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S&P Capital IQ


09/11/17 10:00:06 AM



This week's Focus Stock of the Week is Arrow Electronics (ARW: $77) which carries CFRA's highest investment recommendation of 5-STARS, or Strong Buy. ARW is a global provider of products, services, and solutions for both electronic component and computing original equipment manufacturer (OEM) customers. Despite a rich history dating back to 1946, ARW remains a relatively unknown company.

Our Strong Buy recommendation reflects our belief that ARW remains one of the few distributors with end-to-end capabilities (from semiconductor to data solution) that has properly invested in its delivery model capabilities (digital, cloud and IoT platforms). Ultimately, this has led to ARW being able to differentiate its value proposition from its main competitor (Avnet), who consequently divested its computing business (Technology Solutions) earlier in 2017. This led to favorable market share shifts for ARW at value-added-resellers (VARs) and presents material revenue opportunities (upwards of $1B) which start to take hold in Q4 2017.

Looking ahead, we believe many tech-related companies now sport full valuations after outsized gains (IT sector up 19% vs. 9.8% YTD for the S&P 500) fueled recent multiple expansion. As such, we think ARW remains an excellent candidate for investors seeking refuge in value orientated names (10.6X '17 EPS), versus the S&P 500 Technology sector, at 18.8X next twelve month EPS estimates.

When gauging specific vertical exposure, we believe ARW's largely dispersed product portfolio helps temper segment volatility. According to the Semiconductor Industry Association (SIA), semiconductor consumption for mobile, PC and laptops across the industry is nearly 50%, while ARW's exposure resides at 8%-10%, and more weighted towards industrial automation, robotic and machine. ARW currently has no customer accounting for more than 3% of sales while it expands its overall base (rose 25% last year). We also note its digital reach helps leverage its install base to capture incremental IT spend, as ARW's digital and cloud platforms are well on track to a $1 billion run-rate by the end of 2017.

For revenues, we see a rise of 9% in 2017, followed by a 4.5% increase in 2018. ARW's largest of its two operating segments (Components) comprises 70% of its mix. This continues to be a bright spot and rose 16% in Q2, with double-digit growth in Asia, America, and Europe. Largely helped by its diverse product mix in semiconductors, electro-mechanical, and memory, we think ARW is poised to continue outpacing GDP by 2-3X. While backlog remains elevated, we think this remains favorable, given widespread demand across all regions, stable lead times, and no material uptick in cancellation rates. Interestingly, its book-to-bill remains solid at 1.14X but does not reflect recent share shifts.

Enterprise computing solutions (30% of mix) remains a drag (down 6% in Q2), largely driven by challenged legacy storage/server trends. Going forward, we think server declines moderate and storage continues its transition to newer offerings (hyper-converged and solid-state), which are growing at double-digit rates. Further, through ARW's sticky relationships (VARs), its software mix has swelled from 30% to 70% over the past 10 years, reflecting its push into security and virtualization.

ARW continues to post an industry-leading operating margin, which we see at 4.3% in 2017 and 4.5% in 2018, outpacing peers by around 2X. Despite pressure from semi consolidation, ARW continues to deliver consistent margins. Instead of employing a deep cost rationalization (at the expense of growth) approach taken by peers, ARW has made proper investments to bolster its customer fulfillment business to drive operating leverage. We think this allows ARW to make continual progress towards its 5% longer-term goal.

We see EPS of $7.25 in 2017, rising to $7.89 in 2018. That said, we think ARW could realize incremental sales and margin expansion as it ramps recent supplier wins. While temporary, we note Q2 operating cash flow was negative, due to recent inventory builds to meet robust demand into 2018. Going forward, we think ARW returns to more normalized levels of cash flow generation (70% of net income) while maintaining its focus on capital allocation to shareholders ($1.4B in buybacks over last 5 years). Lastly, leverage remains modest (2.4X net-debt-to-EBITDA) lending room for strategic M&A if presented.

Our 12-month target of $91 is on 11.5X our FY 18 EPS estimate, a discount to peers at around 13.1X. We believe ARW remains a top-tier distributor with solid execution, which has subsequently enabled it to capture market share from direct competitors. As such, we think ARW deserves to trade closer to peers.

Risks to our recommendation and target include rapid deterioration in the global economy, greater than expected pricing pressure, and smoother than expected execution from competitors. Lastly, if market share shifts were to fail to materialize, this would adversely curtail ARW's outlook.

CFRA's views on stocks are constantly re-evaluated. Please refer to our most recent publication on this stock to see our current view.


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