Celestica Inc. (NYSE: CLS) fell by 11% in a deeply negative market on 10/28/20 despite the company reporting 3Q20 revenue that exceeded expectations and rose year-over-year. Non-IFRS EPS in 3Q20 more than doubled year-earlier adjusted earnings, and EPS guidance also topped expectations. Management’s midpoint revenue guidance for 4Q20, however, was below the pre-reporting consensus forecast and signals a return to negative top-line comps.
At a time when technology companies are reporting strengthening demand trends across
multiple end markets, including computing, networking, cloud, and edge devices, CLS
shares have fallen sharply. The stock is down over 25% in the past three months just as
demand accelerates across the technology eco-system.
As a manufacturer of traditional technology hardware such a servers, switches and routers, Celestica is confronting a demand environment in which customers’ appetite for traditional networking and computing hardware has been diminished by cloud, as-a-service, and other transformative technologies. From an individual-company perspective, Celestica is winding down its Cisco relationship.
The two main segments of ATS and CCS diverged in 2Q20, with the larger CCS business growing year-over-year while ATS declined. Continuation of that trend and below-target margins in ATS could weight on revenue growth and undermine recently achieved margin progress, in our view.
We are more favorably disposed toward CLS than we have been in years, given clear margin progress.
CLS is down 27% in 2020 year-to-date versus a 15% decline for EMS peers. CLS declined 7% in 2019 versus a 42% gain for the electronic manufacturing services (EMS) peer group. CLS declined 16% in 2018, compared with a 27% decline for peers. CLS shares declined 12% in 2017, lagging the 4% gain for peers. The stock also lagged in 2016, rising 7% while the peer group increased 28%. CLS shares declined 6% in 2015 but rose 13% in 2014.
Non-IFRS earnings of $0.32 per diluted share more than doubled from $0.13 a year earlier, and were up seven cents sequentially. Non-IFRS EPS easily beat the $0.25 consensus estimate. Management withheld 3Q20 guidance, but suggested that 3Q20 could ‘look a lot like 2Q20,’ when revenue was $1.49 billion and non-IFRS was $0.25 – both of which formed the consensus.
Celestica returned to top-line growth in 2Q20 and built on that momentum in the third quarter. Non-IFRS earnings over the past few quarters have also soared from year-ago levels. Celestica dissipated some of investors’ positive sentiment by guiding for revenue that will again be below year-earlier levels. At the same time, Celestica is operating more efficiently, leading to what appears to be sustainable margin progress.
CEO Rob Mionis believes the multi-year portfolio transformation is driving the strong sequential and annual trends in sales and profits growth. Regarding the pandemic, operation have stabilized and the supply chain continue to improve. Celestica is still seeing ‘a fair amount of demand volatility,’ according to the CEO, as end markets remain unevenly impacted by COVID-19.
Specifically, Celestica is seeing demand strength in semiconductor capital equipment, health technology, and in JDM (joint design & manufacturing, in which the OEM and contract manufacturer collaborate on design and engineering). At the same time, Celestica has seen weakening in other technology and non-technology markets, with the most profound weakness in aerospace & defense.
As a result, the gulf persisted in 3Q20 between the performance at Advanced Technology Solutions (ATS) and Cloud & Connectivity Solutions (CCS). The CCS business exceeded internal revenue-growth expectations, and margins exceeded the target range of 2%-3%. Growth was particularly strong in communications, with more moderate strength in enterprise. ATS, which focuses on non-technology opportunities that are often mission-critical and higher-margined, was down annually. Despite cost productivity actions taken within ATS, the segment badly missed its 5%-6% operating margin target range.
For 3Q20, ATS revenue of $526 million (34% of total) was down 6% annually though up 5% sequentially. ATS profits was up 26% year-over-year and quarter-over-quarter. ATS margin of 3.7%, though up 90 bps year-over-year, remained below the 4%-6% target range.
CFO Mandeep Chawla attributed the annual top-line decline mainly to COVID-19-related impact, focused in industrial with the most severe impacts in A/D. This was partly offset by new program ramps in health tech and semiconductor capital equipment. Sequential revenue growth was broad-based.
ATS had been Celestica’s growth engine for many years. The resulting surge in data traffic has driven the need for more robust computing, cloud and networking infrastructure along with secure end-point devices.
Celestica’s CCS business has benefited in this environment. After declining 18% in 2019 and 10% in 1Q20, CCS has grown in mid- to- high single digits over the past two quarters. For 3Q20, CCS revenue of $1.02 billion (66% of total) rose 7% year-over-year while growing 3% sequentially; this business grew in double digits on an annual and sequential basis in 2Q20 as the pandemic began to drive data consumption growth. CCS operating profit of $41 million was up 50% annually, while segment margin of 4.0% expanded 120 bps year-over-year and 40 bps quarter-over-quarter. CCS has expanded margins sequentially for six consecutive quarters.
Within CCS, Communications revenue (45% of total company revenue) was up 9% annually, while enterprise revenue rose 2% year-over-year; enterprise backed down sequentially from 2Q20, while communications grew quarter-over-quarter. Enterprise has been under pressure over the past year as Celestica continues to disengage from former top customer Cisco Systems.
Celestica’ JDM business continues to ramp a number of new programs and is well-aligned with the fluid demands of hyperscale customers. Year-to-date, JDM has achieved about $600 million in revenue, or 14% of total company revenue through the nine months, up 90% year-over-year. Growth in JDM is impressive, given that JDM is a relatively new variation on the ODM model.
Celestica returned to providing guidance for its year-end quarter. The ATS business is forecast to decline in low-double-digit percentages year-over-year. Within CCS, communications is forecast to increase in low-single-digit percentages, while enterprise is forecast to decline in low-double-digit percentages. As a result, Celestica’s midpoint revenue guidance for 4Q20 of $1.4 billion is consistent with a 6% annual revenue decline.
We are more favorably disposed toward CLS than we have been in years, given clear margin progress. Given secular and company-specific challenges now complicated by the global pandemic, however, the CLS shares continue to appear fairly valued by historical standards and relative to peers.
EARNINGS & GROWTH ANALYSIS
The company revenue was above the $1.49 billion consensus forecast. Non-IFRS earnings of $0.32 per diluted share more than doubled from $0.13 a year earlier, and were up seven cents sequentially.
Non-IFRS EPS easily beat the $0.25 consensus estimate. Management withheld 3Q20 guidance, but suggested that 3Q20 could ‘look a lot like 2Q20,’ when revenue was $1.49 billion and non-IFRS was $0.25 – both of which formed the consensus.
For 4Q20, Celestica returned to providing formal financial guidance. At the revenue midpoint. And non-GAAP EPS is forecast at $0.22-$0.28 per diluted share.
FINANCIAL STRENGTH & DIVIDEND
Cash was reduced by the $143 million purchase of Atrenne Integrated Solutions, funded by cash on hand and debt; and by the purchase of Impakt Holdings.
Celestica has substantially reduced its share base with a series of normal course issuer bids (NCIB). The diluted share base has declined from more than 212 million shares to about 128 million at present. We expect Celestica to continue to buy back and cancel its stock going forward. The long-term goal is to return approximately 50% of free cash flow to shareholders through stock buybacks.
MANAGEMENT & RISKS
Robert Mionis has been CEO of Celestica since mid-2015. Mandeep Chawla is CFO; he previously served in that role on an interim basis.
CEO Mionis came in as a company outsider from private equity firm Pamplona Capital Management. Prior to his stint at Pamplona, CEO Mionis served for six years as CEO of StandardAero, a global aerospace overhaul & repair company. He also held senior posts at Honeywell Aerospace, GE, and Allied Signal.
The planned Impakt acquisition, and that of Atrenne in spring 2018, is consistent with management’s goal of growing the ATS business, which has a favorable business profile. ATS tends to have a diverse, fragmented customer set, which reduces revenue and EPS volatility; entails long-term, high value add contracts, which are beneficial to margins; and enables best-processes sharing across multiple verticals.
Celestica has had to contend with revenue lost from prior customers and end markets, including solar panels and Blackberry and more recently Cisco.
We are more favorably disposed toward CLS than we have been in years, given clear margin progress. Given secular and company-specific challenges now complicated by the global pandemic, however, the CLS shares continue to appear fairly valued by historical standards and relative to peers. We are reiterating our HOLD rating.