The Long Case For Celestica

Summary

• Celestica is trading at lower multiples than its industry peers.
• An increased focus on its diversified business, away from communications, merits a multiple expansion in the future.
• Increased defense spending and changes to U.S. trade policies by the Trump administration are also positive catalysts.

52-Week High : $14.70

52-Week Low : $8.83

Last 12 months EPS : $1.21

Last 12 months revenue (in millions) : $6,133

Target Price : $17.36

Rationale :

Celestica (NYSE:CLS) is trading at lower multiples than its industry peers as a result of its higher concentration of revenue coming from communications, but with an increased focus on its diversified business, I foresee multiple expansion in the future.

Therefore, I used a sum-of-parts valuation, putting an EV/EBITDA multiple of 8x 2019E EBITDA for its diversified business and an EV/EBITDA multiple of 6x 2019E EBITDA for its traditional communications, servers, storage and consumer businesses.

Additionally, the market is overlooking its solid fundamentals and superior financial performance as well as its potential future growth opportunities resulting from increased defense spending and changes to U.S. trade policies by the Trump administration.

Relevant Comps

Benchmark Electronics Inc. (BHE)

Flex Ltd. (FLEX)

Hon Hai Precision (OTCPK:HNHAF) (HNHAY)

Industry Co. Ltd.

Jabil Circuit Inc. (JBL)

Plexus Corp. (PLXS)

Sanmina Corporation (SANM)

Catalyst

Catalysts for my investment thesis include increased global military spending, changes to U.S. trade policies by the Trump administration, future acquisitions and increased analyst coverage.

Thesis Introduction

I recommend buying Celestica, an innovative supply-chain services provider, and believe it is undervalued by up to 30%. The company is mispriced due to justifiable future multiple expansion as well as unrecognized growth potential. The market is overlooking its solid financial position and track record, discounting Celestica as a communications company relative to its peers and the company has low investor awareness due to limited sell-side coverage.

Additionally, investors do not realize Celestica's growth potential. In light of increased global defense spending and potential changes to U.S. trade policies, the company may exceed its growth expectations through organic growth or through acquisitions.

My price target is $17.36 based on an EV/EBITDA multiple of 8x 2019E EBITDA for the diversified part of the business and a multiple of 6x 2019E EBITDA for the rest of the business, which gives the stock an upside of 19.7%.

Key investment risks

Primary risks to my investment thesis include underperformance of key customers, Celestica's diversified end-market business generating less than expected revenue and increased competition in the EMS industry.

Company Background

Celestica Inc. is an Electronic Manufacturing Services (EMS) provider that designs and manufactures electronic components and markets its products and services to original equipment manufacturers (OEMs). Additionally, it develops smart supply chain solutions for clients’ entire product lifecycles from design and engineering to manufacturing and after-market services. The markets that Celestica serves include enterprise and cloud solutions, communications, aerospace & defense, renewable energy, industrial, health tech, semiconductor capital equipment and consumer.

Investment Thesis & Catalysts

I view Celestica as a long-term value investment. The company is currently mispriced and trading at lower multiples than the rest of the industry and has much more growth potential than the market is pricing in. Despite solid fundamentals and great financial performance in 2016, Celestica Inc. is still trading at lower multiples than its peers.

The company has a clean balance sheet, producing solid working capital and is not very leveraged.

• Current Ratio: 1.9x
• Net Working Capital: $543.6 million
• Interest coverage ratio: 18.2x
• Debt/Equity Ratio: 0.2x
• Net Cash Position: $312.5 million

Celestica is generating consistent cash flow, repurchasing its stock and repaying its debt.

• Operating Cash Flow: $173.3 million
• Free Cash Flow: $132.1 million
• $52.5 million common stock repurchased in 2016
• $79.5 million debt repaid in 2016

Celestica has also been outperforming the majority of its competitors within the EMS industry. The Electronic Manufacturing Services sector is extremely capital intensive, and Celestica has been deploying its capital more efficiently than its competitors with a 10% return on invested capital, compared to an industry median of 9%.

Additionally, management was able to maneuver within a challenging environment with volatile demand in 2016 and still achieve solid revenue growth of 7% while the median revenue growth of the industry was -3%. Furthermore, Celestica was able to generate an ROE of 12%, compared to the industry median of 11%, while maintaining less leverage than most companies in the sector.

The market is undervaluing Celestica because of its communications business. Investors are looking at Celestica and valuing it at lower multiples because it has a higher concentration of its revenue coming from communications compared to the rest of the industry (42% of total revenue in 2016). However, management is putting greater focus on its growing, more attractive, higher-margin diversified business which includes the aerospace & defense, semiconductor equipment, smart energy, industrial and health-tech industries. Even after the recent decision to exit the lower-margin solar panel business in 2016, Celestica's diversified business grew over 10% and generated over 30% of total revenue. Celestica will continue growing its diversified end-market business.

I valued the company using a sum-of-parts valuation method, placing an EV/EBITDA multiple of 6x 2019E EBITDA on its traditional communications, storage, servers and consumer parts of the business while putting an EV/EBITDA multiple of 8x on its diversified business. This led me to a valuation of $17.36 per share.

Investors do not recognize the full growth potential resulting from increased military spending. Since 2013, global defense spending has been steadily increasing after 5 years of decline, and totaled $1.76 trillion in 2015.

This is mainly due to increasing global tensions, as a mix of terrorist attacks and global political conflicts have caused countries around the world to upgrade their military capabilities. Through this military expansion comes future opportunity and some of Celestica's key customers will capitalize on this growth. Honeywell (HON), for example, recently signed its largest ever defense contract with Indonesia. As they continue to enter into more contracts like this, Honeywell will look to EMS companies like Celestica to manage its growing supply chains. With the recent Karel Manufacturing acquisition as well as its vertically-integrated product offerings and global capabilities, Celestica is positioned well to outcompete its competitors and win contracts within the growing aerospace & defense sector. This will help boost revenue above current expectations and allow management to achieve its double-digit revenue growth target for its diversified business.

In addition to this organic revenue growth, Celestica will look for strategic acquisitions to increase its global manufacturing and supply-chain capabilities. With over $557 million in cash and very little debt, it is well positioned to finance its future acquisitions either through use of cash or issuance of new debt.

Potential changes in U.S. trade policies can drive further growth. The market is somewhat skeptical because over 70% of Celestica's revenue is generated in Asia. Moving forward, there might be an opportunity to expand its market presence in the United States, as it is growing more likely that the Trump administration will impose higher tariffs on countries such as China and Mexico. This would severely impact companies whose products are manufactured in these countries, and they would be forced to restructure their supply chains or risk incurring higher costs associated with importing them to the U.S. However, it can also be costly for a company to complete this task in-house. In order to reduce costs, this can be outsourced to EMS providers like Celestica, which has the supply chain expertise and global manufacturing capabilities, to step in and efficiently reform the supply chain. Celestica already has 6 customer experience centers in the United States, with the newest built in Q1 of 2017 in Silicon Valley, where its design and engineering teams work side-by-side with its clients to develop innovative supply chain solutions.

I believe that there is a high-percentage chance that the Trump administration alters U.S. trade policies which could lead to further revenue growth for Celestica. Therefore, my top-line expectations are more optimistic with 3-year revenue growth of 4% compared to analyst consensus of 1.5%.

As the market becomes more informed, this can spur investor interest. Currently, Celestica is only covered by 11 analysts and is a relatively unknown name in the market. Therefore, it is overlooked by investors who are more attracted towards bigger companies in the industry such as Flex Ltd. And Jabil Circuit Inc. However, if it continues to beat earnings expectations, outperform the industry and expand its diversified end-market business, the market will take note and more analyst coverage is likely. As coverage grows, I believe the market will begin to recognize that Celestica is an undervalued company. With a P/E of 14 and an EV/EBITDA of 6.8, which are both below Celestica's historical averages as well as the rest of the industry and $52.5 million of stock repurchased in 2016, the company is trading at a discount and presents an attractive investment opportunity.

Investment Risks

1. Underperformance of Key Customers: With 68% of its revenue coming from its top 10 customers, and over 10% generated from Cisco (CSCO) and Juniper Networks (JNPR), respectively, Celestica is subject to risk associated with the performance of its top customers. However, growing opportunities in the U.S. as well as its growing diversified end-market business can help Celestica diversify its sources of revenue and become less dependent on specific customers.
2. Intense Competition in the EMS industry: This industry is extremely competitive as companies compete for contracts with key customers. There have been growing trends of consolidation within the industry as well as aggressive pricing tactics. Furthermore, some companies have been limiting the number of EMS providers they hire in order to better streamline their operations. With vertically integrated service offerings and global capabilities, Celestica is positioned well to win key contracts but may suffer some loss on margins due to decreasing prices.
3. Diversified End-Market business generating less-than-expected revenue: My thesis is heavily dependent on management being able to grow its diversified business and take advantage of future opportunities. I am predicting that, with the boost from tailwinds in the aerospace & defense sector, management can achieve its double-digit revenue growth target for its diversified revenue segment. However, other sectors within this segment may underperform and cause the company to grow below my expectations.

Investment Summary

I view Celestica as a long-term value play and believe that it is currently trading at a discount relative to its intrinsic value. The market is mispricing Celestica, overlooking its solid fundamentals and financial performance, and valuing it at lower multiples because of its communications business. Additionally, investors do not recognize the full growth potential of the company due to increased global spending as well as tailwinds in the aerospace & defense sector. As a result, I believe that Celestica has an intrinsic value of $17.36.

(Editors' Note: This is a republication of an entry in the Sohn Investment Idea Contest. All figures are current as of the entry's submission - the contest deadline was April 26, 2017).

Analyst’s Disclosure: I am/we are long CLS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.