Prepared remarks
Welcome to the Avnet Third Quarter Fiscal Year 2024 Earnings Call. I would now like to turn the floor over to Joe Burke, Vice President, Treasury and Investor Relations for Avnet.
Thank you, operator. I'd like to welcome everyone to the Avnet Third Quarter Fiscal Year 2024 Earnings Conference Call. This morning, Avnet released financial results for the third quarter fiscal year 2024 and the release is available on the Investor Relations section of Avnet's website, along with a slide presentation which you may access at your convenience. As a reminder, some of the information contained in the news release and on this conference call contains forward-looking statements that involve risks, uncertainties and assumptions that are difficult to predict. Such forward-looking statements are not a guarantee of performance, and the company's actual results could differ materially from those contained in such statements. Several factors that could cause or contribute to such differences are described in detail in Avnet's most recent Form 10-Q and 10-K, and subsequent filings with the SEC.
These forward-looking statements speak only as of the date of this presentation, and the company undertakes no obligation to publicly update any forward-looking statements or supply new information regarding the circumstances after the date of this presentation. Please note, unless otherwise stated, all results provided will be non-GAAP measures. The full non-GAAP to GAAP reconciliation can be found in the press release issued today as well as in the appendix slides of today's presentation and posted on the Investor Relations website. Today's call will be led by Phil Gallagher, Avnet's CEO; and Ken Jacobson, Avnet's CFO. With that, let me turn the call over to Phil Gallagher.
Thank you, Joe, and thank you, everyone, for joining us on our third quarter fiscal year 2024 earnings conference call. I am pleased to share that we delivered another quarter of financial results in line with our guidance. In the quarter, we achieved sales of $5.7 billion and adjusted operating margin of 3.6%, highlighted by a 4.1% operating margin in our Electronic Components business. And we generated nearly $500 million of cash flow from operations. This demonstrates that we can maintain reasonable profit margins even during the challenging cycles we face. As I have mentioned on previous calls, we've been working through an inventory correction on a global basis over the past couple of quarters. And while we have made progress in working down our inventory levels, we, like many in the industry, still have ways to go. Our customers are facing a variety of factors that are contributing to the current challenging business environment, including elevated inventory levels, some cash flow constraints, diminished customer visibility, and shortened lead times.
These market conditions are among the most challenging in recent memory. At times like this, I am proud to have one of the most experienced and dedicated teams on the field. As you all know, the economic conditions evident in the second quarter continued in the third quarter. Sequentially, demand declined across most of the end markets we serve. However, defense and data center markets showed improvement. On a year-on-year basis, transportation was a bright spot with increasing demand globally. 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. On the IP&E side, lead times and pricing are generally stable, and we are seeing increasing demand for interconnect products and capacitor families, most notably channel.
Our backlog is lower as a result of shorter lead times and customers working through their inventory on hand. Cancellations have remained at normal levels. As expected, our global book-to-bill ratio remained below parity at the end of the third quarter, though modestly above last quarter, led by our Asia region, which finished the quarter approaching parity. I'm really pleased by the work of the team in improving our inventory position. It is worth noting that we reduced inventory and reduced our receivables at the same time, demonstrating sound working capital management. This is a key focus area for our organization, and we expect to see further progress in the current quarter, which should drive solid cash flow from operations. I'm proud of our position as a key enabler of healthy, more reliable supply chains in the Semiconductor and Electronic Components ecosystem, and it's only getting stronger.
Our position at the center of technology supply chain allows us to pursue opportunities with our long-standing customers and suppliers who increasingly rely on Avnet to meet their needs. With that, let me turn to the third quarter results. At the top line, our Electronic Components business declined in revenues across all the regions, but I will note that the third quarter of fiscal year '23 in EMEA was a record revenue quarter, so they're going against some tough comparisons. In EMEA, we're glad to see that demand in the transportation end market increased sequentially, and the defense end market decreased on a year-on-year basis. In the Americas, demand in the transportation end market increased on a year-on-year basis. And in Asia, demand in the transportation, compute, and consumer end markets all increased on a year-on-year basis. We continue to move successfully up the value chain.
In the quarter, our engineering teams continued to engage with our customers and suppliers on the design wins and registrations, which drove increases in revenues and margins and further validates the value proposition we deliver in any type of market. Before we get into Farnell's results, I now let you know of a leadership change in that business. Chris Breslin, our Farnell President, is leaving Avnet. I want to thank Chris for leading the Farnell team over the past 6 years. Given their close proximity, industry knowledge, and proven track record, I've asked 2 of our veterans, EMEA core business leaders, to temporarily assume executive oversight for the Farnell organization. I want to reiterate that Farnell remains a critical part of Avnet's overall success and value proposition, so stay tuned for upcoming announcements on the Farnell leadership transition. In the third quarter, Farnell's sales were up sequentially, led by strength in IP&E products and single-board computers.
However, margins are not where they need to be. As a result, we are making cost reductions primarily related to warehousing costs, freight, marketing costs, and headcount. We are well on our way to achieving our previously disclosed savings target, which should be substantially implemented by the end of June, so improvement should be apparent in the second half of the calendar year. As a key player in the supply chain, we continue to leverage our value proposition in areas such as demand creation, IP&E, and embedded computing. With our global sales force and our technical capabilities, I believe we have all the right resources to grow the top and bottom lines over the long term. And while it's difficult to say just when this correction will have run its course, I am encouraged by a number of signs I see at Avnet and in the market. First, current business activity in our Asia region is indicating that we are likely near the bottom and may potentially see some sequential growth as we move through the balance of calendar 2024.
Second, we are seeing a nice pickup in bookings in our IP&E business and at Farnell as well. Finally, the industry sources we follow, as well as the customer supplier executives I meet with regularly, are projecting a return to growth as we move into calendar year 2025. To conclude, we remain focused on bringing our considerable experience and relationships to bear as we navigate this choppy period. We are managing the things we can control, delivering increasing value to our customers and supplier partners, reducing working capital, especially inventory, aligning costs, and driving shareholder return. I believe we have the right strategy and team members in place to both drive and benefit from the market recovery. Again, I want to thank our team for bringing their unmatched expertise to work every day. It is important to Avnet, and it's important to the industry. With that, I'll turn it over to Ken to dive deeper into our third quarter results.
Thank you, Phil. Good morning, everyone. We appreciate your interest in Avnet, and for joining our third quarter earnings call. Our sales for the third quarter are approximately $5.7 billion, in line with guidance and down 13% year-over-year. On a sequential basis, sales were down 9% in constant currency due to expected sales declines in the Western regions and a seasonal decline in Asia due to Lunar New Year. On a year-over-year basis, sales declined in constant currency, 7% in Asia, 15% in EMEA, and 18% in the Americas. From an operating group perspective, Electronic Components sales declined 13% year-over-year and 10% quarter-over-quarter in constant currency. Farnell sales declined 10% year-over-year and 11% in constant currency. Farnell sales grew 3% sequentially in constant currency. For the third quarter, gross margin of 11.8% was 62 basis points lower year-over-year but up 46 basis points sequentially.
EC gross margin was down year-over-year primarily due to a lower mix of sales from the Western regions. EC gross margin increased sequentially, primarily due to the seasonal mix shift to the Western regions. Farnell gross margin continued to be down year-over-year but was higher sequentially, largely due to the pricing stability and an improved demand for IP&E products. Turning to operating expenses. Selling, general, and administrative expenses were $467 million in the quarter, down 6% year-over-year and largely flat sequentially, with a slight increase due to differences in foreign currency exchange rates. As a percentage of gross profit dollars, selling, general, and administrative expenses were 70% in the third quarter. For the third quarter, we reported adjusted operating income of $203 million, and our adjusted operating margin was 3.6%. By operating group, Electronic Components operating income was $217 million and EC operating margin was 4.1%.
This was the ninth consecutive quarter of EC operating margin being above 4%. Farnell operating income was $16 million and Farnell operating margin remained at 4%. As we communicated last quarter, we have initiated cost reduction actions at Farnell, which when completed, will provide annual expense reductions of between $50 million to $70 million. We had completed approximately 2/3 of the reductions as we exited the third quarter. The remainder of the reductions are expected to be completed over the next couple of quarters. Additionally, due to our current sales outlook and demand environment, we are taking action to reduce total Avnet operating expenses by $40 million to $60 million per year. These actions include a combination of permanent and temporary cost reductions across all regions. We will continue to make operating expense investments where needed, but the current market conditions require some incremental cost actions.
Turning to expenses below operating income. Third quarter interest expense of $73 million increased by $2 million year-over-year and was down approximately $1 million sequentially. Our adjusted effective income tax rate was 24% in the quarter as expected. Adjusted diluted earnings per share was in line with our expectations of $1.10 for the quarter. Turning to the balance sheet and liquidity. During the quarter, working capital decreased $574 million sequentially, including a decrease in reported inventories of $364 million, a $194 million decrease in receivables, and a $16 million increase in payables. Working capital days increased 8 days quarter-over-quarter to 115 days. Our return on working capital decreased accordingly on the lower operating income. Our inventories were down 6% during the quarter, reflecting decreases across all regions within EC and, to a lesser extent, Farnell. The decline in EC inventories was net of increases in inventory due to strategic opportunities.
Inventories for these arrangements are expected to build into the June quarter with the underlying inventory selling through by the end of the calendar year. We expect continued overall progress on achieving inventory reductions during the fourth quarter, excluding these strategic arrangements. As Phil has mentioned many times, part of our role at the center of the technology supply chain is to play a shock absorber between our suppliers and customers. Despite the near-term challenges of the current market environment, we still want to be opportunistic as new business opportunities present themselves, even those opportunities that may require additional inventory. We take a holistic approach when evaluating any such opportunities but are disciplined in making sure there's a proper ROI for Avnet in any such arrangements. Our decrease in working capital led to a decrease in debt of $495 million.
We generated nearly $500 million of cash from operations in the quarter, and we have generated $650 million of cash from operations over the past 4 quarters. We expect to generate positive operating cash flow in the fourth quarter, although more modest than this past quarter. We ended the quarter with a gross leverage of 2.5x, and we had approximately $890 million of available committed borrowing capacity. Regarding our capital allocation, we continue to prioritize our existing business needs. As previously noted, we are driving working capital reductions to be more in line with our current level of sales. During the quarter, cash used for CapEx was $42 million, primarily to support a new distribution center being constructed in EMEA. We expect CapEx to return to historical levels in the fourth quarter of fiscal 2024 of approximately $25 million to $35 million per quarter. In the third quarter, we paid our quarterly dividend of $0.31 per share or $28 million.
We have $232 million left on our current share repurchase authorization entering the fourth quarter. As a result of our strong cash flow generation, we expect to repurchase Avnet shares in the fourth quarter. Our shares continue to trade at a meaningful discount to book value as book value was $55 a share for the third quarter. Turning to guidance. For the fourth quarter of fiscal 2024, we are guiding sales in the range of $5.2 billion to $5.5 billion, and diluted earnings per share in the range of $0.90 to $1. Our fourth quarter guidance assumes current market conditions persist and implies a sequential sales decline of 3% to 8%. This guidance assumes below seasonal sales declines in the Western region and below seasonal growth in sales in Asia. This guidance assumes similar interest expense compared to the third quarter, an effective tax rate of between 22% and 26%, and 91 million shares outstanding on a diluted basis.
Before we take questions, I want to echo Phil's sentiment in thanking our team for staying focused on the things that will drive success for us in the coming quarters, most importantly; closely monitoring operating expenses, generating operating cash flow from working capital reductions, and winning new sales opportunities to drive profitable growth and continued market share gains.
Questions and answers
Our first question is from Matt Sheerin with Stifel.
Phil, for your forecast indicating below seasonal performance across all regions, can you elaborate on the sequential growth in Asia? This suggests year-over-year declines of approximately 20% to 25% in the Americas and EMEA. Do you believe this is the final inventory drawdown? Are there any signs indicating that we may be approaching stability in customer orders? Is there anything that makes you hopeful this could be the low point?
Coming down. Could you hear me?
Yes, I didn't hear you the first part, Phil.
Let me start over. Thank you, Matt. I appreciate it. I mentioned earlier that I'll begin with Asia. As stated in our communication, we believe we have reached the lowest point in Asia. We are observing moderate forecasts for 2024. While this is moderate, it’s still positive news. Historically, many trends start in Asia and then move to the West. In Europe, the challenge with the year-over-year decline is that we are coming off record highs, which complicates the perception. It's difficult to determine if this is truly the lowest point. It seems possible, but there are many mixed signals out there, so I hesitate to assert that. However, we do expect a gradual rebound in the second half of the year, extending into 2025.
Okay. And then on the cost cutting, I think you said it was a $40 million annual run rate. When should we think about those costs coming out? Will it start in the June quarter? And what should we think about OpEx sequentially? Will that be down or will that be up?
Yes, Matt, this is Ken. I'd just say that a lot of those actions for the new incremental actions beyond Farnell are actually occurring kind of as we speak during the quarter, so expect it to be more of an FY '25 kind of benefit. And think about OpEx being down next quarter slightly due to the Farnell actions plus the volume decline.
Okay, great. And just quickly as a follow-up, that would imply that gross margin actually holds fairly steady. And I would think that, that might be down because of the mix?
Yes. I think there's a mix offset by some opportunistic things that are kind of balancing it out, so gross margin is holding up to slightly in the EC business.
Our next question is from Joe Quatrochi with Wells Fargo.
Maybe just on the EC margin front. As you consider that mix benefit, we assume that margin can remain above the 4% threshold for the June quarter?
Yes, Joe, I would say it could be slightly below or slightly above the 4%. It's within that range, depending on the regional mix outcome. The guidance suggests it's around the 4%, but it could vary a bit.
Okay. And then as a follow-up, I think last quarter, you talked about discussions with your suppliers and customers kind of suggested that you were thinking about inventory reductions continuing through the large percentage of this calendar year. And I guess my question is, is that still the right way to think about it? Or has that maybe even pushed a little bit into 2025 as you just think about returning to growth in 2025? I guess, have there any change really in how you think about the trajectory of inventory reductions to the base of this year?
No, I wouldn't say really a change. I think that we are happy that we started some progress. Again, we haven't had much progress there. Flattish has been or stable has been our commentary in the last couple of quarters. So feel good about the direction we're headed. Still a lot of work to do is how I'd characterize it. So think about it through the remainder of the calendar year, still knocking away at that because the sales levels are down as well.
Our next question is from William Stein with Truist Securities.
First, I'm hoping you can comment on order trends in the first month of the current quarter and how they might have progressed relative to what you characterized for the last quarter. And then I do have a follow-up.
Yes, I'll address that, Will. Thank you. The order book-to-bill ratio has seen some modest improvement. We're observing more progress in the Asia Pacific region. Additionally, we've noted improvements in Farnell and in the IP&E segment, particularly with connectors and other balanced products. Consequently, there is some recovery in the book-to-bill metric. However, the main challenge remains with lead times and existing inventory, as we are working to encourage customers to provide us with a clearer pipeline and greater visibility. We act as a middleman to assist suppliers in obtaining the visibility they need, but this is not yet occurring on a broad scale. That's what we are focusing on. Nonetheless, there has been slight improvement this quarter compared to last quarter.
That helps. I have a follow-up regarding the end market. My channel checks in the middle of the quarter indicated a recovery or at least some better-than-expected conditions in the automotive sector, which aligns with what a few semiconductor companies mentioned. It's still surprising and perhaps puzzling for investors because when they look at the Tier 1 suppliers and the original equipment manufacturers, their business doesn't seem to be improving significantly. I wonder if this situation is due to these companies having already stocked materials for electric vehicles, which means they need to place new orders for internal combustion engines and hybrids. Or could it be related to an inventory mismatch or possibly that they reduced their inventory too much? Any insights you could provide on this would be very helpful.
Yes, it really is a mixed situation. Over the past week, different reports have surfaced, with some indicating negative trends and others highlighting positives. As you pointed out, it largely depends on the type of content in the vehicle, whether it's for internal combustion engines, electric vehicles, or advanced driver-assistance systems. The content in electric vehicles is considerably higher. Even now, I'm reviewing the numbers, and we did see year-on-year growth last quarter. We refer to it broadly as transportation, so it's more encompassing than just automotive, although automotive makes up the majority. Looking at a three-quarter trend globally, we still observed year-on-year growth, not just last quarter but over the past three quarters as well. Regionally, the situation might vary a bit, but that's our perspective at this moment.
Our next question is from Ruplu Bhattacharya with Bank of America.
Maybe this time, I'll start with Ken. Ken, can you remind us what revenue level is necessary to maintain the components operating margin above 4%? I know you mentioned some restructuring and cost control. How is that divided between Farnell and Components?
Yes, I believe most of the cost actions you will observe for the rest of the year will relate to Farnell, as the core business is currently implementing some of these measures. In response to your earlier question regarding guidance implying a figure below 4%, I would suggest that we are essentially at 4%. So, I would reframe it to say that this revenue level, depending on the regional mix, is where we need to be to maintain the 4%, since the guidance suggests we are around that mark. There may be some variation of plus or minus 20 basis points dependent on the contributions from EMEA and Americas versus Asia and other factors, but we are at that level, barring any significant increase in demand creation mix or improvements in supply chain and service scaling beyond our current expectations.
Okay. Okay, that's helpful. And Ken, maybe another one for you. Can you talk about how you think about the cash conversion cycle trending over the next couple of quarters? How should we think about free cash flow? Then you laid out uses of cash. I mean, can you give us your thoughts on buybacks and any opportunity for M&A in this environment or not?
Yes. I mean, I think we'd expect positive free cash flow. We are going to be in the market in the fourth quarter buying back shares. We believe they're still at a great value, considering they're well below book value. I would not anticipate any M&A through the remainder of this calendar year. I think we're always looking. But again, looking at smaller like IP&E type acquisitions, nothing transformational. But at this point, we're probably not going to be active in M&A over the next few quarters. And CapEx should return to normal levels. So think about it as $25 million to $35 million a quarter as a normal run rate.
Okay, that's helpful. Can you discuss your focus areas for revenue growth in the next 12 months? Which markets or geographies do you think will recover sooner, and where do you believe Avnet is best positioned? Are there any areas where you're currently investing to better position the company for recovery, even in this challenging environment?
Thanks, Ruplu. That question covers a lot of ground, so I’ll try to summarize. We believe Asia Pacific is set to recover, which is positive for us. We are well-positioned in that region and continue to gain market share. As we've mentioned in previous earnings calls, we aim to keep our team intact and avoid overreacting to market changes. We’ve experienced strong momentum for several quarters and are being prudent about where we cut expenses while still making necessary investments. We continue to invest in various verticals. Although the industrial sector has been more affected, we are still well-positioned there and will maintain our focus. We briefly discussed transportation earlier, and that market remains promising for us, so we are investing in it. Additionally, the defense and aerospace sectors are likely to grow due to current global circumstances. Within our company, we are concentrating on IP&E, which is starting to recover, which is encouraging, specifically from a book-to-bill perspective.
We also mentioned Avnet Embedded, which is a growing business that generates higher margins. This area involves designing and manufacturing boards for the verticals we discussed, including medical. We want to keep focusing on these sectors without overreacting, managing what we can, reducing inventories, generating cash, and ensuring we serve our customers and suppliers effectively.
There are no further questions at this time. I'd like to hand the floor back over to Phil Gallagher for any closing comments.
Great. Well, I want to thank everyone for attending today's earnings call, and I look forward to speaking to you again in our fourth quarter fiscal year 2024 earnings report in August. Have a great summer.
Ladies and gentlemen, this does conclude today's conference. You may disconnect your lines at this time. Thank you for your participation.