Avnet (NYSE:AVT) is a global distributor of electronic components, enterprise computer and storage products, IT solutions and services and embedded subsystems. It has two primary operating groups: Electronic Marketing (60% of revenue) and Technology Solutions (40%). Both groups have operations in each of the three major economic regions: Americas, EMEA (Europe, Middle East and Africa) and Asia.
EM markets and sells semiconductors, interconnect, passive and electromechanical devices and embedded products. The segment provides value-added services offering design chain services, which help clients in accelerating their time to market, and supply chain services, which help clients in managing their supply chain more efficiently.
TS focuses on the value-added distribution of enterprise computing servers and systems, software, storage, services and complex solutions.
Avnet has low margins but it's exposed to future big trends like "internet of things" (from 10 to 50 billion devices expected on the internet by 2020), big data, smarter grids and healthcare. Avnet's differentiation strategy consists in offering complementary services to clients in order to enhance their engagement with the company and gain a competitive advantage over peers.
I will discuss Avnet's financial metrics and ratios compared with those of Arrow Electronics (NYSE:ARW), a direct competitor that reported 21 billion in sales in 2013. Please note that Avnet's fiscal year ends in June while Arrow's in December. Metrics are reported using calendar years and updates on Avnet's first half 2014 are provided.
Sales increased at 11% CAGR in the last 5 years, from 16.2 billion in fiscal year 2009 to 27.5 billion in 2014. Much of the revenue growth was realized in fiscal year 2011 when Avnet acquired competitor Bell Microproducts, which accounted for nearly 3 billion in sales at that time. Since 2009, Avnet has completed 42 acquisitions that contribute approximately 7.5 billion in revenues. After 2 years of zero growth, sales picked up in fiscal year 2014 (+8% on a YoY basis). Without considering acquisitions worth 500 million in sales, revenue grew +5.2% YoY, +4.8% in constant currency. Organic sales growth was mainly driven by EM segment, which increased +8.2% YoY in constant currency, while TS remained flat.
Semiconductors accounted for nearly half of total revenue in fiscal 2014, computer products 38%, connectors 3% and passives, electromechanical and other 11%.
By geographic area, sales were located 40% in the Americas (17.6% EM, 22.1% TS), 30% in EMEA (18.5% EM, 11.5% TS) and 30% in Asia (24% EM, 6.3% TS).
By comparison, Arrow's sales have grown 5% annually since 2009, from 16.7 billion to 21.3 billion in 2013.
Arrow had higher gross margin than Avnet in the last 5 years, especially from 2010 to 2012, although gross profit has been volatile. The difference was less in operating profit margin and net margin due to lower incidence of SG&A expenses (-8.4% last calendar year vs. -8.8% for Arrow) and lower incidence of taxes. Interestingly, Avnet presented higher gross profitability (gross profit/assets).
Avnet's management is working on improving profitability, which is always a concern when a company grows through acquisitions and bears many cost-reduction charges. Management stated that the company's operating leverage isn't fully utilized and organic sales growth will contribute to margins expansion. Last quarter Avnet invested in working capital to sustain future sales growth so I won't be surprised if the company will experience organic revenues growth coupled with margins expansion in the short term, while it is still bearing restructuring and integration costs.
During the last annual meeting with shareholders, the CEO and the CFO of the company stated that, to enhance the company's profitability, only acquisitions with a return on capital employed in the 14%-16% range will be realized.
Margins improved in the last 4 quarters. Although gross margin was stuck to 11.7%, operating profit margin rose to 2.9%, net margin increased to 2% and gross profitability rose to 28.66%.
Return on capital analysis highlights that Avnet has been generally more profitable than Arrow when accounting for capital employed, although profitability is decreasing. It's worth noting that Avnet's total capital has grown in line with sales (11% CAGR) while Arrow's capital has grown 11% annually but compared to a much smaller growth in sales (5% CAGR). Considering "tangible capital" only, Avnet's capital has grown 10% annually vs. Arrow's 9% so a higher share of Arrow's asset growth has been generated by goodwill and intangibles.
Considering trailing results up to June 2014, all ratios improved: ROA increased to 7.3%, ROE rose to 11.9%, ROTC, ROIC and ROCE increased respectively to 6%, 10.9% and 13.2%.
Higher Avnet's profitability is reflected into higher asset turnover, as shown in the table above.
Arrow had a shorter cash conversion cycle than Avnet last year but this number was roughly equal in previous years. There are however differences: Avnet generally takes less days in collecting credit from customers and paying off debt to suppliers, it also better manages the inventory.
Last 4 quarters, Avnet's cash conversion cycle was 54 days due to a reduction in days sales outstanding and days on hand not fully compensated by less days payables outstanding.
Better asset management is the main source of Avnet's higher profitability compared with Arrow, as shown by the DuPont decomposition below:
The main source of Avnet's higher ROE is asset turnover that overcomes lower operating profit margin and lower financial leverage (less risk). As reported above, last year Avnet's ROE increased to 11.6% due to an increase in operating profit margin (2.87%), lower interest expense rate (-0.96%) and higher tax retention rate (77%). Asset turnover increased to 2.53 while financial leverage decreased to 2.37.
Avnet historically has been less leveraged than Arrow. Currently, Avnet has a better financial position with $900 million in cash on balance sheet as of June month end compared with $1.2 billion in long-term debt while Arrow has $2.1 billion in long term, only $300 million in cash and a higher Debt / Equity ratio. Although debt / equity ratios aren't low, interest coverage ratios are healthy and cash from operations sufficient for both companies.
On a trailing basis, Avnet's financial ratios improved. Debt / Total capital decreased to 0.57, Debt / Equity decreased to 1.30 and interest coverage ratio increased to 9.55 although CFO / Debt decreased to 0.11 due to investments in working capital.
Balance sheet's countercyclical nature of the two companies could provide a nice cushion in case of an industry downturn: during crisis periods, working capital is reduced because it must support lower sales level and cash is released. In 2009-2010, cash was more than 10% of assets but this wasn't the result of a higher debt level.
Dividend and share repurchase program
Avnet started a $500 million share repurchase program in August 2011, subsequently increased to $750 million. Up to June 2014, Avnet repurchased 18.1 million shares at $29.5 average price, reducing share count of approximately 10% and $215.9 million is still available for future purchases. During fiscal 2014 the company started paying a $0.15 quarterly dividend ($82.8 million annually) and, last quarter, announced a 6.7% dividend increase to $0.16. The dividend is clearly sustainable considering that Avnet's cash flow from operations last fiscal year (June 2013 to June 2014), was $237 million after a $484 million investment in working capital. The high level of cash flow from operations compared to total amount of dividend paid and 900 million of cash on balance sheet can sustain this dividend growth rate without precluding to Avnet profitable investment opportunities.
As of August month end, Avnet and Arrow's trailing ratios are as follows:
From the above ratios, Avnet is clearly undervalued compared to Arrow and also considering its own 5-years average P/E ratio of 13.9. The biggest difference is on Price-to-Tangible-Book ratio where Arrow is valued 88% more than Avnet. Tangible assets are in particular inventory and receivables that constitute more than 70% of total assets on balance sheet. Applying Arrow's ratios to Avnet's financial metrics provides an implied potential upside from 12% (P/S and EV/EBIT) to 22% (P/E) for a company with better return on capital employed, 1.45% dividend yield and lower financial risk (I didn't consider here P/TBV ratio because of the big difference).
According to Morningstar, both companies are also undervalued considering industry's average ratios which currently are 14.4 P/E and 1.6 P/B. Applying these multiples to Avnet's figures raises the possible appreciation to 27%.
This is a conservative potential upside because it considers only a stock's re-rating to peers' level. Avnet's last income statement reported 11.7% gross margin, $94.6 million in restructuring and integration costs (-0.3% of sales) and 22% tax rate. The company's average gross margin for the last 10 years has been 12.3%, although it was over 13% before the financial crisis. Applying 12% gross margin (which is lower than historical average and just 0.3% higher than current level) to fiscal 2014 revenue, eliminating restructuring and integration costs but raising tax rate to 30%, results in potential EPS of $4.30. At Arrow's current P/E ratio, Avnet's share's fair price would be $59.2, +33% from current valuation, and that's without considering potential sales growth. If management buys back shares for the remaining $215.9 million at current price, the fair value would rise from +3.5% (considering trailing EPS) to +5% (considering EPS as calculated above).
According to reported metrics, Avnet is more profitable and less risky than Arrow, despite that it trades at lower multiples. Furthermore, both companies' shares are undervalued compared to average industry ratios and, trading at 11 times trailing P/E, Avnet is cheap on an absolute basis as well. After 5 years of low margins, consolidation and growth through acquisitions, there are signs of improvement in the electronic wholesale sector. Organic growth, together with cost-cutting initiatives and consolidation of acquired businesses, will drive Avnet's margins up and this could act as a catalyst for a re-rating of the stock.
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The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.