RealMoney Silver - Celestica's a Rising Star

Celestica's a Rising Star
By Bill Trent
RealMoney.com Contributor
5/9/2008 3:16 PM EDT

The electronic manufacturing services industry is notorious for having fairly high financial and operating leverage. This leverage, in turn, tends to exaggerate the industry's response to the business cycle. When profits start to turn up, the leverage can send the stocks soaring.

The problem is often in timing. When will the market bottom, allowing investors to capture the maximum portion of the potential gains? Given the high exposure these companies can have to single customers or industries, it can often be determined in part by the health of their customers.

If I had to make a call today in this space, I think I'd go with Celestica (CLS) and avoid or short Jabil (JBL) .

Indecent Exposure

In 2007, Cisco (CSCO) accounted for 15% of Jabil's total revenue, and Nokia (NOK) made up 13%. In the latest quarter, Hewlett Packard (HPQ) was a 10% customer, but Nokia was not. 29% of total sales were into consumer markets, which is not the place to be.

Although Cisco's earnings exceeded estimates Tuesday night, it is only because those estimates had fallen steadily over the last 90 days. The cautious guidance suggests that the company either won't need as many boards or it'll negotiate even more ferociously for price. Either way, its suppliers could face a tough period.

Tero Kuittinen has been reticent about Nokia's outlook, saying that softening demand for expensive handsets at the same time that large touchscreens are capturing the imagination of consumers could mean a nasty double whammy.

Cisco is also Celestica's largest customer. Cisco and IBM (IBM) each account for about 10% of Celestica's revenue. However, the company's end-market exposure is much more favorable: 28% enterprise and just 11% consumer. And at least IBM has been boosting its guidance and its dividend.

Head to Head

Partly as a result of the divergent exposure, fundamentals for the two companies are moving in opposite directions. Jabil has seen its per-share earnings estimates for the fiscal year ending in August plunge from $1.32 three months ago to just $1.06 today. Next year's forecasts have also been slashed from $1.74 a share to $1.34. Meanwhile, the 2008 per-share estimate for Celestica has skyrocketed from 53 cents to 72 cents since the company's strong earnings report in late April.

What's more, the earnings at Celestica appear to be of higher quality than those of Jabil. Based on the accrual ratio, there is a 33% difference between Jabil's accounting earnings and its cash earnings. The lower the ratio, the more similar the cash and accounting earnings, which reduces the likelihood that discretionary items are fueling the earnings report. Celestica's accruals are half the level of Jabil's.

Both companies have generated strong free cash flow over the last 12 months. Celestica generated $500 million in cash from operating activities and used just $66.3 million for capital expenditures. The resulting $434 million in free cash flow amounts to nearly a 20% free cash flow yield. Jabil, meanwhile, generated $383 million in free cash flow over the last 12 months, resulting in a 16.6% yield.

In both cases, the free cash flow is overstated somewhat due to declines in working capital investments. Since both companies were affected, though, the relative advantage for Celestica still seems meaningful. Furthermore, its cash flow from operations has been generally improving over the last five years. Though Jabil's also improved following the tech/telecom bust, it has been heading the wrong way for the last couple of years. Celestica's turnaround just seems more reliable to me.

From a valuation perspective, both companies are trading below book value, and the growth rates expected for each look to me to be within the margin of error. So the choice seems easy to me. I'd go with the one whose estimates and cash flow are moving in the right direction.