Arrow Stands out Among Distributors for Moatworthy Efficiency, Profitability

Analyst

William Kerwin

We think Arrow Electronics is one of the premier global value-adding distributors of electronics. Arrow uses its excellent sales, marketing, and net working capital management expertise to provide its supplier partners with a long tail of small customers while using its partnerships to service customers with a broad semiconductor selection—increasing profits for both ends of the supply chain in the process. We think Arrow is a more efficient operator than many of its distributor peers, which, along with its differentiated engineering expertise and design generation, leads to it holding among the best operating margins in the business. 

In our view, Arrow is such an effective and streamlined operator that it earns an economic moat, while none of its peers under our coverage do. Arrow’s cash conversion cycle and average inventory days lead other top global distributors, which allows it to earn slim, but reliable, excess returns on invested capital. We also think a focus on high-value semiconductors for transportation and industrial applications augments its returns. Its proficiency in chip distribution has led to it offering the broadest line card of any global chip distributor and the top market share in North America, including several high-profile exclusive supplier relationships, like with Texas Instruments and Analog Devices. 

Going forward, we expect Arrow to benefit from trends toward an expanding “Internet of Things” and rising chip content in electric vehicles, autonomous vehicles, and industrial applications. We also think the company has considerable room to expand its customer base—globally, distributors account for only about 25% of chip sales, and an increasingly complex supply chain will make value-added distributors even more critical, in our view. We think Arrow gives investors an opportunity to play into the broader semiconductor and enterprise networking markets, while providing sizable shareholder returns along the way. Finally, we expect the firm to modestly expand its midcycle margins as its geographic mix normalizes and growing volume provides it with some operating leverage.

Business Strategy & Outlook

We assign Arrow Electronics a narrow economic moat rating based on intangible assets in the form of engineering expertise and sales and marketing proficiency. Arrow is a value-added distributor of semiconductors and other electronics, connecting large suppliers to a plethora of small and midsize customers. We think Arrow is an essential intermediary in the electronics supply chain, adding application-specific engineering knowledge to a broad line card of products to service customers and allowing large suppliers to outsource sales and marketing while reaching a wider customer base. We think Arrow’s value proposition allows suppliers and customers alike to run more efficiently and more profitably, and we predict this will allow the firm to earn economic profits over the next 10 years. 

Arrow’s sales of electronic components—semiconductors, passive components, and memory—made up 76% of sales in 2021. Demand creation makes up roughly 30% of components sales and is where we believe Arrow derives its greatest differentiation—showing intangible assets in the integration of chips and other components into final designs. In demand creation, Arrow will send in a field engineer to work with a customer—providing multiple designs with various component combinations and testing each one—and secure a socket for a final design for 18 to 24 months. In this scenario, customers benefit from expert implementation of the best-suited parts for their product without the time and expense of exploring every option and keeping talented engineers on payroll to integrate them all. On the other side of the equation, suppliers receive guaranteed, locked-in demand, and pay a premium for it— typically Arrow earns 300-400 basis points higher margin for demand creation than regular fulfillment. Despite accounting for a minority of revenue, Arrow’s demand creation allows it to earn significantly higher gross and operating margins than competitors like WPG or WT Micro that rely mostly on fulfillment services. In our view, this engineering capability isn’t easily replicable by other distributors, and allows Arrow to earn stronger returns on invested capital than its counterparts. 

In addition to engineering expertise in demand creation, we think Arrow’s expansive customer network and its proficiency in sales and marketing in its fulfillment business represent intangible assets that benefit the profitability of both sides of the components supply chain. Arrow’s fulfillment business makes up the remaining 70%-80% of its component sales. While the market for fulfillment distribution is very fragmented, Arrow holds the top market share in North American chip distribution, and second globally, which we posit is the result of its network of 180,000 small and midsize customers and the broadest semiconductor selection of any distributor—covering one third of global chipmakers. A chipmaker’s sales and marketing team can typically supply 100-200 customers directly, and they rely on Arrow to service a global base of smaller customers. Arrow spends considerable time with customers even in fulfillment, working to understand the application at hand and fill the socket with the best-fit component. Purchasing from Arrow isn’t simply a stop-and-shop process—the firm uses a large salesforce to build relationships with customers, discussing component selection, payment terms, and project timelines. In short, Arrow markets components, extends credit to customers, and manages working capital—lifting these burdens off the suppliers. In doing so, suppliers earn higher margins by reaching an expansive customer base with relatively low sales and marketing investment. On the flip side, Arrow culls the world of components for small customers and helps them select those best suited for their application. It can also be a buffer to customers in times of supply chain disruption, and customers earn higher margins by lifting the costs of sorting through different component options and engaging with multiple suppliers off of their payrolls. 

While other distributors offer the same basic value proposition for fulfillment, Arrow stands out by focusing on higher-value products and being the superior operator, in our view, which makes it moatworthy. Arrow’s components business is heavily weighted toward semiconductors, which is a higher-margin business than less differentiated passive components. Furthermore, within semiconductors, Arrow focuses on higher-value, stickier applications like transportation and industrial products. This compares to competitors like WPG and WT Micro that have large global market shares for semiconductor distribution but rely heavily on smartphone and PC applications where large customer power compresses margins and erodes switching costs. Beyond focusing on more lucrative markets, Arrow is simply an excellent operator. Arrow has the shortest average cash conversion cycle over the last five years of any of the top four global semi distributors (Arrow, Avnet, WPG, WT Micro), and its annual inventory days over the same period are rivaled only by WT Micro, which benefits from a greater mix toward fulfillment. We think this is evidence to Arrow’s sales and marketing proficiency and organizational efficiency. In our view, the combination of a heavier mix of demand creation than competitors, unrivalled operational efficiency, and a focus on higher-value markets results in Arrow boasting the largest operating margin of any top global distributor, for 10 years running. We also think that its elite management of working capital allows it to earn enduring excess returns on invested capital, while its chief competitor, Avnet, with a similar business model, does not. 

Finally, Arrow derives 24% of sales from its enterprise computing solutions, or ECS, business, where it sells IT solutions. Arrow sells hardware like storage and networking equipment alongside security and analytics software to small value-added resellers, or VaRs, that then implement them into solutions at end customers. In ECS, Arrow again applies its sales and marketing and working capital management expertise, but leaves the actual IT implementation to the resellers, who maintain relationships with their own end customers. We think Arrow’s ECS business holds intangible assets in sales and marketing, and as a result forms an essential part of the supply chain for complex IT architectures. Arrow serves over 20,000 VaRs that are mostly small and regionally based. These VaRs are experts on the practical implementation of on-premises servers, hybrid cloud deployments, and other complex IT projects, but use Arrow to access a wide selection of products from suppliers they wouldn’t be able to deal with directly. Arrow also acts as a managed service provider for the resellers, managing subscription payments with its suppliers. Similarly, suppliers can sell products to Arrow and access a broad network of resellers that wouldn’t be otherwise reachable, allowing for their solutions to proliferate among smaller end customers. Perhaps most importantly, a supplier doesn’t have to directly manage and track payments with a plethora of smaller customers, dealing instead with Arrow, which will ensure timely subscription revenue. Similar to its components fulfillment business, Arrow can increase profits for both buyers and sellers of IT solutions with its sales and marketing proficiency while earning itself a large enough margin in doing so to earn economic profits, which we expect to continue over the next decade.

Narrow

Economic Moat

Arrow Electronics

Arrow Electronics, Inc. is a provider of products, services, and solutions to industrial and commercial users of electronic components and enterprise computing solutions. It operates through two segments: Global Components Business and Global Enterprise Computing Solutions. The Global Components segment is involved in the marketing and distribution of electronic components and provides a range of value-added capabilities throughout the entire life cycle of technology products and services through design engineering, global marketing, and integration, global logistics and supply chain management. The Global Enterprise Computing Solutions segment provides computing solutions and services which include datacenter, cloud, security, and analytics solutions. The company was founded by Robert W. Wentworth and John C. Waddell in 1946 and is headquartered in Centennial, CO.

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Arrow Electronics, Inc. engages in the provision of products, services, and solutions to industrial and commercial users of electronic components and enterprise computing solutions. It operates under the Global Components Business and Global Enterprise Computing Solutions (Global ECS) segments. The Global Components segment focuses on the marketing and distribution of electronic components enabled by a comprehensive range of value-added capabilities and services. The Global ECS segment is involved in providing comprehensive computing solutions and services. The company was founded by Robert W. Wentworth and John C. Waddell in 1935 and is headquartered in Centennial, CO.

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