Arrow Electronics, Inc. (ARW) Q2 2011 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Arrow Electronics second quarter earnings conference call. My name is Latasha, and will be your coordinator for today. [Operator Instructions] I would now like to turn the call over to Ms. Greer Aviv. Please proceed.

Thank you. Good afternoon, everyone, and welcome to the Arrow Electronics second quarter conference call. I'm Greer Aviv, Senior Manager of Arrow's Investor Relations program, and I will be serving as a moderator on today's call. If you would like to access today's call via webcast, please visit our Investor Relations website at www.arrow.com/investor and click on the webcast icon. With us on the call today are Mike Long, Chairman, President and Chief Executive Officer; Paul Reilly, Executive Vice President, Finance and Operations and Chief Financial Officer; Andy Bryant, President, Global ECS; and Peter Kong, President, Global Components. By now, you all should have received a copy of our earnings release. If not, you can access our release on the Investor Relations section of our website. I would also like to point out that we issued a CFO commentary that has been posted to the Investor Relations section of the website that should be used as a complement to the earnings press release. You can access a copy of our earnings reconciliation for the second quarter in our press release or on the Investor Relations section of the website. Before we get started, I would like to review our Safe Harbor statement. Some of the comments to be made on today's call may include forward-looking statements, including statements addressing future financial results. These statements are subject to a number of risks and uncertainties that could cause actual results or facts to differ materially from such statements for a variety reasons. Detailed information about these risks is included in Arrow's SEC filings. We will begin with a few minutes of prepared remarks, which will then be followed by a question-and-answer period. As a reminder to members of the press, you are in a listen only mode on this call, but please feel free to contact us after today's call with any questions you may have. At this time, I would like to introduce our Chairman, President and CEO, Mike Long.

Thank you, Greer, and thanks to all of you for taking the time to join us today. I'm proud to announce that we generated record sales and earnings per share of $5.5 billion and $1.36, respectively. Consolidated second quarter sales of $5.5 billion grew 20% year-over-year, with excellent growth in both global ECS and global components. Sales in ECS were above normal seasonality on a sequential basis, driven by broad strength across products and geographies. In global components, year-over-year sales growth was very strong and sequential sales were in line with normal seasonality. We continued to see terrific margin improvement this quarter, as gross margins increased to 110 basis points year-over-year due to acquisitions and our efforts to drive increased gross margins across the business. Returns continued to demonstrate our commitment to creating shareholder value with return on invested capital of 13.6%, well within our long-term target range, and a return on working capital of 31.9%, ahead of our target. Global component sales growth was very strong again this quarter, driven by year-over-year increases across a wide number of products sets and verticals in our core business around the globe. On a sequential basis, sales were in line with normal seasonality, though slightly below our initial expectation for another quarter of above seasonal growth. We saw a continuation of strong sales and a book-to-bill trends in April and in May, and then growth slowed in June, and book-to-bill fell below 1. This well-publicized economic challenge in Europe have resulted in a more cautious marketplace. While the government in China continues to raise interest rates to curb inflation, despite a modest slowing of the economy there. Gartner recently reduced its outlook for semiconductor sales, 5% growth from previous expectations of 6%. We believe this is a short-term issue and our underlying components business remains healthy. The modest oversupply of inventory at the end of the second quarter, as well as these macroeconomic factors will likely temper the growth we will see in the third quarter. In our Global ECS business, growth was above our expectation and normal seasonality on a sequential basis. The ECS team posted second-quarter revenue driven by impressive year-over-year growth in all of our product lines. With proprietary servers, industry-standard servers and software, all growing in excess of 25%. We continue to execute on our growth strategy as evidenced by the recent expansion into new markets such as unified communication and our expanded supplier relationships. Andy and his organization are doing a tremendous job of bringing value to our customers and suppliers, and we're clearly being rewarded for this. Industry analysts expect global IT spending to grow 7% in 2011, driven by enterprise hardware and cloud services. In discussions with customers and suppliers, they also expect growth to remain healthy in the second half of 2011. Value-creating M&A remains an important focus for us, particularly those acquisitions which fit well with our strategy to expand into faster growing, high-margin products and services that span the full life-cycle of technology and complement our core business. This activity continued in the second quarter with 3 additional strategic transactions. In June, we announced the agreement to acquire the assets and operations of Seed International, a value-added distributor of embedded products with 14 offices across China. This acquisition brings Arrow an expanded presence in China, while strengthening our relationships with the key supplier. We have completed acquisition of Cross Telecom, a leading North America service provider of Converged and Internet Protocol technologies and unified communication. Cross strengthens our customer and supplier relationship, as well as our industry and technical expertise in the unified communication, telephony and managed services industry. And lastly, we acquired Pansystem, a distributor of high-performance wire, cable and interconnect products to the aerospace and defense, automotive and industrial markets in Italy. This acquisition expands A.E. Petsche's offerings for customers and gives suppliers greater access to this significant market. We continue to execute on our strategy to grow ahead of the market in our core components and ECS businesses as well as the momentum that we have built over the past 2 years. Our differentiated strategy to expand into high-margin, high-growth product sets and services that create more value for our customer base and make Arrow stronger with our customers and suppliers has served us well. I'd like to reiterate some of the key messages we presented our recent investor day, with the theme of strength, growth and momentum. We're extremely confident in the long-term outlook for our business and continue to believe we'll be a $26 billion-plus premier electronics company by 2013. We are excited about the prospects for future growth as we expand and diversify into new markets, products and services. We have meaningfully expanded our addressable market over the last 2 years through the acquisitions we have done, adding almost $150 billion of future opportunity. We continue to execute on our sales excellence strategy, which can be seen in our gross margin results. Our gross margin has improved since the downturn, while at the same time, our market share has gone up and we've outgrown the market. While demand may be moderating in the short term, we remain focused on growing sales faster than the market, increasing the markets we serve, growing profits faster than sales and increasing our return on invested capital. Paul will now provide an update of our financial results for the second quarter.

Thanks, Mike. Second quarter sales of $5.5 billion were in line with our expectations, in line with normal sequential seasonality and represent an increase of 20% year-over-year. As Mike said, we again posted a record level of sales. Pro forma for acquisitions, and excluding FX, sales were up 3% year-over-year. As Mike also mentioned, this year-over-year performance was across all geographies and all businesses. Our consolidated gross profit margin was 13.9%. That's an increase of 110 basis points year-over-year, with 30 basis points from our legacy businesses and 80 basis points from acquisitions. Operating expenses as a percentage of sales increased 80 basis points year-over-year. Pro forma for acquisitions, excluding foreign exchange, operating expenses were up only 2% year-over-year, and would be 8.4%, net of acquisitions or some 10 basis points less than Q2 2010. To assist you with your analysis, on an absolute dollar basis, operating expenses increased year-over-year as follows: Acquisitions added $88 million of expenses, the weakening dollar added $19 million of expenses due to financial statement translation and there was a $15 million increase in expenses, for organic investments and the variable costs tied to increased sales. Operating income was $253.6 million, that's an increase of 30% year-over-year. In the second quarter, we continue to demonstrate the leverage inherent in our business. Operating income, again outpaced sales growth by 1.5x year-over-year. Operating income as a percentage of sales, again increased, up 40 basis points year-over-year. Our effective tax rate for the quarter was 30%, and for modeling purposes you should assume that our tax rate, the next few quarters will be between 30% and 31%. Net income was $159.8 million, that's an increase of 32% year-over-year. Earnings per share were at $1.38 and $1.36 on a basic and diluted basis, respectively. Again, a record level of earnings for Arrow. We generated $35 million in cash from operations in the second quarter, even as we continued to support growth initiatives on both sides of our business. And on a trailing 12-month basis, we generated $290 million in cash flow from operations, during a period when revenues grew and we invested for even additional growth beyond that. Return on working capital of 31.9% was the second highest level of Q2 ROWC in the last 5 years and remains above our long-term target. Return on invested capital of 13.6% is considerably ahead of our weighted average cost of capital and is within our long-term targets. We also completed our previously announced $50 million buyback authorization during the second quarter, bringing the total amount return to shareholders to $250 million over the past 2 years. Our board has approved an additional $100 million repurchase authorization, which we believe is an effective method of returning capital to investors. This of course is a high-level summary of our financial results for the second quarter. For more detailed information regarding the business unit results, please refer to the CFO commentary published this morning. Looking to the third quarter, we believe that total sales will be between $5.15 billion and $5.55 billion, global components sales between $3.7 billion and $3.96 billion and global enterprise computing solutions sales between $1.39 billion and $1.59 billion. As a result of this outlook, we expect earnings per share on a diluted basis, excluding any charges, to be in the range of $1.17 to $1.29 per share. In the third quarter, we expect Global ECS sales to be in line with the midpoint of normal seasonality. Sales in our core global components business are expected to be in line with the low-end of normal seasonality reflecting a modest oversupply of inventory in the supply chain at the end of the second quarter and weaker global macroeconomic conditions. The outlook for our seasonality is based on a constant currency for both our businesses.

Thank you, Paul. Latasha, please open up the call for questions at this time.

[Operator Instructions] Your first question comes from the line of Brian Alexander with Raymond James.

Just on the linearity in the components business, Paul or Mike, it seems like the trend is weakened throughout the quarter given the comments that April and May were tracking to plan. So June must have been below your expectations by something like 10% to 15%, because you missed the midpoint of your components revenue guidance by 5% and it sounds like it was entirely due to the last month of the quarter. So is that the right way to think about it? And if so, why would September be in line of the low end of seasonality and not below seasonal, given your comment that customer purchase requirements are down versus the prior quarter?

Brian, the April and May, as you indicated, were strong for us and the book-to-bill dropped off below 1 in June. The piece that gives us confidence was that July bookings have now rebounded back above the 1 level. We do believe there was some inventory rebalancing that was taking place in June and part of the beginning of July as the business again continued to accelerate a little bit in the month of July from a bookings point of view. And we have said that we don't believe the -- Japan was that material, but when you start moving somewhere between $40 million, $50 million to $100 million dollars between quarters, we believe that, that was about the extent of what we saw in terms of changes. And you know our sequential guidance we give you guys as far as being in seasonality or out of seasonality is not that big of a difference. So all in all, we've seen the business pick up again, and we're extrapolating that out for the quarter and gave you our best view into our backlog, as we see it right now going forward.

Just a follow-up on that, Mike, the July book-to-bill, back above 1, is that true in every region?

It is above 1.1 in North America. It's about 1.2 right now in Europe and Asia Pac is just a tick below 1 right now, and we believe that will come back also.

And just a follow-up for Paul on share count, what are you embedding in the third quarter guidance? And does that include any benefit of the $100 million buyback you just announced?

Thanks, Brian. There is no assumption of buyback in that earnings-per-share guidance that we gave. So any impact from the buyback would actually drive that number up a bit.

Yes. I guess maybe the better way to ask is, would you expect to be active, given today's stock action?

We'll have an orderly plan to ensure that we are in the market buying back shares. The pace of buyback will be dependent upon share price, because for sure, we believe that there is an opportunity for us to be prefunding, if you will, next year's equity award at a very attractive price right now.

Your next question comes from the line of Craig Hettenbach with Goldman Sachs.

Mike, now that you have a couple of quarters under your belt for a number of the acquisitions over last year, can you just talk about the integration? Any revenue synergies you're seeing? You talked about the PAN expansion, but just implications for your revenue growth as we go forward here?

Sure. Some of the things we started to find out, which we thought would be true, if I go all the way back to the Petsche business, we started to see some synergies from the customer base that was dealing with Petsche, starting to buy from the core component side of the business, and that was a help for us. As we started to expand the services within our account base, we also were seeing an uptick in some of the like customers purchasing more components from us at the same time. We've been pretty happy with what we've seen, we've also established that there's a timeframe of probably 6 months for these acquisitions to come in, start working with the core where we start to see the cross-selling benefits that Peter Kong has been talking about. And that has worked out in our favor at this point in time and we've been pleased with the acquisitions that have come in. And of course, Richardson and Nu Horizons are still recently in, so we haven't seen the uptick with those businesses at the levels we would expect to see over the next quarter. As far as the computer products business goes, we're starting to see an increase of services and going in and through our current reseller base that we haven't seen before, and believe that will keep a consistent growth prospect for us, as IT looks like it's going to continue to be fairly strong for the second half of the year. Does that get at it for you?

It does. And then I have a follow-up for Paul. It looks like the EPS outlook and revenue kind of match. So I just wanted to get any color on just your ability now to kind of fine tune the model, right, so as growth has softened a bit, it looks like you're able to take the OpEx out, but any color there will be helpful.

Yes, for sure, like we have demonstrated and we will continue to demonstrate, our ability to be nimble around our cost structure reflect the realities of the business. With that said, we do believe this is no more than a choppy economic environment and the business remains healthy over the long term. So when you combine that with our past history of being very nimble around expenses, you can be assured that we're watching it very closely, and we'll pull the levers as required. And that means that if the broad economy looks better, we'll continue to be aggressive around accelerating sales growth and investing in the business. And if it looks like it's going to be more of a flat period, then we'll pull back on the investment and rethink how we're spending the dollars that we have. The one thing that we do always do is think about how we can be more efficient, more productive. So that we can ensure that not only does the infrastructure that we have today support a higher sales level, but in fact, make the cost structure more nimble to be able to handle even more sales going forward. So I think, it's long-winded way, so I should probably just say, yes, we'll stay very much focused on expenses, we're committed to driving a higher operating income percent. We're committed to driving a higher return and that's a critical aspect as we go forward.

Your next question comes from the line of Jim Suva with Citi.

I have one question and then a quick follow-up question. You guys have really been pushing forward into this nontraditional distribution, IT service role, with your aftermarket businesses, your end-of-life businesses and things like that. Now that you've folded in a few more acquisitions or in process of it, can you give us a flavor for the magnitude of right now, currently where we sit today, how much of a percent of sales is it for Arrow? Are we talking kind of 2%, 3% neighborhood, below 5% or are we approaching 10%? And maybe just give us a few milestones that you'd like to see going forward on this? And then I have a quick follow-up.

Okay. I'll let Paul give you the financial data around what acquisitions have contributed for us and then I'll give you a little bit bigger picture.

Yes. So when we look at it, and as we disclosed in our financial statements, the overall acquisition pace -- and really, Jim, I'm talking about the acquisitions that were either partially in the second quarter of last year as well as since that point in time, contributed about round numbers, $600 million of incremental sales in last year's second quarter, and that's how the pro forma is calculated. And that's a combination of the traditional business, like Nu Horizons, the new product extension, like Richardson. It's the ITAD business that we got with Converge and Intechra, it's the managed service provider and unified communications in Andy's business in Shared Technology, and there's a few others in there that I haven't mentioned. So that's about the high-level view of what the pro forma impact was on last year's second quarter. And if you go to the Q, you'll be able to see some more of the details behind that. So I hope that helps you get an idea on where the pace of sales is and what the impact is for the acquisitions.

And then my follow-up question is when we look about these choppy conditions, whether it be stock prices or debt financing globally, and given Arrow's financial strength, does this kind of bring M&A a little bit closer to, "Hey guys, let's giddy up and get going on this," a little bit more and take advantage of this and be opportunistic, or how should we think about that?

Yes, I think this comes into the overall. We will continue to expand with our services and product portfolio expansion into the near future. We believe the more value and the more products we can bring to our customer base, it will be nothing but a benefit for us. And a lot of that will depend on how the markets remain attractive, the M&A markets. As you know, we've taken a very disciplined approach and a real respect for how we evaluate these acquisitions as far as what they can do for us over time and the benefits that they can bring. So if they fit within our financial guidelines, Jim, we will continue to be aggressive with them.

Your next question comes from the line of Scott Craig with Bank of America Merrill Lynch.

Two questions, first on the inventory side of things. It sounds like you saw a rebound back on the book-to-bills, but do you feel that most of the inventory has now cleared out, Mike, that we're getting more towards the end of July and you saw the bounce back? And then, Paul, on the gross margin front, citing acquisitions and mix, can you maybe go into a little more detail on the mix side of things on a year-over-year basis and a quarter-over-quarter basis, just provide a little bit more color around there?

I'll start with the inventory. We believe there's a rebalancing going on. I also believe that in terms of mix of the inventory, there will be a balance that will continue on for the quarter. The benefit that we're seeing right now is an uptick in booking, and we're watching everything very close. And it's my belief that we should be able to naturally balance the inventory with not a lot of fluctuation. If we just remain committed to it and continue to watch our bookings and the products that are going out the door, but we're not expecting any, what I would say, huge movement in the inventory over the quarter. And Paul?

Yes. So Scott, on the GP performance, and I'll try to give you some data around raw GP. So keep in mind that we always have adjustments for freight and for reserving, et cetera, but this is really the street level. In the components business, we were up in 2 of the 3 regions in raw GP. So the street-traded GP we were up in the core business there, so that's stripping out any of the low-working capital and low GP business. So we look very positive on that because that's great news for us. The one region that was not up, was down only about 10 bps. So when we look at it, we feel we're still making good progress around the commitment we made coming out of the downturn that we will continue to push GP up, so that's just on the components side. And then we saw a similar type of activity on the computer products side, where we saw GP go up in the various product sets as well as in the regions also. So, yes, for sure, a little bit of mix impact. We have 2 low-margin, low-working-capital requirement businesses that we're quite keen on because they have great returns. One was down in revs, and one was up in revs, so they kind of offset each other.

Your next question comes from the line of Sherri Scribner with Deutsche Bank.

I wanted to get a sense of the inventory, you gave some commentary in the scripts in the prepared remarks, but in terms of where you're seeing the most inventory buildup, can you give us some sense of which geographies and specifically, which products? I know you mentioned mobile phones in Asia as one of the issues.

We saw following our business, there was a little bit of inventory build in Europe, that fundamentally had to do with Japan. We did track some of this back to Japan. So we believe there's a little bit of inventory they needs to come out in Europe. In Asia Pac, the pause there was primarily from media tech, in fact, I could almost say it all is, because the core business is looking pretty good. And that was on low-end handsets that we haven't seen the rebound of that product line in the Asia Pac business. But we did have a few investments in the passive, electromechanical side of our inventory. We believe that was some balancing we did, and the commodity inventory is another place right now that customers are looking at doing some balancing and making sure they have their mix right, so when the demand does come the cheaper components are not creating any problem. But overall, we're not trailing anything to a specific supplier or a specific product line where things would be out of whack.

Okay, that's helpful. And then looking at the geographic split in some of the commentary, it looks like the Americas piece of the business was strong across both components and ECS. I know that number -- I'm just looking at the raw number not with FX, but it seems like your strength is really being driven by the Americas right now, is that fair to say?

Americas had a very nice quarter. We were very pleased with the progress that happened in the Americas, and the other thing that would go back to Craig's earlier question, we have seen some cross-selling benefits from the services expansion in the Americas that has also helped that components number. And we expect that to continue to move in to the other regions a little bit later.

Your next question comes from the line of Amitabh Passi with UBS.

I just wanted to clarify, your components business in Europe was down 9% sequentially. Mike, was all of that related to Japan? And did it all happen late in the quarter? Or was there other stuff with respect to some of the end market exposure you have, that affected the performance in that segment and in that geography?

Yes, the segment as I said had a tough June, and we are early now in the July, month of July, we saw quite a rebound out of Europe with the business. In Europe, it was a little bit more broad-based and we did have a couple of our larger customers that had a slowing in June. But again, it's appearing that it's more of inventory balancing. And if you bring it back and look at from really a higher level in the business, I got to tell you, if we didn't have all the chatter we're hearing out there about the economy, we would be relatively cautious to say it looks a lot like a normal summer slowdown in a normal trend of business. And we're clearly not panicking, but we're watching. And we're watching the business pretty close, and we're seeing what looks like normal trending in this business. Although the numbers are a little different than we would call normal trending, but they're not that much different. So hopefully, that gives you a view of what we're looking at, because we are in the summer.

Sure, sure. And so then should we expect that over the next 2 to 3 months within the September quarter the inventory adjustments should largely be behind you? And then, should we see a meaningful improvement in the return of working capital in Europe, which was down over 800 basis points?

Yes, that would be our expectation. We will continue to run our business, given the booking levels and the billing levels in each market, and those inventories will match that market. We've done that in the past, and even if you go down to when we had the severe downturn, we managed our inventories right along with that downturn. We're never far away from being able to get the inventory balanced right where it should be. And right now as I've said, we've given our guidance, and our inventory will be in line with that guidance.

Got it. And just finally for me, Paul, hypothetically speaking, if we assumed your sales are to remain flat next year, do you think you could still hold gross margins flat? And is there enough in the way of OpEx efficiencies to maybe hold off [indiscernible] and maybe offset any sort of normal cost inflation that you might see in OpEx?

Okay, so let me just make sure I understand the hypothetical question correctly, if 2012 sales are flat with 2011 sales, can we maintain in the same level of GP? I do believe so, and in fact, there probably would be a shift in product sets that might even support it going higher. And do I think we could be more efficient and more effective? I do believe we could. I also believe we could continue to work on lowering our tax rate. And in fact, get an increase in net income that way, when you rack that all up.

Your next question comes from the line of Matt Sheerin with Stifel, Nicolaus.

I want to get back to the question of inventory, but really focus on Arrow's inventory. You talked a bit a lot about the inventory rebalance or correction at customers, your inventories were up, it sounds like you're going to start working it down. And was that up, Mike and Paul, because obviously your expectations for sales in the quarter were higher and you got caught with some inventory at the end of quarter? And if so, what areas was that in? And how should we expect to see that play out in the September quarter?

Sure. Paul, do you want to give him a profile of where the increase came?

Sure. So Matt, you're absolutely right. Our expectations were for higher sales in the month of June, after the strong performance in April and May. We had no reason to think it was going to come to a slowdown period. We profile and get inventory coming in 3 months in advance, we place the orders. Cancellation times are not that short. So we still had some shipments coming in, but we didn't have them going out the door. So for sure, that's the case. We pulled the lever on that for new incoming inventory to make sure we can work it down, to ensure that we can have the right balance, generate stronger cash flow in the second quarter and go forward from there. So absolutely, that's what happened and absolutely feel good about what's going to happen from a cash flow point of view. As we proved it -- we proved last year, we have very little risk when we have too much inventory, as long as we're able to make sure we push that out over a couple of quarter period of time. But looking at the inventories and really where it's changed, we had as Mike mentioned, a little bit too much inventory in the European business. Kind of ironic because if we compare it year-over-year, last year we were still in a period of allocation, and now we're in a period of normal lead times. So in a period of allocation as you know, you always have higher turns. But the turns that we had in Europe were still, still at a good level from a historical point of view. The turns also in Europe -- in Asia, same type of thing, slower than they were a year ago, a bit slower than they were in the first quarter, but still at a very good level from a historical point of view. Actually, North America was up in inventory turns year-over-year, but it was a bit behind the first quarter. So if I was to point at it and rank them, for sure Europe was probably at the top of our list for needing to do better, followed by Asia and North America finally taking that last spot.

And is that sort of across the board in terms of product categories, components, semis, analog passives, et cetera, or is it more on the commodity side?

The commodity inventory is primarily the inventory that got balanced, Matt. The results of some balancing, as I had indicated in the PEMCO side of the house. We have been more cautious on the allocated type products that existed out there right now, because those pipelines, we would like to see them stay balanced going into the future. And pushing back on that supply chain ends up pushing back on manufacturing right now, and we have seen an increase in the July bookings. And in fact we would really -- not only hurt ourselves but hurt our customers if we reacted too negatively to those types of products.

Okay, that's helpful. And then just my follow-up regarding your component revenue in Asia. You talked about some weakness pertaining to media tech. But if -- certainly you've been tracking down year-over-year now for the last 2 quarters, and even greater than that when you count the acquisitions that are embedded in your Asia business, so can you talk about kind of your strategy there? Your profile by end market or product category and how you feel -- how you're positioned going forward?

Yes. In Asia Pac, the growth in our core business was good, Matt. That increased 7% year-over-year, and there was good performance in greater China. The total decrease was about 9%, and it was almost all related to the low-end handsets, and that mobile market decreased quarter-over-quarter 19% and 47% year over the year. So it really comes down to doing the math in there, you'll see it's one supplier and it's the Taiwanese business we have.

Is there much left there then in that business? Or has that bottomed, do you think?

Well, I would say that at this point in time, it should be at the bottom or getting awfully close to it.

Your next question comes from the line of Shawn Harrison with Longbow Research.

Just wanted to focus in again on working capital. Days payable, I guess were a little bit worse than I would have anticipated this quarter. Maybe if you could just talk about kind of the sequential decline in DPOs and where we should expect that for the back of the year?

Yes, Shawn, so you're right, the DPO went down a few days. Some of that had to do with timing on the cutoff of the quarter. Some of it has to do to the fact that we need to do better in that area. And some of it has to do with the fact that, quite honestly, we took shipments in that we thought we were going to ship out and increased the denominator, if you will, in the calculation and we didn't make the shipments. So the sales dropped off at the end, the last 2 weeks of the quarter impacts the calculation. We'll have it back in line for Q3, potentially, it actually could be artificially low as we work the inventory down and then go back to a more traditional Q4-over-Q4 level. So I don't see that as a big challenge for us, to say some of it's the calculation, some of it's the drop off in the sales of the last few weeks, some of it's around just timing.

Okay. And then just a follow-up, just on ECS, when considering kind of the gross margin trends for the back half of the year and it looks like at least based upon industry forecast, we are going to see a very -- or pretty strong second half in terms of IT hardware and services demand, is there anything within the product mix that would press your gross margins year-over-year sequentially as particularly heading into the fourth quarter that you would see some type of EBIT margin degradation?

Matt, Andy will give you a little more detail of the product mix.

I think as noted, we have seen a very nice pickup in demand and enterprise spending and our business strategically has stayed very focused on the data center. And so the rebound in proprietary server, the way that we've grown software and services to become a bigger percentage of our business, I believe gives us optimism that we can maintain margins. Certainly, there's always pressure on hardware margins, but I think the way our strategy is playing out and the way we're driving the mix gives us the confidence that the second half will hold.

Is there anything within kind of the weakness experienced in the U.K. that could pressure margins further from here? Or if you kind of think, maybe the U.K. weakness has bottomed out?

We still are seeing overall, in our business pretty strong. And if you remember, Andy and his team had made a big commitment to expanding all across Europe. And we have seen the benefit from that expansion, especially in proprietary service -- proprietary servers, software and services. And if you take overall in the business, the software and the services piece, software is up 29% for Andy's business year-over-year, and his services content is up almost 50% year-over-year. And we expect that growth to continue to accelerate for him and his team, going throughout the year. So conversely, we believe that will have an improvement benefit for us versus a decline.

Your next question comes from the line of William Stein with Crédit Suisse.

I'm going to beat this inventory thing to death, but I think aside from the last question, if you could all confirm that the inventory discussion you were having was more around your customers not your own business, that was the adjustments that's going on?

The inventory nature of our business is being adjusted all the time. Our inventory gets adjusted every quarter with the incoming flows and the outgoing flows of inventory. That is in direct correlation to what we see with our customer base. And we believe that in different parts of the world, customers were doing some balancing. And again, the positive note of that balancing was that the July book-to-bill started to increase again, which said that to us, as the inventory was balancing, customers did see a need to increase purchasing to make sure that they were going to get the products when they needed it.

I appreciate that, Mike, I just want to make sure I understood the comments that were made before. Aside from the last question on this, the previous several and in the press release, you were referring to customers' inventory levels, is that?

Right, right.

Okay. And can you comment as to whether that's -- is it their inventory in raw materials that they built up in anticipation of shortages related to the events in Japan? Or is it more wip and finished goods where they're seeing demand slow down and having to react to that or any color you could provide on that would be helpful. Then I do have one follow-up.

No, we haven't received an awful lot of negative press from customers that their products are slowing down in a big way. Remember, it is not uncommon after a series of high growth and high allocation, which we had, for customers to move into the summer and start to rebalance their inventory. It's a normal peak that happens when the business is operating, what I would say, at a more consistent level than it has been with the high-growth. And when you have the allocation range we have and parts start to free up, those orders start to go into the customers. And from the looks of things this time, it appears that we're in better shape than some of the past cycles, as far as customers overbuying. I think customers tempered themselves much more this time than they had in the past, and I actually believe that, that's good for the business, it will help keep the business more in line. And the good news behind that again was the increase of bookings that we saw in July. If we not -- we'd not have seen the increase in book-to-bill in July, we might have been here with a little different story.

And then the follow-up, if I can, I'd love to hear about stronger or weaker end markets in both of the 2 segments if you can.

I can tell you that year-over-year in the medical business for us and in lighting, in the Americas between quarters has been a bright spot. We've seen a bright spot in Europe year-over-year in automotive, the lighting business and the medical business there. And in Asia Pac it's been lighting and transportation, which has been the bright spots for that business. We see more of an uptick I think in the enterprise business around banking, and we also saw an increase in productivity in that business. I think it was more of the medium business segment over the course of the last year. That benefit for us has largely come from both businesses expanding their marketplace and coming up with wider solutions. So all in all, the spending that we have seen from our customer base has been relatively broad-based. And again, we didn't see a huge increase in our top 10 customers, which means they weren't driving everything we've seen this year, it's been coming from a wide variety of customers, and that's where we believe the true benefit is.

Your next question comes from the line of Ananda Baruah with Brean Murray.

And maybe just a follow-up for Andy. Andy, could you -- I guess, I was interested in getting your thoughts on -- from your customer base, and any interesting features that are going to be coming to market, broadly speaking, I don't know, over the next 6 to 12 months, that they seem to be particularly excited about? I mean, I know a lot of your suppliers, a lot of your partners have come out with some interesting features, functionality. Over the last couple of quarters, as they're saying is meaningful, so I'd love to just get your thoughts there.

Well, I think, really my view is that -- it's business as usual. The data center is getting a lot of focus right now and what you're seeing is a pretty strong refresh evident of our server growth for the quarter. I think a lot of customers are obviously looking at ways to utilize cloud. So that would be my answer to you. The biggest focus within the VAR base and our end-user base is how to use the internal cloud as well as hybrid and external models. And then finally, the continued convergence of voice and data. Those would be the comments I would make on that.

Okay. That's helpful. And I guess just a follow-up on the components business, the areas that you've seen, the uptick in bookings in July, and I apologize if I missed this, are those the same areas in which you've seen sort of strength throughout the regions that you just referenced? Maybe, Mike -- and if not, can you sort of just give us the specifics where the component upticks in July have come from?

The declines that -- the year-over-year sort of quarter-over-quarter places that have been stronger are the ones I outlined before, an additional benefit for us has been in the alternative energy market. There was a modest decline there, but some of these markets -- these declines are looking again like normal seasonality. The lighting and traffic business, if you will, has been pretty exceptional growth throughout, just given the proliferation of the LED lighting products, and that also drags along with it a fair amount of spend on the components side to drive that lighting. Again, the biggest segment that I would say we've seen a decline, that's probably a better way of saying it, would be around aerospace and in EMEA. The aerospace in U.S. has been an under 5% decline for us, but the aerospace in Europe has been more around the 11%. That's the one that looks the worst to me at this point in time.

Your final question comes from the line of Brendan Furlong with Miller Tabak.

Question on the ECS in Europe and just this preamble or the statement that you gave that -- on the website, gross margin down 50 bps because of mix in the quarter. If you could just tell us what that mix issue was, where it was on the IT side? And if that mix concern or mix issue continues in the back half of the year? And then on the gross margin on the components side, up phenomenally in the quarter, but assuming that things are getting a little bit softer here, what sort of gross margin compression can we expect on the components side? And I have a follow-up for Mike.

Andy, why don't you go ahead and take the ECS, please.

Sorry, your comment is about -- your question is about the go-forward outlook again for gross margin?

Well, it's more on the ECS, you said on the statement, the CFO statement that ECS gross margins were down 50 basis points sequentially because of mix, and I'm wondering what that mix is, what's that negative mix impact in the quarter?

Okay. Yes, I'll answer that question, there's 2 things driving that, one is the fact that we had a very strong quarter in industry-standard servers, which as you know has a lower EP, but lower cost to serve also and great returns. We also had a bit of a change in our geographic mix in Europe with some of the acquisitions that we did. So those were the drivers, if you will for the lower GP.

Okay, and that -- so then that, sorry, go ahead.

Well, just to give you an idea, the year-over-year billing increase in industry-standard servers were up 55.5% for Andy and his team. And in the quarter, if you just take the most recent quarter, they're up 35-plus percent. So there's your biggest mix change.

Okay. And then on the component gross margin, you can expect some compression here into the next couple of quarters?

We're not expecting a lot of compression in that business at all.

Okay. And a question for you, Mike, the European business on the components down quite a bit in the June quarter, but yet the book-to-bill is back substantially to a 1.2 book-to-bill, pretty much within the space of 1 month from what you're saying, April and May was okay, June was bad, and now we're back to 1.2 book-to-bill. I'm struggling with that in terms of seasonality, anything it just seems -- I'm struggling with this, I don't know if you can educate me and set me right.

Paul, why don't you go ahead and take that. Let him know the trends a little bit, you have those with your fingers.

Sure, absolutely. So as Mike said, we had a very strong April and May, but unusually weak June. That 120 is really at or slightly ahead of normal July seasonality. So we're very keen to make sure that we got it off the right base. Because you're right, if you have a low number 1 month, it could be artificially inflated the next. But that's slightly ahead of the book-to-bill that we normally see in the month of July. It's a good month for bookings for the month of September, with not as much in the way of shipments. And just as an aside, it's the second highest book-to-bill in the month of July we've had in Europe, in the last 5 years.

I guess what I'm struggling with is, why would the book-to-bill be so good if demand has rolled off and customers are rebalancing their inventory? Rebalancing the inventory takes generally longer than a month?

No and that is why I say it's for July shipments.

Thank you. If you have any questions about the information presented today, please feel free to contact Paul, Mike Taunton or myself. Thank you, and have an nice day.

This concludes the presentation. Thank you for your participation, and you may all now disconnect. Good day.