Based in Phoenix, AZ, Avnet, Inc., (AVT) is one of the world's largest distributors of electronic components and computer products. The company s customer base includes original equipment manufacturers (OEMs), contract manufacturers, original design manufacturers and value-added resellers (VARs). Avnet maintains an extensive inventory, including electronic products from over 300 component and systems manufacturers, which it distributes to about 100,000 customers through 250 worldwide locations. The product set is composed of semiconductors (approximately 62% of 2006 revenue), computer products (30%), connectors (4%), and passives, and electromechanical & other (4%). Avnet operates in two segments the Electronics Marketing (EM) Group and the Technology Solutions (TS) Group. The EM Group distributes semiconductors and Interconnect, passive and electromechanical devices (IP&E), and provides supply chain management, inventory replenishment system and non-complex engineering design services. The TS Group distributes mid- and high-end servers, data-storage gear, networking equipment and software, besides offering some services. In fiscal 2005, the largest supplier to TS was IBM, accounting for 18.7% of AVT's total sales. The EM segment generated approximately 62% of the $15.68 billion of fiscal 2007 revenue, while TS contributed the remaining 38%.
The company has separate divisions to meet the individual requirements of different classes of customers like OEMs, independent software vendors (ISVs), system builders, system integrators, value-added resellers (VARs) and end-users. It provides real-time information about product availability and offers related services that enhance the value of the products sold. Avnet generates approximately 51% of its revenue from operations in the Americas 31% from Europe, the Middle East, and Africa (EMEA) and 18% from the Asia/Pacific region. Revenue contribution from the Asian market has grown every year for the last three years by a total of 159.7%. EMEA and the Americas have grown 45.9% and 43.7% during the same time period. In the past, management had pursued a strategic acquisition policy that increased the size of the firm. In the last two years, the company made two major acquisitions, which significantly increased the revenue base and expanded margins. Growth in the EMEA region is likely to be driven by rough and hazardous (RoHS) products. Europe leads other regions in the adoption of RoHS standards, so management expects the RoHS adoption in Europe to aid the learning curve for future RoHS sales in other regions.
Competitors: Avnet's primary competitors are Arrow Electronics, Future Electronics and Agilysys. Smaller companies specializing in a single product or groups of products provide additional competition. Despite the large number of competitors, Avnet has been able to maintain its market position. The company's range of products and services, solid inventory and strong customer relationships has helped it secure a substantial share of the market.
EM segment: Avnet closed the acquisition of privately held Memec Group Holdings limited, a major competitor, on July 2, 2005. Total consideration included $418 million in AVT stock, $64 million in cash and the assumption of $194 million in net debt for a total value of $676 million. This works out to a 0.3x price to 2004 sales multiple. Memec generated $2.289 billion in revenue during 2004, and served the communications (39% of total revenue), industrial (29%), computing (22%), consumer (4%) and other (6%) end markets. Memec has been integrated within the EM unit. Management expects to derive $150 million in cost synergies with approximately $105 million coming from labor force consolidation, and approximately $15 million each from facilities consolidation, IT and other areas. There was an additional $10 million in financial synergies, as a result of the elimination of Memec's high interest bank debt.
Memec has been fully merged into the EM operations. The revenue, cost and financial synergies are expected to continue. Management has retained the Japanese workforce in its entirety (AVT did not previously have a presence in the country), and has made only limited reductions in the Asia/Pacific region overall. Memec has brought with it an experienced team, and management expects to retain key personnel. The expected quarterly savings by the end of fiscal 2006, after complete integration, was originally estimated to be $30 million (excluding interest expense savings from the retirement of Memec's long term debt). A further $7.5 million of potential synergies per quarter had been identified. Integration activities were completed in Q406. In the December quarter, Avnet closed a small semiconductor and embedded systems business in Italy for $3.32 million (net of cash acquired).
The company has a large market share and Memec opened the door to several other niche markets. Avnet's position in Asia has been much strengthened by the acquisition, improving its growth prospects significantly. However, with the acquisition of Memec, the company has a larger percentage of business flowing from Asia, and Asia is likely to be the largest growth driver given current outsourcing trends. Management stated that the business in Asia is associated with lower ASPs and also lower costs. While other factors may help margin expansion, a larger percentage of Asian revenue in the mix enhances Avnet's basic low-margin profile. The current margin expansion is deceptive, since it comes from weakness in low-margin Asian revenue rather than strength in high-margin Americas and EMEA revenue.
TS segment : The TS strategy has been to focus on the software and services area. Management has been expanding software and services, offering complete solutions to customers. This side of the business is likely to witness strong growth. Management expects the small and medium business market to offer attractive growth opportunity, and believes that more and more software vendors will enter the market through this channel. The microprocessor business remains very weak. The price war between AMD and Intel continues to increase volatility in this market. The AMD business is more profitable than the Intel business, according to management, prompting it to de-emphasize the Intel business. The weakness in microprocessors is the main reason for the continued weakness in the Asia/Pacific region.
Avnet continued to expand its TS business globally with the acquisition of Azure, which was closed down in April 2007. The Azure acquisition expanded the company's presence in Singapore, Malaysia, and other Southeast Asian countries. With this acquisition, the company expects to generate an additional annualized revenue of $90 million.
In October 2007, the company acquired Magirus. This acquisition will expand the company's presence in Europe and the Middle East in its TS business and will make it the largest value-added IT distributor in the region. The acquisition is expected to generate an additional annualized revenue of approximately $500 million.
On the first day of Q3 of fiscal 2007, the company closed the acquisition of Access Distribution for $410 million (subject to any minor changes that might occur as a result of alterations in audited book value). The acquisition was cash- and debt-funded. Access Distribution, the leading value-added distributor of Sun Microsystems, was integrated into the TS unit and the integration was completed on June 2007. This acquisition enhances Avnet's position at Sun Microsystems, as well as at several other providers of new high-growth technology products in the security, networking and VoIP markets. Roughly 90% of the Access business is currently generated in the U.S., while the balance comes from Europe. The geographic mix of business is a positive, since these regions typically generate higher margins than Asia.
Last year, Avnet expanded its relationship with Sun's StorageTek(TM) and started distributing their products. Avnet Partner Solutions started distributing disk systems, network-attached storage (NAS) systems, storage management software, storage networking and tape storage, as well as Sun Fire(TM) servers in the U.S. With these additions, the company now offers a complete storage solution that includes disk and tape hardware, software and services. The recent addition of Access further increases the company's position at Sun Microsystems.
Most recently, the company acquired IT solutions division of ACAL PLC which will significantly expand its product line by adding complimentary products in high growth segments including storage area networking or SAN, wired and wireless networking and security, and document management. ACAL IT Solutions markets portfolio from leading suppliers including, Brocade, Cisco, Emulex, Juniper, and QLogic. In addition, ACAL IT Solutions brings a suite of services that will enhance the company's ability to deliver service and solutions that meet the increasing complex requirements of the combined customer base. The acquisition was completed in Q2 of fiscal 2008 and is expected be accretive to calendar 2008 EPS by $0.03 to $0.04 per share.
Most of the large distribution companies run on razor-thin margins, therefore the possibility of marginal increases through cost reductions are minimal. Therefore, acquisitions play a major part in the growth strategy of these companies. Both the Memec and Access acquisitions significantly increase the company's scale of operations, hastening the realization of long-term financial goals within a shorter time frame.
ROCE: The company has a value based management (VBM) policy. Under this, the company's driving value initiatives were focused on creating shareholder value by managing the financial performance of all the Avnet's business units to a return on capital employed (ROCE) of at least 12.5% to 14.0%. The trailing 12-month ROCE was 12.8% in Q1, up 1.5% year over year.
Quarterly Discussion: The company reported revenues of $4.7 billion in the second quarter of fiscal 2008, up 22.2% from a year ago and up 13.7% sequentially. The growth was led by a strong performance in both the TS and EM segments. Organic revenue growth (adjusted for the change in the method of accounting related to the supplier services contracts and the impact of acquisitions and dispositions) was up 6.3% year over year and up 2.5% excluding the impact of changes in foreign currency exchange rate.
Overall gross margin dipped slightly to 12.5% from 12.7% in the prior-year period and 12.8% in the prior quarter due to a higher percentage of lower-margin TS as compared to EM in the business mix. TS revenue comprised 48% of the total revenue, up from 40% in the year-ago quarter, mainly due to higher aqcuisition activity at TS compared to EM. Operating margin was 4.4%, up from 4.2% registered in the the corresponding quarter of fiscal 2007 and 4.0% generated in the prior quarter.
The EM segment reported $2.48 billion in revenue, down 0.4% sequentially but up 6.2% year over year mainly due to strength in Americas(?). Revenues were up 2.4%, when adjusted to exclude the impact of changes in foreign currency exchange rates. Sales in Amercia were up 3.7% year over year and up 1.9% sequentially. Sales from Asia was up 8.5% year over year. On a reported basis, sales from EMEA region were down 0.6% sequentially and up 5.8% year over year. On a proforma basis, sales were down 1.5% to adjust the acquisition of Betronik in the second quarter of fiscal 2008. Operating income of $126.6 million was up 6.4% from the corresponding quarter of fiscal 2007, generating an operating income margin of 5.1%. The cash cycle declined by 6 days compared to the year-ago quarter. At the end of the reported quarter, the EM's book-to-bill ratio was 1.
The TS segment reported $2.27 billion in sales, which was up 46.0% year over year and up 41.0% sequentially, as December is a seasonally strong quarter for TS. On a pro forma basis, (adjusted for the change in the method of accounting related to the supplier services contract and the impact of acquisitions and dispositions) revenue was up 6.9% year over year. On a pro forma basis, sales in Americas, EMEA, and Asia were up 6.6%, 1.9% and 45.6% respectively. Operating margin of 4.4% was up from 4.1% recorded in Q2 2007 as a result of change in net revenue acounting from the sales of supplier service contracts.
During the second quarter, the company generated $83.8 million of cash generated from operations. The company ended the quarter with $417.1 million of cash and equivalents, down from $521 million of cash and equivalents at the end of last quarter. Avnet had approximately $1.28 billion of long-term debt and liabilities at the end of Q2, up from approximately $1.26 billion at the end of the prior quarter.
High level of Debt : The company sold two-thirds of its 8% notes (due November 2006) in the September quarter, exchanging them for $250 million worth of 6% notes due September 2015. It also issued 6.625% notes to repurchase its outstanding 9% 93/4% notes. Although this reduced the interest as well as extended the payback period, debt reduction was minimal. While the Moody's debt rating upgrade from Ba2 to Ba1 and the S&P outlook change from negative to stable are encouraging, the total debt position remains high in our opinion.
The Access acquisition has driven the share price to all-time highs however, we remain concerned about the above-outlined issues, especially the high level of debt. We are reiterating our Sell recommendation primarily based on the absence of near-term catalysts and concerns related to its high level of debt.