Jul 29, 2009
Executives
Mike Long - Chief Executive Officer Paul Reilly - Executive Vice President & Chief Financial Officer Andy Bryant - President of Global ECS Peter Kong - President of Global Components Greer Aviv - Manager of Investor Relations
Analysts
Brian Alexander - Raymond James. Craig Hettenbach - Goldman Sachs William Stein - Credit Suisse Matt Sheerin - Thomas Weisel Partners Shawn Harrison - Longbow Research Brendan Furlong - Miller Tabak Sherri Scribner - Deutsche Bank [Amanda Buroer] - Brean Murray Jim Suva - Citigroup
Operator
Welcome to Arrow Electronics conference call to discuss their second quarter earnings. At this time, I would like to turn the call over to Greer Aviv for opening remarks and introductions.
Greer Aviv
Good morning everyone and welcome to the Arrow Electronics second quarter conference call. I am Greer Aviv, 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. Presenting on the call today are Mike Long, Chief Executive Officer and Paul Reilly, Executive Vice President and Chief Financial Officer.
Also joining us are Andy Bryant, President global ECS and Peter Kong, President global components. By now you should have all received a copy of our earnings release.
If not you can access the release on the Investor Relations section of the website. Before we get started I would like to review Arrow’s 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 can cause actual results or facts to differ materially from such statements for a variety of reasons.
Detailed information about these risks is included in Arrow’s SEC filings. We will begin with several 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 any questions you may have. At this time, I would like to introduce our CEO, Mike Long.
Mike Long
Thank you, Greer and thanks to all of you for taking the time to join us this morning. We executed well in the second quarter, with sales and earnings per share at the high end of our updated expectations.
Despite turbulence in the global economic environment and ongoing uncertainty in our supplier and customer base, our cash flow generation continues to be exceptional with more than 300 million in cash from operations in the second quarter, making our 11 consecutive quarter of positive cash flow generation. Additionally, working capital management remains at best if class levels with working capital to sales declining almost 300 basis points year-over-year.
I am pleased to report that we have achieved a targeted level of expense reductions we communicated to you back in February, which enabled us to reduce expenses at a faster rate than the decline in sales on both the year-over-year and sequential basis. However, the cost savings we have generated through these initiatives have not been enough to offset both the ongoing sales decline in margin pressures we have experienced during this downturn.
In light of this, we have an additional $100 million in annual cost reductions that will be implemented in the second half of 2009. Paul will provide you with additional details on the savings a bit later in the call.
The actions we are taking will insure we maintain profitability and enhance our operational efficiency, while still moving forward with our strategy to growth sales and market share as well as optimize growth profit. Despite the challenges of a weakening economy and ongoing cost reduction activities we continue to invest in opportunities to enhance our growth and enable us to become more efficient in a productive organization.
As I shared with you at Investor Day on June 4 we’re excited about the benefits our global ERP implementation will provide as well as the competitive advantage we believe we will gain through this improved efficiency. I’m happy to report we have achieved another significant ERP milestone.
With the recently completed transition of our Australian, New Zealand business on July 6. This is the first global components location to use new Oracle ERP system to manage all of its manage processes, including customer information, solution development, supplier information, supply and demand planning, procurement, inbound and outbound logistics, the value added services, payments and collections.
In a very complex transition, we have been able to meet all of our customer and supplier requirements. We will complete the final leg of our enterprise computing solutions conversion in August, which will result in our entire North American ECS organization being on one platform.
In summary, we delivered on our commitment to radically simplify the business while remaining focused on our long term goals. We will continue our strategic evolution to a sales excellence organization through profitable market share growth, gross profit optimization and continued operational efficiency.
We will maximize our cash flow to ensure we are well positioned to capitalize on opportunities that present themselves as a result of the downturn protect our financial strength. We believe the actions we’re taking today will ensure we maintain and enhance our leading position as we emerge from the downturn.
Our enterprise computing solutions segment sales of $1.1 billion increased almost 5% sequentially, though this was at the lower end of our expectations, the lower than expected growth was primarily as a result of lower demand and IT spending. As capital intensive projects, continue to be highly scrutinized and delayed in some cases.
By product type we saw increases in all categories, with double digit growth in storage, software, and proprietary servers. We are confident that our strategy of portfolio diversification will continue to pay-off as the need for complex technology systems to provide security and storage solutions has not diminished despite the macro headwinds.
We are pleased with the strides of our European business, following the successful integration of LOGIX. We’ve been gaining share in this region and driving improved gross profit margin.
This coupled with the expense control have led to greater levels of profitability on a pro forma basis. While we have more work ahead of us, we’re encouraged by the results we’ve seen to-date.
The business climate is still tough, but ECS remains well positioned for growth when the market returns. Our mix of services software and storage are helping us weather the downturn specifically, the fall-off of server sales.
As I mentioned earlier, in the coming months we’ll be completing our or Oracle implementation across North America. We will continue to strengthen our service offerings and remain committed to continuing the increase our depth and mid-market solution, storage and software.
However, visibility remains limited. We will stay diligent on controlling our cost and focusing on growing market share despite the challenges that lay ahead of us.
Looking ahead to the third quarter, we would expect sales growth including the impact of foreign exchange to be inline with the normal seasonal range. Global components had sales of $2.3 billion, came in ahead of the midpoint of our expectations driven by strength in Asia, as well as the solid finish to the month of June for our North American business.
While our revenue results exceeded expectation, operating performance continues to be impacted by a change of sales mix and gross profit pressure. Looking ahead to the third quarter, we believe we’ve seen signs of stabilization in the Asia Pac region.
While we are encouraged by one month of stability in North America as we have said previously, our European business continues to be the main area of concern and focus for us and we’ll work to insure we’ve return this business to acceptable levels of profitability. Design win activity across the global components organization remains very high, a positive signal that customers are continuing to design new products in anticipation of future market strength.
This also bodes well for our margins when demand resumes, and new product designs are put into production. Sales in North America declined 27% year-over-year and 3% sequentially inline with the low end of normal seasonality.
While the quarter got off to a slow start in April and May, we experienced a relatively strong close to the month in June. Both bookings and billings showed an increase for the quarter and our backlog is up for the first time in several quarters.
We ended the June-quarter with a book-to-bill of 1.06, which is above the previous quarter, and year ago level and cancellation rates are at the lowest levels we have seen in the past 12 months. We continue to execute on our cost reduction targets in North America.
We would again expect sales in the third quarter to be inline with normal seasonality in North America. Business conditions in Europe remain challenging as sales declines continue declining 41% year-over-year and 16% sequentially, excluding the impact of foreign exchange sales were down 31% year-over-year and 20% quarter-over-quarter.
Book-to-bill was below one in all regions and while we’ve made progress on our cost reduction initiatives and our European business, we continue to face significant headwinds in this region. As you will hear in more detail later, we have plans to reorganize our cost structure in order to reposition the business for profitability.
Similar to what we saw last quarter, customers in Europe remain cautious and the marketplace is uncertain. For the third quarter, visibility remains limited especially given the impact of the European holiday in July and August.
We would expect sales to be inline with the low end of normal seasonality. In Asia Pac sales increased 10% year-over-year and sequentially, inline with the higher end of normal seasonality.
The better than expected revenue growth was driven by strong performance in China as a result of the local government stimulus program. While our ultra source business performed well driven by growth in cell phones and other consumer items, looking ahead to the third quarter we would expect sales growth to continue, but be at levels below normal seasonality.
Taking a look at the leading indicators, pricing at the customer level remains competitive at all regions. However the supply chain is the most efficient we have seen compared to any other downturn.
Our book-to-bill in components was above 1, finishing the first quarter at 1.02 on a global basis; this is up from the same quarter a year ago. Although down modestly from our first quarter.
Levels in North America and Asia Pac remain above one while Europe continues to be below pretty and very weak. Importantly, cancellation rafts in second quarter have returned to more favorable levels and we actually saw rates decrease globally.
The results of our quarterly customer survey in North America shows the outlook for purchase requirements strengthen modestly on a sequential basis making the first improvement we have seen in this metric since the second quarter of 2008. While we view this as a positive data point, along with recent indications from suppliers that they have seen an up tick in business trends, the distribution industry continues to lag manufacturers.
Thus our marketplace remains uncertain with limited visibility. As always we monitor the behave behavior of suppliers closely.
We will focus on driving profitability sales and market share growth throughout our global components organization. Paul will now give you a more detailed review of the second quarter financials.
Paul Reilly
Thanks Mike. As reflected in our earnings release, there are a number of items that impact the comparability of our results with those in the trailing quarter and the second quarter of last year.
I will review our results excluding these items to give you a better sense of our operating performance. As always, the operating information we provide to you should be used as a compliment to our GAAP numbers.
For a complete reconciliation between our GAAP and non-GAAP results, please refer to our earnings release or the earnings reconciliation slide at the end of the webcast presentation. Second quarter sales of $3.4 billion were ahead of the midpoint of our expectations and represent a decrease of 22% year-over-year and a decrease of 1% on I sequential basis.
Pro forma for LOGIX and excluding the impact of foreign exchange, sales declined by 20% year-over-year and 2% sequentially. Global enterprise computing solution sales decreased by 19% year-over-year and increased 5% sequentially to $1.1 billion in the second quarter.
Although they were at the low end of our guidance, pro forma to include the acquisition of LOGIX and excluding the impact of foreign exchange, sales were down 21% year-over-year and increased 3% sequentially. The second quarter for ECS as once again demonstrated our commitment to improving productivity and efficiency along with maintaining financial strength.
Our focused efforts resulted in operating expenses declining 20% year-over-year on a pro forma basis. Our gross margin decreased 40 basis points on a year-over-year basis we did an increase of 10 basis point sequentially as product mix had a positive impact in this quarter.
Our operating margin was down 130 basis points year-over-year, against a very tough comparison and increased 10 basis points from the first quarter. Focused management of working capital resulted in a decrease in working capital to sales of almost 470 basis points year-over-year to a record low level, an increase in return on working capital of more than 3X compared to last year’s second quarter.
Global component sales of $2.3 billion decreased 23% year-over-year and 3% sequentially or a decline of 19% year-over-year and 5% sequentially excluding the impact of foreign exchange. Similar to ECS, we are focused on improving operational efficiency and cost containment activities throughout our global components organization.
Particularly, given the uncertainty that still exists in the marketplace we were able to decrease our operating expenses by 28% year-over-year and 7% sequentially. Unfortunately, significant gross margin pressure more than offset the expense reductions we achieved resulting in lower levels of operating profit on both at year-over-year and sequential basis.
Gross margins continue to be negatively impacted by a change in our geographic mix of businesses as Asia Pacific becomes a larger portion of total component sales, while competitive prices also influence our performance. Disciplined working capital management resulted in an almost 200 basis point year-over-year decrease in working capital to sales.
Please refer to the appendix for our slide presentation for a breakdown of revenue by geography. Our consolidated gross profit margin was 11.9%, a decrease of 220 basis points year-over-year primarily, due to an increase in the mix of business from Asia Pac as a percentage of total sales, increased pricing pressure in both our global components and global ECS segments and ongoing weaknesses in the North American and European components businesses.
On a sequentially basis, gross margins decreased 70 basis points, also due to mix changes with Asia Pac and ECS. Operating expenses as a percentage of sales decreased 30 basis points year-over-year and sequentially to 9.8% representing a record low second quarter level.
On an absolute dollar basis, operating expenses declined 25% and 4% on a year-over-year and sequential basis, respectively. As you can see in slide 15, a fully implemented the cost reduction activities we laid out for you in February and operating at the full quarterly run rate of savings.
As Mike alluded to you earlier, we’ve made the decision to institute additional round of efficiency and cost actions. As you’re well aware, economic conditions have continued to deteriorate throughout the second quarter particularly, in Europe.
We’ve put in place plans for an additional wave of actions to ensure we maintain accepted levels of profitability for Arrow and to maximize our financial foundation. The previously announced $175 million in cost reductions was an immediate response to the downturn and related financial crisis.
In addition to permanent reductions, we’ve also implemented in our initial cost reduction actions, although workforce actions including lower incentive structure, mandatory unpaid time-off and elimination of salary increases are all aspects of the discretionary spending were curtailed. We’re now moving forward with the second wave of actions we believe will result in business simplification and alignment with market opportunities.
The majority of the impact will occur in our European components business, through management de-layering, consolidation of back-office functions and integration in streamlining of local and regional structures. We estimate that the total impact of these actions will reduce costs by more than $100 million on an annual basis bringing our total reductions the $275 million.
Importantly, we will do this while still selectively investing in the company with initiatives such as ERP, vertical markets, emerging markets and our talent. Again, these are not easy decisions to make, but we believe these actions are necessary to properly position our company to move forward with our long term growth objectives.
It has been our consistent message we remain committed to ongoing efforts to improve efficiencies across our organization. Operating income was $70.5 million, a decrease of 59% year-over-year and 17% sequentially; operating income, as a percentage of sales decreased 190 basis points year-over-year due to a mix in gross margin pressure, sequentially our operating margin was down 40 basis points.
Our effective tax rate for the quarter was 31.6% and given a limited visibility with respect to our geographic sales and profitability, we currently have, we would expect this rate to hold for the remainder of the year. Net income was $37.2 million, down 64% compared with last year and down 13% sequentially.
Earnings per share were $0.31 on both a basic and diluted basis. This represents a decrease of 63% compared to last year’s second quarter on both a basic and diluted basis.
Mike said this marks our 11 consecutive quarter of positive cash flow generation with cash flow from operations in excess of $300 million and with over $1 billion generated over the last 12 months. Focus management of working capital enabled us to achieve a record low level of working capital to seams of 12.6%, a decrease of 290 basis points year-over-year, as we continue to efficiently manage all levels of our working capital.
This remains a critical aspect of our strategy as it creates flexibility for us as we go forward. Our balance sheet and capital structure remain strong, with conservative debt levels, net debt to capital at record low levels, and a net debt to EBITDA ratio of less than 1.5.
This gives us strength to participate to a greater extent in the overall marketplace. We have a conservative debt maturity profile with no maturities coming due until the fourth quarter of 2010.
We have more than enough cash to fund this. Now, more than ever, we believe there is a tremendous opportunity to reinvest in our business for organic growth.
Our financial strength and conservative balance sheet are competitive advantages that will allow us to draw future growth. In addition to our cash, our access to $1.4 billion in committed liquidity facilities provides us with flexibility to take advantages of opportunities that may arise as a result of the downturn.
We remain committed to creating shareholder value and generating returns in excess of our cost of capital over long term.
Mike Long
Thanks, Paul. We performed well in the second quarter, hitting the high end of our guidance and exceeding street estimates.
We have worked very hard over the last several years to make sure that we stayed financially strong and delivered solid levels of profitability while simplifying the business. We are cash flow positive throughout the cycle, have dramatically reduced our debt and have significantly improved our working capital management.
We fully expect to continue protecting our balance sheet to insure we remain financially strong, which will allow us to take advantage of any of the opportunities that may exist to grow the business. The additional $100 million in cost savings we have targeted will enable us to streamline our cost structure and continue to improve efficiency.
We showed you the evolution of our strategy at Investor Day and we are now going into the acceleration phase of that strategy. We fully intend to use the benefits of the efficiency gain from ERP implementations and the benefits of our balance sheet financial strength to go out and propel ourselves into new markets, new products and new customers.
As a result of our efforts, we are well positioned to gain market share. However, we view this as a long term strategy that we are working on and I know many of you on the call today are more interested in the near term.
As you heard us discuss business conditions remain challenges and we have seen accelerating sales declines in Europe, which is one of our most profitable businesses. As I said in the beginning of this call, we are taking the appropriate actions to maintain profitability and enhance operational efficiency while still moving forward with our strategy to growth sales and market share as well as optimize gross profit.
Nonetheless, our ability remains limited and we are not prepared to call the bottom. Looking ahead to the third quarter, we believe that total sales will be between $3.1 billion and $3.7 billion with global component sales between $2.1 billion and $2.5 billion and global enterprise computing solutions between $1 billion and $1.2 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 $0.25 to $0.37 per share.
Greer Aviv
Thank you, Mike. Please open the call to questions at this time.
Operator
(Operator Instructions) Your first question comes from Brian Alexander - Raymond James.
Brian Alexander - Raymond James
Just on the margin pressure on the components business, my quick math suggests that the gross margins in your components business were down maybe 100 basis points sequentially and maybe even 200 versus a year ago. Would you agree that’s kind of the order of magnitude we are talking about, and could you talk about how much of the margin decline in components is due to geographic mix versus competitive pressures?
Finally, on that subject, is more of that competitor pressure is it coming from competitors or is it more coming from the supplier community? And then I have a follow-up.
Paul Reilly
Hey. It’s Paul.
Thanks for joining us. Your numbers are in the ballpark, correct.
When we look at sequentially and year-over-year, about 50% of that change is driven by geographic mix. So that is the first driver absolutely the first driver.
Another driver would be a change in mix in our product sets, which impacts that and then finally as you suggested there is margin pressure more at, what I would call the customer level than at the GP level. So more at what we compete at the customer than from the supplier.
Brian Alexander - Raymond James
So, I guess the follow-up would be Paul, what’s going to cause gross margins in the components business to rebound from where they are today? Do you need to count on supply demand imbalances, IE shortages to drive the gross margins higher?
Or do you think even a gradual recovery could bring the gross margins back to where they were before? I’m just not clear how we get back to, where we were maybe three or four quarters ago?
Thanks.
Paul Reilly
If we had a hard allocation, in fact GP would go well ahead of where it was just four quarters ago. So, for sure there are lots of different bits and pieces that are impacting the margins going back-up, but the first thing that would happen is we show a stability and growth in North America and in Europe even at a slower pace than Asia Pac, GP would back up.
The second thing would be that, the pace of recovery could impact GP. So if this was to be a D-type recovery, we’d see a rapid increase in GP and if it was to be more like U, we’d see a more gradual increase.
We don’t see any indications that this is a permanent change in the way that customers approach to the business. I guess the last thing I would say, Brian is that remember the richer GP comes from supply chain engagements, and those are a much bigger percentage of our business in Europe and North America than they are in Asia Pac today.
So as those markets grow also, in addition to just having an impact on the leverage or in the mix, we’d also see an increase in supply chain engagements which have a higher or richer profitability profile.
Mike Long
Brian, this is Mike. I’d also like to add that, our design win activity is up to record levels not only in North America and Europe, but also in Asia and as those sales rebound with the new products coming out, they are at a much higher margin profile than we have right now.
So we do believe that, we’re in a position to regain most of the margin decline that we’ve seen.
Operator
Your next question comes from Craig Hettenbach - Goldman Sachs.
Craig Hettenbach - Goldman Sachs
If I could just follow-up on the gross margin and really put design creation. Do you have much visibility from your customers in terms of the pipeline and when those products would be set to release over the next couple of quarters?
Mike Long
Actually, what we have right now is limited visibility that we’ve set. The visibility in the go forward business, if you will would allow us to forecast out much longer than we can today.
Our customers today are really coming in and buying and augmenting the inventory that they have on their shelf, and thus are not making longer term commitments. That’s what gives us the limited visibility to what we’ve had in the past.
What we can tell you is, as the market starts to return, and we see those new products being released we have a higher percentage of designs today, than we have had at any other time, which would suggest that the margin on those would be higher and we would get a positive mix going forward, but that’s about as far as I can go and tell you right now given the visibility we are seeing from the customer base.
Craig Hettenbach - Goldman Sachs
If I could follow up on the topic of M&A, with the balance sheet and good shape and cash flow generation strong, any thoughts about potentially going on the offensive or what you seen in terms of opportunity for M&A both components and ECS.
Paul Reilly
So far today we continue to evaluate the opportunities we’ve seen in the marketplace that would help us round out our portfolio if you will and build some strategic capabilities that we couldn’t build internally. We have been and we are going to continue to be disciplined in how we evaluate these acquisitions to insure that they’re really aligned with our financial strategic and cultural goals.
So, regardless of where we are in the cycle, we are disciplined about our approach and we will be taking advantage of those opportunities as we do present themselves, either now or later in the cycle.
Craig Hettenbach - Goldman Sachs
Last one if I could, I know you mentioned the components business in North America has jumped around a bit, strong month of June, any visibility into the start of July here for North America components?
Paul Reilly
As we said, the North American business was inline with the low end of normal seasonality and we did experience a strong close to the month of June, which did carry into the first couple of weeks of July and both our bookings and billings showed an increase for the quarter and out backlog was up for the first time in several quarters. We did end June with a book-to-bill of 1.06 which is above the previous quarter and even a year ago level and we are also seeing that our cancellation rates are down to the lowest level we have seen in the last 12 months.
That’s why we believe that looking into the third quarter we’ll expect to be in line with normal seasonality.
Operator
Your next question comes from William Stein - Credit Suisse.
William Stein - Credit Suisse.
Following up on the last question and the comments from your Analysts Day about new vertical market focus and the components business, you kind of restated that on the call. Should we think about this as perhaps a shift in strategy, a bit more toward developing growth internally as opposed to acquiring companies?
Paul Reilly
I would call it augmenting. We are in a position that we can take advantage and will take advantage of opportunities that exist to help us grow geographically or by product, or augment our current quarter sales.
We are making sure that we can grow organically as well, and the vertical strategy is as a result of what fundamentally happened in the business over the last several years that a lot of the big CMs if you will have moved out of North America and what we are seeing now is a wider range of customers in different segments that have different requirements. So we’ve aligned our sales force to those segments, to give the customers that are here today, that are designing and growing their business more support and in essence attempting to grow our customer base at the same time.
William Stein - Credit Suisse.
Then on the system side, it seems that the guidance for next quarter is quite a bit higher than normal seasonality. Do I have that right and can I read that as maybe a bit of a push some revenue maybe on the server side, from June to September?
Paul Reilly
What we have seen is the, the business climate is still tough. What you may be see there can is a little bit of mix of your services software and storage.
They’re really helping us weather this downturn and they’re really helping us weather specifically the drop off in server sales. The visibility does remain a little limited.
We don’t see the bottom yet, but we are seeing a favorable mix in our forecast going forward r in the third quarter.
William Stein - Credit Suisse.
Really, I guess the point I am trying to make is I think normal seasonality is down about 10%, in September and do I have that right? And you are guiding I think…
Mike Long
Paul, do you want to.
Paul Reilly
Sure, Mike. You’re absolutely right.
The normal range is 5% to 15%, down in this quarter. Keep in mind we are a little bit disappointed in Q2.
We think we are going to get that back, but there is a meaningful impact when we start to see increases in product that’s like software and services, where we use net revenue accounting in accordance with U.S. GAAP and we have servers and storage where we use gross.
So really what we’re seeing is that we’ll see a bit of a clang in mix and that accounts for vast majority of the change when you look, and try to compare seasonality. Finally, also there is some impact from foreign exchange with the euro up by it look yesterday, but it’s up 141, 142 and in the second quarter it was like 136 for us or in that range.
So there’s an impact to that also.
Operator
Your next question comes from Matt Sheerin - Thomas Weisel Partners.
Matt Sheerin - Thomas Weisel Partners
So just following up on Will’s question regarding the computing business, as you said it was at the low end of your guidance. How much of that was affected by Sun Microsystems and the pending acquisition, where you saw any impact or negatively at fall customers there?
Paul Reilly
We did not see what we would call something abnormal between our suppliers in the quarter. That business for us held up pretty well going through quarter.
It was down some, but overall it wasn’t worse than our other suppliers. I do believe that with a little clarity around the Oracle and Sun merger that we will see benefits.
We’re partners with both of these guys, and I think that in the near term they’ll get it right and start putting out more information, but we don’t believe or I don’t believe what you had alluded to, and others have alluded to regarding the commission incentives affected us all that much as the distributor.
Matt Sheerin - Thomas Weisel Partners
So it was down evenly across your three platforms?
Mike Long
I think you could safely say that, yes.
Matt Sheerin - Thomas Weisel Partners
Then moving back to the components and your guidance there, I think you said that Asia which had been above seasonal levels in the last quarter or two is trending below seasonality a little bit in September. Is that right and can you explain that?
Mike Long
Yes, Peter, would you like to.
Peter Kong
Yes, I think that’s mainly because of the second quarter is a lot stronger than the normal seasonality. So as a result, you will see performance below seasonality.
Matt Sheerin - Thomas Weisel Partners
Would you say then there were some inventory build just in anticipation of production going up in the third quarter? Is that it?
Peter Kong
I think that happens actually in the second quarter. That is some inventory replenishment, which really drives the growth in the second quarter.
Matt Sheerin - Thomas Weisel Partners
Then Mike you talked about normal seasonal trends in North America and then below normal in Europe. Could you remind us what the seasonal trends are by region for components?
Mike Long
Yes, the North America seasonal trend is flat to minus 2%, in Asia its plus 15% to 20%, and Paul do you have the number off the top of your head for Europe.
Paul Reilly
Yes, Europe is also flat to minus 3%, 4% it’s impacted by currency also, but that’s the range what we see from Q2 to Q3.
Matt Sheerin - Thomas Weisel Partners
One final question if I may, regarding the cost reduction program, the new one in primarily in Europe; that looks like a big slug of your overall expenses there, obviously a pretty big undertaking over the next few quarters. Could you tell us how that plays out maybe by dollar amounts and when you start to see the real savings, and then also what you’re going to do to try to prevent any distractions or interruptions in business as you consolidate both offices and people?
Paul Reilly
Matt, in looking at it, you know and I guess everybody knows that you need to get work council approval before you can actually execute on these types of actions. So we’ve actually gone through and got a piece of that out.
Already there’s approvals are out and we’re waiting on some others, the work counsels have been support of actions as they face the realities of the economic conditions there. We’ll probably be at full run rate for the European piece in the fourth quarter, starting October 1 give or take, the rest of the world will see the impact at least for half of the Q3 time period also.
It is spread out across different functions and responsibilities. One of the things we are continuing to do is to protect the sales teams.
So, really what we are seeing is that there’s a minimal impact on sales compared to other functions. A lot of it is coming through delayering management; a lot of it is coming.
So those folks that are focused on customers are not being impacted in general and where there are sales type roles being impacted, that are very high level that’s not impacting the day-to-day execution with the customer? So, we would expect minimal impact, if any at all with the customer level.
That’s true even at the supplier level.
Mike Long
I would like to add to that, even with our first wave of cuts and the second wave, we have not been targeting our sales force or our design engineering sales force. As we have said we have seen design levels at a high rate.
That does have a direct impact on our margin, and our sales people do have a direct impact on our customer service. Those are two areas that given our strategy that we laid out at Investor Day that we want to make sure that we impact or save and keep those people employed as we go through the cycle.
Operator
Your next question comes from Steven Fox - CLSA.
Steven Fox - CLSA
First of all, a little bit surprised by all of the questions about normal seasonality given the cycle that we’re in terms of the recession. I was wondering some of the comments you made about what your customers are talking about in terms of component demand for the rest of the year.
If you step back and sort of gadget what type of recover we potentially can have, what are the good signs versus the bad signs you are seeing that you are seeing right now and we should maybe pay attention to.
Paul Reilly
Sure. A good sign is, as we have already highlighted to you has been the amount of design work that is going on in the field in all three regions.
We believe that even though the business has dropped off, that many customers are continuing to invest in new products and new technology; that as the market starts to return those sales will start to kick in. I can consider that something that givers me great comfort around the margin.
The negative cycle, Steve that we have also discussed with you has been the unpredictability of the daily sales rate, and those sales rates have a high fluctuation in them and once those daily sales rates start to level out and become more predictable, our visibility will go up. So, today while we have seen an increase in June in the North America business, we still see some volatile in the daily sale and that’s something that doesn’t give us enough comfort yet to call the bottom throughout the industry.
Steven Fox – CLSA
Secondly on the enterprise business, you mentioned deferrals, further look at just enterprise spending at the customer levels, was that a backward looking comment about the June quarter, or are you still seeing it in this quarter and what could it mean for the rest of the year when you we normally see a descent spending.
Paul Reilly
As you know, what we have moved into with the computer business is that the last month and specifically the last couple of weeks of the quarter have started to be the biggest ship days are not started, but the business has been more augmented by the tail end of the quarter. As we look at our pipeline, some of the systems if you will get pushed a little bit in to the next quarter.
I wouldn’t suggest that they go away; I would say that they do that for budgetary reasons. The funnel today we do believe supports the guidance we gave you, but again our visibility in this business is actually more limited than the components business, because the daily rates at the beginning of the quarter are at the most volatile for us.
Operator
Your next question comes from Shawn Harrison - Longbow Research.
Shawn Harrison - Longbow Research
Getting back to the restructuring savings, if my math is correct it’s about $0.60 and annualized benefits earnings are about $0.15 a quarter as you enter 2010. Are there any headwinds to that that would dilute the impact or should we expect earnings power because of these savings to improve $0.15 once the actions are completed?
Paul Reilly
Shawn, remember as a starting point, that we intentionally included in our first wave what I would call temporary cost savings and I use as an example, to sacrifice of employee benefits or reduction in target levels of incentives and furloughs. We’ve had some conversation that ‘what pace will they comeback when the recovery is in place?’
So when you look at it, I can’t tell you when they’re going to comeback, because I can’t tell you when the recovery is going to occur, but we’ve been very thoughtful in trying to project to the future that we had to cover those costs with other types of permanent actions. We think that’s in our next round of cuts of about $100 million.
That’s the one caveat put out there. Then as to your question itself, one other things that we have to be careful about is, the 175 is fully baked into Q2.
So then we got to talk about ‘okay, if you have $100 million plus going in,’ going forward, if you say, you got to cover the temporary costs that brings it down to 60, then you got a tax effected that’s $36 million bucks, that’s comes out to about $0.30 and you break that down by quarter, it’s about $0.07 by the time you get a full run rate, which we expect to be in Q4. So for sure we’ll see some EPS pick-up in 2010 as we get a full year impact, but I think it’s a little bit less than the numbers you were putting out there.
Shawn Harrison - Longbow Research
I wanted to be sure not to gross up the EPS impact too significantly. Second, just on your inventory positions, do you see on the components side continued inventory reduction activity in the back half of the year or are you happy with kind of where the turns are looking into the second half of ‘09?
Paul Reilly
Shawn, we are not troubled by where our inventory levels are today. We think that it’s the appropriate level for business activity in the third quarter.
If there was to be a pick up in activity levels in the fourth quarter, that we can see as we get through Q3, we might be increasing inventory levels to match that. If there was to be a decline in the fourth quarter, I would imagine sometime in the third quarter, we might trend downward.
What we’re really focusing on is, the quality of our inventory. Remember that that’s an important aspect going forward.
The other factor is that, we did see a pick up in what I would call some supply chain engagements in third quarter. Some times that inventory turns slower, so when it comes out it has an ordered effect on the inventory turns.
So we’re managing it in total. I don’t see a real need for us to reload hard or to drain it even harder and quite honestly we manage all the working capital as a single pool and actually what we’re focused on is, opposed to just one line item which would be the inventory.
Shawn Harrison - Longbow Research
Two final quick follow-ups, any updates on the Cisco you see as initiative and that maybe just commentary on share gains? I know they’re pretty strong over the past nine to 12 months?
Mike Long
Okay. On the Cisco, I think Andy, would you like to weigh in on that.
Andy Bryant
Well the Cisco process has been very good. We met with Cisco management in the month of July.
I think it’s safe to say, ours has been a very proactive two-way dialogue with how the value-added channel might benefit Cisco’s enterprise data center strategy. The channel executives for Cisco are in the pros of going through some decision making and I would expect that some time in the coming quarter a decision will be forth coming.
Mike Long
Your second question, around market share, thanks for noticing. Yes, we are pleased over the last couple of quarters and our sales force really rising up to the challenge and going out and generating some new business for us in this downturn.
The attitude for us of our sales force has been good. They continue to support their customers.
They continue to support them with design activity and making sure that their inventories are delivered on time. We are enjoying some of the highest rates, our fill rates if you will on time deliveries that we ever had.
So, we are not viewing our inventory as a problem, and all-in-all during the time our customer complaints are at an all low level. So we are pretty happy with the sales force continuing to support the customer base.
Shawn Harrison - Longbow Research
So, suffice to say that your rate of gains, you’re still continuing at a pretty similar level.
Paul Really
Right.
Operator
Your next question comes from Brendan Furlong - Miller Tabak
Brendan Furlong - Miller Tabak
Basically circling back, and a bunch of questions have been asked already, but on the component operating margin and weakness, how much of that is weighted to Europe and how much of it is gross margin related versus operating census.
Mike Long
When I look at it, it’s being driven by when you talk about the operating income level, two big factor, one is the sales decline, but as we’ve talked about we’ve been able to call back most of that drop in operating income percent through efficiencies and cost action. So the big driver this time around is gross profit.
As you mentioned about 40% to 50% of the GP decline in that business is driven by mix. Then if you look at the individual regions, so the other 50% which is driven by real margin pressure at the customer level, I would say that Asia-Pac and the North American businesses are right around the same level, though the level of pressure in Europe from the customer side is probably 2X, what we were seeing in the North American and Asia Pac regions.
Brendan Furlong - Miller Tabak
On the gross margin, by my estimates, roughly you’re below 13% on the gross margin line on components. When do you think you can get back over 13% again?
Just on the higher level, bigger picture, I know you’re not going to talk about 2010, but on the bigger picture level and gross margin for 2010, what should we think about it?
Mike Long
Again, one thing that we’ll be dependent will be upon the pace recovery, the second thing that we’ll be dependent upon is our growth initiatives with the vertical markets, whether they’re geographic, those have an impact also. The recovery will drive the phase of supply chain engagements and design wins going from new product R&D to new product introduction.
So a lot of it’s dependent upon the economy. One of thing that we had done; it’s really interesting when you look at it.
Our operating income percent is really if you break it down by region, very nice in our ECS, in our North American components, so both businesses in North America. You look in the Asia-Pac business, it’s still pretty stable there.
So, the big drag for us right now is Europe and we think these actions we are taking now, even with the minimal sales recovery in 2010 would get Europe back to more traditional levels of operating income performance.
Brendan Furlong - Miller Tabak
To the point on Europe, the PMI data of Europe and some of the semiconductor guids you’ve been supporting this earnings season, showing some incremental demand if you will on the industrial and even the auto segment out of Europe, should we expect somewhat of a seasonal Q4 for your component business out of Europe, better than it is right now, put it that way?
Mike Long
Well, as we said before, traditionally distribution tends to lag what we hear from your suppliers and while we have heard the same thing you did around the industrial market, and around the automotive market, we have not seen our booking rates stabilize that I’d be able to validate your question.
Operator
Your next question comes from Sherri Scribner - Deutsche Bank
Sherri Scribner - Deutsche Bank
I was hoping to dig into the balance sheet a little bit following on Sean’s question. In terms of the cash conversation cycle, at least my math and the way I calculate it, it looks like you’re at a pretty low level for your cash conversation cycle.
If you’re managing the balance sheet sort of as one group, would you expect those levels to stay the same as we move into 3Q and 4Q or do you think we’ve really hit a bottom on the cash conversion and you’ll start to see that tick-up through the end of the year?
Paul Reilly
I would say that our cash performance to-date and our cash-to-cash cycle has outpaced our expectations. So to keep rate of improvement every quarters sequentially is going to be tough for us.
I do think there’s opportunities for us to improve the cash-to-cash cycle and I think we’ll able to do that. To be perfectly frank, I’m not sure we’ll see that improvement in Q3, but for sure I would expect that to happen again in Q4.
Sherri Scribner - Deutsche Bank
Then in terms of the PP&E, it looks like it ticked up sequentially and it doesn’t look like your CapEx ticked up, so I’m just trying to understand, did you build something? Why would that number be moving up a little bit?
Paul Reilly
The major driver for our increasing PP&E and the major driver of capital expenditure is all around our ERP rollout and that’s the biggest driver. If you’re looking at it on a gross basis, if there’s any difference beyond capital expenditures, it would be because of the change and foreign exchange rates, which ticked up from the end of the March quarter, which is what you use for the balance sheet end of quarter, to the end of the June quarter.
Operator
Your next question comes from [Amanda Buroer] - Brean Murray.
Amanda Buroer - Brean Murray
I guess just a follow-up to the cash. The cash cycle, the result of which drove sort of net interest expense down pretty substantially in the quarter, given the way you guys are driving cash, is that the current level sort of the correct level to think off for the near future.
Can you even improve or are you guys internally even thinking of further improvement in that area?
Paul Reilly
Well we’re always looking at our capital structure, and one of the thing is that we have to make sure we strike the proper balance; it’ll be for all of our stakeholders. So that would be, our shareholders or lenders, our willing to finance the company for growth.
So those are the things that we have to balance out and they’re impacted in the short term by the credit markets themselves. So we’re constantly trying to evaluate that, but one thing we don’t want to do is to be in a position where we’re paying too much or too little interest, and we’ll just keeping managing that the best way we can.
Obviously, that’s also impacted by things like changes in interest rates on a macro basis. We have cash that’s invested that earns a return, and we also have fixed and floating rate debt next year.
So if rates were to go up, we’d earn more on a deposits, but we’d also have to pay a bit more on some of our borrowings, rates go down it’s just the inverse.
Amanda Buroer - Brean Murray
So I mean, I guess as a takeaway of all, sort of I guess current levels are reasonable, sort of twice triangular around for the near future until we see any significant changes in rates and stuff?
Paul Reilly
I would say that’s for sure for the third quarter and I’ll have to see how we come out of the quarter from a cash-to-cash cycle and what our cash flow generation is and then we’ll see our thoughts for Q4 at that time.
Amanda Buroer - Brean Murray
Then just one quick clarification follow-up, back to the inventory comments that you guys made and then your satisfaction of your current inventory levels going into 3Q; I just want to make sure those were with regard to your overall inventory and not just components inventory.
Paul Reilly
Absolutely, for the whole business.
Operator
Your next question comes from Jim Suva - Citigroup.
Jim Suva - Citigroup
Kind of a simple question here, it maybe difficult to answer, but when is Europe going to get to the level of operating at the level of being satisfied. It seems like we’ve been talking about Europe for quite some time long?
Paul Reilly
I’m going to take a shot at answering that one first. We’ve been talking about the decline in Europe probably for about three quarters.
Remember that historically and for sure we’ve seen that even now. The European marketplace has traditionally trailed North America by two to three quarters, that’s true.
This recession with the exception of the U.K., which probably entered the recession, because of the same type of mortgage pressures etc, at the same time the U.S. did.
So we’re seeing history repeated itself here. So we are at really one to two quarters now of acceptable level of performance in North America.
So I would suggest that we’re probably one to two quarters away; I would say two quarters, not one, quarters away from getting back to acceptable levels of operating income performance in European business. So, in my own mind I would say we fully expect internally to be back to acceptable levels January 1, 2010.
Though I’m hoping none of your European colleagues are listening, because we’re going to tell them we expect that October 1, 2009.
Operator
I would now like to turn the conference back over to our speakers for any additional comment or closing remarks.
Greer Aviv
Thank you. Before ending today’s call, for those participating in the webcast we will quickly scroll through the slide referenced in our webcast, that contain a reconciliation between GAAP and adjusted results.
This reconciliation is also included in our earnings release and both the release in this presentation will be available on our website. I would like to thank all of you for taking the time to participate in our call this morning.
If you have any questions about the information presented today, please feel free to contact Paul, Mike or myself. Thank you and have a nice day.
Operator
That will conclude today’s conference. We thank you for your participation.