Avnet (NASDAQ:AVT) and Electronic Arrow (NYSE: ARW), two value-added distributors of electronic components outperformed the iShares Semiconductor (SOXX) ETF which has held some of the biggest names in manufacturing since its inception. of this year, during a period marked by higher inflationary pressures and supply chain problems.
The question is whether this outperformance can continue in the face of growing uncertainty, this time on the demand side.
Thus, the purpose of this thesis is to assess how these two companies can move forward, and to that end, I begin by providing an overview of their importance in the supply chain for the components used to manufacture anything. that is, cars, computers and mobiles. mobile phones.
Importance in the supply chain
These companies may differ in their market capitalization (as per the table below), their structure, the specific markets they serve or the suppliers they have agreements with, but they both play a vital role in the supply chain. component supply. I coined the term “VARs” because they add service and design value to the electronic ecosystem.
In other words, Arrow and Avnet position themselves between OEM manufacturers who need components to make cars or computers and the suppliers who 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 myriad of OEMs, subcontractors and suppliers.
Moreover, far from passively transmitting customer orders to suppliers, they actively aggregate them using analytics tools to predict consumption patterns. Only then do they place orders.
In addition to their logistics role, these companies are also involved in product design by helping companies redesign printed circuit boards with their teams of Field Application Engineers (FAE) using advanced design tools to this effect. Thus, by participating in the manufacturer design process, Arrow and Avnet are able to create demand for specific chips made by selected suppliers, while ensuring their timely supply. For their efforts, both companies are rewarded by suppliers whose components get the go-ahead for manufacturing.
Now, under normal circumstances, FAEs mainly work with small businesses 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 doing so, their own engineers select the components and issue supply orders to the two distributors.
However, in the current supply chain environment, exacerbated by Chinese shutdowns, where conventional delivery times have stretched and hurt even top network equipment manufacturers like Cisco (CSCO), executives companies think differently. For example, Avnet and Arrow are receiving more phone calls for design work, and integrating value-added services such as product design into the distribution process has resulted in higher gross margins for both companies, such as shown in the graph below, with Arrow (in blue) at the top.
However, achieving margins and profitability of capital also depends on being able to sell products in stock quickly in order to prevent cash from sitting idle in warehouses for too long.
Stocks and return on capital
As far as the US manufacturing industry is concerned, there is currently an imbalance between low inventory levels of component suppliers like Taiwan Semiconductor Manufacturing (TSM) on the one hand and high inventory levels on the other. from OEM manufacturers.
As for Arrow and Avnet, both companies’ inventory levels have risen quite sharply since the start of 2021, as shown in the chart below. However, given the strong demand environment for everything related to electronics and the solid order book (or orders not yet honored), this additional stock should not normally be a problem for the two distributors since it should be converted into revenue as part of the seasonal business cycle.
However, in the case of a worst-case scenario of recession, things may turn out to be different.
In this case, looking deeper into inventory, instead of increasing in volume, they have instead increased in terms of components that have more value per unit (cost more), as these are the ones that manufacturers could not not get their hands on earlier in the supply shortage. Thus, manufacturers may have high inventory levels, but they cannot dispense with components that are in distributors’ inventory to manufacture finished products.
When it comes to pricing power, despite navigating through the various variable costs such as commissions, freight, and logistics, both companies have been able to pass the costs on to customers, which partly explains their recent gross margin gains and increasing returns on investments.
When it comes to returns, Arrow has a significantly higher return on investment at over 16%, as shown in the blue chart below. This is because of its much higher revenue level compared to Avnet. Additionally, Arrow’s operating expenses as a percentage of total revenue are also lower at 7.7% compared to Avnet’s 8.56%, meaning it is more profitable.
On the other hand, Avnet has a lower debt ratio than Arrow and pays dividends at a yield of 2.2%. Additionally, the company’s non-GAAP EPS for Q3 2022 exceeded consensus by 39%, while Arrow hit 19% in Q1 2022. Now both of these quarters end in April 2022, and Avnet’s higher earnings growth is a big reason why investors have rewarded it with better price performance year-to-date.
Evaluations and key points
The higher price performance is why Avnet bears a higher non-GAAP price to earnings ratio, as shown in the table below, but given that its revenue growth for the last reported quarter was of 31.96%, almost four times Arrow’s 8.21%, that means it should be valued more in terms of price-to-sales ratio. Adjusting based on Arrow’s P/S of 0.25x and Avnet’s current stock price of $45.8, I get a target of about $57 (45.8 x 0 .25/0.20).
As for Arrow, one of the reasons why it experienced lower revenue growth than its counterpart is because of its product line, i.e. hardware (IT) related sales facing challenges from the side of supply during the last quarter. Going forward, there could be short-term demand-related weakness, with the situation only improving in the longer term as the company’s hardware backlog continues to grow amid sustained demand for hybrid cloud. So unless you want to invest for the long term, Avnet is not a buy at this time.
Continuing further, I have a buy rating on Avnet, but investors are warned that the stock could dive further in the current very volatile market conditions where there is a lot of uncertainty about the capacity of the Reserve federal government to fight inflation smoothly. Some economists even speak of a temporary economic contraction, which could see the S&P 500 fall below the 3600 level. Thus, some may prefer to wait until the dust has settled 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 product suppliers with better cost metrics in addition to the time factor are likely to become more pronounced. At the same time, with greater regionalization (as opposed to globalization) of component sourcing in the future, where new foundries like GlobalFoundries (GFS) will be gradually added to the equation, costs are expected to rise. That said, with digital transformation and electrification, companies are expected to continue to increase semiconductor density or the number of chips used in the same electronic device, thereby ensuring sustained revenue streams for both companies.