Arrow Electronics, Inc. — Form 10-Q Summary
Business Context and Reporting Period
Arrow Electronics is a global distributor of electronic components and enterprise computing solutions. Its two segments are Global Components and Global Enterprise Computing Solutions (ECS). This unaudited report covers the quarter ended April 2, 2016, compared with the quarter ended March 28, 2015.
- Approximately 67% of first-quarter 2016 sales came from Global Components and 33% from Global ECS.
- Sales increased across all geographic regions, with first-quarter 2016 sales of $5.474 billion in the Americas, $1.666 billion in EMEA, and $1.188 billion in Asia/Pacific.
Financial Performance and Key Metrics
| Metric | Q1 2016 | Q1 2015 | Change |
|---|---|---|---|
| Sales | $5.474 billion | $5.002 billion | +9.4% |
| Gross profit | $748.9 million | $685.3 million | +9.3% |
| Gross margin | 13.7% | 13.7% | Flat |
| Operating income | $181.4 million | $177.4 million | +2.2% |
| Operating margin | 3.3% | 3.5% | Down 20 bps |
| Net income attributable to shareholders | $106.2 million | $106.1 million | Essentially flat |
| Diluted EPS | $1.14 | $1.09 | +4.6% |
| Adjusted net income attributable to shareholders | $132.2 million | $127.8 million | +3.4% |
- Global Components sales increased 9.8% to $3.676 billion; adjusted for currency and acquisitions, sales increased 4.4%.
- Global ECS sales increased 8.6% to $1.798 billion; adjusted for currency and acquisitions, sales increased 2.9%.
- Adjusted operating income was $215.1 million, or 3.9% of sales, versus $204.7 million, or 4.1%, in the prior-year quarter.
- SG&A increased 11.3% to $505.8 million, and SG&A as a percentage of sales increased to 9.2% from 9.1%.
- The effective tax rate was 27.8% in both comparable quarters; the adjusted 2016 effective tax rate was 27.6%.
Cash Flow, Liquidity, Debt, and Capital Allocation
- Cash used in operating activities was $36.6 million, an improvement from $241.6 million used in Q1 2015. Working-capital investment remained significant, particularly in receivables and inventories.
- Cash used in investing activities was $95.8 million, including $46.5 million for two acquisitions and $49.3 million of capital expenditures. ERP-related capital expenditures were $16.6 million.
- Cash provided by financing activities was $253.6 million, primarily reflecting $265.0 million of net proceeds from long-term bank borrowings.
- Cash and cash equivalents increased to $394.7 million from $273.1 million at December 31, 2015. Approximately $355.8 million was held outside the United States and was intended to remain permanently reinvested abroad.
- Total debt was approximately $2.695 billion, including $46.1 million of short-term borrowings and $2.649 billion of long-term debt, compared with total debt of approximately $2.425 billion at December 31, 2015.
- Borrowings under the asset securitization program increased to $325.0 million from $75.0 million. The program has $900.0 million of capacity and matures in March 2017.
- The company had an undrawn capacity balance of approximately $1.413 billion under its $1.5 billion revolving credit facility, subject to borrowing terms and covenants. The facility matures in December 2018.
- Management stated that available cash, borrowing capacity, expected operating cash flow, and capital-market access should be sufficient for projected needs for the foreseeable future.
- The company repurchased $2.5 million of shares under its announced $400 million program during the quarter. As of April 2, 2016, $317.3 million remained available under the program.
Material Changes Versus the Prior Comparable Period
- Reported sales growth was strong, but organic growth was more moderate at 3.9% after adjusting for currency and acquisitions.
- Operating margin declined from 3.5% to 3.3%, primarily reflecting higher operating expenses and restructuring, integration, and other charges.
- Interest and other financing expense increased to $35.6 million from $30.9 million due primarily to higher average debt outstanding.
- Reported net income was essentially unchanged, while adjusted net income increased because the 2015 period included a debt-prepayment loss and an investment-sale gain and the 2016 period included higher special charges.
- Q1 2016 included $20.8 million of restructuring, integration, and other charges, compared with $16.2 million in Q1 2015. The 2016 amount included a $13.2 million fraud loss, $2.5 million of restructuring and integration charges, and $1.6 million of acquisition-related expenses.
- The company completed two acquisitions in Q1 2016 for $45.6 million net of cash acquired; management stated that their impact was not material.
- Foreign currency translation produced a $73.2 million increase in other comprehensive income, compared with a $198.4 million loss in the prior-year quarter.
Guidance, Outlook, Commentary, Risks, and Unusual Items
- The filing does not provide explicit quantitative quarterly or full-year revenue or earnings guidance.
- Management described customer and supplier visibility as limited because substantially all sales are made on an order-by-order basis rather than under long-term contracts.
- Key business risks include demand and pricing changes, product supply constraints, supplier relationships, competition, margin pressure, global economic conditions, acquisition integration, ERP implementation, legal and regulatory matters, and the ability to generate cash flow.
- A criminal fraud event resulted in unauthorized transfers of $13.2 million from a European company account. An independent investigation and legal actions were ongoing. Approximately $29.0 million of cash was frozen in outside bank accounts and was considered probable of recovery.
- Management disclosed a material weakness in internal control over financial reporting related to preventing or timely detecting unauthorized cash disbursements. Remediation actions included enhanced approvals, centralized review, disbursement limits, security communications, fraud-reporting protocols, and personnel changes. Management expected remediation to be completed during Q2 2016.
- The company remained in compliance with debt covenants and reported no material changes to previously disclosed market risks or risk factors.
- Environmental contingencies remain associated with former Wyle facilities. Estimated additional costs were $0.4 million to $0.75 million for Huntsville investigations, plus estimated remediation costs of $3.0 million to $4.0 million, and $13.5 million to $24.5 million of additional Norco activities. The ultimate costs remain uncertain.
- Pending legal, regulatory, environmental, product, labor, and tax matters could produce additional liabilities, although management did not currently expect other matters to materially affect results.
- The company was evaluating recently issued accounting standards, including revenue recognition, leases, financial instruments, and stock compensation. Adoption effects were not yet determined, except that the inventory guidance adopted January 1, 2016 had no material impact.
Investor Verification Checklist
- Verify the remediation and subsequent testing of the material weakness involving unauthorized cash disbursements.
- Track recovery of the approximately $29.0 million of frozen cash and any further fraud-related charges or legal developments.
- Assess leverage, refinancing plans, and renewal risk for the $325.0 million asset securitization borrowing maturing in March 2017.
- Monitor organic sales growth, operating-margin pressure, and the effect of acquisitions and foreign-exchange movements.
- Review cash conversion and working-capital trends, particularly accounts receivable, inventory, and accounts payable.
- Follow the ERP implementation, acquisition integration, restructuring spending, and related execution costs.
- Evaluate potential environmental and other contingency costs, recognizing that the filing does not establish a clear upper bound for certain liabilities.