Celestica's (CLS) CEO Rob Mionis on Q2 2016 Results - Earnings Call Transcript

| About: Celestica Inc. (CLS)

Celestica, Inc. (NYSE:CLS)

Q2 2016 Results Earnings Conference Call

July 21, 2016, 05:00 PM ET

Executives

Lisa Headrick - Senior Director, Investor Relations

Darren Myers - Chief Financial Officer

Rob Mionis - President and Chief Executive Officer

Analysts

Matt Sheerin - Stifel Nicolaus

Thanos Moschopoulos - BMO Capital Markets

Gus Papageorgiou - Macquarie

Paul Steep - Scotia Capital

Robert Young - Canaccord Genuity

Daniel Chan - TD Securities

Presentation

Operator

Good afternoon, ladies and gentlemen, and welcome to the Celestica earnings call for the second quarter of 2016. At this time, all lines are in a listen-only mode. I would now like to turn the meeting over to one of your hosts for today's call, Lisa Headrick, Senior Director, Investor Relations. Please go ahead.

Lisa Headrick

Good afternoon and thank you for joining us on Celestica’s second quarter of 2016 earnings conference call. On the call today are Rob Mionis, President and Chief Executive Officer, and Darren Myers, Chief Financial Officer.

This call will last approximately 45 minutes. Darren and Rob will provide some brief comments on the quarter and then we will open the call for questions. During the Q&A session, please limit yourself to one question and a brief follow-up. We will be available after the conference call for additional follow-up. Please visit www.celestica.com to view the supporting slides accompanying this webcast.

As a reminder, during this call, we will make forward-looking statements within the meanings of the US Private Securities Litigation Reform Act of 1995 and applicable Canadian securities laws related to our plans for future growth trends in our industry, our anticipated financial and operational results and performance and financial guidance. Such forward-looking statements are based on management's current expectations, forecasts, and assumptions, which are subject to risks and uncertainties that could cause actual outcomes and results to differ materially from conclusions, forecasts or projections expressed in such statements.

Please refer to our cautionary statements regarding forward-looking information in the company’s various public filings, including the cautionary note regarding forward-looking information in today's press release. We also refer you to the company’s various public filings which contain and identify material factors that could cause actual results to differ materially from those contained in our projections or forward-looking statements and which discuss material factors and assumptions on which such forward-looking statements are based.

These filings include our most recent MD&A, annual report on Form 20-F filed with and subsequent reports on Form 6-K furnished to the US Securities and Exchange Commission and our annual information form filed with the Canadian securities administrators which can be accessed respectively at sec.gov and sedar.com.

During this call, we will also refer to certain non-IFRS financial measures which include adjusted gross margin, adjusted SG&A, adjusted operating earnings or adjusted EBIAT, adjusted operating margins which is adjusted operating earnings as a percentage of revenue, adjusted net earnings, and adjusted EPS, return on invested capital or ROIC, inventory turns, cash cycle dates, free cash flow, adjusted tax rate, and adjusted tax expense.

These non-IFRS measures do not have any standardized meaning under IFRS and may not be comparable with other non-US GAAP or non-IFRS financial measures presented by other public companies, including those presented by our major competitors. We refer you to today’s press release which is available at celestica.com for more information about these and certain other non-IFRS measures, including a reconciliation of the historical non-IFRS measures to the corresponding IFRS measures where comparable IFRS measure exist.

I will now turn the call over to Darren Myers.

Darren Myers

Thank you, Lisa. And good afternoon, everyone. Celestica delivered a strong second quarter with year-over-year growth in revenue, operating margin and return on invested capital. Second quarter revenue of $1.49 billion was at the high-end of our guidance range, led by program strength in our communications end market.

Let me begin with a few highlights for the second quarter. Revenue in the quarter increased 5% compared to the second quarter of 2015, primarily due to new programs in our diversified markets and strong program demand for certain programs in our communications market. Revenue from our diversified markets grew 13% year-over-year and represented 30% of total revenue, up from 28% of total revenue in the second quarter of 2015.

IFRS net earnings were $36 million, a 50% improvement from $24 million a year ago. Adjusted operating margin of 3.8% improved 40 basis points year-over-year and was 30 basis points above the midpoint of our guidance. Adjusted earnings of $0.29 per share was above the midpoint of our guidance, largely due to increased revenue and strong operating margin performance. Adjusted earnings per share was negatively impacted by $0.02 from higher taxes as a result of foreign-exchange movements. And we achieved a return on invested capital of 20.9%.

Moving on to revenue from an end market perspective. Our diversified end market represented 30% of our total revenue for the quarter. Diversified revenue decreased 2% sequentially and increased 13% year-over-year, which was slightly below our expectations due to a push out of certain solar programs within our energy business. The year-over-year increase in our diversified revenue was primarily due to new program ramps in our energy business and, to a lesser extent, growth in our aerospace and defense end market.

Our communications end market performed better than expected, represented 41% of total revenue and was up 18% sequentially due to seasonal strength and the strong program demand, including from new programs. Compared with the second quarter of 2015, communications revenue was up 8% as a result of new program ramps, demand strength in optical and progress with JDM. This growth was partially offset by demand reductions in some of our legacy programs.

Our storage business came in slightly below our expectations and represented 17% of total revenue for the second quarter. Storage revenue increased 19% on a sequential basis, in part due to seasonality, as well as new program revenue. Compared to the second quarter of 2015, revenue from our storage business was down 5% due to demand softness, offset in part by new program win.

Our server business represented 9% of total revenue and was up 6% sequentially, slightly above our expectations. Server revenue decreased 7% compared to the second quarter of 2015, primarily due to demand softness.

And finally, our consumer end market, representing 3% of total second quarter revenue, was relatively flat from a dollars point of view year-to-year and sequentially.

Our top ten customers represented 67% of revenue for the second quarter, up 2% from the first quarter of 2016 and down 1% from the same period last year. For the second quarter, we had two customers individually contributing greater than 10% of total revenue.

Moving to some of our other financial highlights for the quarter, adjusted gross margin of 7.7% was up 50 basis points sequentially, primarily due to increased volume and improved program mix within our diversified and communications markets. On a year-over-year basis, adjusted gross margin was up 60 basis points driven by improvements in our diversified markets, led in part by stronger margin performance in our energy and semiconductor markets.

Our adjusted SG&A expense for the second quarter was $51 million, above our expected range of $47 million to $49 million due to $2 million of foreign exchange losses recorded in the quarter.

Adjusted operating earnings for the quarter were $57 million or 3.8% of revenue, which was above the midpoint of our guidance primarily due to the increased revenue and adjusted gross profit performance.

On a year-over-year basis, operating margin increased 40 basis points, driven by increased revenue and improved gross margin performance, which was partially offset by higher SG&A expenses.

Our adjusted tax rate in the second quarter was 23.1%, above our expected range of 17% to 19%, primarily due to taxable foreign exchange from weakening currencies in Malaysia and China. The higher tax expense from taxable foreign exchange resulted in a $0.02 per share impact on IFRS and adjusted earnings per share for the quarter.

For the first half of 2016, our adjusted tax rate was 17.4% including the impact of taxable foreign exchange.

Adjusted net earnings for the second quarter were flat year-to-year at $42 million as compared – as improved operating margin performance was offset by higher tax expense. Adjusted earnings per share of $0.29 increased $0.04 year-over-year, reflecting the favorable impact of lower outstanding shares, primarily as a result of the shares we repurchased and canceled in 2015.

Second quarter IFRS net earnings were $36.2 million or $0.25 per share compared to $24.2 million or $0.14 per share in the second quarter of 2015, reflecting other recoveries recorded in the second quarter of 2016 as well as the lower share count.

Return on invested capital for the quarter was 20.9%, up from 19.6% for the same period last year.

Moving to working capital, our inventory increased $50 million from the end of the first quarter of 2016 to $906 million at June 30. Inventory increased to support our overall growth and due to some late demand changes in the quarter. Inventory turns for the quarter were 6.2, consistent with the last quarter. We're targeting improvements in our inventory turns for the second half of the year.

Capital expenditures were approximately $18 million or 1.2% of revenue for the second quarter, within our estimated range. Cash cycle days for the second quarter was 47 days, consistent with the first quarter of 2016. Our free cash flow for the quarter was negative $24 million compared to positive free cash flow of $2 million for the same period last year. Free cash flow was negatively impacted by higher working capital required to support our growth.

Moving to our balance sheet, our cash position remained strong. Our cash balance decreased by $39 million sequentially to $473 million. During the quarter, we repaid $16 million of our outstanding debt. Our net cash position at June 30 was $193 million, reflecting amounts outstanding on our term loan of $225 million and $55 million drawn on our revolving credit facility.

As an update to our normal course issuer bid, during the first quarter, we highlighted that we had paid a broker $30 million as part of a program share repurchase or PSR. As expected, the PSR was completed in May 2016 and resulted in the cancellation of 2.8 million subordinate voting shares or approximately 2% of our outstanding shares at a weighted average price of $10.69 per share. At the end of the second quarter, we had 141 million subordinate and multiple voting shares outstanding.

Moving forward to our guidance for the third quarter of 2016. For the third quarter, we're projecting revenue to be in the range of $1.475 billion to $1.575 billion. At the midpoint, revenue is projected to increase 8% year-over-year and 3% sequentially. At the midpoint of our guidance, we expect adjusted operating margin to be approximately 3.6%. Third quarter adjusted earnings are expected to range from $0.27 to $0.33 per share. Our adjusted SG&A expense for the third quarter is projected to be in the range of $48 million to $50 million. And we estimate an annual adjusted tax rate range of 17% to 19%. Our third quarter guidance assumes the annual rate and excludes any impacts from taxable foreign exchange.

I would now like to turn the call over to Rob for some additional comments on the second quarter and third quarter outlook.

Rob Mionis

Thank you, Darren. And good evening to everyone on the call. And thank you for joining us today. As Darren highlighted, Celestica delivered solid operating results in the second quarter, led by year-over-year growth in revenue, operating margin, and return on invested capital. In the third quarter, we are targeting to deliver our fourth straight quarter of year-over-year revenue growth, driven largely by growth in our diversified end market and, more recently, program strength in our communications end market.

Let me provide some additional perspective on the second quarter. I'm very pleased that Celestica delivered 5% year-to-year revenue growth with operating margins of 3.8%, a 40 basis point improvement relative to the same period last year.

Relative to the second quarter of 2015, our growth was led by diversified markets, which was up 13%, driven by increased revenue in energy and aerospace markets. In addition, we grew 8% year-over-year in our communications end market, led by strong program demand and the timing of new program revenue.

Our second quarter operating margin of 3.8% was above the midpoint of our guidance range, resulting from the leverage gained with the higher revenues, in addition to favorable program mix largely in our diversified and communications end market.

Now, let me turn to our third quarter outlook and our overall end market. In our diversified markets business, we are expecting revenue to be up sequentially in the mid-single digits, largely driven by continued growth from our solar business, including revenue from the second quarter push-outs.

Relative to the third quarter of 2015, we expect growth in the low double digits, primarily as a result of new programs in our energy end market as well as new programs in our aerospace and defense business.

Let me provide some additional color on our solar business. I am pleased that we continue to see improvements in our operational performance. As Darren mentioned earlier, we did experience a softer second quarter within solar end market due to the timing of certain programs. In the third quarter, we are expecting improvements in revenue and profitability. We continue to focus on improving our performance, while managing a dynamic demand environment.

Despite short-term volatility, we are encouraged by the longer-term demand trends and have a robust sales pipeline of opportunities across the broad customer base. We believe we are very well positioned to capitalize on this high growth market with the leaders in this space.

Moving to our communications end market, our communications end market is expected to increase in the mid-single digit sequentially due to continued program demand strength as well as new program ramps. On a year-over-year basis, we expect communications revenue to be up in the low-double digits based on program demand strength and new programs. Although we're not providing longer-term guidance, the third quarter is typically our strongest quarter for communications.

Our storage revenue in the third quarter is projected to be relatively flat to slightly up sequentially. On a year-over-year basis, storage is expected to increase in the mid-single digits, largely driven by new program revenue.

Our service end market is expected to be down quarter-to-quarter in the mid-single digits as a result of lower anticipated demand. Compared to the third quarter of 2015, the service business is expected to be flat.

And finally, our consumers business, which represents 3% of our overall revenue in the second quarter, is expected to be down in the 30% range both sequentially and relative to the same period last year. We were notified during the second quarter that an aftermarket program with one of our largest consumer customers will be exiting during the third quarter as a result of supplier consolidation. Although the revenue is not overall material to Celestica, we do expect some profit pressure as we exit the year.

In summary, although the overall end markets remain dynamic, I am very pleased that we're driving towards year-to-year revenue growth for the fourth straight quarter in a row. In the second quarter, we delivered solid performance driven by strong execution and continued growth from our diversified business, bolstered by strong demand within communications.

Now, I’d like to give you an update on our key priorities that I highlighted in our last earnings call. Our first priority is to build upon the strong foundation we have at Celestica by increasing the investments in the front end of the business, to accelerate revenue and operating margin growth.

In the first half of the year, we have taken targeted steps to increase our front-end focus. While our bookings continue to track at historical levels, we're seeing early indicators that our efforts are increasing in our sales activities.

Our second priority is to improve the overall profitable performance of our diversified markets business. Throughout 2016, we have seen profitability improvements across several of our submarkets, including solar and semiconductor businesses. These improvements, in addition to our increased revenue, have contributed to our year-over-year profitability improvements. The leadership changes made earlier in the year and an increased focus by the team is starting to have an impact.

Our third priority is to continue to evolve our customer and product portfolios in order to drive consistent growth with strong operating margins. We have made progress in this area as demonstrated by our 18% year-over-year growth for the first half of 2016 in our diversified business. We're focused on continuing to organically grow our diversified business, while also looking to add additional capabilities to corporate development activities.

We are investing in additional resources to drive our market and product diversification strategy. Towards that end, we have hired a Chief Strategy Officer, who will be building up our strategy in corporate development office to accelerate our transformation. While we are earlier in our transformation, I am pleased with the steps we have taken.

And finally, generating strong free cash flow and return on invested capital remains a top priority. Year-to-date, our return on invested capital of 19.3% is up relative to the same period last year, while free cash flow of negative $59 million is down. Free cash flow for the first half of the year has been negatively impacted by our strong growth and the dynamic demand environment. We expect positive free cash flow in the third quarter and continue to work towards our goal of $100 million of free cash flow for the year, although our higher growth is putting pressure on our full-year number.

As I have said previously, Celestica’s business is solid. We have a strong platform to build on and we have focus on taking our company to the next level. My leadership team and I are excited about the opportunities in front of us as we continue to focus on accelerating value for our customers and driving financial and operational improvements for our company. I am pleased with achieving three quarters of consecutive year-to-year revenue growth and forecasting a fourth in the third quarter.

I'm also encouraged with the progress we're making on our strategy to drive long-term profitable growth. I look forward to sharing our progress in the coming quarters.

That concludes our prepared remarks. Laurel, please open the call for question.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] Your first question comes from the line of Matt Sheerin from Stifel. Your line is open.

Matt Sheerin

Yes, thanks. And good afternoon, everyone. So just a question regarding the growth you’re seeing in the communications segments. You talk about program strength and the new program wins. Just to get a sense, is this new business from customers that are just consolidating their own supply base or is there any outsourcing sort of left in that business which is fairly mature from a contract manufacturing standpoint? I’m just trying to get a sense. And maybe – perhaps industry consolidation has also been beneficial to you?

And then, how much of that is also being driven by the JDM programs that you’re doing and what percentage of your relationships there do include some of that JDM at some of the things that you’re doing on that side of the business?

Rob Mionis

Thanks, Matt. The communications market continues to be dynamic, but we are, to your point, on some very good programs. We are benefiting from the Metro 40G build out and that really plays to our strength with respect to optical systems, optical components and the data interconnect. And we are basically experiencing a program ramp.

We also do have our JDM offering within communications, it being relatively small relative to the whole, but it’s very fast growing and we’re excited about the possibilities and the growth profile of that JDM profile moving forward.

Matt Sheerin

And then in terms of the guidance, sort of backing into margin and gross margin, it looks like gross margin will be flat to down despite the revenue up. Does that make sense? Or is gross margin up, but SG&A is up commensurately with that?

Darren Myers

Hi, Matt. Darren here. All in all, if you look at the second quarter, it certainly was a strong quarter. So we talked about it in our prepared remarks. But a lot of good things happened. The team did a phenomenal job, driving the execution, cost, recoveries as well, and we had favorable mix. So the margin was higher than we certain forecasted and is higher than where we’ve been. So that’s one of the phenomena going into the third quarter that’s impacting us. We are also investing in the business, so a little bit in the SG&A. But, again, we had a $2 million FX hit in the second quarter on SG&A.

And the third item which Rob alluded to or commented on in his prepared remarks is we had a program – an aftermarket program in our consumer business that is disengaging with us and as a result of that there is some profit headwinds and that's all factored in the guidance for third quarter.

Matt Sheerin

Okay. So it looks like – maybe it’s 10 to 20 basis headwind, which will only last a quarter or so. Is that fair?

Darren Myers

It’s just that the profit of that business goes away, so that is a headwind, and then we’re continuing to invest in the business. We’ve talked before – there’s a couple of points. So we’ve talked before about what level are we at the 3.5%. And I think based on today’s mix and what we see right now, I would use $1.5 billion, which is reflective of our guidance right now. And with that, we’re still bumping around in that breakeven zone in solar and semiconductor. So there’s still a 30 basis point opportunity on those businesses, getting them to the target margins of the company. Hopefully, that answers your question there, Matt.

Matt Sheerin

Got it. Yeah, that was helpful. Okay, great. All right. Thanks a lot.

Darren Myers

Okay. Thanks, Matt.

Operator

Your next question comes from the line Amit Daryanani from RBC. Your line is open.

Unidentified Analyst

This is Jay [ph]. I’m calling in for Amit. And can you please touch upon your expectations for long-term growth within the non-tech segments?

Rob Mionis

What segment?

Darren Myers

In the diversified. You mean in the diversified?

Unidentified Analyst

Yes.

Darren Myers

Yeah.

Rob Mionis

Okay. It’s Rob. Overall, our strategy is to defend our very strong position within C&E and also to accelerate our growth within diversified. We’re very pleased with, frankly, the growth that we have seen out of diversified year-to-date [indiscernible] I think we just posted 13% year-to-year. We’re also planning on accelerating the growth of our diversified business of supplementing our organic activities – inorganic activities, i.e. M&A accelerators within the diversified business.

Darren Myers

It’ hard to give you one number. We don’t have a stated target of our annual goal. But if you did read different reports, you’ll see rates in the high-single digits in the diversified market, of course, depending on which market you look at. So that's very general comment. We’re looking to go north of that certainly organically and, as Rob says, to augment that with corporate development and M&A activity.

Unidentified Analyst

Okay, that’s helpful. And, I guess, in terms of the long-term margins, I guess, the margins will be higher versus corporate average in the long-term, but how should we think about the current margin profile versus your corporate average?

Darren Myers

We’re not disclosing the individual segments, the margin performance of them. One of our goals is to improve diversified. So by nature of that, it’s to say that it has been below the company average and we’re working to improve that. We’re seeing year-over-year improvements and have made good strides in that. There’s more work to be done there in terms of potential margin improvements that we can make and that we’re continuing to focus on.

Unidentified Analyst

And the last one for me is, when you guys do M&A, what size company do you typically target?

Rob Mionis

Good question. It really depends, Jay, on the sector that we’re looking in and also what’s available. General view, and I’ll kind of be somewhat opaque, is bigger is better, but not too big to the point where it’s an integration mess. So it's kind of very difficult question to answer. I would say – Darren, what do you think in terms of overall size?

Darren Myers

Ideally, they’re bringing in $200 million, $250 million of revenue. But, again, as Rob says, it depends. There’s capability adds. There’s a number of different factors that we would look at.

Rob Mionis

Another way of saying it is, we’re not actively fishing for huge deals, if you will. At this stage of the game, it’s sizable tuck-ins that will really give us incremental capability and accelerated growth.

Darren Myers

Thanks, Jay. Next question please.

Operator

Thank you. Your next question comes from the line Thanos Moschopoulos from BMO Capital Markets. Your line is open.

Thanos Moschopoulos

Hi, guys.

Rob Mionis

Hi, Thanos.

Thanos Moschopoulos

Hi, good afternoon. You mentioned that solar and semi are still running at close to breakeven. What really needs to change? Is that a function of volumes getting up or are there certain programs that just need to hit their stride from a yield perspective?

Rob Mionis

Hey, Thanos. In semi – semi cap, just to break down our business, is comprised of high-level assembly and we also have a machining operation. High-level assembly is actually doing very well. We’re seeing some signs of improved demand and it’s ramping quite nicely. On the machining side, we do have some excess capacity right now which we’re planning to take out over the coming quarters. And we’re also planning on making some investment in the semi cap businesses to drive improved productivity moving forward. So for it to have sustained growth in the long-term, we really need machining, the volume to return and also we need to reduce some excess capacity at the same time.

Within our solar business, which really impeding our target level of profitability, is two things. One is, as Darren and I alluded to in our call, we do have somewhat of a choppy and dynamic demand environment and we do think that will stabilize over a period of time. We also have some high-cost capacity that we’ve had with us this half of the year and we plan on taking that out during the second half of the year and that should give us some improved profitability moving forward.

Darren Myers

And, Thanos, for those of those, I would think about it for you guys, because of the actions in the – those investments in order to drive some of these actions are cost around these actions, it’s really probably into next year before we start seeing some of the improvements there.

Thanos Moschopoulos

Okay, that’s helpful. And then finally, aerospace and defense, can you provide us an update there? Imagine that the Honeywell assets are probably ramping and that’s contributed to growth. Any other dynamics in that segment?

Rob Mionis

I’ll start. Maybe Darren can finish. But broadly speaking, our strategy within aerospace and defense has been to take our wonderful proof points that we have to a large audience. I'm very much encouraged that our sales pipeline is building very nicely and we’re engaged in very nice discussions with a broader set of audiences on building that portfolio moving forward. As I’ve mentioned on previous calls, we are very capable in this area. We do circuit cards. We do line replaceable units. We also have – we do MRO as well in this space. And then very excited about the future in terms of the growth and the forecast. I’ll turn it over to Darren.

Darren Myers

Yes. Thanos, the growth we’ve had from the Honeywell part, that’s pretty much lapped because we did that in Q1 2015, so we’ve seen the full year of that. As I mentioned, we had some growth from our airspace and defense. Most of it was in the energy business year-over-year, some from aerospace and defense and it was from new program wins, a little bit smaller, similar in the size of the Honeywell transaction that we did. We’re making good improvements – good activity in the funnel and some active engagements. Certainly, some new relationships have opened up for us. So from a longer-term perspective, things look quite good in that market.

Thanos Moschopoulos

Great. Thanks, guys. Nice quarter. And I’ll pass the line.

Darren Myers

Thanks, Thanos.

Operator

Your next question comes from the line of George Papageorgiou with Macquarie. Your line is open.

Gus Papageorgiou

Thanks. It’s actually Gus Papageorgiou. Just a quick question on – thanks for the color on your communications business. But could you also just touch on storage and servers. You’re looking for kind of up or flat year-over-year growth in those industries. And a lot of your end customers are seeing kind of negative growth. So could you just touch a little bit on the dynamics there?

And then also, just as a follow-on, is there any reason to believe that we wouldn’t see traditional seasonality this year with Q4 being your strongest quarter? Thanks.

Rob Mionis

Yeah. On storage, generally speaking, external storage is quite cold and tempered these days and internal storage is running quite hot. The increase that we've seen seasonally is really, again, driven by seasonal demand. We are guiding flat revenue as we go into quarter three. But the growth and the successes we have are generally driven by program mix. Some are going up and some are going down.

Darren Myers

I’d say, in both of them, Gus, it’s the new wins because, you’re right, the markets generally are going down and we’re certainly seeing that. But there’s been – team’s done a good job with wins last year that we’re – and those programs happen to be doing well for us.

On your other question on seasonality, I think our seasonality has changed as a company with communications being a larger part. If you look back in the last number of years, communications tends to be higher in Q3. So that I think will change our dynamic. We’re not giving guidance for the fourth quarter. But I do want to highlight that to you because it does change what you'd expect for fourth quarter for us.

The other item I would note is we talked about a push-out of a program, probably at about a $20 million push-out in solar into the third quarter and we’re going to catch-up for that in the third quarter. So that’s helping the third quarter forecast as well.

Gus Papageorgiou

Okay, great. Thank you very much.

Darren Myers

Thanks, Gus.

Operator

Your next question comes from the line of Paul Steep with Scotia Capital. Please go ahead.

Paul Steep

Thanks. Rob, can you maybe talk a little bit about the automation efforts that you’d highlighted last quarter in terms of how we should think about what type of margin lift we should benefit from and when that would impact? Is that likely to be a 2017 event?

And then secondly, maybe Darren could talk a little bit about inventory build. It’s been impacting your free cash the last couple of quarters. Is this just related to new wins or is there another dynamic at play? Thanks.

Rob Mionis

So on new automation, Paul, thanks for bringing it up. We really have some fantastic capability. We not only have some good point solutions, but we have some great automation integration capability. And we’re moving down the maturity path of going from automation to the connected factory again, which has been able to connect what we call the physical and the digital world. We are accelerating our paths this year in terms of deployments and tripling the amount of investment that we’re making in automation and connected factory. But the way I look at this is it’s somewhat of a journey as we’re building out our roadmaps. And I think we’re well along the journey, but it's probably hard to project what kind of margin impact we’re going to get off of that.

And I’ll turn it over to Darren for the second question.

Darren Myers

Paul, on inventory, we’ve been impacted the last two quarters, I would say, on churn. We're seeing ups and downs. We’re pleased with the upside and the team, throughout the operations, did a great job delivering it. But within that, there’s still a lot of ups and downs. So that has certainly been impacting us. And then, of course, a big driver has been the growth, has been impacting the turns. The solar push-out, that $20 million I talked about as well, hit us on inventory. So from a free cash flow point of view, first half of the year has been under pressure based on the growth and on the churn. We expect that to improve in the third quarter, generate positive free cash flow. But there’s a number of variables happening in the markets. I think this year, although we’re always pushing for our goal of 100, it is a lot of work to be done to get there this year.

Paul Steep

Great, thank you.

Darren Myers

Growth in that first half. Thanks, Paul.

Operator

Your next question comes from the line of Robert Young with Canaccord Genuity.

Robert Young

Hi, good evening. I was hoping that you could talk about the semiconductor and smart energy components. I think last quarter you said that there was a potential for a 40 basis points improvement to overall margins. Now, this quarter you’re saying 30. And so, has something changed in the potential improvement or have you pushed that business forward? I think you said it's still close to breakeven.

Darren Myers

It’s bumping around. The math gets you sometimes to 30, sometimes to 40, so it’s still in that 30 to 40 basis point range, Rob. There was improvements and we’re expecting some improvements as we go forward. But it's in that range.

Robert Young

Okay. So no real change from last quarter?

Darren Myers

Not significant, no.

Robert Young

Okay. And then you’ve talked now a couple times about the increasing investment in the sales, corp dev, front-end. And so, is that something that drove improvement in the top line this quarter, in the current quarter now, or is that something that you’re expecting to drive benefits in 2017 or later? Like, how should we be thinking of the benefit from that investment?

Rob Mionis

So these investments will have a longer-term impact on our growth and profitability. But, basically, our strategy is – just to recap it is where we think we have a leading market position or we know we have a leading market position and where we have strong value proposition, we are investing in sales resources, business development resources in order to capitalize on that growth. I’m encouraged by the early signs of our pipelines building, but it has to work its way through the sales process into the bookings process and then converting that into revenue. And that, especially in the diversified business, does take a period of time.

Darren Myers

Rob, sorry. Of course, on the corporate development side, you can get a faster benefit, but certainly don't expect one in the short term, though, in an acquisition side or any material ones.

Robert Young

Okay. And I think you mentioned that there was a benefit in the pipe in the aerospace component. Is that an area where you're waiting the investment?

Rob Mionis

No. On that, I was referring to is the investments that we made in sales resources and business development resources. They’re providing solutions and responding to quotes. And as a result of that, we think about our sales pipeline as a funnel. So the size of the funnel, if you will, is growing with opportunities and we’re encouraged by that progress. Obviously, we have to turn those opportunities into hard bookings, and that's what we’re working on doing. And, again, that will take a little bit of time. But encouraged, again, by the fact that the investments are starting to have some early indications of success.

Robert Young

Okay, great. Thanks a lot.

Operator

Your question comes from the line of Jim Suva with Citi. Your line is open.

Unidentified Analyst

Hi. This is Athiya [ph] here on behalf of Jim. Just quickly, like any color you can provide on impact – macro impact from Brexit on your end customer, if that resulted in any kind of demand pause towards the end of the quarter? Thank you.

Darren Myers

Hi. It’s Darren here. We haven't – from a Brexit point of view, first of all, our exposure, direct exposure, in the UK is incredibly nominal, less than a percent. And for us, the only impact, I would say, is the currency impacts and some of the volatility in currency. We haven't seen anything from customers from a demand point of view of changes to their order patterns or anything directly related to Brexit.

Unidentified Analyst

Okay, thank you.

Darren Myers

Maybe one more question, operator, if there is anymore.

Operator

We do have another question from the line of Daniel Chan of TD Securities. Please go ahead.

Daniel Chan

Hi, Darren.

Darren Myers

Hi, Daniel.

Daniel Chan

Just a quick question in terms of capital use. How are you prioritizing your options? Is it debt reduction or share buybacks? Did you fund another PSR this quarter?

Darren Myers

Pardon me. Daniel, you’re cutting out a little bit there. Do you mind repeating that question?

Daniel Chan

Hello. Can you guys hear me now?

Darren Myers

Yeah. Now, we can, Dan. Thanks.

Daniel Chan

Okay. Just in terms of capital use, how would you prioritize your options? Is it going to be for debt repayment or are you guys – did you guys mention that you’ve funded another PSR this quarter?

Darren Myers

No, that was the PSR we funded previously, just those shares were canceled. Right now, our real focus is investing in the business and keeping as much powder as we can for investing in the business. We’ll still do some buybacks, but really, right now, we want to focus on making investments in the business.

Daniel Chan

Okay, thank you.

Darren Myers

Okay, thank you.

Rob Mionis

Thank you all for dialing in. Thank you for your support and we look forward to updating you next quarter. Good evening.

Operator

Ladies and gentlemen, this concludes today's conference call. You may now disconnect.