ARROW ELECTRONICS, INC. annual report, FY2017

Arrow Electronics, Inc. — FY2017 Form 10-K Summary

Business context and reporting period

Arrow Electronics is a global distributor and solutions provider serving more than 150,000 industrial and commercial customers in over 80 countries. Its two reportable segments are Global Components, which represented approximately 68% of 2017 sales, and Global Enterprise Computing Solutions (ECS), which represented approximately 32%. The filing covers the fiscal year ended December 31, 2017; quarterly data indicates fourth-quarter sales of $7.63 billion and net income attributable to shareholders of $53.9 million.

Financial performance and key metrics

Metric	2017	2016	Change
Sales	$26.813 billion	$23.825 billion	12.5%
Gross profit	$3.357 billion	$3.144 billion	6.8%
Gross margin	12.5%	13.2%	Down 70 bps
Operating income	$928.5 million	$858.5 million	8.1%
Operating margin	3.5%	3.6%	Down 10 bps
Net income attributable to shareholders	$402.0 million	$522.8 million	Down 23.1%
Diluted EPS	$4.48	$5.68	Down 21.1%
Cash flow from operations	$124.6 million	$359.7 million	Down $235.1 million

Adjusted net income, excluding amortization, restructuring and integration charges, asset impairment, investment and debt-extinguishment losses, and the Tax Act impact, increased to $679.0 million from $609.8 million. Adjusted operating income increased to approximately $1.091 billion, or 4.1% of sales, from $987.0 million, with the adjusted margin unchanged.

Segment sales: Global Components increased 19.0% to $18.330 billion; Global ECS increased 0.8% to $8.482 billion. Excluding currency and acquisitions, Components increased 18.2% while ECS declined 0.3%.
Segment operating income: Components generated $801.0 million versus $686.5 million; ECS generated $445.1 million versus $441.8 million.
Balance sheet: Cash and equivalents were $730.1 million; accounts receivable were $8.171 billion; inventories were $3.303 billion; total assets were $16.463 billion; long-term debt was $2.933 billion; and shareholders’ equity was $4.952 billion.
Working capital: Accounts receivable and inventory represented approximately 69.7% of total assets, compared with 67.6% in 2016. Working capital as a percentage of sales increased to 17.6% from 16.1%.
Investing and financing: Capital expenditures were $203.9 million, including $62.5 million for the global ERP initiative. Financing cash flow was $256.7 million, including $986.2 million of net note proceeds, $558.9 million of note redemptions, and $174.2 million of share repurchases.
Liquidity: Arrow had a $1.8 billion revolving credit facility, a $910.0 million asset securitization program with $490.0 million outstanding, and no borrowings under its revolving facility or commercial paper program at year-end. Management stated that available liquidity, expected operating cash flow, and capital-market access should meet foreseeable needs.

Material changes versus the prior comparable period

Sales growth accelerated substantially, led by strong demand, supplier awards, and growth across Components’ regions and vertical markets. ECS was broadly flat after a weaker first half.
Gross margin declined 70 basis points, primarily because of increased lower-margin distribution services in the Americas and EMEA Components businesses.
Operating expense leverage improved: reported operating expenses were 8.6% of sales versus 9.3% in 2016.
GAAP net income declined despite higher operating income because of a $59.5 million debt-extinguishment loss, a $14.2 million investment loss, higher restructuring and integration charges, a $21.0 million impairment of assets held for sale, and a $124.7 million unfavorable net Tax Act impact.
Operating cash flow fell sharply as higher sales required substantial increases in accounts receivable and inventory. Working-capital investment consumed approximately $1.5 billion of cash before the offset from higher accounts payable.
Debt was refinanced through $500.0 million of 3.875% notes due 2028 and $500.0 million of 3.25% notes due 2024. The refinancing contributed to the debt-extinguishment loss but extended or reduced the cost of portions of the debt portfolio.
Arrow completed two immaterial acquisitions and increased its ownership of Data Modul AG to 69.2%. Subsequent to year-end, it acquired eInfochips for approximately $318 million and Commtech for approximately $22 million.

Guidance, outlook, commentary, risks, and unusual items

The filing does not provide formal numerical 2018 guidance. Management’s stated objectives are to grow sales faster than the market, grow profits faster than sales, expand served markets, and increase return on invested capital. Visibility is limited because substantially all sales are order-by-order rather than under long-term contracts.

Tax Act: The 2017 tax provision included a $196.0 million transition-tax expense and a $71.3 million deferred-tax benefit. The company was still assessing the law under SAB 118 and expected to record adjustments in 2018. The final impact could be material.
ERP implementation: Arrow completed implementation of a global components ERP system in January 2018. Management had not identified significant issues at filing, but acknowledged that adverse implications could emerge.
Restructuring and unusual charges: Restructuring, integration, and other charges were $91.3 million, including $46.8 million for efficiency initiatives, $16.7 million of pension settlement expense, $7.7 million of acquisition-related charges, $3.1 million of real-estate losses, and $2.1 million of additional Wyle environmental accrual.
Fraud and controls: A 2016 impersonation fraud caused unauthorized European cash transfers. Management implemented remediation, and management and Ernst & Young concluded that internal controls over financial reporting were effective as of December 31, 2017. The controls assessment excluded three 2017 acquisitions representing less than 1% of assets, sales, and net income.
Environmental contingencies: Wyle-related remediation remains subject to uncertain timing and scope. Estimated additional costs were $4.7 million to $10.4 million for Huntsville and $18.5 million to $29.0 million for Norco, excluding potentially unquantified future costs.
Market and operating risks: Principal risks include semiconductor and IT cyclicality, supplier concentration and cancelable distribution agreements, inventory obsolescence, competitive pricing pressure, international and currency exposure, cybersecurity and privacy incidents, product liability, acquisition integration, goodwill impairment, regulatory compliance, and customer credit risk.
Interest-rate and currency exposure: Approximately 82% of debt was fixed-rate and 18% floating-rate. A one-percentage-point change in average interest rates was estimated to increase 2017 financing expense by $13.4 million. A hypothetical 10% decline in foreign exchange rates against the U.S. dollar would have reduced 2017 sales by approximately $764.2 million and operating income by approximately $40.5 million.

Most important facts for investors to verify

Whether the strong Components growth and supplier-award activity can continue without further erosion in gross margin.
Whether ECS returns to sustained organic growth after its essentially flat 2017 performance.
Conversion of earnings into cash, particularly accounts receivable, inventory, and working-capital management.
Final 2018 accounting and cash-tax effects of the Tax Act, including the transition tax, GILTI, and BEAT provisions.
Post-year-end integration and financial contribution from the eInfochips and Commtech acquisitions.
Execution and reliability of the newly implemented global ERP system.
Debt maturities, refinancing needs, covenant compliance, and reliance on the asset securitization program.
Ultimate Wyle environmental remediation costs and the probability of insurance recoveries, which were not recorded as receivables.
Potential effects of supplier changes, technology cycles, customer defaults, inventory obsolescence, cybersecurity events, and foreign-currency movements.