| ARROW ELECTRONICS INC Item 1A Risk Factors |
| Described below and throughout this report are certain risks that the company’s management believes are applicable to the company’s business and the industry in which it operates |
| There may be additional risks that are not presently material or known |
| There are also risks within the economy, the industry and the capital markets that affect business generally, and the company as well, which have not been described |
| If any of the described events occur, the company’s business, results of operations, financial condition, liquidity or access to the capital markets could be materially adversely affected |
| A large portion of the company’s revenues come from the sale of semiconductors, which is a highly cyclical industry, and an industry down-cycle could have a material adverse effect on the company’s business |
| The semiconductor industry historically has experienced fluctuations in product supply and demand, often associated with changes in technology and manufacturing capacity, and is generally considered to be highly cyclical |
| During the last three fiscal years, sales of semiconductor products and related services represented approximately 53prca of the company’s consolidated sales, and the company’s revenues, particularly in its electronic components group, tend to closely follow the strength or weakness of the semiconductor market |
| For example, as a result of the semiconductor industry downturn in 2001 and 2002, the company’s revenues fell from dlra12dtta0 billion in 2000 to dlra9dtta4 billion in 2001 and dlra7dtta3 billion in 2002 |
| The company also generated a net loss in 2001 and 2002 |
| While the semiconductor industry has strengthened in recent years, it is uncertain whether this improvement will continue, and future downturns in the technology industry, particularly in the semiconductor sector, could have a material adverse effect on the company’s business and negatively impact its ability to maintain current profitability levels |
| If the company is unable to maintain its relationships with its suppliers, its business could be materially adversely affected |
| Substantially all of the company’s inventory has been and will be purchased from suppliers with which the company has entered into non-exclusive distribution agreements |
| These agreements are typically cancelable on short notice (generally 30 to 90 days) |
| There are also certain parts of the company’s business that rely on a limited number of suppliers |
| For a significant portion of the company’s Arrow Enterprise Computing Solutions business, the company relies on three suppliers |
| To the extent that the company’s significant suppliers are unwilling to do business with the company, the company’s business could be materially adversely affected |
| In addition, to the extent that the company’s suppliers modify the terms of their contracts with the company (including, without limitation, the terms regarding price protection, rights of return, rebates or other terms that are favorable to the company), or extend lead times, limit supplies due to capacity constraints or other factors, there could a material adverse affect on the company’s business |
| The company operates in a competitive industry and continues to be under the pressure of eroding gross profit margins, which could have a material adverse effect on the company’s business |
| The market for the company’s products and services is very competitive and subject to rapid technological change |
| Not only does the company compete with other distributors, it also competes for customers with many of its own suppliers |
| This is particularly true of the company’s larger customers whose volumes of purchases make them more attractive to suppliers for direct sales |
| Additional competition has emerged from third party logistics providers, fulfillment companies, catalogue distributors and on-line distributors and brokers |
| Additionally, prices for the company’s products tend to decrease over their life cycle |
| Such decreases often result in decreased gross profit margins for the company |
| There is also substantial and continuing pressure from customers to reduce their total cost for products |
| Suppliers may also seek to reduce the company’s margins on the sale of their products in order to increase their own profitability |
| The company expends substantial amounts on the value creation services required to remain competitive, retain existing business and gain new customers, and the company must evaluate the expense of those efforts against the impact of price and margin reductions |
| 8 _________________________________________________________________ [63]Table of Contents Further, the manufacturing of electronic components and computer products is increasingly shifting to lower-cost production facilities in Asia, most notably China |
| Suppliers in Asia have traditionally had lower gross profit margins than those in the United States and Europe, and typically charge lower prices in the Asian markets for their products, which places pressure on the company to lower its prices to meet competition |
| Thus, the company’s consolidated gross profit margins have eroded over time, from 16dtta7prca in 2003, to 16dtta2prca in 2004, and 15dtta6prca in 2005 |
| If the company is unable to effectively compete in its industry or is unable to maintain acceptable gross profit margins, its business could be materially adversely affected |
| Products sold by the company may be found to be defective and, as a result, warranty and/or product liability claims may be asserted against the company which may have a material adverse effect on the company |
| Products sold by the company are at prices that are significantly lower than the cost of the equipment or other goods in which they are incorporated |
| Since a defect or failure in a product could give rise to failures in the end products that incorporate them (and claims for consequential damages against the company from its customers), the company may face claims for damages that are disproportionate to the sales and profits it receives from the products involved |
| While the company and its suppliers specifically exclude consequential damages in their standard terms and conditions, the company’s ability to avoid such liabilities may be limited by the laws of some of the countries where it does business |
| The company’s business could be materially adversely affected as a result of a significant quality or performance issue in the products sold by the company, if it is required to pay for the damages that result |
| Although the company currently has product liability insurance, such insurance is limited in coverage and amount |
| Declines in value and other factors pertaining to the company’s inventory could materially adversely affect its business |
| The electronic components and computer products industries are subject to rapid technological change, evolving industry standards, changes in end-market demand and regulatory requirements, which can contribute to the decline in value or obsolescence of inventory |
| During an economic downturn, it is possible that prices will decline due to an oversupply of product and, therefore, there may be greater risk of declines in inventory value |
| Although it is the policy of most of the company’s suppliers to provide distributors with certain protections from the loss in value of inventory (such as price protection, certain rights of return and rebates), the company cannot be sure that such protections will fully compensate it for the loss in value, or that the suppliers will choose to, or be able to, honor such agreements |
| For example, many of the company’s suppliers will not allow it to return products after they have been held in inventory beyond a certain amount of time and, in most instances, the return rights are limited to a certain percentage of the amount of product the company purchased in a particular time frame |
| In addition, as discussed below, the company historically has sold products that contain substances that are now or will soon be regulated by various environmental laws |
| Some of the company’s inventory may become obsolete as a result of these or other existing or new regulations |
| The company is subject to environmental laws and regulations that could materially adversely affect its business |
| The company is subject to a wide and ever-changing variety of US and foreign federal, state, and local laws and regulations, compliance with which may require substantial expense |
| Of particular note are two recent European Union (“EU”) directives, known as the Restriction of Certain Hazardous Substances Directive (“RoHS”) and the Waste Electrical and Electronic Equipment Directive (“WEEE”) |
| These directives restrict the distribution of products within the EU of certain substances and require a manufacturer or importer to recycle products containing those substances |
| Failure to comply with these directives could result in fines or suspension of sales |
| Additionally, RoHS may result in the company having non-compliant inventory that may be less readily salable or have to be written off |
| In addition, some environmental laws impose liability, sometimes without fault, for investigating or cleaning up contamination on or emanating from the company’s currently or formerly owned, leased or operated property, as well as for damages to property or natural resources and for personal injury arising out of such contamination |
| As the distribution business, in general, does not involve the manufacture of products, it is typically not subject to significant liability in this area |
| However, there may be occasions, including through acquisitions, where environmental liability arises |
| Such liability may be joint and several, meaning that the company could be held responsible for more than its share of the liability involved, or even the entire share |
| In addition, the presence of environmental contamination could also interfere with ongoing operations or adversely affect the company’s ability to sell or lease its properties |
| The discovery of contamination for which 9 _________________________________________________________________ [64]Table of Contents the company is responsible, or the enactment of new laws and regulations, or changes in how existing requirements are enforced, could require the company to incur costs for compliance or subject it to unexpected liabilities |
| The foregoing matters could materially adversely affect the company’s business |
| The company is currently involved in the investigation and remediation of environmental problems at two sites as a result of its Wyle Electronics acquisition, and the company is in litigation related to those sites |
| As a result of its acquisition of Wyle Electronics from the VEBA Group (“VEBA”) in 2000, the company assumed Wyle’s outstanding liabilities, including the responsibility for certain environmental contamination at sites formerly owned by Wyle |
| Two sites are known to have such contamination, one at Norco, California, and the other at Huntsville, Alabama, and the company has thus far borne most of the cost of the investigation and remediation of each, under the direction of the cognizant state agencies |
| The company has expended more than dlra13 million to date in connection with these sites |
| The company has also recently received and is reviewing a demand regarding alleged contamination at a third site related to Wyle, in El Segundo, California |
| The agreement pursuant to which the company bought Wyle from VEBA contains an indemnification from VEBA to the company for all of the costs associated with the Wyle environmental obligations |
| VEBA’s successor-in-interest, EON AG, acknowledged liability under the VEBA contractual indemnities with respect to the Norco and Huntsville sites, and made a small initial payment, but has subsequently refused to make further payments |
| As a result, the company has initiated litigation against EON AG and certain others in the United States District Court for the Central District of California and in the Regional Court in Frankfurt am Main, Germany |
| The company believes strongly in the merits of its case and the probability of recovery from EON AG, but there can be no guaranty of the outcome of litigation, and should the company lose on all of its claims in both cases, it would bear all of the cost of the Wyle environmental obligations |
| Because characterization and remedial design is not yet complete at any of these sites, the future costs in excess of accrued costs associated therewith are as yet undetermined and could have a material adverse effect on the company |
| The company has accrued the minimum of the estimated range of costs associated with the Wyle environmental obligations and, during the fourth quarter of 2005, has recorded a dlra10dtta3 million offset relating to the probable recovery of costs from EON AG In addition, the company is, along with other parties, a defendant in a suit filed by 91 plaintiff landowners and residents in Riverside County Court in California for personal injury and property damages allegedly caused by the contaminated groundwater and related soil-vapor found in certain residential areas adjacent to the Norco site |
| Wyle Laboratories, formerly a division of Wyle Electronics, has demanded defense and indemnification from the company in connection with the litigation, and the company has, in turn demanded defense and indemnification from EON AG The claims for indemnification are at issue in the US District Court and Frankfurt Regional Court proceedings |
| While the company believes strongly in the merits of its claim for indemnification against EON AG, and has no reason to believe that the plaintiff’s allegations of damages in the Norco matter pending in Riverside County have merit, there can be no guaranty regarding the outcome of either matter, and should the company be found to be liable for damages to the Riverside plaintiffs and EON AG found not to be liable to indemnify the company for those damages, it could have a material adverse effect on the company |
| The company may not have adequate or cost-effective liquidity or capital resources |
| The company needs cash to make interest payments on and to refinance indebtedness, and for general corporate purposes, such as funding its ongoing working capital and capital expenditure needs |
| At December 31, 2005, the company had cash, cash equivalents, and short-term investments of dlra580dtta7 million |
| In addition, the company currently has access to credit lines in excess of dlra1dtta1 billion |
| The company’s ability to satisfy its cash needs depends on its ability to generate cash from operations and to access the financial markets, both of which are subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond its control |
| The company may in the future need to access the financial markets to satisfy its cash needs |
| The company’s ability to obtain external financing is affected by its debt ratings |
| Any increase in the company’s level of debt, change in status of its debt from unsecured to secured debt, or deterioration of its operating results may cause a reduction in its current debt ratings |
| Any downgrade in the company’s current debt rating could impair the company’s ability to obtain additional financing on acceptable terms |
| Under the terms of any external financing, the company may incur higher than expected financing expenses and become subject to additional 10 _________________________________________________________________ [65]Table of Contents restrictions and covenants |
| For example, the company’s existing debt agreements contain restrictive covenants, including covenants requiring compliance with specified financial ratios and a failure to comply with these or any other covenants may result in an event of default |
| An increase in the company’s financing costs or a breach of debt instrument covenants could have a material adverse effect on the company |
| The agreements governing some of the company’s financing arrangements contain various covenants and restrictions that limit the discretion of management in operating the business and could prevent the company from engaging in some activities that may be beneficial to its business |
| The agreements governing the company’s financings contain various covenants and restrictions that, in certain circumstances, could limit its ability to: • grant liens on assets; • make restricted payments (including paying dividends on capital stock or redeeming or repurchasing capital stock); • make investments; • merge, consolidate or transfer all or substantially all of its assets; • incur additional debt; or • engage in certain transactions with affiliates |
| As a result of these covenants and restrictions, the company may be limited in how it conducts its business and may be unable to raise additional debt, compete effectively or make investments |
| The company’s failure to have long-term sales contracts may have a material adverse effect on its business |
| Most of the company’s sales are made on an order-by-order basis, rather than through long-term sales contracts |
| The company generally works with its customers to develop non-binding forecasts for future volume of orders |
| Based on such nonbinding forecasts, the company makes commitments regarding the level of business that it will seek and accept, the inventory that it purchases, the timing of production schedules, and the levels of utilization of personnel and other resources |
| A variety of conditions, both specific to each customer and generally affecting each customer’s industry, may cause customers to cancel, reduce or delay orders that were either previously made or anticipated |
| Generally, customers cancel, reduce or delay purchase orders and commitments without penalty |
| The company seeks to mitigate these risks, in some cases, by entering into noncancelable/nonreturnable sales agreements, but there is no guaranty that such agreements will adequately protect the company |
| Significant or numerous cancellations, reductions or delays in orders by customers could materially adversely affect the company’s business |
| The company’s non-US locations, particularly Asia, represent a significant and growing portion of its sales, and consequently, the company is increasingly exposed to risks associated with operating internationally |
| In 2005, approximately 47prca of the company’s sales came from its operations outside the United States |
| During 2004 and 2003, approximately 46prca of sales were from locations outside the United States |
| As a result of the company’s foreign sales and locations, its operations are subject to a variety of risks that are specific to international operations, including the following: • import and export regulations that could erode profit margins or restrict exports; • the burden and cost of compliance with foreign laws, treaties and technical standards and changes in those regulations; • potential restrictions on transfers of funds; • foreign currency fluctuations; • import and export duties and value added taxes; • transportation delays and interruptions; • uncertainties arising from local business practices and cultural considerations; and • potential military conflicts and political risks |
| 11 _________________________________________________________________ [66]Table of Contents In the event the company makes acquisitions, it may not be able to successfully integrate such acquisitions or attain the anticipated benefits |
| While acquisitions no longer represent a major part of the company’s core growth strategy, the company will continue to consider financially attractive and strategic acquisitions as opportunities arise |
| If the company is unsuccessful in integrating the acquisitions it does make, or if integration is more difficult than anticipated, the company may experience disruptions that could have a material adverse effect on its business |
| In addition, the company may not realize all of the benefits it anticipates from such acquisitions |
| For example, a certain portion of the purchase price for most acquisitions is considered goodwill, an asset |
| In the event that an acquired company does not perform as anticipated, the value of the goodwill may have to be written down, which could have a material adverse effect on the company |
| If the company fails to maintain an effective system of internal controls or discovers material weaknesses in its internal controls over financial reporting, it may not be able to report its financial results accurately or timely or detect fraud, which could have a material adverse effect on its business |
| An effective internal control environment is necessary for the company to produce reliable financial reports and is important in its effort to prevent financial fraud |
| The company is required to periodically evaluate the effectiveness of the design and operation of its internal controls over financial reporting |
| These evaluations may result in the conclusion that enhancements, modifications or changes to internal controls are necessary or desirable |
| While management evaluates the effectiveness of the company’s internal controls on a regular basis, these controls may not always be effective |
| There are inherent limitations on the effectiveness of internal controls including collusion, management override, and failure of human judgment |
| In addition, control procedures are designed to reduce rather than eliminate business risks |
| If the company fails to maintain an effective system of internal controls or if management or the company’s independent registered public accounting firm was to discover material weaknesses in the company’s internal controls, it may be unable to produce reliable financial reports or prevent fraud and it could have a material adverse effect on the company’s business |
| In addition, the company may be subject to sanctions or investigation by regulatory authorities, such as the Securities and Exchange Commission or The New York Stock Exchange |
| Any such actions could result in an adverse reaction in the financial markets due to a loss of confidence in the reliability of the company’s financial statements, which could cause the market price of its common stock to decline or limit the company’s access to other forms of capital |
| The Commerce Department may levy substantial fines on the company or may limit its ability to export products |
| Under US Export Administration Regulations (“EAR”), administered by the Bureau of Industry and Security of the Department of Commerce (“BIS”), licenses or proper license exceptions are required for the shipment of certain US goods and technology to certain countries, including China, India, Russia and other countries in which the company operates |
| Non-compliance with the Export Administration Regulations can result in a wide range of penalties including the denial of export privileges, fines, criminal penalties, and the seizure of commodities |
| In September 2004, the company made a preliminary, voluntary disclosure to the BIS advising them that it suspected that its Hong Kong subsidiary, Arrow Asia Pac, Ltd, may have exported or re-exported certain products without the required licenses |
| The company performed a review of its historical shipments from North America and the Asia/Pacific region to determine the number and nature of any violations |
| In March 2005, the company advised the BIS that it had identified 28 export or re-export shipments, over a five-year period, that may constitute violations of the EAR The statutory maximum civil penalty for each violation of the EAR identified is dlra11cmam000 for all but two of the shipments in question, which are subject to a higher statutory maximum civil penalty of dlra120cmam000 per violation |
| However, because it is not known whether the BIS will agree with the company’s count or characterization of the violations, and because penalties for such violations may also include export prohibitions or restrictions, it is not possible at this time to determine the extent of the penalties the company may incur |
| In the event that BIS views these shipments as violations of the EAR, the company could be fined significant sums and/or its export capabilities could be restricted |
| The company relies heavily on its internal information systems which, if not properly functioning, could materially adversely affect the company’s business |
| Any of these systems are subject to electrical or telecommunications outages, computer hacking or other general system failure |
| Moreover, the company recently initiated the design of a new global financial system |
| The implementation and 12 _________________________________________________________________ [67]Table of Contents installation of this system will be complicated and will take more than a year to finalize |
| There is no guarantee that the implementation will be successful or that there will not be integration difficulties that will adversely affect the company’s operations or the accurate recording and reporting of financial data |
| Failure of its internal information systems or material difficulties in upgrading its global financial system could have material adverse effects on the company’s business |