Arrow Electronics, Inc. (NYSE:ARW) is a commercial distributor for electronic components, semiconductors, software, and enterprise infrastructure hardware. ARW works with the 871 industry manufacturers to source one of the broadest portfolios of product offerings in the world, serving over 200,000 customers. Arrow generated about $30 billion in revenue over the past year with a market cap of $5.7bn. The company is set to report Q2 earnings August 1st, but anticipated the results by providing preliminary figures. The company announced it is pulling out of the personal computer and mobility asset disposition business. Management also commented that the results for the quarter are lower than previously expected, pointing to slowing market conditions. Naturally the stock sold-off on the news, and we think there is more downside ahead. This article previews the upcoming earnings release and the stock outlook going forward.
ARW monthly stock price chart. Source: FinViz.com
Q2 Earnings Release Preview
Arrow Electronics doesn’t typically provide preliminary results ahead of earnings. This quarter, however, the main development was that the company disclosed to the market that it is closing its personal computer and mobility asset disposition business including a charge of $115 million this quarter related to non-cash impairment of assets and other exit costs. Separately, the company is taking an even larger related goodwill impairment charge of approximately $570 million, considering the business segment exit and in conjunction with lower Q2 earnings expectations. The press release goes on to describe other related impairment chargers that all together total $767 million. The company also plans to initiate an expense reduction program looking to save $130 million in annual costs going forward. The press release included the following comments by management:
“After careful market analysis indicating that business dynamics have changed since we entered this market, we have decided to wind down operations at our personal computer and mobility asset disposition business,” said Mr. Long. “This will allow us to continue to focus on our cross-enterprise strategy to enable next-generation technologies such as artificial intelligence, industrial automation, smart cities and vehicles.”
Consensus GAAP EPS estimates for the second quarter are for a loss of $6.15 compared to a previous estimated profit of $1.69 prior to the announcement. Consensus adjusted EPS estimates, excluding the non-recurring charges, are for EPS of $1.57, which if confirmed will be a decline of 29% year over year. These estimates are within the range guided to by management. Q2 revenue guidance of $7.3 billion represents a decline of 1.4% y/y.
More concerning here was management’s view that the business conditions remain weak with “deteriorating demand conditions in the global components business“. Indeed, the market response here was to sharply pull back growth estimates for the next three fiscal years. Compared to $29.7 billion in revenues ARW reported for 2018, the expectation now is that this remains relatively flat at $30.4 billion by 2021.
Trading-based valuation multiples at least suggest ARW could be something of a value pick at current levels with a price-to-sales ratio of 0.2x and P/E ratio of 8.3x, but we see it more of a “value trap” in our opinion. Going back two decades, these multiples have reached levels even lower this decade and are structurally pressured based on its low margin distribution business and cyclical exposure. The gross margin was just 12% in Q1, which has trended lower from levels above 13% as recently as 2017.
Free cash flow, which reached annualized levels above $500 million in 2015, has been trending lower in recent years and was negative $135.7 million over the trailing twelve months in Q1 2019. Given the outlook for weak growth and lower earnings this year, expect free cash flow to remain negative in the near term. It’s worth noting that the balance sheet position remains stable with ample liquidity represented by a current ratio of 1.7x, so the company does not have any liquidity issues. What ARW needs is a significant rebound in the electronics market that is currently depressed by macro factors like global trade uncertainty and overall slowing demand from Asia. Without a clear catalyst for an electronics component demand turnaround in the near term, we see ARW challenged to maintain margins while devoting its efforts to cost-cutting efforts.
Looking back at the P/E ratio time series history for ARW’s shares, the stock traded as low as 5.5x back in 2011. The current forward P/E of 9.3x on estimates the company will still earn $7.31 per share this year suggests there is downside to the stock price relative to its own trading history. We set a price target at $58.50, representing 8x forward earnings and 13% downside from the current share price.
We think the combination of weak outlook including no-growth and declining cash flows will maintain the negative sentiment on ARW going forward and drive shares lower. Don’t expect any surprises in revenue or EPS during this upcoming earnings release as the numbers should be otherwise be in line with the recent guidance update. We’ll be looking for the evolution of the financial margins to see trends in the underlying market demand and profitability. The gross margin in particular has been trending lower in recent years, which suggests a poor pricing power dynamic and softer market conditions. Expect an overall messy release during this transition quarter, which will include multiple charges and require multiple adjustments to observe underlying conditions. We see risks to the downside in revenue estimates going out 1-2 years as the operating environment could get worse before it gets better.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The information contained herein is for informational purposes only. Nothing in this article should be taken as a solicitation to purchase or sell securities. Investing includes risks, including loss of principal.