Business Context and Reporting Period
Arrow Electronics, Inc. filed this unaudited Form 10-Q for the quarter and six months ended July 2, 2016. Arrow distributes electronic components to original equipment manufacturers and contract manufacturers through its Global Components segment and provides enterprise computing solutions to value-added resellers through its Global ECS segment. Approximately 66% of first-half sales came from Global Components and 34% from Global ECS.
Financial Performance and Position
| Metric | Q2 2016 | Q2 2015 | Six Months 2016 | Six Months 2015 |
|---|---|---|---|---|
| Sales | $5.972 billion | $5.830 billion | $11.446 billion | $10.832 billion |
| Gross profit | $798.8 million | $768.6 million | $1.548 billion | $1.454 billion |
| Gross margin | 13.4% | 13.2% | 13.5% | 13.4% |
| Operating income | $223.6 million | $206.9 million | $405.0 million | $384.4 million |
| Operating margin | 3.7% | 3.5% | 3.5% | 3.5% |
| Net income attributable to shareholders | $134.3 million | $123.9 million | $240.5 million | $230.0 million |
| Diluted EPS | $1.45 | $1.28 | $2.59 | $2.37 |
Adjusted operating income, excluding identifiable intangible amortization and restructuring, integration, and other charges, was $254.1 million, or 4.3% of sales, in the quarter and $469.2 million, or 4.1% of sales, in the first six months. Adjusted net income attributable to shareholders was $152.7 million in the quarter and $285.0 million in the first six months.
- Global Components sales increased 3.6% in the quarter and 6.6% year to date; Global ECS sales were flat in the quarter and increased 4.0% year to date.
- First-half operating cash flow was $111.3 million, down from $219.4 million in the prior-year period.
- First-half investing cash use was $145.8 million, including $45.5 million for acquisitions and $88.3 million for capital expenditures. ERP-related capital expenditures were $31.4 million.
- First-half financing cash inflow was $270.6 million, primarily from $233.0 million of long-term bank borrowings and $67.6 million of short-term and other borrowings.
- Cash and cash equivalents were $495.8 million at July 2, 2016, compared with $273.1 million at December 31, 2015. Approximately $444.6 million was held outside the United States and intended to remain permanently reinvested overseas.
- Total debt was approximately $2.730 billion, consisting of $111.3 million of short-term borrowings and $2.619 billion of long-term debt. The company had $45.0 million outstanding under its $1.5 billion revolving facility and $335.0 million outstanding under its $900.0 million asset securitization program.
- Accounts receivable were $5.705 billion and inventories were $2.504 billion at July 2, 2016. Accounts receivable and inventories together represented approximately 63.4% of total assets.
Material Changes Versus the Prior Comparable Period
- Sales increased 2.4% in the second quarter and 5.7% in the first six months. After adjusting for foreign currency and acquisitions, first-half sales growth was 1.6%.
- Gross margin improved 20 basis points in the quarter and 10 basis points year to date.
- Operating income increased 8.0% in the quarter and 5.4% year to date, while reported operating margin improved in the quarter and was unchanged year to date.
- Net income attributable to shareholders increased 8.3% in the quarter and 4.6% year to date. Diluted EPS increased despite lower weighted-average shares, reflecting share repurchases.
- Operating cash flow declined by $108.1 million year to date, primarily reflecting working-capital changes, including reductions in accounts payable and accrued expenses.
- Acquisition spending decreased substantially from $470.7 million in the first half of 2015 to $45.5 million in the first half of 2016. Arrow completed two immaterial acquisitions in the first half of 2016 for $44.6 million, net of cash acquired.
- Interest and other financing expense increased to $39.0 million in the quarter and $74.6 million year to date, primarily due to higher average debt outstanding.
Guidance, Outlook, Commentary, Risks, and Unusual Items
The filing does not provide specific quantitative revenue, earnings, or margin guidance. Management stated that sales are generally made on an order-by-order basis rather than under long-term contracts, limiting visibility beyond a few months. Management expects available cash, borrowing capacity, future operating cash flows, and capital-market access to be sufficient for projected needs for the foreseeable future.
- Restructuring, integration, and other charges were $16.1 million in the quarter and $36.9 million year to date, including efficiency initiatives, acquisition-related costs, fraud-related items, and a $12.2 million Wyle defined-benefit-plan settlement charge.
- The company recorded a $3.9 million fraud loss, net of insurance recoveries, during the first six months. In the second quarter it recorded a $9.3 million credit related to insurance recoveries and incremental fraud-related expenses. Approximately $29 million of cash remained frozen in external bank accounts and was considered probable of recovery. The investigation and legal actions remained ongoing.
- Management identified a continuing material weakness in internal control over financial reporting related to preventing and detecting unauthorized cash disbursements. Remediation measures included enhanced approval procedures, centralized review, cash-disbursement limits, security communications, new fraud protocols, and replacement of responsible personnel. Testing of remedial controls began in the second quarter.
- Environmental liabilities related to former Wyle facilities remain uncertain. Estimated additional costs were $3.3 million to $4.75 million for Huntsville investigative and remediation activities and $12.4 million to $24.5 million for Norco activities, with potential additional costs not currently estimable.
- The company was in compliance with its debt covenants as of July 2, 2016 and reported no material changes in market risk from its 2015 Form 10-K.
- Forward-looking risks include global demand and pricing, product supply, supplier relationships, competition, margin pressure, ERP implementation, acquisition integration, foreign exchange, legal and regulatory matters, and cash-flow generation.
Most Important Facts for Investors to Verify
- Whether the remediation plan eliminates the material internal-control weakness and prevents further unauthorized cash transfers.
- The eventual recovery of the approximately $29 million of frozen cash and the final outcome of the fraud investigation and related legal actions.
- Operating cash conversion and working-capital requirements, particularly accounts receivable, inventory, and accounts payable trends.
- Refinancing or repayment plans for the $335 million asset securitization balance maturing in March 2017 and other debt maturities.
- Progress and cost performance of the ERP initiative and restructuring programs.
- Final environmental remediation costs at the Huntsville and Norco sites, which may exceed currently estimated amounts.
- The sustainability of reported growth after adjusting for acquisitions, foreign currency effects, restructuring charges, amortization, and other unusual items.