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Arrow Electronics, Inc. (NYSE:ARW)

Q3 2007 Earnings Call

October 23, 2007, 11:30 AM ET

Executives

Sabrina N. Weaver - Director, IR

William E. Mitchell - Chairman, President and CEO

Paul J. Reilly - Sr. VP and CFO

M. Catherine Morris - Sr. VP and President, Arrow Enterprise Computing Solutions

Michael J. Long - Sr. VP and President, Arrow Global Components

Kevin Gilroy - Sr. VP and President, Arrow Enterprise Computing Solutions

Analysts

Matt Sheerin - Thomas Weisel

Jim Suva - Citigroup

Steven Fox - Merrill Lynch

Brian Alexander - Raymond James

Jeff Walkenhorst - Bank of America

Thomas Dinges - J. P. Morgan

Carter Shoop - Deutsche Bank

Operator

Good day and welcome to Arrow Electronics Conference Call to discuss their Third Quarter Earnings. As a reminder, this call is being recorded. At this time, for opening remarks and introductions, I'd like to turn the call over to Ms. Sabrina Weaver. Please go ahead ma'am.

Sabrina N. Weaver - Director, Investor Relations

Thank you. Good morning everyone and welcome to the Arrow Electronics third quarter conference call. I am Sabrina Weaver, Arrow's Director of Investor Relations and I will be serving as the moderator on this morning's call. Today's call is also available via webcast. To access this webcast or future webcasts, please visit our Investor Relations website and click on the webcast icon.

With us on the call today are Bill Mitchell, Chairman, President and Chief Executive Officer; Paul Reilly, Senior Vice President and Chief Financial Officer; Kevin Gilroy and Cathy Morris, Presidents of Arrow Global Enterprise Computing Solutions and Mike Long, President of Arrow Global Components.

By now, you all should have received a copy of our earnings release. If not, you can access our release on the Investor Relations section of our website. Before we get started, I would like to review Arrow's Safe Harbor statement. Some of the comments to be made on this morning's call may include forward-looking statements, including statements addressing future financial results that are subject to a number of risks and uncertainties that could cause actual results or facts to differ materially from such statements for a variety of reasons. Detailed information about these risks is also included in Arrow's SEC filings.

We will begin with several minutes of prepared remarks, which will then be followed by a question-and-answer period. As a reminder, to members of the press, you are in a listen-only mode on this call. But please feel free to contact us after today's call with any questions you may have. At this time, I would like to introduce our Chairman, President and CEO, Bill Mitchell.

William E. Mitchell - Chairman, President and Chief Executive Officer

Thanks Sabrina and thanks to all of you for taking the time to join us this morning. The third quarter was a complicated one for us. On the positive side, our level of sales as well as working capital sales remained near record levels and we continue to generate positive cash flow, as we generated the highest level of cash flow for any third quarter in 6 years.

Our balance sheet and capital structure remain very strong. Profits while strong were however at the low end of expectations. In our Components business, pricings pressures increased in September as competition intensified in all regions. In enterprise computing solution, unfavorable product mix affected margins and we made a conscious decision to invest in important strategic investments for the future. We will continue to invest in what we see as very positive long-term future of Arrow, in vertical market initiatives, in geographic initiatives in Asia and Europe and further penetrating the small and medium size businesses, to truly own the segment, and in global systems to leverage our scale worldwide to transform the way we do business.

But we will take and have taken steps to be more efficient in all areas of our business to make sure that we provide premium returns to our investors. The strategic initiatives, we are pursuing are resonating strongly with our business partners and we intend to continue them. However, and as always, you can be assured that we will make the necessary adjustments to achieve our financial targets in the timeframes we have committed to.

In our Enterprise Computing Solutions Group, we again outgrew the market with year-over-year growth in all product lines, including proprietary servers. In the third quarter, sales pro forma for acquisitions more than doubled the rate at which the overall market is expected to grow. Our business is performing well; our product mix had a negative impact on profitability this quarter. And has been reported by major suppliers in this area, uncertainty in the capital markets led the end of quarter hardware weakness.

We also made a conscious decision to invest in several strategic investments that will transform this business and a combination of product mix and continued strategic investments made our operating results challenged for the quarter. We believe this is a short-term phenomenon and expect results to return to more normal operating levels in the fourth quarter.

On the Component side of our business, we continued to gain share as competition intensified this quarter, primarily in September and throughout all regions. The weakness in our large customer segment continued and this coupled with the weaker than expected European market, put pressure on results. And market demand was as expected elsewhere. We had good success with efficiency initiatives to drive down our operating expenses worldwide.

Let's now review some of the key financial highlights. We grew 17% year-over-year on pro forma for acquisitions. This was at the high end of expectations and demonstrates that we continue to have success in the markets we serve. Earnings per share were at the lower end of expectations, for the reasons cited in my previous comments. They were however at new record levels.

Cash flow generation was strong again this quarter at $171 million. In the last 12 months, we have generated more than $900 million in cash flow from operations. This is something the company has never done in the period of growth and this was our sixth year of positive cash flow generation. We are proud of the excellent cash flow management throughout the company.

Working capital to sales remained near record lows, at 15.4%, as we continue to be focused on managing or asset base and our return on working capital reached the highest third quarter level since the bubble year of 2000 while our return on invested capital was higher than our weighted average cost of capital for almost four years. And this is not simply been done in the past.

So, in summary, it was a challenging and complicated quarter. We grew faster than the market, generated significant amount of cash flow and generated returns in excess of our cost to capital. We continue to make strategic investments in our future; we are committed to generate consistent short-term performance, as we also invest in Arrow for the long-term. Paul will now give you a more detailed view of the third quarter and then Cathy and Michael will discuss their business' performance in greater detail.

Paul J. Reilly - Senior Vice President and Chief Financial Officer

Thanks, Bill. As reflected in our earnings release, there are a number of items that impact the comparability of our results with those in a trailing quarter and the third quarter of last year. I will review our performance, excluding these items to give you a better sense of our operating results. As always the operating information, we provide to you should be used as a compliment to our GAAP numbers. For a complete reconciliation between our GAAP and non-GAAP results, please refer to our earnings release or the earnings reconciliation slide at the end of the webcast presentation.

Sales for the third quarter were $4 billion, an increase of 17% year-over-year and flat sequentially. Pro forma for the impact of the KeyLink, Alternative Technology and InTechnology acquisitions, we grew sales by 4% over last year. Global Enterprise Computing Solutions achieved its 15th consecutive quarter of year-over-year sales growth, with total sales up $1.2 billion. Sales increased 97% year-over-year and decreased 8% quarter-over-quarter, in line with normal seasonality. We continue to outgrow the market with sales increasing 15% over last year, pro forma for the acquisitions of KeyLink, Alternative Technology and InTechnology.

Operating income as a percentage of sales decreased 80 basis points year-over-year, as a result of unfavorable product mix and investments in the future growth of our business. Yet our return on working capital improved over 40% year-over-year in the third quarter. Global component sales of $2.9 billion increased 3% sequentially as normal seasonal weakness in Europe was offset by the typical holiday build in Asia Pac.

Sales were flat year-over-year, as the well publicized weakness was in the large EMS customer base in North America and Asia Pac continues to linger. Despite stronger than anticipated competitive pressure this quarter, intense focus on cost containment and ongoing initiatives to drive down our operating expenses enabled us to increase our operating margin by 20 basis points year-over-year and a decrease of only 20 basis points sequentially. So, we continue to improve our working capital management, with a 240 basis point drop in the ratio of working capital to sales compared to the third quarter of last year.

In Asia Pacific, sales increased 22% sequentially and increased 5% year-over-year to $687 million. We continue to make great progress towards our profitability goals in the Asia Pac region with operating income up 43% sequentially and a 173% year-over-year. Remember that we are strategically passing on high volume, low margin opportunities in the region to focus on a small and medium sized customer base. This, along with other efficiency initiatives enabled us to generate record operating income dollars for any third quarter, while improving our return on working capital by over three times last year's third quarter level.

In Europe, sales of $1 billion decreased 3% in the seasonally soft quarter, and increased 3% over last year's third quarter, which was stronger than normal due to the RoHS conversion. Our continued focus on the broad, small and medium size customer base combined with ongoing efficiency initiatives there resulted in a second highest level operating income to sales for any third quarter since 2000.

In North America, total sales were $1.1 billion, representing a normal seasonal decline of 2% sequentially. While sales decreased 7% year-on-year as a result of continued EMS weakness, we increased return on working capital by 12% over the same period last year. Our consolidated gross profit margin was 13.7%, a decrease of 50 basis points year-over-year, pro forma for the acquisitions was impacted primarily by an increased mix of business in the Global Enterprise Computing Solutions segment due to acquisitions, and increased competitive pressures in our Global Components business.

Gross margin for our core small and medium size customer base in worldwide components decreased 20 basis points year-over-year. Operating expenses as a percentage of sales decreased 30 basis points sequentially, and 60 basis points year-over-year to 9.7%, the lowest level achieved since 2000. We continue to capitalize on opportunities to leverage our global scale and develop best-in-class global practices to transform our organization for the future.

By centralizing certain back office operations in our North American Components business and creating a shared service environment, we've identified $30 million of annual cost savings in the third quarter, approximately $3 million of which we achieved in the third quarter. We expect to realize approximately $7 million in the fourth quarter, and a full run rate amount of $5... $7.5 million in subsequent quarters. Operating expenses in the third quarter included an estimated $4 million or $2.6 million net of tax from amortization of intangible assets related to acquisitions.

Operating income was $162 million, an increase of 5% year-over-year, a decrease of 8% sequentially, as we experienced an increase in competitive pressure in our Components business, a change in product mix in ECS and continued investments that profitably outgrow the market. Operating income as the percentage of sales pro forma for acquisitions decreased 30 basis points year-over-year due to the previously mentioned items.

During the third quarter, the German government signed into law a reduction in its corporate tax rate beginning January 1st, 2008. As such, the settlement of deferred tax liabilities in Germany, principally related to the amortization of intangible for tax purposes should not amortize for accounting purposes will be at a lower rate. As such, we adjust our deferred taxes to reflect this lower tax rates by a net $6 million. This is a non-recurring item and will have a minimal impact on our effective tax rate going forward. Our effective tax rate for the quarter, excluding this tax item was 31.7%, and for modeling purposes, you should assume our tax rate for the fourth quarter will also approximate 31.7%.

Net income was $95 million, up 9% from last year, a decrease of 6% sequentially. Earnings per share was $0.77 and $0.76 on a basic and diluted basis respectively, an increase of 8% and 7% respectively compared to last year's third quarter, and the highest level since 2000. The diluted earnings per share include $0.02 of estimated amortization of intangibles related to acquisitions.

A strong cash flow performance was the positive contributions from all regions, generating a total cash flow of $171 million. In the last 12 months, we've generated more than $900 million of positive cash flow. We expect to be cash flow positive in the fourth quarter.

Our level of net debt remains below $1 billion, our net debt-to-cap declined again this quarter to the lowest level in 10 years. Today's capital markets being able to generate cash and having a more conservative debt level is certainly a competitive advantage for us.

Working capital to sales remained near record low levels this quarter at 15.4%, decreasing over 400 basis points year-over-year on a combination of focused execution and a favorable working capital mix as a result of the KeyLink acquisition. We also achieved the highest level of return in working capital for any third quarter since 2000. The return on invested capital exceeded our cost of capital for the 15th consecutive quarter.

We'll now discuss the results of each of our business units for the third quarter. First, Cathy Morris will discuss our Global Enterprise Computing Solutions business.

M. Catherine Morris - Senior Vice President and President, Arrow Enterprise Computing Solutions

Thank you, Paul. We continued to outgrow the market in the third quarter. Growth was driven by strong double-digit year-over-year performance in industry standard servers, storage, software and services, as well as modest growth in our proprietary server markets. Our standard portfolio and focus on selling total solutions has changed the mix of our business, and we have increased our penetration into rapidly growing market segment. Now, over 60% of our revenues are generated from storage, software and services segments.

Alternative Technology continues to post strong performance with year-over-year sales growth in excess of 50% for the third quarter in a row. Our cross-selling initiatives continue to take hold and year-to-date, we have achieved almost $30 million in additional sales to our targeted pilot program with Alternative Tech.

We also announced the strategic acquisition of Centia and AKS Group, one of the Europe's leading specialty distributors of access infrastructure, security and virtualization software solutions. The addition of Centia/AKS further diversifies our product portfolio in the European region and strengthens our strategic focus on software and solutions.

Our recent acquisitions are performing as we expected. As an example, they have contributed to our year-over-year program and return on working capital. While we achieved strong top line performance with revenue near the high end of our guidance, our mix of product had a unfavorable impact on operating income. As is publicized by major suppliers in the market, uncertainty in the capital markets resulted in end of the quarter weakness in certain hardware lines.

We are making investments in the future growth of our business, such as the fast growing markets of Eastern Europe and high growth customer segments in North America. Our strategy is resonating with our business partners at the highest level. We are laying the ground work and investing in the long-term to create some very exciting opportunities for our vendors and retailer partners.

William E. Mitchell - Chairman, President and Chief Executive Officer

Thanks, Cathy. Mike Long will now come... comment on our global components business. Mike?

Michael J. Long - Senior Vice President and President, Arrow Global Components

Thanks, Bill. In the third quarter, we again gained market share and added to our industry leading position. Our focus on continuously becoming more efficient provided us with an opportunity to drive down operating expenses again while investing in the business. Some structural changes that occurred in our marketplace, causing us to shift the focus of our resources to make sure our cost are inline with the market reality, and we took specific actions in North America in the third quarter.

September was weaker than expected in Europe, and the activity levels in our large EMS segment still remained below last year's levels. This led to an increase in competitive pressures in all regions. In Asia Pac, our business outgrew the market with strong sequential growth on the strength of the mobile and LCD end markets. Our focus on the small and medium size customer segments along with efficiency initiatives in the region are producing consistent increases in profitability as we move closer to our operating targets for the region.

Our investments in this region have been recognized by customers around the world as Arrow Asia Pacific received top ranking for the third consecutive year in EDN Magazine's Worldwide Branding Study.

In Europe, our business was weaker than expected due to the summer holiday period and September was slower than expected. Our performance there was led by Central Europe and Nordic where we continue to leverage our market leading positions. In the third quarter, we established an office in St. Petersburg, increasing our presence in the Eastern European region. We continue to invest in efforts to broaden our existing customer base and drive for more consistent and efficient operations in the European region.

In North America, we saw strength in vertical market initiatives as we achieved record sales in our lighting group and we continue to move ahead with strategic initiatives to further penetrate the small and medium size customer segment. Amidst the continued EMS weakness, the region successfully reduce operating expenses in the third quarter and as Paul mentioned earlier, we have identified additional ways to better leverage our cost structure going forward.

Operational efficiency is a continuous process and we're always looking for ways to consistently improve our operating performance, while meeting the needs of our business partners.

Looking at the global trends, book-to-bill on a global basis increased sequentially to 1.04 on a worldwide basis. Lead times remain stable and are still within normal ranges, between 8 to 12 weeks and we saw no notable increases in cancellation rates. Our quarterly customer survey in North America indicated that the majority of our survey customer base continues to feel inventory levels are well positioned heading to the fourth quarter. Looking forward, we see normal seasonality for Global Components through this point in the fourth quarter.

William E. Mitchell - Chairman, President and Chief Executive Officer

Thanks Mike. Let me close now. Overall, this was a challenging quarter for us. As I stated, we have and will continue to invest in the future growth of Arrow, that's important for us to do and it is important that we do not lose momentum. Even though our performance was near record levels, however, we are not satisfied with the level of profitability this quarter. And we have as we always do taken steps to adjust our business model to reflect the ongoing market realities that we see. We do believe that the profitability was more reflective of short-term market conditions, seasonality and our conscious decisions to maintain strategic investment levels for the future and we fully expect to return to our industry leading levels of profitability in the fourth quarter.

I would like to thank the entire Arrow team for their continued commitment as we move ahead with strategic initiatives and to build that very bright future that we all believe in for Arrow. Looking ahead into the fourth quarter, we generally expect normal seasonality in both of our businesses. We believe that total fourth quarter sales will be between $4.15 billion and $4.45 billion and Global Components sales between $2.65 and $2.85 billion and Global Enterprise Computing Solution sales between $1.5 and $1.6 billion.

Earnings per share on a diluted basis excluding any charges and including estimated amortization of intangible assets of $0.02 to $0.03 a share are expected to be in the range of $0.90 to $0.95 a share, an increase of 25% to 32% from last year's fourth quarter.

We are managing our business with strong financial discipline and we are continuing to pursue growth initiatives to ensure that we outgrow the market. We are confident of our ability to perform in any marketplace, due to our strong global market position, our broad customer base and our global scale. We continue to invest in initiatives that will increase our ability to serve us our customers by entering into new geographies, by expanding our product and market offerings and by leveraging our cost structure to be able to provide enhanced services. And we will continue to create value for our business partners and our shareholders, while we invest in future growth and profitability.

Sabrina N. Weaver - Director, Investor Relations

Thank you, Bill. Please open up the call to questions at this time.

Question And Answer

Operator

Thank you, Ms. Weaver. [Operator Instructions] Our first question comes from Matt Sheerin, Thomas Weisel Partners

Matt Sheerin - Thomas Weisel

Yes, thank you. My first question is in regard to the Components business. You talked about there are several areas of weakness, Europe and then also pricing pressure. Yet your guidance implies a return to more normal seasonal patterns and the constant numbers looks like operating margins will come back pretty very nicely. And I know you got the strength in the computer business. But just help us understand what's happening in Europe, are you starting to see things come back there. And then also are you continuing to see the pricing pressure on the Components business or is that starting to ease a little bit?

William E. Mitchell - Chairman, President and Chief Executive Officer

Mike, why don't you take that one?

Michael J. Long - Senior Vice President and President, Arrow Global Components

Okay, well Matt. One of the strengths of our business is the diverse nature of our customer base and the breadth of the industries that we cover. We benefited from exposure to sort of the non-traditional, what I call, some of the specialty markets that exist out there and that would be industrial, the military, the aerospace markets. While we've seen the well-publicized weakness in the large EMS segment and how that affected our business, as you know, during that time we have been working to increase our penetration in the small to medium account base. And I actually see that as the piece right now that will provide us the return to normal seasonality for Arrow in the fourth quarter.

Matt Sheerin - Thomas Weisel

Okay. And that book-to-bill you talked about; is it positive in Europe as well.

Michael J. Long - Senior Vice President and President, Arrow Global Components

The book to bill for us overall Matt is 1.04. Again we did see softness in Europe, it was a little stronger than we had expected. And to be honest with you, that showed up in September as more of a negative than the typical bounce back that we get after the summer holiday. We have seen Europe slow from where it was before.

Matt Sheerin - Thomas Weisel

So, it hasn't come back yet?

Michael J. Long - Senior Vice President and President, Arrow Global Components

It has not come back yet, yes.

Matt Sheerin - Thomas Weisel

Okay, that's in your guidance, okay. And then so would that then also have a negative impact on your gross margin mix in the Components business in this quarter or is that properly factored into your guidance.

Michael J. Long - Senior Vice President and President, Arrow Global Components

I think, the current guidance we submitted does show any margin changes that we've talked about.

Matt Sheerin - Thomas Weisel

Okay and just last question on the computer business, you talked about product mix adversely affecting your margins. Could you be more specific about that?

William E. Mitchell - Chairman, President and Chief Executive Officer

Cathy, why don't you take that one?

M. Catherine Morris - Senior Vice President and President, Arrow Enterprise Computing Solutions

Well, it was a weakness across multiple different product mixes, between technology as well as vendors and as you know certain suppliers have come out with the uncertainty in the capital markets, resulted to some end of the quarter weakness for and certain hardware line. So, it is across multiple vendors and across multiple technology and Kevin, I don't know I you want to add anything?

Kevin Gilroy - Senior Vice President and President, Arrow Enterprise Computing Solutions

No, I think that's pretty much clear.

Matt Sheerin - Thomas Weisel

But, did it also impact rebates and other margin support that you guess from vendors because of that? I mean does that play a roll there?

M. Catherine Morris - Senior Vice President and President, Arrow Enterprise Computing Solutions

No, at the end of the day, our rebates and our front end and back end compensations are things that we negotiate every quarter as everyone does in our industry. And we did not see any difference as a normal quarter we do, in our front end and back end compensation.

William E. Mitchell - Chairman, President and Chief Executive Officer

Matt, one follow on to that that might provide some additional details. One of the things that is clearly have been going on and has been widely commented on is the shift between proprietary servers and industry standard servers. We have very strong results in industry standard and software and storage and services and although we were positive even in proprietary, we weren't as positive as we were in the other things. That is part of a longer term secular trends that's been well focused upon. And that we think is certainly something that we've seen and we will continue to see. At the same time, we saw more product mix exacerbated in this quarter that really was due to some of the uncertainties and some of the capital end markets and again that was highly publicized. And we would expect that to be a more short-term impact as we would expect those markets to recover overall.

Matt Sheerin - Thomas Weisel

Okay. That helps. Thank you.

Operator

And we'll take our next question from Jim Suva with Citi.

Jim Suva - Citigroup

Great, thank you very much. Can you a little bit specifically about, again just don't get profitability of ECS of only 3.3% and it was the lowest in multiple years, and it look like sales came in. Did you have to like more aggressively bid in to get that sale or how should we think about that and what type of visibility do you have that that will return because the 3.3% is very, very concerning?

M. Catherine Morris - Senior Vice President and President, Arrow Enterprise Computing Solutions

I think, there are two important things to think about here and that's the nature of our product mix with the acquisitions and then geographic footprint that the acquisitions have provided and then what that seasonality means to us. So, traditionally, third quarter is the soft quarter in Europe. Traditionally, third quarter is the soft quarter in certain supplier results. And with the new mix of business that we have in ECS, I think that's the part of the phenomenon that we are seeing in the third quarter and as we said, we expect the fourth quarter to return back to the levels of profitability that we have seen.

Jim Suva - Citigroup

With the KeyLink acquisition though, doesn't it change the mix a little bit as I thought that was very accretive? And how should we kind of think of that because a rebound to more normal when we are layering on a more accretive acquisition, I guess I am just struggling to triangulate that?

M. Catherine Morris - Senior Vice President and President, Arrow Enterprise Computing Solutions

I think if you look at the seasonality of the major products that KeyLink sells that you will see that that's seasonality tracks with our results.

Jim Suva - Citigroup

And your visibility is calling for return to normal for December.

M. Catherine Morris - Senior Vice President and President, Arrow Enterprise Computing Solutions

Yes.

William E. Mitchell - Chairman, President and Chief Executive Officer

Yes. Jim, you're bringing up the good point again. And one of the things that has occurred as a result of what we think, a very strong strategic moves on our part, is that because of increased exposure to our European operations and because of the way our suppliers' profile has changed. The seasonality of the business is probably more pronounced than it has been in the past. That's... we have recognized that, and we are certainly taking steps to overcome that. But, one of the things that has happened as we dramatically changed our profile over the last 12 to 18 months is that we do believe the seasonal trends will be a bit more pronounced in the future than we have seen in the past, because of increased geographic, both exposure and opportunity in Europe and also because of the mix shifts which we overall view as very positive. Again, we believe that a number of things came together in the third quarter, not only mix but some uncertainty in end markets that made this a bit below where we would have liked and expected them to be. But we do fully expect to be back on track in the fourth quarter and beyond.

Jim Suva - Citigroup

And quick clarification, when you say back on track, are you building any type of discount for that softness that you saw at the end of September from the... you mentioned some of the text spending softness or are you expecting that to completely, 100% rebound?

William E. Mitchell - Chairman, President and Chief Executive Officer

We are expecting normal seasonality and normal results in the fourth quarter.

Jim Suva - Citigroup

Thank you.

Operator

And we'll take our next question from Steven Fox, Merrill Lynch.

Steven Fox - Merrill Lynch

Hi, good morning. First of all on the Components side, could you just be more specific on what you meant Mike, when you said there was a structural change that caused you to shift... that's caused the shift in focused end market reality in North America, I'm not quite sure what that mean?

Michael J. Long - Senior Vice President and President, Arrow Global Components

Yes, I am sorry. As you know, we've seen business transfer from the U.S. to Asia, specifically around the large EMS customers, not only over the last year, but in prior years. And if you also look at the general market of North America, it's not projected to grow this year, while we are seeing the fast... faster pace growth in the Asian market. And as a result of that, as you know, we've had to do some right sizing in our business to become more productive and we are going to continue to look for more opportunities to make that happen so --.

Steven Fox - Merrill Lynch

So, was that a surprise in the quarter specifically, or you are just highlighting it as a long-term trend that continues?

Michael J. Long - Senior Vice President and President, Arrow Global Components

It's a long-term trend that has started a couple of years ago and its continuing. I do not see the slow down in it. It is not in response to the quarter, but I think that something that we have to intent to over the long-term to keep our business healthy, and that's exactly what we are doing.

Steven Fox - Merrill Lynch

Okay. And then just one other question on the Components, what... where specifically then was did you see the increasing competitiveness. Was it among distributors, and if so, in what region?

Michael J. Long - Senior Vice President and President, Arrow Global Components

Actually what has happened is it's become increasingly competitive in all regions, we saw Europe become more competitive after the holiday into the September timeframe as the market did not come back, as much as we had expected. The lack of the North American market in terms of overall growth has caused competitiveness there. And as you know, Asia has been a highly competitive market from day one. So, I'm not saying right now it's easy in any market and we don't expect it to be for the next quarter.

Steven Fox - Merrill Lynch

But that's actually in the distribution channel competing or you're saying just general pricing pressure on top of that?

Michael J. Long - Senior Vice President and President, Arrow Global Components

That's in the distribution channel.

Steven Fox - Merrill Lynch

Okay. And then on last question please, Paul. On the investment spending that you called out, how much of a drag was that on the quarter?

Paul J. Reilly - Senior Vice President and Chief Financial Officer

See, that's a competitive advantage for us that we're not quite ready to disclose because we have multiple programs around that. So, I think we are going to keep that one in advance at this point in time.

Steven Fox - Merrill Lynch

Fair enough. Thanks.

Operator

And we'll take our next question from Brian Alexander, Raymond James.

Brian Alexander - Raymond James

Thanks. Just back to the Enterprise Solutions business, sorry to beat a dead horse, but your overall sales were basically in line your guidance and our estimates. Your profitability was 15% below expectations. All I really hear about is mix shifts within that business, which sounds like proprietary servers were not as robust as you expected, and one of your major vendors' results I think support that. But this has been happening for a while now, and it doesn't seem like it was more pronounced this quarter than in prior quarters. So, was there anything else besides mix that caused margin weakness in the computer business in a... for example, was there margin weakness within certain product categories, etcetera. And what gives you the confidence again that you will come back in Q4 and beyond in this segment to your range of I think 4.9 %to 5.3% operating margin, given that we do have secular trends away from proprietary servers. Your margins have been falling for the last couple of years and you're probably going to end up this year 50 basis points below the low end of that guidance. Thanks.

M. Catherine Morris - Senior Vice President and President, Arrow Enterprise Computing Solutions

So, I'll start on the first subject. And I won't take personal offense to being called a dead horse thing. But one very important part about our results in the quarter are the investments that we are making in the business and the acquisitions were just the forefronts of the investments that Arrow is making in the ECS business. We are making significant investments in the business ahead of revenue and that's on the front end in the selling motion as well as on the back end in our systems and integrating transforming our business to a solution sale model. As we mentioned have moved over 60% of our sales coming from different markets of software, services and storage, away from the proprietary server markets, so we are quite pleased with our progress there. So, to answer your first question, this was specifically is it all market... margin degradation, and the answer is no. It is also conscious investments into the business. And I am sorry, the second part, I think is a secular...?

Brian Alexander - Raymond James

Well, I guess, the bigger picture question here is the range of 49 to 53 for your timeless business model still appropriate in light of the changing mix that you are saying, in light of the increased investments, and the time... what's the timeframe on when we might be able to achieve that, if it's still a relevant range?

M. Catherine Morris - Senior Vice President and President, Arrow Enterprise Computing Solutions

Well, we do feel very confident that we will hit our targets in 2008. And I also would encourage everyone to keep in mind that KeyLink is only into its second quarter of integration, Alternative Tech and InTech have only been in the fold of the family for nine months. And the cross-selling initiatives and the full power of these initiatives to be leveraged in the system have yet to be actually realized.

William E. Mitchell - Chairman, President and Chief Executive Officer

And Brian --.

Brian Alexander - Raymond James

We are on the investments in this business. We are... I guess, we are investing in sales headcount and back-end systems to I guess, to accelerate the growth of existing franchises as opposed to investments in new product lines, new vendors or new geographies?

Kevin Gilroy - Senior Vice President and President, Arrow Enterprise Computing Solutions

Brian this is Kevin, I mean, we are making investments in the solutions area. It gets back into your comment about proprietary versus industry standard servers and blade. Let me just comment on that one and I will go into our solutions initiatives. First, we do see Q3 slowdown in proprietary although we did have growth as an anomaly. We track our funnel, our pipeline, we talk to our suppliers and we have multiple data points that we look at to see are these trends or these anomalies. So, we do believe Q3 was an anomaly. Having said that, we are very aware that there is as Bill said a secular trend toward ISS and blade, but what we are seeing and what we are delivering is blades and industry standard servers sold in a solution methodology that's blades with security software, virtualization, edge, the edge layer, all of those capabilities and capacities brought by our acquisition of Alternative Technology in the U.S. So we do think that our margins will improve, come back to where they should be in Q4 and in '08.

Our solutions selling approach that Bill mentioned, we continue to make those investments particularly in mid markets where that route to market has not been clear for our suppliers, it has not been clear for our resellers, with some compelling work being done there, some profound work being done, we soft launched this week, some of the low hanging fruit on our mid market initiative and we will continue to roll out the more compelling components of it in Q1of '08.

William E. Mitchell - Chairman, President and Chief Executive Officer

Brian, it's Bill again. Just a quick follow-up on that, I think what we saw in the third quarter were... and this is why it's been a complicated and challenging quarter for us, is a number of things that really were short term anomalies. There are some longer term trends, the switch from industry standard... to industry standard from proprietary and a very conscious decision on our part to continue with what we believe are very powerful investments to change. Our selling motion and our go-to-market strategies and we think those are the right ones to do. All of that came together and we have results that were below what we would like them to be. And we have every intension of getting those back on track for the fourth quarter and beyond. We think we are on the right track, and we think, we know what we need to do and are doing those things. And we remain very bullish about this... the long-term opportunities in this marketplace.

Brian Alexander - Raymond James

Thanks Bill. Just one last one on the Components side. I guess, why do we think, we are seeing more competition now given that it seems like inventories are as lean as they've been in a while in the supply chain. All the cycle indicators seem to be stable. Your suppliers are generally reporting in line results, I heard you on the weaknesses you saw in September in Europe, but you said that the competition was really broad-based, I guess, why do you think, we are seeing it now. And then, I don't know that we ever got any answer on the Matt's question before. Are we seeing that competition continue at that same level into October?

William E. Mitchell - Chairman, President and Chief Executive Officer

So, let me try to put your questions in order. But in general again, if you look at the PC... the results, a lot or around the PC industry as you know which has been absolutely on fire for a period of time here. We do not really participate in the PC industry, so, there is a difference there. If we take a look, Asia has been competitive from day one. So that was no change. The competitive nature in Europe as I said before, as a result of the business not strengthening have caused the channels to go after more orders more aggressively. Also North America, we have seen the competitive pressures pick up, especially around the high dollar volume products that require engineering that didn't exist before. And that's mainly because that market has not grown this year and we have seen that in this quarter in particular, more aggressive pricing in the channel than we have seen in some time. I would expect that to continue into October as your question asked Brian.

Brian Alexander - Raymond James

Thank you very much.

Operator

And we will take our next question from Jeff Walkenhorst, Bank of America.

Jeff Walkenhorst - Bank of America

Hi, good afternoon. I am wondering if we can talk... a lot of grounds already been covered on the computing side, or I may touch on that. But Paul, could you talk about the organic growth and I think you mentioned that the overall performance growth if you back out the acquisitions for the total company was 4%. I Actually have a number that's less than that which makes me think that maybe the numbers I am including for the acquisitions are too high so may be the acquisitions, whether its KeyLink or Alt Tech is underperformed. Could you talk on that for a second, please?

Paul J. Reilly - Senior Vice President and Chief Financial Officer

Yes, Jeff, we can help you offline with the actual details of the numbers that you are using in your model. But when we looked at it, we know Alternative Technology is up over 50% year-over-year, as an example. InTech is tracking exactly to the plan that we had for them as justification for the business model. KeyLink is a little bit harder for us to delineate because we have merged it into our existing IBM business. And the segment has the bid to get customers in the right place. But once again, when you look at the business model, what we expected their quarterly sales rate to be combined with our existing business, it seems to be tracking now, to what we thought was going to happen. So, when we look at it, we think those three acquisitions performing at least to plan and in fact Alternative Technology we know is much better than planned because of the... there is no way we are going to be a 50% growth rate year-over-year there.

Jeff Walkenhorst - Bank of America

And have the margins outperformed with Alt Tech with the revenue strength on that front?

Paul J. Reilly - Senior Vice President and Chief Financial Officer

Yes, it's pretty interesting. The returns that we had set as targets for Alternative Technology are in excess of the target. So, we are seeing good performance there also. And the margin seem to be holding up pretty well in the core business there. I would say that we are also being opportunistic. So, there is a chance for us to take a larger sale with maybe little less margin, we are willing to do that as long as the returns profiles fit our overall targets. And they are outperforming that also. So, when we look at Alternative Technology, I see that as a real win for us. Both from a financial performance point of view and to Kevin's point before about part of the... a critical part of our solution set, where we are able to sell the entire solutions to the customers and not just bits and pieces of it.

Jeff Walkenhorst - Bank of America

Okay. So, on an organic growth basis, you guys do believe that the ECS segment was up 15% year-on-year?

Paul J. Reilly - Senior Vice President and Chief Financial Officer

Yes.

Jeff Walkenhorst - Bank of America

Okay. We will come back to that offline. But the last thing, I am kind of wrapping with this, the visibility given what happened in the third quarter. And it seems like there maybe some broader macro weakness, then what has happened in... on Wall Street. Are you seeing that at all, kind of outside of the channels, your different data points on the industrial side or even aerospace?

Paul J. Reilly - Senior Vice President and Chief Financial Officer

I think --

Jeff Walkenhorst - Bank of America

As you move in through October and into the fourth quarter?

Paul J. Reilly - Senior Vice President and Chief Financial Officer

Jeff, our commentary on the capital markets were really driven towards the impact in the month of September they had on our computer products business. So, if that's the question you are asking, you are asking about component side. We haven't seen the components too much to settle in the marketplace because of the threat of a crisis in the month of September.

Jeff Walkenhorst - Bank of America

Right I mean, I guess, I'm talking kind of both components and computing. But so, you are confident based on your data points that you will see the sequential improvement in margins come back up to a level in the fourth quarter.

Paul J. Reilly - Senior Vice President and Chief Financial Officer

Absolutely, with the way the markets look today we absolutely believe that we'll be able to deliver the fourth quarter.

Jeff Walkenhorst - Bank of America

Right. Good luck guys.

Paul J. Reilly - Senior Vice President and Chief Financial Officer

Thank you.

Operator

And we'll take our next question from Thomas Dinges, J.P. Morgan.

Thomas Dinges - J. P. Morgan

Hi, good afternoon guys. A real quick one for you, if you back into it, you get about maybe $0.04 from the restructuring cost savings next quarter. Is that kind of roughly equal to what you guys, you think you are seeing on the pricing environment and kind of just the overall slowdown there or is it even kind of a little bit worse than that, I'm just trying to tie these two together like a lot of guys are, in this call.

Paul J. Reilly - Senior Vice President and Chief Financial Officer

Yes, and that's a good question, Tom. Really when we looked at it in the components world, we were not making these actions or taking these actions because of a perceived short term pressure in the marketplace around competitive pricing. We're taking these actions on a pretty regular basis. We've been doing it now for several years. The fact of the matter is that we do try to usually aggregate them. So, it's not debt by a thousands cuts. But in fact, we are able to go through a profit that's very respectable to the employees and we move people into either new roles around the company all at once. So, it really it wasn't an action that we took in response to the short-term pressure we see in the marketplace. But as Mike mentioned, we're looking longer term to where we should be investing, what our cost structures should be and what the growth rates are to make sure that we are positioned in the right marketplaces to be able to maximize profitability.

Thomas Dinges - J. P. Morgan

Okay. And then a quick one for Bill. Obviously, you've been getting this question a ton of different ways in terms of whether its macro weakness or whatever, but I'll ask you a different question which is; as you look at the environment you are seeing over the next 12 months, obviously you guys have done some timely acquisitions over the last couple of years. But the underlying backdrop has been, you had reasonably good economic growth globally now that probably gets... it changes quite a bit especially in some of the bigger markets here that you've already seen. So what is the pipeline overall look like on the acquisition front as it seems like those are going to play much bigger role for you guys continuing to drive earnings higher as the macro is probably a little bit softer as you look out over the next 12 months?

William E. Mitchell - Chairman, President and Chief Executive Officer

Tom, a couple of responses to that. First of all, in terms of the acquisitions that we've made, I'd point out again that we are in the early stages of the integration of a number of those, with Alternative Tech, with InTech, with KeyLink with our new AKS Centia and we would certainly expect to see improvements as those integrations take hold and we move much more towards the solution sale on and that begins to have some real impact. So yes, we do expect some positives from that.

In terms of new acquisitions they are going on, and that's obviously something that we don't comment on, we clearly view acquisitions as a way to strategically accelerate our strategic goals and if there are attractive acquisitions out there that are accretive to earnings, that are affordable to us, that operationally fit and that's strategically important, we are well positioned with our strong balance sheet to move forward with those and we'll continue to look at those as accelerators. I'd also point out though that in terms of our organic growth that we continue to outgrow the markets organically, we certainly did that in our ECS business very substantially, probably 2x and we may not have been clear in our Components business, but as best we can tell, the data is not all in yet, we outgrew the market in the Components business too and continued to gain share which we have done for a number of years. So, we'll continue to invest in the futures, much of those investments will be paying off in the 2008 period and beyond.

We have tried to make our company as impervious as it can be to macro economic conditions by keeping ourselves in strong financial position, by not getting jerked around, by changes in interest rate or short-term issues and credit markets and we think we'll protected on that, we think we are well protected on currency swings, so we think we are in good conditions. Clearly, we are not impervious to everything that goes on in the macro world. If the world goes into a recession, we'll be impacted by that. By and large, the world looks pretty good to us right now. There are clearly some issues in the U.S., the U.S. is not the driver of the global economy that it was a few years ago and certainly 10 or 15 years ago and so as we continue to see strength in the Asian economies, the Europe did appear to slow down a bit to us, but by and large that's still okay, and so we think we are well positioned and we'll make whatever adjustments are necessary to make sure that we deliver the results.

So I'm pleased with where we sit both from the acquisitions that we made, the acquisitions that we could look at through our very strong balance sheet and the organic growth that we are generating and we'll continue to make sure that we've got the cost structure in line and the profitability structure in line to deliver those results and we want to be able to do that no matter what the market conditions that we see. That's really how we are trying to run the company. Long answer, I hope that helps you.

Thomas Dinges - J. P. Morgan

No, it does, thank you very much.

Operator

And we'll take our next question from Carter Shoop, Deutsche Bank.

Carter Shoop - Deutsche Bank

Hi guys. Couple of quick ones here; for the Centia, I think I'm pronouncing that correctly and AKS acquisition, did that close and is that factored into guidance?

Paul J. Reilly - Senior Vice President and Chief Financial Officer

Yes, it's closed, and yes, it's factored into guidance.

Carter Shoop - Deutsche Bank

Okay. And then in regards to the both the depreciation and amortization, that was below my expectation as well as the interest expense combined that added about $0.03 sequentially to EPS. Can you comment on why both of those were down and where your expectations are for 4Q?

Paul J. Reilly - Senior Vice President and Chief Financial Officer

Yes, Carter, let me start backwards with the interest, so we expect our interest expense to be about the same level in the fourth quarter as it is in the third quarter. The fact of the matter is that we had a another really terrific cash flow quarter and we keep kind of saying to ourselves that we don't think we can keep this pace of improvement and how we manage all the working capital going and then the team comes up with more creative ways of being more thoughtful and how we manage it. So we are getting a better improvement... better performance there than we thought we could do and then we think that's very positive for us as we go forward.

On the depreciation and amortization, some of that is changing because of the impact of the valuation approach to the intangibles we are getting in acquisitions, so you have up to a year to do that under the U.S. accounting rules and we are working through all of that, so I think that depreciation and amortization will be marginally higher in the fourth quarter than it was in the third quarter.

Carter Shoop - Deutsche Bank

Okay, great, thanks. In regards to Components, can you may be single out the two categories, may be the best and the worst performing product categories within components, kind of broad basis?

Paul J. Reilly - Senior Vice President and Chief Financial Officer

Yes, that's a question that we don't like to answer Carter, because sometimes people can triangulate to suppliers, sometime it's competitive so, we are probably not going to address that one at this point in time.

Carter Shoop - Deutsche Bank

Okay. In regards to inventory turns, can you break out what they did sequentially by division?

Paul J. Reilly - Senior Vice President and Chief Financial Officer

Sure, I can ask to do that for you to Mike.

Michael J. Long - Senior Vice President and President, Arrow Global Components

I can tell you that our inventory turns sequentially in Global Components went up by 40 basis points and that was really driven by our Asia Pac business as well as our North American business, both had improvements in turns. Our European business had a flat inventory turns in Components.

Carter Shoop - Deutsche Bank

Great, thanks. And last the question for you, in regards to margin expansion, to get that midpoint of guidance, assuming the midpoint of revenue there, it looks like about a 40 basis point margin expansion and I know a lot of different people have asked this question. Can you maybe talk about where you expect the largest sequential improvement in margin, be at either the components division or the hardware division?

Paul J. Reilly - Senior Vice President and Chief Financial Officer

Yes, Carter, we differently expect that to come out of the ECS business as one factor, Cathy and Kevin talked about the seasonality that we'll get out of KeyLink which will have a natural uplift. We'll see some payoff from the investments we made also in the third quarter, so that would have the biggest uplift for sure in operating income percent. Our expectations are that Mike and his team of components will continue to drive improved performance there also, so we are pretty confident that both businesses will drive for improved operating income percent in the fourth quarter.

Carter Shoop - Deutsche Bank

Great. Let me sneak in one more here. In regards to the pricing pressure intensifying in most the geographies, are you saying that with most of your competitors or is there just a couple of large competitors where you are seeing that environment intensify?

Paul J. Reilly - Senior Vice President and Chief Financial Officer

Carter, my response to that would be that, this is not a onesie twosie type approach, this is more of a broader type phenomenon we are seeing, so not just big, not just small but shift across the entire industry at this point in time.

Carter Shoop - Deutsche Bank

Great, thank you.

Operator

And with no other questions left in the queue, I'd like to turn the call back over to Ms. Weaver for any additional or closing remarks.

Sabrina N. Weaver - Director, Investor Relations

Thank you. Before ending today's call, for those participating in today's webcast we'll quickly scroll for you the slide referenced in our webcast that contain a reconsolidation between GAAP and adjusted results. This reconsolidation is also included in our earnings release. Both the release and this presentation will be available on our website. I'd like to thank all of you for taking a time to participate in our call this morning. If you have any questions about the information presented today, please feel free to contact Paul or myself. Thank you and have a great day.

Operator

And once again, ladies and gentlemen that does conclude today's conference call. We do thank you for your participation, you may disconnect at this time.

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Source: Arrow Electronics, Inc. Q3 2007 Earnings Call Transcript
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