2023-11-06 12:33:26 ET
Summary
- Celestica Inc. is a $3-billion market cap company based in Toronto, Canada, that offers supply chain solutions across the globe.
- Celestica Inc. has experienced strong financial performance, with revenue exceeding guidance and non-IFRS adjusted EPS exceeding expectations.
- Both segments achieved strong results, with the CCS segment benefiting from an improved business mix and the ATS segment delivering solid revenue growth.
- With strong market positioning and favorable growth trends, I believe Celestica stock could potentially double in value over the next 2-3 years.
I wrote about Celestica Inc. ( CLS ) (TSX: CLS:CA ) exactly 3 months ago when the stock was trading at $21.1. At the time, the company had just come to the top of Seeking Alpha's Quant Ratings and I decided to pay close attention to this small-cap company at the time because of its cheap valuation multiples and fast-growing financial performance. As time has shown, my buy recommendation has paid off:
Today I decided to update my coverage again and check to what extent my earlier recommendation to buy is still valid.
In case you hear about this company for the first time, Celestica Inc. is a $3-billion market cap company based in Toronto, Canada, that offers supply chain solutions across North America, Europe, and Asia. According to the latest press release , CLS operates through 2 segments:
- Advanced Technology Solutions [ATS] - 42% of total revenue - delivers innovative supply chain solutions to customers in Aerospace and Defense (A&D), Industrial, HealthTech, and Capital Equipment industries;
- Connectivity & Cloud Solutions [CCS] - 58% of total revenue - focuses on providing supply chain solutions to customers in the communication and enterprise sectors, particularly those related to servers and storage.
In other words, the company provides a wide range of product manufacturing and supply chain services, including design, engineering, component sourcing, electronics manufacturing, testing, logistics, and after-market repair. They also offer hardware platform solutions and management services for various industries, such as aerospace, defense, HealthTech, capital equipment, and communication and enterprise markets.
Both of the company's divisions achieved quite strong results in Q3 FY2023 . The CCS segment benefited from an improved business mix, particularly in their hyperscaler portfolio, resulting in a segment margin of 6.2%, the highest ever. The ATS segment delivered solid double-digit year-over-year revenue growth, driven by new program ramps and demand strength in their aerospace business.
As a result, Celesticas' reported revenue of $2.04 billion exceeded the high end of their guidance range. Their non-IFRS adjusted EPS amounted to $0.65, also exceeding the high end of their guidance range. This was driven by their non-IFRS operating margin of 5.7%, marking their 15th consecutive quarter of year-over-year non-IFRS operating margin expansion. Overall, CLS not only exceeded its internal expectations (the guidance) but also Wall Street's consensus expectations :
At the end of the third quarter, the company had ~$353 million in cash, while the cash cycle improved by 1 day quarter-on-quarter, but is still far behind last year (9 days difference YoY). CLS is managing its inventory on the balance sheet and working capital generally very effectively. Despite the year-on-year decline in the cash cycle, CLS's cash generation still looks solid: Adjusted FCF (non-IFRS) amounted to $34.1 million in the third quarter of FY2023, compared to $7.4 million in Q3 FY2022. At the same time, the company’s liquidity is also strong with a current ratio of >1.4. CLS' credit risk also appears to be quite insignificant: FCF can cover all debt in less than 3 years; the debt-to-equity ratio continues to decline and currently stands at 0.27, while the times-interest-earned ratio is above 4, which I think is quite good in our rising interest rate environment.
During the latest earnings call , the executives noted that the interest expense is expected to reduce slightly due to improved cash conversion, and it may be ~$70 million for next year.
During the Q&A session, the management clarified that the demand side is robust (especially from the hyperscaler customers), and growth is pacing with material availability, which is anticipated to improve early next year. Networking demand is recovering, and inventory burn-down is nearly complete for top customers. Increased demand for proprietary computing and the ramping of new 800G programs in the second half of 2024 is expected to drive further growth.
CLS has invested in capacity expansion, with 80,000 square feet coming online in the first quarter of 2024 in Southeast Asia and an additional 50,000+ square feet of capacity in Thailand to support AI growth. Therefore, in general, I expect that CLS should have no problems in terms of capacity to ride the growing demand of its end markets.
Looking ahead, Celestica's management guided Q4 FY2023, with expected revenues in the range of $2.0-2.15 billion, representing a slight increase compared to Q4 FY2022 (+1.6% YoY). Non-IFRS adjusted EPS for Q4 is expected to be in the range of $0.65-0.71 per share, indicating a YoY improvement of +23%.
CLS also raised its preliminary outlook for FY2024, with an expectation of non-IFRS adjusted EPS growth of 10% or more compared to its 2023 outlook. This growth is projected to be driven by higher revenue across their end markets and a solid non-IFRS operating margin.
When the company just released its Q3 FY2023 results, the stock fell >13% despite beating consensus EPS and revenue numbers, precisely because of the new guidance. The fact is that CLS expects a bit smoother revenue growth for the fourth quarter than analysts predicted. Even now that a few days have passed since the release came out and Wall Street has adjusted its expectations to the new guidance, the consensus estimate for revenue is still slightly higher than what CLS expected for Q4:
The same applies to the EPS consensus for FY2024: management expects EPS growth of 10% or more (year-on-year) in FY2024, and the market is granting a premium of around 297 basis points to this forecast:
In general, given the current acceleration in demand for its products, I do not think it will be difficult for CLS to reach its target, even taking into account the existing premium. In recent years, CLS has consistently outperformed consensus EPS numbers by a wide margin, and given the relatively small premium in analyst forecasts, I think this will continue going forward:
At the same time, it cannot be said that CLS shares are overvalued today - the opposite is probably the case. Yes, from a historical perspective, CLS is trading today at a slight premium to its 10-year average EV/EBITDA ratio. However, the implied P/E ratio for next year is pricing in a ~40-50% decline in the multiple, which is likely unsustainable given continued business growth.
Another possible explanation for why forward EV/EBITDA should be higher than the historical norm is the margin expansion we have seen in recent years.
If the current trend continues, I think CLS will have to have a much higher valuation multiple. For example, if we take the entire IT sector as a basis, then when the median EBITDA margin of ~9.18% is reached, CLS's EV/EBITDA should theoretically also trend towards the median EV/EBITDA of ~13.6x . If we subtract the discount for the size of the company (CLS is a small cap or a tiny mid-cap if you will), then I think the EV/EBITDA should be around 10-11x. With such a multiple [its mid-point] and margin expansion, CLS's market capitalization should be $8.31 billion at the end of fiscal 2025 on projected revenue of $8.89 (consensus) and adjusted net debt of $260 million. Thus the long-term upside potential is ~2.7 vs. today's value. Even with a larger discount to its valuation, CLS looks like a potential double within the next 2-3 years in my view.
The Bottom Line
Please beware that investing in CLS stock comes with several potential risks. First off, there is industry risk, as the electronics manufacturing services sector is cyclical and sensitive to fluctuations in demand for electronic products. Customer concentration risk is another concern, as a significant portion of Celestica's revenue is derived from a limited number of clients, making it vulnerable to reductions in business from key customers.
Additionally, foreign currency risk arises from operating in various foreign markets, leaving the company exposed to exchange rate fluctuations that could negatively affect earnings. Furthermore, staying competitive in the rapidly evolving EMS industry requires continuous technological investments and any failure to keep pace with advancements may lead to a loss of market share.
Furthermore, it is clear from CLS's price action that such a strongly one-sided upward movement cannot always be sustainable. The market's reaction to small differences in guidance and consensus confirmed this last week: Investors need to be prepared for high volatility and the likelihood that the CLS stock price may cool down at any time.
But despite the big risks, I look at the company's business and I like Celestica more and more. The company seems to be very well positioned in its market and I believe it can further expand its sales volumes and margins. Therefore, I expect its valuation multiples to continue to rise - fortunately, there is still some room to do so as industry medians are still well above CLS's historical norms. If things continue as they have over the past few quarters, I expect CLS to at least double in value over the next 2-3 years. But of course, such bold conclusions come with equally bold underlying assumptions. Every reader needs to do their own due diligence before buying CLS stock.
I remain bullish on CLS and recommend you follow this stock closely.
Thanks for reading!
For further details see:
Why Celestica Stock Could Be A Potential Double Within The Next 2-3 Years