U.S. Markets close in 1 hr 16 mins

Edited Transcript of ARW earnings conference call or presentation 1-Aug-19 5:00pm GMT

Q2 2019 Arrow Electronics Inc Earnings Call

MELVILLE Aug 6, 2019 (Thomson StreetEvents) -- Edited Transcript of Arrow Electronics Inc earnings conference call or presentation Thursday, August 1, 2019 at 5:00:00pm GMT

TEXT version of Transcript

================================================================================

Corporate Participants

================================================================================

* Christopher David Stansbury

Arrow Electronics, Inc. - Senior VP & CFO

* Michael J. Long

Arrow Electronics, Inc. - Chairman, President & CEO

* Sean J. Kerins

Arrow Electronics, Inc. - President of Global Enterprise Computing Solutions

* Steven J O'Brien

Arrow Electronics, Inc. - VP of IR

================================================================================

Conference Call Participants

================================================================================

* Adam Tyler Tindle

Raymond James & Associates, Inc., Research Division - Research Analyst

* Joseph Michael Quatrochi

Wells Fargo Securities, LLC, Research Division - Associate Analyst

* Mark Trevor Delaney

Goldman Sachs Group Inc., Research Division - Equity Analyst

* Matthew John Sheerin

Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Senior Equity Research Analyst

* Paramveer Singh

BofA Merrill Lynch, Research Division - Associate

* Shawn Matthew Harrison

Longbow Research LLC - Senior Research Analyst

* Steven Bryant Fox

Cross Research LLC - MD

* William Stein

SunTrust Robinson Humphrey, Inc., Research Division - MD

* Zhen Yang

Citigroup Inc, Research Division - Assistant VP

================================================================================

Presentation

--------------------------------------------------------------------------------

Operator [1]

--------------------------------------------------------------------------------

Good afternoon. My name is Rob, and I will be your conference operator today. At this time, I would like to welcome everyone to the Second Quarter 2019 Arrow Electronics Earnings Conference Call. (Operator Instructions) Thank you. Mr. Steve O'Brien, you may begin your conference.

--------------------------------------------------------------------------------

Steven J O'Brien, Arrow Electronics, Inc. - VP of IR [2]

--------------------------------------------------------------------------------

Thanks, Rob. With us on the call today are Mike Long, Chairman, President and Chief Executive Officer; Chris Stansbury, Senior Vice President and Chief Financial Officer; Andy King, President, Global Components; and Sean Kerins, President, Global Enterprise Computing Solutions.

As a reminder, some of the figures discussed on today's call are non-GAAP. You can access our earnings release at investor.arrow.com along with the CFO commentary, the non-GAAP earnings reconciliation and a webcast of this call. We will begin with a few minutes of prepared remarks, which will then be followed by a question-and-answer period.

I'll now hand the call to our Chairman, President and CEO, Mike Long.

--------------------------------------------------------------------------------

Michael J. Long, Arrow Electronics, Inc. - Chairman, President & CEO [3]

--------------------------------------------------------------------------------

Thank you, Steve, and thanks to all of you for taking the time to join us today. We appreciate you joining us for the July 15 for our business update call, where we discuss the expected results for the second quarter at a high level as well as our proactive responses to the current market conditions.

As you saw in our earnings release, our results are in line with the expectations that we outlined on our business update call. So rather than cover the same ground, let me begin by updating you on the longer-term strategic positioning of our business. I will then share some additional observations on the current market conditions and now that we've had time to conduct a more detailed review of our second quarter data.

We continue to advance toward our goals of scaling engineering services and leading the convergence of information technology with operational technology. Our value proposition is clear, we build solutions for industry-specific goals.

Our customers benefit from Arrow's unique ability to deliver complete end-to-end solutions, and Arrow is the only company with the ability to integrate the hardware and software to enable upstream data integration. This means our customers get a unified set of solutions that are ready to go and repeatable. That repeatability is a key part of achieving our goal to expand and leverage engineering services.

To reiterate what I said on July 15, we're taking important steps to best position the company to achieve this. Through our $130 million cost optimization program, we have established a clear plan to enhance efficiency. Rest assured, we will not be cutting back on engineering or in our demand and design creation efforts. Looking at the savings in more detail, approximately half comes from the upgrade and completion of internal systems, most notably our global ERP system for global components that we completed last year. Our commitment to automation is delivering significant back-office savings in areas like IT, accounting, order processing and shipping, just to name a few. The foundation of our business has never been more sound.

We're currently experiencing weaker demand in key verticals like industrial, transportation, including automotive. However, based on the massive electronic content growth we have forecasted for these industries, we're confident that growth will return in the not-too-distant future. In fact, the wind-down of our PC and mobility device disposition business will allow us to further accelerate implementation of the next-generation technologies such as artificial intelligence, industrial automation, smart cities and vehicles.

We believe these technologies will not only enhance our business and returns to shareholders, but also improve people's lives. Taking a step back, I want to discuss the near-term market conditions we're facing as we work to deliver on our long-term goals. While forward indicators are mixed, we're encouraged that our design activity has held up well and is consistent with last year's levels. This suggests that customers are continuing to design next-generation products, despite the difficult market conditions.

So far this correction has been contained to a lower number of new orders and some pushouts, both factors suggest we'll see a quick recovery when conditions improve. Our indicators are consistent with past market corrections. Backlog declined from the first quarter and declined year-over-year. Lead times contracted this quarter, more for semiconductors than for passive and electromechanical parts. The overall book-to-bill was below parity at 0.95 exiting the second quarter and it was below parity in all regions.

Our Americas customer sentiment survey results were similar to what we heard last quarter with a large portion of the customers saying they had too much inventory and a very small portion reporting that they did not have enough. The ratios here are similar to those we've seen during past market downturns.

Looking more closely at global components margins, the decline in margins has been driven mostly by customer mix and secondly, by regional mix. In other words, the margin pressure we're experiencing from customer mix is the function of the fact that sales to our larger, better-capitalized customers who rely less on designs and engineering are holding up far better than sales to the smaller customers who rely more on our services. Most importantly, we expect our business mix to normalize quickly when conditions improve.

Turning to our enterprise computing solutions business, the demand environment for this business in the quarter was consistent with our expectations. Billings grew at a low single-digit rate year-over-year, led by infrastructure software and security. IT hardware demand particularly in the areas of storage and proprietary servers, declined. We believe this means customers are utilizing the IT hardware products purchased during the recent refresh cycle and are increasingly cautious towards major new investments based on an uncertain economic climate. Although this has challenged our efforts to improve our profit performance, we do expect enterprise computing solutions' operating income to increase year-over-year in the third quarter.

In closing, we're proactively addressing items within our control, believe we have built a diverse and resilient business. We have a clear plan in place to preserve and improve our profits, capitalize on the incredible opportunities available to us and leverage our existing engineering capabilities. Our $130 million cost optimization program combined with the wind-down of the personal computer and mobility assets disposition business will enable us to fully focus on longer-term strategies and to enable next-generation technologies. I look forward to updating you on our performance and our progress in the coming quarters.

I'll now hand the call over to Chris to provide more details on our second quarter results and our expectations for the third quarter.

--------------------------------------------------------------------------------

Christopher David Stansbury, Arrow Electronics, Inc. - Senior VP & CFO [4]

--------------------------------------------------------------------------------

Thanks, Mike. Second quarter sales were $7.27 billion, excluding the PC and mobility asset disposition business. Sales increased 2% year-over-year adjusted for the wind-down and changes in foreign currencies. The actual exchange rate for the quarter was $1.12 to EUR 1, in line with the rate we had previously used for our forecast.

Global component sales of $5.19 billion, excluding the PC and mobility asset disposition business increased 2% year-over-year adjusted for the wind-down and changes in foreign currencies. In Europe, sales increased 4% year-over-year as adjusted. Europe sales have increased year-over-year for 25 straight quarters, adjusted for acquisitions and changes in foreign currencies. In the Americas, sales decreased 3% year-over-year. Asia sales increased 4% year-over-year and achieved a record second quarter level. The sales contribution percentage from Asia was also an all-time record for any quarter. While this is a near-term headwind to margins, there will be regional variances over time, and we do not anticipate that regional mix will be a headwind to returns.

Global components operating income decreased 21% year-over-year and decreased 19% adjusted for dispositions and changes in foreign currency. Operating margin was 4%. We expect to make progress towards returning to the 5% operating margin level we achieved in 2018. First, through our cost optimization program and then from a return to a more optimal product and regional mix when demand conditions improve.

Enterprise computing solutions sales of $2.07 billion increased 1% year-over-year as adjusted. Sales decreased 2% year-over-year as reported and were within our previous expected range. Billings increased at a low single-digit rate year-over-year adjusted for changes in foreign currencies and increased in both regions. Growth was driven by infrastructure software security and industry-standard servers.

Enterprise computing solutions Americas sales were flat year-over-year adjusted for changes in foreign currencies. Sales declined 1% year-over-year as reported and in Europe, sales increased 5% year-over-year as adjusted. Sales decreased 3% year-over-year as reported.

Enterprise computing solutions operating income decreased 8% year-over-year, adjusted for changes in foreign currencies and dispositions. Operating income decreased 10% year-over-year as reported. Returning to consolidated results for the quarter, total company operating expenses were flat year-over-year as adjusted. Consolidated operating income decreased 21% year-over-year adjusted for the wind-down, last quarter's disposition and changes in foreign currencies.

Interest expense was $52 million, below the guidance we provided on our Q1 earnings call due to lower borrowings during the quarter and slightly lower interest rates on floating rate debt. The effective tax rate for the second quarter was 27.5% above the high end of our 23.5% to 25.5% target range and our prior second quarter expectation of 25.5%. A larger relative profit contribution from higher tax jurisdictions caused the higher effective tax rate. We now expect our third quarter and full year 2019 effective tax rate to be at the high end of our target range. Beyond 2019, we continue to believe our 23.5% to 25.5% target range is valid.

Net income was $137 million, down 28% year-over-year as adjusted. Earnings per share were $1.60 on a diluted basis, down 25% year-over-year as adjusted. We estimate the stronger dollar negatively impacted earnings per share by approximately $0.06 and negatively impacted earnings per share growth by approximately 2 percentage points compared to the second quarter of 2018.

Operating cash flow was $405 million. The strong operating cash flow was driven by a greater ability to convert EBITDA to cash flow in the current weak demand environment and by a reduction in working capital, including inventory. We expect to further reduce working capital in the second half of 2019.

We repurchased approximately 2 million shares of our stock during the quarter for $150 million. We repurchased approximately $361 million over the last 12 months and have reduced shares outstanding by approximately 4%. Over the same 12 months, we have also reduced borrowings by approximately $369 million. Our near-term priorities for cash continue to be both share repurchases and debt reduction.

Please keep in mind that the information I've shared during this call is a high-level summary of our financial results. For more detail regarding the business segment results, please refer to the CFO commentary published this morning.

Now guidance. Turning to our outlook, we're providing guidance, excluding the PC and mobility asset disposition business. However, the contribution from this business will be included in our reported income statement for the third quarter. As we did this quarter in our press release, we'll provide all the reconciling items to exclude this business from our ongoing results.

We believe that total third quarter sales will be between $6.85 billion and $7.25 billion with global component sales between $4.925 billion and $5.125 billion and global enterprise computing solutions sales between $1.925 billion and $2.125 billion. We expect interest expense to be approximately $54 million.

Our guidance assumes an average non-GAAP tax rate at the high-end of the target range of 23.5% to 25.5%. We expect average diluted shares outstanding of $85 million. And as a result, we expect earnings per share on a diluted basis, excluding any charges, to be in the range of $1.62 to $1.74. The average U.S. dollar to euro exchange rate we're using for forecasting purposes is $1.12 to EUR 1. This was the average for the month of July. We estimate changes in foreign currencies will have negative impacts on growth of approximately $90 million or 1% on sales and $0.05 or 2% on earnings per share compared to the third quarter of 2018.

--------------------------------------------------------------------------------

Michael J. Long, Arrow Electronics, Inc. - Chairman, President & CEO [5]

--------------------------------------------------------------------------------

Thank you, Chris. Rob, would you please open the call to questions at this time?

================================================================================

Questions and Answers

--------------------------------------------------------------------------------

Operator [1]

--------------------------------------------------------------------------------

(Operator Instructions) And your first question comes from the line of Adam Tindle from Raymond James.

--------------------------------------------------------------------------------

Adam Tyler Tindle, Raymond James & Associates, Inc., Research Division - Research Analyst [2]

--------------------------------------------------------------------------------

I just wanted to maybe start on a near-term question and then ask a bigger picture question. Near term, the Q3 revenue is declining sequentially, but operating profit dollars look actually fairly stable sequentially. So just hoping you can maybe talk through the moving parts there and particularly the timing of that $130 million annualized cost savings. How much of that is reflected in the Q3 guidance?

--------------------------------------------------------------------------------

Christopher David Stansbury, Arrow Electronics, Inc. - Senior VP & CFO [3]

--------------------------------------------------------------------------------

So Adam, we don't expect to be at full run rate on savings until the end of the fourth quarter, so going into next year. So we don't have a full quarter in for Q3, particularly given the timing. You think of approximately half that, and then we'll ramp between there and the end of the year.

--------------------------------------------------------------------------------

Adam Tyler Tindle, Raymond James & Associates, Inc., Research Division - Research Analyst [4]

--------------------------------------------------------------------------------

Okay. That's helpful. And maybe big picture question for Mike. With the disposition business write-off now getting into the rearview mirror, if you could maybe just take a step back because this was once a promising part of the value proposition for a full lifecycle distribution model and you made heavy investments there. Could you maybe just reflect on the learnings from that experience, any internal changes to the strategic planning process as a result? And why the current investments in things like eInfochips and IoT should look differently than the asset disposition business?

--------------------------------------------------------------------------------

Michael J. Long, Arrow Electronics, Inc. - Chairman, President & CEO [5]

--------------------------------------------------------------------------------

Yes. So the asset disposition business, if you remember when we got it, it was a business that really benefited customers to get rid of their old assets, and we could refurbish and resell those in other marketplaces. And how it used to work is, there was a profit share program with those customers. What it's evolved to is, customers having a warehouse full of products and wanting one cash check for them. And basically over a 10-year period that we had this business, those retail sort of prices that you would charge for it became readily available on the Internet. So it became harder and harder to make a profit from the buy to the sell. We really did see this coming, had put some things into place to help that, but it became very clear that this value proposition for the customers was less interesting to them than when it started. And we didn't see the benefits going forward in our strategy. And in fact, what we saw was eInfochips, our investments in design engineering generating much higher incomes and also directly driving the sales of our products and really are getting to a point that we didn't want to have a nonancillary business around that wasn't really driving the strategy and driving the future growth. And while it was a nice to have part to complete the entire lifecycle of product, I view it as totally unnecessary because we can now partner with different people and different marketplaces and have exactly the same effect.

--------------------------------------------------------------------------------

Operator [6]

--------------------------------------------------------------------------------

And your next question comes from the line of Shawn Harrison from Longbow Research.

--------------------------------------------------------------------------------

Shawn Matthew Harrison, Longbow Research LLC - Senior Research Analyst [7]

--------------------------------------------------------------------------------

First question is for Chris. Chris, where do you think you can get operating cash flow now for the year? And also maybe a target for how much inventory can come out in the back half and a cash cycle number, if I may?

--------------------------------------------------------------------------------

Christopher David Stansbury, Arrow Electronics, Inc. - Senior VP & CFO [8]

--------------------------------------------------------------------------------

Yes. So we obviously had a great Q2, in part that was, I think, driven by a recovery from Q1, which wasn't great. So as we look at Q3, I don't think we'll be at Q2 levels. I'd like to see us in the $200 million to $250 million range, and we know that Q4 sequentially is usually stronger than Q3. So I'm not going to give you a number for the year, but that's how we see it in total. The way we're going to get there, you'll continue to see inventory come down a bit. We've also really tightened down on our collection efforts and DSO. So I think you'll see improvement in both of those areas and ultimately, the goal is to get cash conversion down from where we've been and we did show improvement in Q2, and we'll continue to drive that forward.

--------------------------------------------------------------------------------

Shawn Matthew Harrison, Longbow Research LLC - Senior Research Analyst [9]

--------------------------------------------------------------------------------

And as a follow-up, Mike, just on the ECS business, a 2-part question. Given some of the slowing you're seeing in the hardware environment, what does that mean for year-end seasonality? And how does it affect the goal of -- I think, you said operating profit dollars would be above third quarter levels of last year, but can you continue to grow operating profit dollars year-over-year into the end of the year if part of the business is slowing?

--------------------------------------------------------------------------------

Michael J. Long, Arrow Electronics, Inc. - Chairman, President & CEO [10]

--------------------------------------------------------------------------------

Yes, I think we can, because typically the fourth quarter, there will still be refresh. There will still be a government refresh that takes place and that will improve the situation from where it is and where our forecast is for the third quarter. So if you look at the third quarter forecast, we expect that we will improve profitability year-over-year for that, which is good news. That comes in right when we -- sort of told you it was, ironically, and believe we didn't do anything to do that other than stick with our plan. And we believe it will continue. What we're seeing there right now honestly is a low-growth scenario. And if there is a low-growth scenario, we would expect the same thing in Q4. We've very rarely seen the same kind of sort of pinch back in the computer business that we've seen in the components business through several downturns. Typically, this business has slowed, but not stopped. And I think the position we're in right now is pretty good and one we can continue to climb out of.

--------------------------------------------------------------------------------

Operator [11]

--------------------------------------------------------------------------------

Your next question comes from the line of Joe Quatrochi from Wells Fargo.

--------------------------------------------------------------------------------

Joseph Michael Quatrochi, Wells Fargo Securities, LLC, Research Division - Associate Analyst [12]

--------------------------------------------------------------------------------

First, I just wanted to try to understand the market dynamics a little bit better. And I understand that your business typically lags some of the semiconductor suppliers. And so I'm just trying to better understand when we look at the 3Q guidance, and you're calling for a sequential decline in the components business relative to some of the semiconductor suppliers guiding for revenue to be up. Just kind of any color you can give on the disconnect there?

--------------------------------------------------------------------------------

Christopher David Stansbury, Arrow Electronics, Inc. - Senior VP & CFO [13]

--------------------------------------------------------------------------------

Well, actually it's interesting, because we've combined the vast majority of the semiconductor suppliers as well as PEMCO suppliers, and we're showing year-over-year decline of that data of around 7%, we're showing about a 6% decline in our data for where our forecast is right now. So we believe we're right in the market. If we take a look at it from a practical point of view, I think there was a little bit, I don't know if you've gotten some of the corrections of the reverse logistics business, it was coming out, but I think there is a little bit of noise in that if you look back. But overall, we believe we're right in the market, and I'm going to say I don't expect a loss of market share and I don't expect too much of a gain of market share during this time frame. So we're going to do what the market does and, I guess, it would be great news if there was another percent in there for us, but we'll let it see how it plays out.

--------------------------------------------------------------------------------

Joseph Michael Quatrochi, Wells Fargo Securities, LLC, Research Division - Associate Analyst [14]

--------------------------------------------------------------------------------

Okay, that's helpful. And then just kind of quickly, in the guidance when we look at what's embedded for gross margin, I know that gross margin is typically kind of down sequentially in the 3Q, but we're kind of already at a more lower level than normal. So can you help me kind of understand what's embedded in the guidance?

--------------------------------------------------------------------------------

Christopher David Stansbury, Arrow Electronics, Inc. - Senior VP & CFO [15]

--------------------------------------------------------------------------------

Well, we do expect that we are bouncing on the bottom right now. So our belief is we're seeing some of the worst of it at this point, pending big declines in an economy in one region or another that we don't see. I mean, if you had a huge decline in the economy in China, obviously, our gross margin is going to go up, volume is going to go down. And if we had a huge disaster in Europe, you would have a little bit of the opposite effect. But if you take a look at past downturns, some of the past downturns down in '09, I think, margins went down about 300 basis points. And this time, we're sitting there a lot less than that. We actually believe the snapback will be quicker for the reasons I said in my opening remarks that we've been limited to incoming orders and mix of customer. So as soon as those customers turn back on, we expect benefit. We have not seen any structural changes by suppliers and don't expect any. I don't think that's in any of the conversations that we have had. I don't see the marketplace generating a ton of bad activity out there. And all in all, so far, this downturn is acting better than others. As far as coming out of it, I think it's great news that we're seeing some suppliers start to see signs of life, because then that means that sort of forecasted within a few months range here that we'll see it start to come back too. So that's all positive news for me, and I'm not expecting a further reduction at this time.

--------------------------------------------------------------------------------

Operator [16]

--------------------------------------------------------------------------------

Your next question comes from the line of Mark Delaney from Goldman Sachs.

--------------------------------------------------------------------------------

Mark Trevor Delaney, Goldman Sachs Group Inc., Research Division - Equity Analyst [17]

--------------------------------------------------------------------------------

First question was about the margin opportunity within components and certainly understand all the cyclical pressures and customer mix issues that you outline, but one of the opportunities for the company had been with newer customers that Arrow had brought on over the last 12 to 18 months that -- those came on at fulfillment margins or is there opportunity to sell the full value of Arrow and turn those into demand creation type margins and improve that way? Maybe you can just talk about some of those company-specific efforts. I know maybe it's lost in some of the cyclical dynamics underway at the moment, but how far along are you with those? And what could that mean for margins maybe for components overall? How many basis points maybe that would add if you're successful with that effort?

--------------------------------------------------------------------------------

Christopher David Stansbury, Arrow Electronics, Inc. - Senior VP & CFO [18]

--------------------------------------------------------------------------------

Yes. I think that the -- structurally, that brings it back to sort of where we were in the past. We typically operated, I think, with about 35% of our business that was in the design creation mode, which operated at about 300 basis points better than sort of core margin for the work that gets done. I'm going from memory now, but I believe it was 22% to 25% after we got some fulfillment orders then that our design win margin had dropped down to. We're working hard to get it back up to that 35% to 40% range of our total sales. So if those were new sales, which we would expect those to be in the future, which is a great place for us to be with growth, then that would give you basically 300 basis points on 10% to 15% of our current business, which I think is easily we'll get it back to even higher profit levels after all the recovery.

--------------------------------------------------------------------------------

Mark Trevor Delaney, Goldman Sachs Group Inc., Research Division - Equity Analyst [19]

--------------------------------------------------------------------------------

Got it. That's very helpful color. And for my follow-up, I'm hoping you can help us to contextualize some of the cyclical dynamics between book-to-bill and revenue timing. And so I know sometimes the bookings are not for the current quarter, but they can extend for a few quarters. And so I imagine with book-to-bill being sub one, it's not necessarily all felt in the P&L in the September quarter, but maybe there are some sort of delay in terms of when we see the full year-over-year decline in your global components business. Maybe just you can help us understand what that delay may be? And when -- if orders are starting to bounce along the bottom, as you described it, what do you think you see the full year-over-year, really the max of the decline?

--------------------------------------------------------------------------------

Christopher David Stansbury, Arrow Electronics, Inc. - Senior VP & CFO [20]

--------------------------------------------------------------------------------

Yes. What we've seen, obviously, I think, we were down to about 0.95 in the second quarter that we announced our book-to-bill at. We have seen an improvement, but it is early in the quarter. We'll sort of start claiming victory when we get back to that 1.1 range that will give us some consistency in that, that things are really on the come. And anything I would say right now between that 0.95 and 1 range just tells us things are sort of sitting where they are. So we do expect to see that, that's when, I think, we can effectively start to say, okay, we're coming off the bottom. But for right now, we think we are on the bottom, and we're going to do the things that we need to do to preserve and grow profits during that time and then as the market changes our expected profit range, we hope to be able to raise, but we'll save that one for another day.

--------------------------------------------------------------------------------

Operator [21]

--------------------------------------------------------------------------------

Your next question comes from the line of Matt Sheerin from Stifel.

--------------------------------------------------------------------------------

Matthew John Sheerin, Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Senior Equity Research Analyst [22]

--------------------------------------------------------------------------------

I guess, a question regarding the inventories. You had some nice reduction quarterly -- quarter-on-quarter and year-on-year. As we look forward and given that lead times have come in and given your own weaker order book, what should we be thinking about inventories and then free cash flow as you get through the year?

--------------------------------------------------------------------------------

Michael J. Long, Arrow Electronics, Inc. - Chairman, President & CEO [23]

--------------------------------------------------------------------------------

I'll answer inventory, Chris can go back to his cash flow answer. The -- I really believe with bouncing on the bottom there's still some more efficiency that we can get out of the inventory. So we still expect the inventory to come down going into the third quarter. Fourth quarter is just too hard to see right now, Matt, because the bookings are going to tell that tale. If products are sitting there at 12 weeks and the bookings came back tomorrow, then that would immediately make a liar of me. So that's not it, but we actually are expecting some better numbers in the fourth quarter, but I would say, you'll see still a third quarter decline in inventory. So, Chris I'll give you the...

--------------------------------------------------------------------------------

Christopher David Stansbury, Arrow Electronics, Inc. - Senior VP & CFO [24]

--------------------------------------------------------------------------------

Yes. So just to build on that, Matt, as I mentioned earlier, I think reasonably in Q3, we could expect $200 million, maybe $250 million, in operating cash flow. Typically, we say that our cash flow over time tracks to about 75% of GAAP net income. Obviously, in a software environment, it's higher than that and that's where I'd expect to be in the back half with Q4 being stronger than Q3.

--------------------------------------------------------------------------------

Matthew John Sheerin, Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Senior Equity Research Analyst [25]

--------------------------------------------------------------------------------

Okay. Great. And then back to the components and the gross margin that you talked about the puts and takes and why it's down mostly on mix. You did also talk about some pricing pressure the last quarter and, I guess, one theory is that pricing is not that tough right now because customers are just living hand-to-mouth and in some cases, they're pushing out or canceling orders, but when volumes come back, we'll see more pricing pressure. What's your thoughts on there -- on that? And how do you weigh taking opportunistic deals versus protecting your margins?

--------------------------------------------------------------------------------

Michael J. Long, Arrow Electronics, Inc. - Chairman, President & CEO [26]

--------------------------------------------------------------------------------

Yes. There is a whole lot packed in there, but I don't think you're going to see a traditional market change when the volumes come back, because the supply chains are becoming narrower and the people that can do the full boat of supply chain services for customers, those companies are becoming more narrow. Plus, I think, we're certainly in a situation where we're not going to lose money or we're not going to lose returns on certain orders. So it's also been our hit of 3 that you can follow the money on these deals, but it takes money to put inventory in for customers and if somebody does do something crazy, usually you end up giving it away down the road because you just can't afford to continue doing it. I don't see that right now, I think there is a -- the margins are where they are going to be prior to coming into the quarter. So I don't see too much price deterioration. What happens, Matt, when there is an immediate drop-off, obviously, your salespeople are used to a certain volume, you're used to a certain volume, everything happens and people do some scrambling. So we did see that on supply chain, but these days the supply chain portion of our business and the design win portion of our business are separated and we know exactly what our costs are. We know what we can and can't take and obviously the mix of that, but we're not going to stop taking supply chain deals. If design is slow, but there will be higher returns there than probably what you've seen in the past. So hopefully that answers the question, but I don't think this is a pricing issue, Matt. I think it's a mix issue. We're seeing the resales hold to where they've largely been. And that's normally when you see them go down when everybody is trying to unload inventory, but if you looked at the inventory efficiency going into this, we don't have to fire sale the inventory like in past downturns and we're not.

--------------------------------------------------------------------------------

Operator [27]

--------------------------------------------------------------------------------

Your next question comes from the line of Steven Fox from Cross Research.

--------------------------------------------------------------------------------

Steven Bryant Fox, Cross Research LLC - MD [28]

--------------------------------------------------------------------------------

Mike, I listened carefully to all of what you just said about the end markets, and I'm just -- I'm still struggling with the idea that you think growth is going to return in not -- in the not too distant future. You got surprised in the month of June pretty quickly, a lot of your suppliers are talking about inventories that won't burn off to the end of the year and your own ECS business is seeing some capital spending pressures, let alone some of the macro that's going on in Germany and other parts of the world. So what am I hanging my hat on if I want to buy into the idea that this is the bottom and things are going to start to improve? What would be the first 2 or 3 things I should think of strongly?

--------------------------------------------------------------------------------

Michael J. Long, Arrow Electronics, Inc. - Chairman, President & CEO [29]

--------------------------------------------------------------------------------

First off, I think I said I think we're bouncing along the bottom, and I think the return is a start of a return and I don't think it's an end of the return. I mean, my personal opinion is we're into next year and that's what I do see. I think, there is some cautious out there. First off, our surprise was exactly as you said, it was in the month of June, and it was an immediate change, which is something different than before. We did see it coming. We just didn't see it starting at the magnitude it started for us. Going forward, I'd still be concerned with Germany. Is Germany going to maintain where it is today? Or is that economy going to get worse? I don't know. You guys are more of an expert on that than I am. So I do see caution there. I do see that China is still struggling, although our position in China is pretty good, but I do see it struggling. And honestly what's going to happen with the tariffs in North America and how much business is going to be driven out of here or driven back in. Right now, we're not seeing business come back in. So I don't know what all the hoopla is about all the grid manufacturing is going to return to North America, because if does, that's a party for us, but I don't see that coming. So I think we're still being cautious, I do believe we're kind of where we are now given the book-to-bills that we have, given the backlog, given what the customers are taking and sending. But if there is another -- Steve, if there is another decline in the economy, I can only react to that. I can't control that.

--------------------------------------------------------------------------------

Steven Bryant Fox, Cross Research LLC - MD [30]

--------------------------------------------------------------------------------

I appreciate that color. That's really helpful. And then just as a quick follow-up, is there any -- when you set guidance for the September quarter, is it similar linearity than what you would normally see? Is that your assumption?

--------------------------------------------------------------------------------

Christopher David Stansbury, Arrow Electronics, Inc. - Senior VP & CFO [31]

--------------------------------------------------------------------------------

Yes. We -- and as you know, Steve, we really have gotten away from the seasonality game, because there is just so much volatility from quarter-to-quarter. I would tell you that back to Mike's point, we really do think we're bouncing along the bottom. We're looking at current demand trends as well as current margin trends combined with our cost actions and where we think we'll be and that's really how we got where we got.

--------------------------------------------------------------------------------

Operator [32]

--------------------------------------------------------------------------------

Your next question comes from the line of Tim Yang from Citi.

--------------------------------------------------------------------------------

Zhen Yang, Citigroup Inc, Research Division - Assistant VP [33]

--------------------------------------------------------------------------------

A follow-up question on inventory. Some industrial automotive component vendors mentioned they're seeing distribution channel inventory correction. And they said the correction normally takes 4 to 6 months, do you think that's a reasonable estimate on the duration of this correction with the current environment? And then I have a follow-up.

--------------------------------------------------------------------------------

Michael J. Long, Arrow Electronics, Inc. - Chairman, President & CEO [34]

--------------------------------------------------------------------------------

Well, June, July, August, you're in 3 months now. So, no, I don't think it's 4 months, because that would mean the next month it's going to return and it's going to be over and I don't believe that. As I said, I believe we're sort of in the belly of the beast here and we're living every day on the book-to-bills we have and what we're seeing. But I'm not projecting anything major before the end of the year, and we'll know more when we get towards the end of this quarter to see how the entire quarter acts. And frankly, more interested in September quarter or the month of September, than I am of what's going on in July, because July, August for us -- August is obviously big European vacations and there is typically a decline in Europe during that period and September, things start to get back to normalize. So, no, I don't think your 4 months is the answer.

--------------------------------------------------------------------------------

Zhen Yang, Citigroup Inc, Research Division - Assistant VP [35]

--------------------------------------------------------------------------------

Got it. And then you mentioned the cancellation rate increased in your slides. Can you talk about how much do you think it is related to double ordering from the trade tension versus the real demand slowdown?

--------------------------------------------------------------------------------

Michael J. Long, Arrow Electronics, Inc. - Chairman, President & CEO [36]

--------------------------------------------------------------------------------

I didn't mention that cancellation rates went up, I said, new orders coming in were declining, but we have seen no change in canceled orders, I believe. Let me just see if I can get you an exact number on this.

--------------------------------------------------------------------------------

Christopher David Stansbury, Arrow Electronics, Inc. - Senior VP & CFO [37]

--------------------------------------------------------------------------------

I think you're probably referring to CFO commentary where there was a -- versus the last quarter, there was a increase in cancellation rates, but we didn't say it was outside the norm, yes.

--------------------------------------------------------------------------------

Michael J. Long, Arrow Electronics, Inc. - Chairman, President & CEO [38]

--------------------------------------------------------------------------------

Yes. That's what I was saying, I don't think there is anything abnormal about that piece of it. And honestly, it's harder to -- let me just talk about the double ordering thing, because it's an interesting dilemma, but it is much harder for an OEM to double order over a period of time because that is controlled all the way back at the manufacturer level. And so the same customer for the duplicate orders gets picked up and your allocation gets cut at the first sign of it looking like it's a double order. So there is protections in there, which, I believe, is one reason that we haven't seen the declines that we've seen in past downturns, because you don't have as much double ordering or any double ordering, but obviously, it's a big marketplace. I'm not going to say none, but you generally don't have that dilemma anymore because it is controlled at the day of order.

--------------------------------------------------------------------------------

Operator [39]

--------------------------------------------------------------------------------

And your next question comes from the line of William Stein from SunTrust.

--------------------------------------------------------------------------------

William Stein, SunTrust Robinson Humphrey, Inc., Research Division - MD [40]

--------------------------------------------------------------------------------

I wasn't expecting to ask this, but suddenly Trump says, U.S. will impose 10% tariffs on another $300 billion of Chinese goods as talks continue. Does that -- does this round of tariffs -- I assume you've done the analysis in advance, does this round influence your business any more or less than the prior rounds of tariffs? And then, of course, I have a follow-up.

--------------------------------------------------------------------------------

Michael J. Long, Arrow Electronics, Inc. - Chairman, President & CEO [41]

--------------------------------------------------------------------------------

Yes. Well, it's an interesting one, because it affects really Germany, China and North America. China -- Germany being China's largest or China being Germany's largest customer and then going back [everywhere between the U.S.]. The point is, it depends on how fast supply chains move, and we do see supply chains moving around today. And as I said, we're not -- these tariffs, we're not having a party in North America with all the factories that are coming back here and opening up. So I'd really like to know where people think that those factories are going, because I'm missing it and with a couple hundred thousand customers, I find it interesting that we wouldn't see it, because all the politicians are talking about it. But it's like anything else. Tariffs are not good, they're not good for the business, they are not good for the manufacturing process, they artificially raise the price of goods and I know if somebody's manufacturing a commodity item and you artificially raise the price, they are no longer competitive in the market. So if their sales go down, somebody else's go up and it depends on how much of that ultimately happens, but I just don't believe tariffs are good for anybody.

--------------------------------------------------------------------------------

William Stein, SunTrust Robinson Humphrey, Inc., Research Division - MD [42]

--------------------------------------------------------------------------------

Yes, fair enough. Let me switch to what I was really planning on asking, your sales in Asia were clearly boosted by share gains. You mentioned that you didn't think share was going to shift around much going forward, but in Q2, it's pretty obvious that you gained share where -- vaguely aware of at least one supplier that put more of its distribution business in your hands over I guess, sort of a competitor. How much of the year-over-year or sequential growth in Asia, however you want to quantify it for us, how much of that should we attribute to these sort of share gains from other distributors versus -- I don't know if you want to call it organic -- but a more natural growth rate?

--------------------------------------------------------------------------------

Michael J. Long, Arrow Electronics, Inc. - Chairman, President & CEO [43]

--------------------------------------------------------------------------------

The share gains in Asia were something that actually happened a long time ago, this is just a result of those share gains. So the interesting thing is it's been integrated into our business already. I haven't recently broke it out that way, but what I can tell you is it has been a positive impact on us, certainly all year. I think some of that was the -- the first quarter of it went back and you're sort of nervous over the mix of the business. I don't expect any more to come in right now at this point in time. I think we're digesting what we have there, but as far as the percentage of the total, I really can't give you that sitting here right now.

--------------------------------------------------------------------------------

Operator [44]

--------------------------------------------------------------------------------

And your next question comes from the line of Param Singh from Merrill Lynch.

--------------------------------------------------------------------------------

Paramveer Singh, BofA Merrill Lynch, Research Division - Associate [45]

--------------------------------------------------------------------------------

Firstly, I wanted to just get a little bit more color on your component margins, going back to that question. You had a 5% margin last year, obviously, you've compressed a lot and that's volume-related, but how much do you think your margin benefit last year was due to some of the premium pricing in the positive components? And what I'm really trying to get at is, as volume comes back, as you do some of this OpEx cuts what level of operating margin can you expect components to get back to? And can you ever get back to that 5% number? And then I have a follow-up.

--------------------------------------------------------------------------------

Michael J. Long, Arrow Electronics, Inc. - Chairman, President & CEO [46]

--------------------------------------------------------------------------------

Yes. I think we're expecting that our long-term rates will go up from where they were. We haven't seen any structural change in the business at this point going forward. We expect that there will be a bigger portion of our business [churn] engineering over the next couple of years. So we're not concerned about the long-term measurement system of this, but when you know we have as big a [guess] as you do, it depends on the market.

--------------------------------------------------------------------------------

Paramveer Singh, BofA Merrill Lynch, Research Division - Associate [47]

--------------------------------------------------------------------------------

But you do think that 5% number is feasible, if and when the volumes come back?

--------------------------------------------------------------------------------

Michael J. Long, Arrow Electronics, Inc. - Chairman, President & CEO [48]

--------------------------------------------------------------------------------

Oh, absolutely. We were above 5% before the market started to decline. So we have the same expectation it will be above 5% when the markets rebound. And obviously, we're putting another $130 million of efficiency on top of that and that will sort of help make sure that happens, actually sooner than we need it to. The $130 million efficiency is to help our earnings, while we're digging out of this. And as the market returns from there, that will be the next level of validation. So we expect to go past 5%.

--------------------------------------------------------------------------------

Paramveer Singh, BofA Merrill Lynch, Research Division - Associate [49]

--------------------------------------------------------------------------------

All right. And then as my follow-up, on the ECS side, obviously, you're seeing a slowdown in hardware, but Arrow had transformed itself into more of a solutions business and now it seems that you're getting more in line with typical capital deployment cycles. Has that organization changed? Are you no longer benefiting from that advantage that you had in selling solutions to end customers, what's really different now?

--------------------------------------------------------------------------------

Michael J. Long, Arrow Electronics, Inc. - Chairman, President & CEO [50]

--------------------------------------------------------------------------------

I don't think there is any difference in what we believed before and what we believe now. I think there is a mix change. I think, as you know, the industry has been struggling with hardware. The storage suppliers have been up and down and sideways, and that market has been highly interesting and moved from proprietary servers to industry-standard servers has been an impact. I think, cloud has been an impact, but I believe those things will sort themselves out. You do see some of the suppliers still coming out with new products and new hardware, and that's just market. Our software -- I mean, year-over-year, our software products are all up significantly. So it's just a matter of that starting to have a bigger impact on our business. And Sean, I'll let you add to that piece of it.

--------------------------------------------------------------------------------

Sean J. Kerins, Arrow Electronics, Inc. - President of Global Enterprise Computing Solutions [51]

--------------------------------------------------------------------------------

Yes, Param, I would just say, don't confuse any hardware headwinds with the change in our strategy. We're still very much focused on the -- kind of the more complex value space. And Mike's right, our software growth from a billings perspective was well into double digits in Q2, and I think that's a proof point that we're moving our model to the new demand trends and more to come.

--------------------------------------------------------------------------------

Operator [52]

--------------------------------------------------------------------------------

There are no further questions at this time. I will turn the call back over to Mr. Steve O'Brien for some closing remarks.

--------------------------------------------------------------------------------

Steven J O'Brien, Arrow Electronics, Inc. - VP of IR [53]

--------------------------------------------------------------------------------

Thanks. In closing, I'll review Arrow's safe harbor statement. Some of the comments made on today's call may include forward-looking statements, including statements addressing future financial results. These statements are subject to a number of risks and uncertainties that could cause actual results or facts to differ materially from such statements for a variety of reasons, and the company undertakes no obligation to update publicly or revise any of the forward-looking statements. Detailed information about these risks is included in Arrow's SEC filings. If you have any questions about the information presented today, please feel free to contact me. Thank you for your interest in Arrow Electronics, and have a nice day.

--------------------------------------------------------------------------------

Operator [54]

--------------------------------------------------------------------------------

This concludes today's conference call. You may now disconnect.