Celestica, Inc.

Good day, ladies and gentlemen. Thank you for standing by and welcome to the Celestica Q2 2020 earnings conference call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question and answer session. To ask a question during the session, you will need to press star 1 on your telephone. Please be advised that today's conference is being recorded. I would now like to turn the conference over to your speaker today. Craig Oberg, please go ahead.

and thank you for joining us on Celeste's second quarter 2020 earnings conference call. On the call today are Rob Mionas, 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 risk 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 today's press release, including the cautionary note regarding forward-looking statements therein, and our annual report on Form 20F and other public filings, which can be accessed at sec.gov and CDAR.com. We assume no obligation to update any 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, gross debt to non-IFRS trailing 12-month adjusted EBITDA leverage ratio, adjusted net earnings, adjusted EPS, adjusted SG&A, and adjusted effective tax rates. 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 second quarter 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.

Thank you, Craig. Good morning, and thank you for joining today's conference call. Blastica's second quarter results reflect solid execution in a dynamic and challenging environment. We had a solid quarter of revenue growth, improved year-over-year and sequential operating margin, generated robust free cash flow, and paid down long-term debt. Throughout this challenging time, our global team has done exceptional work to maintain continuity of operations, safeguard the health of our employees, and deliver on customer commitments. As government restrictions ease around the globe, our operations have substantially stabilized. Our supply chain is gradually returning to normal, and suppliers are working to ramp up capacity to meet increased demand driven by certain end markets. Circumstances continue to change, but we will adapt to address any new challenges. While we are experiencing demand strength in the capital equipment, health tech, and service provider markets, we have seen softness in other markets, including commercial aerospace and industrial. A CCS segment posted another quarter of solid performance, expanding segment margins on a year-over-year basis. In fact, CCS has expanded margins sequentially for the fifth consecutive quarter. and is operating above our 2% to 3% margin range. In our ATS segment, we are seeing solid performance in a number of our businesses. However, ATS segment margins remain below our target range of 5% to 6% due to the demand headwinds in our commercial aerospace and industrial businesses resulting from the pandemic. Overall, we are pleased that the strong foundation and diversification we have built across our end markets is helping us manage through a highly volatile environment. 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 second quarter results.

Thank you, Rob, and good morning, everyone. As a reminder, we did not provide financial guidance for the second quarter of 2020 due to the uncertainty surrounding COVID-19. During the quarter, while we incurred costs related to COVID-19, including PPE, premiums paid to ensure continuity of supply, and inefficiencies related to lost revenue due to an inability to secure supply, these costs were mostly offset by various recoveries. Our second quarter revenue came in higher than anticipated at $1.49 billion, mainly due to strong demand from service provider customers fueled by our JDM offering. Revenue increased 3% year-over-year and 13% sequentially. Our non-IFRS operating margin was 3.4%, up 90 basis points year-over-year and up 50 basis points sequentially. IFRS earnings per share were $0.10 compared to a $0.05 loss per share for the second quarter of 2019. Non-IFRS adjusted earnings per share were $0.25, up $0.13 compared to the second quarter of 2019, and up $0.09 sequentially. Our HCS segment was 34% of our consolidated revenue. down from 39% compared to the second quarter of last year. ATS revenue was down 11% compared to the prior year period and down 9% sequentially. Both the year-over-year and sequential declines were driven by demand weakness in commercial aerospace and industrial, largely due to COVID-19, partially offset by strong demand in capital equipment and new program ramps in health tech. Our CCS segment revenue was up 12% year-over-year and up 29% sequentially due to strength in JDM. including with service provider, and our success in securing critical components to meet increased demand. Within our CCS segment, the communications end market represented 43% of our consolidated second quarter revenue, up from 39% in the second quarter of last year. Communications revenue in the quarter was up 14% year-over-year, largely driven by strength in our JDM business, partly offset by a reduction in Cisco revenue as we continued our planned disengagement. Sequentially, communications revenue was up 27%, driven by demand strength in JDM. Our enterprise end market represented 23% of consolidated revenue in the second quarter, up from 22% in the same period last year. Enterprise revenue in the quarter was up 10% year-over-year, driven by strength in JDM, partially offset by planned disengagements as part of our CCS portfolio optimization program. Sequentially, enterprise revenue was up 32%, primarily due to demand strength in JDM and seasonality. We are pleased by the growth in JDM as we continue to ramp several program wins and support increased levels of demand from our hyperscale customers. In the first half of 2020, our JDM business achieved more than $400 million of revenue, up 85% year over year, and accounted for 14% of our total revenue for the first half of 2020. Our top 10 customers represented 68% of revenue for the second quarter, up from 65% in the same period last year and up from 66% last quarter. For the second quarter, we had one customer contributing 10% or more of total revenue compared to two customers in the second quarter of 2019 and one customer last quarter. Turning to segment margins. ETS segment margin of 3.1% was up 40 basis points sequentially, mainly due to improved profitability in A&D. Our capital equipment business continued its recovery, posting another quarter of profitability as we ramped new programs. Year over year, ATS segment margins were up 30 basis points as improvements in capital equipment driven by higher productivity and volume leverage more than offset reduced profit contribution from A&D. CCS segment margins of 3.6% came in above our target range of 2% to 3% and were up 120 basis points year over year and up 60 basis points sequentially. Both the year-over-year and sequential margin improvements were driven by improved operating leverage, favorable mix, including strong growth in JDM, and the positive impact of our productivity efforts. Moving to some other financial highlights for the quarter. IFRS net earnings for the quarter were $13.3 million, or $0.10 per share, compared to a net loss of $6.1 million, or negative $0.05 per share, in the same quarter of last year. Adjusted gross margin of 7.5% was up 50 basis points compared to last year and up 20 basis points sequentially. Year over year and sequential improvements were largely driven by volume leverage, productivity, and improved mix in CCS. Year over year, our adjusted SG&A of $53 million was down $3 million, primarily due to lower variable spend, partially offset by higher variable compensation. SG&A was up $3 million sequentially. mostly due to unfavourable foreign exchange. Non-IFRS operating earnings were $50.8 million, up $14.1 million from the same quarter of last year, and up $12.7 million sequentially. Our non-IFRS adjusted effective tax rate for the second quarter was 24%, compared to 36% for the prior year period, and 24% last quarter. For the second quarter, adjusted net earnings were $31.7 million, compared to $15.4 million for the prior year period. Non-IFRS adjusted earnings per share of 25 cents was up 13 cents year-over-year, mainly due to higher operating earnings and lower interest expense. Sequentially, non-IFRS adjusted earnings were up 9 cents, mainly due to higher earnings and lower interest expense, partly offset by higher tax. Non-IFRS adjusted ROIC of 12.9% was up 4.5%, compared to the same quarter of last year and up 3.4% sequentially. Moving on to working capital. Our inventory at the end of the quarter was $1.2 billion, an increase of $120 million relative to last year and an increase of $134 million sequentially as we invest in hyperscaler growth and work to burn down inventory in markets impacted by COVID-19. Inventory turns were 4.9, down 0.1 turns year over year and up 0.1 turns sequentially. Capital expenditures for the second quarter were $11 million, or approximately 1% of revenue. Non-IFRS free cash flow was $38 million in the second quarter, compared to $47 million for the same period last year. Year-to-date, we have generated $92 million in non-IFRS free cash flow and continue to target generating $100 million or more of non-IFRS free cash flow in 2020. Cash cycle days in the second quarter were 60 days, an improvement of five days year over year, and an improvement of nine days sequentially. Our cash deposits at the end of June were $222 million, up $87 million sequentially, as we continue to work with our customers on working capital improvements. 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 second quarter was $436 million, down $1 million year over year, and down $36 million sequentially. Combined with our $450 million revolver, which remains undrawn, we continue to have a strong liquidity position of approximately $900 million. We believe we have sufficient liquidity to meet our current business needs. We continue to make progress towards deleveraging our balance sheet in the quarter by repaying $61 million of long-term debt. Our gross debt position was $470 million at the end of June, while our net debt was $34 million, down $25 million sequentially. Our gross debt to non-IFRS trailing 12-month adjusted EBITDA leverage ratio improved by 0.3 turns sequentially to 1.7 turns. At the end of June, we were compliant with all financial covenants under our credit agreement. In the near term, our priority is to continue to reduce our leverage, providing us with increasing levels of flexibility for future investments and lower interest costs. Over the long term, though, our capital allocation priorities are unchanged. We will continue to work towards generating strong free cash flow and plan to return approximately half to shareholders while investing the other half in the business. In the second quarter, we incurred $7 million of restructuring charges, including costs to right-size our commercial aerospace and industrial cost base to reflect a reduction in overall demand. We continue to take restructuring actions in the third quarter. As we look to the next quarter, we continue to see a dynamic environment driven by COVID-19. Although the situation is improving in most jurisdictions and our operations have largely stabilized, given the continuing uncertainty, potential COVID-19 resurgences, and their impact on our customers, supply chain, and factory utilization, we do not feel it would be prudent to provide specific financial guidance for the third quarter. While we're not providing guidance, we do anticipate the third quarter to be largely in line with our second 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.

Thank you, Mandeep. In the first half of the year, we strengthened our position in both CCS and ATS. While we are still facing a variety of headwinds, we believe that the strength of our portfolio is helping to mitigate some of these challenges. We feel that our portfolio shaping and productivity actions over the last few years while difficult at the time, have better positioned us to deliver value-added solutions across a broad set of markets. Now, turning to ATS, the challenges we are experiencing from COVID-19 are adversely impacting several ATS markets while also creating opportunities in others. Our capital equipment business posted another profitable quarter, and we continue to see overall demand building. Our growth is driven by increased demand in our base business, as well as new program ramps across a number of capital equipment and markets. Our success in securing new programs has been enabled by our performance and breadth of global capabilities. In A&D, while we had record-level bookings in the first half of the year and demand in our defense business remained stable, we continue to experience lower demand in our commercial aerospace business. Profit contributions from our A&D business improved sequentially on lower revenue and we continue to take actions to adjust the cost base to reflect this reduced level of demand. The actions we have taken started to yield results in Q2, and we expect A&D profitability to improve as we exit the year, barring any further additional negative impacts from COVID-19. We continue to be a leader in the A&D market, providing the world's top A&D customers with product lifecycle solutions. A good example of that is a recent five-year renewal of our operate-in-place agreement in Mississauga, Canada, with a prominent A&D customer. As a reminder, we support this customer with final assembly, test, and repair and overhaul for key product lines supporting commercial and defense markets. The renewed agreement not only strengthens our relationship with this customer, but provides a strong foundation that enables us to deliver product lifecycle solutions to a broad set of other customers as well. Within industrial, in the near term, we are seeing weak demand across our customer base as a result of COVID-19. As the macro environment improves, we anticipate the industrial market will gradually recover. Within health tech, we continue to see strong demand for diagnostic equipment and modest improvement in the demand for elective surgery products. We expect to see strong growth continue in health tech throughout 2020 as we ramp production of essential products such as medical devices and diagnostic tools that are critical in the diagnosis and treatment of COVID-19 patients. We are happy to do our part in the fight against this pandemic by providing critical solutions to a number of customers. Now turning to CCS. Our CCS segment delivered strong performance as a result of increased demand from our service provider market, as customers expand and upgrade data centers in support of growing cloud and online requirements. The strong revenue growth is driven by key wins over the last 18 months and compounded by the recent surge in demand due to the work and learn from home trend. Growth from our service provider customers more than offset revenue declines from portfolio shaping and communications and enterprise and the impact of COVID-19. Strong margin performance in CCS was driven primarily by portfolio actions, operating leverage, and improved mix, including a growing JDM business. As Vandeep mentioned, our JDM business continues to thrive with another quarter of impressive growth. Within JDM, we invest in leading-edge product roadmaps and design capabilities and provide a full suite of product solutions across all IT infrastructure data center technologies. The combined product lifecycle capabilities of JDM, which are similar to ATS, are intended to help customers reach their markets more efficiently. from design through manufacturing and aftermarket support. JDM drives more value for our customers early in the product lifecycle, thereby creating stickier and mutually beneficial relationships. We believe JDM will continue to be a driver of growth for the company in the future. Turning to the Cisco disengagement, the transition is progressing as planned, and we expect the transition to be largely complete by the end of the year. We have a large funnel of opportunities targeted towards Thailand, and we are pleased with the progress we are making to backfill fiscal revenue with higher value-add solutions. We remain on track to achieve our goals with a richer mix of programs. Looking at our business overall, while there is uncertainty surrounding the impact that COVID-19 may have in the near term, I remain confident in our long-term outlook. I believe that there are tremendous opportunities in front of us, across both ATS and CCS. We believe Celestica has a solid foundation to weather uncertain times. We also believe our balance sheet remains strong as a result of strong free cash flow generation with a moderate amount of debt and high level of liquidity. We are excited about our future opportunities for sustainable, profitable growth. I want to thank our global team who have come together with passion and determination to keep our operations running effectively. Their resilience and commitment to working together to adapt to this situation have been nothing less than extraordinary. We look forward to updating you over the coming quarters. With that, I would like to turn the call over to the operator to begin our Q&A.

Thank you. As a reminder, to ask a question, press star 1 on your telephone. To withdraw your question, press the pound key. Analysts, please limit yourself to one question and one follow-up. Please wait while we compile the questions. Thank you. Your first question comes from the line of Gus Papageorgiou with PI Financial. Please go ahead.

Hi, thanks and congrats on a great quarter. I mean, I know things are very kind of still volatile, but a while ago you provided some kind of long-term goals for your margins. And if you look at the margins this quarter, I mean, CCS is exceeding those margins. ATS still not quite there, but if you were to look at the mix of business and the growing volumes and chips, can you kind of give us an update of what you're thinking in terms of long-term margin goals and if you think they've changed at all? Would CCS be moving higher? Would maybe ATS be moving lower or stable? Just kind of give us any sense of where you think you can be longer term.

Okay. Good morning, Gus, and thanks for the question. So we continue to feel that the target margin range of 3.75 to 4.5 is the right range for us, and the ranges that we have in place for both CCS and ATS continue to hold, so 5% to 6% for ATS and 2% to 3% for CCS. So if I just take each of those, you know, we're very pleased with the performance that we saw in CCS and pleased that they were able to operate above their margin range. You know, it's one quarter and it's too early to say if their target margin range should be raised, but clearly when they have strong operating leverage and very positive mix as they have had, they're going to perform very, very well. On the ATS side, you know, we're seeing good momentum to get back into the 5% to 6% range, but we still have businesses that are not yet there. Capital equipment is continuing to scale. Aerospace and defense, while we started to take some restructuring actions, is not yet where it used to be. And then we're continuing to see ramping programs in industrial and in health tech. There's also a mixed shift that's happening a little bit where we're having a less profit contribution from A&D. So in order to get to the 3.75 to 4.5 on a sustainable basis, we need both of the businesses to be in their ranges. In order for ATS to get back into their range, we need to continue to see improvements in capital equipment and A&D. And we also need to see some level of modest recovery in industrial. And then on the CCS side, you know, if they're operating at the high end of their range, that will support us to get to where we want to go.

Just a quick follow-up. So on the ATS, I mean, you've got chip volumes improving, but aerospace is still weak and, you know, Boeing cancelling programs. I mean, which of these two is the bigger influence, volume increases in chips or, you know, cost restructuring in aerospace?

I'd say that they're both equally important. Both capital equipment and aerospace and defense are larger segments within ATS, as you know. Capital equipment, when it's at full scale, can operate above the 5% to 6% range. They're not there yet. And although we are continuing to see strong market demand, we are also ramping a number of programs that we've won. And so as those programs reach steady state, we'll see improved margin. On the aerospace and defense side, you know, as Rob had mentioned, we continue to have a stable outlook on the defense side. So most of the actions we're taking are in response to the decline in commercial aerospace. And so while we did take restructuring actions in the second quarter, there are actions that are continuing into the third quarter. and we would expect improved profitability in A&D as we go through the year.

Okay, great. Thanks again. Congrats on that great quarter. Thank you, Jeff.

Thanks, Jeff. And your next question comes from the line of Thanos Mochopoulos with BMO Capital Markets. Please go ahead. Thanos, your line is now open.

Oh, sorry. Sorry about that. Rob, as you look across the business, where would you say that there's still some bottlenecks from a supply chain perspective?

Yeah, so from a supply chain perspective, it's actually much improved. We measure shortages that are gating revenue at the beginning of the quarter. And for Q2, it's actually at – I mean, for Q3, it's actually at pre-COVID levels. That being said, we do have some hyper demands. in support of service provider markets, and that's causing us some general consternation in terms of broad electronic components. And there's some high reliability parts that are impacting, you know, our aerospace and defense business that are kind of pacing us as well. But broadly speaking, I would say, at least at this time, the component situation is much improved from a quarter of our status. Okay.

And with an industrial, can you just provide a little bit more color in terms of where the weakness is underlying that segment?

Yes, with industrial, a lot of the revenue declines or the overall majority of the revenue declines are really COVID related. A lot of our market is in Europe. And with the economy shutting down, a lot of our products get installed in homes and businesses and As such, the installs shut down, which kind of shut down the production lines. We do see Europe slowly opening up, which is, you know, a positive sign. And then also, you know, businesses have generally stopped, you know, cutting back on spending. So, you know, broadly speaking, I would say everything in industrial is really driven by COVID. As the COVID environment improves, we do expect the industrial market to gradually improve as well. We also have a fair amount of new programs that are ramping. And, you know, when they actually come to market, that should give us a little bit of an uplift, which will be into next year.

Great. Thanks, guys. That's the improvement in the business. Thanks.

And your next question comes from the line of Robert Young with Canaccord. Please go ahead.

Hi, good morning. I know you said that you aren't giving guidance. I think you said that you expect the current quarter to be in line with Q2. I was wondering, does that apply to the margin strength that you're seeing in Q2? Or are you talking about revenue top line there?

Hi, Rob. Good morning. No, our comments were for our overall results. And so top line and bottom line were strong this quarter.

and while we're not giving guidance for next quarter our expectations right now are that it would be largely in line with what we saw in the second quarter okay great thank you and um i want to talk about the manage in place you talked about the renewed agreement um that's in uh you know one of the weaker segments is the industry moving more towards this type of model looking back over the relationship what are the you know, the positives and negatives of the management place, and do you see this as something that can really expand going forward?

Hey, Rob. You know, I think it's a bespoke offering that, you know, that we have, and it fits certain situations with certain customers. It comes really into play where the risk profile of moving the work is so large that our customer feels it's better to take it over in place, that being large fixed costs or monuments or tribal knowledge. For this renewal, I think it's really timely because it gives us guaranteed market share as the entire commercial aerospace industry is down. And the mix of our operate-in-place agreement is also on the defense side as well. So it's really a stable base And in concert with this, we also extended our long-term contract for CCAs, which we assembled across our global network as well. So it was the OAP and also an extension of a long-term contract that we have with this customer. In terms of expanding it, it's certainly conversations we have with customers. And frankly, we're seeing this in the industrial space. As volumes decrease, our customers are facing utilization issues. and they're looking to us to help solve those issues. Most of it is lift and shift work, but some of it could be operating place agreements as well. Okay, thanks.

And your next question comes from the line of Jim Suva with Citigroup. Please go ahead.

Thank you. You know, I realize you didn't give full detailed guidance, but you mentioned Q3 should be similar to Q2. The question I had though is what are some of the variables? Cause it seems like even in your prepared comments, you mentioned with Q3 governments are opening more supply chains or getting closer to normal or improving and kind of lots of improvement comments. It would seem that that would almost imply that Q3 should be better than Q2. So maybe if you can help me just bridge the misunderstanding I'm having there about why it would be kind of relatively

Flavished sequentially when um, you know, it seems like all the data points around the world are kind of pointing towards You know some improvements in q3 Yeah, good good morning jim, um, yeah, so we didn't provide guidance maybe i'll talk about that first because there does continue to be a tremendous amount of Volatility that we're seeing and so while we are seeing an improvement in even areas like supply chain You saw that in the second quarter, you know, we had $56 million of revenue that was gated from material supply. And when we're starting this quarter, in the third, we have a number that's higher than that. And while our teams did an excellent job working that number down during Q2, the risk continues into the third quarter. And so we have a little bit more of a balanced view. You know, some of the – items that you mentioned are continuing. And so what I would say is that a lot of the momentum that we saw building through the second quarter is now stabilizing. So our factories were at about 95% utilization at the end of Q2. Our expectation is that that would continue through the third quarter. Our critical suppliers impacted is down to very low single digit percentage. We expect that will continue through the third quarter. You know, we continue to see strength in capital equipment. We continue to see strength in health tech. We continue to see strength in service provider demand. But we also continue to see softness on the commercial aerospace side. We continue to see softness on the industrial side. And so we haven't seen a significant change in some of these dynamics from where we've ended the second quarter.

And Jim, I would also add that, you know, based on what we know, we feel good. But based on what we don't know, it gives us concern that the rising case rate, not just in North America, but around the world, It's causing some economies to pull back and putting some restrictions in place, which can impact our facilities, impact our suppliers' facilities. And given the trend lines, we feel we're being prudent.

Great. Thanks so much for the clarifications. It's appreciated. Thanks, Jim. Thanks, Jeff.

And your next question comes from one of Paul's feet with Coastal Capital.

Please go ahead. Great. Could we talk a little bit on ATS within capital equipment? If we assume that, and as I recall, I think in Q3 a year ago, we had, you know, a relatively easy comp. How significant are the ramps if we were to see things sort of, you know, edge down a bit again? Are the new program ramps significant enough to actually have us have year-on-year growth in capital equipment? And then the second quick follow-up would be in CTS, Can you just remind us where we are in terms of your journey on JDM overall? Because it sounds like some good progress there. Thanks.

Sure. So on capital equipment, you know, I do think I agree with you. I think we will have year-over-year growth in Q3. What we've seen in the first half of the year, as you know, is we've seen strength driven by technology buys in five and seven nanometers. To get to the back half of the year, the demand is shifting more towards memory at technology buys for 3D NAND, but there's also capacity buys now coming online in terms of VRAM and NAND to support increased demand. And based on our near-term outlook and chatting with our customers, we do think that growth is sustainable here in the midterm. With respect to JDM, again, we're very pleased with the performance that we have in that business. With COVID, you know, we had a number of next-generation technology wins with 8 out of 10 hyperscalers. What happened during the pandemic, it really accelerated the deployment of these technologies and likely instrumental in increasing the bandwidth given everyone is living online. You know, Mandip mentioned in Q2, JDM almost doubled on a year-over-year basis, and we do expect strong growth for the remainder of this year coming out of customers who buy those products from us.

Sorry, one last one, Rob. Apologies. On display, if we could go back to that, can you talk to us a little bit about OLED and how you're thinking about those ramps? We know things have moved. We know smartphones' demand is weaker, but obviously you were ramping up for significant growth in that area. Where are we? Like, has the pandemic thrown timelines wildly off, or are we more or less on track? Thank you. That's it.

Yeah, thanks for the question. You know, revenue and display is still generally depressed. The projects that we had planned for the back half of this year and into next year are being pushed to the right, largely driven by the pandemic, the Smartphone sales are down and large TV sales are down as well. But as we mentioned, we've taken a number of actions during the press revenues to kind of reposition the business and move the majority of the work to Korea. And we have a long-term view of the industry. I do think when the 5G phones proliferate, the recycle, if you will, and the next generation TVs come in, the Quilt and OLED will be explosive, and we're hopefully really anxious for those days to come. But right now, the market is kind of pushing to the right. The other thing I would add in our display business in Korea is that we've diversified the revenue there. So in Korea, we do more than display now. We also do a fair amount of semi-cap work as well.

Thank you.

And your next question comes from the line of Rupu Bhattacharya with Bank of America. Please go ahead.

Hi. Thanks for taking my questions. Can you give us your revised thoughts on free cash flow in fiscal 20? I think last time, last quarter, you said more than $100 million, but it looks like you've already done $90 million. So any thoughts on working capital, your inventories, and free cash flow?

Yeah, good morning, Rupaloo. So we're pleased with the cash flow performance we've had in the first half of the year, $92 million. We were setting the target to be just over $100 million. We don't expect the second half to be as strong as the first half. And so we continue to be focused on getting it just over $100 million. As you saw, our inventory has been building and we are working aggressively to bring that inventory down. But in some of the longer life cycle businesses like aerospace and defense, it may take a little bit longer. And so we are consuming some cash in there right now. But we do continue to expect good performance in other working capital measures. Deposits are strong. Receivables are strong. And so right now, over the back half of the year, we have nominal expectations.

Okay. Thanks for that. And for my follow-up, I wanted to ask a question on capital allocation policies. So it looks like you've been paying down a significant debt over the last couple of quarters. But given that you have strong liquidity now, does it make sense at this stage of the cycle to look at possible further M&A to supplement the growth that you're seeing, especially given valuations have come down? So can you give us your overall thoughts on capital allocation priorities over the next 12 months?

Thanks. Yes, absolutely. You know, we've been very focused on de-levering because our intention has been to build up our dry powder to give us maximum flexibility. Also, of course, the benefit is that we lower our interest expense and we can work on expanding EPS, which is a core focus for us right now. And so we're very pleased with the performance that we have been able to show. We paid down $122 million of debt in the first half of the year. We're not going to continue at this pace. We do think it's good to have a level of debt on the balance sheet. It helps us in many different areas. But our capital allocation priorities remain unchanged. You know, we have a very good track record of buying back shares. We bought back over a billion dollars of shares over the last 10 years. And so we'll look at various options to return cash to shareholders, buybacks being one of them. But we also continue to have a lot of very interesting opportunities that we're pursuing on the investments in the business side. Our M&A funnel continues to be very active. We are looking at capability-based targets, whether it's in our aerospace and defense segment again or other high-reliability segments as well. And so we'll continue to evaluate those different options, share buybacks versus M&A transactions, at that time and to look at what will drive the greatest level of value for shareholders. But our long-term strategy of 50% back to shareholders and 50% investing in the business remains unchanged.

Thanks for all the details and congrats on the quarter.

Thanks, Ripley.

Thanks. And your next question goes on of Paul Schreber with RBC Capital Markets. Please go ahead.

Thanks very much. Good morning. In regards to the uptick that you're seeing in the service provider space, What's your sense that the increase this quarter and what you expect through the year represents a sustainable higher level of demand as opposed to a pull forward from future periods?

Hi, this is Rob. So, you know, I guess another way to answer the question is do we see a lot of buffering kind of going on? We did see, I think, in the service provider business an increase in buffering in the early part of the year. I call it the first half of the year. We see some of that buffering lessening. I think there's still some in the supply chain, but it's lessening. But despite the buffering, we continue to see strong demand from our service provider customers. We're seeing the strength across multiple customers and multiple technologies. So I think while there could be a pullback at some point, we have good visibility into our customers' demand and we feel it's sustainable in the midterm.

Okay, thanks for that. The second question is specifically honing in on the hyperscalers and JDM. Do you see more opportunities to do additional business with the hyperscalers and in what areas would that be? And then on the JDM or related to that on the JDM, how is R&D spending changing? JDM R&D spending being tracking, and do you also see an opportunity to expand JDM R&D going forward?

Yeah, I'll cover the first part. With respect to the hyperscales, they've been buying our full suite of products in terms of compute, storage, and networking. The predominant growth drivers right now are in the areas of networking, but we're seeing it in all the areas as well. Again, we're doing business with eight out of the ten, and our business with all of them is growing substantially as they pull forward their roadmaps. Where they can't get our next generation products, they're actually buying more of our existing products as well, which is, you know, paying dividends in some of the growth rates that we saw. In terms of R&D spend, I'll turn that over to Mandy. Okay.

Sure. So, you know, we put all of our spend in the R&D line. And so you'll see what we do spend on JDM, $25 to $30 million over the last few years. You know, just as a reminder, we have over 300 design engineers sitting in Shanghai, as well as a number of engineers sitting in other geos as well. We've been very pleased that we've been able to modestly scale that number while dramatically increasing the top line. I would expect that we'd continue to have some level of growth in our R&D spend in the outer years as we sustain these revenue levels, just continuing to invest in various levels of talent and product roadmaps. But just as a reminder, when we talk about JDM's results, we're talking about it inclusive of that R&D spend. And so with the performance that JDM's been having, margins are accretive to the overall company, and that's after paying for the $25 to $30 million of R&D.

All right, thanks for taking my question. Thank you.

Again, if you'd like to ask a question, press star one on your telephone keypad. Your next question comes from the line of Kurt Schwartz with Stifel. Please go ahead.

Hi, good morning. Thank you for taking the questions. I'm hoping you can provide maybe a little bit more color on your manufacturing utilization by region. I know you said you were about 95% globally, so any breakdown by region? by the various regions would be helpful. And then maybe on that topic, I'm wondering if you could perhaps discuss any incremental costs associated with COVID that you're expecting in future quarters, just any framework on how to think about that, and whether some of those government subsidies and customer recoveries mentioned would be expected to continue.

Sure, Kurt. I'll start off. So overall, Mandip mentioned we're at about 95%. China has been well over 90% since early March. Europe is in the 85% to 90% range. Thailand and Malaysia are both north of 90%. North America is in the 85% to 95% range. California and Mexico probably being... the two regions that are dragging the percentages down. The others are north of 90% as well. Hopefully that gives you a little color and I'll let Mandeep take the second part of the question.

And I'm sorry, can you just repeat that second part of the question?

Sure. So just on the topic of utilization and incremental COVID related costs, just wondering if you can provide any color on your outlook for those costs in the coming quarters. which may be expected to repeat. And also you mentioned some government subsidies and customer recoveries benefit in Q2. So wondering if any of that will repeat as well.

Right. And the answer is the net of the impacts was about $2 million in the second quarter. We did see a higher level of costs related to things such as PPE and expedite fees. But, again, we were able to get a number of various recoveries to offset that. Our expectation in the third quarter is that the impact will be largely similar, so a couple of million dollars at this point.

Great. Thank you very much. And then perhaps as a follow-up, just wondering if you could maybe provide any additional commentary on sort of the linearity of demand throughout the quarter and perhaps any notable swings by end market or segment since you have cited demand some, some volatility throughout the business. So any color there would be appreciated.

Yeah. So, you know, similar to the comment that I had made, um, with Jim, the demand, um, uh, swings that we saw, we saw earlier on in the quarter. Um, and so the markets that I referenced that were up, uh, we saw that very early on and then when the markets that were coming down, it happened very early on. Um, those trends continued through much of Q2 and they're carrying into the third quarter as well right now. So we're continuing to execute on a very strong level of demand in service provider, as well as in semiconductor, you know, in health tech as well. But we are expecting commercial aerospace to continue to be depressed, not only into the third quarter, but as we exit this year as well. And industrial, while we do expect the demand to start coming back, it has right now shifted to the right. And so we're taking cost actions with the assumption that those depressed levels of demand will continue for much of this year.

And I would also add that historically speaking, most of our product goes out in the third month of the quarter. During pandemic times, right now within our service provider business, a lot of the demand is being accelerated earlier into the quarter. and has been paced by capacity, material capacity, things on those lines. So the linearity is a little bit improved in certain segments with certain customers.

Understood. Thank you very much.

Thank you.

And there are no further questions at this time. I will turn the call back over to the presenters for closing remarks.

Hi, thank you. This Despite a volatile macro environment, we continue to execute well for our customers. We're able to once again drive sequential operating margin improvement, generate strong free cash flow, and pay down long-term debt in the quarter. Our CCS portfolio continues to perform well and delivered a fifth consecutive quarter of margin expansion amidst our portfolio shaping actions. And in ATS, I'm pleased with the improved profitability of our A&D business and continued strength of our capital equipment and health tech businesses. And while we continue to face uncertainty given this pandemic, I believe we have proven that the Celestica team has the ability to successfully navigate the challenges that might lie ahead. I'd like to once again thank our global team for remaining vigilant and not only keeping themselves safe, but also helping to protect those we interface with. And thank you for joining us, and I look forward to updating you as we progress throughout the year.

This concludes today's conference call. You may now disconnect.