Avnet Stock: Requires A Few More Quarters Before Reaching The Trough (NASDAQ:AVT)

ermingut/E+ via Getty ImagesInvestment summary My recommendation for Avnet (NASDAQ:AVT) is a hold rating. While there are very early indications of AVT approaching the trough of this cycle, I believe it will take a few more quarters before AVT reaches the trough. As this happens, I see the potential for the market to reevaluate multiples downward. That said, if investors have enough patience to wait out a few years, the upside could be attractive. Given my risk appetite, I prefer to wait for more solid signs of recovery before turning positive. Business Overview AVT is a global technology distributor that supports customers across product lifecycles. Segment wise, AVT reports two segments: Electronic Components [EC], which is the bulk of the business (~93% of 1Q24 revenue), and Premier Farnell (7% of 1Q24 revenue). Geography-wise, AVT has a presence across the globe (in 140 countries) and engineers around the world (based on the FY22 investor presentation). Splitting AVT revenue by geography, Americas is ~25% of 1Q24 revenue, EMEA is 36%, and APAC is 39%. Scale is a massive competitive advantage At a high level, AVT’s competitive moat is its massive scale across the globe, which makes it an attractive partner to its customers when it comes to scaling the supply chain and distributing to markets that are hard to reach. First and foremost, there are a lot of stock-keeping units [SKUs] spread across the value chain. In order for a distributor to be an attractive partner (especially towards large original equipment manufacturers [OEMs]), the distributor needs to have enough supply (inventory) capacity to meet the needs of customers, and to do this, the distributor needs both a wide assortment of SKUs and enough stock at all times to meet surge demand (customers also like to has assurance of supply). As per the AVT FY22 investor presentation slide, they hold about 313 thousand SKUs in the EC segment and 945 thousand SKUs in the Premier Farnell segment, which sums up to around ~1.3 million SKUs. AVT is able to hold sufficient SKUs because it has enough demand (from customers) to justify purchasing these inventories. For the smaller player, they are likely to only focus on a more focused basket of inventories that they know have better demand. Additionally, there is the financial aspect to take into account. Holding such a big portfolio of inventories means that the distributor needs a strong balance sheet (a lot of working capital investments involved), and a smaller player is very unlikely to have a balance sheet that can outcompete AVT. For reference, as of 3Q24, AVT held inventories worth $5.7 billion. AVTSecondly, when it comes to distribution capacity, scale matters even more because of the underlying logistic infrastructure involved, from the supply chain to manpower to global distribution capabilities, etc. It makes sense for large OEMs to work with distributors like AVT that can serve their global demand. Subscale players cannot compete with AVT on this front given their smaller footprint. Turnaround is a few more quarters away Redfox Capital IdeasLooking at AVT’s operating history, the business has been through multiple cycles, which is a common characteristic of the industry. The key thing to note is that the cycle always recovers after a downcycle, and I don’t see a difference in the cycle this time around. My belief is that the world is going to increasingly become more digitalized, and this drives up the demand for semiconductors. Comparing the current peak to the trough revenue decline, I believe AVT is still not near the trough of this cycle. The current peak-to-trough revenue decline is only 16%, vs. the average of ~30% over the past 4 cycles. However, there are very positive signs that AVT should see a turnaround in a couple of quarters. While I certainly acknowledge that it is still difficult to pinpoint when the turnaround will happen, the incrementally more positive commentary on the Asia region, as book to bill approaches parity, certainly paints a positive picture that AVT is getting closer to the trough of this cycle. The reason I believe Asia performance is a leading indicator is because it was the first region to see y/y decline, and its peak to trough revenue decline, as of 1Q24, is ~25% (near to the average peak-to-trough decline as mentioned above). What also gave me confidence that the demand/supply situation has gotten a lot better is that pricing has held out very well and that lead times have remained healthy, as noted in the 3Q24 earnings call and what Arrow Electronics mentioned in a recent conference. Based on basic economic principles, for pricing to stay stable, it suggests that demand and supply are pretty balanced (or at least not in a severe oversupply or undersupply situation). In this case, my sense is that inventory levels have eased, which is in line with the progress made by AVT, where its inventory (on the balance sheet) saw a robust sequential decline (the first sequential decline over the past 11 quarters). Looking ahead, pricing should unlikely see a major step down given the sticky inflation, which has upward pressures on labor and component costs. On the IP&E side, lead times and pricing are generally stable and we are seeing increase in demand for interconnect products and capacitor families, most notably Tanh… …Semiconductor lead times have continued to decline over the last several months and are generally stable, although the growth in data center build-outs is driving longer lead times for certain products and we would expect this to continue. 3Q24 AVT earnings call Yes. Yes, I would say overall the pricing environment continues to remain relatively stable, whether it’s the transactional pricing to customers or even on the supplier side, we haven’t seen any significant changes in the pricing environment. …But as we as you mentioned, we look at a number of key indicators whether it’s book-to-bill ratios that have been improving the last three quarters in a row, our backlog levels have been coming down which — they’re still above the pre pandemic highs, but lower in the last three quarters and that’s probably more in-line with normalized lead times. ARW CFO, Stifel Cross Sector Insight Conference Strong cost discipline Although the cycle has not turned, it was very encouraging to see management being very prudent on control expenses. Management expects $40 to $60 million in annual OPEX reductions. While this $50 million (at the midpoint) is not a big step-up when compared to the >$20 billion revenue, because of the thin operating margin (low-to-mid-single-digit percentage), it represents a 3% growth increase to FY23 EBIT. The more important takeaway is that the AVT cost structure is structurally lowered, which means earnings growth in the upcoming cycle is expected to see a stronger acceleration (more room for margin to expand). Valuation Redfox Capital IdeasI model AVT using a forward PE approach, and using my assumptions, I see potential for the AVT share price to trade much lower than where it trades today in the near term and, over the medium term, a potential upside of 38%. The reason I modeled AVT in the way above is because I believe there are still a few more quarters before AVT reaches the trough of this cycle, which will impact valuation in the near term, as can be seen from the recent share price action post the 3Q24 earnings results. However, I also think that the upside could be attractive if investors have patience. In my model, I am assuming AVT to achieve its 4Q24e guidance (management has a good track record of meeting guidance) and FY25e to see the trough of this cycle (using 30% decline as a guide). After FY25, AVT should start to enter the next upcycle. Using the recent two-cycle trend, y/y recovery growth tends to trend towards mid-single-digits and low teens at the early part of the cycle. I have also used historical net margin trends to model out the near-term downcycle. For FY24, I used 4Q24 guidance to back into the earnings figure, FY25 to see 1.4% (I did not use the trough margin saw in FY20 because AVT cost structure is lower today after the cost savings), and earnings margin to recover to 2.3% (pre-covid peak) in the next upcycle. In the near term, valuation multiples could go lower when AVT reports an acceleration in y/y decline (as I modeled above), and based on my FY25 estimates, the stock could be worth $23 (covid trough levels) if it trades back to 8x forward earnings (AVT was trading at this level two months ago). In the medium term, once AVT enters an upcycle, the stock could trade all the way up to the high end of its historical trading range (13x forward PE) as the market starts to price in earnings growth acceleration. As such, I am recommending a hold rating for the near term and believe that investors should wait for more indications of a turnaround before going long. Risk The downside risk for AVT is that, given that lead times have compressed, AVT’s forward demand visibility has become quite limited, which means even management is not able to accurately estimate when the cycle will turn. On top of this, demand could become a lot worse if the Fed decides to raise rates given the sticky inflation environment. Conclusion My view for AVT is a hold rating for now. While there are signs the business is nearing the bottom of the current downcycle, it will likely take a few more quarters before a clear turnaround emerges. This could lead to further valuation contraction in the near term. However, the long-term potential remains attractive for patient investors. The key risk is that limited forward visibility due to compressed lead times makes it difficult to predict exactly when the turnaround will happen. A worsening economic environment could also dampen demand further.

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