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Edited Transcript of ARW earnings conference call or presentation 30-Apr-20 5:00pm GMT

·46 min read

Q1 2020 Arrow Electronics Inc Earnings Call MELVILLE May 15, 2020 (Thomson StreetEvents) -- Edited Transcript of Arrow Electronics Inc earnings conference call or presentation Thursday, April 30, 2020 at 5:00:00pm GMT TEXT version of Transcript ================================================================================ Corporate Participants ================================================================================ * Andrew D. King Arrow Electronics, Inc. - President of Global Components * 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 * Matthew John Sheerin Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Senior Equity Research Analyst * Nikolay Todorov Longbow Research LLC - Analyst * Ruplu Bhattacharya BofA Merrill Lynch, Research Division - VP * Shawn Matthew Harrison Loop Capital Markets LLC, Research Division - MD * Steven Fox * William Stein SunTrust Robinson Humphrey, Inc., Research Division - MD * Tim Yang Citigroup Inc, Research Division - VP ================================================================================ Presentation -------------------------------------------------------------------------------- Operator [1] -------------------------------------------------------------------------------- Good afternoon, and welcome to the Arrow Electronics First Quarter 2020 Earnings Conference Call. (Operator Instructions) I will now turn the call over to Steve O'Brien. Please go ahead. -------------------------------------------------------------------------------- Steven J O'Brien, Arrow Electronics, Inc. - VP of IR [2] -------------------------------------------------------------------------------- Thanks, Christi. Good day, and welcome to Arrow Electronics First Quarter 2020 Earnings Conference Call. 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 will 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. Thanks to all of you for taking the time to join us today. I'd like to start off by thanking my colleagues around the globe for their tremendous efforts during the first quarter of 2020. I'm deeply impressed by their dedication to Arrow and to our customers, many of whom rely on us as a critical supplier for their business. Of course, the health and safety of our employees are always top of mind. And I'm grateful to report that throughout our distribution facilities and offices, our teams continue to do business, while closely following the guidelines of the world's leading health authorities as well as local governments. We've also been able to leverage the early experiences and best practices adopted by our colleagues in China to maintain safe and efficient operations at our other sites around the globe. Unfortunately, our team's hard work this quarter was not as evident as it should be. We just received a legal opinion regarding foreign tax and other loss contingencies for the enterprise computing solutions business. This required us to book charges of $33 million or $0.41 a share to catch up for 5 years from 2015 to 2019. Our review aided by our auditors and outside counsel is ongoing, and this is the best estimate we have at this time. On February 6, we reported fourth quarter results and provided an outlook for the first quarter of 2020. At that time, we couldn't accurately quantify the potential impacts from what would become the COVID-19 pandemic. Therefore, the sales and earnings per share we provided assumed no disruptions to our business as a result of COVID-19. I'm pleased to report that despite facing substantial business disruptions during the first quarter, our business largely performed as we expected. By remaining nimble and flexible, we were able to adapt to these changing conditions, and, ultimately, we executed well despite adversity. We were able to properly align our working capital and deliver strong cash flow, and we also positioned our business for the future. As we reflect on the first quarter at a high level, it's important to recognize that each month saw remarkably different business conditions and operational challenges. Through January, operations were relatively normal and undisturbed by COVID-19, although broader electronic component and IT demand were softening exiting the 2019 inventory correction and tariff-driven market slowdown. In February, we saw the China business come to a halt. While this presented a number of operational challenges, it underscores the essential role Arrow plays in the supply chain as we continue to deliver critical sensors and other electronic parts to our Chinese customers. In March, factories began returning to full capacity in China. In the Americas and Europe, some production lines halted. IT spending also significantly shifted towards enabling remote workers. In this context, we quickly implemented key elements of our contingency business plans to ensure our customers and suppliers were equipped to continue their business operations. In order to maintain our strong financial position, we reduced spending on discretionary projects and items and postponed some investments for the time being, all without compromising our design, engineering, sales and marketing capabilities. As we have taken swift action to adopt to support our businesses and stakeholders through this uncertain time, we have relied on our ERP for key data. We review our global ERP as a key competitive advantage. It provides a detailed line-of-sight into the volumes, prices, inventories, regions, end markets and profits we make on the parts we sell. Importantly, Arrow remains laser-focused on maximizing our near-term results, while we continue to position our business for the long term. Looking to industry needs, while near-term business conditions have remained durable in spite of the broader market headwinds, we realize and recognize that demand can change quickly. First quarter backlog increased from the fourth quarter, the second quarter in a row of sequential improvement. Design activity increased year-over-year in total for the second quarter in a row. Other indicators appear consistent with short run stability. Lead times extended modestly from the fourth quarter, but are shorter than last year. Overall book-to-bill was 1.12 exiting the first quarter. Book-to-bill was above parity and prior year in all regions. Our Americas customer sentiment survey results were similar to last quarter. The portion of customers saying they had appropriate levels of inventory increased compared to last year. The portion of customers saying they had too much inventory remained higher than normal but decreased compared to last year. To-date, we have not faced significant challenges securing the parts our customers need when they need them. Nor do we see signs of hoarding or excess inventory accumulation. Turning to our enterprise computing solutions business in the first quarter. Sales were towards the higher end of our expectations. Demand for traditional ICT solutions declined relative to last year. And towards the end of the first quarter, we experienced a significant shift in demand towards the software required to enable remote workers. Sales of virtual desktop infrastructure, virtual machines and the associated infrastructure and security software were strong. Taking a step back, I want to emphasize that, as a company, we have long believed that doing good is also good for business. To that end, we focused on leveraging our unique technology and supply chain capabilities to help communities through the COVID-19 crisis. To highlight just a few initiatives, we're supporting the VentilatorChallengeUK consortium on their goal to produce 10,000 rapidly manufactured ventilator system units. We also helped develop and provide the artificial intelligence software for an at-home monitoring system that allows COVID-19 patients to avoid hospitals or leave hospitals sooner. This solution is being sold on a not-for-profit basis to caregivers. In closing, we're continuing to support our stakeholders and communities, and we're committed to providing our customers with the products and solutions they need when they need them. We remain disciplined and focused as we operate our facilities and business through significant ongoing challenges. To-date, we've managed to avoid disruptions and expect to continue to do so as a critical provider of the global technology and industrial ecosystems. It's worth noting that we have built a resilient business at Arrow. We're adept at navigating through adverse financial conditions. In fact, we've always emerged from these challenges stronger, and we intend to do just that. We will not stop looking for opportunities to expand our business, drive innovation and improve the performance of our end customers everywhere. We look forward on updating you on our performance in the coming quarters. I'll now hand the call over to Chris to provide more details on our first quarter results and our expectations for the second quarter. -------------------------------------------------------------------------------- Christopher David Stansbury, Arrow Electronics, Inc. - Senior VP & CFO [4] -------------------------------------------------------------------------------- Thanks, Mike. This quarter, based on feedback from investors and analysts, I'm going to keep the review of our results relatively brief to allow more time for questions. First quarter sales were $6.38 billion. Sales decreased 9% year-over-year, adjusted for the wind down, a divestiture and changes in foreign currencies. Global component sales were $4.55 billion. This is at the lower end of our prior guidance and represents a 10% year-over-year decrease, as adjusted. It's worth noting that industry destocking has been going on for more than 1 year. Global component sales have declined sequentially 5 of the last 6 quarters. Global components operating margin was 3.8%. This is the fourth consecutive quarter of year-over-year margin decline for global components. During past market corrections, we've typically seen 5 consecutive quarters of margin decline. Were it not for COVID-19, we should be reaching a margin inflection point. First quarter operating margin increased compared to the fourth quarter despite lower sales. This was due to the normal seasonality in this first quarter also benefited from our cost containment efforts, including last year's cost optimization program. Enterprise computing solution sales of $1.83 billion decreased 6% year-over-year, as adjusted, and were near the higher end of our prior expected range. As we previously outlined, first quarter enterprise computing solutions sales were negatively impacted by the earlier March 28 closing date compared to March 30, 2019. Billings were approximately flat year-over-year adjusted for changes in foreign currencies. We experienced growth in virtualization and compute, infrastructure software, security and storage. Demand for servers, networking and services declined. Global enterprise computing solutions operating income decreased by approximately $45 million year-over-year, including a charge of $30 million related to foreign tax and other loss contingencies related to 5 prior years. We previously estimated operating income would be approximately $11 million lower compared to the prior year due to the timing of the quarter end. The rest of the decline of approximately $4 million was due to less favorable sales mix than what we originally expected as spending priorities shifted during the quarter. Returning to consolidated results for the quarter. Interest and other expense of $43 million was below our prior expectation due to lower borrowings and, to a lesser extent, lower interest rates. The effective tax rate was 29.5%, well above our prior expectation of 24.5%. This was due both to the foreign tax contingencies from prior years and to the timing of discrete items. We expect a 24% effective tax rate for the second quarter at the midpoint of our long-term target range. Earnings per share were $0.97 on a diluted basis, including $0.41 of charges from foreign tax and other loss contingencies. We estimate the stronger dollar negatively impacted earnings per share by approximately $0.02 compared to the first quarter of 2019. Turning to cash flow, we reported strong operating cash flow of $467 million. First quarter cash flow is normally negative, but we tightly managed working capital investments to drive significant year-over-year improvements. In addition, cash flow benefited from our new European accounts receivable securitization program that commenced in January. During the first quarter, we reduced borrowings by approximately $372 million. Our balance sheet is in great shape, and our liquidity position is strong. Current committed and undrawn liquidity stands at over $3.1 billion, not counting our $200 million cash balance. We're also closely monitoring credit and receivables. Collections remain healthy. DSO increased in line with DPO, and this was due to an increase in our services business during the quarter that is neutral to working capital. As we've said in the past, it is fair to measure our performance by the cash conversion cycle, not by any one metric in isolation. The cash conversion cycle was 11 days shorter than Q1 of 2019. We returned approximately $150 million to shareholders during the quarter through our share repurchase plan. Our remaining authorization is approximately $188 million. 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 on our website this morning. Now turning to guidance. We felt it was important to provide you with our best estimates based on orders and demand from our nearly 200,000 customers and early indications from the month of April. While many companies have chosen to forego guidance due to market uncertainty, we want to be as transparent as possible about our expectations for the business. You may have noticed that the ranges we provided in our earnings release for the second quarter are wider than normal, which reflects the higher than normal potential for variance due to our forecast, given the market conditions. With that said, we're forecasting sales to remain relatively flat compared to the first quarter for both the global components and the global enterprise computing solution businesses. This is modestly below normal second quarter results for components and significantly below for enterprise computing solutions. Despite our forecast of flat sales, we expect profits to be higher on a sequential basis as a result of improved sales mix for global enterprise computing solutions and our overall cost containment efforts that will be most visible in corporate expense. With that, I'll turn the call over to the operator for Q&A. ================================================================================ Questions and Answers -------------------------------------------------------------------------------- Operator [1] -------------------------------------------------------------------------------- (Operator Instructions) And your first question is from Matt Sheerin of Stifel. -------------------------------------------------------------------------------- Matthew John Sheerin, Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Senior Equity Research Analyst [2] -------------------------------------------------------------------------------- Just, Mike, regarding the component business, your flat guide seems to be better, if not significantly better than most of the suppliers that you represent that have reported so far in addition to your chief competitor. So obviously, your book is a [little bit] strong, and we've seen that from others as well. What kind of confidence do you have in terms of that outlook? And related to that, are you gaining share at all, specifically, the TI business, which we know, at some point, shifts over to you to some degree? So what is your outlook there? And what can you tell us about the share shifts? -------------------------------------------------------------------------------- Michael J. Long, Arrow Electronics, Inc. - Chairman, President & CEO [3] -------------------------------------------------------------------------------- Yes. First off, Matt, thanks. But we wouldn't have put the guidance out if we weren't serious about it or I didn't think we could hit it. And you have to kind of remember that we've been in a 5-quarter decline already with what was the market slowdown prior to COVID hitting. And so customers were reducing their inventory. Now albeit, are they still reducing their inventory? Possibly. I think there's a lot of question for everybody. First off, we've seen a significant uptick in China. And China has made a pretty strong comeback compared to where they were when they shut down. And we are expecting that to continue through the second quarter. Now by no means are we projecting out the year. By no means are we saying the market is stable and it's going to take off. We just know what we have to ship, plus we're 30 days into the second quarter, and the results so far are looking pretty strong. Right now, we don't have a supplier that is more than 9% of our sales, and we're not seeing any unusual activity to-date with anything that would suggest that one supplier or other suppliers are making a difference. We are seeing in China sort of broad-based increase. In the U.S., we're seeing a little bit less of a decrease than we had expected. And we're seeing Europe sort of hold its own. Now saying that, also looking at the second quarter, you're seeing a reduced number -- reduced percentage versus the year prior also, that is sort of in line with the first quarter. And as you know, for some time, we've been increasing our sales to nontraditional type customers. We continue to see that happening. We continue to see an uptick in our services business. And design wins in a downturn being up is usually good news because that means the customers didn't shut down everything. And we've seen some positive input there. So hopefully, all of that mixed together, Sean -- or Matt gives you a little bit better insight to what we're seeing. -------------------------------------------------------------------------------- Matthew John Sheerin, Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Senior Equity Research Analyst [4] -------------------------------------------------------------------------------- Okay. And regarding any incremental wins on the semiconductor side, there's been talk about that shifting over at some point. Do you have that in your horizon in terms of bookings or what you're seeing? -------------------------------------------------------------------------------- Michael J. Long, Arrow Electronics, Inc. - Chairman, President & CEO [5] -------------------------------------------------------------------------------- I think as we said before, the other competitors have through the end of the year to book their business and get their companies in order. And I don't expect anything to be overly material until we get through the end of the year. And remember this wasn't a huge windfall for us if we go back to the original piece. So don't sort of oversell it or make it a big reason because, otherwise, we'd have to disclose it if it was massive. -------------------------------------------------------------------------------- Matthew John Sheerin, Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Senior Equity Research Analyst [6] -------------------------------------------------------------------------------- Got it. And regarding the computing business, and you talked about a negative mix, rather, hurting your margins. Was that also related to lower rebates because of not hitting certain thresholds on the hardware side? And you talked about favorable mix going into next quarter. Could you be more specific about what you're seeing there? -------------------------------------------------------------------------------- Michael J. Long, Arrow Electronics, Inc. - Chairman, President & CEO [7] -------------------------------------------------------------------------------- Sean, go ahead. -------------------------------------------------------------------------------- Sean J. Kerins, Arrow Electronics, Inc. - President of Global Enterprise Computing Solutions [8] -------------------------------------------------------------------------------- Yes. Sure, Matt. Actually, it was less about the rebate thresholds in the back end that we enjoy with our mix of suppliers and more about the kind of software that we booked-to-billed as the market kind of shifted to remote work and distributed technologies. A lot of that software is departmental in nature. So we tend to treat it as a gross sale versus through agency accounting, which does create some gross margin pressure. But if you look forward, I do think the mix of strength in work-from-home and probably headwinds related to traditional data center spend, we think that's going to continue. So the mix won't shift dramatically, but we're also managing OpEx very carefully in this environment given what we know now. So we do see an opportunity for sequential improvement in operating margin. -------------------------------------------------------------------------------- Operator [9] -------------------------------------------------------------------------------- Our next question is from Shawn Harrison of Loop Capital. -------------------------------------------------------------------------------- Shawn Matthew Harrison, Loop Capital Markets LLC, Research Division - MD [10] -------------------------------------------------------------------------------- I wanted to just dig more in on the big free cash flow number this quarter. And just, I guess, a, how much does the receivable -- or the securitization dynamic in Europe help? B, what type of kind of free cash flow should we anticipate for the second quarter? And C, will you still be buying stock here in the market and look to maybe up that authorization? -------------------------------------------------------------------------------- Christopher David Stansbury, Arrow Electronics, Inc. - Senior VP & CFO [11] -------------------------------------------------------------------------------- Yes, Shawn. So of the cash flow that was delivered in the quarter, about $380 million of that came from the securitization program we did in Europe. That's at very attractive rates. And the cash that we receive there, we basically use to pay down debt and also buy back stock this quarter. As you look at Q2 and, frankly, for the year, we have said, obviously, historically, that somewhere between 70% and 100% of GAAP net income is a good target for cash flow. That didn't work last year, given the wind down, but we were at about 135% of non-GAAP income. So I think you'll see us move back to typical patterns, given where volumes are. So we still see this as an opportunity to generate cash flow. We do have $188 million remaining under authorization. And as we've said in the past, we'll have a balanced approach between managing debt and buybacks as we move through this time. -------------------------------------------------------------------------------- Shawn Matthew Harrison, Loop Capital Markets LLC, Research Division - MD [12] -------------------------------------------------------------------------------- Okay. That's helpful, Chris. And then, I guess, going back to the ECS margin dynamic, you were on pace for it to -- you were seeing kind of margin expansion on a year-over-year basis, at least you saw that for the third and fourth quarters of last year, and you had the issues here in the first quarter. Do you anticipate you'll start to see or get back towards the margins you saw last year in that business with the mix shifting more favorably here in the June quarter? Or is there still some of the software dynamic mix that maybe pressure margins year-over-year? -------------------------------------------------------------------------------- Christopher David Stansbury, Arrow Electronics, Inc. - Senior VP & CFO [13] -------------------------------------------------------------------------------- Well, as I said, Shawn, we are seeing a similar mix as we delivered in Q1. So we do have some opportunities to drive some improvement at the gross margin line, but we're also going to have to complement that with cost containment actions we are taking. And again, we do see an opportunity for sequential improvement. It's really tough to call that beyond the June quarter given what's happening in the external environment. But what we saw at the kind of the latter part of March is kind of consistent with what we see so far in Q2 and what we expect at least for the quarter. But beyond that, it's a little bit tougher to call. -------------------------------------------------------------------------------- Operator [14] -------------------------------------------------------------------------------- Our next question is from Steven Fox of Fox Advisors. -------------------------------------------------------------------------------- Steven Fox, [15] -------------------------------------------------------------------------------- A couple questions, please, on the ECS side. So there's been a number of your OEM partners that have offered up vendor rebates into the channel, marketing dollars and favorable credit terms. Can you just sort of talk broadly how that impacts your business? And within that context, how do you find the general health of the VAR that you are dealing with? And then I have a follow-up. -------------------------------------------------------------------------------- Christopher David Stansbury, Arrow Electronics, Inc. - Senior VP & CFO [16] -------------------------------------------------------------------------------- Sure. So when we look at the reseller community, obviously, we're paying really close attention to credit risk. We have a larger exposure to what I would call, large companies and large resellers that serve them than we do the SMB market in total. Nevertheless, we have really ramped up the process for scrutiny of our AR portfolio in a really robust way. We pay particular attention to the partners we know that are maybe less well capitalized and certainly those that serve the SMB space. And so far, we really haven't seen any disruption or defaults. But I would say with respect to supplier offerings and programs to potentially extend terms, we're always able to do that in a way that we pass on those offerings such that it does not negatively impact DSO. Most of those programs turn out to be working capital neutral for us. And our suppliers are really good at partnering with us as opposed to rolling those things out independently in a way that hurts us. So we're not concerned about those programs. We'll take advantage of them, if it helps us close business, but we won't step into unnecessary risk as we do so. -------------------------------------------------------------------------------- Steven Fox, [17] -------------------------------------------------------------------------------- That's really helpful. And then just as a follow-up on the components side of the business. Mike, you talked about, I guess, a little bit better environment than I would have expected and some other people might have expected. Can you just sort of dig into a little bit on the verticals? Which end markets you're seeing holding up, especially given the risk that you have all these auto plant shutdowns that have some knock-on effects on some industrial customers? -------------------------------------------------------------------------------- Michael J. Long, Arrow Electronics, Inc. - Chairman, President & CEO [18] -------------------------------------------------------------------------------- Yes. The first thing I'll say -- I'm going to turn it over to Andy. But the first thing I'll say is there's not a vertical in the world right now that I can see that is up. So the thing to remember is there was a slowdown going on before COVID. So there was already an economic decline in place that we're just seeing, and it's possibly being exacerbated now because of certain markets like automotive that you see and some of the other markets that are at the early stages of a shutdown or a big slowdown. So we're, obviously, very cautious about the market in general, but we remain committed and pleased by our performance within those markets. So I'll give it to Andy to give you some more specific of the market verticals themselves, but there's not a lot of brightness out there. -------------------------------------------------------------------------------- Andrew D. King, Arrow Electronics, Inc. - President of Global Components [19] -------------------------------------------------------------------------------- Yes. Thanks, Mike. Yes, you're bang on. I'd rather answer that question by saying, which are the ones that are down the most or the ones that are most exposed because every vertical is being impacted through this cycle. And the backdrop is -- the answer we gave earlier is we're not overexposed to any 1 particular vertical or any one particular segment. So we're able to pivot our resources and our focus from segments that are -- have relative -- and I use the word relative health quite quickly and nimbly. But really, automotive is the area that is really well documented as being problematic right now with auto manufacturer shutdowns and Tier 1s and 2s follow suit. Commercial aviation is in the same place. As I say, whilst we sell into those marketplace, we're not overexposed. The general industrial base relative to that is better buoyed by medical. But to be honest with you, Steven, it's pretty much down across the board as we look at those individual verticals, and we play the portfolio game. -------------------------------------------------------------------------------- Operator [20] -------------------------------------------------------------------------------- Next question is from William Stein of SunTrust. -------------------------------------------------------------------------------- William Stein, SunTrust Robinson Humphrey, Inc., Research Division - MD [21] -------------------------------------------------------------------------------- Mike, I wonder when you look at this elevated backlog that you have today, which is a little bit counterintuitive relative to sort of what's going on. I wouldn't even say in the macro, just sort of look out the window and think does it make sense for backlog to be up in this environment. I wonder if you have any comments about your relative confidence in the backlog stability. And maybe more specifically, are you seeing any increased volatility of customer pushes and pulls and adjustments to their backlog to respond to either shortages or not getting parts or getting parts faster than they expected? Any clarification there would be helpful. -------------------------------------------------------------------------------- Michael J. Long, Arrow Electronics, Inc. - Chairman, President & CEO [22] -------------------------------------------------------------------------------- Yes. Certainly. First off, backlog, I would say, steady as she goes. I wouldn't put the term as aggressive as up as you do, but it's looking pretty good. And part of that reason has been the consistent -- or the past 5 quarters where customers, if you look at the customer base that we service, have been getting their inventories in order. So I'll start with we've seen that. The second thing is we have not seen an uptick in cancellations from customers. So it's sort of an interesting dilemma. What we have seen is customers giving us the orders to make sure they're going to get the product when they want it. And so far, they have been, which is why I'm not sure that everybody is on this over-ordering pattern. The market was already in decline. COVID pushed it down. So the real question in my mind that I believe needs to be answered is how much is the impact of COVID over an economy that was already weak? We were 5 quarters into what has traditionally been a 6-quarter downturn historically. And you can go back to the last 2, that pretty much has held true. And the fact that we're just sort of taking a pause here and holding for 1 quarter, I think, is good news. And we'll see how the quarter materializes out from there. But so far, everything has been steady here. Our backlogs are steady. We're not seeing a huge ramp of those. And obviously, you have a decline of 12% year-over-year in your numbers. And of course, book-to-bill is going to look better because book-to-bill indicates the future. It doesn't indicate the past. So when you have a drop like that of year-over-year sales, just be cautious, that book-to-bill is less meaningful because customers are positioning their inventories to match what their MRP requirements are. So hopefully, that gives you a little bit about how we're thinking of it and how it's looking right now. -------------------------------------------------------------------------------- William Stein, SunTrust Robinson Humphrey, Inc., Research Division - MD [23] -------------------------------------------------------------------------------- I appreciate that. One other, if I can. Mike, you mentioned in the prepared remarks you intend to emerge from this current situation as a stronger business. We know that -- or we think that you're gaining some share at what is, I think, your largest supplier. That seems pretty clear. But I wonder if there -- and you're also going through this divestiture of the IT asset disposal business. Any other things that were maybe stimulated by the current situation that could cause a change in the business, either 1 that you're -- 1 that you're practically taking or one that you're sort of pushed into by the environment that would make the company stronger, either in sort of an absolute way or in a relative way versus your competitors? -------------------------------------------------------------------------------- Michael J. Long, Arrow Electronics, Inc. - Chairman, President & CEO [24] -------------------------------------------------------------------------------- Well, as far as it goes towards the competitors, that's hard to see exactly what they're doing in this downturn. But for us, remember, we spoke a little bit early on about the increase of our services business, which we're staying and ties customers closer to us, makes us more sticky, has us more involved in their business, more involved with their products going in and out, more involved from the design point of view. So we're seeing the number of those customers going up, and we think that that is great for the business because that really was the vision. Remember, that was our strategy that engineering becomes a bigger and bigger piece of our business. And it's interesting that we're seeing that despite COVID, despite the downturn, that most of our engineering dynamics are still going up. So customers are viewing us as a trusted source for their future design. So that is 1 area that I do believe we'll come out much stronger as this turns around. We have been able to gain some efficiencies through our ERP system. And this downturn has really shown us how valuable that is in helping us use data to our benefit [as] information before some of the data. Because we had multiple systems, we could never ask the same question everywhere in the world and then come up with the same answer or use the same metrics to have those answers help us around efficiency of our business. So the ERP system now is becoming a tool that we believe is important. And I told you why before because we can see what products are increasing, like, for example, sensors and allows us to go in and take a position on sensors early on that will support not only the customers we have, but the new customers asking for those products. And that was really important when everybody figured out they wanted to build ventilators in the first quarter. And I don't know how many of those ventilators actually got off the engineering pages to get built, but there were a lot of products that went out for that. And it allows us to capture current trends. So those are going to be things that are going to be very important in the future that we stick with and continually improve our situation, continually improve where our people go. We think the company will get much more efficient because of it and allow us to grow faster and preserve working capital in a way that we're not investing in things that maybe aren't so good anymore. -------------------------------------------------------------------------------- Operator [25] -------------------------------------------------------------------------------- Next question is from Joe Quatrochi of Wells Fargo. -------------------------------------------------------------------------------- Joseph Michael Quatrochi, Wells Fargo Securities, LLC, Research Division - Associate Analyst [26] -------------------------------------------------------------------------------- Kind of building on your last answer there on the ERP system, that's really interesting. Do you think that given kind of where your book-to-bill is sitting today, you need to make some working capital investments this quarter? Just trying to think about how to think about inventory. -------------------------------------------------------------------------------- Michael J. Long, Arrow Electronics, Inc. - Chairman, President & CEO [27] -------------------------------------------------------------------------------- No. I think you look at the inventory, the inventory is relatively stable where it is. It could end up going down a little bit, I think, is our plan. So we do plan on generating cash flow and working capital for our benefit. These inventories that we hold for customers presume that they take them at a certain period of time. And if they don't take them, then they lose that inventory. And I think customers right now are trying to figure out how to gear their factories back up and make a living. So I'm not so sure they're willing to get out of place when it comes to getting their product. So all in all, right now, I think we're stable and steady as she goes. We don't have any huge working capital requirements for the second quarter. As I said, we have things that are buttoned down. We still do have the investments in a couple of our logistic centers, which will make them better for the future and more efficient, and we'll continue with those. But pretty much everything else, if it's moving, it's getting shut down. -------------------------------------------------------------------------------- Joseph Michael Quatrochi, Wells Fargo Securities, LLC, Research Division - Associate Analyst [28] -------------------------------------------------------------------------------- That's helpful. And then on the ECS side, I was wondering, is there any update you could give us on the size of your cloud business? I would think that that would have accelerated this quarter. And I think in the past a couple of years ago, you said that was around $1 billion. -------------------------------------------------------------------------------- Christopher David Stansbury, Arrow Electronics, Inc. - Senior VP & CFO [29] -------------------------------------------------------------------------------- Yes. Sure thing, Joe. I think the last time we talked about it, we probably mentioned that we were on a run rate approaching $1 billion. I can say it's now well north of $1 billion. And more importantly, if you get underneath that and you look at the annualized recurring revenue piece of that, while it's a little bit too early for us to call a number, I can tell you that that's growing by double digits pretty consistently, and it grew again by double digits in Q1. So we continue to build that portfolio, both in terms of cloud offerings across the supplier base, but also in terms of our go-to-market capabilities with our ArrowSphere platform, which is really helping us change the way we sell and change the kind of selling partners we engage and in turn make us more and more sticky as we help our partners manage cloud subscription. So we're happy with the progress so far, but we certainly have more to do. -------------------------------------------------------------------------------- Operator [30] -------------------------------------------------------------------------------- Your next question is from Adam Tindle of Raymond James. -------------------------------------------------------------------------------- Adam Tyler Tindle, Raymond James & Associates, Inc., Research Division - Research Analyst [31] -------------------------------------------------------------------------------- I just wanted to circle back to some of the commentary that seemed to allude to TI. And Mike, you mentioned not expecting some big windfall. We'd have to disclose it if it was material, I think, was some of the things that you were saying. But if we look at the sum of the competitor revenue, it is material. So I guess the question would be, where do those billions in revenue go? Is that to say that that revenue is potentially not coming to Arrow? And secondly, that competitor actually grew sequentially with them in an environment where everything is declining. So I'm just a little bit confused as why a customer would want to go with them at this point. And just any color around that would be helpful. -------------------------------------------------------------------------------- Michael J. Long, Arrow Electronics, Inc. - Chairman, President & CEO [32] -------------------------------------------------------------------------------- I mean, you're asking quite the same questions we ask. I don't know the answer to that last question you answered. But what I can tell you is, yes, there are some customers coming. I think there was a relook at exactly what TI said they were going to do. If you go back to the original letter of what TI said, that's exactly what they're doing. And we have no reason to believe that that would be a negative impact on us. And would there be some benefit or some customers that want to come to us? Yes. I think that's true. But the program hasn't changed. So all I'm cautioning you guys is don't make this into something it's not. The questions just keep coming. And I got it, wish I could tell you it was $10 billion, and we we're going to have a pretty good windfall, that would be great, wouldn't it? But it's not that, and I think it's -- everybody's being a little overexuberant about it, and it's not the reason for our performance. -------------------------------------------------------------------------------- Adam Tyler Tindle, Raymond James & Associates, Inc., Research Division - Research Analyst [33] -------------------------------------------------------------------------------- Okay. That's fair. And then also, I wanted to dig into the approximately $30 million in charges. Is it -- could you maybe break that down further into what portion is foreign tax versus loss on investments? What does loss on investments mean? And are the -- what are the gating factors to see that come back into operating profit dollars for ECS? Or should we be thinking about just a permanent $30 million reduction to the run rate? -------------------------------------------------------------------------------- Christopher David Stansbury, Arrow Electronics, Inc. - Senior VP & CFO [34] -------------------------------------------------------------------------------- Yes. No, I'd say it's definitely not a $30 million reduction to the run rate. So let's start there. As Mike mentioned and I mentioned, this took place over 5 years. The bulk of it really surrounds taxes that impact OI, so sales taxes, back taxes, those kinds of things. When we say other contingencies, there was a few things that we caught from a reconciliation standpoint that we felt needed to be cleaned up. But from an ongoing run rate standpoint, I would argue that even if you took the number and you divided it by 5 years, that's not the concern because there's penalties and interest in that, that we're having to deal with as well. So we're on it. And we're addressing the issues, and we'll move forward from here. -------------------------------------------------------------------------------- Michael J. Long, Arrow Electronics, Inc. - Chairman, President & CEO [35] -------------------------------------------------------------------------------- And if I could clarify one thing, if I could, Adam. The $16 million loss on investment you see in the income statement is a mark-to-market on some other investments due to the stock market performance during the quarter and had nothing to do with the charges. -------------------------------------------------------------------------------- Operator [36] -------------------------------------------------------------------------------- Your next question is from Ruplu Bhattacharya of Bank of America. -------------------------------------------------------------------------------- Ruplu Bhattacharya, BofA Merrill Lynch, Research Division - VP [37] -------------------------------------------------------------------------------- Congrats on the quarter. Chris, I just wanted to talk a little bit about the book value per share. It's about $57. One of your competitors took a goodwill and intangible asset write-off. How should investors think about the goodwill on your balance sheet? Have you guys taken a look at that? And any danger of any write-offs in the near term? -------------------------------------------------------------------------------- Christopher David Stansbury, Arrow Electronics, Inc. - Senior VP & CFO [38] -------------------------------------------------------------------------------- Yes. We look at that on a regular basis and pretty much quarterly. And we're good for now. The way you have to evaluate that in terms of whether there's an impairment is in part, anyways, based off of how the market views Arrow. And currently, with the stock above book right now, we're in good shape. So the bulk of the goodwill that exists obviously relates to acquisitions that were done years ago. But we did do a rigorous test as we closed Q1, and we are good. -------------------------------------------------------------------------------- Ruplu Bhattacharya, BofA Merrill Lynch, Research Division - VP [39] -------------------------------------------------------------------------------- Okay. Just on inorganic growth. I mean, valuations for companies have pulled back. I know you need to conserve cash at this point. But at some point, are you going to start relooking at M&A? And how should we think about that going forward? -------------------------------------------------------------------------------- Michael J. Long, Arrow Electronics, Inc. - Chairman, President & CEO [40] -------------------------------------------------------------------------------- Yes. I think the -- again, remember, we told you the uses of our cash. Obviously, internal growth was the most important, and then we look at sort of M&A and then return to the shareholders. There's -- right now, there's probably another one that you would put in there that you would never have had to put in there had it not been for COVID, and that was the -- make sure you preserve enough liquidity to run your business in case of a catastrophe. And I think at this point, we've demonstrated we have the liquidity to run the business. And at this point, our main concern is that the business emerges stronger than it did before. So that would be our first use of cash, whatever that means. And at this point in time, I'm not looking at any big acquisitions that are going to make changes here. I think we just want to see the market get back stable, get back a little more normal. We've got enough to do to keep our business healthy and efficient than delay something else on top of it that's not efficient or has a bunch of problems that, frankly, I don't want to deal with. I've got enough problems right now. And I think we're doing a pretty good job managing them. I just don't want to add to the sack of problems if that helps you. -------------------------------------------------------------------------------- Ruplu Bhattacharya, BofA Merrill Lynch, Research Division - VP [41] -------------------------------------------------------------------------------- Yes. No, that makes sense. And for my last question, Chris, I think you talked about strong book-to-bill 1.12. As we stand here, April 30, can you talk about the relative strength across -- in components across all 3 regions? Which one is trending stronger? Which one is weaker? -------------------------------------------------------------------------------- Andrew D. King, Arrow Electronics, Inc. - President of Global Components [42] -------------------------------------------------------------------------------- Yes. Ruplu, it's Andy. Yes. We've seen the positive trends continue through April, as Mike pointed out. And we're seeing our businesses play out pretty much as we expected. And most noticeable was the expected bounce back in China, and that is indeed what we're seeing. So nothing abnormal to the way we guided in the regional makeup so far. -------------------------------------------------------------------------------- Ruplu Bhattacharya, BofA Merrill Lynch, Research Division - VP [43] -------------------------------------------------------------------------------- And guys congrats again on the strong quarter and also for giving guidance, which is impressive in this environment. -------------------------------------------------------------------------------- Operator [44] -------------------------------------------------------------------------------- Your next question is from Tim Yang of Citi. -------------------------------------------------------------------------------- Tim Yang, Citigroup Inc, Research Division - VP [45] -------------------------------------------------------------------------------- You mentioned the strong design activities actually increased overall on a year-over-year basis. Can you talk about which end markets are driving that design activities? You mentioned, I think, ventilators and also home monitoring devices. Is that the major driver? -------------------------------------------------------------------------------- Michael J. Long, Arrow Electronics, Inc. - Chairman, President & CEO [46] -------------------------------------------------------------------------------- I think what we're going to do is, as far as design goes, we're going to have Andy talk to you about it because it's been a good -- it's actually been a good investment by us over the years that is -- we think is going to pay off, and there's a lot going on now. So Andy, why don't you go ahead and talk about it? -------------------------------------------------------------------------------- Andrew D. King, Arrow Electronics, Inc. - President of Global Components [47] -------------------------------------------------------------------------------- Yes. Tim, we're seeing design activity hold up pretty well, firstly, regionally across the world. So that's an encouragement. We put a lot of investment into Asia in our demand creation facilities, and that's playing out well. In terms of end market segments, as I said earlier on, we're pretty well diversified across those segments. A broad industrial base is obviously a big part of our heartland, and that's really the heartland of our engineering efforts, and we're seeing that continue to play out. But don't forget, we continue to do design work in automotive segments, in aerospace and defense, et cetera, et cetera. So it's the kind of breadth of customers that we touch, the engineering investment that we've made, which is really enabling us to continue to do this through this current market cycle. So hopefully, that gives you a little color about where we're seeing it. -------------------------------------------------------------------------------- Tim Yang, Citigroup Inc, Research Division - VP [48] -------------------------------------------------------------------------------- Sure. Yes. That's very helpful. And then if I use this midpoint of your guidance, and I think it implies operating margins at roughly 3.1%. And I assume that your Q2 SG&A will be very similar to Q1 level, given that there's extra cost to run the warehouse with this virus. So that means your gross margin will be at roughly -- which means that's a 40 basis point year-over-year growth -- I mean, 40 basis point increase on a year-over-year basis. So can you maybe just talk about -- is that the right way to think about your gross margin for June quarter? And then if so, what's driving this gross margin improvement? I think design activity is definitely one. But I think like you have lower volume, but the gross margin improved. And how sustainable this margin performance could be? -------------------------------------------------------------------------------- Michael J. Long, Arrow Electronics, Inc. - Chairman, President & CEO [49] -------------------------------------------------------------------------------- Yes. You've got an awful lot in there, and I'm going to answer kind of yes to all of it, because, as you know, margin isn't a 1 quarter windfall. The other thing is keep in mind is the relative mix of our sales right now is changing very quickly. And that's something that we have not had to deal with before where you have a China shutdown and a month later a China coming back up and so a complete shutdown of sales, which changes your mix a little bit. So don't underestimate that impact on margin or on gross margins. The same thing you have in the warehouses with freight, depending on where we have to ship from because you might have something down in 1 portion of the world that is a more efficient warehouse to ship to that region of a world all of a sudden comes from somewhere else. And our big goal is to service our customers with what they need when they need it. And then the third thing is -- or the third and the fourth thing is our engineering business has stayed stable, which helps the margins and our services business has increased, which increases the margin. So -- and it's really very hard to bring that down to 1 item. But this has been our strategy all along. And so our strategy is playing out that, a, we can operate anywhere in the world at any time under any circumstance. I think the first quarter has shown that we could do that. By the way, at the same time, we sent more than 10,000 people to work-from-home. Don't take that number out of your mind. That's a ton of people that were in the office 1 day and then in 1 day they were home. And there is cost to that, but they have been maintaining their sales orders and the profits on those sales orders. So that has been beneficial, too. So I want to give you a little color before Chris added to it just what we were dealing with in this quarter. So is it lasting? It's hard to say. -------------------------------------------------------------------------------- Christopher David Stansbury, Arrow Electronics, Inc. - Senior VP & CFO [50] -------------------------------------------------------------------------------- Yes. And Tim, a couple of quick points. We are expecting SG&A to go down. So in spite of headwinds on transportation and some of the warehousing challenges that we face, we've gone on lockdown on anything discretionary. We're protecting our key strategic areas, as Mike mentioned, like around design. That's critical to us. That's going to serve us well in the future. I think the other thing is just kind of moving away from operating income margin relates to the question that was asked a little bit earlier. We did have some other operating losses of about $16 million in Q1 that relate to mark-to-market adjustments in some pensions and then also in some other stock investments that we hold in joint ventures. And so that is not expected to reoccur again in Q2. And so that's a tailwind to EPS as well. -------------------------------------------------------------------------------- Operator [51] -------------------------------------------------------------------------------- Our next question is from Nik Todorov of Longbow Research. -------------------------------------------------------------------------------- Nikolay Todorov, Longbow Research LLC - Analyst [52] -------------------------------------------------------------------------------- Can you talk if you have seen any supply chain disruptions and changes into lead times for the hardware portion of your ESS (sic) [ECS] business? And if so, have you seen an impact on demand from that? And just related, I think I heard that you noticed strength in orders for storage. I just want to make sure that's for the software part of storage and not to the typical hardware portion. -------------------------------------------------------------------------------- Michael J. Long, Arrow Electronics, Inc. - Chairman, President & CEO [53] -------------------------------------------------------------------------------- Yes, Sean, go ahead. -------------------------------------------------------------------------------- Sean J. Kerins, Arrow Electronics, Inc. - President of Global Enterprise Computing Solutions [54] -------------------------------------------------------------------------------- So sure, Nik. You know what, let me start with your second question first. So my comments about storage was the hardware storage in the first quarter. We do understand that traditional on-prem infrastructure is somewhat challenged in this environment, although I would say over the long term, I'm highly doubtful that it goes away, and it still remains a significant piece of our business. In terms of the supply chain overall, we did exit the March quarter with a very significant backlog. We have seen that drain somewhat in the month of April. That certainly gives us some confidence relative to our Q2 outlook. I would say the supply chain challenges have not completely abated since the Chinese capacity has opened up to some degree. We've seen some of the component-level challenges moderate. On the other hand, there are still bottlenecks at different points in the process be it assembly, integration and tests, et cetera. And we just continue to work with each of our suppliers on a case-by-case basis to make sure we can meet customer expectations. But in general, lead times haven't extended much further than where they were before this all started. And with the exception of some things that are prioritized for health care and government agencies, we seem to be making progress on it at the moment. -------------------------------------------------------------------------------- Nikolay Todorov, Longbow Research LLC - Analyst [55] -------------------------------------------------------------------------------- Okay. And if I can just follow-up. I think you took some restructuring and costs out last year. Is there any savings that are left to roll on into this year? And do you see the need for additional cost cuts out there than just discretionary that you're taking near term? -------------------------------------------------------------------------------- Christopher David Stansbury, Arrow Electronics, Inc. - Senior VP & CFO [56] -------------------------------------------------------------------------------- So we're -- in Q2, we will lap effectively -- we'll have a full year impact from last year's actions under our belt. The -- in terms of what we're doing right now, it really is cutting discretionary. Our goal is to make sure that we maintain our strategy because that strategy has served us very well over the last couple of years, and that will be what differentiates us coming out of this. So we're doing everything we can to protect that. And we think the actions that we've taken to-date are serving as well. -------------------------------------------------------------------------------- Operator [57] -------------------------------------------------------------------------------- Thank you. We have no further questions at this time. I will turn the call back over to Steve O'Brien for any additional or closing remarks. -------------------------------------------------------------------------------- Steven J O'Brien, Arrow Electronics, Inc. - VP of IR [58] -------------------------------------------------------------------------------- Thank you. In closing, I will review Arrow's safe harbor statement. Some of the comments made on today's call have included 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 [59] -------------------------------------------------------------------------------- Thank you. This does conclude today's conference call. You may now disconnect.