Avnet, Inc. (NASDAQ:AVT) Q2 2024 Earnings Call Transcript

Avnet, Inc. (NASDAQ:AVT) Q2 2024 Earnings Call Transcript January 31, 2024

Avnet, Inc. isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Welcome to the Avnet Second Quarter Fiscal Year 2024 Earnings Conference Call. I would now like to turn the floor over to Joe Burke, Vice President of Treasury and Investor Relations for Avnet.

Joe Burke: Thank you, operator. I’d like to welcome everyone to the Avnet second quarter fiscal year 2024 earnings conference call. This morning, Avnet released financial results for the second quarter fiscal year 2024 and the release is available on the Investor Relations section of Avnet’s website, along with a slide presentation which you may access at your convenience. As a reminder, some of the information contained in the news release and on this conference call contain forward-looking statements that involve risks, uncertainties and assumptions that are difficult to predict. Such forward-looking statements are not a guarantee of performance and the company’s actual results could differ materially from those contained in such statements.

Several factors that could cause or contribute to such differences are described in detail in Avnet’s most recent Form 10-Q and 10-K and subsequent filings with the SEC. These forward-looking statements speak only as of the date of this presentation, and the company undertakes no obligation to publicly update any forward-looking statements or supply new information regarding the circumstances after the date of this presentation. Today’s call will be led by Phil Gallagher, Avnet’s CEO; and Ken Jacobson, Avnet’s CFO. With that, let me turn the call over to Phil Gallagher. Phil?

Phil Gallagher: Thank you, Joe, and thank you, everyone, for joining us on our second quarter fiscal year 2024 earnings conference call. I am pleased to share that we delivered another quarter of solid financial results, which was in line with our guidance. In the quarter, we achieved sales of $6.2 billion. This was slightly above the midpoint of our guidance, down 2% sequentially and down 8% year-over-year. We achieved operating margins of 3.9% highlighted by a 4.3% operating margin in our Electronic Components business. We’ve been working through an inventory correction on a global basis over the past couple of quarters. In addition, we’re also facing weak and uncertain economic conditions which began in Asia, including China and are now present in the West.

This economic softness has resulted in lower demand with some of our customers, which is being magnified by elevated inventory levels across the supply chain. In the quarter, demand was mixed across the diverse end markets we serve. Defense and transportation markets continue to show relative strength, while demand in the industrial, consumer and communications verticals was relatively soft. As semiconductor lead times continue to improve, the pricing environment remains stable, which is a positive sign. And for the majority of the products, we do not expect overall pricing to decline meaningfully in the near term as we see it today. We continue to manage our backlog and close coordination with our customers and suppliers to align with current softening market conditions.

Our backlog activity is centered on pushouts and reschedules rather than cancellations, which are within a normal range. Shorter lead times, however, are contributing to backlogs being lower year-over-year and sequentially. As a result of these factors, our book-to-bill ratio continued to be below parity, though modestly above last quarter. Although our reported inventory levels were up, the increase was driven by a combination of Supply Chain as a Service engagements and foreign currency. Excluding these items, inventory for our core EC business was relatively flat. And our teams are confident that inventory levels for this core business will come down over the remainder of fiscal 2024. Ken will provide further color on inventory and our supply chain as a service offerings.

As I mentioned previously, we are in the midst of an inventory correction. And our team has done a really nice job navigating it with a focus on optimizing our inventory investments today and reducing inventory levels in the coming quarters. We provide our supplier partners with our best read on true end market demand for our customers. I’ve said it before, we view inventory as a vital asset to fuel our business. But with the near-term sales outlook, we are focused on reducing inventory, were elevated and improving our cash conversion cycle. With that, let me turn to the highlights for our business. At the top line, our Electronic Components business saw mixed results across the regions. In constant currency, electronic component sales were down 1% sequentially and 9% year-over-year.

Sales in the Americas were up 1% sequentially and declined 6% year-on-year with defense and transportation as the strongest end markets. Sales in Asia were up 2% sequentially and down 10% year-on-year. In Asia, transportation and communications were our strongest end markets. EMEA sales were down 7% sequentially and 10% year-on-year in constant currency. It is worth noting that EMEA had near record sales in the December quarter last year, Saragon is up against a tough compare. In EMEA, we are seeing softening in the industrial and transportation sectors. For our Farnell business, as expected, sales and profitability were impacted by softening demand, product mix and competitive pricing pressures. Farnell sales were down 6%, both sequentially and year-over-year in constant currency.

Operating margins for Farnell were 4% during the quarter, which is disappointing but in line with our stated outlook. Despite the greater-than-expected sales decline, we were able to hold our operating margin as we began to see the benefits from some of the cost reduction actions we have already taken. We still believe Farnell has a great potential to deliver value to customers, suppliers and is an important part of the Avnet portfolio. We are focused on improving operating margins near term while further leveraging the breadth of Avnet’s customer base and sales force to identify growth opportunities. Our team is focused on several growth and margin expansion opportunities, including demand creation, IP&E and Embedded Solutions. In the quarter, our demand creation design wins and registrations remained strong, and demand creation revenues as a percentage of total revenue was stable on a sequential basis.

We are also pursuing growth in our IP&E business. IP&E products have higher gross margins, and there are many cross-selling opportunities with IP&E components that are complementary to our semiconductor business. Finally, we see exciting opportunities with our embedded business, where we offer embedded board and display solutions. We have the capability to offer both custom solutions and third-party solutions, both of which come with higher gross margins. We continue to find ways to leverage our global sales force and technical capabilities to capitalize on these embedded growth opportunities. Our supplier partners value Avnet’s ability to create solutions for customers that leverage their entire portfolio of products. The importance of solutions selling highlights why our suppliers continue to support our demand creation efforts.

They are also focused on increasing customer count and leveraging the long tail of the industrial sector to generate growth. Our suppliers continue to part with Avnet and distribution in general to help them drive the growth they are seeking. As exciting as these opportunities are, we are still in the midst of an uncertain market. Over the past several weeks, I have met with several CEOs and decision makers at our supplier partners, representing nearly half of our revenues. The consensus sentiment among this group is that overall market softness will continue for at least a couple more quarters, but could extend through calendar 2024. To conclude, we are confident that our strong competitive position and our experience managing through many prior market cycles will serve us well as we navigate through these choppy waters.

I want to thank our team for their dedication and commitment. We believe our people and our culture are key differentiators for Avnet, which enables us to compete well in any market environment. With that, I’ll turn it over to Ken to dive deeper into our second quarter results.

Ken Jacobson: Thank you, Phil, and good morning, everyone. We appreciate your interest in Avnet and for joining our earnings call. Our sales for the second quarter were approximately $6.2 billion, in line with guidance and down 8% year-over-year. On a sequential basis, sales were down 2% in constant currency as expected due to seasonal declines in the Western regions in the December quarter. From a regional perspective, sales in EMEA and the Americas each declined by 6% and Asia sales declined 10% from the year ago quarter. From an operating group perspective, electronic component sales declined 8% year-over-year and 9% in constant currency. EC sales declined 1% quarter-over-quarter in constant currency. Farnell sales declined 4% year-over-year and 6% in constant currency.

Farnell sales were also 6% lower sequentially in constant currency. Sales of single board computers continue to ramp, increasing 32% quarter-over-quarter. For the second quarter, gross margin of 11.4% was 29 basis points lower year-over-year and 43 basis points lower quarter-over-quarter. EC gross margin was flat year-over-year and declined sequentially primarily due to a seasonal mix shift to Asia. Farnell gross margin was down sequentially and year-over-year, largely due to an unfavorable sales mix and from competitive pricing pressures for on-the-board components. Turning to operating expenses. Adjusted operating expenses were $464 million in the quarter, down 4% year-over-year and down 5% sequentially. Operating expenses were down 6% in constant currency year-over-year.

As a percentage of gross profit dollars, adjusted operating expenses were 66% in the second quarter, 68 basis points higher than last quarter. For the second quarter, we reported adjusted operating income of $242 million, which decreased 19% year-over-year. Our adjusted operating margin was 3.9%, which decreased 57 basis points year-over-year and decreased 23 basis points quarter-over-quarter. By operating group, Electronic Components operating income was $248 million, down 16% year-over-year. EC operating margin was 4.3%, down 43 basis points year-over-year and 34 basis points lower sequentially. The sequential decline was primarily due to a combination of lower sales and a seasonal mix shift of sales to Asia. Farnell operating income was $16 million, down 7% year-over-year.

Farnell operating margin was 4% in the quarter, down 20 basis points quarter-over-quarter and was impacted by lower sales an unfavorable sales mix and competitive pricing pressures related to on-the-board components, which was partially offset by lower operating expenses. As we discussed last quarter, Farnell has begun undertaking a wide range of restructuring actions to reduce operating expenses and improve gross margins. Overall, we are targeting annual expense reductions of between $50 million to $70 million, of which approximately 25% was already completed as we exited the second quarter. The majority of the restructuring actions at Farnell will be completed by the end of the fiscal year. We anticipate the next few quarters will be challenging for Farnell as continued demand and competitive pressures for on-the-board components may dampen the expected benefits of lower expenses.

Although these restructuring actions are necessary to ensure Farnell has a sustainable operating expense model through any cycle, we do not take these actions lightly as they impact our people. Turning to expenses below operating income. Second quarter interest expense of $74 million increased by $15 million year-over-year and increased $4 million quarter-over-quarter, primarily due to higher average borrowings. This higher interest expense negatively impacted adjusted diluted earnings per share by $0.12 year-over-year. Our adjusted effective income tax rate was 24% in the quarter as expected. Adjusted diluted earnings per share was in line with expectations at $1.40 for the quarter. Turning to the balance sheet and liquidity. During the quarter, working capital increased by $328 million sequentially, including an increase in reported inventories of $361 million, $171 million decrease in receivables and $138 million decrease in payables.

As a result of this working capital increase, working capital days were 107 days for the quarter, an increase of 6 days quarter-over-quarter. Our return on working capital decreased quarterly on the higher working capital and lower operating income. Let me take a moment to give more color on inventory and the sequential increase in inventory this quarter. The overall increase in reported inventories was driven by an increase in inventory specific to supply chain service engagements and also from changes in foreign currency exchange rates. Inventory related to our traditional core EC business remained flat and was stable in the December quarter. We continue to have line of sight on incoming inventory while we work through the challenges created by elevated inventory levels across the supply chain.

Although we are disappointed that inventory for our core EC business remains flat, we are confident these inventory levels will start to decline in the March and June quarters. From a supply chain as a service perspective, we continue to see an increase in opportunities for this service offering. The customer base for these engagements are typically large OEMs who have historically done their business directly with our suppliers. These OEMs and suppliers are prioritizing resiliency in their supply chains as a lesson learned from the past few years of component shortages, which is driving an increase in these opportunities. As a reminder, these service engagements are separate from our traditional core EC business as the associated inventory is really the inventory of the OEM or the supplier that we hold on their behalf.

The inventory is contractually restricted and the risk profile is different compared to inventories held for our core EC distribution business. The increase in inventories for supply chain services was specific to a few newer engagements that ramp towards the end of the quarter. We would expect inventories for Supply Chain Services to be flat to down slightly in the third and fourth quarters for our existing engagements. Our team remains highly focused on reducing inventory levels where elevated which will help us drive cash flow from operations in the second half of fiscal 2024. The increase in working capital led to an increase in debt of $279 million. During the quarter, we used $42 million of cash for operations. However, over the past 4 quarters, we generated $169 million of cash from operations.

We expect to generate positive cash flow in the third quarter in excess of the cash used for operations during the first half of fiscal 2024. We ended the quarter with a gross leverage of 2.6x, and we had approximately $493 million of available committed borrowing capacity. With regard to our capital allocation, we continue to prioritize our existing business needs, including working capital and capital expenditures. During the second quarter, cash used for CapEx was $82 million, primarily to support a new distribution center being constructed in EMEA. We expect CapEx to return to historical levels in the second half of fiscal 2024 of approximately $25 million to $35 million per quarter. In the second quarter, we repurchased approximately $59 million of the shares.

We used the cash proceeds from our recent legal settlement to buy back shares during the first and second quarters. We have $232 million left on our current share repurchase authorization entering the third quarter. We also paid our quarterly dividend of $0.31 per share or $28 million. For the long term, we remain committed to our road map of delivering a reliable and increasing dividend and share repurchases to increase our shareholder value when we believe our shares are undervalued by the market. Book value per share improved to approximately $55 a share or a sequential increase of approximately $3 a share. As we generate cash flow from operations in the second half of fiscal 2024, we expect to use the cash for a combination of debt paydown and for buying back shares.

Turning to guidance. For the third quarter of fiscal 2024, we are guiding sales in the range of $5.55 billion to $5.85 billion and diluted earnings per share in the range of $1.05 to $1.15. Our third quarter guidance is based on current market conditions and implies a sequential sales decline of 6% to 11%. This guidance assumes sales declines for the Western regions versus typical seasonality of sales growth and a seasonal decline in sales from Asia due to the Lunar New Year. This guidance assumes similar interest expense compared to the second quarter, an effective income tax rate of between 22% and 26% and 91 million shares outstanding on a diluted basis. Implied in our guidance is an EC operating margin above 4%. Although there is some uncertainty in the overall market environment we are currently in, our team will continue to focus on the things that we can control or influence.

This includes being disciplined with our operating expenses, driving working capital reductions and cash flows and winning new opportunities that drive profitable growth and continued market share gains. With that, I will turn it back over to the operator to open it up for questions. Operator?

See also 12 Highest Quality Camera Phones in 2024 and 11 Best Wine Stocks to Buy Now.

Q&A Session

Operator: [Operator Instructions] Our first question is from William Stein with Truth Securities.

William Stein: I’d like to ask — I was going to ask about inventory, but maybe given the way you addressed it already, it sounds like it’s really more of a supply chain issue. So — a supply chain engagement issue. So let me instead ask about that. We’ve heard Avnet talk about supply chain engagements for quite some time. I wonder if you can talk to us about the differences between that business and the more traditional electronic components distribution whether it might warrant reporting the revenue separately and the inventories for that separately? And maybe talk about the different dynamics there sort of inventory turns in that business versus the core returns on invested capital, other metrics that you’re targeting in that business? And I do have a follow-up, if that’s okay.

Phil Gallagher: Yes. Will, thanks. This is Phil, and I’ll probably turn it over to Ken. So — and that’s what we’re working to clarify in the script, okay, to start breaking that out a little bit more. And we’ll pull that string as we move forward. Supply chain is kind of a generic term, too. That’s why we’re kind of defining it as a service because supply chain is what we do. And you’re right, we’ve been doing that for years with our traditional supply chain and our traditional core customers, whether it be consignments of implant stores, compound, point of use replenishment systems, et cetera, et cetera. That still exists. That’s still a big part of our business. The ones that we’re kind of breaking out in the call today and we started to a couple of calls ago, the supply chain as a service are really large OEMs that maybe traditionally weren’t utilizing our supply chain services that are now coming to us.

And they are different financial models, different inventory carrying and working capital models, even with different financing. So that let me turn it over to Ken. He can give articulate a little bit more color on that. But I appreciate the question. We’ll continue to work to break that out and explain more in the future. Ken?

Ken Jacobson: I’d just say, the message we want to kind of convey is that the broader inventory for the EC business is stable. We’re disappointed that it hasn’t gone down yet, right, because that’s something the team is actively driving to do, but we do see line of sight to some reductions in that core inventory to go in the next couple of quarters. As the supply chain as a service inventory, I mean that happens to be our accounting, our reporting, is within our inventory. We’re beginning to give a little bit more color at least on the balance sheet will. So I think the path for further clarity would be first on the balance sheet and then moving to the P&L as those engagements ramp. And so here’s how I’d characterize the difference.

I mean, I think the first thing, these are really large engagements typically, right? So the magnitude of the throughput of components is much bigger. And that’s mostly driven by the fact that the, let’s say, the end customer here in these service arrangements are typically large OEMs. And what we try to comment on it, these are the ones that we typically haven’t been doing business with because they have direct relationship with suppliers and they have their own partners they use. And so this is new opportunities for us because we haven’t really played in the big OEM space. So transportation is one opportunity, but it’s really across all end markets that we’re seeing, including, let’s say, communications and networking and things like that.

But typically, the engagements are driven by the OEM. And typically, what’s happening is we’re kind of procuring on their behalf the inventory that they were normally buying at their pricing most likely, right? So they might have a direct contract or other pricing. So it’s not, let’s say, normal course fulfillment or anything like that. This is really buying based on their contract. And so the main difference we see is the inventory profile we try to talk about it’s not really our inventory even though we report it as such. It’s their inventory, there’s contractual restrictions, right? So it’s really providing the service on their behalf. So from an overall profile, typically the gross margin is better, but it’s not really a top line revenue because of the fact that it’s services revenue versus revenue from the sale of components.

From a return on invested capital, return on working capital, it’s at or above typically where other engagements would be at. We look to find creative working capital solutions for these types of engagements. In some cases, we’ll finance it or we’ll fund it through our own working capital or borrowing capacity. But a lot of times, we’re either trying to have the OEMs bring cash to the table or looking for third-party programs to help us finance that and our commitment really not only to our supplier partners, but also to our teams is the fact that we’re really not trying to restrict our existing business, right? We want to have this be and, not an or, and so we really don’t want to consume our working capital to fund these engagements because we want to protect that for the normal horse of business to grow our long tail of customers and things like that.

So hopefully, that adds the color you’re looking for. And again, we’ll continue to add transparency as these things ramp and get bigger.