|Shares Out. (in M):||85||P/E||8.7||8.0|
|Market Cap (in $M):||6,689||P/FCF||7.9||7.4|
|Net Debt (in $M):||3,149||EBIT||1,286||1,326|
Thesis / Summary
Arrow is a high-quality company with attractive returns on capital and strong EPS growth that is often overlooked by investors because it’s a seemingly boring business in the tech sector that has a limited number of peers. Arrow is typically considered a simple semiconductor distribution business, but the company also provides a healthy menu of value-added services that create deep ties with its customers. I view Arrow as more of a partner than a traditional distributor or supplier. The company has grown its EPS at 11% over the past 15 years, driven by mid-single-digit organic sales growth, stable margins, and counter-cyclical cash flow attributes. Yet, it trades at 8.7x NTM EPS (or about a 50% discount to the S&P 500). I think the company should be able to sustainably grow its EPS at 10% and believe the stock has over 50% upside to fair value.
Business and Industry
Arrow is a leading global value-added supply chain and logistics provider. Basically, it provides economies of scope, acting as a middle-man between a highly diversified supplier base (its largest vendor is 9% of sales) and a fragmented customer base of more than 200,000. It has nearly 350 locations in 80 countries and has had long-standing relationships with both its suppliers and customers, including well known brands such as GE, Boeing, Tyco, Flex, and Lucent.
I had been familiar with Arrow, but viewed the company as more of a simple semiconductor distributor. However, over the past year, I was conducting due diligence on Microchip, which is a semiconductor manufacturer that provides chips for many industrial enterprises. Microchip also has a fragmented client base and I questioned how they maintain such strong relationships with so many different customers. Surprisingly, they said they rely heavily on companies like Arrow and Avnet that not only distribute their product, but also help implement their solutions.
The value to the vendor is that Arrow provides an efficient and cost-effective route to a fragmented market, world class logistics, service, and marketing. The value to the customer includes expertise design assistance, scale purchasing power, financing, and inventory management. Arrow is agnostic to which chips it pushes through and is somewhat considered a non-biased, independent consultant for chip consumers, who will seek Arrow’s opinion in obtaining the most efficient solution.
Within their Components distribution business, roughly 2/3 of the sales are simple fulfillment transactions. But, 1/3 of the business is higher-margin, value-added solutions where Arrow provides engineering and design support. For example, Arrow recently did a project for a large grocery store chain where they designed a store-wide set of chips to track inventory, alert employees of product spills, and sense if a refrigerator door is open. The common perception is that an end customer typically deals directly with the semi-manufacturer, whereas many times the distributor plays a large role in the process.
Roughly 70% of Arrow’s sales and 65% of operating profit come from the components business described above, while the remaining is derived from its Enterprise Computing Solutions (ECS) segment, which provides comprehensive computing resources, including data center, cloud, security, and analytics services.
The ECS business is primarily focused on on-premise datacenter spending, rather than the hyperscale datacenters, where Arrow does not have a meaningful presence. While there is some thought that the large datacenters will account for most of the future capacity, Arrow has been experiencing a strong growth in storage and server sales over the past year. If anything, they believe there will be a shift back towards on-premise datacenter spend as certain workloads and use cases do not makes sense for the public cloud, like big data or AI. I believe that a hybrid cloud will be the long-term winning architecture, which is a positive for Arrow’s business. That said, Arrow sells software-led solutions. Software is 50% of Arrow’s ECS billings, compared to 20% storage and 10% servers.
Having both the components business and the enterprise computing solutions capabilities has become a differentiator and competitive advantage for Arrow. This is particularly true within the evolving Internet of Things market. Electronics, such as Nest Thermostats, Ring cameras, Fitbit watches, Refrigerators, and Washing Machines are becoming increasingly connected to the cloud and the data these products can provide. The hardware companies are evolving and must also tie into this new hybrid model by having data center capabilities. Arrow is the perfect partner to help implement this holistic solution. No other company has this combined offering, with Avnet having sold their enterprise business to TECD a couple of years ago.
For more context on this topic, watch this interview with one of Arrow’s employees:
Industry and Competitive Landscape
Distributors, in aggregate, control about 20% of the total $500b semiconductor market. Within the distribution channel, Arrow is the second largest player with 11% market share, behind WPG at 12% and ahead of Avnet at 10%. Beyond the top 3 players, the market is quite fragmented. WPG is private, but compared to Avnet, Arrow has performed much better. Arrow’s operating margins in their components business have been about 5% versus 3% for Avnet. I think the reason for that difference is that Arrow’s strategy is more focused on the value-added engineering offering. And while business is typically sticky, Arrow was able to win about $1b of business from Avnet (from suppliers such as ADI, SLAB, CY, and ALTR). At first, these new relationships will be more related to simple fulfillment but should evolve to more value-add. Over the past five years, Arrow has organically grown its sales at an average of 8% per year.
In the Enterprise Computing Solutions business, Arrow competes with TECD (which purchased the business from Avnet) and Synnex. Compared to these peers, Arrow is much more weighted towards software and services. This shows in its profitability, as Arrow has enjoyed around a 5-6% operating margin versus roughly 3% for both Avnet and Synnex.
Competitive Advantage, ROIC, and Balance Sheet
Arrow has averaged a 15% return on tangible capital for the past 10 years. Its scale, market share, and scope are the main reasons for its strong profitability, but there are other nuances to the business worth mentioning. First, Arrow is not in the commodity game, which is more competitive, but rather focuses on all-inclusive solutions that should provide better returns. Second, a supplier makes more money on a chip sold through distributors than directly to customers and is, thus, incentivized to sell through distributors. This is commonly misunderstood but makes sense as the vendor doesn’t need to carry the support system for that chip sale (credit, logistics, sales force, overhead).
Another critical attribute of the company is its highly resilient balance sheet. Arrow enjoys return rights or price guarantees on most of its inventory, which also is covered 200% by accounts payable. And, most importantly if sales decline, the company throws off cash. This was evident in 2007-2009 when Arrow produced over $15 of free cash flow per share versus just $8 of EPS. Thus, at 2.2x Net Debt-to-EBITDA, Arrow is within a comfortable leverage range.
Over the past 10 years, Arrow has traded at ~10x NTM P/E (on average), despite growing its EPS at well over 10% per year. My base case is that Arrow should continue to grow its earnings at a double-digit rate and if it traded at a 12x multiple in three years, that would be about 85% upside (or a 23% IRR).
One common concern with Arrow is its exposure to the “semiconductor cycle.” The semiconductor industry has evolved considerably over the past 20 years as chipmakers outsource a larger portion of their manufacturing, making the industry far less prone to booms and busts. Furthermore, only 10% of Arrow’s business is exposed to smartphones or PC’s which are more likely to be cyclical. Lastly, management is not seeing any meaningful signs of inventory builds in the channel.
Another perceived risk is that suppliers could move more to a direct sales model. But, as mentioned above, chipmakers make more profit by selling through the distribution channel.
Last, there is a fear of secular pressures in their Enterprise Computing business. But, Arrow has shifted their business model towards services and software, which now make up about 65% of their sales compared to 10-15 years ago when hardware was 75% of revenue.
Continued EPS growth and multiple expansion.
|Entry||04/03/2019 04:42 PM|
thanks for an interesting writeup. While the company has generated a cumulative ~$3 billion in operating profit over the past 3 years, it has generated just $250 million in cumulative FCF (OpCF- Capex), which is one of the worst FCF conversion rates I’ve seen. Do you know 1) why FCF conversion has been so poor and (2) to what extent do you think it will improve? Thanks
|Entry||04/03/2019 05:00 PM|
hey WeighingMachine, it is pretty simple. There is a meaningful drag from net working capital that they need to fund their strong organic growth. Over the past three years, they have grown their net working capital by $1.7b. But, NWC / Sales has stayed roughly constant, so this is just normal part of the business (sales have increased by 30%). And, given they earn a 15%+ return on tangible capital, that's a great use of capital. Especially since they have protective return rights on the inventory!
The beauty of the business is that if sales slow, this will turn into a source of cash. In 2008/2009, net working capital freed up $700m and that was on a sales base that was 1/2 of what it is today.
The company has estimated that in the current environment, if sales grow at a 5% rate, it would be able to hold net working capital flat.
Hope that helps.
|Subject||Re: Re: FCF?|
|Entry||04/04/2019 10:44 AM|
singletrack, i liked your write up and have taken a brief look this morning.
by my numbers, since '06, the invested capital base of the company has grown by $5.8b and NOPAT has grown by ~$390mm. That equates to a 6.7% incremental return.
is there reason to suspect that ARW will be able to reinvest above its cost of capital going forward? if so, it is certainly cheap. if not, less so.
|Subject||Re: Re: Re: FCF?|
|Entry||04/04/2019 10:49 AM|
what do you think is the normalized organic rate of rev growth and ebit growth over the next 4-5 years?
what is normalized tax rate?
|Subject||Re: Re: Re: FCF?|
|Entry||04/04/2019 11:26 AM|
thanks rhubarb. By my numbers since 2010 (I dont have 2006 pulled in), tangible capital has grown by $2.5b and NOPAT (using a 25% tax rate) has grown by $360m, which is a 14% ROTIC. That's consistent with their overall ROTIC. Including intangibles (which also measures their return on acquisitions), the number is 10%. Also, good. And, that is unlevered.
For tax rate, I think 25-30% is appropriate. But, at the end of the day, I think tax rates have a more dynamic impact on profitability than folks often consider. If two companies are competing in an industry and targeting a 12% return (after-tax) and both of their tax rates drop, then they should just pass that savings through via lower prices and still earn a 12% return. My point is that I'm somewhat agnostic to the tax rate (unless of course there is a difference between where two companies operate) and more focused on after-tax return on invested capital.
|Subject||Re: Re: Re: Re: FCF?|
|Entry||04/04/2019 11:27 AM|
ARW has organically grown faster than GDP for the past five years and I think they will continue to grow at least in line with the global economy going forward. So, let's say 4-5% sales growth.
And, remember, if sales do decline or slow, then they just throw off more cash to benefit shareholders.
|Subject||Re: Re: Re: Re: FCF?|
|Entry||04/04/2019 11:40 AM|
got it. i went back to '06 bc I like to measure from similar parts of economic cycle. But i understand your point. Thanks for response.
|Entry||04/04/2019 12:18 PM|
Condor, I agree with everything you said. My view is always to find the best securities priced cheapest to the present value of their discounted cash flows. Admittedly, I may disagree on which discount rate should be used (or multiple, which is part of why I think the stock is such a good opportunity). But, like you said, if the multiple never gets above 10x, but they are able to grow at 10% EPS, then my return should be mid double digits. Not bad.
Also, a benefit of having a low multiple with a stock that throws off cash is that there is an inherent "put" in place as they are able to retire more shares per dollar of cash flow and keep earnings growth healthy.
That said, you could have made the exact same argument for Ingram Micro five years ago and then, one day, private equity comes along and buys you out at a premium.
I love having a portfolio of healthy seeds planted in the ground without knowing when they might sprout.