Ingram: Celestica is all tunnel and no light

Over the past few months, several analysts upgraded their ratings on shares of Celestica, the contract electronics manufacturer, based on the assumption that the wave of cost-cutting and writedowns was finally over and business might actually start picking up. Guess what? They were wrong. The industry that Celestica relies on for its bread and butter is still in the tank, and margins are getting worse, not better.

Last October, the Toronto-based company (which is controlled by Onex Corp.) saw its stock slide to $10 (U.S.) - down more than 75 per cent from its high last year - after it said the traditionally strong fourth quarter would be weaker than expected due to lower demand for its services from customers. As hopes increased for a pickup toward year end, however, the stock almost doubled in price, getting close to $20.

Now that the fourth quarter has come in at the low end of already-lowered estimates, the stock is once again flirting with the $10 level, having fallen by more than 20 per cent on Wednesday. The biggest disappointment for investors wasn't the double-digit drop in revenue year over year - that was more or less taken for granted. The dark lining to Celestica's results was a loss of market share and slim profit margins.

The company reported what it likes to call "adjusted" or "operating" earnings per share - excluding various writedowns and charges - of 15 cents a share, at the low end of its guidance and a penny below analysts' consensus estimates. Its real bottom line was a loss of $1.90 per share, after the effect of $541-million in charges related to its restructuring program, a program the company said will continue this year.

In what is usually a strong quarter, revenue fell 2 per cent quarter over quarter and 22 per cent year over year. Although sales rose 19 per cent in Europe, the company's operating loss in that region almost doubled. There were a few bright spots: the company boosted its capacity utilization to 50 per cent from 40 per cent, it generated $101-million in cash flow from operations and it has over $1-billion in cash.

At the same time, however, there were some disturbing signals from Celestica's top customers. Sales to the company's top five customers (which are assumed by most analysts to be IBM, Sun, Lucent, HP and Cisco) fell by 23 per cent year over year - again, not that surprising given what has happened in the tech and telecom sectors. But they also fell by 4 per cent over the previous quarter, and sales to the next five largest customers (companies such as NEC and Dell) also fell by about 15 per cent.

Those aren't cheerful numbers for a company that gets about 80 per cent of its revenue from just 10 customers - and it's also evidence, some analysts say, that Celestica's market share is being hurt because it makes primarily high-end servers made by HP, Sun and IBM, while customers are moving more towards the lower end of the market and servers that run the Linux operating system. At the same time, telecom remains weak.

Reaction to Celestica's news was swift. Chris Whitmore of Deutsche Bank said in a report that he has cut his "adjusted earnings" forecast for the first quarter - already one of the lowest on Wall Street - by more than 50 per cent, to 6 cents from 13 cents. For the full year, he reduced his estimate to 38 cents from 65 and for 2004 he cut it to 55 cents from 80. Although Celestica's balance sheet will "enable the company to withstand a prolonged downturn," he said the stock was fully valued.

Needham & Co. cut its operating earnings estimate for the year to 45 cents from 70 and reiterated its "hold" rating, saying "any meaningful earnings recovery" would likely be delayed until sometime next year. A.G. Edwards chopped its 2003 estimate to 50 cents from 90 cents and maintained a "hold" rating, saying it was concerned about "deterioration of the company's fundamentals including market share loss, sequentially lower operating margins and... negative internal growth."

Benoit Chotard of National Bank, meanwhile, upgraded his target price and rating two weeks ago, but after the news came out Tuesday he reduced it again, cutting the stock to sector perform and the target to $28 (Canadian) from $38. "We upgraded Celestica two weeks ago, believing that the restructuring plan was going to provide benefits starting in Q4," he said. Lehman Brothers also cut its forecast to 45 cents (U.S.) in earnings from 73 cents, while JP Morgan cut its 2003 estimate to 72 cents from 94.

The average estimate for adjusted earnings this year is now 51 cents, which makes even Celestica's sharply reduced share price equivalent to 22 times forecast earnings per share - a hefty premium for a company with revenues that are still shrinking, profit margins that are still tightening and market share that is still under pressure.