ARW - Arrow Electronics: Possible Long-Term Buy Case After This Weak Cycle Ends

2023-06-12 10:14:31 ET

Summary

• I continue to recommend a neutral view on ARW due to ongoing risks and uncertainties regarding semiconductor manufacturers bypassing distributors.
• ARW's demand outlook exceeded expectations, however, book to bill ratio still remains below 1x.
• ARW could be an attractive long-term hold with high-single-digits to low-teens IRR if its investment in supply chain pays off.

Recommendation

I continue to hold a neutral view on Arrow Electronics ( ARW ) despite a very well executed 1Q23. The risk and uncertainty remain the same for the stock, in that I'm still worried that semiconductor manufacturers will start selling their wares without going through distributors. That said, I believe ARW might eventually be valued like a tobacco-like company which faces long-term secular decline but is able to consistently churn out huge amounts of FCF to buy back shares, thereby increasing EPS. In the case of ARW, the business has levers it can pull to improve its market position, and it is not serving an industry that is sunsetting. However, now does not seem the best time to place the bets on this happening as the macroeconomy environment is still very uncertain, and investors are risk adverse.

Demand outlook

I'll begin by saying that I was taken aback by ARW's performance in 1Q23. Remember how I said ARW would still experience a downcycle in FY23? Well, the company has proven to be much more resilient than I had anticipated. Quarterly results for the Components division were buoyed by robust demand from both the Industrial and Automotive sectors in EMEA. Revenue from the Components segment was down 5% to $6.86 billion, which was better than even the most optimistic projections made by the company. More importantly, I think management's outlook was better than I expected (management was confident on Europe upcoming performance which I had worries about the possible recession). Also unexpected was the 1Q23 growth in ECS revenue across Europe (which I had expected to face a much weaker macro pressure than the US). Looking ahead, I expect Europe will continue to perform above seasonal trends as underlying customers that delayed their purchases since the war last year or fear of recession to flow back. This applies to both the hardware and software sales – which is evident in the double digits y/y constant currency sales. Notably, the demand comes from verticals that are enjoying strong secular tailwind like cybersecurity, computing, and enterprise software, all of which I expect to continue growing over the long-term. Hence, it has me thinking that maybe things aren't as bad as I feared. However, it is concerning that the book to bill ratio remains below 1x in every region. I don't think ARW has made it out of the woods yet until this number returns to historical norms (more than 1).

Margins

While the demand outlook appears promising, it is important to anticipate potential challenges on the margin front. There are indications of continued weakness, which may intensify in the future. Firstly, the decline in the scarcity of market services, which typically yield above-average gross margins, will have an immediate impact on gross margin due to changes in product mix. Secondly, the ARW inventory has been steadily increasing for eight consecutive quarters due to pricing inflation. This trend raises concerns about the potential impact on gross margin as the inventory transitions from the balance sheet to the P&L statement. Moreover, if inflation subsides and ARW cannot pass on the increased costs to customers, the combination of reduced prices and inflated expenses could further compress margins. The compression of margins will have an impact on how earnings could grow. If revenue grows but margin declines, this will result in a muted impact on the net income line, which will reduce the attractiveness of this investment case.

The new valuation paradigm for ARW?

I've been thinking about how ARW might be valued in the new environment where OEMs are going direct to end users. This competitive threat would limit ARW's ability to grow, but is there no value to be extracted from a business that has proven to be more sticky and resilient than I anticipated? One approach to valuing ARW that I considered was similar to how tobacco companies are valued. ARW and tobacco companies share the following characteristics:

1. Produces a large amount of FCF, resulting in a high FCF yield (6 to 10% FCF yield), and has a shareholder-friendly capital return policy.
2. Faces some form of long-term demand growth headwind (ARW headwind from OEM going direct)
3. Have some initiatives in place to mitigate the impact of the headwind (ARW investments in design services and supply chain capabilities).
4. Have a resilient sticky pool of demand (ARW products are important to various supply chains and are difficult to displace due to their scale).
5. Trades with a PE in the high single digits. ARW has a history of trading between the range of 8x to 10x forward earnings with an average of 9x over the past 10 years.

If viewed through this lens, ARW becomes an appealing long-term hold with a consistent IRR in the high single digits to possibly low teens.

Here's how it could go down: ARW is successful in its initiatives to mitigate OEM competitive threats, and is able to maintain growth at half of its historical rate (5%/ 2 = 2.5%) from FY12 to FY21. Due to the headwinds, ARW valuation remains at this level and continues to generate high single-digit (ARW did this previously before covid) to low-teens FCF yield. The expected annual returns amount to an IRR in the low teens (2.5% earnings growth + 8% FCF yield = 10.5% IRR). If ARW were to revert back to 9x forward earnings (its average), there will be another ~6% upside (9x/8.5x-1).

The flipside of this is that ARW fails to mitigate the OEM competitive threats (like how tobacco companies found new growth avenues in Jules or Vape). Then, this becomes a business that could see structural decline over time. In this case, the returns will be a lot less attractive with negative narratives revolving around the stock.

I reiterate that this is a potential investment case for ARW once we have returned to a more normalized environment, as I am concerned about margin volatility in the near term.

Competition

Due to the semiconductor industry's consolidation of market share and growing preference for direct sales channels, I am most concerned about the threat of competition to ARW. In both cases, market share and profit would be lost for wholesalers like Arrow. Take Texas Instruments as an example: the majority of their revenue comes from direct sales. My worry is not without precedent, and that's why it's important for investors to take notice.

Summary

In conclusion, I maintain a neutral stance on Arrow Electronics despite its strong performance in 1Q23. The risk and uncertainty surrounding the stock remain due to concerns about semiconductor manufacturers bypassing distributors. However, I believe ARW could eventually be valued similarly to tobacco companies, which face long-term decline but generate significant FCF for share buybacks, thereby increasing EPS.

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