ARW - Avnet: Adjusting To The Normalization Of Supply Chains

2023-08-18 02:17:39 ET

Summary

• Semiconductor supply chains are returning to normal, creating a new demand environment for companies like Avnet.
• The company reported positive financial results for Q4 2023, prompting a 3% increase in stock price.
• Metrics like profit margins and cash generation are important to assess AVT's adjustment to the new normal.

The semiconductor supply chains are coming back to normal after the constraints seen in 2021 which even persisted until last year. As such, this creates a new normal for companies like Avnet ( AVT ) located at the very center of the electronics supply chain as I will elaborate on later. In this respect, the company reported its fiscal fourth quarter 2023 (FQ4) financial results two days back when it beat both revenue and non-GAAP EPS estimates, prompting investors to reward the stock with a 3% upside to trades at around $49.

Going against this market optimism, the aim of this thesis is to realistically assess whether the company is adjusting to this new normal, and for this purpose, I will mainly consider metrics like profit margins and cash generation.

First, I highlight the demand-supply situation as well as the inventory position.

Supply Chain Normalization, Inventory, and Cash

According to a Federal Reserve update dated March 6 this year, global supply chains have normalized to the point of being comparable to the period before COVID-19. Noteworthily, the pandemic disrupted procurement networks throughout the world from the end of 2019 as factories in East Asia followed by others in Europe and later in the U.S. were shut down to avoid workers being infected by the virus thereby creating shortages for everything from big machinery to tiny microchips which equip all of today's electronic devices.

Later, while most of the world reopened for business in the later part of 2021 after being injected with immunity-boosting vaccines, lockdown measures continued in China well into 2022. As a result, because of the order backlog created, the demand for chips increased prompting some foundries that produce them to increase prices. Now, there are talks about the inverse happening.

In these conditions, for a company like Avnet which is primarily a distributor of electronic components and whose stocks are made mostly of finished goods, it is essential to consider the inventory level. In this respect, as the supply chain normalizes, customers tend to order fewer goods on a precautionary basis which in turn translates into less demand. Thus, the company has reduced its sales guidance for the first quarter of fiscal 2024 (FY1-2024) to the $6.15 billion-$6.45 billion range.

As such, with its role as a middleman between suppliers and customers, the company needs to manage its inventory level well so as not to suffer from a surplus of stock which may have to ultimately be liquidated at a discount, and at the detriment of the cash flow. Now, as charted below inventory has increased rapidly and reached $5.5 billion in the latest reported quarter, and, according to the management, it may go up again in FY1-2024.

However, according to the management comments during the earnings call, this will be only a temporary increase as inventory is expected to "stabilize". Also, as a result of having readily-available items to be delivered to customers, the company will likely continue to generate cash. For investors, the cash flow generated in FQ4 was $235 million which is a significant achievement given that the company has been consuming money in operations for the most part of the last three years.

Still, this will depend on demand being sustained and in this case, Avnet has continued to see strength in key verticals like transportation, automotive, and industrial (defense and aerospace) which have offset the effects of order cancellations. In this respect, the book-to-bill (or ratio of new orders to completed sales) in the last reported quarter was the same as in FQ3-2023.

Next, I look at margins.

Profitability Impacted

In this case, gross margins are another metric to look for when the supply chain is getting back to normal. The reason is that during periods of high demand, both suppliers and middlemen tend to command better pricing power which they can not only pass on to customers but also take advantage of the situation to charge higher. For Avnet, this should have translated into high gross margins in the 2021 and 2022 period, but, as shown in the chart below, this has not been the case with the figures for fiscal 2021 and 2022 being lower than those in 2018 and 2019, or before the pandemic.

This confirms the executives' stance that they "merely pass along price increases to customers without marking them up", for the company's Electronics Components segment. Therefore, as a result of having established long-term customer relationships, it appears unlikely for the company to face pricing pressures whereby customers ask for lower prices to take advantage of the lower demand environment. Also, certain high inflation-adjusted input prices incurred by suppliers do not currently support the case for lower pricing.

However, there is pricing pressure for the Farnell segment which sells more value-added products like industrial automation and testing kits. In this case, there has been high inventory build-up due to the way products are sourced, and, its dollar value has also depreciated due to unfavorable Foreign exchange conversions and higher inflation-driven prices. Additionally, this has led to higher operating expenses. As a result, Farnell's operating margins have fallen to 8.1% and should not climb back to the 10% historical level for the next several quarters.

As to demand, while it is slightly down in South East Asia, it is holding up better in EMEA (Europe and Middle East Africa), and North America. Detailing further, revenue growth in EMEA was 17% YoY, far higher than the 7% for the Americas while there was an 11% regression in Asia.

Looking ahead, the opposite is expected for FQ1-2024 (which covers the August-October period), with sales in the West expected to decline more as part of seasonal variation while those in the East should increase modestly.

Valuing Using Peer Comparison

Thus, as a result of the combined effect of a reduction in higher-margin European sales and Farnell (as a higher margin business compared to Electronics Component as pictured above) continuing to suffer, adjusted diluted EPS is expected in the range of $1.45 to $1.55, which represents a significant decrease from the above $2 obtained in the preceding six consecutive quarters.

Now, this represents a 38% cut in earnings expectations which is a lot for a company that has beaten both earnings and revenue expectations 12 times during the last twelve quarters implying zero misses. Moreover, looking across the industry, Avnet's performance has been better compared to bigger competitor Arrow Electronics ( ARW ) whose revenue of $8.51 billion for the June quarter missed estimates by $220 million and represented a regression of 10% YoY. Also, Avnet has managed to beat EPS by nearly 25% compared to only 0.07% for Arrow.

On top, the peer comparison below shows that Avnet's P/S multiple trades at a discount of over 37.5% (0.22-0.16)/0.16) compared to its larger peer which is abnormal given its better financial performance.

Thus, adjusting for a 15% upside, I have a target of $56.3 (49x1.15) based on the current share price of $49. This optimism also stems from the reduction in debt by about $51 million with the gross leverage now at 2.2x. Also, the expectation is for cash to be again generated from operations during the next quarter. Moreover, considering that the relatively elevated capital expenditures which were incurred for constructing a warehouse in Europe during fiscal 2023 will be absent in 2024, this should ultimately benefit the free cash flow and ensure the availability of money for dividend payments. For shareholders, the company paid $27 million in quarterly dividends during FQ4-2023.

Moderating in View of Risks

Still, adopting caution, $56 represents a moderate target as it is subject to the $5.5 billion valued inventory being consumed which is in turn subject to expected demand materializing. In this case, there may be an adverse impact on sales due to China's post-Covid recovery which was initially uneven and has now become problematic. At the same time, there is also the situation in the U.S., where the latest data shows that the Federal Reserve could show continued hawkishness, to address the persisting inflation problem.

Moreover, attaining profitability targets also depends on suppliers not charging higher due to their input costs going up, which may result in Avnet facing pricing pressures from customers. This may reduce the ASP (Average Selling Price) as has been the case in the past.

In conclusion, and as pictured below, this thesis has shown that Avnet has reached a peak in both quarterly earnings and revenue growth in FY-2023 . Looking forward, to FY-2024 and beyond, both metrics are estimated to regress.

Still, I have a buy position, as the management has significantly reduced its guidance to adjust to the normalization of the supply chain. Then, there is also the company's ability to continually outperform when announcing quarterly results. Finally, it was equipped with $288 million of cash at the end of July and has readily available finished goods to convert into liquidity.

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