ARW - Arrow Electronics: I See 2 Buy Indicators Approaching

2023-04-20 00:37:22 ET

Summary

• Arrow is a leading value-added distributor of equipment and services across the IT industry.
• The company has shown secular growth in-line with the broader industry, but offers a business profile that endures bear cycles.
• By looking at the current financials, we can determine the outlook as the IT industry cools from a tremendous pandemic era.

Introduction

Arrow Electronics ( ARW ), is a leading tech distributor, but in a business-to-business manner. By incorporating its own expertise and innovation, ARW is able to provide value added services and solutions, thereby generating earnings. While many investors may see the low profit margins and pass the company on first glance, Arrow has a truly stable financial profile. In fact, during bear cycles ARW streamlines operations to increase free cash flow generation in order to maintain their leading market position. This allows ARW stock to be a safe bet on the industry, despite the share price reflecting the broader cyclicality of the industry. I believe investors can capitalize on the opportunity.

Safety in a Cyclical Industry Via Partnerships

One of the biggest issues of investing in the IT industry, and especially semiconductors, is the cyclicality that is pervasive. Even $50 billion market cap plus companies such as Micron ( MU ) are currently seeing drops in revenue greater than 25%. However, the underlying secular trend remains incredible due to the innovative nature of the industry. The question is: what companies remain stable during times of duress? Well, due to a global presence, industry-wide partnerships, and a long history of innovation and success, Arrow is one anti-cyclical investment that performs well during bear markets.

The key is that they are not consumer facing, rather partnering with OEMs to source and design new technologies. This led to the sale of over $35 billion worth of components and solutions worldwide in 2022. Revenues are also evenly spread around the world, so Arrow can capitalize on more favorable growth trends where they arise. Also, there is data from EY and Harvard Business Review that indicates favorable innovation trends during recessions by companies looking to find new growth opportunities. With Arrow being a leading partner in numerous research projects around the world, the outlook remains positive for the company. The following are some examples of their cases:

• Perhaps most famously, Arrow is a major motorsports sponsor in multiple leagues around the world. Best is their partnership with McLaren in the NTT IndyCar Series.

• A partnership with the Make-A-Wish Foundation and Analog Devices ( ADI ) to design a pet dragon, Belle’s Dragon , with innovations in semi-autonomous robotics and virtual reality.

• And, developing a new way to drive a vehicle using motion sensing head controls (for those with disabilities) thanks to Nvidia’s ( NVDA ) deep-learning/AI software and SoC platform, Jetson Orin .

Key Financial Indicators

There are a few key points investors must understand for Arrow Electronics. While revenues are reflective of the broader industry volatility, Arrow’s conservative management prevents major issues from arising in bear markets. Even the profitability chart highlights how profits are difficult to generate during bear markets, although margins are only negative when large acquisitions or spending occurs (4 quarters over the past 25 years). However, margins are generally stable through time and have improved significantly in the latest bull market. This shows that the rise in revenues attributed to value-added services and solutions is increasing compared to component distribution, and I would watch for secular margin expansion to occur.

Margin expansion is also not the only benefit to look forward to in the coming quarters. In both the pandemic and GFC, Arrow saw weak profit generation, but was able to significantly increase cash flow generation. Highlighted in the chart below, Arrow management typically chooses to reduce leverage and increase cash flows in a weak environment. Typically, this involves reducing working capital by selling off inventory. New cash is then used to increase cash levels or reduce debt, along with consistent share buybacks (although no dividend since 1986). When times are good, watch for Arrow to increase spending and this may impact FCF generation, but allows the company to capitalize on market opportunity.

Investor Action

The next factor to consider is what patterns are present in the share price and valuation. While financial performance is improved during bear markets, Arrow shares typically sell off. So it then makes sense to add during a large sell-off as the likelihood of Arrow rebound rapidly is high. Therefore, most would expect that since we are entering a bear cycle, that we should begin to add shares. However, there are some mixed signals currently with the valuation. This is due to the mixed signals that are also occurring across the IT and semi industry.

While commodity components like memory and consumer device components are in a bear market, secular growth of high-end data center, IoT/industrial, and logic components are allowing many OEMS to see favorable market conditions. Global economies are also remaining strong, even as inflation and interest rates remain high. Since Arrow has significant exposure to high-tech, rather than more cyclical commodities, revenues have remained positive over the past few quarters. This has led to a few valuation indicators:

• While on an EV/EBITDA basis Arrow looks extremely cheap (only this cheap a few times prior since the 90s), the issue is that a fall in earnings will damage the valuation in the future (valuation can rise and the share price can still fall). This is exacerbated by the strong trailing twelve month comparables, and relies on continued momentum.

• Coming in relatively in-line with EV/EBITDA is the P/S ratio, with the current 0.2x ratio well below average. The data also shows that investors may not be pricing in the meaningful improvements to both profitability and leverage, based on the disparity between EV/EBITDA level and P/S. However, when looking at the periods where the valuations were even lower than today, it is clear those are buy points.

• The problem is that the Price to Free Cash Flow valuation is signaling risk. In the past, when the trailing P/FCF is exceedingly high it signaled a peak in the bull cycle when spending was high. So, one would assume that the share price will decline moving forward. Just compare the same time periods to the performance chart below, and you will see that there is a chance for losses moving forward.

Conclusion

While Arrow Electronics' historical financial data suggests that they will perform well during a bear cycle, the bottom has not occurred yet, especially considering the share price is trading within 20% of all-time highs. The problem is the valuation currently is suggesting there may be opportunity. But, only if ARW maintains profit generation, revenues, and begins to lift FCF. I do believe that this is possible due to the relative strength of certain IT subsectors, but most investors will want more concrete proof.

Therefore, I would begin to accumulate under two scenarios: revenues and profits begin to fall and the valuation metrics remain low (which will result in a decline in share price), or, if free cash generation increases while earnings and the share price remain stagnant (basically if ARW looks cheap across all three listed valuation metrics). I believe these scenarios may present themselves within the next few quarters, and that Arrow is deserving of consideration for an investment.

Thanks for reading.

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