Celestica, Inc. (NYSE:CLS)
Q3 2016 Earnings Conference Call
October 20, 2016, 17:00 ET
Lisa Headrick Harpell - Senior Director of IR
Darren Myers - CFO
Rob Mionis - President & CEO
Robert Young - Canaccord Genuity
Thanos Moschopoulos - BMO Capital Markets
Paul Steep - Scotia Capital
Gus Papageorgiou - Macquarie Research Equities
Jim Suva - Citigroup
Welcome to the Celestica, Inc. Earnings Call for the Third Quarter of 2016. [Operator Instructions]. I would like to turn the meeting over to one of your hosts for today's call, Lisa Headrick Harpell, Senior Director Investor Relations. Please go ahead.
Lisa Headrick Harpell
Good evening and thank you for joining us on Celestica's third 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 conference call will last approximately 45 minutes.
Darren and Rob will provide some brief comments on the quarter and then we will open the call up 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 U.S. Private Securities Litigation Reform Act of 1995 and applicable Canadian Securities laws, including those related to our plans for future growth, trends in our industry and end markets, 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 U.S. Securities and Exchange Commission and our Annual Information Form filed with the Canadian Securities Administrators which can be accessed respectively at www.sec.gov and www.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 days; free cash flow; adjusted tax rate and adjusted tax expense. These non-IFRS measures do not have any standardized meanings under IFRS and may not be comparable with other non-U.S. 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 www.celestica.com for more information about these and certain other non-IFRS measures, including a reconciliation of historical non-IFRS measures to the corresponding IFRS measures, where a comparable IFRS measure exists.
I will now turn the call over to Darren Myers.
Thank you, Lisa and good evening everyone. Celestica delivered a strong third quarter, with year-over-year growth in revenue, earnings, free cash flow and return on invested capital. Third quarter revenue of $1.55 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 third quarter. Revenue in the quarter increased 10% compared to the third quarter of 2015, primarily due to strong program demand and our communications market and new programs in a diversified end storage markets. Revenue from our diversified markets grew 9% year over year and represented 30% of total revenue.
IFRS net earnings were $54 million, an increase of $43 million relative to the third quarter of 2015. Adjusted operating margin was 3.8%, 20 basis points above the midpoint of our guidance and flat year to year. Adjusted earnings were per $0.43 per share and included net positive tax-related impacts of $0.11. Without this benefit, adjusted earnings per share of $0.32 was above the midpoint of our guidance and we achieved return on invested capital of 21.2%.
Moving on to our revenue from an end market perspective, diversified revenue increased 3% sequentially and 9% year over year which was below our expectations, due to increased volatility in the solar panel market which impacted our third quarter demand. The year-over-year increase in our diversified market was primarily due to new program ramps in our energy business.
Our communications end market performed better than expected, represented 43% of total revenue and was up 10% sequentially due to strong demand, including from new programs. Compared with the third quarter of 2015, communications revenue was up 16% as a result of new program ramps and continued demand strength in optical.
Our storage business came in slightly above our expectations and represented 18% of total revenue for the third quarter. Storage revenue increased 6% on a sequential basis due to new program revenue, in addition to increased demand. Compared to the third quarter of 2015, revenue from our storage business increased 11%, largely due to a new program ramp which more than offset overall end market demand softness in our legacy programs.
Our server business represented 7% of total revenue and was down 8% sequentially and relatively flat compared to the third quarter of 2015. And finally, our consumer end market representing 2% of total third quarter revenue was down 26% quarter to quarter, due to the exit of the program we discussed on our second quarter conference call. Our top 10 customers represented 68% of revenue for the third quarter, up 1% from the second quarter of 2016 and flat relative to the same period last year. For the third quarter we had two customers individually contributing greater than 10% of total revenue.
Moving to some of the other financial highlights for the quarter, adjusted gross margin of 7.3% was down 40 basis points sequentially and down 20 basis points year over year, primarily from reduced profitability in our solar panel business which was impacted by inventory provisions resulting from rapid declines in solar panel market prices during the third quarter. Our adjusted SG&A expense for the third quarter was $48 million, within our expected range of $48 million to $50 million for the quarter and was relatively flat for the same period last year.
Adjusted operating earnings for the quarter were $59 million or 3.8% of revenue which was above the midpoint of our guidance, resulting from higher revenue, some favorability as we exited our consumer program and improved mix, offsetting lower performance in our solar panel business. On a year-over-year basis, adjusted operating margin was flat.
Our adjusted tax rate in the third quarter was 0.5%, below our expected annual range of 17% to 19%, resulting from net beneficial tax impacts of $9 million primarily related to the favorable resolution of our Canadian transfer pricing appeal. In addition, a $6 million interest refund related to this matter was recorded in the third quarter, favorably impacting earnings. Relative to our guidance, these impacts positively impacted IFRS and adjusted earnings per share by $0.11 for the quarter.
For the first three quarters of 2016 our adjusted tax rate was just under 11% and reflects the net tax benefits realized in the third quarter. Adjusted net earnings for the third quarter of $62 million and adjusted earnings per share of $0.43, have approximately doubled year to year, resulting primarily from higher revenue and operating margin, as well as the net tax related benefits discussed.
Third quarter IFRS net earnings were $53.6 million or $0.37 per share, compared to $10.9 million or $0.08 per share, in the third quarter of 2015, reflecting the net tax-related benefits, higher earnings and lower restructuring cost. Return on invested capital for the quarter was 21.2%, up from 20.9% for the same period last year.
Moving to working capital, our inventory increased $24 million from the end of the second quarter of 2016, to $930 million at September 30. Inventory increased to support our overall growth and due to changes in mix. Inventory turns for the quarter were 6.3, a slight improvement from last quarter and flat year over year.
Capital expenditures were approximately $12 million or 0.8% of revenue, for the third quarter. Cash cycle days for the third quarter were 46 days, generally consistent with the second quarter of 2016. Our free cash flow for the quarter was $100 million, compared to free cash flow of $13 million for the same period last year. Free cash flow was positively impacted by improved working capital resulting from favorable program mix and the timing of our collections and payments.
Moving on to our balance sheet, our balance sheet remains strong. Our cash balance increased by $69 million sequentially, to $542 million. During the quarter, we repaid $21 million of our outstanding debt. Our net cash position at September 30 was $283 million, reflecting amounts outstanding on our term loan of $219 million and $40 million drawn on our revolving credit facility.
Within the quarter no shares were purchased for cancellation. At the end of the third quarter we had approximately 141 million subordinate and multiple voting shares outstanding.
Moving forward to our guidance for the fourth quarter of 2016, for the fourth quarter, we're projecting revenue to be in the range of $1.5 billion to $1.6 billion. At the midpoint, revenue is projected to increase 2% year over year and to be relatively flat sequentially. At the midpoint of our guidance, we anticipate adjusted operating margin to be approximately 3.8%.
Fourth quarter adjusted earnings are expected to be in the range of $0.29 to $0.35 per share. Our adjusted SG&A expense for the fourth quarter is projected to be in the range of $47 million to $49 million. And we estimate our fourth quarter adjusted tax rate to be in the range of 17% to 19%, excluding any impact from taxable foreign exchange.
I would now like to turn the call over to Rob for some additional comments on the third quarter and the fourth quarter outlook.
Thank you Darren and good evening to everyone on the call and thank you for joining us today. Celestica delivered another solid quarter, with our fourth consecutive quarter of year-over-year revenue growth. During the quarter we delivered growth in revenue, operating margin, return on invested capital and generated strong free cash flow. We continued to deliver strong operational execution to our customers, while driving productivity improvements across our network. Overall, we're pleased with our year-to-date performance and we're also pleased with our performance relative to our EMS peers.
Our full-year forecast, based on our fourth quarter guidance, equates to full-year 2016 growth of 5% in revenue, with 12% growth in adjusted operating earnings. We expect our diversified markets to grow by 11% for the full year, as we continue to focus on accelerating our growth.
Throughout 2016, the Celestica team has been maintaining focus on our strategic priorities. We're proud to be making meaningful progress towards achieving sustainable, profitable growth and margin expansion.
Let me provide some additional perspective on the third quarter results. Celestica generated $100 million of free cash flow, delivered 10% year-to-year revenue growth, with adjusted operating margins of 3.8%. We're pleased to deliver another strong quarter. Relative to the third quarter of 2015, we generated substantial growth across our three largest markets, communications, diversified and storage, driven by both demand strength and new programs.
Let me provide some additional color on our solar panel business and what we're seeing in this market. Over the last 90 days, the global solar panel market has seen adverse market factors, affecting demand and pricing. Industry overcapacity has led to sharp reductions in demand and pricing for solar panels. Although we have made considerable progress in driving operational improvements in our solar panel business, the third quarter was negatively impacted by the current market conditions. This has delayed our progress in driving this business to target margin. We anticipate the solar panel demand to remain challenging in the fourth quarter and most likely into 2017.
In the near term, we continue to work with our partners and are aligning our cost structure to the lower revenue levels and actively pursuing additional business. In the mid term, we expect the turbulence in the solar panel market to stabilize and we believe in the long term prospects for our energy business. I am also excited about the opportunities and our performance in our other programs within the energy market. At Celestica, our market offering goes beyond panels. We're diversified across the renewable energy ecosystem and manufacture a broad range of products that include solar panels, inverters, energy storage projects, smart meters and other electronic componentry.
We're experiencing strong growth in our power products business and continued to win with the industry leaders in renewable energy, as the industry drives to increase electronics integration. Overall, we remain optimistic on the long term prospects of the renewable energy market, as it is the fastest growing segment of the energy market.
Now, let me turn to our fourth quarter outlook and our overall end markets. In our diversified markets business, we're anticipating revenue to be relatively flat sequentially, with continued soft demand for our energy business. Relative to the fourth quarter of 2015, we expect revenue to be relatively flat, with demand in our semiconductor business expected to offset lower demand from the energy market.
I am also pleased that including our fourth quarter guidance, diversified markets revenue has grown year over year 17 for the last 20 quarters. As mentioned, for the full year, we expect diversified to be up just over 10%.
Moving on to our communications end market. We continue to perform well in this end market. Revenue in our communications end market is expected to decrease in the mid-single digits sequentially, largely due to seasonality. On a year-over-year basis, we expect communications revenue to be up in the low teens, based on program demand strength in our optical business and new programs.
Our storage end market also continues to perform well, primarily due to new programs. Revenue in the fourth quarter is projected to be up sequentially in the mid-double digits, largely due to seasonal demand strength. On a year-over-year basis, storage is expected to be up in the mid-single digits, as new program revenue more than offsets overall lower market demand.
Our service end market is anticipated to be down slightly sequentially, while being down year over year, as a result of overall weak demand in this end market. In summary, despite the challenging dynamics in some of our end markets, I am very pleased that we're continuing to drive year-over-year growth in revenue and operating margins in the fourth quarter. Celestica continues to generate cash, delivers solid returns and is investing to accelerate the diversification of our business.
Now, I would like to give you an update on our key priorities. Our first priority is to accelerate growth in revenue and operating margin by increasing investments in the front end of our business. Throughout the year, we have increased resources and focus in our strategic growth areas and we're beginning to see positive indicators of these efforts in our bookings. Year to date, our bookings in our diversified markets are up significantly relative to last year. Although we won't realize the revenue benefits from these efforts in the short term, we're making solid progress in driving towards continued long term growth in the diversified markets.
Improving the overall profitability performance in our diversified markets is our next priority. Despite the challenges in the solar market, improved performance in our semiconductor and remaining diversified sub-markets has driven continued year-to-year profitability improvements throughout 2016 in this overall market. We continue to make investments in automation, streamlining our processes and reorganizing to reduce complexity and increase the speed-to-outcome to support our goal of continued profitable growth.
Another priority is to continue to evolve our customer and product portfolios in order to drive consistent growth with strong operating margins. Year to date, we have driven 7% revenue growth, with 20 basis points and higher operating margin, resulting from maintaining a strong communications and enterprise base, while driving 50% organic growth in a diversified business.
In addition, throughout 2016 we have increased focus and investments in corporate development to help accelerate our progress within our target growth markets. One area of focus is our aerospace and defense market, where Celestica is a leader and we believe the only EMS company providing the seamless integration of circuit cloud assemblies, box-built and maintenance repair and overhaul services.
To further differentiate us in this market and broaden our capabilities, I am pleased to announce we have signed an asset purchase agreement with Karel Manufacturing, a Mexico-based manufacturing services company that specializes in aerospace and defense. Although the transaction is not material, Celestica will gain additional capabilities in the areas of complex wire harness assembly, systems integration, sheet metal fabrication, welding and machining. The acquisition which is subject to customary closing conditions, is scheduled to close early in the fourth quarter.
It is also a priority to generate strong free cash flow and return on invested capital, as demonstrated by a strong third quarter performance. And lastly during the quarter, Cisco recognized us with a 2016 excellence in sustainability award. This prestigious award recognizes Celestica for demonstrating sustainability leadership above and beyond standard sustainability practices and leading the industry through our approach to sustainability. This award demonstrates our employees' commitment to delivering innovative solutions that enable our customer success and support their business priorities.
In summary, I am pleased about the progress we're making to transform our company and to deliver profitable growth and operating margin expansion. I am also pleased that Celestica is performing well relative to its EMS peer group. The entire Celestica team continues to work together to execute on our strategy, ultimately to deliver more value to our shareholders and customers.
That concludes our prepared remarks. Marianna, please open the call for questions.
[Operator Instructions]. Your first question comes from Robert Young, Canaccord Genuity. Your line is open.
You said that Karel Manufacturing isn't a meaningful economics here, is that included in the Q4 guidance? You said it's going to close somewhere around the beginning of Q4?
It's Darren here. Karel will probably close at somewhere in the fourth quarter. You know, overall, I will tell you the purchase price is in the $15 million range, so is not an overly material acquisition. We're not going to give -- given the size of it, we're not going to give the disclosures or transparency on the metrics of the deal.
No, but we're excited that it really expands our capabilities where we already have a leadership position. And the capabilities that we're picking up really will help us in the future.
Is there anything new that is providing, any new capabilities you didn't have before?
Yes, several. It has complex wire harness capability, it also has machining, sheet metal and welding. And the machining, one of the products it produces is electronic enclosures, so these enclosures are basically used for avionics, black boxes, so anything you would see in a cockpit, it basically makes enclosures. So this type of capability will enable us to eliminate a margin stack and frankly have a pretty strong growth pipeline lined up for Karel once it closes.
Okay. And then my second question would be around the semi business. I think you said you expected it to offset weakness in solar. Can you give us an update on where that business is relative to the improvements you expected to drive? And I think you've said there was some margin opportunity, if you were to get the solar and semiconductor business back on track where you wanted it, can you update us with that figure? And I'll pass the line.
Rob, overall the semiconductor has made a number of improvements through the year and there's certainly some tailwinds and maybe Rob will give some comments after just about what we're seeing in the market. But performance-wise, things that have been getting better. We've also been investing or taking out certain cost structure that's been hitting us, so I would say it's operating at just in the low levels of profitability now. It is in the black which is good. As we look forward I think into next year, depending on what happens on the revenue side, certainly we would expect to be accretive on the gross margin basis to the company, really in the second half of 2017 depending on revenue.
So that one is making improvements and as we talked about solar panels, the market has caused us some heartburn this quarter. I would say when you normalize the operational improvements that we have made operationally, we're kind of treading water in the solar panel, as we deal with some of this disruption. The combination of those two is still probably around 30 basis points if you were to click your heels and put them at the company average. We're still at around that 30 basis points that we've talked about in the past.
And Robert, I will add on the semi side, in terms of the demand side, we're encouraged that we're seeing some small tailwinds in demand. When you step back and look at the macro environment, we're seeing a ramp-up, obviously, in 3D NAND and growing foundry and logic spending in leading edge and even non-leading edge and we're seeing we're benefactor of that. So we're encouraged with where we're in the cycle and plan on capitalizing on the growth moving forward.
Your next question comes from Thanos Moschopoulos with BMO Capital Markets. Your line is open.
Maybe starting off on the communication side of the business, very good growth there, obviously. Rob, could you maybe quantify qualitatively? I mean, is it more to do with optical or more to do with new programs and share gains? And, I guess in recent weeks there have been some negative data points coming out of the sector, are you seeing any of that? Or are there other factors offsetting your business?
Yes, Thanos, so our growth in communication is really driven by both strong end market demand in optical and also new program ramps. If you peel it back a little bit more, what we're seeing is data center demand and much increased metro network upgrades which is kind of the source of the demand. We're on some good programs and have some great optical capability within our portfolio. And we're taking advantage of that market strength right now. In terms of the overall market, communications buildout seems to be lumpy. We've done our best to forecast guidance into Q4 and beyond that, we will have to see how the markets react and how the continued spending rolls out into 2017 and beyond.
And then now, obviously, with the acquisition this quarter, can you talk a bit about how the M&A pipeline generally has been shaping up in terms of other initiatives, other opportunities you might be looking at beyond the one you will be closing next quarter?
Yes, Thanos. So, as we mentioned last quarter, we recently hired a new Chief Strategy Officer and he is building out his team and the pipeline, in terms of opportunities, is growing. But that will take some time to fully vet out the pipeline and turn some of those opportunities into potential actions which we think might play out into 2017 and beyond. We're planning on being laser focused to make sure whatever we act on really improves the overall valuation of the Company and adds shareholder value.
Your next question comes from Paul Steep with Scotia. Your line is open.
Rob, could you maybe comment -- or maybe it's more to Darren as well, given some of the history on the Company. How has the Company fared in prior cycles when the communications end markets customers have gone through a period of consolidation or other changes which looks like in recent weeks is about to maybe occur in the next little bit?
Darren. Hard for me to think back how we -- I mean, for us, we've continue to perform well with our customers. We're ranked number one and number two on most of our scorecards and perform very well.
We certainly have been the benefactor as customers have gone through that and an example of that was Juniper which we talked about a few years ago. But on the other side there has been losses from time to time. So, for us it is continue to focus on executing, it's focusing on our JDM platforms being more relevant, bringing thought leadership to the industry and trying to position and be a benefactor through these changes. It's certainly the approach that we have.
And then, just to clarify on Karel Manufacturing, are you a substantial portion of the volume already in that business? I.e., is this a play to further vertically integrate and gain the benefits of running your own supply, as well as add the new capabilities that Rob had talked about?
Yes, so it's Karel Manufacturing -- you know, the growth profile really is some product that we're currently outsourcing and we plan on resourcing it to Karel. We also think because Karel will be part of our broader Company with a lot more capability, that we will be able to hunt in new places where Karel was limited in the past. So overall the value proposition for Karel is very strong.
Your next question comes from Gus Papageorgiou with Macquarie. Your line is open.
I just want to touch again on the communication and storage markets. I mean, your performance there is significantly better than the end markets in total. I'm just wondering -- I guess it's partially because of better supply consolidation, like you mentioned Juniper and I guess specific target markets like MetroOptical that you're participating in. How sustainable is this momentum? I mean, do you think maybe going into next year you would revert to the mean of industry growth which is probably negative or do you think you can maintain the kind of superior performance into next year?
We're very pleased with the capabilities we have, the programs we're on, the customers that we're supporting. And we think we're -- based on the current trends, we're very nicely positioned in terms of how that market unfolds in the dynamics of the marketplace. It is probably hard for me to comment at this time.
Yes, Gus, I mean, clearly it is always program-specific and we're on some good programs and have some good winds and we know we have great reputation in that market. So, longer term, it's going to always be hard to beat the market repeatedly. So eventually things do go to where the market forces are, but it certainly depends on the programs you're on.
Do you think there's any more opportunity for supplier consolidation where you can take share? Or do you think things are kind of at an equilibrium right now?
Probably tough for us to say on that side. It's going to be up to the OEMs frankly more than it is going to be with the EMS players.
We have been picking up some share during this cycle, but that is largely based on our programs and our performance that we're performing so well.
Your next question comes from Jim Suva with Citi. Your line is open.
Probably a CEO question and a clarification for CFO. CEO, you'd mentioned the communication tends to be pretty lumpy, but actually looking at your forecast, the results this quarter and the past few quarters, it actually looks like it's not been lumpy. It's actually been very up and to the right. So can you help me understand your comments around lumpy, is kind of looking ahead, we should expect some more bumps, because it looks like it's been cruising along quite strong there and I'm looking at year over year, mostly.
And then, clarifications for the finance side of the call is -- the taxes, the benefit this quarter, is that truly a one-time thing or is there the potential to get some more benefits from that in the quarters ahead or if you get help us understand that. I know you said the outlook is 17% to 19%, but, you know, three months ago I don't think we exactly expected this type of benefit you had and I'm just wondering if there's still more left to that benefit. Thank you.
Yes, Jim. So, the lumpiness was really answering the broad market, you know as data centers gets filled out they tend to go in projects. And some of the metro network upgrades tend to go in projects. But because these are, I guess, long-lasting trends and play to our strengths and basically on the programs that we're fortunate enough to wind, it has been giving us some sustainable profitable growth which we're pleased with, it's just hard to say how long that will last depending on the buying patterns of the ultimate end customers.
And Jim, I would add to that. We're certainly pleased to have -- we have very little if almost no wireless exposure, so you definitely see lumpiness in the wireless market as build outs happen. A significant portion of our communications is in optical which we think has some runaway and some good long term trends, so pleased with that. But hard to say were all those programs will go over the longer term.
From your tax question, it is more one time in nature. So, the benefit was primarily driven this quarter by a positive transfer pricing audit that's been ongoing for years, where we had a positive settlement this quarter, so that drove an $0.11 cent impact overall to the quarter, but for the fourth quarter 17% to 19% is the rate we have guided.
There are no further questions in queue. I will now turn the call back over to the presenters.
Thank you all for dialing in. I appreciate the support and look forward to our call next quarter.
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