Like its longtime rival Arrow Electronics, electronic components distributor Avnet is amidst a gritty transformation of its business, driven by fast-changing customer needs.

Making the kind of move that’s clearly not for the faint-hearted, in February 2017 Avnet — 128th in the most recent Fortune 500 ranking — completed the sale of its technology solutions division. The computer-products distribution business had contributed roughly 40% of the company’s revenue.

The sale, together with a handful of acquisitions Avnet has made since 2016, facilitated the company’s pursuit of its key new strategies. For one, it has refocused efforts on its traditional core business, the heart of which is distributing semiconductors to technology manufacturers.

But that’s only part of a broader reinvention of Avnet, similar to one that Arrow (113th in the Fortune ranking) is undertaking as well. The vision, kicked off in Avnet’s case by its 2016 acquisitions of U.K.-based Premier Farnell and Hackster.io, is to support customers at every stage of product lifecycles, from idea creation through prototype design, manufacturing modeling, product introduction, volume production, and product distribution.

From a finance standpoint, Avnet has set a goal of improving its operating margin from approximately 3.5% currently to 4.5% to 5% within three years.

“Traditionally Avnet was a high-volume, low-margin business,” says the company’s finance chief, Tom Liguori, a recent visitor at CFO’s New York offices. “Prototype engineering is just the opposite — low volume but very high margin.”

How so? For an original equipment manufacturer, time to market is crucial. An engineer can go online to Premier Farnell and order one of every item in a bill of materials, and receive all of them the next day.

“If I’m the prototype engineer, I’m going to get those items, make the prototype, test it, make revisions, and then tomorrow I’m going to do the same thing,” Liguori notes. “And I’m going to keep doing it until I get my design perfected.”

Customers similarly interact with Avnet through each stage of the product lifecycle, and the company’s transaction-based monetization model is thus designed to drive higher margins. Ultimately, customers may order components for the product in large quantities through Avnet’s historical distribution business.

The future could be bright for semiconductor makers and distributors, given booming demand for wireless Internet of Things devices and applications. Serving that demand puts Avnet in the business of writing software code and partnering with platform providers like Microsoft and AT&T to deliver connectivity and security.

Avnet’s customers — numbering some 2.1 million individual engineers — encompass both large manufacturers and startups. Part of the company’s business model is providing online communities that help engineers improve their skills and products.

For example, with the acquisition of Premier Farnell, Avnet gained that company’s element14 community, a discussion-based forum where engineers collaborate to solve one another’s design challenges.

Also, Hackster.io offers education on programming and building hardware.

Dragon Innovation, a company Avnet acquired last August, allows customers to accelerate their time to market by helping them discover fast, simple, and safe ways to manufacture at scale.

Pain Points

It hasn’t all been smooth sailing for Avnet, however. Most notably, a botched ERP implementation in 2015 wrought severe consequences.

“It was a big-bang-type implementation — unplug that one, plug in this one,” says Liguori, who joined Avnet in January 2018, several months after the former CFO stepped down for health reasons. “What immediately happened was that customer-service reps lost a lot of basic things, like the quantities customers ordered and when orders were due. So we had a lot of problems serving our customers.”

As a result of subsequent customer defections, Avnet lost about $1 billion in revenue.

There’s never a good time to lose a billion dollars. But the problems caused by the ERP mess played out during the same time that new CEO William Amelio, who came aboard in late 2016, was spearheading Avnet’s transformation, including the acquisitions and the sale of the computer-distribution business.

The company canceled an investor day scheduled for May 2017 as it continued its efforts to recover from the sales shortfall and refine its messaging about the transformation of the business.

Making matters worse, when Liguori arrived early this year he discovered that Avnet was not competitive from a working capital standpoint.

“The first thing we did was a 10-year history of days receivables, days inventory, and payables,” the CFO says. “What we saw was that the company used to work with net working capital days in the mid-60s. For many reasons, some valid and some just taking our eye off the ball, we ended up at more than 100 days.”

Liguori then set out on a benchmarking effort, working with its banks to assess the working capital efficiency of 11 competitors. The finding: the other companies were averaging 52 net working capital days.

In June, at Avnet’s first investor day since 2015, the company announced a plan to reach a target of 70 net working capital days within three years. That would free up about $1 billion, according to Liguori.

What’s the plan to make that happen?

The answer is not forcing customers into shorter payment terms or delaying payments to suppliers. “There are market terms, and we have to assume we’re going to do those,” Liguori says. “It’s more about blocking and tackling. It’s about discipline.”

For example, improved visibility of inventory in company systems allows procurement to be more efficient.

“Until six months ago, someone in Asia that needed a part for inventory didn’t have visibility into whether the Americas or EMEA could provide that part,” the CFO says. “We had way too many instances where people were buying parts they didn’t have to buy.”

Also, some of the company’s messaging around buying protocols was “off,” Liguori adds, so procurement people were buying parts the company didn’t need at all.

On the receivables side, customers increasingly want to pay for purchases using credit cards or PayPal, and Avnet has to do more to accommodate that. “If you can move from giving somebody a 30-day payment term to having them just use their company P-card to pay, you don’t have a receivable anymore,” Liguori says.

As for payables, Avnet was using many different payment cycles in various regions and countries. In some places vendors were being paid once per month, in others as often as twice a week. Looking at all of the arrangements, the finance team decided that one Avnet unit in Europe had a best practice, which was paying vendors twice per month. That’s now becoming a company-wide standard.

“These are just a few examples,” Liguori says. “What I tell investors is that there’s no silver bullet that’s going to bring our working capital days down where we need them to be. There are going to be many, many examples, and we’re going to manage it centrally.”

Giving Back

Improved working capital was one of three key strategic finance priorities that Avnet outlined at the recent investor day.

However, the savings to be generated from the working capital discipline will be useful for capital allocation, which is the focus of another finance priority. “It will be great to take some money out of our working capital and redeploy it into M&A activities or share buybacks, which offer higher returns,” Liguori says.

There may be opportunities for some “tuck-in” acquisitions of companies that Avnet partners with, he notes. While there are currently no specific plans, 20% of the company’s cash flow is to be allocated for that purpose.

Another 20% of cash flow is earmarked for investment in company systems and warehouses.

The rest, 60% of cash flows, is for shareholders. Avnet began a dividend a few years ago and has been increasing it 5% to 7% annually. The dividend will continue to increase at the same rate, “but that’s only going to take 10% of our cash flow,” Liguori says. “That leaves 50%, and we’re going to use it for buybacks.”

Given the plan to increase operating income over three years, Avnet considers its stock to be undervalued. “If we can buy back stock today at $40, but we think it’s really worth $60 or $70, that will be a very good return for investors,” he notes.

Cost-Minus

The third priority for Avent finance is cost optimization. Efforts in that area break down into four buckets, which collectively are designed to take out $246 million in costs.

First, some of the company’s back-office operations, including inside sales reps, are in low-cost labor markets like Guadalajara, Serbia, and India. Putting more of its activities in such markets is expected to save $50 million.

Another $50 million gain is expected to arise from reviewing and adjusting the number of management levels and spans of control. The company’s acquisition binge has resulted in some excess in that area. It also brings a $40 million opportunity to consolidate back-office operations, standardize processes, and integrate all company operations into the ERP system, which is SAP.

The other $86 million in savings is expected to come from other miscellaneous transformation initiatives. To support them, two years ago the company hired a chief transformation officer, Pete Bartolotta.

“A lot of times when you do cost reduction, it’s a one-time project and it’s done,” Liguori observes. “But while that can work, in my experience you want to get people in a mode of always looking at their processes.”

So, Avnet employees are encouraged to submit ideas for process change. With the past year, the company has standardized business travel under a single travel management firm, found ways to reduce external hedging costs, and eliminated most HR paperwork in favor of online processes.

“Our philosophy here is to focus on what we can control,” Liguori says. “We can’t control our share price or market trends like pricing. What we can control is our strategic building blocks, working capital, capital allocation, and costs.

“Now,” he adds, “we have those strategic blocks in place, and we’re trying to put the cost structure and the financial model underneath them to get the returns we think we can get.”