Component distribution is their bread-and-butter business but high-value demand-creation is what distributors thirst for as electronics industry seeks a return to normality.
After a lull in demand-creation activities during the recent round of component shortages, when supply chain management functions—especially procurement and order fulfillment—took precedence over most other OEM support activities, distributors are angling for a swift return to more value-added services, which help them deepen relationships with component suppliers and OEM customers and defend operating margins.
As in many other economic segments, distributors have learned over the years to prioritize their customers’ immediate needs in times of crisis. The Covid-19 pandemic triggered numerous problems throughout the global economy, which filtered through to the electronics industry and eventually resulted in difficult sourcing situations at OEMs. Component suppliers that had shuttered facilities or slashed production during the outbreak could not as quickly fulfill new orders pouring in from equipment manufacturers that were themselves seeking to satisfy unexpected demand.
As in the past, distributors pivoted quickly to support harried customers. OEMs’ and suppliers’ immediate procurement needs crowded out whatever else component distributors would have rather focused upon. As the shortages intensified late in 2021 and continued through the first half of the next year, distributors directed the bulk of their resources, including working capital and personnel, to assist OEMs navigating through the storm. Supplier needs also became a priority. Industry observers said distributors rolled out creative sourcing strategies that helped mitigate the severity of the shortages.
Actions taken in the last two years included innovative—some would say frantic—sourcing of scarce parts, inventory stocking ahead and in anticipation of customer requirements, and close coordination of demand-supply dynamics with semiconductor manufacturers. Distributors even engaged in atypical practices such as non-cancellable orders with suppliers to calm nerves at vendors hesitant to increase manufacturing capacity. Having been burned in the past when they complied with OEM requests for high production and the addition of new facilities, suppliers needed financial assurances that they would not be left holding the bag if demand fell. Distributors understood, teaming up with OEMs to give suppliers a sense of shared risks.
Most distributors who assumed these risks took hedging measures, making sure OEMs would be on the hook for such commitments to suppliers. They still faced risks, though, as suppliers increased the amount and dollar value of non-cancellable orders, forcing distributors and their customers to assume a greater percentage of the financial exposure. At Arrow Electronics Inc., the world’s biggest component distributor, the value of “purchase obligations” with suppliers increased in 2022, to $13.4 billion, from $11 billion, in 2021.
“Non-cancellable inventory purchase orders were in line with the year-earlier period, and remain elevated above historic levels, primarily due to significant increases in prices and lead times for orders during both 2021 and 2022,” the company said, in the SEC filing. “Additionally, many vendors continue to limit cancellations, although many of the company’s non-cancellable purchase orders are backed by customer purchase orders with Arrow, that are also non-cancellable.”
Working capital jumps
Naturally, working capital expenses at most distributors have risen to support their also much higher sales. Distributor executives say they have allocated more of their working capital to inventory, leading to swollen stocks at the leading market players. Investments also went into warehouse expansion and the automation of delivery services, according to industry executive. Anything to satisfy the customer and grease long-term relationships, industry sources said. Of course, demand-creation activities were not neglected. They only took the back seat while more pressing needs became the primary focus, they said.
“In the recent quarters, we’ve been consuming a lot of cash because we have to invest in the business with working capital,” said Phil Gallagher, CEO of Avnet, during an industry presentation in March. “Our priority was to make sure the business has what it needs to continue. It was not only for working capital but also for digital tools, and IT systems to make us more efficient. Agility is key. Resilience is key. We have a dedicated team that works with the customer on these different transitions.”
Inventories surged as manufacturers, component suppliers and distributors struggled to ensure availability of supplies. At Avnet, inventories increased 35 per cent in the December 2022 quarter, to $4.97 billion, from $3.68 billion, at the end of March. An analogous situation played out at Arrow Electronics, which reported inventories of $5.3 billion in the fourth quarter of 2022, compared with $4.7 billion, at the end of the first quarter of the same year.
Component suppliers reported similarly elevated component stocks. Inventories at Texas Instruments, for example, jumped to $2.8 billion, in the December quarter, from $2.1 billion, as at the end of March. Industry executives attributed the increase in inventory values to pricing pressures. Average selling prices, (ASPs), rose as demand exceeded supplies, giving component suppliers and raw material vendors pricing leverage in procurement negotiations.
“We’ve continued to see our inventory increase quarter-over-quarter for the last six to eight quarters,” said Rick Seidlitz, corporate controller at Arrow Electronics, in a presentation to the financial community earlier this year. “A lot of that has been in support of growth. A lot of the inventory growth is tied directly to pricing increases rather than increasing units. Let us call it healthy growth in our inventory. We had a period when price increases just kept coming. As we exited the year, they slowed down, but they did not stop. We are not seeing the price decrease yet.”
Privately-owned companies like Digi-Key do not typically disclose their working capital ratio as a percentage of sales, but indications are that the Thief River Falls, Minn.-based company also saw a hefty increase in payments to suppliers—to support the surge in 2022 revenue to a record $5.1 billion. Public distributors like Arrow are compelled to publish details, however. The company said its working capital, measured as a percentage of sales, rose to 19.3 per cent in 2022, up 3.5 percentage points, from 15.8 per cent in the prior year.
“The recent global semiconductor shortages have resulted in some suppliers increasing the amount of non-cancellable orders, which limits the company’s ability to adjust down its inventory levels in event of market downturns, and could have a negative impact on the financial results of the company, particularly if the company is unable to pass such non-cancellable terms to customers,” Arrow said.
Still, observers say the pendulum is swinging back, albeit slowly, as the market is not fully shorn of the shortages that drove the last torrid expansion. Pockets of shortages still exist in the supply chain and extended lead-times have not returned to normal levels, according to executives at Arrow Electronics.
“It is just a difficult environment for everybody to operate,” said Arrow’s Seidlitz. “There is room for improvement. Broadly speaking, though, it has stabilized but I do not know if we will ever get back to the old normal.”
Back to the future
Little wonder distributors are eager to resume regular operations and refocus on value-added functions like demand-creation. While they did not intentionally cut back on demand-creation in recent years, such functions retreated a bit into the background. Now, distributors want to talk about and promote their demand-creation activities.
Future Electronics is one of the companies eager to let the world know it was active in assisting suppliers with demand-creation services through the shortages. Fortunately for the Canadian company, STMicroelectronics came in at the right time with a thundering gift when it gave Future an award in January “for its outstanding performance in demand creation in the Asia-Pacific region in 2022.” The award was for a sub-group of ST’s general purpose microcontroller the companies said, in a statement.
“Future Electronics is a long-term partner of Demand Creation preferred by many manufacturers,” the company said, in the statement. “In addition to supporting large-scale customers, it also continues to focus on the mass market, providing small and medium-sized customers with high-quality localized services, complete technical support, and stable supply chain value-added services.”
Distributors have good reasons to get excited by the opportunity to brandish their demand-creation credentials in the face of the world. Distribution is traditionally a low-margin business and any service that can help pump up profitability is treasured. Demand-creation is one of those functions, notes Avnet’s Gallagher. In fact, the company’s decision to acquire UK-based distributor Premier Farnell in 2016 was due to its position as a demand-creation specialist.
“Demand-creation is 32% of our business,” Gallagher said. “This is where we have our 2000-plus engineers. They are doing design, working with our suppliers to get the products designed in at the end customers. Suppliers are leaning in on that [because] we give them the scale they do not get on their own.”
Supporting demand-creation
Distribution executives say their demand-creation services are so profitable that it is unlikely to become an orphan business. In fact, the reverse is likely as reflected in the huge investments franchise distributors continue to make to support demand-creation activities. The biggest distributors and even mid-tier companies in the sector have over the years added thousands of field application engineers or even acquired design engineering focused enterprises.
Arrow, for example, in 2018 acquired San Jose-based design engineering firm einfochips, bringing onboard “over 1,500 IoT solution architects, engineers, and software development resources,” as the company noted in a statement announcing the purchase. Companies like Avnet, Digi-Key, Future, Mouser, Sager, TTI have beefed up their engineering teams and regularly market demand-creation services such as product conception and development, design-for-manufacturability, component engineering, green fulfillment, regulatory compliance, and the like.
Those services will be even more in demand over the next several years as the industry pokes its head out from a downturn that is expected to hurt demand and sales in certain segments in 2023 and part of 2024. With the global economy swooning, the high-tech sector is also expected to receive some blows and climb down from the elevated sales reported recently by OEMs and their supply base.
The ensuing competition for reduced enterprise and consumer demand will be intense. To win, component manufacturers will have to fight harder for every design socket, which will boost the need for demand-creation services provided by distributors. Having a presence in most commercial capitals of the world and in far-flung locations as well as a deep bench of sales representatives who partner with small and medium-tier customers and start-ups will help distributors’ quest for a boost in demand-creation activities.