Thursday, August 03, 2006

Arrow Electronics [ARW] gets a BUY

I love a good boring stock. It’s great to find a company that makes good money while hovering in the background so that its stock is reasonably priced.

Arrow Electronics [ARW] is an electronic parts distribution and logistics company. I remember them as a small company many years ago, but they have grown up to a worldwide supplier with US$11 Billion in sales in calendar year 2005. They used to be just a parts reseller but in this age of internet business they have reinvented themselves by building electronic inventory interfaces with their customers. They have also built a design and support network that helps their customers design products and plan for product lifespans. All these additions build nice competitive advantages for Arrow over their reseller competitors.

Using their competitive advantages Arrow has built itself into the number one supplier in most markets, and is growing rapidly in Asia.

Arrow is, fundamentally, a service company. They don’t manufacture the parts, they distribute them. This tends to lead to low margins, although Arrow has done a good job of holding steady, reaping a bit more margin on 2005 sales than 2004 and earlier. In Q1 2006 margins compressed a little but earnings still came out above estimates.

The financials are what really draw my attention. Price to free cash flow is 9 (a nice and low number), price to earnings is 10 (low end but in line for the industry), and the Net Present Value discount is a stunning 23%! To turn that last calculation around, the company could grow from current earnings at a meager 5.5% annually and still meet my stringent requirement of a 15% discount for finding value stocks. This is on a stock that analysts estimate will grow at 13% per year.

Given that they supply a rapidly growing electronics industry and are a top player, we can expect much better than the minimum 5.5% growth needed to justify the current price. Credit Suisse First Boston, in their “Outperform” rating analysis, note that just applying a price to earnings ratio of 10 to next years estimated earnings gives a price of $32, a 15% gain from its current price. The component sales service industry averages a PE of 10-15.

Analysis of Arrow’s financials show no worrisome pension or accounting issues. I am a little uncomfortable with the way they are accounting for some presumed lawsuit revenue from E.ON AG, but it is a small amount. There is also some worrisome activity around an environmental lawsuit, but it doesn’t appear too bad from the information I was able to dig up.

As usual for a capital-intensive stock I have calculated a Z-ratio (which is like a credit score for a company and rates the likelihood of bankruptcy) (online calculator). ARW scores well with a 3.23, a comfortable rating that suggests little to worry about.

When digging through past performance one notes that the company had
a weak 1998 and 1999 even though that was before the recession of 2001. Digging into the way-back machine, however, shows that the component industry basically imploded in late 1998 through 1999. I have reproduced a couple plots of the components market from 1999 here:

(Graphs excluded because Blogger once again can't handle graphics today. I will post them if they ever get Blogger to work.)

The plots show how from 97-99 the electronic component market collapsed (first plot) after several years of reduced production in the electronics market (second plot).

In the face of such a dramatic industry event the important question is “how did the company handle it?” Arrow focused on costs and service and continued building improved systems to serve the customer. There is no evidence of channel-stuffing or other accounting shenanigans and the company came out stronger than before and took market share because of it. This is a good company to own a piece of.

We are facing into the part of the year with historically weak margins and the company has just pointed that out to analysts, so the stock is presently pretty cheap. If the economy holds this stock should be up nicely by next year, if there is a recession we might need to hold it until afterwards. I would really prefer if it had a dividend to pay me while I wait but it’s still a good buy.

I’m calling this stock a BUY and I have just taken a position in it before posting this article.

Invest Well,
FW

PS: For those of you into sector rotation, this is a service company so the timing is about right.

PPS: ARW is also on the list of Fortune Magazine’s Most Admired Companies which an interesting bit of recent academic research suggests indicates high returns to come.
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