Arrow Electronics (ARW)- A Follow-up to Our Red Flag Note
More concerns with working capital and cash flow
A few weeks ago we highlighted concerns we had with the quality of Arrow Electronics (ARW) 1Q24 in Arrow Electronics (ARW) June Red Flag Note. Given our concerns, we did a full earnings quality review of the company which turned up more troubling signs in the areas of working capital and cash flow that we believe investors should be aware of heading into earnings.
The report begins below but we recommend readers unfamiliar with our earnings quality review process read the following guide first.
A Guide to the BTN Earnings Quality Watch Rating
Our Earnings Quality Watch industry reports provide readers a quick way to identify the companies within an industry that are the most and least exposed to the risk of reporting disappointing results or guidance as a result of recent results being distorted by unrealistic, accounting-related benefits. (Note that the rating does not take into consideration factors such as competition, industry conditions, valuation, expectations, and recent price movements.)
Components of the rating
Accounting disclosures vary between industries based on the differences in business models used by that industry’s participants. Therefore, the makeup and weightings of the components considered in our final rating will differ from industry to industry. For example, depreciation and capex policies will be more important for industrial companies than software companies. Below is an explanation of the components we used for the Communications Equipment industry.
Earnings Management Indications
GAAP accounting results depend heavily on estimates made by management and the company’s auditors. Aggressive assumptions and changes to estimates can lead to unrealistic results. Also, an examination of trends in accrual accounts can uncover early warning signs of slowing growth that have yet to show up in the top and bottom lines. We examine recent results and explore unusual movements in key accounts including:
revenue recognition-related accounts such as receivables, contract assets, and deferred revenue
expense accruals such as bad debt reserves, warranty accruals, and capitalized costs
workings capital movements including inventory and payables
Misleading non-GAAP Adjustments
Earnings Management Indications are concerned with GAAP accounting-related matters that impact results. However, practically all companies apply at least some non-GAAP adjustments when presenting their results with some adjustments almost universally applied in some industries. For example, virtually all tech companies add back stock compensation to non-GAAP earnings. Therefore, our rating system compares the percentage or earnings weighting of the add-back to peers in the industry in addition to considering recent company-specific trends that may impact how realistic the adjustment is.
Insufficient Depreciation/Capex
While depreciation expense is often viewed as an earnings management component, we include it in a separate section given its complicated interrelationship with property, plant, and equipment balances and capital spending trends. Factors considered include the company’s depreciation method, its choice of estimated useful lives, capital spending levels, and its average age of equipment versus its peers in the industry.
Cash Flow Quality
We examine factors impacting cash flow growth such as dependence on factoring programs or stretching payables. We also highlight how much of a company’s cash flow is dependent on considering stock compensation and non-cash items.
R&D Understated by Acquisitions
Many companies acquire vital intellectual property via acquisition, but goodwill is not amortized under GAAP and many add back the amortization of intangible assets which erases the impact of the acquisition on non-GAAP results. We assess how much each company is benefitting from acquisition accounting relative to its peers.
How to Read the Earnings Quality Watch Rating
After considering all the factors, a final Earnings Quality Watch rating is assigned as follows:
Pass- No meaningful concern with the reliability of the company’s recent results.
Caution- We noted signs that we believe indicate that recent results have been impacted by earnings quality distortions, but we see only a moderate risk that the company will report an earnings disappointment related to the distortion in the next 2 quarters.
Alert- We noted signs that we believe indicate that recent results have received a material benefit from earnings quality distortions and there meaningful risk that the company will report an earnings disappointment related to the distortion in the next 2 quarters.
Suggestions for readers managing long portfolios
For all companies of interest with an Earnings Quality Watch rating of Caution or Alert, investors should make sure they have taken all negatively rated factors into account in their risk assessment process.
Note that since factors such as competition, industry conditions, valuation, expectations, and recent price movements are not considered, companies with a Pass rating should not be considered an automatic buy recommendation.
Suggestions for readers managing short portfolios
It is our experience that companies exhibiting signs of earnings management have a higher risk of posting a disappointment. Therefore, we believe all companies with an Earnings Quality Watch rating of Alert are a potentially fruitful place to start looking for potential short ideas. However, we recommend that investors seeking active short ideas take additional considerations into account such as competition, industry conditions, valuation, expectations, and recent price movements before taking a position.
Now, let’s get behind ARW’s numbers…