Earnings Call Transcript - CLS Q2 2020

Operator, Operator

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 speakers’ presentation there will be a question-and-answer session. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker for today, Craig Oberg. Please go ahead.

Craig Oberg, Speaker

Good afternoon and thank you for joining us on Celestica's Second 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 today’s 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 any forward-looking statements 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-months, adjusted EBITDA leverage ratio, adjusted net earnings, adjusted EPS, adjusted SG&A 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 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.

Robert Mionis, CEO

Thank you, Craig. Good morning and thank you for joining today’s conference call. Celestica'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 the 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, Healthtech, and service provider markets, we have seen softness in other markets including commercial aerospace and industrial. Our CCS segments posted another quarter of solid performance, expanding segment margins on a year-over-year basis. In fact, CCS has extended 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 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.

Mandeep Chawla, CFO

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, 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 ATS 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 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 Healthtech. 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 fiscal revenue as we continued our plan for 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 performance and support increased levels of demand from our hyperscale customers. In the first half of 2020, our JDM business achieved over $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, the EPS 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 in programs. Year-over-year, ATS segment margins were down 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 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 unfavorable 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 $0.25 was up $0.13 year-over-year, mainly due to higher operating earnings and lower interest expense. Sequentially, non-IFRS adjusted earnings were up $0.09, 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 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 hyperscale 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 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. And 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 complying 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 lowered interest costs. Over the long term, our capital allocation priorities remain 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 of 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 are 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 will now turn the call over to Rob for additional color and an update on our priorities.

Robert Mionis, CEO

Thank you, Mandeep. In the first half of the year, we have reinforced our position in both CCS and ATS. Although we continue to face various challenges, we believe our strong portfolio is helping to alleviate some of these difficulties. Our efforts in shaping our portfolio and enhancing productivity over the past few years, despite being challenging at the time, have better prepared us to deliver valuable solutions across a wide range of markets. Now regarding ATS, the issues we are encountering due to COVID-19 are negatively affecting several ATS markets while also creating opportunities in others. Our capital equipment business experienced another profitable quarter, and we are seeing an increase in overall demand. This growth is fueled by higher demand in our core business and the ramp-up of new programs across various capital equipment end markets. Our ability to secure new programs stems from our strong performance and extensive global capabilities. In Aerospace and Defense (A&D), although we achieved record-level bookings in the first half of the year and demand in our defense sector remains steady, we are still facing declining demand in our commercial aerospace segment. Profit contributions from our A&D sector improved sequentially, albeit on lower revenue. We are actively adjusting our cost structure to align with this diminished level of demand. The measures we implemented began to yield results in the second quarter, and we expect A&D profitability to rise as we approach the year-end, provided there are no further adverse effects from COVID-19. We continue to lead in the A&D market, offering top-tier customers worldwide comprehensive product lifecycle solutions. A recent example includes the five-year renewal of our operating agreement in Mississauga, Canada, with a leading A&D customer. This partnership supports the customer with final assembly, testing, repair, and overhaul for crucial product lines catering to both commercial and defense markets. The renewed agreement not only fortifies our relationship but also lays a strong foundation to deliver product lifecycle solutions to a broader array of customers. In the industrial sector, we are currently observing weak demand across our customer base due to COVID-19, but we anticipate a gradual recovery when the macro environment improves. In Healthtech, we are witnessing robust demand for diagnostic equipment, alongside modest increases in demand for elective surgery products. We foresee sustained growth in Healthtech throughout 2020 as we scale up production of essential products, such as medical devices and diagnostic tools, vital for diagnosing and treating COVID-19 patients. We take pride in contributing to the fight against this pandemic by providing crucial solutions to numerous customers. Shifting to CCS, our CCS segment has shown solid performance due to rising demand from our service provider market as customers enhance and expand data centers in response to increasing cloud and online needs. The significant revenue growth stems from major wins over the past 18 months, further amplified by the recent upsurge in demand linked to the work and learn from home trend. Gains from our service provider clients have more than compensated for revenue declines due to portfolio restructuring in communications and enterprise and the effects of COVID-19. Strong margin performance in CCS has been primarily driven by portfolio actions, operational efficiency, and a favorable mix, which includes a growing JDM business. As Mandeep mentioned, our JDM business continues to flourish with another quarter of remarkable growth. Within JDM, we are investing in advanced product roadmaps and design capabilities, providing a comprehensive suite of product solutions across all IP infrastructure data center technologies. This combined product lifecycle capability with JDM, similar to ATS, aims to help customers reach the market more efficiently from design to production and aftermarket support. JDM adds value for our customers early in the product lifecycle, fostering stronger and mutually beneficial relationships. We believe JDM will remain a significant growth driver for the company in the future. Regarding the Cisco disengagement, the transition is on track, and we expect it to be mostly complete by the end of the year. We have a robust pipeline of opportunities aimed at Thailand, and we are satisfied with the progress we are making to offset fiscal revenue with higher value-add solutions. We are on target to meet our objectives with a richer assortment of programs. Looking at our overall business, uncertainties persist concerning the potential short-term effects of COVID-19. However, I remain optimistic about our long-term outlook and believe we have substantial opportunities ahead in both ATS and CCS. We maintain a strong foundation to navigate uncertain times, and our balance sheet remains robust due to strong free cash flow generation. With manageable debt levels and high liquidity, we are enthusiastic about our future prospects for sustainable profitable growth. I want to express my gratitude to our global team whose dedication and determination have kept our operations running smoothly; their resilience and commitment to adapt to this situation have been truly remarkable. We look forward to updating you in the coming quarters. Now, I will hand the call over to the operator for the Q&A session.

Operator, Operator

Your first question comes from Gus Papageorgiou with PI Financial. Please go ahead.

Gus Papageorgiou, Analyst

Hi, thanks and congrats on a great quarter. I mean, I know things are very kind of still volatile. But you know a while ago, you provided some kind of long-term goals for your margins. And if you look at the margins this quarter, 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 in chips, can you kind of give us an update of what you are thinking in terms of long-term margin goals, and if you think have changed at all, like would CCS be moving higher with maybe ATS be moving lower stable, just kind of give us a sense of where you think you can be good longer term.

Mandeep Chawla, CFO

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 you to those, we are very pleased with the performance that we saw in CCS and pleased that they were able to operate above their margin range. It is one quarter and it is too early to say if their target margin range should be raised. But clearly, when they have strong operating leverage and very positive factors in play, they are going to perform very, very well. On the ATS side, we are 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 has started to take some restructuring actions and is not yet where it used to be, and then we are continuing to see ramping programs in industrial and in Healthtech. There is also a mix that is happening a little bit where we are 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 the ranges. In order for ATS to get back into their range, we need to continue to see improvements in capital equipment, A&D, and we also need to see some level of modest recovery in industrial. And then on the CCS side, if they are operating at the high end of their range, that will support us to get to where we want to go.

Gus Papageorgiou, Analyst

Just quick follow-up, so on the ATS I mean, you have - improving, but aerospace still weak and Boeing cancelling programs. I mean, which of these two is the bigger influence, volume increases in chips or cost restructuring and in aerospace?

Mandeep Chawla, CFO

I would say that they are both equally important in both capital equipment and aerospace and defense, which are larger segments within ATS as you know. Our capital equipment, when it is at full scale, can operate above the 5% to 6% range. They are not there yet. And although we are continuing to see strong market demand, we are also ramping a number of programs that we have won and so as those programs reach steady state, we will see improved margins. On the aerospace and defense side, as Rob had mentioned, we continue to have a stable outlook on the defense side. So, most of the actions we are 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.

Gus Papageorgiou, Analyst

Okay great. Thanks and again congrats on a great quarter.

Mandeep Chawla, CFO

Thank you Gus.

Operator, Operator

And your next question comes from Thanos Moschopoulos with BMO Capital Markets. Please go ahead.

Thanos Moschopoulos, Analyst

Rob, as you look across the business, where would you say that there are still some bottlenecks from a supply chain perspective?

Robert Mionis, CEO

Yes. So from a pricing perspective, it is actually much improved. We measure shortages that are gating revenue at the beginning of the quarter. And for Q2, it's actually - Q3 is actually at pre-COVID levels. That being said, we do have some hyper demand in support of service provider markets. And that is causing us some general constraints; just some broader electronic components. And there are some high-reliability parts that are impacting the aerospace and defense business that we are facing as well. But broadly speaking, I would say, at least at this time, the component situation is much improved from the quarter.

Thanos Moschopoulos, Analyst

Okay. And within industrial, can you just provide a little bit more color in terms of where the weaknesses are underlying that segment?

Robert Mionis, CEO

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 markets are in Europe, and with the economy shutting down, a lot of our products get installed in homes and businesses and as such, businesses kind of shut down which kind of shut down the production lines. We do see Europe slowly opening up, which is a positive sign. Additionally, businesses have generally stopped their spending. So, broadly speaking, I would say everything in industrial is really driven by COVID. As the COVID environment improved, we do expect the industrial market to gradually improve as well. We also have a fair amount of new programs that are ramping and when they actually come to market, that should give us a little bit of an uplift, which would be next year.

Thanos Moschopoulos, Analyst

Great. Thanks, guys. Absolutely brilliant in the business.

Robert Mionis, CEO

Thanks.

Operator, Operator

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

Robert Young, Analyst

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 are seeing in Q2, or are you trying to really talk about revenue top-line there?

Mandeep Chawla, CFO

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 are 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.

Robert Young, Analyst

Okay. Great. Thank you. And so I want to talk about the management place; we had talks about the renewed agreement that is in one of the weaker segments. Is the industry moving more towards this type of model? Looking back over the relationship, what are the positives and negatives of the management place and do you see this as something that can really expand going forward?

Robert Mionis, CEO

Hi, Robert. You know I think it is a bespoke offering 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 each renewal, I think it is really timely, because it gives us guaranteed market share, as the entire commercial aerospace industry is down. And the mix of our operating price agreement is also on the defense side as well. So it is really a stable base. And in concert with this, we also extended our long-term contracts for CCS, which we assemble across our global network as well. So with the OAT and also an extension of a long-term contract that we have with the customer. In terms of expanding, it is certain conversations we have with customers, and frankly, we are seeing this in the industrial base as volumes decrease, our customers are facing utilization issues, and they are 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.

Robert Young, Analyst

Thanks.

Operator, Operator

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

Jim Suva, Analyst

Thank you. I realized you didn't give full detailed guidance, but you mentioned Q3 should be similar to Q2. The question I have thought is, what are some of the variables, because it seems like even in your prepared comments, you mentioned with Q3 governments are opening more, supply chains are 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 flattish sequentially when it seems like all the data points around the world are kind of pointing towards some improvements in Q3?

Mandeep Chawla, CFO

Yes. Good morning, Jim. Yes, so we didn't provide guidance, maybe I will talk about that first because there continues to be a tremendous amount of volatility now that we are seeing. And so while we are seeing improvement in even areas like the supply chain, you saw in the second quarter we had $56 million of revenue that was gated from material supply. And when we are starting this quarter in the third, we have a number that is higher than that. And while our teams did an excellent job of 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. Some of the items that you mentioned are continuing. And so what I would say is 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 are down to very low single-digit percentages, we expect that will continue through the third quarter. We continue to see strength in capital equipment, we continue to see and Healthtech, 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 in the industrial side. And so we haven't seen a significant change in some of these dynamics from where we ended the second quarter.

Robert Mionis, CEO

Jim, I would also add that based on what we know, we feel good, but based on what we don't know, it gives us concern. The rising case rate, not just in North America, but around the world, is causing some economies to not pull back in some places, which can impact our facilities, impact our suppliers’ facilities and given the trend line for just we feel we are being prudent.

Jim Suva, Analyst

Great. Thanks so much for the clarification. It is appreciated.

Robert Mionis, CEO

Thanks, Jim.

Mandeep Chawla, CFO

Thanks, Jim.

Operator, Operator

And your next question comes from the line of Paul Steep with Scotia Capital. Please go ahead.

Paul Steep, Analyst

Could we talk a little bit on ATS with capital equipment if we assume that, and as I recall, I think in Q3 year-ago, we had relatively easy comparisons. How significant are the ramps? If we were to see things sort of edge down a bit again, are the new program ramps significant enough to actually have us have year-over-year growth in capital equipment? And then the second quick follow-up would be in CCS. 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.

Robert Mionis, CEO

Sure. So, on capital equipment, as you think - I agree with you, I think we will have year-over-year growth in Q3. What we have seen in the first half of the year, as you know, is we have seen strength driven by technology buys in five and seven nanometers. To get to the back half there, the demand is shifting more towards memory, technology buys 3D NAND, but there are also capacity buys now coming online in terms of DRAM and NAND to support increased demand. And based on our near-term outlook and chatting with our customer, we do think that growth is sustainable here in the mid-term. With respect to JDM, again, we are very pleased with the performance that we have in that business. With COVID, we have a number of next generation technology wins with eight out of 10 hyperscalers. What happens during the pandemic is that it really accelerated the deployment of these technologies and likely proved instrumental in increasing the bandwidth given everyone is living online. Mandeep 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 the - by those products.

Paul Steep, Analyst

Sorry, one last one, we are up, apologies. On display, if we could go back to that. Can you talk to us a little bit about OLED and how you are thinking with those ramps? We know things have moved; we know smartphone demand is weaker, but obviously, you were ramping up for significant growth in that area. Where are we like, is the pandemic thrown timelines wildly off or do we have more or less on track? Thank you. That is it.

Robert Mionis, CEO

Thank you for the question. Revenue in displays remains generally low, and the projects we had scheduled for the latter part of this year and next year are being delayed, primarily due to the pandemic and the decline in smartphone sales. Additionally, TV sales have also decreased. As we mentioned, we have implemented several actions during the weak revenue period to reposition the business, moving the majority of operations to Korea. We maintain a long-term perspective on the industry. I believe that once 5G phones become widespread and next-generation TVs emerge, growth in OLED will be significant, and we eagerly anticipate that period. Currently, the market situation is causing delays. Furthermore, I would like to note that in our display business in Korea, we have diversified our revenue streams, so we are involved in more than just displays now, including a considerable amount of additional work.

Paul Steep, Analyst

Thank you.

Operator, Operator

And your next question comes from Ruplu Bhattacharya with Bank of America. Please go ahead.

Ruplu Bhattacharya, Analyst

Hi, thanks for taking my questions. Can you give us your revised thoughts on free cash flow in fiscal 2020? I think last time last quarter you said more than 100 million, but it looks like you have already done 90 million. So, any thoughts on working capital, your inventories, and free cash flow?

Mandeep Chawla, CFO

Yes, good morning, Ruplu. So, we are pleased with the cash flow performance we have 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 a 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.

Ruplu Bhattacharya, Analyst

Okay, thanks for that. And for my follow-up, I wanted to ask a question on capital allocation policies. So looks like you have been paying down significant debt over the last couple of quarters. But I mean, given that you have some 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.

Mandeep Chawla, CFO

Yes, absolutely. So, we have 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 the lower interest expense, and you can work on extending EPS, which is a core focus for us right now. And so we are very pleased with the performance that we have been able to show, we have paid down $122 million of debt in the first half of the year. We are not going to continue at this pace; we do think it is 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. 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 will look at various options to return cash to shareholders; share buyback is one of them. But we also continue to have a lot of very interesting opportunities that we are pursuing on the investment side of the business. Our M&A funnel continues to be very active. We are looking at capability-based targets whether it is in our aerospace and defense segment or other high-reliability segments as well. And so we will continue to evaluate those different options; share buybacks versus M&A transactions during that time and to look at local 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.

Ruplu Bhattacharya, Analyst

Thanks for all the details and congrats on the quarter.

Mandeep Chawla, CFO

Thanks, Ruplu.

Robert Mionis, CEO

Thanks.

Operator, Operator

And your next question comes from the line of Paul Treiber with RBC Capital Markets. Please go ahead.

Paul Treiber, Analyst

Thanks so much. Good morning, just in regards to the uptick that you are seeing in the service providers faith, what is your sense of the increase this quarter and what you expect through the year? And represents this a sustainable higher level demand as opposed to pull forward from future periods?

Robert Mionis, CEO

Hi, this is Rob. So, 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 would call it the first half of the year. We see similar buffering lessening; I think there is still some supply chain, but it is lessening. But despite the buffering, we continue to see strong demand from our service provider customers. We are seeing the strength across multiple customers and multiple technologies. So, I think while that could be a pullback at some point, we have good visibility into our customers' demand and we feel sustainable in the mid-term.

Paul Treiber, Analyst

Thanks for that. Second question is specifically honing in on the hyperscale as in JDM. Do you see more opportunities to do additional business with the hyperscalers and what areas would that be? And then on the JDM, how is R&D spending been tracking? And do you also see opportunities to expand JDM R&D going forward?

Robert Mionis, CEO

Yes, I will cover the first part while the hyperscale, we have been buying our full suite of products, you know in terms of compute, storage, and networking. The predominant growth drivers right now are in the areas of networking, but we are seeing it in all areas as well. Again, we are doing business with eight out of ten, and our business with all of them is growing substantially as they pull forward their roadmap where they can't get our next-generation products; they are actually buying more of our existing products as well, which is paying dividends in some of the growth rates that we saw. In terms of R&D spend, I will turn that over to Mandeep.

Mandeep Chawla, CFO

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

Paul Treiber, Analyst

Alright. Thanks for taking my question.

Mandeep Chawla, CFO

Thank you.

Operator, Operator

Your next question comes from Kurt Swartz with Stifel. Please go ahead.

Kurt Swartz, Analyst

Hi, good morning. Thank you for taking the questions. 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. Any breakdown by the various regions would be helpful. And then maybe on that topic, I'm wondering if you can perhaps discuss any incremental costs associated with COVID that you are expecting in future quarters. Just any framework on how to think about that and whether those - some of those government subsidies and customer recoveries mentioned would be expected to continue.

Robert Mionis, CEO

Sure Kurt, I will follow up. So overall Mandeep mentioned we are at about 95%, China has been well over 90% since early March, Europe is in the 85% to 90% range, Thailand and Malaysia both north of 90%. North America is in the 85% to 90% 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 will let Mandeep take the second part of the question.

Mandeep Chawla, CFO

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

Kurt Swartz, Analyst

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

Mandeep Chawla, CFO

Great. The answer is the net of the impacts was about $2 million for 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 expectations in the third quarter is that the impact will be largely similar, so a couple of million dollars at this point.

Kurt Swartz, Analyst

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 linearity of demands throughout the quarter and perhaps any notable swings by end market or segment since you have cited some volatility throughout the business, so any color that would be appreciated?

Mandeep Chawla, CFO

Yes, similar to the comments that I had made with Jim. The demand swings that we saw earlier on in the quarter, and so the markets that I referenced that were off, we saw that very early on, and then the market started coming down because it happened very early on. Those trends have continued through much of Q2, and they are peering into the third quarter as well right now. So we are continuing to execute on a very strong level of demand in service provider, as well as in semiconductor and Healthtech as well. But we are expecting commercial real estate 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 are taking cost actions with the assumption that those depressed levels of demand will continue for much of this year.

Robert Mionis, CEO

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

Kurt Swartz, Analyst

Understood. Thank you very much.

Mandeep Chawla, CFO

Thank you.

Operator, Operator

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

Robert Mionis, CEO

Hi, thank you. Despite a volatile macro environment, we continue to execute well for our customers. We are 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. In ATS, I'm pleased to improve profitability of our A&D business, and continued strength of our capital equipment and Healthtech businesses. 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 lie ahead. I would like to once again thank our global team for remaining vigilant and not only keeping themselves safe, but also helping to protect those who interface with us. Thank you for joining us, and I look forward to updating you as we progress throughout the year.

Operator, Operator

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