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Edited Transcript of CLS.TO earnings conference call or presentation 29-Apr-20 12:00pm GMT

Q1 2020 Celestica Inc Earnings Call

Toronto May 1, 2020 (Thomson StreetEvents) -- Edited Transcript of Celestica Inc earnings conference call or presentation Wednesday, April 29, 2020 at 12:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Craig Oberg

Celestica Inc. - VP of IR & Corporate Development

* Mandeep Chawla

Celestica Inc. - CFO

* Robert Andrew Mionis

Celestica Inc. - President, CEO & Director

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Conference Call Participants

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* Daniel Chan

TD Securities Equity Research - Research Analyst

* Gus Papageorgiou

PI Financial Corp., Research Division - Head of Research

* Jim Suva

Citigroup Inc, Research Division - MD & Research Analyst

* Kurt Van Orden Swartz

Stifel, Nicolaus & Company, Incorporated, Research Division - Associate

* Paul Steep

Scotiabank Global Banking and Markets, Research Division - Analyst

* Paul Michael Treiber

RBC Capital Markets, Research Division - Director of Canadian Technology & Analyst

* Robert Young

Canaccord Genuity Corp., Research Division - Director

* Ruplu Bhattacharya

BofA Merrill Lynch, Research Division - VP

* Thanos Moschopoulos

BMO Capital Markets Equity Research - VP & Analyst

* Todd Adair Coupland

CIBC Capital Markets, Research Division - MD of Institutional Equity Research

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Presentation

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Operator [1]

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Ladies and gentlemen, thank you for standing by, and welcome to the Celestica First Quarter 2020 Earnings Call. (Operator Instructions) Please be advised that today's conference is being recorded. Analysts, please limit yourself to one question and one follow-up. Thank you.

I would now like to hand the conference over to your speaker for today, Craig Oberg, Vice President, Investor Relations and Corporate Development. Please go ahead.

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Craig Oberg, Celestica Inc. - VP of IR & Corporate Development [2]

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Good afternoon, and thank you for joining us on Celestica's First Quarter 2020 Earnings Conference Call. On the call today are Rob Mionis, President and Chief Executive Officer; and Mandeep Chawla, Chief Financial Officer. 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. Such forward-looking statements are based on management's current expectations, forecasts, and assumptions, which are subject to risks, uncertainties, and other factors that could cause actual outcomes and results to differ materially from conclusions, forecasts, or projections expressed in such statements.

For identification and discussion of such factors and assumptions, as well as further information concerning forward-looking statements, please refer to our press release, including the cautionary note regarding forward-looking statements therein, and our Annual Report on Form 20-F and other public filings, which can be accessed at sec.gov and sedar.com. We assume no obligation to update forward-looking statement, except as required by law.

In addition, during this call, we will refer to various non-IFRS measures, including operating earnings, operating margin, adjusted gross margin, adjusted return on invested capital or adjusted ROIC, free cash flow, EBITDA, gross debt to non-IFRS trailing 12-month adjusted EBITDA leverage ratio, adjusted net earnings, adjusted EPS, adjusted SG&A expense, and adjusted effective tax rate. Listeners should be cautioned that references to any of the foregoing measures during this call denote non-IFRS measures, whether or not specifically designated as such. These non-IFRS measures do not have any standardized meanings prescribed by IFRS and may not be comparable to similar measures presented by other public companies that use IFRS or who report under U.S. GAAP and use non-GAAP measures to describe similar operating metrics.

We refer you to today's press release and our Q1 2020 earnings presentation, which are available at celestica.com under the Investor Relations tab, for more information about these and certain other non-IFRS measures, including a reconciliation of historical non-IFRS measures to the most directly comparable IFRS measures from our financial statements. Unless otherwise specified, all references to dollars on this call are to U.S. dollars, and per share information is based on diluted shares outstanding.

Let me now turn the call over to Rob.

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Robert Andrew Mionis, Celestica Inc. - President, CEO & Director [3]

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Thank you, Craig. Good morning, and thank you for joining today's conference call. Before we discuss Celestica's results, I'd like to take a moment to acknowledge the commitment, teamwork, and creativity displayed by our global team, as they have risen to the challenge of steering the company through the COVID-19 pandemic. Our priority was to put plans in place to help ensure the health and safety of our employees, as we maintained business continuity across the Celestica network. I would also like to thank our customers and suppliers for their partnership in finding ways to work through a variety of restrictions.

Since the beginning of the crisis, Celestica has implemented several preventative and proactive measures to help protect the health and safety of our employees, suppliers, and customers. We continue to promote a range of protocols that include a global work from home policy, physical distancing, enhanced screening, providing personal protective equipment, and shift splitting. We will continue to put safety first, while we work to maximize production uptime.

Now, turning to our first quarter results. Even in this challenging environment, we were able to achieve improved year-over-year operating margin, generate robust free cash flow, and pay down long-term debt. COVID-19 presented a number of challenges that negatively impacted our financial results this quarter. First quarter revenue fell slightly below our withdrawn guidance range, but profitability was ultimately in line with beginning of quarter expectations.

Our CCS segment posted solid margin performance on lower than expected revenue, expanding segment margin sequentially for the fourth consecutive quarter, and operating at the high end of its 2% to 3% target range. In our ATS segment, we are encouraged by capital equipment's return to profitability. Capital equipment had posted a loss for the last 5 quarters, and we are pleased that our restructuring actions and improved mix have accelerated its recovery. However, increasing headwinds in A&D contributed to ATS segment margins below our target range of 5% to 6%.

I will provide some additional color on our end markets, but first, I will turn the call over to Mandeep to give you further details on our first quarter results.

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Mandeep Chawla, Celestica Inc. - CFO [4]

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Thank you, Rob, and good morning, everyone. As a reminder, on March 17, 2020, we reviewed our previously disclosed financial guidance for the first quarter of 2020 in response to the uncertainty created by various government-mandated site closures stemming from COVID-19. Notwithstanding this disruption caused by COVID-19, however, other than revenue, which was $6 million below the low end of our guidance range, our other results were firmly within the ranges originally provided.

Our first quarter revenue came in at $1.32 billion, lower than originally expected, mainly due to an estimated negative impact of approximately $85 million from COVID-19. Revenue decreased 12% sequentially, and was down 8% year-over-year. Our non-IFRS operating margin was 2.9%, up 50 basis points year-over-year, and flat sequentially. Non-IFRS adjusted earnings per share were $0.16 compared to $0.12 for the first quarter of 2019. Our ATS segment revenue was 41% of our consolidated revenue, up from 40% compared to the first quarter of last year. ATS revenue was down 7% sequentially, and down 5% compared to last year.

In addition to impacts from COVID-19, the year-over-year decline was driven by reduced revenue in energy, due to previously planned disengagements and weakness in our A&D business, partially offset by improvements in capital equipment demand. The sequential decline was mainly due to COVID-19 materials and manufacturing constraints, and demand weakness in A&D, driven by the 737 MAX halt, partially offset by improvement in capital equipment.

Our CCS segment revenue was down 15% sequentially, and down 10% year-over-year. The year-over-year decline was primarily driven by portfolio shaping actions. Within our CCS segment, the communications end market represented 39% of our consolidated first quarter revenue, the same as the first quarter of last year. Communications revenue in the quarter was down 10% year-over-year, largely due to COVID-19 impact, partly offset by continuing strength in our JDM business. Our enterprise end market represented 20% of consolidated revenue in the first quarter, down from 21% in the same period last year. Enterprise revenue in the quarter was down 10% year-over-year, largely due to planned disengagements as part of our CCS segment portfolio review, partly offset by higher program-specific demand, including in JDM programs. Our top 10 customers represented 66% of revenue for the quarter, down from 68% last quarter, and up from 62% in the same period of last year. For the first quarter, we had one customer contributing greater than 10% of total revenue, compared to 2 customers year-over-year and sequentially.

Turning to segment margins. ATS segment margin of 2.7% was down 30 basis points relative to last quarter, due to demand softness related to COVID-19 and headwinds in the A&D business, partly offset by strength in capital equipment. Capital equipment returned to profitability for the first time since the fourth quarter of 2018, and as expected, delivered profitability in the single-digit millions. Year-over-year ATS segment margin was up 10 basis points, as improvements in capital equipment performance more than offset inefficiencies due to COVID-19 and headwinds in A&D. CCS segment margin of 3.0% came in at the high end of our target range of 2% to 3%, despite lower than expected revenue. Segment margin was up 10 basis points sequentially, and up 70 basis points year-over-year. Both sequential and year-over-year improvements were driven by favorable mix, including strong growth and operating leverage in JDM, and continued productivity efforts.

Moving to some other financial highlights in the quarter. IFRS net loss for the quarter was negative $3.2 million or negative $0.02 per share, compared to net earnings of $90.3 million or positive $0.66 per share in the same quarter of last year. Earnings per share for the first quarter of 2019 included a $0.75 per share benefit from the sale of our Toronto property. Adjusted gross margin of 7.3% was up 30 basis points sequentially, and up 70 basis points compared to last year. Despite lower revenue and negative impacts from COVID-19, sequential and year-over-year improvements were largely driven by improved mix and productivity.

Our adjusted SG&A of $50 million was down $2.5 million sequentially, primarily due to favorable foreign exchange impacts and lower variable spend. Our adjusted SG&A was down $1.0 million from the prior-year period, primarily due to foreign exchange benefits. Non-IFRS operating earnings were $38.1 million, down $5.6 million sequentially, and up $3.0 million from the same quarter of last year. Our non-IFRS adjusted effective tax rate for the first quarter was 24%, compared to 27% both sequentially and for the prior year period. For the first quarter, adjusted net earnings were $20.7 million, compared to $15.8 million for the prior year period. Non-IFRS adjusted earnings per share of $0.16 was up $0.04 year-over-year, mainly due to higher non-IFRS operating earnings and lower interest expense. Non-IFRS adjusted ROIC of 9.5% was down 1.1% sequentially, and up 1.6% compared to the same quarter of last year.

Moving on to working capital. Our inventory at the end of the quarter was $1.1 billion, an increase of $80 million sequentially, and flat relative to last year. Inventory turns were 4.8, down 0.7 turns sequentially, and down 0.2 turns year-over-year. Capital expenditures for the first quarter were $12 million, or approximately 1% of revenue. Non-IFRS free cash flow was $54 million in the first quarter, compared to $145 million for the same period last year. All but $32 million of our first quarter 2019 cash flow was attributable to the sale of our Toronto property.

Cash cycle days in the first quarter were 69 days, up seven days sequentially, and flat year-over-year. Our cash deposits at the end of the first quarter of 2020 were $135 million, up $13 million sequentially, as we continue to work with our customers on working capital improvements. We continue to improve our working capital performance, and we remain focused on generating more than $100 million of non-IFRS free cash flow in 2020.

Moving on to our balance sheet and other key measures. Celestica continues to maintain a strong balance sheet. Our cash balance at the end of the first quarter was $472 million, down $7 million sequentially, and up $14 million year-over-year. As a result of our high cash balance and our $450 million revolver, which remains undrawn, Celestica's liquidity exceeds $900 million. We believe this liquidity amount is sufficient to meet our current business needs.

As a result of continuing free cash flow generation, we were able to make progress in the first quarter towards deleveraging our balance sheet by repaying $61 million of long-term debt. Our gross debt position was $531 million at the end of March, while our net debt was $59 million, down $53 million sequentially, and down $177 million from the first quarter of last year. Our gross debt to non-IFRS trailing 12-month adjusted EBITDA leverage ratio improved 0.2 turns sequentially to 2.0 turns. At the end of March, we were compliant with all of our financial covenants under our credit agreement.

In the near term, our priority is to continue to reduce our leverage, providing us with increasing level of flexibility and reduced interest costs. Over the long term though, our capital allocation priorities remain the same. We will continue to work towards generating strong free cash flow, and plan to return approximately half to shareholders, while investing the other half into the business.

In the first quarter, we incurred $8 million of restructuring charges. While restructuring costs are forecasted to be lower than anticipated for the Cisco disengagement in 2020, we anticipate taking additional restructuring actions in 2020 associated with adjusting our cost base to reflect shifting demand. As a result, restructuring costs for 2020 will be greater than the forecasted $30 million. We believe that Celestica has a strong operating model and solid balance sheet to weather the current COVID-19 disruption. As we look to the next quarter, we see continued uncertainty surrounding COVID-19. While our operations are largely stabilized, the size and geographic diversity of our network exasperates the high degree of variability surrounding government-imposed workforce restrictions impacting not only our operations, but that of the global supply base.

Therefore, consistent with many of our large customers, we do not believe it would be prudent to provide any specific financial guidance for the second quarter at this time. While we're not providing guidance, we do anticipate the second quarter to be largely in line with our first quarter results, should conditions neither improve nor deteriorate further.

I'll now turn the call over to Rob for additional color and an update on our priorities.

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Robert Andrew Mionis, Celestica Inc. - President, CEO & Director [5]

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Thank you, Mandeep. COVID-19 presented 3 primary challenges in the first quarter, increased material constraints, deferred demand, and operational inefficiencies. First, material shortages increased by approximately 50% in Q1 2020 as compared to the end of 2019. We are actively engaged with our supply base to secure materials, and while we are making progress, there continues to be uncertainty due to COVID-19. Second, while we are experiencing demand strength in capital equipment and service provider, which is fueled by our JDM hardware solutions, we have seen softness in other areas such as A&D and industrial. We are working with customers to adjust and optimize future production schedules, and at this time, we anticipate that most of the estimated demand shortfall resulting from COVID-19 will push into later quarters. Finally, while we have been impacted by government-mandated shutdowns, we are pleased with the work our teams have done to get us back online to meet our customers' requirements.

Currently, our global network is operating at approximately 80% to 85% of normal workforce levels. However, certain sites continue to operate at lower capacity levels as a result of government-mandated operational restrictions currently in effect. Others are operating at near-normal levels, with China at 95% plus. As we think about 2020, we are pleased that we're able to start the year with a solid foundation in CCS and with improving performance in capital equipment. While we are now facing a number of near-term headwinds as a result of COVID-19, we believe the strength of our portfolio will help mitigate some of these challenges.

Turning to ATS. Our capital equipment business was, and continues to be, negatively impacted by COVID-19, due to shelter-in-place orders in various geographies. Currently, our capital equipment facilities in the Bay Area, Oregon, and Malaysia are operating at approximately 60% normal workforce level, while Korea is at full capacity. Despite these challenges, revenue was up 28% year-over-year in the first quarter, and unfulfilled demand from Q1 is expected to be fulfilled in subsequent quarters. The business returned to profitability in the first quarter in the single-digit million-dollar range. The sequential improvement in profitability was helped in part by our productivity initiatives, improved mix, and new program ramps.

The display market remains depressed, and while volumes are improving, we continue to expect near-term softness with a modest recovery late in the year, driven by increased demand for next-generation smartphones and next-generation large form factor displays. As the industry shifts from LCD to OLED, we believe that we are well positioned to support our customers' growth, and have already begun ramping new programs. In our semi cap business, we are seeing full-year demand strength on a year-over-year basis. However, our near-term results were softer than expected, driven by COVID-19. We are pleased with the improved profitability in our capital equipment business, and continue to take a long-term view of this market. With our specialized vertical capabilities, we believe we are well positioned to capitalize on potential long-term demand drivers for this business.

Across the balance of ATS, the challenges we are experiencing from COVID-19 are impacting growth across several markets, while also creating some opportunities. Within industrial, in the near term, we are seeing a modest demand reduction for certain end-market products, as a result of COVID-19. In A&D, we are experiencing headwinds as a result of continued material constraints that have been exacerbated by COVID-19, and a temporary halt of the Boeing 737 Max program. As a result, A&D was largely breakeven in the first quarter of 2020. However, we are expanding on the actions taken in the first quarter to adjust our cost base to this reduced level of demand. Barring any unforeseen increased negative impacts from COVID-19, we anticipate the business to improve its profitability in the near-term. The aviation industry is among the hardest-hit industries by the pandemic. And as such, we anticipate that the COVID-19 will continue to pressure our A&D business in 2020, as weakness spreads to the commercial market, partially offsetting anticipated strength in defense. While we are facing challenges in our commercial aerospace business in the near term, we are pleased that our defense business bolstered by Atrenne continues to perform well. We are excited that Atrenne has received its sixth Four-Star Supplier Excellence Award from Raytheon in the first quarter. This award is a recognition to our team's focus on quality and on-time delivery, each and every day.

Also as mentioned last quarter, we are in the process of expanding one of our Atrenne facilities to accommodate additional ITAR capacity as well as the expansion of our licensing business. We are pleased that these expansion efforts are on track and expect them to be substantially complete by the end of the year.

Within Healthtech, we expect to see strong growth in 2020. While we are seeing a modest near term decline in demand for products used in elective procedures due to COVID-19 priorities, we are pleased with Healthtech's growth including a number of recent wins to partner with our customers in the fight against COVID-19. We are working with Medtronic to quickly ramp the production of ventilators. In addition, we're also collaborating with a Canadian-based medical company to produce ventilators for the Canadian government. Celestica is happy to do our part in combatting COVID-19.

Turning to CCS. Our CCS segment delivered sequential margin improvement for the fourth consecutive quarter and operated at the top end of our 2% to 3% target range driven by portfolio actions and improved mix including more JDM. We are pleased with the performance of our JDM business. At the end of 2019, JDM accounted for $500 million of revenue and in the first quarter of this year, JDM revenue grew approximately 40% year-over-year. This high level of growth was fueled by a number of wins in the service provider market.

Celestica now supports eight out of the 10 world's largest hyperscale service providers, developing technologies, which are deployed throughout their data centers. We are seeing increased demand from service providers as they expand their data centers in support of growing cloud and online requirements.

Current demand growth is largely driven by 2019 wins and accelerated by the recent surge in remote workers' consumption of digital content and the need for artificial intelligence and machine learning technologies to help global governments and agencies combat COVID-19. While we are seeing strong growth in JDM and service provider customers, communication demand softness and portfolio shaping continues to adversely impact our revenue amplified by COVID-19.

Our Cisco disengagement is progressing as planned and we expect the transition to be largely complete by the end of 2020. We continue to work with Cisco to ensure an efficient, seamless and successful transition. We are pleased with the progress of selectively backfill fiscal revenue with higher value-add solutions and continue to have many inquiries about available capacity at our Thailand facility. We have a large funnel of opportunities to backfill Thailand, and we already experienced strong bookings in the first quarter of 2020. We believe we are on track to meet our bookings targets with a richer mix of programs.

While there is uncertainty surrounding the impact COVID-19 may have in the near term, including in our A&D segment, we remain confident in our long-term outlook. We believe that our strength in CCS hardware solutions to support the growing demand for cloud and bandwidth, coupled with our limited exposure to consumer-oriented markets provides us with a solid foundation during these uncertain times. We are excited about our future opportunities with sustainable, profitable growth.

I'd like to thank all of our employees who have focused on keeping our operations running and working together to help mitigate the risks for our customers. Their effort and commitment to working together to adapt to the situation has been nothing less than extraordinary. We look forward to updating you over the coming quarters.

With that I would now like to turn the call over to the operator to begin our Q&A.

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Questions and Answers

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Operator [1]

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Certainly. (Operator Instructions) Gus Papageorgiou with PI Financial.

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Gus Papageorgiou, PI Financial Corp., Research Division - Head of Research [2]

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Congratulations on a good, decent quarter during a challenging environment. I just want to hit on the Cisco disengagement. I imagine it was a pretty complicated undertaking under normal circumstances, but with all the chaos that's going out there in the supply chain, how certain are you that it's going to happen this year and do you know if Cisco has found other providers? And if they don't, if they are unable to find other providers within the time frame that you plan? What is the plan for maybe extending it? Is there any other contracts that would be beneficial for you if Cisco were to extend their supply agreement with you?

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Robert Andrew Mionis, Celestica Inc. - President, CEO & Director [3]

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Hi Gus, it's Rob. Yes. The transition plan that we've looked out with Cisco is complete. So they have found other providers, and we're working with them on a seamless and efficient transition. So while things could change amidst the COVID pandemic, I think they have homes for all the work and we're working through the transition plan. In our side, we're encouraged by the very strong bookings that we've seen to date backfill the Cisco work with programs that are more aligned to our strategy. We are seeing a lot of strength in our service provider business, we have a lot of new wins with Thailand in specific and we have a very strong funnel of growth opportunities, both in comps and enterprise.

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Gus Papageorgiou, PI Financial Corp., Research Division - Head of Research [4]

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Okay, great. I'm sorry, if I could just one more. Good cash flow in the quarter. Do you think by the end of the year you'll be in a net cash position? Obviously, your inventory levels are higher because of material constraints, but if you continue at these levels, do you think by the end of the year you guys will be in a net cash position?

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Mandeep Chawla, Celestica Inc. - CFO [5]

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Hi Gus, Mandeep here. Yes, we're very pleased with the cash flow generation in the first quarter, $54 million. As we mentioned, we're targeting above $100 million for the full year and so that would imply that we'll get pretty close to that. But what I would just say is that the timing, of course, will be up and down given the COVID impact right now. So we do expect to continue to generate strong free cash flow as we go through 2020 and our number one focus right now is to delever. So if the cash generation does come in as expected, we should be getting close to a net cash position.

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Operator [6]

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Todd Coupland with CIBC.

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Todd Adair Coupland, CIBC Capital Markets, Research Division - MD of Institutional Equity Research [7]

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Yes. Just to follow up on the free cash flow. I think you said all the free cash flow was from operations except $32 million. Was that right?

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Mandeep Chawla, Celestica Inc. - CFO [8]

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Hi, Todd. Mandeep here. Actually, we were just providing a bridge on a year-over-year basis when you back out the Toronto property sale. So what we were indicating is that our cash flow is stronger than the previous period when you back out the Toronto sale.

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Todd Adair Coupland, CIBC Capital Markets, Research Division - MD of Institutional Equity Research [9]

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Okay. I just wanted you to give us the goalposts to get $100 million for the year, particularly given you've done pretty well in Q1, in terms of getting halfway there. Just talk about the puts and takes would get you to $100 million.

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Mandeep Chawla, Celestica Inc. - CFO [10]

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Sure. So if you look at our cash cycle performance, we were relatively flat on a year-over-year basis and that is with inventory levels being elevated. As you're aware, in the EMS space, if revenue was to decline, it has an opportunity to kick out much more cash. We currently do you have visibility to generate enough levels of cash flow and it's a combination of slightly lower revenue, but then also continuing working capital performance specifically in the areas of inventory and deposits. We feel like we're making good progress in those areas.

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Todd Adair Coupland, CIBC Capital Markets, Research Division - MD of Institutional Equity Research [11]

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Okay. And then my second question -- follow-up question is, from what you're seeing from your customers at this point and the various government requirements, do you have an opinion on the strength of the recovery? This is obviously a major debate across a number of companies but is it a V, is it a U, is it L? I imagine some of your segments will take longer to come back, such as aerospace, but excluding that, talk about what your customers are telling you in terms of how quickly the business come back once the various regions open up.

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Robert Andrew Mionis, Celestica Inc. - President, CEO & Director [12]

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Hi Todd, it's Rob. Good question. It's certainly a conversation we've been having with all our customers and it does depend, I think, in our CCS business, especially in the service provider in areas that support the hyperscalers. They see things accelerating given the COVID pandemic and the thirst for bandwidth. But in other areas, especially like aerospace I think it's going to be down for a good couple of years. Industrial, I think it's probably more of a U, Health-tech there are some puts and takes. But generally speaking, we see that as a growth business for us and also for industries while there is a push out of elective surgery equipment, there is an out pull and everything else in terms of diagnostic equipment. So it depends on people's mix, but generally speaking, Health-tech will be a growth business for us as well. So it really depends on the segment, but the general sentiment I think is people are hopeful for a U, certainly not a V. The customers are saying -- there is a lot of optimism for U.

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Operator [13]

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Paul Steep with Scotia Capital.

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Paul Steep, Scotiabank Global Banking and Markets, Research Division - Analyst [14]

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Rob, could you maybe talk just a little bit longer term, if you've had any discussions yet or how clients would be thinking about maybe shifting manufacturing capacity? We know we've had some commentary out there, but people realigning supply chains and shifting things, how would Celestica think about that? And then I've got one quick follow-up for Mandeep.

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Robert Andrew Mionis, Celestica Inc. - President, CEO & Director [15]

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Yes. Right now, customers are being very measured in terms of how they're thinking about the long-term footprint. I think early on in the first couple of innings there was the tariff situation and now there's a lot of discussion about localization and things along those lines. Nobody is going overboard, over-rotating at this stage of the game in terms of looking at onshore or anything drastic. I think everybody is looking to have a balanced portfolio that kind of has total landed cost better optimized. So not a lot of discussion right now on any hard [weathered] actions.

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Paul Steep, Scotiabank Global Banking and Markets, Research Division - Analyst [16]

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Perfect. And then Mandeep, how should we think about the operating cost obviously taking into effect your commentary around restructuring in the fact that you'll be above the 30? But if we think about the operating cost in Q1, did we fully have the savings reflected in there at sort of the prior run rate or should we think that there's significantly more to come?

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Mandeep Chawla, Celestica Inc. - CFO [17]

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Let me know if I'm answering your question properly, Paul. We're pleased with the performance that we had in the first quarter, but there were puts and takes in there. As we mentioned, revenue was impacted by about $85 million because of COVID-19 and so had we not had that headwind, revenue would come in a lot stronger and it would leverage, where we see margins potentially expand from there. We also did incur some direct cost relative to COVID-19, about $3 million or so. And so that's weighing down on the results, but we had other benefits on the other side. We had some foreign exchange benefits, we saw some benefits on our tax rate as well. So while providing guidance going into the second quarter, we expect that there is going to be some moving pieces, you hit on one of them which is the improved profitability in certain areas. A&D was approximately a breakeven business in the first quarter. Now, we've already started to take some cost actions, but we need to take more cost actions and rightsize that business, and right now the plans that we have are indicating a greater level of profitability in A&D as we move into Q2. So the actions are continuing

And I'll just touch briefly on the restructuring plans for the full year. As mentioned, we originally had anticipated $30 million of restructuring charges for the year. The good news is that because of the strong growth that we're seeing in Thailand, not only from new wins that we're getting into backfill Cisco, but also a lot of demand strength from service provider, we are able to redeploy more resources and assets than what we had planned. And so that original $30 million is coming in lower. However, as we add on additional actions to, as we've mentioned, we are seeing that that will add to it. So right now our restructuring outlook for the full year is in the range of $30 million to $45 million.

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Operator [18]

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Rob Young with Canaccord Genuity.

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Robert Young, Canaccord Genuity Corp., Research Division - Director [19]

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The $85 million impact that you're (inaudible), I think might use that as a way to calibrate Q2. So I was curious if you could talk about how much of that was driven by China and if part of that $85 million would have happened maybe in the second half of March as the impact of COVID-19 radiated outwards?

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Mandeep Chawla, Celestica Inc. - CFO [20]

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Actually, let me talk about COVID-19 for a moment and Rob can add on as needed. So there's kind of 3 legs to the stool here: there is the demand side, there is impacts on the material side and then there's operations. On the demand side, we talked about the $85 million. About 2/3 of that was in the CCS business and as you know, the majority of CCS operations are in the Asia region. One of the challenges that we've been having, it has been on the material supply. So the demand outlook as Rob have mentioned and in one of his earlier response is pretty strong. Although there are some puts and takes in aggregate, the demand outlook continues to be relatively strong. The material constraints were a challenge and that's one of the reasons that inventory has increased a little bit, that's one of the reasons we had the $85 million of gated revenue and it really has to do with our suppliers, being able to get back fully online and right now, there is a portion of our suppliers that are not yet fully online, which is causing some of these challenges. The other big unknown right now is we're very pleased that the operating network is running at 80% to 85% utilization and we would hope that over time that that would improve, but it's a very large unknown right now and so right now we're anticipating as we go into Q2 that -- it won't get materially better, but it also won't get materially worse.

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Robert Young, Canaccord Genuity Corp., Research Division - Director [21]

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Right. So if I set aside A&D as something, though the bigger impact is just not demand. It would be in your ability to operate some of the facilities and then the ability to secure enough supply to build. Is that correct to say?

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Mandeep Chawla, Celestica Inc. - CFO [22]

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Correct. So it's the operating efficiency, to your point, and then it's material supply. If you look at our network right now, across our network, there's only one site that's actually currently non-operating and it's a relatively small site and our expectations are that that site will be back online within the next few weeks. On the operating side, you just don't know if there's going to be another government mandate to shutdown in whichever country you pick. On the supply side, we've been seeing a good level of improvement and what we're finding is that the supply constraints are not coming into China. They're coming out of areas that have been hit after the China pandemic or after the pandemic hit China. So right now, about 50% of those suppliers are currently at some level of disruption. And so the answer to your question is yes, demand we feel is strong right now. We're working very diligently to get the supply and we have dedicated resources on that and they're making very good progress. And then on the operational side, we're pleased, again that we're at the 80%, 85%.

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Robert Young, Canaccord Genuity Corp., Research Division - Director [23]

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Okay. And then last question for me just directionality on the operating margins going forward. Heard a bunch of different things. It sounds as though restructuring A&D may actually be positive for that. The CE business is profitable 2.9% operating margin this quarter was strong. Do you think you can improve on that as you go through the year or is it just too uncertain to tell?

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Mandeep Chawla, Celestica Inc. - CFO [24]

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We're being careful not to provide guidance. There is a lot of uncertainty and so I think the prudent thing would be to do that. It wouldn't really be in any of our benefits to declare that we have tremendous clarity when many of our customers themselves are seeing that they don't. But what we would say is that if you go back and look at how we were thinking about 2020 earlier on, we are looking to expand margins in 2020 compared to 2019. And we're looking to grow our EPS as well in 2020. So the 2.9% in Q1 was up 50 basis points on a year-over-year -- it was up on a year-over-year basis. If that 50 basis points improvement was there in Q1, we're looking for margin expansion as we go through the remainder of the year. But we're not going to give any number at this time.

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Operator [25]

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Thanos Moschopoulos with BMO Capital Markets.

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Thanos Moschopoulos, BMO Capital Markets Equity Research - VP & Analyst [26]

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Mandeep, just to clarify, you said that as we head into the next quarter, you would expect to see some profitability improvement in A&D. So what would be the key offsets given that all else equal, you would think that Q2 looks somewhere to Q1 at a corporate level?

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Mandeep Chawla, Celestica Inc. - CFO [27]

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Well, there are some -- again, impacts from direct cost around COVID. Those will continue to be a little bit of an unknown. We had benefits in the first quarter as I mentioned around taxes as well as foreign exchange. Those won't necessarily repeat themselves going into Q2. And so while we are expecting improvement in A&D and we expect continuing profit contribution from capital equipment, they may be slightly offset. The other thing I would say is that we're very pleased with the performance that we saw in CCS, CCS was at 3% of their margins and that's the high end of their range. I would say at this point, it's not necessarily something that we can just assume is going to continue to be at that level, but business had a very strong level of performance in Q1. We're still anticipating good performance for the remainder of the year, but if the business falls a little bit below 3%, that wouldn't be very far off of our expectations.

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Thanos Moschopoulos, BMO Capital Markets Equity Research - VP & Analyst [28]

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Okay. And just to clarify in terms of the 85% capacity that you're running at currently, what segments are being most impacted by the constraints and the production shortfalls?

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Robert Andrew Mionis, Celestica Inc. - President, CEO & Director [29]

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Hi, it's Rob. Right now, capital equipment is running at about 60% to 70%. They're probably one of the most impacted. That's largely driven by some low utilization in the Bay Area and also Malaysia. As of late, we do expect some of the issues we're having in Malaysia to get better as the company gets over the surge, if you will. That's one of the lower ones. And we're really tracking it more by region than by business. Again, China is almost back to normal levels. Europe is running very strong at 90% plus. Thailand's running at 90% plus. Like I mentioned, Malaysia is getting better, but in the 70% range right now. So overall, I guess I would have to -- thinking out loud, I would have to say capital equipment probably has the longest way to go.

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Operator [30]

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Ruplu Bhattacharya with Bank of America.

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Ruplu Bhattacharya, BofA Merrill Lynch, Research Division - VP [31]

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On the CCS side, just looking at enterprise, the revenues came in better than you had expected. you had guided down mid-20s. It came down 10% year-on-year. Also, on the communication side, it looks like it was slightly worse, down 10% versus flat, you had guided. So maybe if you can drill down what did you -- what was better, what was worse in each of these enterprise and communications end markets?

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Robert Andrew Mionis, Celestica Inc. - President, CEO & Director [32]

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Sure. So what we saw in enterprise -- in Q1, we saw strong demand in storage and compute, supporting the hyperscalers. That was somewhat offset by portfolio shaping, and the balance was resulting from demand dynamics. As we look forward, and then we see -- again, continue our portfolio shaping, and that will again be partially offset with new program ramps and storage and compute supporting the hyperscalers. In comms, what we saw was obviously COVID pressure. We had product and technology transitions and some businesses in traditional comps programs that was partially offset with some new program ramps supporting service providers. And looking forward, we do see some of the unfilled demand in comms from Q1 pushing into Q2. We have some new program ramps and networking supported by our JDM portfolio. We've seen some demand strength in some existing programs in the networking area, and that's being partially offset with some technology transitions.

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Ruplu Bhattacharya, BofA Merrill Lynch, Research Division - VP [33]

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Okay. For my second question, just on A&D, can you help us quantify what the dollar impact was of the materials just that you saw on A&D revenues, and also the dollar impact of the Boeing 737 MAX program? And the genesis of my question is, I mean, A&D is a big part. I mean, you're leader A&D EMS. So given that that segment will be weak over the course of the year, do you still expect ATS segment to grow year-on-year, or do you think the weakness in A&D just kind of masks the growth you're seeing in other parts of the business?

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Mandeep Chawla, Celestica Inc. - CFO [34]

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I'll maybe take the piece around profitability and the outlook, and Rob can add on as well. A&D is our largest segment within ATS, and A&D has been performing very well for a number of years. The challenges around the 737 coming out of the end of last year have already been factored into our -- were already factored into the numbers we're looking at, as we think about this year. And so with material change at this point and what's happening around the 737. We won't give specifics on the direct impact, but what I will share or reiterate from last time is 737 was just a little bit under 10% of our overall A&D revenues in last year. And so the 737, it's not moving too much. On the other side of things though, there were a lot of inefficiencies. So some material continues to be constrained, and that's creating inefficiencies within the network. We saw shutdowns in the first quarter, as well, which drove some of the inefficiencies. But we are expecting a level of profitability as we go into Q2.

To address your question on the 5% to 6% maybe range on the organic growth rate, I mean, commercial aerospace is down significantly, and we are expecting a double-digit decline in our aerospace and defense business in 2020 as a result of that. And so because it's our largest segment, we likely will not hit the 10% growth rate in ATS this year that we're targeting. We're pleased that we were able to get to that rate, 9%, for the last 2 years. You may not see that. But that being said, we're still in the early innings. Capital equipment demand continues to be strong, and we'll see how much of the decline in A&D can be offset by capital equipment.

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Robert Andrew Mionis, Celestica Inc. - President, CEO & Director [35]

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And with respect to the material constraints, out of the $85 million about, I guess about 40% or so was appointed towards EPS. The balance was in about CCS. A lot of the shortages within that 40% were within A&D. Some of them more COVID related, but also, some of them were just other issues that we're working through. We've had some high reliability parts on some very specific programs that have been on allocation for a period of time, and we're working with that supplier to increase their capacity, through just the backlog. So those continue to impede our ability to get revenue out the door.

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Operator [36]

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Paul Treiber with RBC Capital Markets.

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Paul Michael Treiber, RBC Capital Markets, Research Division - Director of Canadian Technology & Analyst [37]

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Just wanted to follow up on a prior comment you made about capital equipment being at 60%, 70% utilization. How does that compare to either last quarter or last year? And then how do you see utilization changing over the year? Is that a fairly rapidly moving item? Or are you looking for that to improve with displays ramping up towards the end of the year?

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Robert Andrew Mionis, Celestica Inc. - President, CEO & Director [38]

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Yes. So the utilization comment was really just on what percent of the total hours available are our employees consuming, if you will. And the 60% to 70%, relative to last year, is about -- we usually at about 100% -- it's bringing that down. It's just -- in Malaysia specifically, government mandates on how many people could be in the building at any given point in time. And based on conditions improving in Malaysia. We see the restrictions being pulled back and our utilization improving over the next several weeks to the full quarter. California is still on the shelter-in-place order. So that will probably still be in place for some period of time. So we're waiting to see that. With respect to display, Korea has been at about 100% utilization. They have not been impacted significantly by COVID, thank goodness. So right now, we're seeing some sequential quarter-over-quarter improvement in display. But as mentioned during the call, we don't see volumes materially improving until perhaps towards the end of the year into next year, as some of the cellphone, smartphone sales start picking up in the industry.

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Paul Michael Treiber, RBC Capital Markets, Research Division - Director of Canadian Technology & Analyst [39]

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That's helpful to understand. For my second question, just in light of globally, the financial constraints and the uncertainty in this environment, do you think it would lead to an overall greater willingness from your end customers to consider outsourcing maybe more so than what they did in the past? Or have you seen any signs of that at this point?

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Robert Andrew Mionis, Celestica Inc. - President, CEO & Director [40]

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Yes, that's a very good question. I think that's especially true in reliability markets. What we've seen in past cycles, as customers work through their cost challenges, and EMS providers like ourselves that are the leaders in A&D, we're a leader in capital equipment, we're a leader, they look to the leaders in those industries to help support them, to help drive supply chain efficiency. So in areas of A&D in particular, we do see a potential benefit. I think if you go through, it's down cycle for us to actually pick up some incremental share where these OEMs were reluctant to outsource in the past at this stage of the game. They probably have a lot of Swiss cheese in their factories, a lot of under-utilized factories, and we can certainly help them through their efforts in terms of lifting, and shifting, and helping them through facility consolidation, and optimizing also on our existing footprint. So we do view that as an opportunity, and especially as it impacts many of our ATS markets.

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Operator [41]

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Matt Sheerin with Stifel.

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Kurt Van Orden Swartz, Stifel, Nicolaus & Company, Incorporated, Research Division - Associate [42]

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Yes. This is Kurt Swartz on for Matt. Question on the health tech business and the ramping of some new COVID-related programs. Just wondering if you can offer a little bit more color on how you expect the incremental COVID-related demand -- how long you expect that to be sustained potentially, and whether this will be a net benefit in the next few quarters, given the reduced demand for surgical products.

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Robert Andrew Mionis, Celestica Inc. - President, CEO & Director [43]

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Yes. Hi, Kurt. Yes, the COVID is actually having a positive impact on ventilators, IVD monitoring devices. So we expect demand for these devices to be strong for the balance of the year. Some of our recent awards that we won for the ultrasounds, for diagnostic equipment, they're accelerations of products that we're currently producing. We also have some incremental awards. So we think that the net benefit for us this year will be north of $75 million, probably fulfilled in the back half of this year. So that -- we already had a fairly high growth rate in our health tech businesses. So we'll actually add to the high growth rate.

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Kurt Van Orden Swartz, Stifel, Nicolaus & Company, Incorporated, Research Division - Associate [44]

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Understood. And then, just another question. Looking at the capital equipment outlook, you mentioned that you expected some of the unfulfilled demand in Q1 to probably come back in future quarters. But I'm just wondering if you may have any commentary on the competitive dynamics in this market and what the timeline may be for that demand coming back. I think one of your peers also indicated that it believed it would gain share due to semi-cap -- in semi-cap, due to supply constraints. So just wondering when those constraints may be lifted and how that competitive dynamic shakes out.

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Robert Andrew Mionis, Celestica Inc. - President, CEO & Director [45]

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As I mentioned, a lot of the Q1 demand that was supply chain constraint, basically really from our suppliers not being fully up to speed, we're pushing for Q2 and subsequent quarters. From a broad markets perspective, what we're seeing is technology buys continuing in areas of logic and 3D NAND. We're seeing memory pickup hopefully in the back half of the year in DRAM and NAND. A large portion of our growth this year is not just increased demand, but it's new program ramps. We won a fair amount of business last year. That business is now in ramp mode. So a good portion of our demand strength is actually coming from these new program ramps. And then, again, more broadly speaking, through the COVID dynamic, we have not heard of any major change in fab plans, are expansions, or upgrades, or pullbacks on technology advancements.

A lot of the issues that we saw in Q1 in the semi-cap industry was really due to logistic issues of our customers' customers having this as we're moving people around, the materials around, or doing the installs, or things along that. So we expect that to get better in subsequent quarters. And also, our supply base, as Mandeep alluded to before, is slowly -- or actually not that slowly, but coming online as those government restrictions are improved. They're getting back online, and we're getting inputs well parts.

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Mandeep Chawla, Celestica Inc. - CFO [46]

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I'll just add to Rob's comment just to reiterate what we had said in our prepared remarks, which was capital equipment was up 28% on a year-over-year basis in the first quarter. And so although there was some demand that pushed out into subsequent quarters, we're seeing very strong levels of top line growth, and it is very much largely on the back of the wins that we've had in that space in 2018 and 2019. And so we do expect a good level of growth just from those share takeaways and new program ramps, even though some ultimate demand may shift between quarters.

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Operator [47]

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Daniel Chan with TD Securities.

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Daniel Chan, TD Securities Equity Research - Research Analyst [48]

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So in the past, you said that if the inventory you're holding goes -- if some of your customers don't hit certain inventory turns, that they essentially pay you fees for holding that inventory for them. Can you give us details on the conditions under which that applies? Obviously, if there is demand, it doesn't hit certain -- their expectations, and they do less inventory, they'll pay. But what about in this environment where you're finding it tough to actually fulfill the request that they're ordering from you?

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Mandeep Chawla, Celestica Inc. - CFO [49]

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Hi, Dan. Mandeep here. Actually, I'll take a step back for a moment and talk about how we looked at the CCS portfolio going back over the last 2 years. Our primary filter has been around ROIC. And so while we ultimately have announced a number of programs that we're disengaging from because we weren't able to address that either by having less invested capital in play or improved profitability, sometimes it's led to us to making a decision to disengage. However, there were a number of customers in our CCS business where we were able to come to favorable terms on, and some of those terms are where we have a inventory turn cash model in place with them. And so if their demand is dropping off or if they need us to buy a lot more inventory to fulfill certain spikes, a lot of times, a cash deposit will come in to help offset that. And one of the things you'll notice is our cash deposits now are up to $135 million. That's up $15 million from the first quarter of last year. And so the conversations we have with our customers are before we tie up even more working capital, let's understand when you're going to use it. And if the time that you need it is a little bit longer than what would be normal, let's have a conversation around deposits. And we found that our customers have been very open to those discussions.

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Operator [50]

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Jim Suva with Citigroup.

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Jim Suva, Citigroup Inc, Research Division - MD & Research Analyst [51]

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It's a pleasant surprise that you actually are talking about Q2 being similar to Q1, and kind of more of a demand push out, as opposed to more of a demand destruction that other companies are talking about because the coronavirus unemployment economic slowdowns and things like that. Can you help us kind of bridge the difference about why your outlook is just so much more positive? Is it a factor that you just have so much more exposure to things like semiconductor equipment and less exposure to maybe cell phones, and PCs, or television, and things like that? But it just seems like your outlook calls for a lot better demand than some of the other companies that we're hearing out there.

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Robert Andrew Mionis, Celestica Inc. - President, CEO & Director [52]

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Yes, I think a lot has to do with the mix, as you mentioned. We view semi-cap as continuing to be strong. Certainly, our service provider business continues to be quite strong. Health tech continues to be quite strong. The headwinds that we're seeing in industrial, we view that more of a push out versus a demand destruction. A lot of our customers' customers factories are not operating or they can't do install, so they're just on pause until the factors come online. I guess the exception would be A&D. Obviously, we announced last quarter, we were seeing some 737 Max headwinds, which is a demand reduction. And now, with the lack of flying and 60% of the world's aircrafts being parked, we don't view A&D demand being pushed out. We view A&D demand being decreased. But again, that's really in our commercial business. About 40% of our A&D portfolio is in defense, and we see that growing in the mid-single digits as well. And as we announced, we're also expanding our Atrenne facility, which is going to be housing just about all defense work as well.

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Operator [53]

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There are no further questions at this time. I would now like to turn the call back over to the presenters for final remarks.

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Robert Andrew Mionis, Celestica Inc. - President, CEO & Director [54]

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Thank you. Given the volatile macro environment, I think we executed well. We were able to drive sequential operating margin improvement, generate strong cash flow, and pay down long-term debt in the quarter. Within CCS, our portfolio continues to perform well. We had margins firmly within their target range unless our portfolio is shaping actions. And in ATS, I'm pleased with the continued growth and improved profitability of our capital equipment business. While we face business uncertainty amidst this pandemic, I'm confident in the Celestica team and our ability to successfully navigate the challenges that may lie ahead. I believe we're taking the appropriate actions to keep our people safe, while remaining focused on delivering for our customers. Thank you all for joining. I look forward to updating you as we progress throughout the year, and best to you and your loved ones in these trying times.

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Operator [55]

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This concludes the Celestica first quarter 2020 earnings call. We thank you for your participation. You may now disconnect.