Arrow Electronics (Arrow) is an example of a company that is effective at driving alignment between operating and business models.
Arrow distributes electronic components and provides enterprise computing solutions to customers worldwide. The customers are OEMs and value-added resellers (VAR) that resell to end consumers and come from a range of industries such as clean energy, infrastructure, and transportation.
Arrow is a truly global operating company with offices in over 55 countries and customer reach in over 200 countries. It is the leader in the components distribution business in the US, EU and China. It has a sizable inventory of $2.5 billion against total current assets of $8 billion (31%). It has a huge salesforce with worldwide coverage and boasts an engineering force to help customers design components or advise on IT solutions.
What is interesting about Arrow is its ability to maintain operating margins of 4% to 5% over the past decade despite the fact that the electronics and IT industry has been rapidly maturing and commoditizing, compressing prices across the industry. Its ability to maintain operating margins comes from its consistent sale of high margin customized products and management of supplier costs. These advantages are enabled through Arrow’s use of technology, labor and intellectual property, key components of Arrow’s operating model.
Arrow offers customers the ability to design its own customized products. It has a design platform (link) that allows customers to design products using either one’s own block diagram or Arrow’s library of templates (called reference designs), and then to export it to a computer-aided design belonging to the customer or to Arrow.
Arrow also provides field application engineers who act as consultants to help customers work out their operating goals and help them choose or design products to serve such goals. Engineers are not billed for their consulting services, so they add value much like a salesperson would for a “pure fulfillment” product (i.e. non-customized product with lower margins) but they are more than salespersons in that they offer technical expertise.
Arrow also provides auxiliary services using its own intellectual property. For example, it offers analytics to forecast life cycle demand for customers, assuring them of delivery, helping them reduce supply gap and the risk of purchasing counterfeit or dangerous products.
Furthermore, Arrow also offers a complete design-to-delivery system for customers. Through a process called “programming”, Arrow allows a customer to send them their design code, and then creates and ships the end product to the customer in an efficient and secure manner, protecting customer’s intellectual property and increasing design flexibility.
In summary, this operating model offers (i) interactive consumer technology, in the form of the web-based design platform, as a design tool for the customer; (ii) integrated labor, in the form of engineer-as-salesperson, that helps identify and articulate an operating need of the customer into a design that serves that need; and (iii) intellectual property, in the form of forecast analytics, that helps the customer determine product order levels. Arrow thus transforms its assets into high margin, profit-generating assets for the customer and ultimately for itself.
When an engineer is able to secure a design from a customer, it is called a “design win.” Through a design win, Arrow secures for the supplier the order of the product and the set of components that make up the product. The supplier then awards Arrow through discounting (e.g. through rebates, price adjustments) its supplies to Arrow, thereby lowering Arrow’s COGS and boosting operating margins. There is usually a tenure to a customer order of 12 to 18 months, during which time inventory is predictable, minimizing Arrow’s working capital associated with inventory purchases.
Arrow’s ability to secure a design win is based on proprietary resources: its design platform’s library of reference designs, forecasting analytics and programming are proprietary and are difficult to replicate at low cost. Its operating model therefore creates and sustains its competitive advantage over other competitors and deters suppliers from forward integration.
Because the design is worked with the customer, Arrow does not incur R&D expenses for any customized products, and Arrow’s operating expenses consist only of SG&A (around 10% of revenues), which includes compensation for staff, maximizing operating margin. This is quite amazing. Thus while the operating model transforms technology and labor into profit-generating assets, sustaining the business model, revenues are redistributed to technology and labor, thereby sustaining the operating model.
Sources: Interview with Steven O’Brien, Director of Investor Relations on December 7, 2015; 2015Q2 Earnings Transcript; 2015Q3 Earnings Transcript; 10K, 2015Q3 10Q.