Ina McGuinness - Abernathy MacGregor William J. Amelio - Avnet, Inc. Thomas Liguori - Avnet, Inc. Philip R. Gallagher - Avnet, Inc..

Matthew John Sheerin - Stifel, Nicolaus & Co., Inc. Madison Suhr - Raymond James & Associates, Inc. Joe Quatrochi - Wells Fargo Securities LLC Jim Suva - Citigroup Global Markets, Inc. Shawn M. Harrison - Longbow Research LLC.

Greeting. Welcome to Avnet's First Quarter Fiscal 2019 Earnings Conference Call. As a reminder, this conference is being recorded. I'd now like to the conference over to Ina McGuinness. Thank you. You may now begin..

Thank you and welcome to Avnet's first quarter fiscal 2019 business and financial update. Before we begin the presentation, let me remind you that today's remarks and presentations contain forward-looking statements, which are statements addressing future financial and operating results of Avnet.

There are several factors that could cause actual results to differ materially from those described in the forward-looking statements. More detailed information about these and other factors are set forth in Avnet's filings with the Securities and Exchange Commission.

Today's call will be led by Bill Amelio, Avnet's CEO, and Tom Liguori, Avnet's Chief Financial Officer. Also here today to participate in the Q&A session is Phil Gallagher, President, Electronic Components. With that, let me turn the call over to Bill Amelio.

Bill?.

Thank you, Ina, and good afternoon, everyone. We begin our new fiscal year with excellent momentum and execution across our business. Revenue this quarter grew over 9% from last year to $5.09 billion. More importantly, adjusted earnings per share were up – $1.03, up a very robust 36% from last year.

This earnings leverage is due to our transformation efforts, which are driving greater efficiencies across every part of Avnet. Our unique ecosystem is creating real differentiation in the marketplace as we build upon our distribution capabilities to becoming a global technology solutions provider. Our Q1 performance was due to strength in many areas.

Vertical markets such as industrial, transportation, defense and aerospace and healthcare were healthy and performed well. In addition, interconnect, passives and electromechanicals or IP&E revenues were robust across all regions.

Momentum in emerging technologies, within IoT as well as blockchain applications, are showing strong pipeline performance, setting the stage for future growth. Turning to Avnet's performance specifically, let me provide a quick update on the progress we were making across our five key strategies that I've laid to you previously.

The first is accelerating our core electronic components business. This past quarter had a number of important developments that I want to share with you. First, our Americas regions had another solid quarter with revenue growth of over 7% from a year ago and operating income that continues to improve.

Both metrics demonstrating the important progress that we have made in the America. Asia had another tremendous quarter with revenues up over 18% from a year ago, reaching $2.1 billion. Even though our margins are a bit smaller in this region, we continue to generate solid returns on our investments in Asia.

Our growth in Asia is adding to profitability in a way that makes sense for us to continue our growth trajectory in that region. EMEA grew less than the corporate average, up a little more than 1% year-over-year, but that's due to an outstanding growth that we've achieved in that region a year ago, making the comparables more challenging.

However, business remains strong in EMEA with IP&E performing notably well. Lastly, I want to note that our supplier line card continues to expand in our components business. We added five new franchises this quarter across connectivity, power control, programmable logic devices.

These new products expand our solutions capability across several key vertical markets and demonstrate the increasing values suppliers see in Avnet's end-to-end ecosystem. Our next area of focus is scaling our high profit margin businesses. Here, let me start with Premier Farnell. Revenues were up 7% year-over-year and operating income was up 25%.

We continue to scale Premier Farnell along with other core component business showing that we can grow revenues and expand margins through targeted integration and operational synergies with Avnet.

This acquisition has been exceptional for us, not only in terms of financial performance, but also in terms of creating a truly unique end-to-end service model. As I stated before, Avnet can now take a customer idea, turn it into a product and then scale that product to market.

Premier Farnell also expanded its supplier relationships this quarter by also adding five new suppliers through their line card. These new additions cover key technologies such as connectors, networking, lighting and single board computers. In IoT, we grew our customer base this quarter by 15% and our revenue pipeline expanded by 30%.

Let me give you an example of Avnet's IoT capabilities that were displayed recently at Life is Beautiful Festival in Las Vegas. We partnered with Not Impossible Labs to design and develop one of the world's most complex wearable devices that allow deaf people to experience music in a rich and comprehensive way.

This device takes music signals from each instrument in a live music setting and transmits those signals to different parts of the body, so the user can experience each instrument fully. The results were literally stunning.

The technology performed flawlessly and demonstrated that Avnet can take a profound idea and turn that idea into a complete solution of hardware, software and connectivity and help scale that product into market. We will be sharing more about this product in the near future.

I can't wait to share more with you about the other incredible products in our pipeline that demonstrate how Avnet is leveraging its technology expertise to create innovative solutions and business models for our customers that will propel our growth in the future. The third area is extending our digital capability.

During this past quarter, our online communities of Hackster and element14 had tremendous growth in user and engagement. We now have over 1.2 million members in our communities with active sessions growing even faster than the member growth, showing just how engaged our members are on these sites.

Our e-commerce momentum is very strong, offering customers a truly omni-channel means of engagement with Avnet. We remain on track to hit our stated goal of achieving $1 billion of e-commerce revenue this fiscal year. Our fourth area is leveraging our ecosystem to expand customer opportunity.

This past quarter, our design engagement showed strong momentum as we exceeded our target and delivered better margins as a result. Our design expertise and capabilities have let us open up a new design center in Guadalajara, Mexico, providing greater access to design engineers at favorable cost profiles.

Our design engagements also bring in an entirely new class of customers to Avnet. We have recently added new customers in diverse categories such as blockchain and cryptocurrency, pharmaceuticals, healthcare, fast food, consumer goods and even furniture makers.

All these engagements provide new revenue streams to Avnet, but in addition, they also open the door for manufacturing, distribution and supply chain services with those customers as well. Avnet's ecosystem is a key reason we continue to expand our customer reach. Partners are also taking notice and are bringing their technology and their customers.

They bring these to Avnet to take advantage of our unique capabilities. One example is Microsoft, who has selected Avnet as their first partner to scale the new 4X4 Azure Sphere chip.

In addition to helping bring their new security products to market, Microsoft is also sending customer opportunities to Avnet in order to help their IoT partners get to market with their solutions, further expanding our customer engagement.

The last area in our five strategies is focusing on driving performance and operational excellence through continuous improvement. I mentioned several times in recent months that we would take out cost while growing the business. We've done just that this quarter.

We are growing again and our cost optimization efforts are delivering profit growth that exceeds revenue growth.

We are now expanding our focus on operational efficiencies by continuing to deploy our transformation initiative, driving additional integration with Premier Farnell and looking more closely at lower-cost regions for expansion and establishing key centers of excellence. In summary, we started our fiscal 2019 with excellent momentum.

More importantly, we're demonstrating our ability to make commitments and consistently deliver against them. The Avnet transformation is in full swing as we demonstrate our new ecosystem and global technology solutions capability. With that, let's hear from Tom for more on our financial performance.

Tom?.

Thank you, Bill. Good afternoon, everyone. Today, we marked another quarter of solid progress. Revenues in Q1 reached $5.09 billion, an increase of 9.2% year-over-year. Adjusted earnings per share increased 36% year-over-year to $1.03. Operating expenses declined $26.4 million compared to the prior year.

Working capital days decreased by 1 day to 83 days and we returned $180 million to shareholders. Before we get into the details, let me flag to you that during the first quarter of fiscal 2019, we adopted new accounting standards related to revenue recognition and the presentation of pension expense.

The adoption of the new revenue recognition standard did not have a material impact on our revenue recognition or with the comparability of financial results of prior periods and future periods.

Likewise, our adoption of the pension expense standard did not have an impact on the company's total net income or earnings per share, though it does result in an increase to operating expenses with a corresponding decrease in other income expense.

As a result, in Q1, pension cost, recorded in operating expenses, increased by $4 million, resulting in a decrease to operating income with an offsetting decrease in other expense of $4 million. We have recast prior-period financials to reflect this change.

In addition, as a result of investor feedback, we modified our calculation of net working capital days. Our objective is for readers of our financial reports to be able to perform the calculation using our published numbers. In the past, we used an average of our monthly working capital balances.

Starting this quarter, we are using an average of the quarter's beginning and ending balances as shown in our quarterly financial statement. We have recast prior-period working capital days in our earnings slides. Okay. Let's turn to our business performance, starting with Premier Farnell.

Premier Farnell continues to perform well and delivered revenue growth of 7.2% year-over-year with an operating income margin of 10.8%. Our fiscal first quarter is traditionally lower due to the impact of the summer holiday season in Europe and therefore, revenues declined sequentially as expected.

Moving on to Electronic Components, the Electronic Components segment sales were up 9.4% to $4.7 billion with an operating income margin of 3.4%, up from 3.2% a year ago and flat sequentially. Turning to geographies, Americas posted year-over-year sales growth of 7.3% and operating income continues to improve.

Our EMEA region delivered 1.3% revenue growth year-over-year or 2.7% on a constant currency basis and continue to lead our regions in operating margin performance. Asia remained our fastest-growing geography by far, reaching $2.1 billion in revenue this quarter, an 18% increase year-over-year and 8.4% sequentially.

Moving down the income statement, gross margin declined 51 basis points sequentially to 12.5% due to the higher mix of Asia revenue. Our management of operating costs led to a year-over-year decline of $26.4 million in SG&A, even as we delivered revenue growth over 9% in the period.

Adjusted operating income reached $182.5 million, up $2.4 million sequentially and up $46 million year-over-year. Adjusted operating income margins increased 66 basis points year-over-year and 3 basis points sequentially to 3.6%.

The stronger dollar against foreign currencies, particularly the Turkish lira, impacted other expenses, negatively impacting earnings by $0.05 per share this quarter. Our tax rate decreased to 20.5%. Turning to the balance sheet and cash flow statement, net working capital days were down by 1 sequentially to 83 days.

Cash used for operations in the quarter was $85 million, which was primarily inventory purchases for Q2 shipments, which are historically skewed to the first two months. As mentioned on the last call, we received $120 million as part of a final working capital adjustment from the sale of our Technology Solutions Business.

Our debt leverage declined sequentially from 2.2 times to 2.0 times and we returned $180 million to shareholders in the form of an increased dividend of $0.20 per share and share repurchases totaling $157 million.

We ended the quarter with $366 million in cash, which was a sequential cash decline of $255 million, which includes an $89 million debt repayment. Our target level for cash on hand to run our business is $250 million to $350 million. As most of you know, we have a detailed plan for achieving a $7 earnings per share target.

We provide a quarterly scorecard to track our progress, which is shown on page 16 of our earnings presentation. Revenue from our higher-margin businesses such as Premier Farnell continued to grow and contribute to our earnings.

As a percentage of our total revenues, our revenue mix from these businesses decreased due to high growth in Asia I mentioned earlier, hence the only yellow. All of our other metrics are green with every operating and capital metric showing solid improvement.

Several of you have asked how we determine whether to pursue a business opportunity, particularly in Asia. Let me shed some light on this. When we evaluate an opportunity in any region, our main question is does it move us closer to our goal of $7 of earnings per share, while generating an appropriate return on capital.

Because our Asia business is generally lower margin, we work with our suppliers and customers there to limit our working capital outlay. If we cannot achieve that, we don't take the business.

Our recent business opportunities in Asia have lower operating margins and by working with suppliers, we have earned returns on working capital in the high teens. With this mindset, we've generated over $150 million in cash flow in Asia during the last two quarters.

As a management team, our priorities are earnings per share growth, operating income dollars and returns on capital. As we move forward with our IoT and demand creation initiatives, we believe 4.5% to 5% operating income margin is clearly doable.

However, right now, we are finding good returns and EPS accretion in Asia, which will tend to lower our near-term operating margin percentage. Looking forward, our outlook remains positive. We ended the quarter with a book-to-bill ratio of 1.04.

This represents a return to normal trends after an extended period of above-average end demand and supply constraints across the industry. In our December quarter, we expect sales to be in the range of $4.9 billion to $5.3 billion. Based on this revenue forecast, we expect adjusted EPS to be in the range of $0.98 to $1.08.

At midpoint, guidance represents year-over-year annual revenue growth of 13% and adjusted EPS growth of 32%. Overall, our Q1 results were at the higher end of our guidance and expectation and we see continued strong performance in Q2 and accelerating through the end of our fiscal year. With that, let's open the line for Q&A.

Operator?.

Thank you. At this time, we'll be conducting a question-and-answer session. Thank you. The first question comes from the line of Matt Sheerin with Stifel. Please proceed with your question..

Yes. Thanks for taking my question. So, just if we can get some more commentary on the demand environment, this week alone, we've seen several of your suppliers and semiconductor companies guiding weaker than seasonal, citing demand issues in parts of auto and industrial and some inventory or order correction.

I know in typical cycles, Avnet seems to see it first and this time you're not seeing it. So, I'm wondering if that may have to do with the mix. You don't have as much auto exposure for instance. Any commentary on just your thoughts on the cycle, considering the contrast between what you're seeing and some of your suppliers..

Matt, good to hear your voice and it was shocking that was the first question that you asked me. Book-to-bills are a bit lower than they've been, but they're still healthy. We believe that we're kind of in a normal range now and we've also seen lead times become more stable. And we haven't seen a big contraction in lead times, but they're stable.

And I think we're entering, as I said, into a more healthy range of our book-to-bills in all regions. Now, when you look at Asia specifically, all of Asia is doing reasonably well. We've seen a little bit of pullback in the China market specifically, but we still remain pretty positive with respect to overall, the rest of the world..

Yeah. Matt, this is Phil. I'll just add to that a little bit. Bill mentioned China and some of the uncertainty with some things going on with tariffs and whatnot, but in the west, still positive book-to-bills. Were they where they were a year ago, no, but they're still in the positive range, which is really good news.

Now, I'll just say I think it would come back to, you alluded to it, Matt, somewhat of a diversification of our customer base. And yeah, when we look at transportation versus just auto, we have a pretty good size presence here that we didn't have years ago and the content is still growing. Okay.

So, we're still seeing growth in the transportation and auto segment and the industrial tail of customers too. But I haven't seen some of the things that we alluded to in the script that non-traditional customers are starting to come out as well. So, overall, still positive and that's what we're seeing..

Okay. Thank you.

And then – and as for the growth that you're seeing in Asia and time you talked about weighing the margins versus returns and that makes sense, but does that mean you're doing more supply chain engagements? I know a few years ago, you were doing some big projects like Apple-related for instance and you pulled out, because they ended up not meeting returns.

Are these kind of high-volume engagements that you haven't done in a while or...?.

Well, some are more higher-volume engagements, but we're making sure that we've got the right terms and conditions with respect to the working capital. So, if we take something that will be a lower-margin deal, it's got to have a high return on working capital.

And we have a pretty good – a pretty tough threshold and discipline that we put in place to make sure that that happens. So, you'll see us do that, but we want to make sure that whatever business we take makes the hurdles and makes the right return..

Okay.

Are these share gains against like local suppliers in Asia or is it against other competitors? Or is it direct business that's going through the channel now?.

It's a little bit of everything that you just mentioned there..

Okay. All right. Fair enough. Thank you..

Thanks, Matt..

Our next question is coming from the line of Adam Tindle with Raymond James. Please proceed with your question..

Hi, everyone. This is Madison on for Adam. Last quarter, you mentioned a goal to get to 4% operating margin sometime in the back half of fiscal year 2019.

You've obviously made good progress toward this goal, but what are kind of the puts or takes or two or three critical factors in getting some additional leverage to push you over the 4% mark in the near term? Thanks..

A couple things I'll mention is one, that we're trying to really focus the company on making sure that we get the right returns back to our shareholders. And one of the ways to do that is to put a deadly focus on EPS. So, that's kind of what I'll say is the top priority thing that we worry about.

The next thing is operating income dollars, followed by returns and then the fourth one would be operating income percentage. So, in that priority, we make decisions as far as our business is concerned.

Some of the key elements that are under our control that we talked about in the last earnings call that we're aggressively moving after is our continued work on transformation, our organizational optimization work that we're doing, our integration between the core Avnet business and Premier Farnell and our movement to low-cost jurisdictions.

So, those elements are some of the key elements we have to control our offset to continue to take down lots of costs. So, we believe that those things alone, as we pointed out in our Investor Day, represent about $245 million of expense take-out.

It gets us in a great position to be able to still improve our earnings per share and our operating income percentage even in a market that might not be as robust as it is today..

Okay. Thanks. That's very helpful. And then, given the continued growth we are seeing, I was hoping you could provide some context for how you're thinking about operating cash flow for the full year, whether it'd be a dollar figure or a certain net income conversion you are looking to achieve. Thanks..

Sure. I think Q1 is a pretty good proxy. If you take our net income and you add back depreciation, amortization and stock comp, you'll get between $140 million and $150 million and that's pretty good number, going forward, obviously, adjusted to what your model says working capital, our target is to bring it down a day or two a quarter.

So, you could add $75 million. Any given quarter is going to be up or down, but that is the way to think about our cash flow..

Okay. Thank you..

Our next question is coming from the line of Joe Quatrochi with Wells Fargo. Please proceed with your question..

Great. Thanks for taking the question and congrats on the results.

I was wondering if first you could kind of remind us on kind maybe your controls to monitor double ordering, cancellations and maybe how that's evolved since the last kind of market downturn or slowdown and then maybe what are you seeing from cancellations kind of relative to last quarter..

Well, the controls that we've got in place are what you just described. We looked at cancellation rates, expedite rates and when you look at that across every geography and every business unit, we haven't seen a market change. So, they've been relatively stable on the same quarter-to-quarter.

So, that gives us pretty good confidence that there isn't a lot of double ordering in place. And I'll let Phil give some more color from a regional standpoint.

Phil?.

Yeah, Bill. A good question and we track this. I think Matt's first question because, typically, we'll see this first. And we look – mostly what we're tracking is the cancellation rates push out. And remember about 50% of our business or more, we're actually taking in customers' MRP.

So we got a really good broad look, okay, and diversified look at the demand. And right now, our typical cancellation rates at any given day, month or quarter is in the 18% to 25% range and we're sitting right there in that range. So, we're not seeing anything abnormal on push-outs or cancellations.

And as Bill talked about earlier, that's why we track lead times so closely with our suppliers and some improvement to lead time, but not a tremendous amount, stable, but not getting worse. But they're not coming in that much either. Okay so, that we watch, because that will then generate what you just asked about.

So, right now again, as we see it today, it looks okay..

Okay. And then for a follow-up, you guys in the last quarter talked about the existing first kind of round of tariffs being 1% of your line card.

I was kind of curious with the incremental $250 billion of tariffs now in place, what percentage of your line card is affected by that and how have you seen that kind of – did you see any change in linearity kind of ending the September quarter?.

No. In fact, last time, when I gave you that number, it was more that we were considering all the tariffs in place. So, it's not a bad number they're using. More importantly is the actions that we put in place to make sure we're mitigating any profit leaking.

So, the things that we've done, as we work with some of our suppliers, is where we could move a source out of China into another dual source, if that's possible, that would be a shipment in the United States, we made that change.

We've also direct shipped from Hong Kong as well as we set up a Guadalajara warehouse in record time and we're funneling shipments through there that go to customers that historically would have gone to the United States and then maybe went to Canada, Mexico, Latin America and South America, now will go through either Hong Kong or Guadalajara.

We're also in a process setting up a free-trade zone and that will be completed rapidly as well, and of course, the final thing on the docket would be duty drawback. So, we're working with our customers and our suppliers to make sure we can effectively manage this. The other thing that we're working with suppliers on is importer of record.

So, if we get our supplier to be importer of record, the tariff to our customers will be less than if we're the importer of record. So, all those actions are in place and we have a pretty comprehensive plan in place and something that both Phil and I review on a regular basis..

Perfect. Thank you..

Thank you. Our next question comes from the line of Jim Suva with Citi. Please proceed with your question..

Thank you very much. You mentioned you're seeing good opportunities in Asia.

Can you walk us through a little bit about as we look forward maybe several years how big of a business that could be, maybe as a percent of your total? And I assume you're able to put in like lower cost support for it and maybe focus on higher velocity or turnover of that to make it economically more viable.

Can you just kind of walk us through if that's the case and how we should think of that versus your core historical presence that you've done with Avnet in its past margins? Thank you..

So, I would put it this way. First of all, think about it this way, Jim. We want to make sure the returns are right. That's the most important. Make sure we get the returns right. So, it doesn't matter what geography we're in, whatever business we take, we want to make sure it's healthy business. And that's what we've been able to achieve.

With respect to a percent decrease over time, that was hard to model, because we also have a lot of moving parts.

I mean we've got other areas that are high growth parts of our company, mainly some of the high margin opportunities that we talked about in the Investor Day, like Avnet Integrated, like Premier Farnell, like what we're doing with the demand creation. So, it makes it a little bit more difficult to model that in place.

So, we haven't really modeled that out over time. Our objective still remains the same, is to grow our EPS to $6 to $7 a share and then to get our long-term operating income margins up in the range that we've talked about previously..

Okay. Can I add also, Jim? You may have missed in the scripts, we talked about our Hong Kong distribution center, it's a perfect example of what you talked about with lower cost, higher velocity.

The reason for opening a new distribution center in Hong Kong is to be able to accommodate higher volume and as we move forward and that gets humming, so to speak, we'll get a lower cost to serve and that's all part of the model of lower cost, lower working capital, high return on capital that makes this work for you..

Hey, Jim, let me add on that, this one. This is Phil as well. And of course, we're going to continue to see growth in Asia-Pacific. There's no doubt. And I think part of our objective and touched on it at Analyst Day, I'll give you two things.

One is we got, as we've proven I think, we've become more efficient, okay, more effective in how we handle the business and manage the business and drive returns.

The other thing that I think everyone needs to remember that Asia's not only organically growing in and of itself in Asia, but it's still a very key component to our customers in North America and EMEA where they do design – a lot of them will manufacture in Asia, where they'll start in the Southeast Asia, going to China, now into Korea, India, what you have.

So, having a presence over there and growth presence is really strategically critical to our customers who are more and more acting global and a large – I'd say 25%, 30% of the business we do in Asia is generated from the west. And that business typically comes in at a higher margin than the indigenous distributors that we compete with in the market.

So, there's a lot of moving parts there, but strategically it's very critical..

Thank you very much for the details. It's greatly appreciated..

Our next question comes from the line of Shawn Harrison with Longbow Research. Please proceed with your question..

Hi, afternoon, everybody, and congrats on the results.

Tom, how much buyback activity has been done here through almost the end of October? And would you consider adding leverage here to buy back the stock now that it's below book value or essentially at book value again?.

Yeah, as you can appreciate, we normally don't give a guidance to our buyback in the upcoming quarter.

We're really sticking to the capital allocation plan we laid out, which is over time 50% of our cash flow going forward to that, but I think you have a fair point in that if you liked our stock at $47, we love it at $38 as far as a return on investment..

But have you been buying stock here in October? Is that something you can answer?.

Let's just leave it at that. Thank you, Shawn..

Okay.

As a follow-up, is there a way to size now that the higher-volume business may be a run rate that you picked up in Asia over the past quarter or two or couple of quarters?.

It's been about $300 million a quarter or so. And it's with many different deals and each one is evaluated individually. We want to make sure that we do have the appropriate margin and capital mix for anything that we do accept, Shawn..

Hey, Shawn, everything what we do in Asia – this is Phil – we model each – we do, by customer, profitability models. So, we go engage with and negotiated customers, there's a very large customer in the U.S. that we just closed, in Asia, it was north of a couple hundred million dollars.

And when we do that, we look at the revenue, the profit, the OpEx, the services, the working capital, including inventory and receivable and say, do we get the appropriate returns? So, we do very specific modeling and isolate these different opportunities as they come in..

Okay. And then, lastly, just a quick kind of question on the tax rate. It fell in the first quarter, you guided down a little bit from your run rate from the second quarter.

Would you expect any further declines in the tax rate as fiscal 2019 progresses or is it – where it's going to be for the rest of the year?.

Yeah. The 20.5%, that's our estimate for the total year..

Perfect. And once again my congrats..

Thanks, Shawn. I would say this, that doesn't mean we're going to stop working on that. Let's assure to that..

Thank you. Thank you. This will conclude our question-and-answer session today and also will conclude today's conference. Thank you for your participation. You may now disconnect your line and have a wonderful day..