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Celestica Inc (NYSE:CLS)
Q2 2020 Earnings Call
Jul 29, 2020, 8:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good day, ladies and gentlemen, thank you for standing by and welcome to the Celestica Q2 2020 Earnings Conference Call. [Operator Instructions] After the speakers' presentation there will be a question-and-answer session. [Operator Instructions]

I would now like to turn the conference over to your speaker for today, Craig Oberg. Please go ahead.

Craig Oberg -- Vice President of Investor Relations

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 US 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 US 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 US dollars and per share information is based on diluted shares outstanding.

Let me now turn the call over to Rob.

Rob Mionis -- President and Chief Executive Officer

Thank you, Craig. Good morning and thank you for joining today's conference call. Celestica 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 pay 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 in 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 and 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 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.

Mandeep Chawla -- Chief Financial Officer

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 the incurred costs related to COVID-19, including PPE premiums paid to ensure continuity of supply, and inefficiencies related to loss 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 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 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 strengthen our JDM business partly offset by a reduction in fiscal revenue as we continued our plan to 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 strengthen in JDM, partially offset by plan disengagements as part of our CCS portfolio optimization program. Sequentially, enterprise revenue was up 32%, primarily due to demand strengthen in JDM and seasonality. We are pleased by the growth in JDM as we continue to ramp several remnants and support increased levels of demand from our hyper scale 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, CCS 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 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 improve 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 billion 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 lowered 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 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 and 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 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 toward 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 lowered interest costs. Over the long-term through, our capital allocation priorities are unchanged. We will continue to work toward 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 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.

Rob Mionis -- President and Chief Executive Officer

Thank you, Mandeep. In the first half of the year, we strengthen 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 are also creating opportunities and 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 end 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 remains 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 action to just 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 operating 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 healthtech, we continue to see strong demand for diagnostic equipment and modest improvements in demand for elective surgery products. We expect to see strong growth continue in healthtech throughout 2020, as we ramped 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 of demand due to the work and learn from home trend. Growth from our service provider customers more than offset revenue clients from portfolio shaping and communications and enterprise and the impact of COVID-19.

Strong margin performances in CCS was driven primarily by portfolio actions, operating leverage and improved mix including a growing JDM business. As Mandeep 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 products solutions across all IP infrastructure data center technologies. Their combined product life cycle capability with JDM, which are similar to ATS are intended to help customers reach their markets more efficiently from design through manufacturing and aftermarket support. JDM drive more value for our customers early in the product life cycle, thereby creating stickier and mutually beneficial relationships. We believe JDM and 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 bundle of opportunities targeted toward Thailand and we are pleased with the progress we are making the back fill 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 the surrounding the impact that COVID-19 might 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 whether uncertain times, we also believe our balance sheet remains strong as a result of strong free cash flow generation, with our 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 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.

Questions and Answers:

Operator

Thank you. [Operator Instructions] Your first question comes from the line of Gus Papageorgiou with PI Financial. Please go ahead.

Gus Papageorgiou -- PI Financial -- Analyst

Hi. Thanks and congrats on a great quarter. I mean, I know things are very kind of still volatile, but 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 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 -- Chief Financial Officer

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's one quarter and it's not -- 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 had, 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 while we started to take some restructuring actions 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 shift that's 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 in 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 -- PI Financial -- Analyst

Just quick follow-up. So on the ATS, I mean, you've got chip volumes 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 in aerospace?

Mandeep Chawla -- Chief Financial Officer

I would say that they are both equally important both capital equipment and aerospace and defense are larger segments within ATS as you know. Our capital equipment when it 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 improve profitability in A&D as we go through the year.

Gus Papageorgiou -- PI Financial -- Analyst

Okay. Great. Thanks, again. Congrats on a great quarter.

Mandeep Chawla -- Chief Financial Officer

Thank you, Gus.

Rob Mionis -- President and Chief Executive Officer

Thanks, Gus.

Operator

And your next question comes from Thanos Moschopoulos with BMO Capital Markets. Please go ahead, Thanos. Your line is now open.

Thanos Moschopoulos -- BMO Capital Markets -- Analyst

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

Rob Mionis -- President and Chief Executive Officer

Yeah. So from a pricing perspective, it's actually much improved. We measure shortages that are dating [Phonetic] revenue in the beginning of the quarter. And for Q2, it's actually -- Q3 is actually at pre-COVID level. That being said, we do have some hyper demand in support of service provider markets. And that's causing us some general consternation in just some broad electronic components. And there's some high reliability parts that are impacting 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 the quarter ago, Thanos.

Thanos Moschopoulos -- BMO Capital Markets -- Analyst

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

Rob Mionis -- President and Chief Executive Officer

Yeah. 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 is in Europe, and with the economy shutting down, a lot of our products get installed in homes and businesses and as such business kind of shutdown which kind of shut down the production lines. We do see Europe slowly opening up, which is a positive sign. And then also, businesses have generally stopped to cut it back on spending. 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 when they actually come to market that should give us a little bit of an uplift, which would be into next year.

Thanos Moschopoulos -- BMO Capital Markets -- Analyst

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

Rob Mionis -- President and Chief Executive Officer

Thanks.

Operator

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

Robert Young -- Canaccord -- 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 -- are you talking about revenue top-line there?

Mandeep Chawla -- Chief Financial Officer

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 -- Canaccord -- Analyst

Okay. Great. Thank you. And so I wanted to talk about managing place, we had talks about the renewed agreement that is in one of the weaker segments, is the industry moving more toward 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?

Rob Mionis -- President and Chief Executive Officer

Hi, Robert. I think it's 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 is better to take it over in place that being large fixed costs or monuments or tribal knowledge. For this 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 it was the OAP and also an extension of a long-term contract that we have with the customer. In terms of expanding, it's certain conversations we have with customers, and frankly, we are seeing this in the industrial space 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 -- Canaccord -- Analyst

Okay. Thanks.

Operator

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

Jim Suva -- Citigroup -- 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 though 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 proving 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 toward some improvements in Q3?

Mandeep Chawla -- Chief Financial Officer

Yeah. Good morning, Jim. Yeah. So we didn't provide guidance maybe I will talk about that first because there does continue to be a tremendous amount of volatility now that we are seeing. And so while we are seeing an improvement in even areas like supply chain, you saw that into 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 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. 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 have ended the second quarter.

Rob Mionis -- President and Chief Executive Officer

And 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 pull back and put in some restrictions in place which can impact our facilities, impact our suppliers' facilities, and given the trend lines, I just -- we feel [Indecipherable].

Jim Suva -- Citigroup -- Analyst

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

Rob Mionis -- President and Chief Executive Officer

Thanks, Jim.

Mandeep Chawla -- Chief Financial Officer

Thanks, Jim.

Operator

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

Paul Steep -- Scotia Capital -- Analyst

Could we talk a little bit on ATS within capital equipment? If we assume that, and as I recall, I think in Q3 year ago, we had relatively easy comp, 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-on-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.

Rob Mionis -- President and Chief Executive Officer

Sure. So, on capital equipment, I do 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 5 and 7 nanometers. To get to the back half there, the demand is shifting more toward memory, technology buys for 3D NAND, but there is 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 customers, we do think that 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 happened during the pandemic, it really accelerated the deployment of these technologies and likely 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 -- the customers who buy those products from us.

Paul Steep -- Scotia Capital -- Analyst

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 we are more or less on track? Thank you. That is it.

Rob Mionis -- President and Chief Executive Officer

Yeah. Thanks for the question. Revenue in displays is still generally depressed. The projects that we had planned for the back half 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 have 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 coming, growth in OLED will be explosive, and we're hopefully really anxious for those days to come. So, 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 have diversified the revenue there. So, in Korea we do more than display now. We also do a fair amount of [Indecipherable] work as well.

Paul Steep -- Scotia Capital -- Analyst

Thank you.

Operator

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

Ruplu Bhattacharya -- Bank of America Merrill Lynch -- Analyst

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 have already done 90 million. So, any thoughts on working capital, your inventories and free cash flow?

Mandeep Chawla -- Chief Financial Officer

Yeah, 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 continued 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 -- Bank of America Merrill Lynch -- Analyst

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

Mandeep Chawla -- Chief Financial Officer

Yes, absolutely. So, 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 the lower interest expense and you can work on extending 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. We have a very good track record of buying back shares. We bought back over $1 billion of shares over the last 10 years. And so we will 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 on 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 will continue to evaluate those different options, share buybacks versus M&A transactions during at that time and to look at what 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 -- Bank of America Merrill Lynch -- Analyst

Thanks for all the details and congrats on the quarter.

Mandeep Chawla -- Chief Financial Officer

Thanks, Ruplu.

Rob Mionis -- President and Chief Executive Officer

Thanks.

Operator

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

Paul Treiber -- RBC Capital Markets -- Analyst

Thanks so much. Good morning, just in regards to the uptick that you are seeing in the service provider space, what's 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 a pullforward from future periods?

Rob Mionis -- President and Chief Executive Officer

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 call it the first half of the year. We see some of that buffering lessening. I think there is 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 sustainable in the mid term.

Paul Treiber -- RBC Capital Markets -- Analyst

Okay. Thanks for that. The 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 or [Indecipherable] JDM, how is R&D spending -- JDM R&D spending been tracking and do you also see an opportunity to expand JDM R&D going forward?

Rob Mionis -- President and Chief Executive Officer

Yeah, I'll cover the first part. With respect to the hyperscales, we'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 are seeing it in all the areas as well.

Again, we're doing business with eight out of 10, 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 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'll turn that over to Mandeep.

Mandeep Chawla -- Chief Financial Officer

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 sitting in other geos as well. We've 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 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 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's after paying for the $25 million to $30 million of R&D.

Paul Treiber -- RBC Capital Markets -- Analyst

All right. Thanks for taking my question.

Mandeep Chawla -- Chief Financial Officer

Thank you.

Operator

[Operator Instruction] Your next question comes from the line of Kurt Swartz with Stifel. Please go ahead.

Kurt Swartz -- Stifel -- 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. So 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?

Rob Mionis -- President and Chief Executive Officer

Sure, Kurt. I'll start off. 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 -- Chief Financial Officer

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

Kurt Swartz -- Stifel -- 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 also, you mentioned some government subsidies and customer recoveries benefit in Q2. So wondering if any of that will repeat as well.

Mandeep Chawla -- Chief Financial Officer

Right. And the answer is that 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 expectation in the third quarter about the impact will be largely similar. So a couple of million dollars at this point.

Kurt Swartz -- Stifel -- 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 the linearity of demand throughout the quarter and perhaps any notable swings by end market or segment since you had cited some volatility throughout the business. So any color there would be appreciated.

Mandeep Chawla -- Chief Financial Officer

Yeah. So, similar to the comment that I had made with Jim, the demand swings that we saw, we saw earlier on in the quarter. And so the markets that I referenced that were up, we saw that very early on, and then when the markets that were coming down, it happened very early on. Those trends have continued through much of Q2, and they're peering 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 and health tech as well.

But we are expecting commercial real estate to continue to be depressed, not only into 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.

Rob Mionis -- President and Chief Executive Officer

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

Kurt Swartz -- Stifel -- Analyst

Understood. Thank you very much.

Mandeep Chawla -- Chief Financial Officer

Thank you.

Operator

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

Rob Mionis -- President and Chief Executive Officer

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 amid 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 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 we interface with. And thank you for joining us, and I look forward to updating you as we progress throughout the year.

Operator

[Operator Closing Remarks]

Duration: 48 minutes

Call participants:

Craig Oberg -- Vice President of Investor Relations

Rob Mionis -- President and Chief Executive Officer

Mandeep Chawla -- Chief Financial Officer

Gus Papageorgiou -- PI Financial -- Analyst

Thanos Moschopoulos -- BMO Capital Markets -- Analyst

Robert Young -- Canaccord -- Analyst

Jim Suva -- Citigroup -- Analyst

Paul Steep -- Scotia Capital -- Analyst

Ruplu Bhattacharya -- Bank of America Merrill Lynch -- Analyst

Paul Treiber -- RBC Capital Markets -- Analyst

Kurt Swartz -- Stifel -- Analyst

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