Arrow Electronics, Inc.
Q2 2010 Earnings Call Transcript

Published: 29 Jul 2010

[Operator:]

Good day and welcome to the Arrow Electronics conference call to discuss the second quarter earnings. As a reminder, this call is being recorded. At this time, I’d like to turn the call over to Greer Aviv for opening remarks and introduction. Please go ahead.

[Greer Aviv:]

Good afternoon, everyone, and welcome to the Arrow Electronics’ second quarter conference call. I am Greer Aviv, Manager of Arrow’s Investor Relations program, and I will be serving as a moderator on today’s call. If you would like to access today’s call via webcast, please visit our investor relations website at www.arrow.com/investor, and click on the webcast icon. With us on the call today are Mike Long, Chairman, President and Chief Executive Officer; Paul Reilly, Executive Vice President, Finance and Operation and Chief Financial Officer; Andy Bryant, President, Global ECS; and Peter Kong, President, Global Components. By now, you should have all received a copy of our earnings release. If not, you can access our release on the investor relations section of our website. Before we get started, I would like to review Arrow’s Safe Harbor statement. Some of the comments to be made on today’s call may include group’s future looking statements, including statements addressing future financial results. These statements are subject to a number of risks and uncertainties that could cause actual results or facts to differ materially from such statements for a variety of reasons. Detailed information about these risks is included in our SEC filings. We will begin with several minutes of prepared remarks, which will then be followed by a question-and-answer period. As a reminder to members of the press, you are in a listen-only mode on this call, but please feel free to contact us after today’s call with any questions you may have. At this time, I would like to introduce our Chairman, President and CEO, Mike Long.

[Mike Long:]

Thank you, Greer, and thanks to all of you for taking the time to join us today. The second quarter was another outstanding quarter for Arrow; as we achieved record level second quarter revenue and earnings per share. Both business units drove the strength in this quarter with continued strong momentum in global components sales, which increased 44% year over year, and better than expected sales growth of 21% year over year in ECS. In addition, our cash flow generation was very good and came in well ahead of our expectations. Operating income growth substantially outpaced sales growth on both the year-over-year and sequential basis. Our operating income margin reached the highest level since the fourth quarter of 2007. Earnings per share more than tripled year over year, substantially ahead of our revenue growth. And we also had a new record for return on working capital, which exceeded 36% in the second quarter and is more than two times greater than a year-ago level. Return on invested capital is also near record levels. These results clearly demonstrate our commitment to sales excellence, operational excellence and the ability to maximize shareholder value. Time and time again, we have proven our ability to manage well through cycles. As you will hear more in detail later in the call, all of our components regions contributed to the superb second quarter results, and we continue to see an upward trend in gross margin. Both the global components and the global ECS businesses posted sales ahead of normal seasonality. We’re especially pleased with our enterprise computing solutions business, with their better-than-normal seasonal sales growth, driven by good double-digit growth in practically all of our products. Our teams around the world have worked diligently to deliver industry-leading results in what is still a recovering global economy, and their dedication to Arrow has certainly paid off. Following the end of the second quarter, we achieved another milestone in our global ERP implementation with the successful go-live in our northern European components business on July 6th. As a result of this go-live, the global components team in northern Europe is now managing critical activities, such as demand creation, quote-to-order, order-to-invoice and other crucial processes with the new system. More importantly, we have not missed an order, receipt of inventory or shipment in northern Europe this month. The transition in this region was seamless, thanks to our CIO, Vin Melvin, and his global team for a job well down and to Brian McNally and the European components team for ensuring a true partnership with the IT team, all working for our collective success. As we have previously mentioned, the pace of activity in northern Europe is 10 times the pace of the activity that we had in the implementation of the Australia-New Zealand conversion. Our solid cash position and strong balance sheet has enabled us to continue to invest in initiatives to grow the business, including our vertical markets, geographic expansion, expansion of our value-added services and our global ERP implementation. We also increased our investment in inventory this quarter, as lead times remain extended and the supply chain is constrained. We’re working to smooth the supply chain for our customers and to keep production moving. During the quarter, we completed the acquisition of Converge and Vertical, as well as announced and completed the acquisition of Sphinx Group Limited, a UK-based value-added distributor of security and networking products. The addition of Sphinx strengthens Arrow ECS by bringing increased scale to Europe and then additional expertise in the high-growth security and networking information technology markets, in addition to a highly talented team and an expanded line card. Cumulatively, these acquisitions are expected to be accretive to earnings by $0.05 to $0.10 per share on an annual basis. In addition to the $0.10 to $0.12 accretion from the A.E. Petsche acquisition we closed in December 2009. I’ll now turn to our business results. Global component sales of $3.3 billion reached a new record level, and we’re ahead of normal seasonality as we saw exceptional sales growth in all of our components region in the second quarter. The Americas, sales continue to rebound, and we are now approaching levels last seen in 2001, driven by strength in both the semi and PEMCO businesses. Operating income in the region more than doubled year-over-year. Our focused efficiency initiatives in Europe and improved market conditions in the region resulted in impressive year-over-year sales growth while operating income had been extraordinary compared to this time last year. Asia Pacific posted its second quarter $1 billion sales level, a record level of operating income dollars. The upward trend in gross margins for the global components business carried into the second quarter, as gross margins expanded 170 basis points year-over-year and is up 40 basis points sequentially. Moving on to current trends, lead times remained extended, bookings increased continually throughout the quarter along with our daily run rates, and book-to-bill in components is above 1.1 on a global basis and is at the same levels we saw in Q2 of 2009. Importantly, we have seen no meaningful change in cancellation rates. Our quarterly survey of approximately 300 customers in North America shows the outlook for purchase requirements heading into the third quarter remained robust. As always, we’ll continue to monitor the behavior of our customers and suppliers closely. We are confident that we’re well positioned to take advantage of opportunities in the marketplace and ensure we outperform the market. Our enterprise computing solutions segment sales of $1.4 billion increased 21% from the same quarter a year ago. Sequentially, sales increased 22% and we’re above normal seasonality and our expectations. Storage, software, services, and industry-standard servers grew at very strong double-digit rates on a year-over-year basis. Sequentially, we saw a very strong growth in proprietary servers along with industry-standard servers, storage and software. Sales growth has been better than expected in ECS and many of our strategic investments and key solution segments are paying off. With our explosive growth in storage and software and an increase in industry-standard servers, our sales mix and business model are changing. At Investor Day, we committed to a $20 million annual efficiency initiative and ECS based on our completed ERP rollout of North America. These savings come from gaining full back office benefits and better resource alignment in our sales coverage models. We executed $8 million of cost savings in June, and we expect the remaining $12 million of actions to [dipper] in Q3. These efficiencies will enable us to maintain our position as the leading provider of value-added enterprise computing solutions. In summary, our performance this quarter was terrific. The second quarter results proved further confirmation of our dedication to a strategic objective while continue to manage the business at best in class levels. Our strategic evolution to a sales excellence organization through profitable market share growth, gross profit optimization and continued operational efficiency is evident across our organization and can be seen in today’s results. Paul will now give you a more detailed review of the second quarter financials.

[Paul Reilly:]

Thanks Mike. As reflected in our earnings release, there are a number of items that impact the comparability of our results with those in the trailing quarter and the second quarter of last year. I will review our results excluding these items to give you a better sense of our operating results. As always, the operating information we provide to you to be used as a compliment to our GAAP results. For a complete reconciliation between our GAAP and non-GAAP results, please refer to our earnings release for the earnings reconciliation slide at the end of the webcast presentation. Second quarter sales of $4.6 billion were ahead of our expectations and represent an increase of 36% year-over-year, an increase of 9% on a sequential basis. This is the third consecutive quarter of year-over-year sales growth coming out of the downturn and represents a record level of revenue for Arrow. Operating income grew more than 2-1/2 times on a year-over-year basis. Global component sales of $3.3 billion increased 44% year-over-year and 4% sequentially, an increase of 46% year-over-year and 7% sequentially, excluding the impact of foreign exchange. Gross margins increased 170 basis points year-over-year and increased 40 basis points from the first quarter that rebounded to 2008 levels. We reduced our ratio of operating expenses to sales to a near record low level this quarter, as we have remained focused on operational excellence and running the business at best in class levels. Our operating profit grew five times and four times faster than sales on a year-over-year and sequential basis respectively, again demonstrating exceptional expense control and operating leverage in our business. And our operating margin increased 300 basis points year-over-year, that’s more than double last year and 70 basis points sequentially. This represents the highest level we have seen in any quarter since the second quarter of 2007 and is above the low end of our long-term targets. All of our regions have seen operating margins rebound to levels in line with or above their respective financial targets. We continue to exceed expectations of our suppliers and customers on a global basis, which is a testament to our commitment to operational efficiency. Disciplined working capital management resulted in a 110 basis point year-over-year decrease in working capital to sales to a record low second quarter level. Our returns on working capital more than doubled and exceeded 32%. This is the highest level of returns on working capital we’ve seen in the last 10 years. Sales in the Americas increased 54% year-over-year and 11% sequentially, substantially ahead of normal seasonality. Our growth is driven by strength across the board in both semis and PEMCO, with notable sales growth seen in the aerospace and defense and lighting markets. Daily run rates improved throughout the quarter, and our backlog is up from the first quarter. Our operating income grew 114% year-over-year and 20% sequentially, that’s more than two times faster than sales year-over-year. Operating margins in the Americas increased almost 220 basis point year-over-year and 60 basis points sequentially. And looking ahead to the third quarter, we would again expect sales to be above normal seasonality in the Americas. The pace of recovery in our European business remained strong as sales increased 52% year-over-year and were off slightly on a sequential basis to $968 million, ahead of normal seasonality. Excluding the impact of foreign exchange, sales were up 60% year-over-year and up 8% quarter-over-quarter. This out performance was driven by strength in all regions in our core business, particularly Central Europe. We saw solid growth in a number of vertical markets including an all-time record level sales in transportation and lighting, and lighting continues to be our fastest growing segment. Our daily run rates were up strong double digit compared to the year-ago period and to a level similar to the sales we saw back in the second quarter of 2008. We continue to see the benefits of our efficiency initiatives in the region as operating expenses for sales declined 460 basis points year-over-year to a level last seen in 2001. Operating income growth has been outstanding and is up almost 70 times last year’s depressed levels and up 13% above the first quarter. Year-over-year and sequentially, operating income significantly outpaced sales growth, while our operating margin has returned to 2007 levels. Looking forward, we would again expect sales growth to be above normal seasonality. Our Asia-Pacific business achieved a record level of sales, gross profit and operating income in the second quarter. Sales growth continued to be strong, increasing 26% year-over-year and growing 1% sequentially of a better than expected first quarter. Our core broad line business was particularly strong, growing by more than 50% year-over-year and 10% sequentially. Growth in the quarter was driven by strength in China and Hong Kong, but we saw strong performance in a number of vertical markets, including lighting, industrial, PEMCO and automotive. Operating profit was up 153% year-over-year and 31% sequentially and increased considerably faster than sales growth. Operating income margin doubled compared to last year’s second quarter to that of the highest level since 2000. Looking ahead to the third quarter, we’d expect sales to be in line with expectations for the market’s growth in that region. Global enterprise computing solution sales increased by 21% year-over-year and increased 22% sequentially to $1.4 billion in the second quarter, ahead of our expectations and above normal seasonality. As Mike mentioned earlier, we have seen a change in our product mix and a shift in our business model. However, we remain focused on managing well our costs and improving productivity, which resulted in an increase in operating profit of 25% year-over-year and 80% sequentially. The second quarter, again, demonstrated the leverage we had in the ECS model, as operating income grew almost four times faster than sales growth on a sequential basis. And looking ahead to the third quarter, we expect sales to be in line with the low end of normal seasonality. Geographically, sales in North America were well ahead of normal seasonality, increasing 32% from the first quarter. On a year-over-year basis, sales increased an impressive 22%. Strong top-line growth coupled with focused expense control resulted in an increase in operating income of 30% year-over-year and 79% sequentially. Operating profit grew 2-1/2 times faster than sales sequentially and return on working capital is at record levels. In Europe, sales were relatively in line with our expectations. Excluding the impact of foreign exchange, sales increased 28% year-over-year and 12% sequentially in line with the high end of normal seasonality. Our efficiency initiatives in the region resulted in an increase in operating profit of 28% from the first quarter, and operating income outpaced sales growth by almost 14 times. Return on working capital in Europe was more than double or more than doubled year-over-year to a record level and is now almost two times of corporate average. Our consolidated gross profit margin was 12.8%, an increase of 90 basis points year-over-year representing a significant improvement in the pace of recovery in our margins. And in fact, we have seen a 130 basis point improvement from the low point in the third quarter of 2009. On a sequential basis, gross margin increased 10 basis points. This marks the third consecutive quarter of gross profit improvement on a consolidated basis. Importantly, gross margin in our core components customer base increased 20 basis points from the first quarter. Operating expenses as a percentage of sales decreased 130 basis points year-over-year and decreased 60 basis points sequentially to 8.5%, representing a record low second quarter level for Arrow and a near record low level for any quarter in our history. Operating income was $194.8 million, an increase of 177% year-over-year and an increase of 28% sequentially. The results this quarter, again, demonstrate our ability to outgrow the market, improve gross profit margins, and the significant operating leverage we have in our model with operating income growing three times faster than sales on a year-over-year and sequential basis respectively. Operating income as a percentage of sales increased 210 basis points year-over-year and effectively doubling and a 60 basis point increase sequentially. Tax rate for the quarter was 31.6% and you should assume, for modeling purposes, it will remain between 31% and 33%. Net income was $121.3 million, that’s up 226% compared with last year and up 31% sequentially. Earnings per share were $1.02 and $1.01 on a basic and diluted basis, respectively. This is a new record level of second quarter earnings per share for Arrow. Cash flow generation was again very strong this quarter and came in ahead of our expectations. We generated almost $65 million in cash flow from operations in the second quarter while investing in the business to support growth. In addition, during the quarter, we repurchased $75 million of our stock, leaving us with $25 million under the board authorization. The board has also authorized management to acquire additional $100 million, bringing the total that can be spent on future buybacks to $125 million. Focused management of working capital resulted in a 100 basis point year-over-year decline in working capital to sales, as we continued to manage efficiently all the leverage within working capital. This represents a record low level for any second quarter in our history. As Mike mentioned earlier, return on working capital more than doubled year-over-year, the highest level yet. From an inventory standpoint, our Q2 inventory turns in North America were 5% better than Q2 in 2008. In Europe, returns are better than Q2 2008 by 10% and finally in Asia, we are 30% better than Q2 2008 in inventory turns. Lead times in 2008, I think we’ll all agree we’re much nearer to normal and today we are extended in the period of lead times. And just to be clear, returns in the second quarter of 2010 were better in every region than 2009 second quarter. So we look at this as good performance. Working capital management in general and inventory specifically remains a critical aspect of our strategy as we go forward. Our balance sheet and capital structure remains strong with conservative debt levels, and the net debt EBITDA ratio is less than 1. This gives us strength to participate to a greater extent in the marketplace. Our financial position remains extremely strong with $1.1 billion in committed liquidity facilities in addition to our cash. We have the flexibility to take advantage of opportunities in the marketplace and finally return on investment capital increased 2-1/2 times over last year’s second quarter to 14.3%.

[Mike Long:]

Thank you, Paul. In summary, our results speak for themselves this quarter, with record level revenue and earnings per share, exceptional returns and very good cash flow generation. Our components business posted another terrific quarter with each of our regions experiencing continued momentum and robust growth trends while generating significant increases in profitability and returns. In ECS, sales growth exceeded our expectations. We substantially improved profitability, and again, delivered exceptional working capital management. I think it’s important to point out again that we did emerge stronger from the downturn, and we are executing on our strategic objectives of profitable market share growth, operational excellence and an increasing mix of value-added services and capabilities. We are in a period of accelerating sales right now, and we believe we are outgrowing the market. There is significant earnings leverage inherent in our model, and we expect to generate premium earnings and returns for all of our shareholders. I would personally like to thank all of our employees around the world for a job very well done and their unwavering commitment to our long-term success. Looking ahead to the third quarter, we believe that total sales will be between 4.39 and 4.79 billion, with global component sales between 3.32 and 3.52 billion and the global enterprise computing solutions sales between 1.07 and 1.27 billion. As a result of this outlook, we expect earnings per share on a diluted basis, excluding any charges to be in the range of $0.96 to $1.06 per share. Greer.

[Greer Aviv:]

Thank you, Mike. Please open up the call to questions at this time.

[Operator:]

Thank you. The question-and-answer session will be conducted electronically. (Operator Instructions). And our first question, we’ll hear from Craig Hettenbach with Goldman Sachs.

[Craig Hettenbach:]

Yes, thank you. Mike, can you provide any more detail on the increase in inventory? How the bill progressed through the quarter? And then also what you’re hearing from your suppliers in terms of the constraints and when they might free up a bit?

[Mike Long:]

Sure as we’ve said, I’ll answer this and I’ll let Paul put some numbers around it. We still see supply constraints in many of the products that we’re selling and conversely to that, we are still seeing good customer demand. What we’re attempting to do is to increase our inventory to make sure that we can supply our customers their needed products to keep production going. And how we’re doing that is, we have our customers now giving us a little longer view into what their production needs are, and that’s helping us balance our inventory to level that should help over time smooth out the supply chain, and it will also help our suppliers get their products to market faster as they’re in the supply constraint period by satisfying more customers. Paul, you want to add to that?

[Paul Reilly:]

Great. From a pace of increased point of view, we saw an up-tick in the first month of the quarter and then another up-tick in the second month and then it flattened out for the third month as we’d expect. Keep in mind though that the sales activity is strongest also in the third month of any quarter, so that’s the way the pace went. We’re trying to manage working capital in total. So we actually saw an increase in inventory at the end of the quarter. We also increased accounts payable. So we’re profiling inventory to meet the needs of our customers as they need it.

[Craig Hettenbach:]

Got it, and then Andy, if I can follow up on the systems, the outlook for the low end of typical seasonality, does that reflect the stronger than expected Q2 or anything else you’ve seen in that market?

[Andy Bryant:]

It’s a little bit tight to the strength of Q2 but also to the seasonality of Europe, which we typically see a little slower business climate in Europe during the summer. So, we’ll have to see how the quarter plays out.

[Paul Reilly:]

Just one other point around that, we’re not quite sure what normal seasonality will be going forward quite honestly Craig, because we’re seeing a change in the model, right Andy? So what we’re seeing is obviously a change in the channel. So, we’re trying to evaluate that at the same time. So, really what we are building on or comparing normal seasonality, two is really a period in time before the model changed. So, it’s a little bit tough to say whether it’s a strong Q2 or products, etcetera. It’s really a change in the model in general.

[Craig Hettenbach:]

Okay. If I could just follow up on the comment on Europe, anything new to report in terms of customer sentiment there or what you’re seeing for Europe specifically in systems?

[Mike Long:]

No, in systems we have not seen an impact in our business. You saw the numbers that we just reported in Europe for Q2, and so quite honestly business has remained pretty strong.

[Craig Hettenbach:]

Okay, thank you.

[Operator:]

And next we’ll hear from Amit Passi with UBS.

[Amit Passi:]

Hi, thank you. I just wanted to follow up on that comment. You talked about potentially a change in seasonality in your computing solutions segment. Hoping you can elaborate a little more, I didn’t quite get that?

[Paul Reilly:]

Yeah, well [Inaudible] and maybe Andy can jump in if I don’t get it right, which is we know that the Sun model is changing with the business being managed now by Oracle. So that change in the model is going to impact seasonality from the standpoint of what drives year ends and pricing around intra-quarter months.

[Andy Bryant:]

Yeah, I would just add that our mix with software and services changes the way we look at seasonality and we’re also heading into, with proprietary servers, we’re heading into the September through December timeline where that typically builds. So, some of this plays out normally. And then, as Paul mentioned, because of our mix change, a little bit of a different percentage looking at Q3.

[Amit Passi:]

Okay, got it. And then just with respect to supply chain constraints, any updates in terms of where you’re seeing some of the biggest pain points, any incremental color?

[Mike Long:]

Sure, I can help you with that. We saw average lead times increase to a range of 11 and 19 weeks, that was up a little bit from last quarter, which we had at 10 to 18 weeks, and Q2 of 2009 when it was really down to the 7 to 13 week range. Sequentially, I’d say the biggest increases we saw were in discrete, analog and electromechanical products. Lead times for the passives came in about one and a half weeks on the high end compared to last quarter. And I would say over the next three months with the exception of memory, discrete and programmable, as well as passives are probably stable to up, standard logic, analog, electromechanical and connectors are stable, and I’d say the expectation for us in embedded is also up a little bit. We see the supply chain, if you will, acting efficient, and that’s the reason that you can see that we have worked to increase our inventory and get levels, so we can smooth the demand patterns to our customers a little better.

[Amit Passi:]

Great and then just one final question. I think, if I include the September quarter, you basically would have seen five consecutive quarters of better than normal seasonality in your components business. Mike, just curious, when do you think we should get back to seasonality, would it be the December quarter? And then, do you have any concerns that we probably could see below normal seasonality as we exit 2010 into the first half of 2011? All I can tell you, I hope it never stops to answer your question, if hope is involved. But what I can tell you is this, our bookings did increase continually throughout the quarter, and so did the daily run rates of our bookings. Our book-to-bill line components was still above the 1.1 level on a global basis and it’s the same level we saw in Q2. Now, if I go along with that, we’ve seen no meaningful change in cancellation rates, and then I compile that with our survey of our top 300 customers in North America, it really showed the outlook for purchase requirements headed into this next quarter remained strong and robust. And it’s still at about four times stronger than a year-ago level. So we have not seen incoming orders increasing - or we haven’t seen a decline in incoming orders or an increase in cancellations, and we are seeing better fulfillment of hard to get parts from our inventory to customers, so we are still in pretty good shape going into the next quarter.

[Amit Passi:]

Thanks a lot for the incremental color. Okay.

[Operator:]

And next we’ll move to Jim Suva with Citi.

[Jim Suva:]

Alright, thank you very much and congratulations to you and your team on our great results and the profitability is very commendable. Can you talk a little bit more on the inventory, exactly how much of it was organic versus I believe you closed three acquisitions in the quarter? And then on that inventory, it seems like, if I get this right, the supply chain with the EMS companies having some shortages and you guys having product available and you’re helping to smooth stuff, some people are kind of saying well, hey, it looks like Arrow may have double ordered some inventory and is sitting on a lot. Help me understand exactly why you need to carry so much inventory and if things are so tight, how come you haven’t been able to clear it, because clearly a sale today is better than a hope for a sale tomorrow.

[Paul Reilly:]

Hey Jim, it’s Paul. Let me lead off with your question around the impact M&A. In fact, if you think of the three acquisitions, Sphinx is one in the ECS business, which you know has inventory turns that are 20 to 30 times. The second one was in Converge, which has very low inventory requirements and high inventory turns. So that was less than $10 million for Converge, less than about $10 million for the Sphinx acquisition. And the other acquisition has no inventory at this point in time. So if you look at it, about $20 million of increase comes from M&A and the rest is organic growth.

[Mike Long:]

Yes Jim, what I would also add is we saw our inventory start to come in towards the end of the quarter and given what the lead times were, many of those investments were placed a quarter ago, if you will. So we’re starting to get the inventory for the orders we had, we still did go out of the quarter with good demand, but as that inventory hit, some of what you see is a little bit of timing issue as well as what I would say strategic investments we made in certain products going into the third quarter.

[Paul Reilly:]

And then finally Jim, one last piece of statistical information. If we look at inventory turns in Q2 in the global components business, they are still above seven turns, and our business model is not really built to have seven turns, it’s actually something less than that. So in fact, the record turns we ever hit was Q1 2010, and we felt we were running too hot, quite honestly. So that’s how I look at it from a statistical point of view. The turns in the second quarter of 2008, while not at the Q1 record levels we set are at levels comparable to the previous records we have set. So, we’re looking at it a service level opportunity for us and not really concerned at this point in time that the levels are out of control or are not manageable.

[Jim Suva:]

And with the lead times three to six months, is it fair to say that since you’ve placed these orders earlier in the year, that then as time rolls forward that next quarter we should also see another bump-up since lead times three months ago were also pretty lean?

[Mike Long:]

Yes, I think Jim, what we would see is something that would be more flattish with what we have right now at the end of the second quarter.

[Jim Suva:]

Alright, thank you and congratulations again for great results, especially on the profitability.

[Mike Long:]

Thanks a lot.

[Operator:]

And Matt Sheerin with Stifel Nicolaus will have our next question.

[Matt Sheerin:]

Yes, thanks, and good afternoon. So a question on your gross margin, which was obviously up nice year-over-year and sequentially. I know that some of it was mix related, but how much of it was a benefit from overall pricing, given that you do have inventory and you do have certain customers that are asking for expedited orders, which obviously puts you in a better position. So, is your pricing helping you here?

[Paul Reilly:]

Hey Matt, it’s Paul. Let me first start off by saying that gross profit was up year-over-year in all regions, and that has nothing to do with mix. So look at each of the individual regions and you look at two business segments, so we were up in each region around the world.

[Matt Sheerin:]

Okay.

[Paul Reilly:]

Most of the up I would say has been as we’ve been getting the inventory, we’ve also been working on longer term orders and if you remember as we started to talk to you about the GP decline, Matt, when you go to buy a car, the car that’s on the lot is much cheaper than the car you need three months from now, and our ability to strategically place our inventory has had an impact for us. The changing demand requirements, though, I might add for you, in aerospace and defense we’ve seen an increase quarter-over-quarter. We’ve seen the alternative energy market pick up for us substantially as well as the lighting market. And with the added design win work, you’ll remember we talked about the increase in design wins and design activity we had which would lead to higher gross margin for us, those are really what account for it.

[Matt Sheerin:]

Okay, so it’s a mix in business, increased value add, but also opportunistic or strategic buying, where you’ve got inventory that you’re buying ahead of market price increases and you’re getting a benefit there; is that fair?

[Paul Reilly:]

I think that’s fair, but that would be the least amount of it, because as you know the ability to really build inventory at a great pace right now isn’t there given the extended period of lead times.

[Matt Sheerin:]

Okay, great. And just finally on your comments about components, it looks like Asia was up about 1%. Is that seasonal? It looks like it might be a little bit less than seasonal? Are you starting to see any signs of sluggishness in Asia at all?

[Paul Reilly:]

Hey Matt, yes. It is what we consider less than normal seasonality, but you got to bifurcate two businesses. So, when you look at our core broad line business in Asia Pac, we were up 10% on a sequential basis, which is above normal seasonality. In our ultra source business, that’s where we saw a drop-off around low end handsets. So, when you really look at it, there was very good growth in our broad line business and more of a short-term settlement in the marketplace for the ultra source business.

[Mike Long:]

Matt, I think I can help you a little with the Asia Pac piece is that, we still saw a consumer very strong. The data processing business, the industrial business, the lighting business and the automotive business were all up more than double digits. The only place we saw a slowing in Asia Pac region, which is what equates to our ultra source business, was in the communication market. Every other market there, we did see relatively strong increases quarter-on-quarter. So we can pinpoint it directly to the communications business.

[Matt Sheerin:]

Okay, so the book-to-bill in Asia in that core business that you talked about, is that in line with the company average then?

[Mike Long:]

Yes.

[Matt Sheerin:]

Okay, alright, thanks a lot.

[Mike Long:]

Alright.

[Operator:]

And we’ll move on to Brian Alexander with Raymond James.

[Brian Alexander:]

Maybe just one follow-up on inventory. If you’re buying inventory to meet production schedules, with inventory up 22% sequentially in the June quarter, why wouldn’t you expect your component sales to be up more than mid single digits in terms of your Q3 outlook, and then I have a couple of follow-ups in the computing business.

[Paul Reilly:]

Sure Brian, its Paul. So, once again we have to parse the businesses, right. So we’re seeing good sales growth in North America and Europe well above normal seasonality is the first reason why our inventory is up. Second reason is that we see this as an opportunity for us to take advantage of the marketplace. You may recall we’d spoken about this over the last six quarters or so, but we said we would use our balance sheet opportunistically to be able to drive and get more market share. So that’s why we were deciding to hold a bit more inventory, to be able to take advantage of disruption in other customers. Not our customers, but other customers’ supply chain. It’s an opportunity that we see. It’s a strategic move we see to be able to get new customers and new market share by having the inventory on hand that’s either in short supply or very difficult to get.

[Brian Alexander:]

Okay. And then just on the computing business, the Sun Oracle relationship, how much incremental revenue do you think from here is at risk? And is that really what the primary delta is in terms of your Q3 outlook, relative to what we would consider to be normal seasonality, although I realize that’s changing?

[Andy Bryant:]

Yes Brian its Andy. We’ve seen in our entire proprietary server portfolio, we almost got back to a little growth in the second quarter and Sun was actually the second strongest line in the quarter. So, I think our risk is mitigating. I think we see an opportunity actually to have an upside in Europe. We are undergoing an expansion with Oracle Sun in Europe as they look at the countries that they want to roll out their value-added distributor model in. We’ve been assigned a global account rep from Oracle, which is a positive sign. So we just have to see how their product cycles play out and where they go with their hardware sales, but I think we are getting to the point where the risk of revenue decline is going to mitigate a bit.

[Brian Alexander:]

And then final question, how should we think about, maybe for Paul, the operating margin progression for the computing business in the back half of the year, given that your largest supplier is refreshing its mid range line, and this tends to have above average margins. So that would suggest that your mid range of mix probably gets better in the back half of the year, certainly in Q4, and you’ve got incremental cost savings. I think you said earlier of about $12 million going forward. So should we expect some pretty meaningful operating margin expansion in the computing business on a year-over-year basis in the second half?

[Mike Long:]

Your analysis is correct. Its the pace of new product introduction that picks up in the fourth quarter around proprietary service. We should see a good uplift in operating margin.

[Brian Alexander:]

Thank you very much and nice job.

[Mike Long:]

Thanks Brian.

[Operator:]

And William Stein with Credit Suisse, will have our next question.

[William Stein:]

Great, thanks. I’m wondering if the component shortages that you discussed limited your own revenue in the quarter, on the component side in particular obviously.

[Mike Long:]

That’s an interesting question. We believe that we’ve been going at it the last several quarters with about the same amount of unfulfilled orders. So pending the orders flopping into the next quarter, we think right now we are doing a pretty good job filling what we have and we would expect to stay on that pace. If you really look at how we’ve positioned ourselves, we’ve seen the business start to materialize in the desing win activity that we had discussed in the previous several quarters, and those are really key products for our customer base and it’s important that those are the products that we have on the shelf, as well as that mix of products is a higher margin product for us and is helping to lead some of our margin expansion efforts, but I don’t believe that it would be a significant amount of increase in sales if we would have fulfilled every one of those quarters.

[William Stein:]

It sounds like there was some mixed opportunity, but it didn’t increase sequentially.

[Mike Long:]

Yeah. Anytime you have an extended lead-time situation, you always have mixed opportunity. It flows all the way back from the supplier, through us and to the customer. And as these shortages abate a little, there will still be opportunities, but the customer needs the full bill of material or products, so they can go into production, and when you miss one and they don’t go into production, you do not realize that. But today, from what we are hearing from our customers, the standard flow of production and the line down situations are much much less than they were a quarter ago and even a quarter before that.

[William Stein:]

Okay, and then like everyone else I’m also going to focus on systems for a second. It looks like if assuming the Converge and Vertical revenue was contemplated in the guidance, it looks like organic growth is down about 18% sequentially, which it looks like well below the low end of what used to be typically seasonality. So first, is my math correct there, down about 18%? And then second, with Sun changing, I would assume that that would kind of moderate the seasonality instead of exaggerate the seasonality that we’re seeing, let’s say from June to September, but generally throughout the year? I’m a little confused there. I’d appreciate any help understanding that.

[Paul Reilly:]

Hey Will, it’s Paul. A couple of points of clarity from our side. The Converge business is part of the component segment, and Sphinx is part of the ECS segment. Second thing was, their results were not included in our guidance, because we were not sure of the actual closing. So we did have one month of Converge and a couple of weeks of Sphinx, so it really didn’t have a meaningful impact on sequential growth or anything like that. So by our counts, sequentially sales increased 22%.

[William Stein:]

That’s the September guidance.

[Mike Long:]

Oh, sorry about that.

[William Stein:]

Yeah.

[Mike Long:]

Yeah, so we still think we’ll be within the low end of normal seasonality for Q3.

[William Stein:]

Thank you.

[Operator:]

And next we’ll move on to Steven Fox with CLSA.

[Steven Fox:]

Hi, good afternoon. Not to beat a dead horse on the inventories, but is there any way to parse the difference between, say the fast-moving parts in the components inventory and the slower moving parts? And then secondly, could we step back and look at the computing business from a cyclical standpoint. Any signs that you would point to that the cycle has legs beyond say Q4 of this year that would be encouraging to investors at this point.

[Paul Reilly:]

Steve it’s Paul. I’ll take the first question, which is around the quality of the inventory. We have seen very little dollar change in what we might call slow moving inventory. So we look at the quality of the inventory, it’s all fresh by moving product at this point in time. So we don’t see any meaningful growth around the globe in that business. In fact, if my recollection was right, we still see improvements in Asia-Pac and in Europe, and we saw a small increase -- what I mean by small increase of less than $20 million in North America, in that bucket of inventory.

[Steven Fox:]

Okay.

[Mike Long:]

Steve, I’ll try to add a little color if you will, to what we are seeing on the IT side of the house. We do see spending returning to more normalized levels. We do see some areas growing faster than others. As an example, everyone knows proprietary servers were suppressed going into the quarter, but we did see a 21% increase in proprietary servers quarter-over-quarter and they actually outpaced the increase in industry standard servers for the first time in a long time. Our storage products are still growing very strong year-over-year in the 29% range. Having said that, as we are looking to the seasonally strong fourth quarter, right now, we see no reason to expect anything other than normal seasonality going into the second half of the year here.

[Steven Fox:]

That’s encouraging. Thank you very much.

[Mike Long:]

Right.

[Operator:]

And just a five-minute warning. Next we’ll move to Brendan Furlong with Miller Tabak.

[Brendan Furlong:]

How are you doing everybody? Earlier on in the call in the preamble, you said that the gross margin is in an upward trend. Nobody seems to have challenged you on that one and I was just curious if you could throw some color on what that upper trend actually means.

[Mike Long:]

Yeah. From our viewpoint, you may recall that we saw a rapid sharp decline in gross profit entering the economic malaise if you will, that started in 2008, and we said that the recovery would continue slow, slow for sure, about the same pace as the downturn. So we continue to see on a region-by-region basis improvement in gross profit percentage. So we still see that momentum continuing into Q3 and we see normal seasonality, which is fully our expectation into Q4. Then we would expect to see that GP continue to move upward.

[Brendan Furlong:]

And I know you are not going to endorse this, but assuming that the last four or five quarters were above normal seasonality we’ve had in components, certainly leading clients to a halt, what do you think the impact will be on that improvement in gross margin situation in terms of regressing or what have you?

[Mike Long:]

Well from my viewpoint, and you are right, I’m not going to endorse the idea that’s kind of growing to a halt. I think one of the things that we ought to keep in mind as we start to count the number of quarters and we think it’s four, not five, but anyway whatever it may be, is we’re coming off in an unusually low level of revenues. So we are trying to get back to a new level of normalcy. With that said, if it was growing to a halt, but lead-times stayed around normal, there should be no negative impact on gross profit percent. And as we’ve been saying, the biggest area of opportunity regionally for us in gross profit is in Europe. And Europe really came into the recovery about two quarters later than North America. So we would think that if you were to see a slowdown in the recovery in North America at the top line, we probably have two more quarters to go in Europe. So we’d see that also continuing to grow. So it’s a lot of different data points, a lot of different moving parts, but doesn’t necessarily mean that it would shut down in one quarter. And for sure, at that point in time we’d still look for opportunities to increase it, and don’t believe that there would be a decline in gross profit then.

[Brendan Furlong:]

Okay, that’s kind of what I was looking for. And then my other question, the SG&A that end at sales were pretty much record lows. Do you plan to keep it at kind of record lows on a quarterly basis or am I reading too much into this, that you are kind of expecting things to moderate so much next year and that’s why you’re keeping your expenses at such low levels?

[Mike Long:]

There’s several factors that go into this. First off, we did get our enterprise-computing group on a new computer system. That has helped us with efficiencies in the back office, and those efficiencies we would see going forward. As we continue to do our implementation of the system, in the components group we expect to get efficiencies on that as we go forward. Right now, our third quarter that we gave you is bank in it and still shows good cost, what I would say containment, but I would also say that we have done some new hiring at the same time and we are able to get the back end of our system more efficient as we continue to expand with that, and we’ll continue to hire where necessary. But we are not expecting any major change in our expense levels.

[Brendan Furlong:]

Excellent. Thank you very much.

[Operator:]

And next we’ll move to Sherri Scribner with Deutsche Bank.

[Sherri Scribner:]

Hi. Thank you. You provide a bunch of different details on the segments and geographies. I was hoping we could maybe take a step back and if you could give us like, your view on how the geographies are progressing. I know Europe was a bit behind. It seems like from your commentary that all of the geographies continue to move along and you are not seeing any hiccups. I just wanted to get your thoughts?

[Mike Long:]

Yeah. Well, Asia, we’ve seen the sales growth in Asia-Pac for us be very robust. It’s been growing double-digits compared to last year. Asia-Pac did achieve a record level of sales, gross profit and operating income in the second quarter. The core business that we have was really particularly strong, growing almost 50% year-over-year. And then we saw as I had indicated before, strong performance in a lot of the vertical markets around lighting industrial and PEMCO and automotive and the slowdown that we saw there was in our lower margin, ultra source business, primarily tied to the communications market. So overall we’ve seen a pretty good marketplace there. The pace of recovery that we’ve seen in Europe remains very strong. That out performance was actually driven in all regions of our core business, but particularly Central Europe as a continued strength in our alliance customers, which are some of the larger customers in that region. The vertical markets, we did see several of them start to kick on, but we saw I would say the exceptional market for us, where transportation and lighting, and lighting continues to be the best growing segments. So we see that continuing on if you will for Europe. Our sales in North America if you will were substantially added. While I would say normal seasonality would be there, but that was driven across the Board in both semiconductor products and in our passive products. We did have notable growth, if you will in the aerospace and defense and lighting market industries, but what is really encouraging about North America is the daily run rates improved as the quarter went on and our backlog, meaning customers placing long-term orders on us was also up compared to the first quarter. So we expect the sales to continue in that market, and really the vertical performance there, again airspace, alternative energy, lighting were the main drivers for the quarter for us.

[Sherri Scribner:]

Okay, that commentary is helpful. And then at the analyst day there was a lot of questions about Europe and the impact of what was perceived at that time to be a weakness in Europe. It doesn’t sound like you saw any weakness in Europe. Just wanted to get a sense of did you have currency impact from what was going on during the quarter?

[Mike Long:]

I’ll let Paul answer the currency piece. As far as Europe, you’re correct. We’ve continued to see Europe perform and perform well this quarter.

[Paul Reilly:]

And Sherry, from a currency translation impact, it was about a negative $0.02 for us this quarter, compared to the rate we use for giving guidance.

[Sherri Scribner:]

Right. Okay great. Thank you.

[Operator:]

And next we’ll take a question from Shawn Harrison with Longbow Research.

[Shawn Harrison:]

Hi good afternoon. Hopefully, two brief questions. At ECS, EBIT margins were up slightly year-over-year, even though sales were much higher. Is the variance just in the terms of where they potentially could be, just solely mix right now? And to your earlier comment that you would just need to see some server refresh be relatively healthy from your largest customer coming back in the fourth quarter, and you should see a more normalized level of profitability there?

[Mike Long:]

I think you’ve pretty much nailed that. We did see increases. As I said, we for the first time really saw some improvement in the proprietary servers and as we go back into the second half of the year, if the refresh that we’ve all been discussing on this call comes true, for sure you’ll see benefits of that.

[Shawn Harrison:]

Okay, and then my follow-up question is on acquisitions. You’ve done a number of deals in the first half of the year. Maybe you can comment on your appetite for larger acquisitions, say 500 million in revenues or larger or if you are still looking for the kind of more smaller and midsize acquisition opportunities? Thank you.

[Mike Long:]

You know, I’d love to give you detail, but I just won’t do it. I think we are making acquisitions but we think make the best spends for Arrow. And gain we are making our acquisitions based upon services that we want to bring to the market, the relative benefit in either the computer or the component space for us. It really doesn’t matter the size of the acquisition. Every one of these acquisitions have to produce financially for Arrow and for our shareholders, and that’s really how we’ve been doing it and that’s how we’ll continue to do it.

[Shawn Harrison:]

Okay. Thank you very much.

[Operator:]

And we’ll take a follow-up question from Amit Passi with UBS.

[Amit Passi:]

Just a quick clarification. The share buy-back that you did in the quarter, I understand there’s about 25 million still left on the existing 100 million and then you said you got another 100 million approved by the Board?

[Mike Long:]

Correct.

[Amit Passi:]

Any sense of -- I mean, is there a timing limitation as to when you exhaust the full 125 or any sense of how we should think about your interest in buying stock at these levels?

[Mike Long:]

There is no time limit, and that’s the best we can tell you at this point in time.

[Amit Passi:]

Okay. Alright, thank you.

[Operator:]

And that will conclude the question-and-answer session. I will turn the call back over to the speakers for any additional or closing remarks.

[Greer Aviv:]

Thank you. Before ending today’s call, for those participating in today’s webcast, we will quickly scroll through the slides referenced in our webcast that contain a reconciliation between GAAP and adjusted results. This reconciliation is also included in our earnings release and both the release and the presentation will be available on our website. I would like to thank all of you for taking the time to participate in our call this afternoon. If you have any questions about the information presented today, please feel free to contact Paul, Mike Taunton or myself. Thank you and have a nice day.

[Operator:]

And that will conclude today’s call. We want to thank you for your participation.