Based in Phoenix, AZ, Avnet, Inc., (NYSE:AVT) is one of the world's largest distributors of electronic components and computer products. The company's customer base includes original equipment manufacturers [OEMs], contract manufacturers, original design manufacturers and value-added resellers [VARs].
Avnet maintains an extensive inventory, including electronic products from over 300 component and systems manufacturers, which it distributes to about 100,000 customers through 250 worldwide locations. The product set is composed of semiconductors (approximately 62% of 2006 revenue), computer products (30%), connectors (4%), and passives, electromechanical & other (4%).
Avnet operates in two segments: the Electronics Marketing [EM] Group and the Technology Solutions [TS] Group. The EM Group distributes semiconductors and interconnect, passive and electromechanical devices [IP&E], and provides supply chain management, inventory replenishment system and noncomplex engineering design services.
The TS Group distributes mid- and high-end servers, data storage gear, networking equipment and software, and also offers some services. In fiscal 2005, the largest supplier to TS was IBM (NYSE:IBM), accounting for 18.7% of AVT's total sales. The EM segment generated 65% of the $14.254 billion in fiscal 2006 revenue, while TS contributed the remaining 35%.
The company has separate divisions to meet the individual requirements of different classes of customers like OEMs, independent software vendors [ISVs], system builders, system integrators, value-added resellers [VARs] and end-user customers. It provides real-time information about product availability and offers related services that enhance the value of the products sold.
Avnet generates approximately 51% of its revenue from operations in the Americas; 31% from Europe, the Middle East, and Africa [EMEA]; and 18% from the Asia/Pacific region. Revenue contribution from the Asian market has grown every year for the last three years by a total of 159.7%. EMEA and the Americas have grown 45.9% and 43.7% during the same time period.
In the past, management had pursued a strategic acquisition policy that increased the size of the firm. In the last two years, the company made two major acquisitions, which significantly increased the revenue base and expanded margins. Avnet closed the acquisition of privately held Memec Group Holdings limited, a major competitor, on July 2, 2005. Total consideration included $418 million in AVT stock, $64 million in cash and the assumption of $194 million in net debt for a total value of $676 million. This works out to a 0.3x price to 2004 sales multiple. Memec generated $2.289 billion in revenue during 2004, and served the communications (39% of total revenue), industrial (29%), computing (22%), consumer (4%) and other (6%) end markets.
Memec has been integrated within the EM unit. Management expects to derive $150 million in cost synergies with approximately $105 million coming from labor force consolidation, and approximately $15 million each from facilities consolidation, IT and other areas. There was an additional $10 million in financial synergies, as a result of the elimination of Memec s high interest bank debt.
Avnet's primary competitors are Arrow Electronics, Future Electronics and Agilysys. Smaller companies specializing in a single product or groups of products provide additional competition. Despite the large number of competitors, Avnet has been able to maintain its market position. The company's range of products and services, solid inventory and strong customer relationships have helped it secure a substantial share of the market.
Strategic acquisitions continue to pave the growth path
Memec has been fully merged into the EM operations. The revenue, cost and financial synergies are expected to continue. Management has retained the Japanese workforce in its entirety (AVT did not previously have a presence in the country), and has made only limited reductions in the Asia/Pacific region overall. Memec has brought with it an experienced team, and management expects to retain key personnel.
The expected quarterly savings by the end of fiscal 2006, after complete integration, was originally estimated to be $30 million (excluding interest expense savings from the retirement of Memec's long term debt). A further $7.5 million of potential synergies per quarter have been identified. Integration activities were completed in Q406. In the December quarter, Avnet closed a small semiconductor and embedded systems business in Italy for $3.32 million (net of cash acquired).
On the first day of the last quarter, the company closed the acquisition of Access Distribution for $410 million (subject to any minor changes that might occur as a result of alterations in audited book value). The acquisition was cash and debt funded. Access Distribution, the leading value-added distributor of Sun Microsystems (NASDAQ:SUNW), will be integrated into the TS unit. This acquisition enhances Avnet's position at Sun Microsystems, as well as at several other providers of new high-growth technology products in the security, networking and VoIP markets.
Roughly 90% of the Access business is currently generated in the U.S., while the balance comes from Europe. The geographic mix of business is a positive, since these regions typically generate higher margins than Asia. However, management stated that last quarter Access had lower gross margins than the EM unit, indicating that the consolidated company will have a larger chunk of lower-margin business. Management continues to expect the acquisition to add $2 billion in annual sales, add $0.20 to the 2007 EPS, and bring in cost synergies of around $15 million.
Since Sun Microsystems closes its year in June, and typically experiences strong seasonality in this period, the Access business is expected to have a significant impact on current quarter results. Whether the cost synergies kick in as expected remains to be seen. Most of the large distribution companies run at razor-thin margins, therefore the possibility of margin increases through cost reductions is minimal. Therefore, acquisitions play a major part in the growth strategy of these companies.
Both the Memec and Access acquisitions significantly increase the company's scale of operations, hastening the realization of long-term financial goals within a shorter time frame.
The EM segment could remain under pressure
The company has a large market share and Memec opened the door to several other niche markets. Avnet's position in Asia has been much strengthened by the acquisition, improving its growth prospects significantly.
However, with the acquisition of Memec, the company has a larger percentage of business flowing from Asia, and Asia is likely to be the largest growth driver given current outsourcing trends. Management stated that the business in Asia is associated with lower ASPs and also lower costs. While other factors may help margin expansion, a larger percentage of Asian revenue in the mix enhances Avnet's basic low-margin profile. The current margin expansion is deceptive, since it comes from weakness in low-margin Asian revenue rather than strength in high-margin Americas and EMEA revenue. The Asian business is expected to pick up next quarter, North America is expected to be slightly up, while Europe experiences weak seasonality. Therefore, gross margins at the EM unit will likely decline next quarter.
Growth in the EMEA region is likely to be driven by rough and hazardous [RoHS] products. Europe leads other regions in the adoption of RoHS standards, so management expects the RoHS adoption in Europe to aid the learning curve for future RoHS sales in other regions. The EMEA business was very strong in Q3, since it was the only region that remained unaffected by the continued weakness at several high volume EMS customers serving the communications infrastructure market. Although management indicated improvement in EMS bookings trends, the timing of a turnaround remains uncertain.
The core TS business continues to be impacted by declining microprocessor sales
The TS strategy has been to focus on the software and services area. Management has been expanding software and services, offering complete solutions to customers. This side of the business is likely to witness strong growth. Management expects the small and medium business market to offer attractive growth opportunity, and believes that more and more software vendors will enter the market through this channel. The microprocessor business remains very weak. The price war between AMD (NYSE:AMD) and Intel (NASDAQ:INTC) continues to increase volatility in this market. The AMD business is more profitable than the Intel business, according to management, prompting it to de-emphasize the Intel business. The weakness in microprocessors is the main reason for the continued weakness in the Asia/Pacific region. Based on rough calculations, TS revenue excluding the Access contribution, declined -34% in the last quarter. With the region experiencing strengthening orders in the last quarter, revenues are expected to pick up next quarter. And since Asia is a low-margin region, this revenue growth is likely to come at the cost of margins.
The core business is underperforming
Last year, Avnet expanded its relationship with Sun, and started distributing Sun's StorageTek products. Avnet Partner Solutions started distributing disk systems, network-attached storage [NAS] systems, storage management software, storage networking and tape storage, as well as Sun Fire servers in the U.S. With these additions, the company now offers a complete storage solution that includes disk and tape hardware, software and services. The recent addition of Access further increases the company's position at Sun Microsystems. Management did not break out the revenue contribution of the two acquisitions in the last quarter, and did not indicate what it expects the acquisitions to contribute in the fourth quarter. Access generated $413 million in the March 2006 quarter. Management expects the business to grow to an annual sales level of $2 billion. Therefore, conservatively, if we consider that sales were up 5% on a year-on-year basis, the Access contribution in the last quarter would be $434 million. Deducting this amount from total revenue indicates a double-digit sequential decline in core revenue (including Memec).
Some key metrics remain favorable
Inventories are at acceptable levels, lead times are steady and average selling prices [ASPs] are stable. Order cancellations are at normal levels. Although the operating margin increase in the last quarter was helped by weakness in lower-margin business. This was the fifth consecutive quarter that EM generated 5%+ operating margins. The TS segment had another quarter of 4%+ operating margins. We believe this to be a very encouraging trend. Management's execution is commendable, as the company has generated stable operating margins since the September 2002 quarter, and has grown operating margins every year since fiscal 2002. In fiscal 2006, revenue grew 28.8%, while the pro forma EPS increased by $0.53.
Our long-term concern regarding the firm s capital structure remains
The company sold two-thirds of its 8% notes due November 2006 in the September quarter, exchanging them for $250 million worth of 6% notes due September 2015. It also issued 6.625% notes to repurchase its outstanding 9-3/4% notes. Although this reduced the interest and also extended the payback period, debt reduction was minimal. While the Moodys debt rating upgrade from Ba2 to Ba1 and the S&P outlook change from negative to stable are encouraging, the total debt position remains high in our opinion. Interest payments had a -$0.15, -$0.12 and -$0.13 impact on the EPS in the September 2006, December 2006 and March 2007 quarters, respectively, and reduced the GAAP net income by -15.9% in the last quarter. We expect interest payouts to remain substantial in the future as well.
The Access acquisition has driven the share price to all-time highs; however, we remain concerned about the above-outlined issues, especially the high level of debt. We are reiterating our Sell recommendation in view of the rich valuation.
INDUSTRY OUTLOOK - POSITIVE
The outlook for the Electronics Industry continues to improve. After enduring a two-year slump the worst ever growth started stabilizing. Inventories are currently at satisfactory levels, with more than a few companies generating significant sales growth. With demand picking up in key end markets and most fabs running at near-peak levels, capacity expansions are likely to continue until 2008-end.
The industry includes manufacturers and distributors of a wide range of electronic parts, as well as electronics manufacturing services (or EMS) firms who contract out with original equipment manufacturers [OEMs] like Cisco (NASDAQ:CSCO) to build subassemblies and finished products. Throughout the technology downturn, demand for consumer-oriented items like cell phones, digital cameras, and printers held up relatively well, while spending on computers and communications infrastructure was particularly hard hit. Post-bubble, the industry seems to have shifted gears to more consumer-oriented growth. While computing is being driven by product cycles, communications infrastructure is seeing a very slow pickup, based on technology upgrades.
On the other hand, handsets and consumer electronics goods continue to do well. The SIA has forecasted that most of the semi growth over the next few years will come from the consumer segment. Over the last few years, electronic component suppliers have been shuttering plants and moving more production to low cost regions like China. While the moves make sense, a number of companies have been forced to take large restructuring charges that have hurt their returns.
Long-term growth prospects are above average, in our opinion, due to the proliferation of electronic applications and the ongoing trend toward outsourcing. Further, given the amount of cost cutting that has occurred, profit margins should respond quickly to a pick up in key end markets.
Avnet is the leading supplier of electronic components and computing products. The company's primary competitors are Arrow Electronics, Future Electronics, Memec and Agilysys, as well as smaller competitors who specialize in a single product or group of products. Despite the large number of competitors, Avnet has been able to maintain its position. A key driver of success in the distribution business is the availability of a wide range of quality products that can be marketed to a broad customer base over a large geographical area.
This must be counterbalanced with sufficient supplier protection agreements that guard against product obsolescence and price erosion in order to minimize inventory risk. Avnet maintains a large inventory, $1.62 billion at the end of last quarter, which enables customers to use a single vendor and a simplified procurement process.
The company has separate divisions to meet the individual requirements of different classes of customers, like OEMs, independent software vendors [ISVs], system builders, system integrators, value-added resellers, as well as end-user customers. Avnet provides real time information about product availability and offers related services that enhance the value of the products sold.
On April 26, 2007, Avnet announced results for the third quarter and fiscal year 2007 ending March 2007. Last quarter, management decided to report supplier service sales on a net basis rather than on a gross basis. This effectively reduces revenue and COGS by $188 million, while the impact on gross profit dollars, operating profit dollars and net profit dollars remain unchanged. The top line was -2.9% short of the consensus estimate of $4.214 billion, even after neutralizing the effect of the supplier service sales. Revenue for the period was $3.904 billion, up 0.3% sequentially, and 8.0% year-over-year. Grossing the sales from supplier service contracts, quarterly revenue was $4.092 billion.
The company disposed off two TS and two EM business units in the third and fourth quarters of fiscal 2006, respectively. These units generated around $59 million in revenue in the third quarter of last year. Excluding this revenue and netting revenue in the year-ago quarter for supplier service contracts, third quarter 2007 revenue was up 10.9% year-over-year.
Revenue fell short of management's guidance range of $4.1-4.3 billion (up 5.4% to 10.5% sequentially), mainly due to continued weakness at the EM unit. EM generated 62.3% of total revenue in the last quarter, compared to 67.7% of total revenue in the year-ago quarter. TS generated 37.4% of total revenue, compared to 32.3% in the year-ago quarter. The growth in the TS unit is mainly attributable to the Access acquisition.
The EM segment posted $2.445 billion in revenue, up 4.7% sequentially and down -0.1% year-over-year. These results were at the low end of management's expectations of $2.43-2.53 billion (up 4.3% to 8.5% sequentially). The Americas was up 2.6% sequentially, (37.6% of EM revenue) the EMEA region was up 17.9% sequentially (37.2%), and Asia was down -7.5% (25.3%). Purchasing patterns of North American and Asian EMS firms serving the communications market remained soft in the last quarter.
While non-EMS sales in North America were relatively strong, sales were soft across the board in Asia. Europe has a lower concentration of EMS business, and was seasonally strong in the last quarter. The strength in Europe helped generate a positive book-to-bill ratio. Management stated that the higher utilization rates of most semi companies remained a positive influence on the ASPs, which were in turn helping Avnet deliver higher margins.
The semiconductor cycle is likely to dip over the next two years, which does not bode well for components distributors. EM segment growth rates have been dropping off, and the seasonally stronger third quarter was only up mid-single digits. The inventory correction in the communications market started in the summer, and it looks as if the market is yet to recover. The microprocessor business is suffering a setback, as the price war between Intel and AMD continues.
INSIDER TRADING AND OWNERSHIP
The top five institutional holders are Fidelity Management & Research Co (13.6% of the total shares outstanding), Barclays Global Investors (11.6%), First Pacific Advisors (6.6%), Snow Capital Management LP (4.1%) and Aronson & Partners (3.7%). All the top holders in the previous quarter with the exception of Barclays liquidated their holdings. Barclays increased its holdings by 237%. Insiders hold 3.0% of the company's shares and were net sellers of the stock over the last three months.
The softness at some large-volume EMS customers continues to pressure the EM business. EM margin expansion in the last quarter stems from a drop in lower-margin business rather than an increase in high-margin business. Avnet is being adversely affected by the price war between Intel and AMD; it is expanding its relationship with AMD even as its Intel business shrinks. The guidance for the EM unit is up 1% (in-line with typical seasonality in the last three years) and that for the TS unit is up 18% (mainly due to the Access acquisition and the typical strengthening of the Sun business in June). The company has over $1.1 billion in long-term debt, and a net debt position of over $911 million. While the Access acquisition will raise revenue and EPS, the valuation appears rich in our opinion.
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