Stuck in the Middle

Arrow Electronics' Bill Mitchell sees "services" as the panacea for his commodity company. If only they made more money.
Wholesaling is a tough way to make a living--especially if what you are selling is in a downward price spiral. That sums up the business of Arrow Electronics of Melville, N.Y. 

Arrow spent 15 years buying up smaller distributors to gain efficiencies and pricing power. It links 600 suppliers of computer chips, capacitors and myriad other components with 150,000 customers that make subsystems for PCs, cell phones and autos--a $50 billion market. Now consolidation is ebbing, and Arrow--and rival Avnet in Phoenix--look a lot like hamsters on wheels. Huge contract manufacturers like Flextronics and Solectron are buying more parts directly from suppliers, cutting out distributors, while prices for chips (half of Arrow's total sales) drop 30% annually. For the 12 months through March, Arrow earned $235 million on revenue of $10.7 billion, an anorexic 2.3% net margin; Avnet, with $10.9 billion in sales, eked out 1.6%. 

So maybe it's no surprise that Arrow's chief executive, William E. Mitchell, is preaching the power of "services"--a familiar bromide and ostensible refuge for commodity industries. By services Mitchell means anything beyond matching suppliers with customers--such as providing financing, on-site inventory management, parts-tracking software and chip programming. On the supplier side Arrow collects fees (in the form of cheaper parts prices) for helping parts- makers win placement in the latest electronic gadgets. 

Wall Street has bought the pitch: Services have helped triple Arrow's share price, to $29, or 14 times trailing earnings, in three years. 

But the trouble with services: getting paid for them. "It looks good in an annual report," quips Robert Freid, president of Contract Manufacturing Consultants. Savvy buyers wrangle services from distributors by agreeing to buy more components, undercutting margins on the contract. "Customers will and can use the components business against you to gain the services," admits Darr Greenhalgh, Arrow's director of supply chain solutions. 

And lots of electronics customers wonder what all the fuss is over services anyway. "I have a hard time trying to understand the value [distributors] are bringing," says Twee Pham, marketing director at Express Manufacturing, a $50 million (sales) maker of circuit boards for telecom and water systems. Express tried letting a big distributor (which Pham won't identify) manage its component inventory on-site but eventually dropped the service because it figured it could manage on its own. 

Mitchell insists services should help boost Arrow's return on capital from 9% to between 12% and 15%. Mighty optimistic: The last time that figure cleared 12% was during the bull market in 1996, according to Value Line. (Unlike IBM, Hewlett-Packard and others, Arrow doesn't report figures for services separately in its P&L.) "We add several points of margin where we [offer] services," Mitchell says. 

Mitchell, who took the helm in 2003, has been here before. In the late 1990s, after 20 years at electronics maker Raychem, the industrial engineer from Princeton turned Memorex's dying data storage business into what became an $800 million "global services" division within Solectron. 

Success at Arrow will mean bagging more customers like AMX Corp. in Richardson, Tex. The $100 million (sales) maker of audio and video equipment used to buy parts from Avnet and Canada's Future Electronics. Two years ago Arrow stole the account by offering a slew of services geared to bringing AMX's products to market faster and cheaper. For instance, Arrow keeps three material planners on-site at AMX who handle parts flow and look for ways to substitute parts that Arrow can supply for less. 

Result: AMX's total procurement costs have dropped 20% and new products take just 7 months to get to market versus 15, says AMX operations head Carl Evans. In return AMX gave Arrow an exclusive supply contract worth at least $20 million annually. Arrow says the relationship is profitable; Evans is so happy that he gives presentations at road shows for Arrow investors. 

Funny thing about that AMX pitch, though. While the key to selling services is demonstrating the value customers should receive for those extra fees, Evans admits that he was never completely certain that Arrow, for all its nifty services, could save AMX any money. Says he: "You had to have some faith." 

Mitchell, in another stab at services, is beefing up software that helps customers identify parts that are easily available, soon to be obsolete or made according to new environmental standards. A valuable service, perhaps--so long as smaller customers don't feel sloughed off. "My impression was that the salespeople weren't being pushed to help me anymore," says the president of a $4 million circuit-board assembler in Illinois. 

Kishor Patel, owner of Absolute Electronics in Menomonee Falls, Wis., poses perhaps the biggest hurdle for Mitchell and services: "Everybody is doing the same thing," Patel says. "The only difference is how many lines they carry." And, of course, the price.