Day two of our Global Technology Conference. My name is Ruplu Haracharya, and I'm with the IT Hardware Equity Research Team, and I cover distributors. We're honored to have Arrow Electronics today, and we have President and CEO Sean Kerins. Sean is a veteran in the industry. He's been with Arrow for 18 years, or it's his 18th year with the company, so he's seen many ups and downs. We hope to have a great conversation. Sean has held many different hats. I think he was COO as well, and he's headed their ECS business, which is the Enterprise Computing Solutions business. Sean, thank you so much for coming today.
Thank you, Ruplu, and good morning, everybody. Thanks for having me.
Great. As is tradition, I'm going to start with a very high-level question. Give us your opinion on where we are in the semi-cycle, and as you look out, what's your vision for Arrow for the medium term, and maybe even what your focus areas are for the next 12 months?
Absolutely. The semiconductor cycle, as many of you know, has probably been one of the longest and most profound, both to the upside and the downside, that the industry has maybe ever experienced, or at least in quite some time. I think, as we said during our Q1 earnings report, we do believe we've seen the bottom. I think the slope of recovery is a little bit harder to predict, but we believe the leading indicators always suggest that recovery is in flight. If we look at our own leading indicators like book-to-bill ratios, they're all above parity in all three of our regions. Our backlog is building again, not just in magnitude, but also out in time, which gives us basically the benefit of improving visibility.
Of course, if we look at the preponderance of the suppliers that we represent in the electronics market, we typically follow our suppliers by a quarter or two, and you're seeing many of those guides now trending more positively. We believe the right things are happening, and things should improve from here. Now, as far as our priorities, obviously, we didn't sit still while we were managing the down portion of the cycle. We got real clear about our investment thesis, our growth priorities. We feel like we have good exposure to good end markets in both segments, and so we have a lot of clarity as to where we want to go from here. We also spent time on the things that we can control, like working capital efficiency and making incremental progress with respect to our cost structure. That work will continue even as the recovery unfolds, but I think we're feeling more optimistic now, certainly, than we've been in quite some time.
That's great. I want to touch on many of these things that you mentioned. As people would know, there are two segments to the business. There's the Global Components business, and then there's the ECS business, which is the Enterprise Computing Solutions business. Let's start with the core business and just talk to us about where we are, which innings are we in terms of there was an inventory correction that was happening for a long time. Are we still in an inventory correction? Are we out of it? Just give us your thoughts on that.
Yeah. Broadly speaking, I would say that the inventory piece of the correction is behind us. Now, are there still pockets of excess inventory at different places throughout the ecosystem? Yes. By virtue of the way our backlog is building and the longer-term visibility that we're now getting to real OEM production plans and demand projections, we feel like the worst of the excess is behind us. Obviously, some level of replenishment is what's been driving better activity levels for us since the start of the year. I think we have a lot of good data to support that conviction.
Let's talk about that. Are you getting any indications that customers are actually pulling inventory now? Maybe what are you seeing in terms of your backlog? What's a typical backlog? What's the backlog now? What are lead times doing? What type of visibility do you have going forward?
If you think about, if you start with lead times, obviously, supplier lead times extending well beyond normal levels is what drove the big disconnect between supply and demand, which drove the upside of the cycle. Supplier lead times have long since normalized, and they're at sort of historical averages across most technology categories for us. We haven't seen any of them go out yet, and that's making customers more comfortable that they don't have to place orders as early as they once did. To your point and to your question about visibility, if you go back a year, our backlogs typically didn't project much beyond any given current quarter. Now, our backlog is building out in time, meaning well into the third quarter, even with customer request dates now into Q4 in various places throughout the world. That tells us visibility is improving, and we're getting a better snapshot of real customer demand versus that which was impaired by the excess inventory levels. Again, we think the right things are happening because this was cyclical recovery.
Are you getting any longer-term forecasts from your customers, say, in the automotive segment? Because there have been burns coming during COVID in terms of getting piece parts. Do you think that has changed the industry in terms of how soon they order a product from you?
I think that most OEMs of any size and scale are all revisiting the way in which they manage their supply chains in total, not just the electronics piece of it. That's really given rise to our ability to leverage all of our supply chain assets throughout the world and actually play a different role for them going forward. That's a good thing. How quickly they make those changes, especially in industries like automotive, that's a little harder to call. As you know, some of those processes and patterns were fairly well entrenched, but I do think people are now much more sensitized to the criticality of electronic components in all of their products, and therefore looking at ways to how they can streamline and improve their visibility to their supply chains to get what they need, where they need it, when they need it.
That's our job, and that means we can play a really good role on behalf of large OEMs, not just the mass market in the form of traditional distribution. Are we getting longer-term forecasts per se from any given customer or vertical? Not necessarily, but all the market data that we've assembled would suggest the long-term CAGR for the electronics industry is still a healthy one. It's in the 5%-6% range. Even if you exclude for things like memory and GPU, which we don't participate in as significantly, we still like the growth rates, wherein one of our pillars of our investment thesis is really growing at or above market. We think the electronic technology is now so pervasive in so many verticals and use cases that the opportunities are only going to continue to multiply, so we feel good about the long term. The inventory did have to correct, and recovery patterns do have to emerge, and they are.
Got it. No, that makes sense. Let's talk a little bit about demand by region and demand by vertical. Give us margins, at least from my experience in the components business, depend on the regional mix. Talk to us about how different regions are trending and how different verticals within the regions are trending.
Broadly speaking, the biggest verticals for Arrow are first and foremost industrial, and then transportation, including automotive, and then aerospace and defense in the West. After that, you get into a handful of pretty material verticals, but probably lower tier in nature versus the first three, one being medical systems and devices, one being alternative energy, one being network and comms infrastructure, and then the others being consumer and compute. Those would sort of comprise our top eight or nine, if I counted correctly. Obviously, that mix varies across region. Typical with a cyclical recovery, Asia and China kind of lead the global market out of the bottom, and we're seeing that with the activity in our Asia business. They were above seasonal in the first quarter. Our guide reflects the same for them in the second quarter. That is what's driving your point about regional mix.
When Asia is really strong relative to the west, you get a little bit of a margin headwind. On the other hand, as the market normalizes and the west returns to fuller scale, that will normalize. The other aspect of margins is a function of customer mix. In the west, we've seen a return from the large OEMs as the mass market returns at more scale, and that really is our sweet spot, with a DTAM probably on the order of $200 billion globally, with tens of thousands of customers for us to go serve. As and when that really returns at full scale, that's where our suppliers want us to be. That's where our demand creation motion is most relevant, and the margins are most attractive. We think as those things normalize, we're going to like the longer-term trajectory for operating margins in the business. Obviously, we're starting from a lower jump-off point. The baseline was reset, so that will take some time, but those are the steps that are necessary for that to play out.
Makes sense. You talked about growing faster than the market, and one of the things that I think Arrow has done better than competitors is to really be able to capture share, at least over the last year. Talk about some of the competitive advantages you have, and how are you driving this above market growth, and what is the playbook here? What is driving that growth for Arrow?
If you're talking just electronic components for a second, we think the playbook is still pretty consistent with the playbook that has served us well so far. We have a vast array of supply chain assets throughout the world, and that really positions us to serve the large multinationals for those that want a very consistent experience throughout the world, as well as go deep in the mass market in each of our operating regions. We've always been focused on the mass market. We've always led with engineering, and we have engineering both in the form of field application engineers, where we get design in demand creation opportunities, as well as engineering and design services, where we actually function as a product of the product development or an extension of the product development teams of some of our larger OEM customers and suppliers.
We think the engineering leadership and the investments we made in engineering, along with our supply chain assets, really gives us some great capabilities and advantages throughout the world. I would say the fact that we've devoted time in building up some of our value-added offerings and capabilities, those that take us beyond traditional distribution alone, it gives us a chance to distinguish us in the market depending on what a supplier or customer's needs are. It's really important, Ruplu, to recognize that the market is enormous, and customers and suppliers oftentimes have different needs. It's not a one-size-fits-all market. Our electronic components business spans a spectrum from fulfillment all the way through demand creation. It includes the value-added offerings and capabilities I talked about.
When we sit down with a large customer or supplier, we have the opportunity to really listen to what it is they're trying to solve for and then position the right combination of assets and capabilities to fashion the right solution for them. It means that in some cases, we're playing primarily a fulfillment role and leveraging our global footprint to do so. In some cases, it means we're playing a supply chain management as a service role where we're not participating in the traditional distribution model at all. We're actually helping them manage their electronic supply chain on an outsourced basis so that they can go focus on the things that they're really good at, and we can earn a fee for helping them do so, which, by the way, is another way for us to participate in not just the market for DTAM, but the market for TAM. Now, I know that over time, it'll be helpful for us to give you something that helps you quantify the impact of that contribution to the business in total, but it's one of the examples of how we can serve the market in a variety of ways, and we try to do so with the right set of capabilities to be flexible to deliver.
You talked about value-added services. For those in the audience who don't know, maybe just talk to us about in the components business, what is it that you're distributing? How much of the business is semiconductors? How much is IP&E? What are these value-added services that you're providing, and how do you see that growing over time?
Broadly speaking, if you think about our mix from a pure component perspective, I think we reported at the end of fiscal 2024 that IP&E was 16% of our global component sales. That tells you, obviously, the rest was semi, but a subset of the rest was also in the form of services: supply chain management services, engineering services, and then integration services. Supply chain management services I just talked about, engineering services I mentioned, and we made an acquisition a few years ago called eInfochips to give us scale, to give us relevance, and to give us great credentials in the market for long-term engineering services engagements with some pretty large OEMs throughout the world, both in the automotive sector and beyond.
Integration services is a business where we design and build bespoke solutions in edge environments that embed all the necessary compute, storage, software, and even things like wireless connectivity. That is a business that shows up in use cases like medical imaging, physical surveillance, digital displays in retail environments, and even data center appliances on the traditional data center floor. We like that because, as you know, compute and electronics are now moving into all kinds of edge environments. They are not as concentrated in a few spots and verticals as they once were, and that gives us exposure to other pieces of the market and therefore more things to sell to more customers. All of those services are accretive to the gross margin profile of the electronic components business in total. That is why they are high on the list for investment as and when the market continues to recover.
Since we're on the topic of margins, talk to us about what are the drivers, both for the upside and downside for operating margins in the components business. What drives margins, and how do you see margins trending over the medium term?
We think that now that we're in some form of recovery, we think the outlook for the operating margin equation continues to get better. Again, things will take some time to play out. If you think about the building blocks for operating margin, first, it starts with more scale. That will give us the benefit of additional operating leverage just based on a similar, if not lower, fixed cost structure. The second will be kind of the return of the mass market at more scale, which lends itself to more design starts, more design in and demand creation, win opportunities. As those win rates improve again, those are helpful to us on the gross margin line. The third building block is our continued specialization into the market for IP&E.
The gross margin profile relative to semiconductor is significantly higher by an order of magnitude, hence our interest in continuing to pursue it. It's also highly complementary to our presence in the markets for things like industrial, transportation, and aerospace and defense. There's lots of cross-sell, upsell that we can take advantage of just by way of relationships. The last building block is really the continued growth in our value-added offerings, as I just described. All of that taken together is what puts us back on the path to what we think will be not just mid-cycle, but long-term operating margin targets that obviously are healthier than where we are today.
Okay. That makes sense. I want to talk about a topic that's a very fun topic, which is tariffs. Everybody seems to be, that seems to be a question at every meeting nowadays.
I'm guessing this is the first time this came up at the conference.
Yeah, that's right. Talk to us about how tariffs impact both the top line as well as the bottom line. Can you talk about for the stuff that you're selling in the U.S., how much of that is coming from China and other regions that are impacted by tariffs? Are tariffs a good thing for Arrow, or are they negative? Give us your thoughts on this.
Let's take that question last, but I'll try to unpack the tariff story as best we see it. First thing I would do is just draw you back to what we guided for our second quarter. Turns out we did something pretty unique compared to most of the other people in our space. We actually separated the top line impact that we saw from tariffs for things that we had to pass on to our customers from the guidance we gave around the underlying core business. We did that because we wanted to give you our best view of how the cycle was actually playing out, not something that was going to be muddied by how much of this is really an impact of tariffs or tariff pull-ins. That's number one.
I think in the course of doing that, we estimated a number that was maybe 2%-4% of our global component sales in the quarter, which is not overly material. That was even based on policies that were in effect at the time, which have changed since. That number likely will even be smaller yet again. That's the top line assessment. We look at this thing in two ways. One is we look at making sure we're really clear on what tariffs will be assessed, some of which we can draw back from the government for product that will be re-exported outside the U.S., some of which will land in the U.S., and therefore we have to pass on the appropriate tariff to customers. We do so with no intent to make even a penny of margin. It's a complete pass-through.
Ultimately, we would view the top and bottom line impact as being entirely neutral. Obviously, there is a collection process that has to ensue, and that takes a little bit of time to play out. That is the stance we have taken. Based on the experience we have gleaned since 2018, when the first round or an earlier version of this regime was in place, we have certain processes in place. We have implemented foreign trade zone capability. We have got intelligent sourcing and routing capabilities to assist customers. We are implementing processes at the quote front line as well as the customer support functions in the back end to mitigate all of this as much as possible. I feel very comfortable that we have got lots of great people and expertise focused on it.
You can imagine like many companies, we're all working really diligently to get our arms around it, but we feel like we have a good handle on what it could look like. The wild card is what a steady state tariff environment will look like. I don't think anybody knows. We got to be prepared for the most extreme version of all of this, but hope for something better. Right now, we don't think that it's been overly material to demand for us in Q1 or in our outlook for Q2, and we'll take it one quarter at a time.
Have you seen any change in customer or supplier behavior? Have you seen any pricing changes as a result of this? Have you seen any change in end market demand?
We haven't seen. Obviously, there's been lots of conversations with large customers as to how best to manage all this. Quite frankly, that's our job. Yes, we want to make sure that we assess the tariffs that we'll be exposed to and how best to recover them. Ultimately, one of our competitive advantages is we sit in a perfect position to help customers navigate this, and that's where we spend a lot of time. Yes, a lot of customers are really exploring, hey, what kind of exposure does their bill of materials present for them? What can we do for them to optimize around things like country of origin? How can we help them think about the next generation of their products so they can design for optimizing around tariff exposure among other variables?
Those conversations are only picking up in frequency and intensity, and that's a good thing because we think it sheds a light on some of our non-traditional capabilities that you might not always think of that we spend a lot of time resourcing and executing on in the market. We haven't seen significant pull-in behavior in the U.S., for example. If that were the case, you'd see a pretty big uptick in our backlog for relative shipments relatively soon. That's not been the case. As I said earlier, our backlog is building, but it's also extending out in time, and that wouldn't fit the bill for someone that was trying to avoid a tariff. We also have pretty good visibility to all the content that we import from China as country of origin.
We haven't seen a material buildup in the backlog for any of it, which would be another signal. Look, it doesn't mean there isn't some of this going on. There is. We're probably seeing some of it in China on a reciprocal basis, which might be contributing to some of the really good activity we're seeing in that market. Again, overall, we don't anticipate it as material, at least not yet. Great opportunity for us to serve our customers in different ways and with capabilities they haven't fully appreciated until they really need this kind of help.
Okay. Let's move on to the ECS segment. Talk to us about what are some of the products that Arrow focuses on in terms of distributing, and how is that business trending? Can you talk to us about backlog and revenue trends? Which products are hot, which are not?
Yeah, certainly. I think I may have dropped my mic. Let me just get re-miked here. If you think about that business, the strategy is really simple. Right technologies, we focus on the market for cloud, hybrid cloud, and then infrastructure software, number one. Right market segments, we focus on the mid-market versus the very large enterprise because that's where our suppliers want to see us, and that's where we're best rewarded for our value-add and capabilities. Then three, right go-to-market model, which is increasingly all about the adoption at further scale of our ArrowSphere digital enablement platform, which is also contributing to the continued buildup in the recurring revenue piece of our total volume. Good things are happening in that business. We've seen both GP dollar and OI dollar growth over the last three quarters, year-on-year in succession. Our guide reflects the same again for Q2.
We've enjoyed some recent wins from pretty good-sized suppliers that recognize what we're doing and feel like we're well-suited for them. A VMware appointment in North America, a Citrix appointment both in North America and Europe, a CrowdStrike appointment in North America, which will deepen our presence in the market for cybersecurity. We feel like we've got the right strategy. We feel like we're replicating the success that we've enjoyed in Europe for some number of years to put us on the same path in North America. That'll take a little time to continue to get more scale, but things are improving there from here, and the trajectory for the business based on the end markets in which we compete, we think are pretty promising.
One thing I think that is underappreciated by investors is this recurring revenue portion of the ECS business. Talk to us about how that is trending. How large is it? How should we think about trends in that business? If you can weave in how that impacts margins, because I think last quarter revenues were up strong, 18%, but I think operating margin was down year-on-year, 34 basis points. Not that it's a big thing, but how should we think about margin trends versus revenue in this business?
Probably two separate questions here. One is just about the recurring piece of our total mix. As you know, we now disclose billings because we think that's an accurate reflection of the real market activity in which we participate each quarter. If you did the math on that, you'd figure out roughly what it looks like on a full year basis. The recurring piece of our total volume on a gross billings basis is now approaching 1/3, and it's been steadily growing a little bit each year for the past few years. This is one of the reasons why we're now starting to disclose it. We agree with you that we think the more recurring in nature our business is, the better the contribution margins ultimately will look like. We serve it differently, which is digitally.
It's very sticky, and it gives us a chance to re-engage customers on an ongoing basis. Given our strategy, which is more cloud and more infrastructure software, which increasingly is being sold on a subscription basis versus with a perpetual license, we think that mix will only continue to grow in that fashion. The question you have about margins is really just the function of whether or not you're talking about margins as a percent of sales, reported sales, or margins as a percent of billings. The reported sales number will be a little bit volatile from one quarter to the next simply as a function of agency accounting. It's a little bit of a distraction. It's why we started to report billings. Our operating margins as a percent of billings were flat year-over-year in Q1.
We guided they would be at least flat year-over-year in Q2. The margin profile for the business is stable. Given what I just talked about, we think it continues to improve a little bit over time. Do not let the reported sales metric alone be too much of a distraction. That is simply a function of accounting, and that will vary a little bit from one quarter to the next. We like the markets in which we play. We like the offerings that we are driving, and we like the nature of them mainly in the software and services realm and what that means for the margin profile of the business over time.
Got it. We have about two minutes left, and I'd like you to cover how you think about shareholder returns, how you think about investing in the business, capital allocation, and finally, what is the market missing? Why should investors invest in Arrow right now?
If I start there, I'll be a little bit repetitive, but we think we're aligned to attractive end markets with healthy growth potential in both operating segments. We think we have an investment thesis based on growing at or above market in both part one. Part two, we think we have clarity around our go-to-market and investment priorities such that we can drive margin expansion over time through part one mix and part two, kind of an enduring productivity flywheel, which will create reinvestment capacity back into those growth priorities I talked about. Then part three, making really constructive use of excess cash. Historically, our capital allocation priorities have been very specifically about organic growth, selective M&A, and then capital return in that order. I would say that's still the right set of priorities in the right order. However, I would also say we're taking a more constructive look at the role that M&A will have to play as a way to augment and accelerate our progress with respect to the growth priorities I outlined.
Great. I think we covered a lot of different topics. Sean, thanks for coming. I think you're doing a great job. Arrow is on the right path. Thanks again for coming. Thanks for sharing all these details, and great to have you today.
Thank you, Ruplu. Great to meet you in person. Thank everybody for joining. Appreciate it.