Celestica: Improved product strategy to fuel a rebound (NYSE:CLS)

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by Celestica (NYSE:CLS) Early results will continue to be masked by macro headwinds and adjustments to the CCS segment to increase margins. We remain optimistic about the new product line and management’s focus on growth and profitability. Valuation (P/S of 0.21x in FY’21 assuming sales of 5.46bn (-5% y/y) remains modest (tangible book value of $1.24bn and TBV/Share of 9 .67x) compared to the rebound potential towards the second half of the year.

Expect a gradual rebound in growth

Growth in HPS (hardware platform solutions) and key verticals of ATS (advanced technology solutions) continues to be offset by Celestica’s exposure to the weak aerospace sector and the exit of the Cisco Systems business low margin. Last quarter, Celestica rebranded the JDM (Joint Design and Manufacturing) business to a new label called HPS. HPS is the fast growing part of the CCS (connectivity and cloud solutions) segment. The remaining CCS business consists primarily of the Enterprise segment, which includes server and storage businesses. The storage business has not seen the best growth in recent years due to the maturity of the industry. Celestica noted in the latest results that HPS business grew 80% in fiscal year 2020. To provide better color on revenue growth drivers, Celestica highlighted Lifecycle Solutions, which will combine HPS and ATS. As Celestica digests headwinds (A&D (aerospace and defense segment)) for the ATS business, lifecycle solutions will provide a consistent growth picture throughout the year. Celestica highlighted improved booking momentum (9 new customers) in the ATS segment, which adds confidence in growth prospects.

Growing pandemic-inspired demand for chips that power everything from communications and IT infrastructure to personal computing, gaming and healthcare electronics will drive global spending on manufacturing equipment up 8% in 2020 and a 13% increase in 2021 – Semi

The improved growth outlook will be fueled by strong demand in the capital goods segment. Celestica highlighted industry sources predicting growth in wafer manufacturing equipment this year. The forecasts are consistent with the expected surge in demand for gadgets driving new habits (gaming, remote learning/working, video conferencing) since the start of the pandemic. These forecasts will help the growing healthcare sector, which has done the heavy lifting in recent quarters. Readers will recall that the healthcare industry has seen high demand for equipment (ultrasound PPE, diagnostic equipment, anesthesia, respiratory, patient monitoring, imaging devices) related to the COVID virus.

Improvement of the product range and cost optimization to increase margins

Margins and cash flow continue to benefit from an improved product mix and a prudent cost management strategy. Celestica saw improved margins in both operating segments in Q4’20. The ATS segment margin increased by 3.9% year-on-year while the CCS segment margin increased by 3.4% year-on-year. CCS continues to benefit from the decline in low-margin Cisco business, which is expected to continue into 2021. Celestica attributed ATS’ margin improvement to volume growth and ramping up productivity. ATS should also benefit from a rebound in the high-margin A&D segment. Celestica noted that restructuring charges will remain a modest impediment to margin growth, with significant improvement expected in 2022. Celestica also expects more investment in HPS and ATS. In addition to a slight decline in working capital (assuming increased inventory in ATS and HPS), we expect Celestica to reach its FCF target of $100M+ in 2021. FCF margin will also benefit from its modest requirements CapEx at 1.5% of revenue with CapEx forecast of $85 million in 2021, assuming FY21 revenue of $5.4 billion. This is an increase compared to 0.9% of revenue in 2020. The decline in CapEx in 2020 can be attributed to the shift of COVID projects to the current year.

Valuation rebound in 2H’21

Celestica’s dynamic rating recognizes the potential of rapidly changing segments. This includes HPS, which was up 80% from 2019. Growth options in ATS (Healthcare, Capital Equipment) will continue to offset weaknesses in A&D. Guidance for the first quarter calls for lower growth in all segments due to unfavorable compositions. This will cut the momentum. Improved profitability and cash flow (FCF 2020 at $126m) adds some stability to the valuation outlook. Celestica also benefits from its attractive cash position as it accelerates investments in fast-growing segments.

While cash stands at $464 million, Celestica also has an unused credit facility of an additional $450 million to supplement its liquidity. Total debt is $589 million. Celestica has indicated that it remains in compliance with its financial covenants. Finally, Celestica highlighted the leverage ratio of gross debt to TTM adjusted EBITDA of 1.6x, which is considered healthy. As a result, a rebound in 2H’21 provides some reassurance making the valuation attractive at 0.21 P/FY’21 sales. In addition to macroeconomic uncertainty and its concentration of activity with major customers, we expect a gradual easing of risk premiums as we approach the second half of the year. In addition to its ongoing share buyback plan, the case for multiple expansion is strengthened.

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