Arrow Electronics Inc.

Moat: 2/5

Understandability: 3/5

Balance Sheet Health: 4/5

A global provider of products, services, and solutions to industrial and commercial users of electronic components and enterprise computing solutions.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Arrow Electronics is a global provider of products, services, and solutions to industrial and commercial users of electronic components and enterprise computing solutions. Essentially, it acts as a large distributor between manufacturers of electronic components and the companies that use them.

Business Overview

Arrow’s business is comprised of two main segments:

  1. Global Components: This segment is the larger revenue driver for the company. It focuses on distribution of electronic components. Sales are segmented into Americas, EMEA (Europe, Middle East, and Africa), and Asia-Pacific.
  2. Global ECS (Enterprise Computing Solutions): This segment offers enterprise computing solutions, such as cybersecurity, cloud, AI, and analytics. This business also sells and leases hardware and software products.

It is important to notice that there has been a major shift in revenue from components to enterprise computing solutions. This may be a result of current technology trends and a push from ARW to improve higher margin and growth businesses.

  • Demand for Electronic Components: Despite ongoing supply chain issues, demand continues to grow in most segments.
  • Shift towards digital solutions: With the development of the internet, there has been increased demand for software and digital services.
  • Consolidation: The electronics distribution industry is highly fragmented, which may lead to consolidation.
  • Supply Chain Issues: Despite some signs of recovery from past supply chain challenges, volatility, extended lead times, and higher shipping expenses are likely to continue to affect ARW.

Margins

  • ARW is a low-margin business, typically achieving less than 20% in gross profits.
  • Operating margins are even lower, around 4% to 6%, demonstrating significant competition and pricing power challenges.
  • High operating expenses are the reason for this, often exceeding the margins from sales.

Competitive Landscape

  • The electronics distribution industry is extremely competitive and fragmented with a large number of companies competing for contracts.
  • Major competitors include Avnet, Digi-Key, Mouser, and a number of smaller specialized distributors.
  • While there are some companies that serve specific geographies, competition is mainly on global scale.
  • A challenge is the continuous competition in pricing, as manufacturers can also sell directly to consumers, and in order to maintain strong business, distributors must offer great service, and be more price-efficient.

Due to highly competitive environment, profit margins in electronic components distribution can not be predicted. And even though the current state of supply shortages, where there are more demand than supply, should have provided higher margins, the overall profit margins have not increased.

What Makes ARW Different?

  • Global Scale: Arrow operates in several different geographical segments around the globe, which in theory, allows for diversification of geographical and political risks.
  • Large Inventory and Wide Product Variety: Arrow offers a wide product portfolio, which it manages through a large scale distribution network, which reduces its customers hassle and helps with its supply chain capabilities.
  • Focus on Technology and Solutions: Unlike other distributors, ARW is increasingly focusing on solutions to businesses, mainly through the Global ECS segment. These solutions focus on cyber security, data analytics, IOT and Cloud-Based Solutions, and give ARW opportunities for higher growth and profit.

Financial Analysis

  • Revenue: Revenue comes from product and service sales to industrial and commercial customers. Revenue is split between two main segments, Global Components, which focuses on electronic components, and Global ECS, which focuses on IT and software solutions. In recent times, the revenue has seen a slowdown due to reduced demand in major markets and negative effect of foreign exchange, with growth expected to continue to stagnate in the near term.
  • Profitability: As previously mentioned, gross and operating margins are low, demonstrating a highly competitive industry. Net income is heavily impacted by any changes in gross margins and interest rates. There has been a major focus by management in the previous couple of quarters to improve overall margins, however.
  • Balance Sheet: The balance sheet is quite healthy, with total assets outweighing liabilities and good equity. A big portion of assets are made up of property, plant and equipment, inventories and receivables, meaning that ARW has a very traditional business. There is a significant amount of debt, which has been increasing slightly in the past few years.
  • Cash Flow: Historically the company has a negative cash flow from operations, as a result of a need to invest significant sums of money to maintain their operations and to be able to offer their wide variety of products. Even while reducing inventory, ARW has seen a negative cashflow, but expects this to normalize as conditions improve. They have been able to use debt to meet these needs.

Major headwinds for the company include supply chain issues that are still being present and a decrease in demand, due to global recessionary fears. These two reasons are severely hurting the company and leading it towards low margins and negative cash flows.

Moat Rating: 2 / 5

Arrow has a narrow moat.

  • Scale Advantage (Limited): Arrow benefits from its large distribution network, which would be costly for others to replicate. Yet, due to the low barriers of entry into the industry, the edge is very limited and can be quickly overtaken by well-capitalized competitors. Furthermore, the global nature of the industry means that local smaller distributors can operate effectively and profitably.
  • Switching Costs (Limited): Arrow has been trying to integrate itself in a customer’s business, but the lack of strong switching costs is very obvious as customers often switch distributors based on price.
  • Intangible Assets (Limited): ARW has established a well known brand, which is valuable, but does not help much with their pricing power, as their products are not differentiated.
  • Network Effect (None): Due to nature of ARW business, a network effect is very hard to establish. As it provides products to other businesses, it doesn’t connect users together, hence this economic moat is non-existent.

The company’s moat is highly susceptible to rapid changes in technology and customer preferences. Their strong competitive advantages depend mostly on their scale and distribution network, which is quickly becoming outdated in today’s technologically changing world. The company’s move to solutions-based services may improve their moat, but it is too early to have any conclusive evidence.

Moat Risks

  • Technological Disruption: The electronics industry is very prone to fast and continuous technological advancements, which may make the company’s offerings less valuable and attractive. Competitors that provide better services and products or adapt to trends quicker might threaten ARW’s long-term stability and profitability.
  • Economic Downturns: ARW’s business is highly dependent on economic growth and development. A major recession may lead to reduced demand, which will damage margins and revenue.
  • Increased Competition: The electronics distribution industry is highly competitive and fragmented. New entrants may decide to enter ARW’s segment, and new companies may appear that are technologically superior. As a result, margins and pricing pressures may squeeze profitability.

Business Resilience

ARW is a large, diversified distributor that carries many different types of components and services with many customers worldwide, which provides good diversification. Furthermore, ARW has an advantage over most companies when it comes to building and maintaining a complex and large global distribution network that is not as easy to copy. However, these advantages are easily outweighed by the low margins, high competition and low switching costs of the industry as a whole. The business is also heavily exposed to economic cyclicality and has shown low resilience in downswings.

Understandability: 3 / 5

ARW is a complex company. While the business of distributing products is easy to understand, they also offer financial services, and enterprise IT solutions. Understanding their financial statements, coupled with the complex business model, and the constant changes in technology requires a very skilled investor, which warrants a 3/5 in understandability.

Balance Sheet Health: 4 / 5

The balance sheet is in good shape with high liquidity, good equity, and adequate assets. However, it also contains a considerable amount of debt and has shown a slightly negative cash flow. The company is heavily reliant on debt, which increases risks.