The stage is set for a new round of consolidation in the electronics components distribution market. Though still suffering from the effects of margin pressures, supplier and customer consolidation, commoditization and an almost morbid obsession with design engineers, distributors are about to embark upon the latest in a string of M&A actions that will improve the survivors’ competitiveness.
Unlike in the recent past -- when the biggest distributors led the sector’s M&A push – local and regional players with sales in the $200 million to $2.5 billion range will be involved in the latest cycle. They aim to be consolidators wherever possible, defending hard-won market share and design engineering turfs from the likes of Arrow Electronics Inc. and Avnet Inc., both of which have set their sights on the higher margins enjoyed by high-value, service-oriented distributors.
The competition will be stiff. Industry veterans say they can feel the change in the air; sales growth is bubbling up and distributors are looking forward to a stronger year although the economic and political environment remains clearly uncertain. And yet, the demand and supply situation has markedly improved to the point where “it is tilting out of balance, everyone is positive and lead times are stretching out,” said the CEO of a small electronics component distributor in North America. “The economic momentum is finally swinging up and it is flowing into electronics.”
Some of the impetus for further distribution consolidation is coming from changes in the ranks of component suppliers and the inevitable thinning out of product lines. The semiconductor landscape has changed dramatically in the last several years following a raft of mergers and acquisitions. Many of the once famous names in the industry have either disappeared or are on the verge of being gobbled up, vanishing into a void that now includes storied names like Fairchild Semiconductor, Agere Systems, Altera and Freescale Semiconductor. Soon the group will be joined by others, including NXP Semiconductor and Avaya, which struck a deal to buy Broadcom in 2015 but chose to pick the acquisition’s name. The surge in semiconductor mergers has put a squeeze on the electronics supply chain and impacted distribution.
Distributors haven’t seen strong upper single digit to double-digit growth in a while but industry executives have been saying a rebound is imminent since the second half of 2016 as demand accelerates for connectivity (IoT) products, automobile and industrial electronics. Semiconductor sales, for example, could jump anywhere between 11 percent and 16 percent this year, rising to a potential high of $392.5 billion from an estimated $338 billion in 2016, according to market researcher Future Horizons.
“The industry doesn’t do a good job of forecasting demand so all numbers are issued with a pinch of salt,” said Malcolm Penn, principal analyst at Future Horizons. “Nevertheless, many signs point to a strong upswing. Unit shipment remains strong, capacity is constrained, pricing has started to come up and nobody is putting in new capex. Confidence is the only missing element.”
Distributors are not lacking in confidence right now. They may be wary about margin growth; it’s a sore point for the entire industry. On the positive side, established companies in the information technology and electronics markets are generally flush with cash. Years of tight cost management and steady – albeit unremarkable growth – have swollen their coffers. This, coupled with low debts at most companies in the sector, including the smallest distributors, and low bank financing rates means the grounds are fertile for acquisitions.
Larger distributors have also pared down debts and have relatively high cash reserves and bank credit facilities. The recent sale of Avnet’s Technology Solutions division will buoy the company’s cash hoard, and it has promised to use the extra funds to reduce debts at Premier Farnell, the European distributor it purchased last year. Some of the extra capital will end up in the company’s M&A pool, according to CFO Kevin Moriarty.
“[We will] maintain the same capital allocation priorities we have pursued in the past,” Moriarty said, while presenting the fiscal 2017 second quarter results last month. “Number one, maintain and grow our dividend; two, invest in organic growth; three, pursue value creating acquisitions and; fourth, return excess cash to shareholders via our disciplined share repurchase program.”
Avnet in the Mix
Avnet tapped offshore funds (about $100 million) and lending facilities to help pay for Premier Farnell but in the recently ended December quarter it reported $1.3 billion in cash and short-term investments. Long-term debts, meanwhile, rose to $3.4 billion from $2.6 billion in the immediately preceding quarter. However, the company has a hefty $1.5 billion line of credit with a syndicate of banks, which it can tap for acquisitions.
If the right opportunities come up, we expect Avnet to tap these resources and its strong cash flow to fund the purchase of small to medium size enterprises. Avnet executives have indicated they expect future growth to come through both organic expansion and acquisitions.
“We will continue to look at opportunities as they present themselves, especially in the areas where we think there's potential to disrupt the models of distribution and therefore we’ll make the necessary investments,” said William Amelio, Avnet’s CEO, while discussing the December results. “You could potentially see us do acquisitions in the design area, where we have opportunities to reduce time to market for our customers.”
Normally, one would expect Avnet to wait a while before taking on another company similar in size to Premier Farnell. However, Amelio has wagered everything on returning Avnet to its component distribution roots and aims to establish a leading position in the design engineering market. This means Avnet can be expected to point its acquisition resources at any of the medium-size distributors in the Western hemisphere.
What would the Phoenix-based top-tier distributor be looking for in such acquisitions? It is likely to target companies that have a sizeable following in the design engineering community, strong online presence, a robust database and cost-cutting opportunities. The companies that have this profile today are mainly enterprises that started out as catalogue distributors but which have developed and maintained a strong following amongst engineers.
A few such value-service distributors, some private and others publicly traded, are in North America and in Europe. Avnet would have to be prepared to pay a premium if it aims to add any of these companies to its portfolio. And it must assure shareholders the investment would be accretive immediately to earnings. One way to do this is by ensuring a smooth and successful integration of Premier Farnell, a process well underway, according to company executives.
“Premier Farnell performed quite well last quarter,” said Gerry Fay, president, Avnet Global Business Units, during the January quarterly conference call with analysts. “They've met the high end of our expectations; they’ve arrested their margin erosion and now have actually improved our margins. We [want] to see continued margin improvement from Premier Farnell going forward.”
High-Value, Fatal Attraction?
There are numerous reasons why value-added, service distributors have become very attractive to investors and potential buyers. Key amongst these reasons is the connection the companies have with the design engineering community, currently the most sought after set of people in the electronics value chain. Even Premier Farnell, which had struggled in recent years, still commanded a premium when Avnet sought to buy it because of its design engineering community and data base.
The high-value distribution segment caters primarily to design engineers and companies that have long served the segment are leveraging their roots as catalog distributors to win engineering loyalty. In the last decade, these companies – Digi-Key and Mouser Electronics in North America, and Electrocomponents in the U.K., are prime examples – have built robust digital communities and offerings, layering these on top of aggressive marketing campaigns aimed at enticing engineers to patronize them for quick and less invasive services.
However, the value-service segment is also quite as fragmented as the entire distribution market; no single company, for example, has more than a few percentage points in market share. Therefore, the segment, too, is ripe for consolidation and we believe opportunities exist in this area for the leading players to merge with or buy rivals. The privately-owned distributors and those that are a part of bigger publicly-traded enterprises, like Digi-Key and Mouser, may be difficult to pry loose from current owners. On the other hand, they may also emerge as consolidators, depending on the long-term goals of their owners.
Additionally, the consolidation of the segment may be delayed by the earlier predicted sales upsurge, a development that could convince some of the players that continuing as standalone enterprises may be in their interest.
But the old challenges that spurred previous market consolidation remain relevant even today. These include issues related to market evolution and product/process innovations, changes in supplier and customer demands and the globalization of the design chain. Additionally, commoditization remains a challenge for all players in the electronics supply chain; OEMs and EMS providers demand lower pricing with each new sourcing agreement but they also want this to come with an assortment of free value-added services.
What about Arrow, other Players?
Arrow Electronics’ strategy may diverge slightly from its biggest North American rival’s. The company has successfully built up its digital presence over the last decade and appears to be playing all segments of the market. In contrast to Avnet, Englewood, Colorado-based Arrow is keeping its enterprise computing solutions business and believes this makes it a stronger player in the technology market. It is unlikely to divest the business and has, in fact, made strategic acquisitions to boost the unit’s market presence.
In the components distribution business, Arrow plays all sides of the field. It continues to pursue design engineering business and – through its Verical unit – maintains a presence in the commodity volume procurement market. About two-thirds of Arrow’s annual sales come from the components distribution operation, however, and the company cannot afford to yield the M&A field completely to Avnet.
Avnet’s purchase of Premier Farnell may, therefore, spur Arrow to make a similar push in Europe or in the United States. It must be willing, though, to pay a premium for any of the prime targets in the high-end, value distribution market. Alternatively, the company may opt to go for smaller distributors in Europe and North America to cement its standing on the regional markets.
Other mid-size players are lurking in the field. Warren Buffet’s Berkshire Hathaway enterprise can make waves in the sector via its wholly-owned TTI Electronics and Mouser Electronics. So far, the company hasn’t made any efforts to bulk up in the market but it can easily morph into a major player in the segment by making a play for one of the high-value distributors in North America and Europe. Such a move could make it difficult for Arrow and Avnet to establish a lock on the Western design engineering market.
The other two regional distribution markets of Japan and Asia (mainly China) have different dynamics that I will address in a separate article. For now, we believe the Chinese market remains very fluid. It is transitioning from a mainly commodity procurement market filled with dozens of small and medium size enterprises into a higher-value industry. That process will take some time, however, and involve a lot of bloodletting. Although all the major distributors have a presence in China they continue to approach the market warily and have not been as active in consolidating the admittedly young market.
In the last year, for example, Avnet has disengaged from a high-volume supply relationship in China because the business wasn’t as profitable as the company would like, according to Fay. A few other distributors have also been examining their position in the margin-challenged China market and have walked away from deals they consider minimally profitable. Some distributors in Europe have also dialed back their presence in parts of Asia, preferring to first strengthen or revive core operations.
This would seem to be a smart strategy, for now. As Chinese OEMs move up the value chain, however, and as the country’s start up culture evolves, they would need strategic distribution partners that can offer first-rate supply chain management services. At EPSNews, we expect some of the medium-size Chinese distributors to come into play over the next several years as the market matures.
In the short term, most M&A activities in the mid-tier distribution market will continue to take place mainly in North America and in Europe. So, we expect companies that are currently reporting sales in the $100 million to $1.5 billion range to come under the acquisition radar of their bigger competitors.
That is, if they are not the ones bulking up through acquisitions.