Avnet Inc

NASDAQ:AVT

Earnings Call Analysis

Declining Sales and Restructuring Efforts

The company reported a 19% year-over-year revenue decrease with adjusted operating margins falling to 3.9%. Electronic Components saw a 16% drop in operating income, and Farnell's operating income fell by 7%. The company is implementing restructuring actions targeting $50-$70 million in annual expense reductions, 25% of which are completed. The firm anticipates challenging quarters ahead due to competitive pressures but expects inventory levels to decrease in the upcoming quarters. Third-quarter guidance is set for sales between $5.55 billion to $5.85 billion and diluted EPS of $1.05 to $1.15.

Quarterly Performance in a Challenging Economic Climate

In the recent earnings call for Avnet's second quarter of fiscal year 2024, the company reported sales of roughly $6.2 billion, aligning with their guidance but representing an 8% decline year-over-year and a 2% decline sequentially. Economic softness, initially emerging in Asia and now widespread, in combination with high inventory levels, has led to lower demand from customers, particularly in the industrial, consumer, and communications verticals. Despite a general decline, shipments of single board computers increased significantly, up 32% quarter-over-quarter. Operating margins saw a decrease to 3.9%, and the company experienced a 19% decrease in adjusted operating income to $242 million year-over-year.

Inventory Challenges and Strategic Maneuvers

Avnet faced inventory-related impediments, with a reported increase mainly attributed to Supply Chain as a Service engagements and foreign currency fluctuations. The core Electronic Components business's inventory remained steady, but reductions are anticipated in the upcoming March and June quarters. The company is also targetting a decline in inventories for Supply Chain Services in the foreseeable future. On a more practical note, to navigate through the existing inventory challenges, and efforts are underway to decrease overall levels and optimize cash flow throughout the remainder of fiscal 2024.

Sector-Specific Insights and Market Expectations

Defense and transportation markets continued to present relative strength in terms of demand, while other sectors struggled. Lead times for semiconductors are improving, and pricing remains stable. The management is not expecting significant price reductions for most products shortly. They have also communicated to suppliers a clear view of true end-market demand to manage expectations and inventory levels accurately.

Regional Performance Variability

Reviewing Avnet's performance on a regional level, sales in the Americas showed slight growth sequentially but dipped year-over-year. In Asia, despite sequential growth, there was a significant year-over-year decline, with transportation and communications as strong sectors. Europe, the Middle East, and Africa (EMEA), experienced both sequential and year-on-year declines, partially attributed to going up against a tough comparison from the previous year's records.

Operational Efficiency and Restructuring Efforts

In response to current market conditions, Avnet has engaged in a series of restructuring initiatives, particularly within its Farnell business. Actions taken are aimed at reducing operating expenses by $50 million to $70 million annually, with about a quarter of this reduction already realized as the company ended the second quarter. Additional actions are expected to be completed by the end of the fiscal year.

Financial Health and Capital Allocation

Avnet has witnessed a quarterly increase in working capital days, negatively impacting return on working capital. Regarding financial health indicators, the company reported an increase in debt and a higher interest expense, which detracted from adjusted diluted earnings per share. Nonetheless, Avnet maintains a gross leverage of 2.6x and has substantial committed borrowing capacity. The firm has also prioritized capital expenditures, such as the construction of a new distribution center in EMEA, and plans to normalize CapEx in the latter half of fiscal 2024.

Outlook and Guidance for Upcoming Quarters

Looking ahead to the third quarter of fiscal 2024, Avnet anticipates sales to range between $5.55 billion and $5.85 billion, with diluted earnings per share expected to be between $1.05 and $1.15. A sequential sales decline of 6% to 11% is projected, partially due to the typical seasonality observed in the Western regions and the impact of the Lunar New Year in Asia. The company remains committed to driving positive cash flow and sustaining shareholder value through dividends and share repurchases when opportune.

Management's Confidence Amid Market Softness

Despite challenging market conditions and the anticipation that market softness could persist, Avnet's management remains confident in their competitive position and their historical success in managing through various market cycles. The consensus among executives at supplier partners is to expect continued market challenges in the upcoming quarters, and potentially through calendar 2024. Still, Avnet believes its strategic actions and experience will help navigate this uncertain period effectively.

Earnings Call Transcript 2024-Q2

[Operator]

Welcome to the Avnet Second Quarter Fiscal Year 2024 Earnings Conference Call. I would now like to turn the floor over to Joe Burke, Vice President of Treasury and Investor Relations for Avnet.

[Joseph Burke, executive]

Thank you, operator. I'd like to welcome everyone to the Avnet Second Quarter Fiscal Year 2024 Earnings Conference Call. This morning, Avnet released financial results for the second quarter fiscal year 2024 and the release is available on the Investor Relations section of Avnet's website, along with a slide presentation which you may access at your convenience.

As a reminder, some of the information contained in the news release and on this conference call contain forward-looking statements that involve risks, uncertainties and assumptions that are difficult to predict. Such forward-looking statements are not a guarantee of performance and the company's actual results could differ materially from those contained in such statements. Several factors that could cause or contribute to such differences are described in detail in Avnet's most recent Form 10-Q and 10-K and subsequent filings with the SEC.

These forward-looking statements speak only as of the date of this presentation, and the company undertakes no obligation to publicly update any forward-looking statements or supply new information regarding the circumstances after the date of this presentation.

Today's call will be led by Phil Gallagher, Avnet's CEO; and Ken Jacobson, Avnet's CFO.

With that, let me turn the call over to Phil Gallagher. Phil?

[Philip Gallagher, executive]

Thank you, Joe, and thank you, everyone, for joining us on our second quarter fiscal year 2024 earnings conference call. I am pleased to share that we delivered another quarter of solid financial results, which was in line with our guidance.

In the quarter, we achieved sales of $6.2 billion. This was slightly above the midpoint of our guidance, down 2% sequentially and down 8% year-over-year. We achieved operating margins of 3.9% highlighted by a 4.3% operating margin in our Electronic Components business. We've been working through an inventory correction on a global basis over the past couple of quarters. In addition, we're also facing weak and uncertain economic conditions which began in Asia, including China and are now present in the West. This economic softness has resulted in lower demand with some of our customers, which is being magnified by elevated inventory levels across the supply chain.

In the quarter, demand was mixed across the diverse end markets we serve. Defense and transportation markets continue to show relative strength, while demand in the industrial, consumer and communications verticals was relatively soft. As semiconductor lead times continue to improve, the pricing environment remains stable, which is a positive sign. And for the majority of the products, we do not expect overall pricing to decline meaningfully in the near term as we see it today. We continue to manage our backlog and close coordination with our customers and suppliers to align with current softening market conditions. Our backlog activity is centered on pushouts and reschedules rather than cancellations, which are within a normal range. Shorter lead times, however, are contributing to backlogs being lower year-over-year and sequentially. As a result of these factors, our book-to-bill ratio continued to be below parity, though modestly above last quarter.

Although our reported inventory levels were up, the increase was driven by a combination of Supply Chain as a Service engagements and foreign currency. Excluding these items, inventory for our core EC business was relatively flat. And our teams are confident that inventory levels for this core business will come down over the remainder of fiscal 2024. Ken will provide further color on inventory and our supply chain as a service offerings.

As I mentioned previously, we are in the midst of an inventory correction. And our team has done a really nice job navigating it with a focus on optimizing our inventory investments today and reducing inventory levels in the coming quarters. We provide our supplier partners with our best read on true end market demand for our customers. I've said it before, we view inventory as a vital asset to fuel our business. But with the near-term sales outlook, we are focused on reducing inventory, were elevated and improving our cash conversion cycle. With that, let me turn to the highlights for our business. At the top line, our Electronic Components business saw mixed results across the regions. In constant currency, electronic component sales were down 1% sequentially and 9% year-over-year. Sales in the Americas were up 1% sequentially and declined 6% year-on-year with defense and transportation as the strongest end markets. Sales in Asia were up 2% sequentially and down 10% year-on-year. In Asia, transportation and communications were our strongest end markets. EMEA sales were down 7% sequentially and 10% year-on-year in constant currency. It is worth noting that EMEA had near record sales in the December quarter last year, [indiscernible] are going up against a tough compare. In EMEA, we are seeing softening in the industrial and transportation sectors.

For our Farnell business, as expected, sales and profitability were impacted by softening demand, product mix and competitive pricing pressures. Farnell sales were down 6%, both sequentially and year-over-year in constant currency. Operating margins for Farnell were 4% during the quarter, which is disappointing but in line with our stated outlook. Despite the greater-than-expected sales decline, we were able to hold our operating margin as we began to see the benefits from some of the cost reduction actions we have already taken. We still believe Farnell has a great potential to deliver value to customers, suppliers and is an important part of the Avnet portfolio. We are focused on improving operating margins near term while further leveraging the breadth of Avnet's customer base and sales force to identify growth opportunities. Our team is focused on several growth and margin expansion opportunities, including demand creation, IP&E and Embedded Solutions.

In the quarter, our demand creation design wins and registrations remained strong, and demand creation revenues as a percentage of total revenue was stable on a sequential basis. We are also pursuing growth in our IP&E business. IP&E products have higher gross margins, and there are many cross-selling opportunities with IP&E components that are complementary to our semiconductor business. Finally, we see exciting opportunities with our embedded business, where we offer embedded board and display solutions. We have the capability to offer both custom solutions and third-party solutions, both of which come with higher gross margins. We continue to find ways to leverage our global sales force and technical capabilities to capitalize on these embedded growth opportunities.

Our supplier partners value Avnet's ability to create solutions for customers that leverage their entire portfolio of products. The importance of solutions selling highlights why our suppliers continue to support our demand creation efforts. They are also focused on increasing customer count and leveraging the long tail of the industrial sector to generate growth. Our suppliers continue to part with Avnet and distribution in general to help them drive the growth they are seeking. As exciting as these opportunities are, we are still in the midst of an uncertain market. Over the past several weeks, I have met with several CEOs and decision makers at our supplier partners, representing nearly half of our revenues. The consensus sentiment among this group is that overall market softness will continue for at least a couple more quarters, but could extend through calendar 2024.

To conclude, we are confident that our strong competitive position and our experience managing through many prior market cycles will serve us well as we navigate through these choppy waters. I want to thank our team for their dedication and commitment. We believe our people and our culture are key differentiators for Avnet, which enables us to compete well in any market environment.

With that, I'll turn it over to Ken to dive deeper into our second quarter results.

[Ken Jacobson, executive]

Thank you, Phil, and good morning, everyone. We appreciate your interest in Avnet and for joining our earnings call. Our sales for the second quarter were approximately $6.2 billion, in line with guidance and down 8% year-over-year. On a sequential basis, sales were down 2% in constant currency as expected due to seasonal declines in the Western regions in the December quarter. From a regional perspective, sales in EMEA and the Americas each declined by 6% and Asia sales declined 10% from the year ago quarter. From an operating group perspective, electronic component sales declined 8% year-over-year and 9% in constant currency. EC sales declined 1% quarter-over-quarter in constant currency. Farnell sales declined 4% year-over-year and 6% in constant currency. Farnell sales were also 6% lower sequentially in constant currency. Sales of single board computers continue to ramp, increasing 32% quarter-over-quarter. For the second quarter, gross margin of 11.4% was 29 basis points lower year-over-year and 43 basis points lower quarter-over-quarter. EC gross margin was flat year-over-year and declined sequentially primarily due to a seasonal mix shift to Asia. Farnell gross margin was down sequentially and year-over-year, largely due to an unfavorable sales mix and from competitive pricing pressures for on-the-board components.

Turning to operating expenses. Adjusted operating expenses were $464 million in the quarter, down 4% year-over-year and down 5% sequentially. Operating expenses were down 6% in constant currency year-over-year. As a percentage of gross profit dollars, adjusted operating expenses were 66% in the second quarter, 68 basis points higher than last quarter. For the second quarter, we reported adjusted operating income of $242 million, which decreased 19% year-over-year. Our adjusted operating margin was 3.9%, which decreased 57 basis points year-over-year and decreased 23 basis points quarter-over-quarter. By operating group, Electronic Components operating income was $248 million, down 16% year-over-year. EC operating margin was 4.3%, down 43 basis points year-over-year and 34 basis points lower sequentially. The sequential decline was primarily due to a combination of lower sales and a seasonal mix shift of sales to Asia.

Farnell operating income was $16 million, down 7% year-over-year. Farnell operating margin was 4% in the quarter, down 20 basis points quarter-over-quarter and was impacted by lower sales an unfavorable sales mix and competitive pricing pressures related to on-the-board components, which was partially offset by lower operating expenses. As we discussed last quarter, Farnell has begun undertaking a wide range of restructuring actions to reduce operating expenses and improve gross margins. Overall, we are targeting annual expense reductions of between $50 million to $70 million, of which approximately 25% was already completed as we exited the second quarter. The majority of the restructuring actions at Farnell will be completed by the end of the fiscal year. We anticipate the next few quarters will be challenging for Farnell as continued demand and competitive pressures for on-the-board components may dampen the expected benefits of lower expenses. Although these restructuring actions are necessary to ensure Farnell has a sustainable operating expense model through any cycle, we do not take these actions lightly as they impact our people.

Turning to expenses below operating income. Second quarter interest expense of $74 million increased by $15 million year-over-year and increased $4 million quarter-over-quarter, primarily due to higher average borrowings. This higher interest expense negatively impacted adjusted diluted earnings per share by $0.12 year-over-year. Our adjusted effective income tax rate was 24% in the quarter as expected. Adjusted diluted earnings per share was in line with expectations at $1.40 for the quarter.

Turning to the balance sheet and liquidity. During the quarter, working capital increased by $328 million sequentially,including an increase in reported inventories of $361 million, $171 million decrease in receivables and $138 million decrease in payables. As a result of this working capital increase, working capital days were 107 days for the quarter, an increase of 6 days quarter-over-quarter. Our return on working capital decreased quarterly on the higher working capital and lower operating income.

Let me take a moment to give more color on inventory and the sequential increase in inventory this quarter. The overall increase in reported inventories was driven by an increase in inventory specific to supply chain service engagements and also from changes in foreign currency exchange rates. Inventory related to our traditional core EC business remained flat and was stable in the December quarter. We continue to have line of sight on incoming inventory while we work through the challenges created by elevated inventory levels across the supply chain. Although we are disappointed that inventory for our core EC business remains flat, we are confident these inventory levels will start to decline in the March and June quarters. From a supply chain as a service perspective, we continue to see an increase in opportunities for this service offering. The customer base for these engagements are typically large OEMs who have historically done their business directly with our suppliers. These OEMs and suppliers are prioritizing resiliency in their supply chains as a lesson learned from the past few years of component shortages, which is driving an increase in these opportunities.

As a reminder, these service engagements are separate from our traditional core EC business as the associated inventory is really the inventory of the OEM or the supplier that we hold on their behalf. The inventory is contractually restricted and the risk profile is different compared to inventories held for our core EC distribution business. The increase in inventories for supply chain services was specific to a few newer engagements that ramp towards the end of the quarter. We would expect inventories for Supply Chain Services to be flat to down slightly in the third and fourth quarters for our existing engagements. Our team remains highly focused on reducing inventory levels [ where ] elevated which will help us drive cash flow from operations in the second half of fiscal 2024. The increase in working capital led to an increase in debt of $279 million. During the quarter, we used $42 million of cash for operations. However, over the past 4 quarters, we generated $169 million of cash from operations. We expect to generate positive cash flow in the third quarter in excess of the cash used for operations during the first half of fiscal 2024. We ended the quarter with a gross leverage of 2.6x, and we had approximately $493 million of available committed borrowing capacity. With regard to our capital allocation, we continue to prioritize our existing business needs, including working capital and capital expenditures.

During the second quarter, cash used for CapEx was $82 million, primarily to support a new distribution center being constructed in EMEA. We expect CapEx to return to historical levels in the second half of fiscal 2024 of approximately $25 million to $35 million per quarter. In the second quarter, we repurchased approximately $59 million [ for ] shares. We used the cash proceeds from our recent legal settlement to buy back shares during the first and second quarters. We have $232 million left on our current share repurchase authorization entering the third quarter. We also paid our quarterly dividend of $0.31 per share or $28 million. For the long term, we remain committed to our road map of delivering a reliable and increasing dividend and share repurchases to increase our shareholder value when we believe our shares are undervalued by the market. Book value per share improved to approximately $55 a share or a sequential increase of approximately $3 a share. As we generate cash flow from operations in the second half of fiscal 2024, we expect to use the cash for a combination of debt paydown and for buying back shares.

Turning to guidance. For the third quarter of fiscal 2024, we are guiding sales in the range of $5.55 billion to $5.85 billion and diluted earnings per share in the range of $1.05 to $1.15. Our third quarter guidance is based on current market conditions and implies a sequential sales decline of 6% to 11%. This guidance assumes sales declines for the Western regions versus typical seasonality of sales growth and a seasonal decline in sales from Asia due to the Lunar New Year. This guidance assumes similar interest expense compared to the second quarter, an effective income tax rate of between 22% and 26% and 91 million shares outstanding on a diluted basis. Implied in our guidance is an EC operating margin above 4%. Although there is some uncertainty in the overall market environment we are currently in, our team will continue to focus on the things that we can control or influence. This includes being disciplined with our operating expenses, driving working capital reductions and cash flows and winning new opportunities that drive profitable growth and continued market share gains.

With that, I will turn it back over to the operator to open it up for questions. Operator?

[Operator]

[Operator Instructions] Our first question is from William Stein with Truth Securities.

[William Stein, analyst]

I'd like to ask -- I was going to ask about inventory, but maybe given the way you addressed it already, it sounds like it's really more of a supply chain issue. So -- a supply chain engagement issue. So let me instead ask about that. We've heard Avnet talk about supply chain engagements for quite some time. I wonder if you can talk to us about the differences between that business and the more traditional electronic components distribution whether it might warrant reporting the revenue separately and the inventories for that separately? And maybe talk about the different dynamics there sort of inventory turns in that business versus the core returns on invested capital, other metrics that you're targeting in that business? And I do have a follow-up, if that's okay.

[Philip Gallagher, executive]

Yes. WIll, thanks. This is Phil, and I'll probably turn it over to Ken. So -- and that's what we're working to clarify in the script, okay, to start breaking that out a little bit more. And we'll pull that string as we move forward. Supply chain is kind of a generic term, too. That's why we're kind of defining it as a service because supply chain is what we do. And you're right, we've been doing that for years with our traditional supply chain and our traditional core customers, whether it be consignments of implant stores, compound, point of use for [ point ] systems, et cetera, et cetera. That still exists. That's still a big part of our business. The ones that we're kind of breaking out in the call today and we started to a couple of calls ago, the supply chain as a service are really large OEMs that maybe traditionally weren't utilizing our supply chain services that are now coming to us. And they are different financial models, different inventory carrying and working capital models, even with different financing.

So that let me turn it over to Ken. He can give -- articulate a little bit more color on that. But I appreciate the question. We'll continue to work to break that out and explain more in the future. Ken?

[Ken Jacobson, executive]

I'd just say, the message we want to kind of convey is that the broader inventory for the EC business is stable. We're disappointed that it hasn't gone down yet, right, because that's something the team is actively driving to do, but we do see line of sight to some reductions in that core inventory to go in the next couple of quarters. As the supply chain as a service inventory, I mean that happens to be our accounting, our reporting, is within our inventory. We're beginning to give a little bit more color at least on the balance sheet will. So I think the path for further clarity would be first on the balance sheet and then moving to the P&L as those engagements ramp. And so here's how I'd characterize the difference. I mean, I think the first thing, these are really large engagements typically, right? So the magnitude of the throughput of components is much bigger. And that's mostly driven by the fact that the, let's say, the end customer here in these service arrangements are typically large OEMs. And what we try to comment on it, these are the ones that we typically haven't been doing business with because they have direct relationship with suppliers and they have their own partners they use. And so this is new opportunities for us because we haven't really played in the big OEM space.

So transportation is one opportunity, but it's really across all end markets that we're seeing, including, let's say, communications and networking and things like that. But typically, the engagements are driven by the OEM. And typically, what's happening is we're kind of procuring on their behalf the inventory that they were normally buying at their pricing most likely, right? So they might have a direct contract or other pricing. So it's not, let's say, normal course fulfillment or anything like that. This is really buying based on their contract. And so the main difference we see is the inventory profile we try to talk about it's not really our inventory even though we report it as such. It's their inventory, there's contractual restrictions, right? So it's really providing the service on their behalf. So from an overall profile, typically the gross margin is better, but it's not really a top line revenue because of the fact that it's services revenue versus revenue from the sale of components.

From a return on invested capital, return on working capital, it's at or above typically where other engagements would be at. We look to find creative working capital solutions for these types of engagements. In some cases, we'll finance it or we'll fund it through our own working capital or borrowing capacity. But a lot of times, we're either trying to have the OEMs bring cash to the table or looking for third-party programs to help us finance that and our commitment really not only to our supplier partners, but also to our teams is the fact that we're really not trying to restrict our existing business, right? We want to have this be an and, not an or, and so we really don't want to consume our working capital to fund these engagements because we want to protect that for the normal horse of business to grow our long tail of customers and things like that. So hopefully, that adds the color you're looking for. And again, we'll continue to add transparency as these things ramp and get bigger.

[Philip Gallagher, executive]

Great explanation, Ken. And well, it is a good question. Apologize for a lengthy answer because it is complex, and we want to be transparent. And what brought some of these on is the breakdown in supply chain late over the last 3 years, and where customers got caught short as we all know, right, with the shortages and the stoppages and supply chain. So some of these opportunities even come those from our suppliers have being asked is beginning to be asked to do things that maybe is not in their core. So they bring it to us and we go work it together. So I'll leave it at that, and then we can pick it up later, if you like.

[William Stein, analyst]

If I could just ask one follow-up. So I think you've made this explanation of the increased inventory from the from the supply chain engagements or supply chain as a service engagements, but I think you said that the -- for the core EC and Farnell business, it was flattish and you were trying to bring it down. All the semi companies I cover have -- or most of them have talked about a significant decline in channel revenue in the last couple of quarters. And I'm just trying to -- obviously, I don't cover every semi company in the world, but I'm wondering if you can help me sort of reconcile these data points when many of the larger semi companies are talking about channel sales being down any way that you might be able to reconcile that I can't recognize, it's not so obvious to me.

[Philip Gallagher, executive]

Clarification, channel sales to the channel. Will, you are talking about our sales out [ and ] sales into us.

[William Stein, analyst]

In.

[Philip Gallagher, executive]

Well, our sales out, I think we guided. I mean, so we hit the December. So we were pleased with that. So -- and we believe we gained some share. Sales in all the suppliers are a little bit different. Obviously, there's a few that probably need a little bit more help than others. But we're -- even when we're up in inventory I've said this before. It's not across all the suppliers. I mean we could use more inventory in a lot of areas that still might be a little tight. It's in a handful of suppliers that might even be heavier ship in debit. So I think the important thing is we're working on our suppliers, as we said in the script, I mean every day with our customers trying to balance the true demand as best we can see it in the outlook and we pipeline accordingly. But overall, the behavior from the suppliers has been good. They've been good partners. And as we said, I think 2 calls [indiscernible] there's 1 or 2, we've had some opportunistic opportunities that we've taken advantage of, and it's been a win-win.

[Operator]

Our next question is from Ruplu Bhattacharya with Bank of America.

[Ruplu Bhattacharya, analyst]

Phil, in the prepared remarks, I think you said that you can -- your conversations with the CEOs have been showing that market softness in the last couple of quarters or through 2024. I think last quarter when we spoke, the thought was that the channel is going through an inventory correction, which is until the mid of 2024. Has your thought process on that changed as your viewpoint changed do you think that the inventory correction take longer? And do you see like -- it just sounded like you think that the markets are going to be weaker longer. Just your overall thoughts on that?

[Philip Gallagher, executive]

Yes. I think -- I still think it's somewhere around midyear. I might stretch into the September quarter, Ruplu. Things have changed. I mean, things changed in 90 days -- from 90 days ago with some of the softness in industrial and whatnot, we pointed out, and our suppliers are pointing out. But I still think it's [ mid-'24 ] into December for the inventory correction. And then we'll see if there's growth or statement remains flat through 2024. It's just too far out to call that. But I do think as we bring our inventory down, which we believe we would do in the next several quarters. That would be a positive sign. We'll spin off cash and we'll go from there, and then we'll see what kind of growth the market dictates at that point in time.

[Ruplu Bhattacharya, analyst]

Okay. Let me ask, Ken, a question on margins. I think you said EC margins in the guide can stay above 4%. So can you comment on what revenue level you need to see to keep those margins above 4%. And the same question on Farnell margins. How should we think about that trending over the next couple of quarters? What are the puts and takes there? I mean it was at 4% this quarter. Do you think there's a chance that -- how quickly can that recover? What do you need to see there?

[Ken Jacobson, executive]

Yes. Maybe I'll take the Farnell question first, Ruplu. I'll just say I think in the December quarter, the Farnell sales were a little softer than we had anticipated, which kind of hurt the ability to provide a healthier operating margin. We have the expense actions ongoing. But I think the challenge with Farnell is really competitive pressures on the board components. Now that the on-the-board components are more available with lead times coming down, right, there's less demand from the catalog or high service distributors. And then on top of that, the high service competitors have a lot of inventory, including Farnell having a lot of inventory, so that's putting further pressure on the pricing. So we're seeing those 2 headwinds. And so that's why we kind of gave the outlook that it's going to be a tough couple of quarters for Farnell as that business gets through the inventory we feel decent that margin levels have stabilized, but unfortunately, they're a little lower than we had anticipated. And the cost actions are going to take a little time as well. So that's why we kind of signaled it's going to be perhaps more of the same for the next couple of quarters with Farnell with opportunity to kind of uplift that margin modestly over the -- as we ended the year.

Talking about the EC business, what I would say is I think implied in the guidance, which I talked about a little bit is normally, we would get a seasonal uplift in the West, right? So we get a robust shift in business from Asia to the West, which helps on the margin. We're still seeing some of that, but because the West is expected to be down in the March quarter versus typically up, we're not getting the uplift that we normally would see there with a favorable mix. And so what I would say is, hey, we're kind of at the revenue levels, right, to kind of maintain that. But typically, we're not going to get into the fourth quarter. But typically, you see Asia rebound a little bit coming off the Lunar New Year. So that would be typically what would happen in the fourth quarter, as you'd see Asia up a little bit from whatever they do in the March quarter.

But with that being said, we're continuing to drive it. And as Phil noted, we're going to control expenses. And we're going to continue to work on that core inventory, and we wanted to go from stable to down where that inventory is elevated, the team is working on it. And so we're going to focus on the cash flow and getting the inventory down. And try to compete well in the market where we have opportunities. We're still seeing some opportunities out there, but it's definitely more challenging than it was 9 days ago.

[Ruplu Bhattacharya, analyst]

Okay. Let me just sneak one more in. You mentioned expenses. Maybe both for you and Phil. Phil, I think you said you're making investments in the sales force? I mean you talked about demand creation and IP&E and embedded. So I guess my question is, do you need to invest in more sales force to train them or to hire more people. At the same time, you're doing restructuring in Farnell. So I mean if you can reason like what your expectation is for OpEx as a percent of gross profit going forward and the type of investments you see happening over the next couple of quarters?

[Philip Gallagher, executive]

Yes, you got it Ruplu. I'll let Ken answer that [indiscernible] in that GP. Look, we've been managing our expenses. I mean we have not increased our expenses as a percent. And we've been actually -- I always say that, yes, we're always reducing expenses while we need to make investments. And some investments might be in productivity tools, RPAs, things on those lines now artificial intelligence/machine learning. So we're putting more and more investment behind the, I'll call it, the digital side of the equation. As far as sales force, our field application engineers, our design solutions and yes, we mentioned embedded. We're well staffed there. We've invested there appropriately. We are not removing investments in that space that drives the growth and the profitability of the company. So there's no movement of foot in the core to adjust anything in those areas. And we've articulated clearly, we'll come back more on the Farnell restructuring is separate as Ken pointed out. Ken, on net GP.

[Ken Jacobson, executive]

Yes. I mean I think sales are coming down Obviously, Ruplu implied in the March guidance that the OE to GP is going to be impacted accordingly in terms of percentage. But I would just think about it as kind of flattish. I mean, where we are making investments, we're trying to self-fund we are focused on expense discipline. So what I would say is we're kind of more of the same outside of Farnell, but depending on our view of how long the demand softness may look at, we might have to take a harder look at more expense actions. But again, anything we do there, we're going to protect for the medium term and long term and really focus on the opportunities we see out beyond the horizon of where the demand is soft.

[Operator]

Our next question is from Joe Quatrochi with Wells Fargo.

[Joseph Quatrochi, analyst]

A couple if I could. Maybe just kind of first sticking with the Farnell. The cost restructuring that you're putting in place, do we think about that $50 million to $70 million is flowing to the bottom line for the total kind of company P&L? Or are there areas that maybe there's a little bit of offset from a cost perspective just as we're thinking about OpEx?

[Ken Jacobson, executive]

Yes. I think first thing I'd say is it's an annual amount, and I think there are other factors to consider. So I'd say I don't know that I would be a direct one for one. It depends on volume and other things. But I think from a Farnell perspective, right, I think that you can kind of start to build that in to the operating margin as we exit the year.

[Joseph Quatrochi, analyst]

Okay. And I assume you meant fiscal year. And then just as a follow-up to that. Maybe just kind of trying to understand what's changed from 90 days ago and just understanding maybe it's the kind of the mix of demand of the areas that are starting to maybe see incremental weakness I guess, how do I think about just your exposure, the mix exposure of, say, industrial to like Western regions relative to Asia and just kind of what's incrementally weaker relative to last quarter?

[Philip Gallagher, executive]

Yes, I'll take that, Joe. Thanks. I think what we've seen it vary global basis, I'd sum it up that where we've seen probably the greater weakness and it's been very strong and really some of those would be in the industrial space, okay? And that's our -- let's call it between 25% and 33% of our business is industrial. It's really broad, okay? But that's come down a little bit sequentially and year-on-year. That's been particularly strong. The industrial has been particularly strong in Europe. And Europe, as we pointed out, has had 3 record quarters until this past quarter. So we've been performing well as that got soft that obviously affects us. If you look at the transportation overall, I know there's a lot of mixed signals out on transportation. That's still holding up pretty good. It's down sequentially and down year-on-year, but I would say modestly in single digit. So still holding up and it's actually up in the Americas was more down in Europe, again, which is our second largest vertical. Defense, unfortunately, with what's going on in the world today is actually quite healthy, and we see that continuing to stay strong.

[Operator]

[Operator Instructions] Our next question is from Matt Sheerin with Stifel.

[Matthew Sheerin, analyst]

Phil, I wanted to get back to the inventory issues. I appreciate the commentary about the supply chain engagements as a service. But it seems like it's more -- you're actually you're buying the inventory, you're carrying the inventory, that's a working capital burden for you. And so when you talk about inventory, and I know it's restricted, but that's still inventory on your books, right? So when we think about your over 100 days of inventory, what's the target for the next 2 to 3 quarters? And is there a thought to given to working with OEM customers, where they're actually owning the inventory, it's more consigned so it's a true as-a-service model because it seems like it's a traditional model where you're carrying the cost of that inventory.

[Ken Jacobson, executive]

Matt, I mean -- this is Ken. I guess I'd start with is, I think there's alternative forms of funding of the inventory in general, right of the components part of what you're talking about is really an accounting versus how you actually perform the service, right? So you need physical custody, you need in our warehouses to move it, right? You think about the OEM that may not have manufacturing and things like that. So this gets to a lot of complications in terms of there's one, how you account for it and how we report it in our financials, and there's 2, is how do you actually conduct the service for OEMs that are without manufacturing footprints and things like that, right? So I think there's tax things, legal entity things that get into why someone like Avnet needs to step in to provide the service versus other parties.

So I guess how I'd characterize it, we do feel it's a different risk profile. We do feel that we've got enhanced protection for this product versus, let's say, normal course of business product. So we do view it differently, even if it's currently reported in the same line item as the other inventory, and that's what we're trying to convey. But part of that becomes in, how do you provide the service. And if it's consigned then that means something that OEMs could already do the supply chain on their own, right? In some cases, it's not consigned, but it's -- the capital is provided by the OEMs in some cases, they want capital being part of the service, right? So it's a mixed bag. And our view is we're trying to maintain flexibility to provide the services they need but measure it based on the returns we get and the fact that it won't restrict our normal course of business opportunities, right, with the capital restriction, right? We've got enough, let's say, elevated inventory levels in our normal course of business, we're not compounding the issue, if you will with these engagements. And that's been transparent with the customers we're working with. And so they kind of understand that this is kind of separate.

[Philip Gallagher, executive]

Yes, Matt, so it's just -- thanks, Ken. Yes, the inventory days are certainly up a little bit higher than we'd like it to be. And as I said in the script, we're not -- I mean, inventory is not a bad thing. We have maybe a little too much, but it's not aged, it's not a liability. We do want to start bringing it down in the March quarter as we bring it down relative to the sales, it's a math issue, the days of inventory. So we would expect to [indiscernible] come down as well. But the key is just making sure we got the quality inventory as we bring it down, start generating more cash. So again, we got to support the market that we see going forward and balance the right investments in inventory is one of the big ones.

[Matthew Sheerin, analyst]

Got it. And then just related to that, your interest expense obviously has gone up significantly, it looks like it's kind of -- it's a $300 million run rate for fiscal '24. 2 years ago, it was $100 million. That's obviously a huge swing in EPS. So Ken, is that a priority in terms of working down at short-term borrowings and getting that interest expense down.

[Ken Jacobson, executive]

Yes, Matt, 100%. I mean, I think the -- we need to get the cash flow and that cash is going to be used in part for debt pay down, right? I mean there's a combination of factors driving that. But clearly, the elevated inventory is a big piece of that over the past year and even longer than that. So I would say that is a focus. And the cost of borrowing is definitely much more expensive than it was in the past, but we need to get that down. And it's going to take some time, though, I would caution.

[Operator]

Our last question is from Toshiya Hari with Goldman Sachs.

[Toshiya Hari, analyst]

The first one is on long-term margins. And Ken, I think this predates you as a CFO. But back in June '22 at the Analyst or Investor Day, you guys threw out a medium-term operating margin target of above 5%. And I realize we're at the close to the trough of the cycle. But Farnell, I think at the time, operating margins were in the mid-teens. You're currently at 4% or 5%. I think EC has held in really well. But do you think the above 5% cross cycle or medium-term target is still intact and you're comfortable with that? Or have there been sort of fundamental permanent changes that would kind of swing that view?

[Ken Jacobson, executive]

Yes. Thanks, Toshiya. I mean I'm generally familiar with, obviously, those targets to put out. And I would say we are not coming off of those targets. We see opportunity. Now clearly, we're a little bit backwards, right? So we've got to get back to where we were. But again, the EC business holding up in the third quarter. You mentioned the trough. I've just knocked on wood there. But let's -- we see opportunity, and we see that some of the markets we're in have growth, we do see right now, Phil made some commentary that pricing in general is holding up pretty well. We are still focused on gross margin. So even if there is pressures on some level of pricing, what we're focused on those higher margin opportunities. We use supply chain as a service as higher margin. Phil talked about demand creation, IP&E, some of our embedded solutions products. So those are all higher-margin type opportunities relative to kind of the baseline margin we have. And then Farnell, obviously, getting that back is key, and that's going to take longer than we would have liked or expected because of where -- how far down has come, but we still see those opportunities medium term. And we think the overall health of our business and the overall opportunities we're seeing when we talk to our supplier partners, I mean I think we're definitely excited for the future, even though it's going to be some choppy waters here for the next couple of quarters.

[Toshiya Hari, analyst]

Okay. That's helpful. And then as my follow-up on free cash flow generation going forward. You guys spoke to a declining inventory or managing that better going forward. You also noted that CapEx should normalize lower, I forget at what point, but you talked about that. So it feels like you've got pretty good tailwinds from a free cash flow perspective, middle part of the year, back half of the year. A, is that the right way to think about sort of the trajectory of free cash flow; and b, if there's any quantitative guidance you can provide on that, that would be super helpful for perhaps calendar '24.

[Ken Jacobson, executive]

Yes, I think that's right. I mean I wouldn't get into calendar '24, but what we did say for this next quarter for the March quarter was cash flow in excess of what we used in the first half of the fiscal year and that the CapEx levels are normalized, so we would expect positive free cash flow in the third quarter. And to answer your question, as the inventory goes down, right, then the cash flow accelerates, -- so we see line of sight to that in Q3 and Q4. We're not going to give quantitative numbers, but we see lots of opportunity and we want to drive large cash flow numbers.

[Operator]

Ladies and gentlemen, there are no further questions at this time. I'd like to hand the floor back over to Phil Gallagher for closing remarks.

[Philip Gallagher, executive]

Great. Thanks a lot. And I want to thank everyone for attending today's earnings call, and I look forward to speaking to you again at our third fiscal quarter earnings report in May. Thank you very much. Have a great rest of the week.

[Operator]

Ladies and gentlemen, this does conclude today's conference. You may disconnect your lines at this time. Thank you for your participation.