ARW - Arrow Electronics: Weakness In Semiconductors Creating Challenging Hurdles

2023-11-19 23:44:33 ET

Summary

• ARW is experiencing declining sales and inventory buildup due to weakness in the semiconductor industry.
• Arrow Electronics' net margins are better than peers but its growth outlook is not promising.
• Management plans to reduce inventory and improve lead times, but uncertainties surrounding the business warrant a hold rating.

Summary

Arrow Electronics, Inc. ( ARW ) provides products, services, and solutions to both industrial and commercial users of electronic components. It operates in two segments: Global Components and Global Enterprise Computing Solutions.

I am recommending a hold rating for ARW as the weakness in the semiconductor industry, in general, is causing its sales to decline in the third quarter. On top of that, its inventory buildup is concerning. However, management expresses their intention to reduce it starting in the next quarter. Its growth outlook isn't as promising as well, but I note that its net margins are better than peers. Therefore, all these led me to give a hold rating for ARW for the time being.

Financials

When I analyse ARW's past few years' financials, it's clear that its business is cyclical in nature, and this is not a surprise to me as they operate in the semiconductor industry, which is a cyclical sector. In 2020, its sales were flat due to the pandemic. In 2021, it grew ~20% once global lockdown was over and demand for semiconductors rose. In addition, the global semiconductor shortage also significantly boosted demand as customers rushed to stock up on inventory. After this rush, there was a glut, which resulted in its sales gradually declining. Despite the ups and downs, ARW managed its margin exceptionally well, as its gross margins stayed flat during this period at ~12%. Net income is also very consistent at ~3%.

Valuation

Based on my view of the business, I anticipate an 11% decline in ARW's sales for FY23, followed by an 8% decline for FY24, and these assumptions align with the market consensus. This projection is influenced by its third-quarter sales decrease of 14% and the overall weakness of the semiconductor industry as discussed. Currently, it is plagued by high inventory levels, which might be eroding its margins due to the costs associated with them. However, I do note that management is taking active measures in the upcoming quarter to reduce its inventory. Therefore, I expect its margins to remain relatively stable at about 3%.

Peers overview:

ARW now trades at ~8x forward PE, which is lower than the peers' median. Although ARW's net margin of ~3% greatly surpassed peers' median of 1.45%, its poorer sales growth outlook offset it. For 2023, ARW is expected to decline by 11% based on Managements' fourth quarter forecast of $7.50 to $8.10 billion in sales, while peers' median is a positive 2%. Overall, the weakness in the semiconductor industry is taking its toll on everyone, but ARW is getting hit harder. With such a poor outlook, it's fair to use its current 8x forward sales. With a modest upside of 8%, I recommend a hold rating for the time being due to the uncertainty surrounding ARW's business.

Comments

ARW reported 3Q23 sales of ~$8 billion when compared to 3Q22 ~$9.2 billion, which represents a decrease of 13.6% year over year. When looking at segment levels, both global components and Enterprise computing solutions decreased by 14% and 10% year over year, respectively. On top of declining sales growth, its consolidated gross margin contracted to 12.2%. Overall, it looks like ARW is having a tough time. The decline in results was mainly driven by weakness in the semiconductor industry. The semiconductor industry's sales decreased 4.5% year over year in September. Ever since 2022, semiconductor sales growth has been declining and has never recovered back up above 0% growth.

Apart from declining sales and gross margins, inventory buildup has always been a key concern for ARW. In this quarter, its inventory increased again. High inventory levels can severely impact ARW in many ways. Firstly, holding costs will erode into its already low margins. Secondly, it also creates cash flow issues as cash flows are tied up in inventory. Lastly, it might hurt its declining sales even more if ARW must clear excess inventory and sell it at a discount. However, this time round, management explained the reason that they increased its inventory was because of an attractive opportunity that they could not forgo. If it did not seize this opportunity, its inventory could have decreased. Moving ahead into the next quarter, ARW will continue to downsize its inventory levels when it converts its backlog. Thus, ARW's inventory is expected to decline in the next quarter onwards.

The lead times for ARW are normalizing as end-market customers trimmed down their inventory. When end-market customers trim down inventory, it often leads to improved inventory management practices which encourages more stable ordering. Stable ordering creates stable demand which allows ARW to streamline its production process, scheduling, and supply chain, which leads to improved lead time. In addition to lead time improvements, ARW also gains more visibility into short- and medium-term demand. This increased visibility aids ARW in managing the dynamics of mixed end-market demand and makes it easier to gradually reduce the accumulation of delinquent backlog.

ARW's working capital management is impressive. Even though sales declined 14%, it still manages to improve its operating cash flow [OCF] by reducing working capital. The reduction helped it generate a strong $322 million in OCF in this quarter vs last year's same period of $141 million. In the future, as ARW targets to reduce its inventory levels, I expect this to contribute towards reducing its working capital which will improve its OCF for the next quarter and into 2025. With this strong OCF generation, I anticipate ARW to continue its share buyback program and return value back to shareholders.

Risk & conclusion

There is a risk that if the semiconductor industry were to recover faster than expected, it might cause ARW's next quarter's result to surpass expectations. If the decline in sales is not as bad as anticipated or if it reports a slight positive improvement, given its much better net margins, ARW's multiple will expand towards peers' medians. An improvement to 10x forward PE will have a potential upside of 35%.

Due to the overall weakness in the semiconductor industry, ARW's third-quarter results took a hit as consolidated sales declined and sales across all segments declined as well. On top of these, its inventory buildup is concerning as well. On the flip side, as customers trim their inventory, it improves ARW's lead time, which gives them visibility into demand and helps reduce delinquent backlog. In addition, although sales declined, its impressive working capital management actually improved its OCF. Although its growth outlook is weaker than its peers, it surpassed its median net margins. However, on the back of its weak outlook, I am recommending a hold rating until I start to see improvements in its sales.

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