Solid sales, solid growth

Bill Mitchell, president and CEO of Arrow Electronics, talked about China, the growing need for information and what’s changing in the global supply chain. Excerpts:



In the US and Europe, distribution is a two-horse race between Arrow and Avnet. Asia is a whole different story, though. How do you see that evolving?

In 2003, the top 10 distributors in greater China—which is Taiwan, Hong Kong and the Mainland— accounted for 33 percent of the total DTAM [distribution total available market]. The DTAM was about $14 billion then. In 2005, the top 10 distributors accounted for about 50 percent of the business, and the DTAM was $23 billion. If you go back and do the math, the top 10 distributors have picked up all of that growth in market share and more. During that time period, there have only been 13 announced acquisitions. One was ours, one was Avnet-Memec, and WPI bought a few smaller ones. Then if you look at the top three—WPI, Avnet and Arrow—we’re roughly the same size. WPI is a little larger, but they have a bigger CPU and DRAM business, which are businesses we choose not to compete in. If you do it on a like-for-like basis, the top three have gone from 12 percent to 13 percent of total market in 2003 to about 30 percent share. So what’s happening in Asia without great acquisition is the top three are starting to emerge. The next five have also grown. Then there are a whole bunch of companies in the ‘all other’ category, which are losing share.So is the market consolidating?

Yes, but not by acquisition. We have made a few, like everyone else, but nothing major. A good benchmark is that a number of the publicly traded distributors in Asia have a market cap that is below tangible net worth. The market is saying, ‘We don’t think you’re worth the assets you have on your books.’ What that means is the Taiwan model, which is a low-margin, high-asset velocity model, works as long as you have access to free money or negative interest money. That’s no longer true. Interest rates have started to rise. If you’ve got a business that makes a 5 percent gross margin and a 2 percent operating margin, and you’re holding three months of inventory and giving 90-day terms to your customers, that only works when you have free money and access to cash. That means you can go get cash and it doesn’t cost anything.



Are you able to charge for those services for indigenous companies in China?

In China, where family is still an important element, a manufacturer may give the contract to a cousin for less money. It’s changing because that cousin can’t do what needs to get done. He can’t provide the complete set of services necessary to meet the demands of a market that is gaining sophistication. We are beginning to see differentiated margins based upon the value-added services we can provide. That’s down at the small and medium-sized customer level, which is a segment I believe is underreported and underappreciated for how big it really is. That was absolutely invisible to the outside world because it was mom and pops that dealt with the aunt and uncle down the street. As that starts to scale, they need access to a broader line card and supply chain services and purchasing power. It will never get to the margin level we see in North America and Europe because the cost of service is lower in China. What we had predicted is that ultimately the operating margin would be pretty close in other parts of the world, and because of the higher percentage of exports, which is always a higher-asset velocity model, your return on working capital would be little better and taxes would be a little lower. That makes Asia not as dilutive to earnings. We’re starting to see that happen, and without acquisitions.



So the government subsidies are gone?

Yes. That’s what I believe the market is saying by valuing these companies at less than the physical assets on their books.



That sounds like a vote of confidence. Simon Wong, the chairman of WPI, asked what we’re going to do with it. I said we’ll either invest more, sell it or keep it. So far, we’ve kept it. They’re clearly emerging as one of the three top players in Asia. The three top players are pulling away. There’s now a middle tier, which I believe will consolidate. And then there’s the ‘all other’ category, that will look a lot like Europe does today, where the top 10 have 85 percent or 90 percent of the market. In the US, the top 10 have 95 percent to 97 percent. WPI is clearly emerging and they’re looking at more value-add services, increasing their margins, not doing so much low-margin fulfillment. WPI is one of those companies that for a good portion of this year has sold below tangible net worth. They’re making a 2 percent operating margin and break-even on invested capital. That all works as long as capital is free. They’ve been quite public about changing their mix from high-volume Taiwan ODMs to a broader customer base. That’s where we are, and we are in a good position to compete with them and others.



Is there a possibility of picking up new clients with in-plant stores and other things that would further increase your knowledge of what inventory is out there?

Yes. We can extend some of the learning we have that can help others. We’re starting to do that on a small basis. We’ve learned some things. We’re focused less on the really big contract manufacturers, who are already our customers. It’s the small and midsize contract manufacturers, of which there are about 500 or more in China alone and 1,000 in the US. Ten years ago you wouldn’t even have called them contract manufacturers. They assemble the module into a final product. Those are the ones who want us to help because we have better tools, better visibility, better leverage with suppliers and better logistics handling capabilities. That’s been a nice part of our business for the past year or so.



Looking at your own balance sheet, you’ve been on a pretty good run. Why?

We have set as a company goal that we will outgrow the market. That means we should be growing market share, and we have been. In fact, we have 14 consecutive quarters where we have outgrown market share. We also said we’d grow profits faster than sales. Our expenses grew significantly less than our topline growth. Over time, that means your profits go up. Our inventory turns during that time have gone from four to close to seven. All of a sudden we’re starting to spin off cash, which is good. We’ve taken about $1.8 billion in debt off the balance sheet. There are no magic bullets. We started with a lean sigma concept. It’s a matter of how we improve step by step, region by region, process by process. It’s just work. Focus on the top line— value-add business—coupled with continuous improvement that keeps your expenses low.



Isn’t this part of China’s grand plan to seed the market in manufacturing and distribution, then move up in the value chain into design next?

Exactly. There was speculation several years ago that as the market grows and matures, it will move away from this high-velocity fulfillment model to the one we see in North America and in Europe. That’s differentiated services—services for specific market segments. There is a differentiable automotive sector and a differentiable industrial sector. There’s a communications sector, wireless sector, consumer electronics and computing sector. Three years ago it was all basically export manufacturing, large contract manufacturers and OEMs. As that market develops, it looks very much like the markets we see in North America and Europe, albeit on a less mature scale. But now you have to add value-added services like design creation capabilities, supply chain services and advanced logistics. You also have to start thinking about funding working capital because you can’t get money. The Chinese government is squeezing it.



At some point there have to be acquisitions, though, right? Otherwise competition gets too intense because $1 billion distributors can hire talent and offer competitive services. I would certainly expect that to happen. We don’t know when, but if you look at the North American market, there are tipping points. You get to where people say, ‘I’m not going to make it here and I need to find a bigger partner or sell out.’ We don’t have a lot of visibility into what’s happening in that other 50 percent. This is like the US in 1970. There were thousands of little companies. You can see them in any major city if you go into the electronics malls. But it’s sorting itself out and playing to the strengths of a couple of big global players.



WPI seems to have grown particularly fast. Is it sustainable?

Arrow owns 5 percent of WPI.



How good is your information system these days to prevent inventory build-up problems?

We spent tens of millions of dollars in logistics and systems capabilities to have a lot more visibility into where things are and where they’re moving. We have contingency plans to avoid double booking and double ordering—all the stuff we got caught with in 2001. The channel has been pretty well in balance for quite awhile. Every quarter we survey our customers, too. It’s a very rational market now.



With your information network, you have significant better visibility than most companies. Will you become a supplier of that kind of information? We do see that as a real strategic capability, but I doubt we’re going to get into the business of selling that. I do believe we will utilize it to help our customers understand the broader markets they’re in, and that becomes part of the value add we can provide to them. One of the things we talk a lot about is that big global distributors see every technology in every end market and in every geography. The real spot we serve is the small and medium size customer, and the advantage to that is everything is statistically relevant. It’s not just one customer who depends on what Cisco is doing. That’s a real strategic advantage.



Given all of that, what do you see going on in the giant electronics market?

The investment world keeps trying to talk us into a downturn. What we have seen in the larger markets is good underlying strength almost anywhere. We don’t see anything that’s too hot, or anything that’s really down. Everything is within normal operating limits now. We saw the first half of this year was up substantially. RoHS in Europe was good for us. Asia continues to move forward. In the US, industrial electronics is permeating through. The US electronic market is alive and vibrant. The European market is pretty good. The Asian market is pretty strong.



How is Latin America doing?

It’s okay, but still not growing as fast as China and India. All of Eastern Europe is showing good growth rates.



Where on the globe are you not well represented?

Eastern Europe and Japan. We have basically no presence in Japan.



Is part of that slow ramp up due to purchase of new technology?

Yes. We have made technology investments, and we continue to make technology investments. The amount of information we generate every day is huge. We have 35,000 transactions a day, and there are inventory moves and purchases that go along with that. Computers do that really well.



Do you have to buy your way into that market?

Probably. We have an 8 percent share of Marubun, a distributor in Japan. If you look at the distribution market as a percentage of the total market, in North American and Europe it’s on the order of 25 percent. About 2 percent goes through directed distribution, which is typically fulfillment. In Asia, it’s about 25 percent of the total market, but about a third is directed. We think that will shrink over time. In Japan, it’s totally different. About 20 percent goes direct, 20 percent goes through in-house distributors. NEC and Mitsubishi have their own distributors. Another 30 percent goes through the big trading houses like Mitsui, and the balance goes through independent distributors. The markets operate differently inside of Japan.



One last question: What as a percentage of revenue are you investing in technology, because for a distributor that’s essentially your R&D?

Our capital expenditures are not high. It’s a couple percent of sales. But what you don’t see is that embedded in our expense structure is a substantial investment in IT tools, supply chain tools, tracking tools, and design-win tools. We’ve never fully disclosed what that number is, but it’s substantial and it’s growing. That’s our advantage. That’s our real R&D. It doesn’t show up in capex.