Arrow And Avnet: Key Players In The Components Supply Chain


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Both Avnet (NASDAQ:AVT) and Arrow Electronics (NYSE:ARW), two electronics components value-added distributors have outperformed the iShares Semiconductor ETF (SOXX) which holds some of the manufacturing industry’s top names from the beginning of this year, during a period marked by higher inflationary pressures and supply chain issues.

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Data by YCharts

The question is whether this outperformance can continue in the face of growing uncertainty, this time with respect to the demand side.

Thus, the aim of this thesis is to assess how these two companies can fare going ahead, and for this purpose, I start by providing insights as to their importance in the supply chain for components used to manufacture anything from automobiles, computers, and mobile phones to wearables.

Importance in the Supply Chain

These companies may differ in their market caps (as per the table below), the way they are structured, the specific markets they serve, or the suppliers they have agreements with, but they both play an essential role in the components supply chain. I coined the term “value-added distributors” as they add value in terms of services and design in the electronics ecosystem.

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Peer comparison (www.seekingalpha.com)

In other words, both Arrow and Avnet are positioned between OEM manufacturers which need components to manufacture cars or computers and the suppliers which produce them. This is rather a simplistic view as there are many more stakeholders and component types involved here with these two companies orchestrating the supply chain itself with its multitude of OEM manufacturers, subcontractors, and suppliers.

Moreover, far from passively transmitting client orders to suppliers, they actively aggregate these using analytics tools for forecasting patterns of consumption. It is only afterward that they place orders.

In addition to their logistics role, these companies are also involved in product design whereby they support companies in redesigning circuit boards with their teams of field application engineers (FAEs) using advanced design tools for the purpose. In this way, by participating in the manufacturers’ design process, Arrow and Avnet are able to create demand for specific chips manufactured by selected suppliers, while at the same time ensuring their timely supply. For their effort, the two companies are rewarded by the suppliers whose components get the go-ahead for the manufacturing part.

Now, in normal circumstances, FAEs mostly work with smaller companies or entrepreneurs who want to test new ideas. In contrast, large computer manufacturers like HP (HPQ) or Dell (DELL) prefer to use in-house talent to design products. In so doing, their own engineers select the components and issue sourcing orders to the two distributors.

However, in the current supply chain-constrained environment exacerbated by Chinese lockdowns, where conventional lead times have become stretched and even hurt the topline of networking equipment producers like Cisco (CSCO), corporate executives are thinking differently. Thus, both Avnet and Arrow are getting more phone calls for design work, and integrating value-added services like product design into the distribution process has resulted in higher gross margins for both the two companies as shown in the chart below, with Arrow (in blue) leading.

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Charts built by the author using data from (www.seekingalpha.com)

However, achieving margins and return on capital also depends on the ability to sell products lying in inventories rapidly in order to avoid money sitting idle in warehouses for too long.

Inventories and Return on Capital

Looking at the U.S. manufacturing industry, there is currently an imbalance between, on the one hand, the low inventory levels of component suppliers like Taiwan Semiconductor Manufacturing (TSM) and on the other, the high stock levels of OEM manufacturers.

As for Arrow and Avnet, both companies’ inventory levels have increased rather steeply from the beginning of 2021 as shown in the chart below. Now, given the high-demand environment for everything to do with electronic goods and the solid backlog (or orders not yet fulfilled), this additional inventory should normally not constitute a problem for the two distributors as it should be converted to sales as part of the seasonal business cycle.

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Data by YCharts

However, in the case of a worst-case recession scenario, things may turn out to be different.

In this case, looking deeper into the inventories, instead of increasing in volume, they have rather increased in terms of components that hold more value per unit (cost more), as these are the ones that manufacturers could not lay their hands on earlier in the supply crunch. Thus, manufacturers may have high inventory levels, but, they can’t do without the components lying in the distributors’ inventories in order to produce the finished products.

As to pricing power, despite navigating through the various variable costs like commissions, freight, and logistics, the two companies have been able to pass on costs to customers, which partly explains their recent gross margin gains and increase in returns on investments.

Looking at returns, Arrow has a significantly higher return on invested capital at over 16% as shown in the blue chart below. This is explained by its much higher revenue level compared to Avnet. Furthermore, Arrow’s operating expenses as a percentage of total revenues are also lower at 7.7% compared to Avnet’s 8.56%, signifying that it is more profitable.

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Data by YCharts

On the other hand, Avnet has a lower debt to equity ratio than Arrow and pays dividends at a yield of 2.2%. Also, the company’s non-GAAP EPS for the third quarter of 2022 beat consensus by a whopping 39% whereas Arrow achieved 19% in Q1-2022. Now, both these quarters end in April 2022, and Avnet’s higher earnings growth largely explains why investors have rewarded it with better year-to-date price performance.

Valuations and key takeaways

Higher price performance is the reason Avnet bears a higher non-GAAP price to earnings multiple as shown in the table below, but given that its revenue growth for the last reported quarter was 31.96%, or nearly four times Arrow’s 8.21%, it means that it should be valued more in terms of trailing price to sales ratio. Making an adjustment based on Arrow’s P/S of 0.25x and Avnet’s current share price of $45.8, I obtain a target of approximately $57 (45.8 x 0.25/0.20).

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Peer Comparison (www.seekingalpha.com)

As for Arrow, one of the reasons it has seen less revenue growth than its peer is because of its product mix, namely hardware-related (computing) sales facing supply-side challenges in the last reported quarter. Going forward, there could be a short-term demand-related weakness, with the situation only improving in the longer term as the company’s hardware backlog continues to grow against the backdrop of sustained hybrid-cloud demand. Thus, unless you want to invest for the long term, Avnet is not a buy for the time being.

Pursuing further, I have a buy rating on Avnet, but, investors are warned that the stock could dip further in the current highly volatile market conditions where there is a lot of uncertainty about the Federal Reserve’s ability to combat inflation in a smooth manner. Some economists are even talking about a temporary economic contraction, which could see the S&P 500 falling to below the 3600 level. Thus, some may prefer to wait for the dust to settle before buying the stock.

Finally, both Arrow and Avnet play key roles in the supply chain, and with their deep understanding of the supplier ecosystem, their functions as providers of products with better cost metrics in addition to the time factor are likely to become more pronounced. At the same time, with more regionalization (as opposed to globalization) of component sourcing in the future whereby new foundries like GlobalFoundries (GFS) are gradually added to the equation, costs should rise. This said, with digital transformation and electrification, companies should continue to increase semiconductor density or the number of chips used in the same electronic device, thereby guaranteeing sustained revenue streams for the two companies.



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