ARW - Arrow Electronics: Upcoming Downcycle Is Inevitable

Summary

• In 4Q22, ARW reported in-line revenue and operating EPS, with growth in demand creation and design wins. However, I expect the upcoming downcycle is inevitable.
• The biggest risk is competition from semiconductor manufacturers going directly to customers.
• I believe the current price of ARW stock is fairly valued by the market.

Recommendation

The current price of $132 per share of Arrow Electronics ( ARW ) stock seems fairly valued to me. Although I think ARW's investments in design services and supply chain capabilities will pay off and that buybacks will have a material positive impact on EPS, I would advise caution when it comes to the stock due to cyclical and competitive fears. As for the latter, I'm still worried that semiconductor manufacturers will start selling their wares without going through distributors. As a result, businesses like ARW's terminal growth and profit margins would be under more stress than ever.

Latest earnings highlights

ARW reported 4Q22 revenue of $9.32bn which was in-line with consensus. Sales for Global Components [GC] came in at $6.83 billion, while sales for Enterprise Computing Solutions [ECS] totaled $2.50 billion. Gross margin was 12.9%, which was a decrease of 40bps compared to the previous year. This decrease was mostly caused by a return to normal market conditions in the GC segment, but it improved by 10bps compared to the previous quarter due to a better product mix in the ECS business. Operating EPS was $5.69, in-line with consensus.

Demand outlook

According to management, demand creation as a percentage of total revenue increased in the quarter along with design registrations and design wins. All else being equal, I think this is encouraging for the firm's through-cycle margin profile. That said, I don't think these are enough to cushion the upcoming downcycle.

Capital allocation

In 4Q22, ARW repurchased stock worth $300 million and reaffirmed its commitment to returning all excess cash to shareholders. To supplement the remaining $329 million on its current program, ARW has announced a $1 billion share repurchase authorization . ARW will likely keep up its consistent buybacks as I foresee FCF generation to increase going forward as a result of the industry downturns, which have historically been times of higher FCF generation.

Here comes the down-cycle

While I did say that FCF for ARW should increase in a down cycle, the bad news is that a down cycle is indeed on the horizon. In 4Q22, book-to-bill ratios dropped below parity in all regions, and management noted signs of demand moderation, especially in Asia. The reopening of China and its potential effect on local and global demand is still an unknown, but I expect demand to be slow because retailers and wholesalers have had time to stock up on goods for their customers over the past few quarters.

Margins impacted

Downturns in the economy aren't the only thing hurting profits; normalization in shortage market activities is, too. Due to fewer shortage market activities in the Components division, the company's gross margin dropped by 40bps in 4Q22 compared to the same period last year. I expect this will be a drag on profits beginning until product lead times return to their pre-pandemic averages. Management commentaries are in-line with my thoughts as well, which means shareholders have to bite the bullet on this.

Additionally, ARW 4Q22 inventory hit a new all-time high of $5.32 billion. My biggest concern here is that carrying too much stock into a cyclical and possibly protracted downturn will force ARW to do markdowns, thereby compressing margins.

Guidance

ARW's midpoint revenue forecast for 1Q23 of $8.63 billion was 5% higher than consensus. For the GC segment, ARW guided sales of $6.55 billion to $6.85 billion, and for the ECS segment, it guided sales of $1.78 billion to $2.08 billion. Management has guided a midpoint operating EPS of $4.50, which is 9.0% higher than the consensus estimate, using a 23.5% tax rate and a diluted share count of 59.5 million.

Valuation & model

At the current price of $132.51, I think ARW stock is fairly valued by the market. It's clear that the story ARW is telling investors right now is not good: the company is likely to enter a downcycle in FY23 and possibly early FY24. My estimates indicate that the current valuation of ARW, based on consensus figures, is reasonable. As we get closer to FY24, however, when investors begin to look beyond this weak period, you could make the case that ARW deserves to trade at a through-cycle multiple of 9x. However, there isn't much to look forward to on the upside either.

Risk

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

I believe the current stock price of ARW is fairly valued. In 4Q22, the company reported in-line revenue and operating EPS, and management indicated growth in demand creation and design wins. However, book-to-bill ratios have fallen below parity, and demand is expected to be sluggish due to inventory buildup. Gross margin decreased in 4Q22 due to normalization in shortage market activities and high inventory levels. While buybacks are going to continue as ARW generates elevated FCF in a downcycle, I don’t think it is sufficient to cushion the potential growth slowdown and margin compression. Also, the risk from semiconductor manufacturers selling directly is worrisome, potentially reducing market share and profit for distributors like ARW.

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