million in cash, leaving us with approximately $1.8 billion of liquidity.

Looking forward to Avnet's second quarter fiscal 2010, after adjusting for the extra week in our fiscal Q1, we expect normal seasonality at TS, and slightly better than normal seasonality at EM, as the supply chain in the west continues to adjust. Therefore, TS sales are anticipated to be in the range of $1.95 billion to $2.25 billion, and sales for EM are expected to be between $2.15 billion and $2.45 billion. Avnet's consolidated sales are forecasted to be between $4.10 billion, and $4.7 billion for the second quarter of fiscal 2010. Based upon that revenue forecast, we expect second quarter fiscal year 2010 earnings to be in the range of $0.52 to $0.60 per share.

The above EPS guidance does not include any potential restructuring integration charges. In addition, the above guidance assumes that the average Euro to US dollar currency exchange rate for the second quarter of fiscal 2010 is 1.48 to 1. This compares with an average exchange rate of 1.32 to 1 in the prior year second quarter and 1.43 to 1 in the prior sequential quarter. Now let me turn it back over to Roy to provide closing comments for the quarter. Roy?

Thank you, Ray. In summary, the first quarter of fiscal 2010 reinforced our belief that technology markets have bottomed, but it did not necessarily provide definitive insight into the rate of this cyclical recovery. While a strong book-to-bill ratio led to an above normal seasonal outlook at EM, it is still difficult to discern how much of that demand is related to ongoing supply chain adjustments and lengthening product lead times. Versus growth in end demand.

At Technology Solutions, where we are forecasting normal seasonality for the December quarter, it appears that end users are now spending more than they were over the past few quarters. In aggregate, we do believe we are at the beginning of a cyclical recovery that most likely will be gradual in nature. This was a demand rather than supply-driven down cycle. The rate of growth during the recovery should to a large degree correspond to the rate of improvement in global GDP. Over the past four quarters, as the extent of the downturn became clear, we've been focused on reducing cost, conserving cash and strengthening our balance sheet. Looking back, the Avnet team did a commendable job managing through those issues as evidenced by the sequential improvement in many financial metrics for the September quarter. With a strong balance sheet and more stability in the end markets, we are increasing our focus on profitable growth. Organic growth remains our top priority.

At Electronics Marketing, we continue to invest in product line extensions like LEDs and high performance batteries as well as explore new opportunities to expand in the embedded computing space. At Technology Solutions, we continue to build on the success of our industry-leading solutions path, reseller enablement program, with new solutions practices. While expanding our franchise relationships globally and investing in Asia. Recently, TS introduced a new solution practice focused on the high growth networking and security market while also adding Sun Microsystems in China and VMware in India.

In addition to enterprise-wide organic growth initiatives, we continue to explore potential value creating acquisitions around the globe. With a rock solid balance sheet, leading scale and scope and an experienced leadership team, we intend to take advantage of opportunities to continue investing in value creating M&A that will both strengthen our market position and enhance our financial performance. In summary, we remain committed to growing shareholder value and will continue to react to and capitalize on the challenges and opportunities presented by our served markets. With that, let's open up the lines for Q&A. Operator?

Thank you. Ladies and gentlemen, at this time we will be conducting a question-and-answer session. (Operator Instructions). Our first question comes from the line of Craig Hettenbach with Goldman Sachs. Please proceed with your question.

Thank you. On the topic of gross margin, both you and Arrow had been expecting for September quarter roughly flattish gross margin and at both companies it was down. So just want to get some color into December quarter that by group you expect it to be up, if there's anything you can provide there that gives you the confidence to guide it flat to up.

Hi, Craig. It's Roy. So two things. One, one primary issue that was different than what we anticipated going into the September quarter was the rate of mix shift into Asia, so that's one of the factors. The other thing that we did not fully anticipate was the gross margin declines at our EM business in Europe. It really mirrored what happened in the Americas in the prior quarter. And as we pointed out on the call, we did see a nice recovery in the Americas and we believe that Europe will follow as the supply chain adjustments play themselves out there.

As far as the coming quarter, our expectation is that gross margin will improve at EM globally, and then at Tech Solutions, it's going to be somewhere between flat and up slightly based on our current expectations, and then of course what happens is TS will grow much more rapidly than EM in the December quarter based on the year-end IT activity. So at the Enterprise level, we expect it to be flattish. Depending on mix, perhaps up just a little bit.

Great. If I could just follow up, just sticking with gross margins. Anything in terms of lead times and backlog and pricing, if you think we're kind of near the trough of that at this point?

Well, look, let me take a shot at that. I think that in the September quarter and certainly spilling over into the December quarter, we're seeing in the components market a significant number of product shortages that are driven by the capacity reductions that had been put in place, coupled with seasonal factors. What's not clear, Craig, is what happens after we get through December and on into the March quarter. So in the short term, the answer to your question is yes. Last quarter and this quarter in terms of incoming orders, we're seeing extended product lead times in certain cases. That is creating more firmness in the market. But we're not clear yet what happens as all the capacity comes back on line and the seasonal factors are behind us.

Great. Very helpful. Thanks so much.

You're welcome.

Our next question comes from the line of Steve Fox with Calyon Securities. Please proceed with your question.

Hi, good afternoon. Could you just, Roy, talk a little bit about the Technology Solutions business? Obviously, you're getting a good seasonal lift. Is there anything in the customer base or in the product demand that would suggest that this may have more legs into next year or anything you could point to at this point?

Well, Phil or Rick, do you want to take a shot at that?

Yes, hi, this is Phil Gallagher. How you doing? Actually, if we look at the overall mix in the hardware and the software and the services, we're actually seeing some accelerated growth in the software area of the business which is positive. But in the hardware, the servers continue to grow at a good rate. Our storage business was up well, quarter-over-quarter and we saw good progress year-over-year. But I wouldn't say there's anything specific in one air of the business or one technology is driving the other or far exceeding the other but -- then you got the practices, virtualization's growing well, networking's growing well, so you've got certain areas of the business in the practices area are increasing maybe at an accelerated rate but in all regions, really. Rick, I don't know if you want to add anything to that.

Hi, Steve, it's Rick. Based on what we saw from a seasonality perspective here, things picking up in the latter half of the calendar year, that led us to the outlook for December quarter. Heading into calendar 2010 we have all new IT budgets and all new resets. Very much a 90 day business as we talked about in the past. We'll be watching very closely.

Is there anything you could say about the pending Sun Oracle deal in terms of its impact on your business?

Yes, Phil Gallagher again. I'll take that one. At this point, we really have pretty much what you have as far as the news on the outcome on how that's going to roll. Sure, customers and like many of us would like to know a lot more. At the same time, relative to our expectations in the Sun business unit, we're performing relatively well and frankly in the past quarter a bit better than we expected. We're kind of in the wait and see mode as well but our charter will be to align as quickly as possible to that strategy as they roll it out and the structure as they roll it out. Not much more than you know other than we were a little pleasantly surprised with some of the Sun business outcome this past quarter.

Great. Thank you.

Steve, it's Roy. I want to add one last comment regarding expectations. It is very difficult to look forward and forecast accurately but the facts that we know are that our IT business on a broad base, so you heard Phil say across product categories, it was also true geographically, so across geography, across product categories, we were better than seasonal, even if you exclude the 14th week and then on top of that the year-over-year revenue declines improved across the board similarly. So those are two facts, and I guess the question in my mind is why would that reverse itself here in the December quarter and going into 2010. It strikes me that we are past the trough, barring some other event that we don't yet know of turning things back around.

Great. Thank you, Roy.

You're welcome.

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

Thanks. Just back to gross margin, surprisingly, but how much of the improvement that you're looking for in December EM global gross margin is due to the regional mix, perhaps Asia's going to be down as a percentage of the total EM sales, versus underlying improvement in the Americas and Europe where there's been more pressure?

Brian, it's a combination of both. So we're expecting, what, Harley, pretty much normal seasonality in Asia this quarter?

Correct.

Whereas America and Europe are where we're going to get the better than normal. So there will be that effect, Brian, but I will also tell you that we would expect in both America and Europe to see some improvement in gross margin on a regional basis.

Just longer term, Roy, if this recovery continues, how much of the decline that you've seen in EM which may be over a couple hundred basis points of gross margin, how much of that do you think you could ultimately recover. If the supply chains become structurally more efficient where there's more stability and lead times generally speaking, I guess what are the drivers that will allow you to show material gross margin improvement from here? Thanks.

Yes. So if you recall last quarter, we tried to describe a basket or variety of late cycle market pressures, and there really are a number of them that range from competitiveness between distributors, the products that we buy on market price, where we're in essence playing a market maker role and doing a little bit of speculating. There are some vendor rebates. It's not like the IT business but that's a factor. There's a whole host of things that drive margin pressure late in these cycles. None of which are structural or even secular in nature.

So it is -- it continues to be our belief that we will recover most, if not all, of the gross margin on a region by region basis. But recall, we think that so far, roughly half of the decline we've seen at EM is strictly mix. And that mix is a function of what happens to our growth in Asia versus our growth in America and Europe on a go-forward basis. So the mix piece is sort of independent wild card and as you know we manage the regions independently for appropriate returns on capital. The margin within the region is what we think will get back most, if not all, and I would say that's over a three, four quarter period of time.

Roy, if I could add one comment. I think unless I heard incorrectly, Brian, you said a couple hundred basis points.

At the EM global level.

That would not be accurate unless you go back multiple years. If I go back three years, it's far less than that.

So Brian, we'll circle back to you on that one.

Okay. Thanks.

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

Yes, thank you. Roy and Harley, just back to the whole issue of demand and your book-to-bill. You're looking at and you talked about some component shortages. There's some suppliers out there with very high book-to-bills, 1.3, 1.4 which is obviously either artificial or means that there's clear double ordering. And everyone says of course that they don't see it. Of course, you don't see it until the orders are cancelled. Do you have any idea or indication that you may be getting orders from customers that are ordering from competitors or suppliers and when would you actually see that?

So, again, I'll take the first shot and Harley, please feel free to chime in. But Matt, the book-to-bill ratio is too good. What's happening is product lead times extending are forcing customers to buy further into the future than they really have the ability to accurately forecast. So that's happening. From our perspective, we can't identify double ordering. We don't see a lot of that going on. So I don't think that's a pervasive problem at this point.

But I would tell you that the book-to-bill ratios are about customers buying for longer periods, much more so than it is about customers buying more in terms of higher volumes in a current period. So we think that demand is at least stable, maybe it is improving slightly in addition to seasonal factors. But not at the rate bookings are improving. The bookings are being driven by extended product lead times, that drives the book-to-bill ratio and we think that will most likely rationalize itself in the first part of calendar 2010. Harley, anything you want to add?

Yes, I would agree. We scrupulously manage our backlog because it obviously drives our inventory acquisition decisions, and we do not see a lot of evidence of that, nor have we heard from any of our key suppliers that they're seeing that. I think as Roy suggested, we would tend to look more towards companies who are buying expanded quantities in anticipation of pickup in their end demand, some of which could be anticipatory or speculative but not duplicate buying with multiple distributors. We just don't see much evidence of that.

Would you say then at this stage of the cycle that book-to-bill number is not as meaningful as it would be at other stages? Meaning we shouldn't get too concerned about it?

I wouldn't get particularly concerned about it and I think that's probably a reflection of the fact that the supply chain in general has done a much better job of managing supply.

Hey, Matt. Let me just say this. Strong book-to-bill is better than a negative book-to-bill. So I think you have to take it as a positive indicator.

Sure.

But I would not take it as a clear reflection that revenue is going to rise at a significant rate in the coming quarter. If customers are buying three months' worth instead of buying two months' worth, that doesn't necessarily indicate any change in the monthly rate.

That makes sense. And then sort of as a follow-up but related, then looking at your own inventory picture, A, do you have suppliers that are encouraging you, asking you to start to build some supply? And B, what is your strategy there? What is your outlook on inventory?

So not to be a smart aleck, but the answer at the end of every quarter to your first question is yes. As I said before, Matt, we manage it based on our perception of the backlog and what we need, that measured over lead times. So are suppliers getting concerned? I think so. Is there a little more pressure? I think so. But ultimately we manage it based on what we view as actual end demand.

Okay. And then so your outlook for inventory, do you expect to build it? Do you think it will go down on a days basis, particularly in the next quarter, given the seasonality in the computing business?

At the Enterprise level, Matt, that could in fact be true. We would expect EM inventory to track pretty much in line with revenue. TS as you know, it's not a heavy inventory-driven business model and typically we do get the benefit of the big TS year-end in the December quarter. Let me just point one thing out, though. Again, impossible to quantify, but we believe that the 14th week in our quarter just ended actually flattered velocity somewhat, and so maybe those two factors are going to offset each other, causing velocity and turns to be roughly flat sequential.

Got it. Okay. Thank you.

You're welcome. Brian, it's Roy. I want to circle back to your EM comment. And it turns out to be a subtlety. Harley's comment about the gross margin being down far less than 200 basis points is absolutely correct, if you compare it to other Q1s. If you compare it to peak margin quarters, which typically happen in March or June, then it is closer to the 200. Let's go, operator, to the next question.

Our next question comes from the line of Shawn Harrison with Longbow Research. Please proceed with your question.

Hi, good afternoon.

Hi, Shawn.

Hi. Looking at operating expenses into the December quarter, how much of a dollar amount should we see roll off? Would it be the full $25 million or will it be less than that? And then as we look through fiscal 2010, maybe just the yardstick of how much OpEx would come back for each incremental dollar of sales, at least initially here out of the gate.

Hi, Shawn, it's Ray. I guess from an expense perspective, looking at Q2, we would expect expenses to come down roughly in the range of 10 to $15 million. A number of different factors keep in mind. One, the extra week obviously will reduce expenses. Currency's going the wrong way, that will increase expenses a little bit and business forecasts from a sales perspective is expected to be higher as well. So right now we're looking at Q2, roughly down 10 to $15 million on a sequential basis.

And then going out?

I guess going out, we'll start managing the business the way we've managed in the past relative to drop-through and that will be a determining factor in what actually happens to our expenses and since we're obviously behind, a lot of our return goals, you would expect to see a fairly significant amount of drop-through on a go-forward basis, at least in the initial few quarters or so as business begins to improve.

So Shawn, what happens is if you think about it, initially, let's say with the first dollar, there's only what I would describe as pure operating expense. So freight charges, commission costs, things of that nature, and as the business continues to grow, depending somewhat on where -- which group and which region, there will be some additional personnel required or additional hours worked and we will slowly begin to add expenses back in the business. Our intent and our management style here as you can see in the last cycle, how we managed our way through that, we will start with a very high expectation on drop-through, so how many -- what percentage of the gross profit dollar growth drops through into operating income and then that will diminish over a multi-quarter period of time from numbers like 90% to numbers more like 50% as we reach our long-term hurdle rates for return on capital. So the answer -- in other words, the answer to your expense question is somewhat dependent on what revenue turns out to be and the mix of that revenue starting in the March quarter.

Okay. Okay. And then second, just getting back to inventory and kind of the cash cycle and cash generation. If you see continued growth in 2010, is it possible to generate positive free cash flow? Because it looks like with demand coming back and needing to add maybe a little bit of inventory, it would be difficult to generate positive free cash.

Yes, let me -- if I just point you to the slide in the deck related to the rolling four quarter cash flow, what you could see is we sort of bottomed out in the last cycle with cash from operations in the $450 million range and then we jumped it up to a billion one as we were liquidated receivables and inventory. My expectation is that, yes, we will be cash flow positive. We won't be 450 positive because of the level of profitability, but I think we should be cash flow positive for the year and then the cash flow improving along with profitability.

And Shawn, again, the biggest variable there, you know, we're going to keep managing the business the way we have been. I have a huge amount of confidence in our team. I'm very pleased with our asset velocity. The thing that drives cash flow in our model is the rate of revenue growth. So the chances of negative cash flow are only there in the event of rapid revenue growth. If you think it's going to be more modest revenue growth, then there really should not be a problem generating positive cash flow.

Thank you.

You're welcome.

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

Thank you very much and congratulations, gentlemen.

Thanks, Jim.

The topic I wanted to ask a little bit was about seasonality, when we get to a normal state. We've kind of been out of a normal state for quite some time and I know that you know you guys have been doing a lot of restructuring, cost cutting and moving around different personnel and people and things, but on the top line seasonality, you know, for each of the businesses, say you just guided to a soft for the December quarter but I guess kind of March, June and September I typically would have thought that Avnet is March quarter for computing down 23 to 19%, then up 10 to 15, then September down 10 to 5 and on the components up 5 to 9 in March, flat to up 2 in June and down 1 to 4 in September. Is that still valid or has the business changed and what would we in a normal state expect to see the different businesses do?

Jim, I think that we are approaching a normal state now, as the markets are recovering. I think that the supply chain reaction is perhaps causing the EM seasonality to be stronger than normal. But that should normalize over this quarter, perhaps the next quarter. And then I would think we would be more in a normal range. The second thing I would say is that in our December Analyst Day that's coming up in New York, we'll relook at that, based upon our current mix of business by region and by group, and if there's any changes or tweaking to the seasonality, we'll update you at that time. But set that aside. I think we're heading towards normal seasonality and over the next few quarters, that's probably a pretty good guess right now for where things will wind up.

Okay. Then as a quick follow-up, can you discuss a little bit about -- you laid out some goals last year at your Investor Day to get to corporate-wide operating margins of, say, 4.1 to 4.9% which are a long ways from now. We've all gone through a lot. Can you maybe let us know about some milestones? A, are those margins still obtainable at some point and if so, what revenue levels? And B, should we kind of be looking for some other type of milestones, say to get to operating margins of 3% or how should we -- I don't want people to get too over the front of their skis about how well business is going right now.

Yes, I think that -- I guess I'm going to answer that a couple ways. One, I think I'd actually like to defer the answer to the December meeting, officially. Two, what I'd like to say is that from my perspective, everything we've said to you in December is true. It happened. We executed. But there's one thing that we did not anticipate, that is having an impact on the timing of the margins and that's this gross margin pressure at EM in America and now in Europe. So that -- I think what it does, Jim, is it serves to add maybe two or three quarters, maybe maximum four, two to four quarters to the full recovery in margins. Other than that, everything we said in that December meeting last year has played out.

Okay. That's good and very fair. Just a housekeeping, last item, then I'll hop off. Tax rate, what should we expect?

We're guiding now to 29 to 32% at this point in time.

Thank you and congratulations.

Thanks, Jim.

Thanks, Jim.

Our next question comes from the line of Sherri Scribner with Deutsche Bank. Please proceed with your question.

Hi, thank you. I think a lot of the questions that I had have been answered but I just wanted to ask -- maybe this is a little bit nit-picky. I'm trying to understand the tax piece that you took, $0.02 per share. It sounds like it's something related to taxes last year. It's probably part of your regular operating expenses, we just had sort of a shift in time so I was hoping to get a little more detail on that.

The adjustment that we recorded during the quarter does relate to prior years and it's a combination of a number of different items relative to trueing up some audits and trueing up some tax returns that go back a couple years.

Okay.

But would I characterize them as ongoing in terms of our rate? I don't think so. That's why we kind of excluded them and put them in a separate category. Just because of the nature of what the items were.

But they're all related to operations, they're not related to anything sort of extraordinary, other than adjusting past quarters?

That is correct. Yes, that is correct.

All right. Thank you.

You're welcome.

Our next question comes from the line of William Stein with Credit Suisse. Please proceed with your question.

Thanks. Wondering if you could talk a little bit about demand if the components business in the two main channels, I guess EMS versus OEMs. Then I have a follow-up.

Okay. Harley?

Yes, hi, Will. Separating out OEM from contract manufacturing, we actually had a better than expected September in our contract manufacturing space. They started to gain some strength through the quarter and finished stronger than we would have expected. Again, still down year on year, but finished stronger than we would have expected, including in America, which we think is telling us that the principal customers that they serve are maybe -- they're a good example of where the supply chain is correcting. So we can't comment too much on their end demand but clearly it looks like the contract manufacturers have done a much better job in this cycle in managing their inventory and they started to be more active as we closed out the September quarter.

Continuing in the current quarter? That kind of strength?

Through the first three weeks of the quarter? Yes.

Okay. And then regarding the mix shift to Asia, is there any reason why we should think -- I guess there's certainly been a long-term shift in that direction in the components business. Do you believe the downturn accelerated that, that makes some of the shift we're seeing geographically maybe more permanent than temporary?

My opinion is no. I don't believe so. I actually wouldn't have been surprised to see the opposite, that you started to see more forces around keeping manufacturing where it was. But I think the net of it all in all is I don't believe the downturn has contributed to an acceleration of outsourcing.

Will, this is Roy. Let me give you a different answer for a different reason. I think the downturn negatively impacted the Western regions more than the east, so as a result of that, Asia as a percentage of our revenue increased more rapidly than it otherwise would have. Which is different from Harley's point, which is we did not see an acceleration of outsourcing to Asia as a result of the downturn.

All right. Thank you.

You're welcome.

Our next question comes from the line of Amitabh Passi with UBS. Please proceed with your question.

Hi, thank you. Can you hear me?

Yes, we can.

I guess my first question was just either Roy or whoever else, I just wanted to get your updated thoughts on which factors could positively affect your server business in 2010. There seems to be some increasing expectation of a server refresh cycle potentially in 2010 and I was curious to see what you're hearing or seeing from your customers or suppliers.

Okay. I'll take that. Thank you very much. This is Phil Gallagher. As I said earlier, the server business continues to grow by the way, both in the industry standard service as well accelerated. This will determine how the budgets are called out for the fiscal -- for the calendar year and re-you up up for the next year, whether or not that capital spending will further increase the server spend. Very tough to forecast by server, whether industry standard or not but right now we've seen increases quarter on quarter. We've seen increases on a year to year and right now that's really the best forecast that I could see at this point in time, by server technology.

Rick, I don't know if you have anything you want to add to that. I mean, it's really -- I'll tell you, we had a -- I will expand on that. We had a Sun partner conference in IBM partner conference in the last 90 days, actually specifically last 60 days. We had approximately 500 of our closest partners there between the two conferences and overall, still a question mark as to what the next year's going to bring. As we all know. But there is some cautious optimism from the partners that there's going to be continuous increased spend in some of that space. We saw some nice tick-ups in the last quarter in some larger than normal size types of contracts being awarded that we hadn't seen before. So we just take all that input as best we possibly can, work with our solutions and our marketing teams, with our partners, to drive the total value and we'll see how that turns out in the next several quarters.

Great. Appreciate the additional color. And then I just had one follow-up question. I was trying to better understand the -- what exactly is pressuring gross margin in your North American and European EM business and is it simply a function of revenues being lower than where they were, that's sort of pressuring margins and as revenues recover do margins come back and is there any potential for you to achieve maybe slightly better margins at lower levels of revenue?

It's much more complex than revenue. So revenue's a factor, but things like ASP momentum. If ASPs are dropping, that tends to have a negative pressure on our gross margin. If the ASPs are stable, typically our margin is stable and that means we would recover from some of these levels and then of course if ASPs expand, we actually get a lift in gross margin. The mix of business, which customers are hot and which ones are not, we've seen the industrial base, our broad base of small to medium sized customers sort of lagging in this recovery. That's been a factor. So we actually think that there are a host of factors. Again, we've tried to describe this as late cycle market pressures. Volume is one of them but it's --it's hard to say exactly but I'm going to tell you it's only 10 or 20% of the issue. There's 80% involved in a variety of other factors.

Got it. Thank you.

You're welcome.

Our next question comes from the line of Brendan Furlong with Miller Tabak. Please proceed with your question.

Thank you. Good afternoon. Nice to see the next quarter, the operating margin, up significantly here but looks like it's all coming from -- pretty much all from the comments you made on gross margins from SG&A and as we look forward, it sounds like you're telling us that gross margins are going to be under pressure for another few quarters and expect SG&A to stay low again but once or if gross margins start to come back sometime next calendar year, then the SG&A can start to creep back up again, they start to offset each other. Is that the way to look at it?

Well, I think what we're trying to tell you is that gross margin on a bi-region basis, we think is most likely already troughed and is beginning to improve here in the December quarter, but it gets masked a little bit by the huge mix shift from EM to TS. In the March quarter, and Brendan, never say never and -- or never say always, but in the March quarter, because of the mix shift away from TS and back to EM and even more notably, EM in the west as opposed to EM in the east, we absolutely should see gross margin expansion in the March quarter.

And we should key our SG&A off the gross profit, then, not the revenue?

We manage SG&A to gross profit dollar volume. When we see gross profit dollar volume, and then depending on the return level of that business unit, we allow for incremental expense based on this drop-through formula.

Understood. And my last question, only other question I have is the regional mix, looking at your nearest competitor, various things going on with Asia and what have you but the European business you guys seem to have outperformed or not done nearly as much on a year-to-date basis the last three quarters. Is there an explanation for that? On a reported basis now, not adjusting for currencies.

Well, so one explanation is we had an acquisition at the beginning of the calendar year called Abacus. It's been quite successful. The integration has gone very well. And by the way, the last piece of that integration is scheduled for this quarter. But I think aside from that, we've had a fairly stable management organization, fairly stable set of strategies. We've got an aggressive approach to the market with three separate semiconductor companies, plus an IP&E Company, now an embedded Company, so we've got multiple selling organizations and we feel that our team is performing well in that region on a relative basis. The region has been stressed but we think specifically in the components business, looks like it bottomed in the June, July time frame and we're on the road to recovery.

Understood. Thanks a lot.

You're welcome.

Our last question comes from the line of Ananda Baruah with Brean Murray. Please proceed with your question.

Thanks, guys for taking the question. I guess a bigger picture margin question, given everything you see going on, pushes, pulls in the regions with gross margin and OpEx and stuff that we've talked about. You know, assuming that we have -- assuming that we see sort of typical seasonal demand maybe on the softer side as we go forward here, when we thing about the incremental margins kind of coming out of the downturn, I believe in 2003, 2004, you put up like six or eight quarters of incremental operating margins that were kind of -- I think they were like 10 to 12%, somewhere in that range, for quarters. Given the nature of this downturn, do you think you can do those same kinds of margins for whatever period of time it might be? Do you think they're stronger? Do you think they're softer? Just wanted to get your take there, and maybe the reasons behind whatever your answer is.

It's a difficult question but I'll give you my thoughts. I think we can do close or the same margins on a region by region basis. And then what's going to be the biggest determinant of Avnet Inc's margin will be the mix of business between the groups and the regions. At this point I don't see anything structural indicating that we won't get each individual regional unit back to its previous highs and perhaps even better than that, in cases like TS Europe, TS Asia, et cetera.

Okay. Great. Thanks a lot.

You're welcome.

There are no other questions in the queue. I would like to turn the floor back over to management for closing comments.

Thank you for participating in our earnings call today. As we conclude, we will scroll through the non-GAAP to GAAP reconciliation of results presented during our presentation along with a further description of charges that are excluded from our non-GAAP results. This entire slide presentation, including the GAAP financial reconciliations, can be accessed in downloadable PDF format from our website under the quarterly results section. Thank you.

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