Description

I am recommending a long in Avnet.

Avnet is the world’s largest semiconductor distributor with 24% share of the third-party distribution market, versus 20% for WPG and 20% for Arrow. Third-party distribution has historically represented ~25% of the served addressable market (versus 75% by direct sales). Chip suppliers like NXP, Broadcom, Xilinx, etc. generally use distributors like Avnet to reach small and midsize customers that are difficult and expensive to serve directly.  While semiconductors are often associated with cyclical markets for PCs, tablets, and mobile phones, Avnet is primarily a distributor to a customer base of ~110k small and medium sized customers across a diversified base of mostly non-PC/tablet/mobile end markets ( ~15% military / aerospace, ~17% industrial, ~13% communications, and ~8% medical exposure). ~70% of the business comes from low-margin supply chain services (inventory management, warehousing, etc.), while ~30% of revenues typically from “demand creation”, where they receive higher margins and favorable rebates from suppliers by basically providing an extended sales force function on behalf of chip suppliers through an internal corps of technically-knowledgeable field application engineers. The business is reasonably attractive and has historically generated LSD growth and low-double-digits returns on capital, though that has been depressed for reasons I will talk about later.

Avnet has undergone significant positive change over the past two years. First, the Company divested its low-margin, secularly challenged IT distribution business to Tech Data at a highly attractive valuation, becoming a pure-play on its more attractive semiconductor business. As a result, Avnet is now under-levered with a high-quality balance sheet and continues to generate strong free cash flows, which the Company is redirecting towards aggressive and highly accretive share repurchases (~$460mm remains on the existing authorization = ~9% of the market cap; this is on top of ~$400mm already repurchased in the past twelve months). Second, the Company upgraded the Management team after some very significant screw-ups that the new Management team is now working through. The new CEO and CFO has brought much greater operational discipline into the business. The Company has hired McKinsey to architect a transformation plan and is working through 450 workstreams (centralizing pricing, managing inventory, expanding e-commerce, improving field application engineers) to restore operating margins from a depressed ~3.5% level to its historical 4-5% margins. Third, the Company has been investing significantly in its e-commerce platform where it distributes chip products through a web platform and acquired a digital catalogue distributor in the UK called Premier Farnell to accelerate these efforts.  E-commerce is a meaningful opportunity for Avnet as it is a much higher margin channel (I estimate ~10%+ operating margin channel) and allows Avnet to reach deeper into its SMB customer base. Furthermore, e-commerce is meaningfully underpenetrated in the chip market versus other areas of distribution (i.e. industrial distributors) and represents an attractive long-term business opportunity.

These positive developments have been overshadowed by several negative ones that the Company is now working through. First, one of their most important suppliers, Analog Devices, acquired Linear Technologies and decided to drop Avnet for its competitor Arrow. As a result, Avnet lost a very significant and high margin supplier. Second, the previous Management undertook a disastrous ERP implementation that ultimately failed (warehouses were forced to process orders manually), and the ERP failure created significant shipment disruptions to customers. This ultimately led to the CEO’s terminations. During that process, several key chip suppliers freaked out and Avnet lost some other important supplier authorizations. Then, after telling investors that the ERP system had been stabilized, the Company announced that they had to re-do their ERP implementation, incurring significant capex in the current fiscal year and adding further disruption risk.

The good news is that ERP system looks to be finally stabilized, incidents are now coming down significantly (down 90% y/y), and the elevated capex cycle experienced in the fiscal year should start to improve over the next few years. Furthermore, Avnet was been holding significant excess working capital to support customers and suppliers as they underwent the second round of the ERP implementation. As the ERP system has stabilized, Avnet now has the opportunity to work off significant excess working capital, freeing up a lot of free cash flows for further share repurchases and investments in the business. Lastly, Avnet has been winning some high-quality chip authorizations to replace the lost of Analog, and feedback in the industry suggests that Avnet has turned the corner on recent issues and making the right investments.

I believe now is an attractive time to invest. As the Company rebounds from the impact of recent issues, where there are early indicators, works towards the low-end of its 4% margin goals, and right-sizes its balance sheet with continued share repurchases, I believe Avnet can potentially earn $6.50 per share by 2020 on LSD revenue growth. At 10x P/E, that is a ~$65 share price for up 50%. On the downside, the stock is now trading below its book value with a high-quality leverage position, where a significant amount of that book value is comprised of inventory where Avnet is price-protected from obsolescence by the supplier. Book value has historically been a good “floor” for the share price, and book value should grow as they generate earnings and continue to repurchase shares below book value. I believe the risk/reward is attractive.  

Catalyst

Share repurchases, new authorizations, improving margins