Avnet - Q1 2013

Transcript

Vince Keenan (Head of Investor Relations)

Good afternoon and welcome to Avnet's first quarter fiscal year 2013 business and financial update. If you are listening by telephone today and have not accessed the slides that accompany this presentation, please go to our website and click on the icon announcing today's event. As we provide the highlights for our first quarter fiscal year 2013, please note that in the accompanying presentation and slides, we have excluded the gain on bargain purchase associated with an acquisition and restructuring integration and other items for all periods presented. When discussing pro forma sales or organic growth, prior periods have been adjusted to include acquisitions and the impact of divestitures. In addition, when we refer to the impact of foreign currency, we mean the impact due to the change in foreign currency exchange rates when translating Avnet's non-U.S. dollar-based financial statements into U.S. dollars.

Finally, when addressing working capital, return on working capital employed, and return on capital employed and return on working capital, the definitions are included in the non-GAAP section of our presentation. Before we get started with the presentation from Avnet Management, I would like to review Avnet's safe harbor statement. This presentation contains certain forward-looking statements, which are statements addressing future financial and operating results of Avnet. Listed on this slide are several factors that could cause actual results to differ materially from those described in the forward-looking statements. More detailed information about these and other factors is set forth in Avnet's filings with the Securities and Exchange Commission. In just a few moments, Rick Hamada, Avnet's CEO, will provide Avnet's first quarter fiscal year 2013 highlights.

Following Rick, Ray Sadowski, Chief Financial Officer of Avnet, will review some other financial highlights, our return on capital performance, and provide second quarter fiscal 2013 guidance. At the conclusion of Ray's remarks, a Q&A will follow. Also here today to take any questions you may have related to Avnet's business operations is Phil Gallagher, President of Technology Solutions, and Harley Feldberg, President of Electronics Marketing. With that, let me introduce Mr. Rick Hamada to discuss Avnet's first quarter fiscal 2013 business highlights.

Rick Hamada (CEO)

Thank you, Vince, and hello everyone. Thank you all for taking the time to be with us today and for your interest in Avnet. Our Q1 results represent a disappointing setback in our short-term performance expectations. Key segments of our served markets slowed during the quarter beyond our initial expectations, leading to a dramatic impact on our bottom line results as our revenues in the higher margin Western regions declined double-digit percentages year-over-year. Our Americas region was the weakest relative to our expectations as pro forma revenue declined 14% both sequentially and year-over-year. Our EMEA region, which has been dealing with slowing economic activity for the past year, experienced a fifth consecutive quarter of year-over-year revenue decline as pro forma revenue was down 8% in constant currency.

As a result, enterprise revenue of $5.9 billion decreased 8.7% year-over-year and 8.4% on a pro forma basis in constant dollars. While Q1 is typically our weakest revenue quarter each fiscal year, our sequential revenue decline was beyond normal seasonality due primarily to the unexpected double-digit percentage decline in our Americas region across both operating groups. Gross profit margin was essentially flat year-over-year but down 37 basis points sequentially. The negative leverage from the loss of gross profit dollars due to the decline in revenue in the higher gross profit margin Western regions had a significant impact on our bottom line as operating income dollars declined 41.3% sequentially to $137 million and operating income margin of 2.3% was down 137 basis points from the June quarter.

Given these developments, we increased our previously announced $40 million to $50 million of planned expense reductions and completed $90 million of annualized reductions that will positively impact our December quarter. Consistent with our portfolio management methodology, the majority of the expense actions are focused on those parts of our business that have been most impacted by the loss in revenue and where profitability is below our stated goals. On the bottom line, EPS declined $0.31 per share from the year-ago quarter to $0.59 due primarily to the year-over-year decline in operating income as a result of the significant drop in revenues. Return on capital employed declined both sequentially and year-over-year to 7.9% and was below our cost of capital for the first time since the Great Recession.

As noted in my opening comments, we are very disappointed with this performance and will continue to act with a sense of urgency to appropriately align our resources to current market conditions. Accordingly, we are in the process of identifying additional cost reduction actions that will positively impact future quarters. As is typical in periods of low or negative growth, due to the countercyclical nature of our balance sheet, we generated cash from operations for the fourth consecutive quarter, bringing the total for the last 12 months to $814 million. We continued with our share repurchase program and during the September quarter purchased another 4.17 million shares at an average market price of roughly $31. When combined with the share repurchases since the program's inception in August 2011, we have purchased a total of 15.44 million shares at a total cost of $456.6 million through the end of September.

Since October 1st, we have invested an additional $61 million in our share repurchase program. After a challenging fiscal 2012 characterized by the electronic component supply chain correction at EM and weakening demand for data center products at TS, we entered fiscal 2013 with the expectation for a certain level of stabilization in our served markets. The first quarter of fiscal 2013 demonstrated that macroeconomic uncertainty continues to adversely impact our end markets as our previously stronger performing Americas region experienced an unanticipated decline in demand at both operating groups. We are confident that our strong competitive position and experience managing through many industry cycles will serve us well as we navigate the current market conditions and focus on short-term profitability as a step to resuming progress toward our long-term targets. Now let's turn to the operating groups.

In the September quarter, electronics marketing's revenue came in at the low end of seasonality for the third consecutive quarter as pro forma revenue declined 3.2% sequentially in constant dollars as compared with a typical range of +1% to -3%. Reported revenue of $3.65 billion decreased 4.3% year-over-year and pro forma revenue in constant currency was down 4.8%. The Americas region came in below expectations as pro forma sales declined 11% both sequentially and year-over-year. In the EMEA region, year-over-year pro forma revenue declined 5% in constant currency, making it the fifth consecutive quarter of revenue contraction. The Asia region exceeded expectations as pro forma revenue grew nearly 8% sequentially and 1% year-over-year.

EM's gross profit margin declined 27 basis points from the prior year quarter and 48 basis points sequentially, driven by lower than expected gross margin in the Western regions and the geographic mix shift to lower margin Asia region. The combination of the declines in the revenue and gross profit margins drove operating income down roughly 23% sequentially and year-over-year to $146.3 million. As a result, operating income margin came in at 4%, representing a decline of approximately 100 basis points from both the June and year ago quarter as the loss of gross profit dollars from the declines in revenue in the Western regions and the contracting gross margin had a significant impact on EM's profitability. In response to the softening in the industrial end markets in our higher profit regions, EM took actions to reduce expenses in the September quarter.

These actions included a reorganization of the Americas sales force to better align resources with the current market opportunities and a decision to exit the commercial components business in Latin America outside of Brazil. Return on Working Capital declined 427 basis points from the year ago quarter, primarily due to the decrease in operating income as working capital continues to be effectively managed by our team. After adjusting for acquisitions and changes in foreign currency exchange rates, working capital decreased by 8.3% year-over-year and was up less than 2% sequentially, primarily due to a decrease in accounts payable related to lower inventory purchases at the end of the quarter. On a pro forma constant currency basis, EM's inventory was down slightly from the June quarter, and inventory turns have remained steady over the past three quarters.

EM's book-to-bill declined throughout the quarter with a noticeable drop in the month of September and came in at 0.95-to-1 for the full quarter. Customers continue to be very cautious in placing new orders given the lack of end market visibility coupled with short and stable lead times. Even though it remains difficult to determine demand trends going forward in the current environment, it appears that the electronic components technology supply chain is being effectively managed. EM remains well positioned to weather this downturn and deliver margins back within our target range when seasonal growth returns. Similar to EM, TS experienced a weaker than expected top line in the Americas region. In the last two weeks of the quarter, customers delayed IT projects, contributing to an 18% decline in pro forma revenue both sequentially and year-over-year.

The EMEA region experienced its seventh consecutive quarter of negative year-over-year growth as pro forma revenue declined 11.7% in constant dollars. At the global level, revenue of $2.2 billion declined 12.5% sequentially and 13.9% year-over-year on a pro forma basis in constant dollars. Gross profit margin was roughly flat with the year ago quarter and declined 46 basis points sequentially as an improvement in Asia was more than offset by declines in the Western regions. The loss of gross profit dollars in the Americas region had a significant impact on the bottom line as TS operating income declined $31 million year-over-year and operating income margin decreased 94 basis points to 1.6%. Operating income and operating income margin also declined in the EMEA region as the expense reductions made in previous quarters were not enough to offset the continued decline in revenue.

As a result of the decline in profitability, particularly in the Americas region, return on working capital decreased dramatically. Given this performance, we have taken significant steps to improve profitability and continue to identify additional actions that will positively impact results after this seasonally strong December quarter. As a final note, we completed the acquisition of Magirus, which will expand our footprint in the EMEA region with key suppliers in high growth technologies. Even though the continued soft market environment in EMEA creates short-term obstacles to profitability in the region, the addition of Magirus will strengthen our competitive position and provide additional opportunities to accelerate profitable growth when spending on IT infrastructure improves. Now I would like to turn the commentary over to Ray Sadowski to provide more color on our financial position and economic profit performance. Ray?

Ray Sadowski (CFO)

Thank you, Rick, and hello everyone. Due to the significant decline in revenue late in the quarter in both of our operating groups, our key financial performance metrics came in well below expectations. As Rick mentioned, the weakness in the Western regions was a primary contributor to the below seasonal growth and significant decline in profitability. Even though we increased our cost reductions during the quarter, they could not be completed in time to have a meaningful impact on the quarter's expenses. As a result, our operating income margins declined to a level last seen during the Great Recession in fiscal 2009, and our return on capital dropped below our cost of capital. As you can see on this slide, our economic profit was negative this quarter as the positive economic profit at EM was offset by the negative results at TS.

This performance is clearly not acceptable to our team, and we are confident that the actions we have taken and will continue to take will restore our returns to appropriate levels. As we have clearly demonstrated in the past, we know how to adjust our business to cycles and emerge a stronger company. One of the key attributes during any slow period is our ability to generate cash. As Rick mentioned earlier, we generated $814 million of cash flow from operations over the past 12 months and during that time have invested significantly in our share repurchase program. Even with the significant investment in our own stock, our balance sheet remains strong, and we have ample liquidity to manage through the current environment, which is characterized by macroeconomic uncertainties.

We ended the September quarter with over $1 billion of cash on the balance sheet and over $830 million of available credit from our short-term borrowing facilities. Overall, we are well capitalized to weather the current market conditions and possess the financial flexibility to continue to invest in the profitable growth opportunities when market conditions improve. Looking forward to Avnet second quarter fiscal 2013, we expect EM sales to be in the range of $3.35 billion to $3.65 billion and sales for TS to be between $2.6 billion and $3 billion. Therefore, Avnet's consolidated sales are forecast to be between $5.95 billion and $6.65 billion. After adjusting for acquisitions and changes in foreign currency exchange rate, the midpoint of revenue guidance for EM and TS represents sequential growth of approximately -6% for EM and +17% for TS, respectively, which is below normal seasonality at both operating groups.

Based upon that revenue forecast, we expect second quarter fiscal year 2013 earnings to be in the range of $0.79 to $0.89 per share. The above EPS guidance does not include any potential restructuring charges or any charges related to acquisitions and post-closing integrations. The guidance assumes $139.7 million average diluted shares outstanding used to determine EPS and an effective tax rate in the range of 27% to 31%. In addition, the above guidance assumes that the average euro to U.S. dollar currency exchange rate for the second quarter fiscal 2013 will be 1.29-1. This compares with an average exchange rate of 1.35-1 in the prior year second quarter and 1.25-1 in the first quarter of fiscal 2013. With that, let's open the line for Q&A. Operator?

Operator (participant)

Thank you. Ladies and gentlemen, we will now be conducting a question and answer session. If you would like to ask a question, please press star one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star two if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. One moment, please, while we pull for questions. Please limit your question to one question and one follow-up. Thank you. Our first question comes from a line of Brendan Furlong with Miller Tabak. Please proceed with your question.

Brendan Furlong (Equity Research Analyst)

Good afternoon, everybody. How are you doing? A couple of questions. On the TS side, your guidance for the December quarter, it looks like you're guiding more or less seasonal if you plug in midpoint guidance. Obviously, that's off of a less than seasonal September quarter, but what are the risks of guiding for kind of a seasonal up December quarter here given what's going on out there?

Rick Hamada (CEO)

Yeah, Brendan, this is Rick. I'll take a stab and make sure we're on the same page with the actual numbers and then ask Phil or Ray to jump in. The +17%, which is, think of that as the organic sequential growth rate expected, we believe is below a typical seasonality that we would see for a year-end quarter. So I guess I'm just trying to challenge the assumption that it's a midpoint or regular seasonality there. Maybe the factor that may be escaping you is the fact that there's a significant chunk of revenue expected now for our recent Magirus acquisition as part of the reported number.

Brendan Furlong (Equity Research Analyst)

Oh, yes, sorry. My bad there on Magirus. Sorry. How do you describe what the Magirus revenues are on a quarterly basis?

Rick Hamada (CEO)

No, I think we referred to the business as a roughly $500 million annualized business at the time of the transaction.

Phil Gallagher (President of Technology Solutions)

So, Brendan, this is Phil. So typical seasonality for us is +20 to +25. So coming into +17, we think is conservative. And based on what we saw in June and September quarter closes, we felt that was about the right guidance to go with. But we're still expecting a bit of a year-end pickup with the capital expenditures, but just tough to forecast much beyond that at this point in time.

Brendan Furlong (Equity Research Analyst)

Right. I was. As I say, my mistake there on the Magirus. And then, I guess, one on the EM side, do you think that EM Asia will do a catch-up of what's going on in the U.S. and European markets in the December quarter? It was well ahead of expected. And I see the Asian distributors, the Taiwanese distributors certainly had a very strong quarter too, but is there a chance that then we get that back in the December and March quarters?

Phil Gallagher (President of Technology Solutions)

Go ahead, Rick, you want to jump in?

Rick Hamada (CEO)

Yeah. Hi, Brendan, it's Rick.

Phil Gallagher (President of Technology Solutions)

All right.

Rick Hamada (CEO)

I would categorize what we saw in Asia as above what our expectation was when we set the guidance, but not particularly inconsistent with normal seasonality for that region. I actually saw the announcement as well from one of the larger Asian distributors earlier, and their sequential actually was identical to ours. So it looks pretty consistent with what's happening in that region. So our guidance expectation for December looks for Asia to be about normal seasonality, which is typically flat to down a little bit in the December quarter.

Brendan Furlong (Equity Research Analyst)

Okay. And if I can add one, I think one more in, if I can, I'll be cheeky. On the gross margin front, total corporate revenue below seasonal on both sides of the business. Do you expect a similar hit to gross margins as we saw in the September quarter, or what should we see there?

Rick Hamada (CEO)

Yeah, Brendan, good question there. I would tell you that the way we factored into our guidance with slightly below the normal seasonality, we have put that factor into our equation, and it's reflected in our overall guidance.

Brendan Furlong (Equity Research Analyst)

Okay. Great. Thank you.

Operator (participant)

Thank you. Our next question comes from a line of Shawn Harrison with Longbow Research. Please proceed with your question.

Shawn Harrison (Vice President and Senior Research Analyst)

Hi. Just wanted to, I guess, touch on EM in terms of where we're at in the quarter. It seems the guidance implies maybe a stability in terms of the revenue run rate on an organic basis. If you could just kind of walk through where the book-to-bill you think will shake out for October, kind of how the daily sales run rates are changing, and then just what were the products you're walking away from in Latin America as well?

Brendan Furlong (Equity Research Analyst)

Yeah, Ardick, go ahead.

Harley Feldberg (President of Electronics Marketing)

Yeah, Sean, it's Harley. So let me give you a little bit more data than you asked because I'm sure it'll come up after you. Our book-to-bills in the September quarter were below parity, as I believe we said in the release. And we ended up below one in all regions, actually, which is fairly unusual for us. When we look forward and when we look at the small amount of data that we have so far in October, and please keep in mind it's three weeks' data, in a quarter, by the way, that typically is a bit unpredictable as we get into the holidays in the latter part of December, the book-to-bill has returned, again, in all regions, conversely to what I said in September, to be positive.

So again, I caution this three weeks of data, but it's an interesting contrast to us as we look at the limited amount of data looking into the December numbers.

Shawn Harrison (Vice President and Senior Research Analyst)

Just what are you walking away from in Latin America?

Harley Feldberg (President of Electronics Marketing)

Oh, I'm sorry. In Latin America, the detail on what was in Rick's comments is what we call the commercial component business that principally came to us via the Bell acquisition. So there are some drive business, some memory module type of business. That type of commercial component business is what we're walking away from.

Shawn Harrison (Vice President and Senior Research Analyst)

And then just, I guess, one more follow-up on EM. Do you think the market itself in the Americas was down as much as you were sequentially, or are there components within the EM business that maybe underperform the general market?

Harley Feldberg (President of Electronics Marketing)

Thank you for the question, by the way, because it's an important one. When we look at the number, we tend to parse it two ways. As you know, we have essentially two businesses in Americas. We have what I call our legacy components business and our embedded business. The embedded business has two elements in it: the previously mentioned commercial component volume business and then an OEM embedded business. Our legacy component business in Americas was down more than what would be normal in seasonality due to the, I think Rick described in his opening remarks around customer behavior, customer conservatism. But a good portion of the overall reduction is really an accelerated reduction in the embedded business in the area we discussed a moment ago, which was high single-digit reduction.

So that high reduction in that piece of the embedded business, I believe, does make the Americas overall number look decreased at a rate a bit higher than what the market probably overall did.

Shawn Harrison (Vice President and Senior Research Analyst)

Okay. That's very helpful. Thanks so much.

Operator (participant)

Thank you. Our next question comes from a line of Amitabh Passi with UBS. Please proceed with your question.

Amitabh Passi (Senior Equity Research Analyst)

Hi. Can you hear me?

Phil Gallagher (President of Technology Solutions)

Yeah, Amitabh, we got you.

Brendan Furlong (Equity Research Analyst)

Hey. Hey, Rick. How are you?

Phil Gallagher (President of Technology Solutions)

Hello.

Amitabh Passi (Senior Equity Research Analyst)

I guess my first question, Rick, now that you've had some time to reflect on the September quarter, can you help us understand what do you think went wrong? How do you sort of reassure investors that the model is more resilient than sort of the whipsawing we saw from June to September? Because the performance was probably one of the weakest we've seen over the past several years.

Rick Hamada (CEO)

Yeah. Fair point. Probably the same reason I used the term disappointing setback, Amitabh. So I would tell you that tracking the revenue declines with so much back weighting on the computer business in particular, now that we've seen that twice in a row, I'd say once can be an anomaly, and two times now, you've got to call a trend that something's different here. And again, you can see that factored into our December guidance. The margin deterioration because of the slowdown in the West was a little bit tougher to discern. And one of the reasons was, for example, our components business in the Americas, if we looked at the intra-quarter year-on-year, in other words, let's look at July versus year-ago July, August year-ago August, September year-ago September, it actually got worse as the quarter went on. So it was deteriorating during the quarter there.

So as you bring in the early results in the first few weeks of the quarter, there really wasn't a flashing red light on the dashboard that would have indicated we've got something else to address overall.

However, as you could also see, based on the fact that we actually came in with $90 million of expense actions, that is, even though we're obviously going to be conservative when we set expectations for $40 million-$50 million, I would tell you that as we actually got into the process of looking where the gaps were in our portfolio, where the returns were low, where the revenue decreases were having the most impact, and that's where we target our resource actions, obviously, we factored some of that knowledge during the quarter as we saw things slow down that contributed to bringing in a much stronger expense reduction number than even we had talked about on August 8th, I think our call was.

So always lessons that can be learned from the scenario, but there was a certain amount of sort of, I guess, accelerating deterioration that we just didn't quite catch up with.

Amitabh Passi (Senior Equity Research Analyst)

I appreciate it. Then just for my follow-up, Phil. It looks like TS came in about $200 million lighter than your original expectations. Can you just help us understand between your four major areas, servers, storage, networking, software where you saw the biggest weakness, and how do you see trends going into the December quarter?

Phil Gallagher (President of Technology Solutions)

Yeah. Yeah, no problem. Thank you. Basically, you just look at those categories you just talked about. Storage, if you look at that, I'll give you year-on-year, we were actually up into the double-digit range. Okay. So that was very positive. We saw increases in network and security, positive as well when we captured the technologies that play in that space. Virtualization was also up. Okay. So those were the categories that we saw positive trend continued through the quarter. Where we saw the biggest dip was in servers. Industry standard globally was actually up close to double-digit, and the balance was down. Okay. So servers overall is where we saw the biggest drop. One other category of technology that we track and have in our portfolio that some others don't is what we call the PC components. Okay.

If you look at the drives and the processors and the bulk of that's in Europe and Asia for me, that was down very significantly. Okay. That was the steepest drop that we saw was in the PC components arena.

Amitabh Passi (Senior Equity Research Analyst)

And then into the December quarter?

Phil Gallagher (President of Technology Solutions)

Well, it's still tough to say. Part of the drop for us was what projects didn't come through. I'm sure that's a question that someone's going to ask here very shortly: what do we see at the end of the quarter? And we just see the sales cycles continuing to get delayed and being more evaluated. As we sit right now, it's really tough to call how it's going to go through the quarter. We're expecting what we just talked about, the 17% increase. But storage continues to be positive, bright light for us. Virtualization continues to be good. Too soon to call the server market right now. And we do expect a bit of a pop-up in PC components, but again, too early to really call. Right now, I'm safe to say storage and virtualization looks bright.

Amitabh Passi (Senior Equity Research Analyst)

Thank you.

Operator (participant)

Thank you. Our next question comes from a line of Scott Craig with Bank of America Merrill Lynch. Please proceed with your question.

Scott Craig (Managing Director and Deputy Head of US Equity Research)

Hey, thanks. Ray, this is a question for you on the margin side. Can you maybe take us through EM and TS? I know there was a lot of moving parts going on in the quarter we just finished, but if you look at the guidance, you're looking for a pretty big improvement in the margins of either and/or both of those businesses. So can you take us through some of the things that are pushing and pulling on that, whether it's geo mix or product mix, some of the restructuring coming through, and just help us understand how we get to the improvement in margins? Thanks.

Ray Sadowski (CFO)

Sure. So I guess a couple of different things. One, as you would typically expect on a sequential trend, you would see TS margins typically moving up a little bit just based upon the volume of business. So you'll see their gross profit margin tick up as well as their operating income margin move up just from that seasonal effect of their business overall. So that's, I guess, probably the biggest factor if you look at it from the Avnet level overall. We do expect at this stage from a gross profit margin perspective for the most part, no further deterioration in margins in the EM organization. So planning flattish-type margins from that perspective going forward from the gross margin perspective. And then finally, when you take into account the expense reductions.

So fairly, as Rick mentioned in his opening remarks, it took out $90 million of expenses on an annualized basis. A little bit of that already reflected in our numbers, roughly 20%. So you have the balance of that all being reflected in Q2. So when you factor in all of those, and I guess I'll say one other thing from an expense perspective, at least going forward sequentially, you will recall that typically we have a fairly significant move up in sequential expenses in the first quarter related to our stock compensation program. Well, that will come back down again as is typically the case in the second quarter. So when you factor in that item plus the expense reductions, it gets us to our overall expectation from a profitability and margin perspective.

Scott Craig (Managing Director and Deputy Head of US Equity Research)

Okay. Thank you.

Operator (participant)

Thank you. Our next question comes from a line of Ananda Baruah with Brean Capital. Please proceed with your question.

Ananda Baruah (Managing Director and Senior Equity Research Analyst)

Hey. Thanks, guys, for taking the question. I mean, I guess another one on the margins. I guess how should we envision the path back to sort of, I guess, margins where they were a year ago to start? I guess if we get the normal seasonality, say, just for the sake of argument, in the first half of next year with the cost reductions that you've implemented that you're looking at doing in addition, is that enough to get us back sort of all things equal on mix, or is it going to take something more than that?

Rick Hamada (CEO)

Yeah. And, Rick, make sure I understand the premise here. If you're saying that calendar 2013 starts off with "normalized sequential seasonality" for both our businesses with the expense actions done, the ones being contemplated this quarter, that would put us on a trajectory to get back and cross over hopefully back to full recovery on the margins of both businesses by the fourth quarter.

Amitabh Passi (Senior Equity Research Analyst)

By the June quarter. So got it. So if we do normal seasonality in March and June in TS and EM, you can have margins back north of 3%, overall margin back north of 3% by then.

Rick Hamada (CEO)

Again, the biggest part of that assumption is "normal seasonality." Okay. A lot of assumptions.

Amitabh Passi (Senior Equity Research Analyst)

Understood. Understood. Understood. But just for baseline assumption. Okay. And then just to follow up if I could is, could you talk a little bit about the pricing environment and sort of pricing both from the vendor level as well as what you saw in the channel? And do you think that in a softer environment like this, vendors will have to change their programs with you guys over the next couple of quarters?

Phil Gallagher (President of Technology Solutions)

Yeah. Maybe comments on components around the terms business maybe, or?

Harley Feldberg (President of Electronics Marketing)

Hi, Ananda. Could you give me a little more on that question? I'm not sure I understood your last sentence.

Amitabh Passi (Senior Equity Research Analyst)

Yeah. Sorry about that, guys. I mean, I'd love to hear you have on both sides of the business. I was actually asking more specifically to TS since it was so soft. But the question is, what are you seeing from pricing in general? And I guess pricing from the vendors as well as pricing what's going on going to customer in the channel. And given the environment is softer, do you think that vendors may adjust sort of their programs with you guys over the next couple of quarters?

Rick Hamada (CEO)

Yeah. Again, this is Rick. I'll take a stab, and Phil, if you want to add a few things as well. So Ananda, the gross margin issue that we talked about in the Western regions was less pronounced at TS than EM. And primarily, I'll tell you, it's a function of the fact of when you're short in revenues, you don't optimize your profitability with that business, right? The conversations with the suppliers regarding the appropriate amount of incentives and all the support for whether our technical resources, our sales resources, our dedicated resources, etc., those are constant conversations that are always taking place. And obviously, we have a keen interest in making sure that those are aligned to the current market realities and then any given cycle, right?

Other than that, Phil, I'm not sure of any particular behavior change or any other trends going on with the suppliers or customers.

Phil Gallagher (President of Technology Solutions)

No, not that you don't see naturally in cycles like this. There's always natural margin pressure in the system from the suppliers and the customers. But if you look over the last eight quarters, okay, our margins overall stabilized, particularly from two years ago. So I would say we're rolling fast to keep the margins stable. It's a balancing act as you want to drive sales and the market gets competitive, but there's been no wholesale changes really from the supplier side that we've seen.

Amitabh Passi (Senior Equity Research Analyst)

Great. Thanks a lot.

Operator (participant)

Thank you. Our next question comes from a line of Sherri Scribner with Deutsche Bank. Please proceed with your question.

Sherri Scribner (Director)

Hi. Thanks. Ray, question for you. Thinking about the SG&A, there's a lot of puts and takes with the acquisitions coming on and then compensation expense that usually shows up in the first quarter. Can you give us a sense of on a dollar basis if SG&A is going to be up to include the acquisitions or flat, or where do you expect that to be?

Ray Sadowski (CFO)

All right. So if we walk through the expenses, we expect expenses going forward to Q2 to be roughly flat to down slightly. On the increase sequentially, you have two items. One is FX and the other is currency. The impact of—I'm sorry. I did that twice today. I apologize. FX and M&A. That's my second time I've done that, so I apologize. So two items pulling it up. One is FX and one is M&A. And roughly speaking, sequentially, the impact of those two items is roughly $28 million to $29 million, all right? And so if you look at starting from that perspective and then coming down from there, you essentially have, I'll say, three items in total. One is equity compensation expense coming down, and that'll come down by roughly $9 million.

And then you have a combination of all of our expense reductions and everything else bringing us down to what we think will be relatively flattish to down slightly sequential expenses.

Sherri Scribner (Director)

Okay. Great. That's very helpful. And then just a question on TS and EMEA. I think you said this is the ninth quarter of revenue declines in that segment, or maybe you said seventh quarter of negative growth in that segment. It seems like a segment that's been struggling a while. Are there some significant changes that need to be done there that haven't been done? Was that part of your restructuring? Obviously, Magirus will help on the revenue growth this quarter, but what else needs to be done there to fix that? Thanks.

Phil Gallagher (President of Technology Solutions)

Yeah. Sure. Thanks. Yeah. So you got that right. It's been several quarters of decline. Now, some of that we need to keep in mind was following the post-Bell acquisition as well. And we've talked about that prior as we continue to deselect revenue, whether it be in the process arena I just talked about or getting out of Italy about a year ago. So some of this is very conscious, okay, from the standpoint of, again, revenue selection, okay, and trying to drive our operating margins up, which we saw very good progress in the last four quarters prior to this September quarter. So Graham and the team have been managing the expenses. They had significant reductions last quarter as well as the quarter before. And we're looking at further reductions this quarter prior to the Magirus synergies coming in. So we're really managing the overall portfolio.

A lot of the decline this past quarter in Europe is obviously tied some to macro, but also we have a heavy weight toward that PC components business, the processors and drives, which really doesn't fall in enterprise, but it's in Graham's business, and that was down in the 30%-40% range from a year ago. Okay. So that also exasperates it. So when you start to break it down by technology and commodity, it starts to look much better, but we still have to.

Sherri Scribner (Director)

Okay. Thank you.

Operator (participant)

Thank you. Our next question comes from a line of Craig Hettenbach with Goldman Sachs. Please proceed with your question.

Craig Hettenbach (VP)

Yes. Thank you, Phil. Thanks for the color on the product segments and growth in the quarter. Looking at it from a different angle, the shortfall that you saw in the quarter at the end, can you talk about was that broad-based? Were there any particular segments that came under more pressure late in the quarter?

Phil Gallagher (President of Technology Solutions)

Yeah. Great. Thanks. And just going back to the commodity question earlier, one thing I didn't mention was we saw good growth in services, which I didn't acknowledge that, and software held its own relative to the marketplace, which are two areas of focus for us moving forward. As far as the drop-off, I love to say it was a certain segment, a certain vertical. It really was across the board, but predominantly in the larger, bigger deals, okay, that come as the quarter closed out. They just got reevaluated, held, what have you, but it's very difficult to pinpoint it to an exact vertical. It was pretty much across the board, customer behavior, just pushing the deals out or putting them on hold or reevaluating them. And they predominantly were in the larger deals.

Craig Hettenbach (VP)

Okay. If I could follow up, Rick, after the $90 million cost cuts, at this point, when you're looking for more to take out, is it more of a fine-tuning, or can you help kind of size it up a little bit in terms of what other actions you can take?

Ray Sadowski (CFO)

Yeah. So Craig, I would tell you we haven't quantified anything at this particular point. I do not anticipate it's going to be anywhere close to the same magnitude that we've taken in September. It is adjusting to the continued developments and conditions that we're experiencing and working with right now. And the eye is towards making sure that we take a look at that plan for the rest of the fiscal year and very much focused on recovering our operating margin at both groups as understanding their trajectories, taking a look at the heat map as to where the revenue gaps or performance declines are. And that's where we'll continue to focus and do things. However, I just don't think it's going to be anywhere the magnitude as the step we took in the September quarter.

Amitabh Passi (Senior Equity Research Analyst)

Okay. Thank you.

Operator (participant)

Thank you. Our next question comes from a line from Brian Alexander with Raymond James. Please proceed with your question.

Brian Alexander (Director of Equity Research)

Thanks. Ray, based on your comment before that the expenses will be flat to down slightly, I think I heard in the December quarter on a sequential basis, it would imply that gross margins are also basically flattish sequentially to get to your operating margin, I think, of about 3% despite mix shifting toward TS in a pretty major way. And that seems counter to typical seasonality. So can you just go back over those comments? I want to make sure I understood that correctly.

Ray Sadowski (CFO)

Sure. I think I understood the comments. So if you're looking at the gross profit margin, I would agree that we would expect gross profit margin to essentially be flattish. A couple of things. One on TS, you would typically see some improvement in its margins. As I mentioned earlier, we're not expecting any deterioration in the GM gross profit margins, maybe a slight uptick. Again, mix of business is a little bit different than it was a year ago. So keep in mind that we've seen, as an example, within EM, you've seen some strength in Asia versus some weakness in America. So factoring all of that in, you get to sequentially what we're forecasting to be roughly flattish gross profit margin. The math you have is essentially correct.

Brian Alexander (Director of Equity Research)

Okay. Then maybe for Phil, just on the revenue weakness, I think the Americas down 18%, Europe down 12% year-over-year, pro forma. Clearly, the market's weak, but I don't think it's that weak. We'll see what your competitor says next week. But just based on your best guess, how much of that softness do you think is market-driven versus Avnet-specific? And within that, how much would you call out to maybe product mix being disadvantaged versus execution or competitiveness? Thanks.

Phil Gallagher (President of Technology Solutions)

Yeah. And it's tough to pinpoint, Brian. It's a good question. We're certainly studying that. And we're also looking at the supplier reports that have come out recently the last several days to a week. And we're lining up pretty well with those, which is positive. There is some product mix. I mean, if you look at the disparity, and it's tough because I don't live there, okay, and our competitors outside. I don't know all that they have and all that they're doing. But there is a pretty significant geographic mix right now that's different, okay? We are in Latin America, and we're in Asia-Pacific. And even across Europe, there's different presence across Europe by country and different strength by country. And if you look at technology, where in Europe we have been traditionally not very strong with virtualization, we've not had across Europe a very strong storage portfolio.

That has certainly hurt some of our growth there versus some of our competition. Now, that's resolved, okay, with the Magirus acquisition. It's going to bring us very good strength in both storage, EMC in particular, Cisco, and VMware that we've not had. So we think we're positioning ourselves to better compete from a technology standpoint. The last area around, if you will, from a commodity or product portfolio differences, and I alluded to it multiple times today, is what we call PC components. And I can give more details on that later. But in rough and tough terms, that's somewhere in any one region between 8%-10% of the revenue or upwards of 16% of the revenue. And if that's down 30% or 40% on a year-over-year, it does have a pretty significant impact on the overall numbers.

That all said, we track by supplier, and we're getting that data in daily, and we're pressing the team. We've not seen any anomalies of significance with any of the suppliers yet. We continue to gather that data. And what do we do? We're going to take corrective action to resolve it. In the end, as far as execution goes, we own that. And we need to fix the top line while balancing out with margins to the question earlier. And we don't want to forsake the margin that we've been able to hold up, net gross margin, by just driving revenue. So that's always the tricky balancing act when you get into markets like this. Hopefully, I answered your question.

Brian Alexander (Director of Equity Research)

Yep. Just one quick final one for Ray again. The DSOs ticked up about three days sequentially and five days year over year. I'm just wondering what drove that, given that I think the quarter weakened as it progressed in both segments. Thanks. That's it.

Ray Sadowski (CFO)

Yeah. I don't know of anything specific that would have driven that. So you obviously have some normal mix of business. And I just don't know whether we've extended some terms in the short term in this kind of environment, which we don't do a lot of, but we do occasionally. And that might cause a little bit of the extension of days.

Brian Alexander (Director of Equity Research)

Okay. All right.

Ray Sadowski (CFO)

Just the one thing we focus an awful lot on, which is delinquencies. From that perspective, no issues there at all. Delinquencies and therefore overall bad debt type situation is still very, very strong.

Brian Alexander (Director of Equity Research)

Okay. Thanks very much.

Operator (participant)

Thank you. Our next question comes from a line of Matthew Sheerin with Stifel Nicolaus. Please proceed with your question.

Matthew Sheerin (Managing Director and Senior Equity Research Analys)

Yes. Thanks. So I do have a couple of questions. One is, Phil, you talked several times about the PC components business being a drag. And I know that when you did the Bell Micro acquisition two or three years ago, Ray was saying that the jury was still out in the long term in terms of how that PC part of the business would fit. And it looks like at this stage, it doesn't look like a very attractive business. It's not that complementary to the rest of your focus on enterprise data center on the computing side. So have you looked at divesting at least part or all of it? I know you're doing some moves in Brazil, but that's fairly small. So have you looked at that and take us through the process?

If you did, how easy would it be or difficult would it be to extract that business from your operations?

Harley Feldberg (President of Electronics Marketing)

Matt, I'm going to defer to Phil if it's okay to react because it crosses both operating groups. Some of that business is still in Harley's and.

Ray Sadowski (CFO)

Yeah, Matt. I'll add some historical perspective as well because we have had segments of this business which have been provided an opportunity for us to create long-term returns consistent with our expectations. And part of the evaluation with the Bell acquisition, we had, for example, a pre-existing relationship with AMD for many years. And subsequent to the Bell deal, we brought over, I think, the number that was advertised at the time, roughly a $1 billion HDD business. There was a significant portion there, let's call it 25%, that was in the embedded space going to OEM customers, principally also with integrated systems, we're very excited about. And then that evaluation, I think Ray was referring to, was, "Hey, on the remaining $600 million to $700 million here, we obviously got to make judgments over time.

What can meet the test of being able to sustain our returns through cycles, long-term, etc.?" That evaluation continues. We will continue to keep you updated as it goes. But as far as a major divestiture move, we're going to try to package up all the pre-Bell or former Bell activities and then make a significant move and a divestiture along those ways. I don't think that's in the cards for us.

Matthew Sheerin (Managing Director and Senior Equity Research Analys)

Okay. Fair enough. What was the revenue run rate of those PC component operations in Latin America that you're exiting? I know that's on Harley's side, right?

Rick Hamada (CEO)

Yeah. So, Harley, a revenue number for Eddie's, what he exited from?

Harley Feldberg (President of Electronics Marketing)

I would annualize that, Hi Matt, at about $200 million.

Brian Alexander (Director of Equity Research)

Okay. So that revenue is going to go away on that quarterly run rate in the December quarter. So is that part of the down 6% guide?

Ray Sadowski (CFO)

Yes. Yes, it is.

Harley Feldberg (President of Electronics Marketing)

Yes, it is.

Matthew Sheerin (Managing Director and Senior Equity Research Analys)

Okay. Okay. And then just the last question again for you, Harley, on the components business. I know the mix certainly worked against you in gross margin. But given that a lot of the business, given very short lead times here, we're seeing a lot of jump ball, if you will, type of orders from customers. So wouldn't you be seeing some pricing pressure? I've talked to several competitors that are seeing pricing pressure on deals. Some of them have pointed to Avnet and your other competitors as being competitive there. So how much of that is playing into it? And how much are you being disciplined in terms of walking away from those deals?

Harley Feldberg (President of Electronics Marketing)

Yes. Great question, Matt. When you think of the sequential gross margin deterioration for EM, the way I would think about that is a typical quarter for us, the cost of mix would be down 15-20 basis points because of a mix shift. So that occurred, and as you heard us talk earlier, that occurred to a greater degree than we've seen in a number of years. So the significant majority of our sequential gross margin deterioration was clearly just a mathematical calculation driven by regional mix. With that said, I believe your assertion is correct. There's clearly a degree of our gross margin deterioration, albeit a smaller part, that I would call pricing pressure really resultant from a stagnant, low-growth environment. So I think your theory is very valid.

Matthew Sheerin (Managing Director and Senior Equity Research Analys)

Going forward, are you taking a more disciplined approach, or are you just right-sizing the cost structure so that you can go after that business and lower gross margin?

Harley Feldberg (President of Electronics Marketing)

Well, as I'm sure you would agree, it's always a fine balance. There are pieces of business, as we illustrated by some of the stuff that we walked away from, that's not strategic to us. So we wouldn't chase low-margin business just for top-line revenue. But in a challenged market, of course, we're going to compete effectively on our core business. And I believe that increased level competition will likely continue until we start to see some relief in the broad industrial market.

Matthew Sheerin (Managing Director and Senior Equity Research Analys)

Gotcha. Okay. Thank you.

Operator (participant)

Thank you. Our next question comes from a line of Jim Suva with Citi. Please proceed with your question.

Jim Suva (Managing Director)

Thank you very much. If I could ask a question on the rebates, the topic of rebates. In the last recession, I think the rebates had to be reset. And can you just let us know, were all the rebates reset to give you the same financial benefit going forward or lesser or more? And just discuss the rebate situation that impacted due to this demand shortfall. Thanks.

Rick Hamada (CEO)

Hey, Jim, this is Rick. I do remember 2008 as well. I think I tried to characterize in the earlier comments on this that certainly when you don't make your revenue targets, there are certainly some impacts. However, the gross margin deterioration we referred to in the Western regions was more muted at TS versus EM. It was really a function of not achieving those revenue targets. However, it wasn't a major rebate story like 2008, where there were a bunch of cliff-vested types of incentives that you either get 100% or zero. Some of the factors that created that debacle back in, if I remember correctly, it was the March quarter of 2008. The R-word really isn't a major part of the story here. The R-word that applies is revenue. It was the shortfall in revenue that really drove the issue here.

There really wasn't a sub-story regarding the rebates. Again, as I indicated, we are in constant dialogue and conversation with our suppliers in all cycles and all markets to try to keep the incentives aligned, not only for us, but also for the entire ecosystem in the channel to accomplish the goals that they want to accomplish.

Jim Suva (Managing Director)

Right. And then as a follow-up, though, if demand remained at somewhat of a tepid level, the question is, are you able to still economically get the rebates that traditionally were based on a higher volume level?

Rick Hamada (CEO)

We do work with all of our suppliers, and they have a vested interest in making sure that their incentives are aligned to be able to encourage the channel to continue to promote and make investments to help them achieve what they want to in the marketplace.

Jim Suva (Managing Director)

It sounds like they've been reset to a more reasonable volume level then.

Rick Hamada (CEO)

Well, they're competitive. They're staying in touch with the marketplace here and working to modify as they go based, again, on the adjustments to their plans.

Jim Suva (Managing Director)

Great. Thank you very much. That's good to hear.

Operator (participant)

Thank you. Our next question comes from a line of Steven Fox with Cross Research. Please proceed with your question.

Steven Fox (Founder and Managing Partner)

Thanks. Good afternoon. Just one from me. Going back over the TS guidance, I guess if I back out Magirus, you're looking at about half the rate, roughly, of sequential growth off of a lower base than you would have expected. I'm still trying to understand how you're getting to that number. Is there anything that's going on relative to some of the push-outs in terms of booking those in the first month of the quarter? Is there anything else in terms of the mix that we should consider, like for example, the PC component business flattening out or actually getting better off these bad numbers? Can you just sort of dive into that a little bit more? That'd be great. Thanks.

Rick Hamada (CEO)

Yeah. This is Rick. Let me take a stab, make sure I understood the question, and give you some perspective, and let me know if we hit the mark. So I think you made a claim in there that the sequential guidance was something like half normal seasonality. And again, what we're saying is 17% when normal, I think for us, would be between 20% to 30%, somewhere around 25%. Okay?

Steven Fox (Founder and Managing Partner)

I'm backing out Magirus. I'm looking at trying to look at.

Rick Hamada (CEO)

What are we? 17 is the organic rate. Okay? So Magirus is actually higher. One other factor for long-term Avnet watchers, if you want to really check your data sheets, is that our fiscal calendar will end on December 29th, right? So December 31st is a Monday, and that'll actually be the first fiscal day of FY 23. So we're back in that time of the Avnet fiscal calendar where there may be just a little bit of spillover from what would traditionally be Q2 revenue into Q3. And that had a very minor impact on our expectations. But as you can imagine, we have gone through all the expectations to produce this guidance with a fine-tooth comb.

Steven Fox (Founder and Managing Partner)

So is there anything in particular that you're hearing from the customers? Because you just went through a quarter, and you've even described the last couple of quarters as being disappointing. That makes you think you're not going to have a third month of this fiscal quarter that is equally disappointing, especially since it's so much bigger than prior months.

Rick Hamada (CEO)

Yeah. Steve, I think we're trying to get a little smarter. As I said, when you see it happen once, it's an anomaly. If you see it happen twice, you have a trend. And we've had now the June and September quarters, we've had much more muted quarter-end closes from an activity and business level than we normally would have expected. And that has absolutely adjusted our expectations that we're laying out here. However, as Phil pointed out, we do still expect a nice sequential revenue increase in this space due to the general seasonal factor of year-end and what some will typically call the budget flush.

Steven Fox (Founder and Managing Partner)

Fair enough. I appreciate the color. Thanks.

Operator (participant)

Thank you. Our next question comes from a line of Louis Miscioscia with CLSA. Please proceed with your question.

Louis Miscioscia (Managing Director)

Okay. Great. On the TS side, you mentioned the proprietary servers were down. Could you mention how much they were down and maybe how much the industry standard were up? And then has the mix shifted enough that maybe it's starting to stabilize? Because proprietaries will probably be down for a very long time on a year-over-year basis, being the next number of years.

Phil Gallagher (President of Technology Solutions)

Well, yeah, this is Phil. Thanks. I'll give you a range. The industry standard servers were up in the 10%-15% range, and the proprietaries down, let's say, in the 20% range, roughly.

Louis Miscioscia (Managing Director)

And then, how about the mix or the size in comparison to the entire TS or whatever kind of proportion you want to give us?

Phil Gallagher (President of Technology Solutions)

As well as the TS, I mean, if you look at the servers, as I mentioned earlier, it was definitely the area that we had the biggest shortcoming to the numbers that we needed to achieve. If you could do the math and get all the numbers by technology, it was clearly the server category for us that was the softest and pretty much in line with the balance of our overall performance.

Louis Miscioscia (Managing Director)

I guess I'm trying to get at, is the drag going to start to slow because the size of proprietary is low enough, or is that not really the case yet?

Phil Gallagher (President of Technology Solutions)

It's certainly declining, but not the case yet.

Louis Miscioscia (Managing Director)

Okay. And then, just last question. Any new logos to the TS group that might help, besides, obviously, the acquisition in Europe?

Phil Gallagher (President of Technology Solutions)

Any new what? Lou, M&A or what?

Louis Miscioscia (Managing Director)

No, new logos. Any new big OEMs that you've signed up recently that might help going into calendar 2013?

Phil Gallagher (President of Technology Solutions)

There are no new signings, but with the Magirus acquisition, we are expanding our relationship with Cisco into Europe, which we're very excited about.

Harley Feldberg (President of Electronics Marketing)

Further strengthening EMC and VMware.

Phil Gallagher (President of Technology Solutions)

Correct.

Louis Miscioscia (Managing Director)

Okay. Great. Thank you.

Harley Feldberg (President of Electronics Marketing)

Yeah. The other area I'll just add to that. I guess the other area would be if you look at some of the M&A we've been doing most recently, and this is still with TS, outside of Magirus, which brings us a whole nother value side of the equation in Europe, which we're very excited about. The last four or five acquisitions we've done between Ascendant, most recently Braveheart, Pepperweed, Canvas. These are all new brands and opportunities that we have to further incrementally grow the business both in the Americas as well in Europe. Some of those have presence in Europe as well. So they're not necessarily new suppliers, but they're certainly new opportunities we have to leverage as we get into 2013.

Louis Miscioscia (Managing Director)

Okay. Thanks, guys.

Operator (participant)

Gentlemen, there are no further questions at this time.

Vince Keenan (Head of Investor Relations)

Thank you for participating in our earnings call today. As we conclude, we will scroll through the non-GAAP to GAAP reconciliation of results presented during our presentation, along with a further description of certain charges that are excluded from our non-GAAP results. This entire slide presentation, including the GAAP financial reconciliation, can be accessed in downloadable PDF format at our website under the quarterly results section. Thank you.

Operator (participant)

Ladies and gentlemen, this does conclude today's teleconference. We may disconnect your lines at this time, and thank you for your participation.