Description

Celestica Inc (CLS) is a Canadian listed electronics contract manufacturer based in Toronto.  CLS is also listed on the NYSE and all numbers in the write-up are in CLS’ reported currency of USD.  We have been following the EMS space for some time and wrote-up Flex Inc (FLEX) on this forum in July of last year.  Using a conservative 10-12x 2023 EPS inc SBC, we see a year-end 2022 stock price of $19.56 to $23.47 representing 140% to 190% upside, a ~90% IRR to YE22 at the midpoint.  Additionally, as CLS' revenue continues to shift more towards higher-margin and longer-lifecycle industrial verticals, we see upside to the multiple range of 10-12x as believe the Company should trade more inline with industrials type businesses.

There are several main aspects to our thesis, which we discuss below: A) the market underestimates the quality of the business despite mid-teens ROIC's due to optically low margins; B) margin expansion as the Company's revenue mix-shifts towards its higher margin ATS segment and HPS vertical; C) aerospace now troughing, pre-pandemic aerospace was a low teens % of revenue; D) an inflection in the high-margin Display vertical; E) the Company's exit of their Cisco relationship (low-teens % of revenue) in 4Q of 2020 due to low-margins is obfuscating underlying core revenue growth; F) healthy competitive landscape in the EMS industry as companies grow their design capabilities to expand customer value-add, focus on more industrialized verticals, and focus on margins & cash flow versus revenue growth; G) a resumption of share repurchases in 1Q21, along with a commitment to repurchase more aggressively if the stock reaches tangible book, which is 6% below today, providing good downside support; and H) significant upside to street numbers.

As background, CLS has two segments: Advanced Technology Solutions (ATS) and Connectivity and Cloud Solutions (CCS).  In 2021, we estimate ATS will be ~41% of 2021 revenue and CCS 59%.  ATS comprises aerospace and defense (~30% of the segment), industrial (~30%), health tech (~10%), and their capital equipment business (~30%).  CCS consists of enterprise communications, telecommunications, servers, and storage businesses.  CLS's Hardware Platform Solutions (HPS) (formerly "Join Design & Manufacturing or "JDM") is within their CCS segment.  JDM is higher margin (3.5%+) than the rest of CCS and growing significantly faster with guidance of double-digit growth this year on the back of 80% last year.  JDM provides broad end-to-end services throughout the product lifecycle, from design to aftermarket and supplies 8 out of the Top 10 hyperscalers.  Based on recent data points on hyperscale capex we also a chance for upside to CLS's HPS guidance of low double-digit growth in 2021. 

1. Business Quality: Similar to our FLEX thesis, EMS businesses are frequently passed over due to optically low margins.  This misunderstanding misses a core aspect of the EMS business.  The vast majority of EMS COGS are variable, we estimate 80%+, with the majority of that being pass-through raw materials costs, which is especially important in today's rising cost environment. This is why CLS and the industry have consistently generated double-digit ROIC and strong cash flow despite low operating margins.  CLS is no exception, posting an average 14% ROIC from FY16 to FY20.

2. Mix-Shift: Consequently, the biggest driver of gross margin is product mix.  CLS has guided ATS margins to 5-7% long-term versus CCS in the 2-3% range.  ATS has been operating under the 5-7% range recently due to the depressed aerospace environment.  Despite this, they expect to be back in the range in the 2H of this year.  More on this later in the write-up, but they expect high-margin Display to contribute materially next year off low-levels currently, which will provide a tailwind to ATS margins in 2022 as well.  The CCS segment has been above 3% lately due to the strength of higher-margin HPS and the benefit of the CSCO exit.  We believe the 2-3% guidance is too low and expect them to raise the target range in the future.  We expect the higher-margin ATS segment to be ~41% of revenue this year and ~45% in 2023, up from 33% of revenue in 2018.  We expect this mix-shift will help expand overall margins towards the higher-end, if not above, their 3.75-4.5% margin target.  We also believe they will eventually increase their overall margin target. 

3. Aerospace - CLS has a long-standing reputation in the aerospace and defense market and is one of the leading EMS providers for the vertical.  Prior to the pandemic, we estimate aerospace represented a low double-digit % of revenue and defense mid-single digits.  Obviously, the pandemic disrupted the aerospace market.  However, CLS believes aerospace revenue has now troughed and will sequentially grow from here.  Importantly, ATS has guided to 10%+ growth in ATS without assuming a rebound in aerospace until 2023.  Consequently, a faster recovery in aerospace would be upside ahead of revenue tailwind in 2023.  Notably, the aerospace industry has taken out capacity due to the severity of the recent downturn.  As a result, we believe they will look to outsource more as they grow business back.  When they do, CLS is positioned to win a lot of that business given their track record, reputation for quality, and safety qualifications in the sector.

4. Display - Display falls within CLS' Capital Equipment vertical (~30% of ATS revenue) in addition to semicap.  Historically, CLS only supplied into the semicap industry but given similar capability and expertise requirements for Display and Semicap in 2018 they acquired display equipment manufacturer Impakt for $330mm.  Display has been in a trough for several years now, but is expected to grow materially starting in late 2021 / early 2022.  CLS recently hosted a call to highlight their Capital Equipment business (semicap and Display) during which they outlined a 27% Display Equipment TAM CAGR from 2021 to 2025 driven by increased commercial adoption of OLED, growth in large-format panels and next-generation panels, IoT, and an increased need for smart screen applications driving micro LED growth.  Importantly, Display is significantly higher-margin and above the high-end of the ATS targeted 5-7% - we believe it may be materially so.  Consequently, we expect Display to be a tailwind to ATS revenue and margins over the next few years.  In 2022, we believe Display could be a 2-3% ATS revenue tailwind, along with a positive margin impact.  Overall, the Capital Equipment is a strong vertical for CLS where they have been taking share (largely from smaller sub-system players) and the Company expects the Cap Equipment vertical to grow 30% in 2021.

5. CSCO Exit - As mentioned above CLS has fully exited their Cisco business due to cyclicality and low margins.  Cisco was a low-teens % of revenue so the impact was significant, Cisco will be a 10% headwind in 2Q and 3Q and 3% in 4Q, leaving 2022 as a clean year with no headwind.  As a result of the exit, headline revenue has been negative but excluding CSCO we expect CLS to grow HSD overall in 2021.  

6. Competitive Landscape - as we mentioned in the comments section of the FLEX write-up, there has been a significant improvement in the EMS competitive environment over the past couple years.  After following the EMS industry for a number of years, we have noticed a much greater focus on margins and cash flow versus revenue growth leading to a more disciplined pricing environment and thus higher ROIC's and margins.  Part of this has been driven by management changes (eg FLEX and SANM).  Instead of competing for the same low-margin, highly-cyclical networking contracts, EMS companies are now focusing more on specific industrial verticals (eg Healthcare, Capital Equipment, A&D, etc) that have higher-margins, longer product lifecycles, and much less cyclical.

7. Repurchases - the Company has restarted their share repurchase program and on November 10th launched a Normal Course Issuer Bid allowing them to repurchase up to 10% of shares outstanding.  Additionally, the Company has committed to purchase aggressively if the stock price approaches tangible book value.  As of 1Q tangible book was $7.66, just 6% below today's price.  Consequently, with a net cash position, the Company has a significant level of firepower that we believe provides good downside support for the stock.

8. Upside to Street: as we saw with FLEX, the street struggles to effectively model the inflection around EMS margins from portfolio recalibration and a shifting mix.  We see the same playbook here with CLS, and see ~10% upside to street EPS estimates for 2021 and 30%+ in 2022.

 Catalysts:

1. ATS Margins: we believe CLS will reach 5% ATS margins in 3Q or 4Q of this year, which we believe is an important milestone for investors.  As display contributes next year, we see them progressing towards the high-end of the range as well. 

2. HPS Guidance: we believe the Company's guidance for HPS growth is potentially conservative and could raise guidance around double-digit growth this year. 

3. Lapping of CSCO: we expect the Company to return to y/y growth in 4Q of this year, helping lift the overhang of negative y/y revenue growth. 

4. Display: display has yet to contribute but we believe will help drive upside to next year's numbers when the Company provides guidance.

Risks:

1. Aerospace delayed recovery: we think this risk is largely mitigated given the low expectations of the Company for the pace of recovery along with recent data points around the return of travel. 

2. Semicap downturn: CLS has continued to take share in the vertical and we see continued share gains going forward.  Data points also point to a robust semicap environment in the coming years.  We believe the recovery in Display would help offset a downturn in semicap.  We see CLS as a much better way to play the strength of the semicap industry versus the more expensive semicap stocks.

3. Hyperscale downturn: we see more upside than downside related to the HPS segment given the data points around hyperscale capex growth.  The street is calling for hyperscale capex to be up 26% in the 2H of 2021 vs the 1H.  Additionally, at current hyperscale revenue forecasts, hyperscale capex spend of 20% in 2021 and 4% in 2022 would yield declining capex intensity of 1% in 2% in 2021 and 2022.  Given the growth in cloud and competitive nature of the industry, we believe decreasing capital intensity is unlikely. 

4. M&A: given their balance sheet strength, CLS is evaluating M&A as a use of cash.  Given tight hurdles for acquisitions, the Company has been largely quiet since their acquisition of Impakt.  However, the Company has a robust pipeline.  If the Company were to make an acquisition, we would expect it to be accretive given their hurdles.  With a net cash position we also believe adding some leverage would be positive financial engineering and potentially help the liquidity of the stock.  

Catalyst

see above