Modine Manufacturing Co

NYSE:MOD

Earnings Call Transcript 2022-Q1

[Operator]

Good morning, ladies and gentlemen, and welcome to Modine Manufacturing Company's First Quarter Fiscal 2022 Earnings Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded.

I would now like to turn the conference over to your host, Ms. Kathy Powers, Vice President, Treasury, Investor Relations and Tax.

[Kathy Powers, executive]

Good morning, and thank you for joining our conference call to discuss Modine's first quarter fiscal 2022 results. I'm joined on this call by Neil Brinker, our President and Chief Executive Officer; and Mick Lucareli, our Executive Vice President and Chief Financial Officer.

We'll be using slides for today's presentation, which can be accessed either through the webcast link or by accessing the PDF file posted on the Investor Relations section of our website, modine.com.

On Slide 2 is our notice regarding forward-looking statements. This call will contain forward-looking statements as outlined in our earnings release as well as in our company's filings with the Securities and Exchange Commission.

With that, it's my pleasure to turn the call over to Neil.

[Neil Brinker, executive]

Thank you, Kathy, and good morning, everyone. Before reviewing our first quarter results, I would like to provide an update on our most important strategic initiatives and provide some additional information on our recently announced leadership changes. To start off, I would like to provide an update on our Automotive exit strategy and the current status of the sale of our liquid-cooled Automotive business, Dana.

As I mentioned last quarter, the regulatory process in Germany has taken longer than originally expected. In response to concerns raised by the authorities, we voluntarily withdrew our regulatory filing in May. We then work with Dana to revise the transaction and have resubmitted the filing in Germany, reflecting the new transaction. We will continue to work through this regulatory process, but cannot provide an estimated date of completion or guarantee any outcome. Both companies are committed to completing the sale, but at this point, it remains subject to approval by the German regulatory authorities.

Now I would like to move on to the state of our markets. In general, we continue to enjoy a robust business environment, which is positive for revenue, but is creating inflationary challenges. A number of items negatively impacting the first quarter, including incremental material and supply chain costs, along with continued impact of the tight labor markets. Metal's costs have continued to rise with aluminum, copper and steel prices up substantially from the prior year. In addition, we are working through mill capacity constraints, which impact both our direct spend and supplier availability. We are relying on alternative sourcing when necessary and are recovering inbound premium freight costs wherever possible.

From a logistics standpoint, we are dealing with the shortages of sea containers out of China, which is also driving up costs and are routing international inbound shipments to alternative ports in order to minimize the impact of the West Coast congestion. Like many others, we are definitely experiencing temporary cost issues and inefficiencies driven by all these supply chain issues. We have dedicated resources, managing our supply base and logistics, prioritizing our greatest needs and establishing dual sourcing where possible.

To address labor shortages, we are sharpening our demand planning process so that we can more efficiently manage our manpower requirements and avoid overloading our daily capacity. We're also using 80/20 to differentiate lead times by product and region. And finally, we continue to monitor the impact of the chip shortage, particularly related to our Automotive business. This is an evolving situation, and we are developing plans and actions on how to mitigate the potential impact on our operations.

Next, I would now like to discuss our recently announced leadership changes and give an update on our business transformation. I'm very pleased to have Adrian Peace and Eric McGinnis join our executive management team. Both Eric and Adrian have over 25 years of global industrial leadership experience and a proven track record of driving profitable P&L growth.

Adrian will be leading our CIS segment and comes to Modine with a tremendous amount of global leadership experience, executing on business turnarounds and driving operational excellence. Adrian spent 23 years with GE, where he served as President and CEO of their Consumer and Industrials Business in Latin America, and prior to that, served as President Chemicals and Monitoring Solutions in North America, GE Water, and Process Technologies. From there, we moved on to Grainger and was tasked with leading their international growth strategy, and lastly, to Republic Services, where he served as the Senior Vice President, Emerging Business Operations and led their sustainability initiatives.

Our 80/20 work and the CIS segment will provide a road map of priorities for Adrian, and I'm confident that he will be able to improve margins in this segment by focusing our resources on our most important products and customers. This includes improving pricing on low-volume products, removing complexity through product line simplification and implementing precision-selling techniques to differentiate how we engage commercially. I know that he is up for this challenge and his leadership will allow us to achieve our goals.

Eric McGinnis will be leading our Building HVAC segment and is coming to us from Regal, where he most recently served as the President of their Industrial Systems segment. As many of you know, Regal has been on an 80/20 journey for several years and has undergone a successful business transformation, both improving businesses and through a successful growth and acquisition strategy. Eric's experience with 80/20 and his prior role as Vice President Business Development, where he led Regal's M&A and Strategy Group, make him the perfect candidate to lead our Building HVAC segment. Eric will be responsible for leading our transformation in this segment, which shares some of the fastest-growing end markets for Modine.

Using the 80/20 framework, we have been focusing on segmentation, which involves creating market-based verticals led by general managers who can operate entrepreneurially while improving speed and accountability. Each of these general managers will have a supporting organization structure designed to focus commercial resources and drive end market demand and share growth.

We are currently focusing on several attractive markets, including data centers, heating and indoor air quality for schools and commercial buildings. As I shared last quarter, we are expecting the strong growth in our data center markets to continue and are providing leadership and resources necessary to allow the continued success of this business. We plan to launch a new computer room air handling unit in both Europe and the U.S. later this year that will provide higher system efficiency and flexibility through customization and controls, targeted at both the colocation and hyperscale markets. To support these initiatives, we have shifted our plant in Spain from our CIS organization to Building HVAC to provide additional capacity for growth in the data center market. This is an exciting time for Modine as we built the foundation for our future. We're getting our leadership team in place to strengthen our commercial and operational organizations so that we can reduce complexity and accelerate growth.

Now I'd like to turn the call over to Mick, who will review our results for the quarter and provide the segment updates.

[Michael Lucareli, executive]

Thanks, Neil, and good morning, everyone. Please turn to Slide 5. To help understand the underlying trends and results. I'll focus today on adjusted earnings. Our press release and appendix include additional information, U.S. GAAP results and complete reconciliations.

During the quarter, we included $11.1 million of adjustments, which are comprised of 3 main categories: First, we incurred a $6.6 million loss on the sale of the air-cooled Automotive business in Austria, which was completed during the quarter. Also as part of our Auto exit plan, we had a number of items that netted to nearly 0, including other divestiture cost and a net impairment reversal. Next, we recorded $3.5 million of environmental charges related to a previously owned U.S. manufacturing facility. Third, we incurred $900,000 of reorganization and restructuring cost. First quarter sales and earnings were quite strong as expected, despite a number of obstacles within the supply chain, mostly relating to tight labor markets and material prices and shortages. Like many companies, our first quarter sales growth was quite strong due to significant impacts from the pandemic last year and favorable foreign exchange rates.

Sales were up 42% and over 35% on a constant currency basis as all segments reported significant improvement. Modine's adjusted EBITDA was up 62%, driven mainly by the higher sales volume. On the right side of the slide, we show the major components of the $12.8 million increase in adjusted EBITDA. Our gross profit margin showed a 150 basis point improvement. Partially offsetting the strong volume, the quarter is impacted by material inflation along with higher supply chain costs. Despite our price adjustment mechanisms, we absorbed approximately $13 million of higher material costs.

As Neil mentioned, we are experiencing very tight labor markets and other cost increases, but our plants are working hard to generate savings to offset these headwinds. SG&A had an $8 million negative impact on adjusted EBITDA, but was lower as a percentage of sale. The change mostly reflects the return to normal compensation and benefit levels at the prior year included $5 million of savings from temporary COVID actions. And finally, there was a net positive foreign exchange impact of approximately $2 million. Adjusted earnings per share of $0.20 was $0.29 higher than the prior year.

Now let's review the segment results. Please turn to Slide 6. The Building HVAC segment reported another solid quarter with sales up 26% from the prior year. This increase was driven by heating sales in the U.S., which were up over 50%. Commercial ventilation demand remains high, particularly for school products as they prioritize indoor air quality and leverage federal funding. Data center sales were up 11%. Markets remained strong and our order book shows higher growth levels for the balance of this year with our new product offerings and increased manufacturing capacity. As we anticipated, adjusted EBITDA was relatively flat versus the prior year despite the higher sales.

The gross margin was lower than the prior year due to the rapid increase in metal prices, particularly steel. Our teams are already adjusting pricing plans and mechanisms to offset these negative impacts. In addition, temporary cost savings actions in the prior year helped boost the profit margins. Last, we are adding resources in this segment to support data center growth in line with our strategy. This contributed to higher cost and will be more than offset with the planned revenue growth. Given all these factors, we anticipate an increase in the second quarter profit margin and for the balance of the year.

Please turn to Page 7. CIS sales were up 30% or 24% excluding a favorable currency impact. The increase was primarily driven by a 38% increase to commercial HVAC customers and a 44% increase in the refrigeration market. Similar to Building HVAC, we are adjusting our commercial strategies to address rising commodity cost, which will lead to further margin improvement. As a reminder, we are in the process of consolidating our global data center business under one organization, which will reside under Building HVAC. In July, we began moving the financial reporting for data centers from CIS to Building HVAC. This will not only align our internal teams, but help our investors to better follow the future growth trends. SG&A increased this quarter due to the lack of COVID savings, but declined as a percentage of sale. Adjusted EBITDA improved $4 million on higher sales, resulting in a 90 basis point profit margin improvement.

Please turn to Page 8. The Heavy Duty Equipment markets are experiencing very robust recoveries from the pandemic levels. Sales in the HDE segment were up 63%, with higher sales in all of our end markets. Medium and heavy-duty truck sales were up nearly 80% with significant increases across all regions. Bus and specialty vehicle sales increased over 50%, with the largest growth in the Americas region. Our off-highway sales were up nearly 50% globally with the largest gains recorded in the Americas and Europe. The gross margin improved 200 basis points to 11.2%, which is lower than our recent run rate. This is primarily due to the significant rise in materials, freight and packaging costs.

As a reminder, our HDE and Auto segments are generally more susceptible to material fluctuations and the timing of related pass-through agreements. We are working diligently to maximize the recovery of all cost, but we anticipate that will take another quarter before we see it flow through. SG&A was up approximately 13%, but well below the rate of revenue growth. As a result, adjusted EBITDA was up $9.9 million, including a 310 basis point improvement in the EBITDA margin.

Please turn to Page 9, and I'll shift to the Automotive segment. First quarter sales were up 28%, excluding a $7 million positive currency impact driven by higher market demand, primarily in Europe. Adjusted EBITDA for the segment was $2.3 million, up $900,000 from the prior year, primarily due to the volume increase, largely offset by higher material cost and the impact of COVID savings in the prior year. We anticipate more difficult comparisons in our Auto business during the balance of the year. Last year, Auto sales rebounded quite quickly after the initial COVID wave and remained relatively strong for the full year, making sales comps more difficult. In addition, we benefited from a number of COVID cost savings initiatives last year, especially across Europe. Lastly, we are seeing some reductions in orders due to supply chain shortages of semiconductors. Bear in mind that the balance of the year will exclude the air-cooled business, which was sold in our first quarter. The estimated annual revenue impact will be approximately $55 million to $60 million.

Now moving to the balance sheet. Please turn to Slide 10. As anticipated, our first quarter free cash flow was negative, which is normal for our first fiscal quarter. This was due to the planned increases in working capital and the timing of incentive compensation payments. The first quarter of last year was unusually strong from a cash flow perspective due to COVID-related cash preservation efforts, along with a drop in working capital due to the lower sales. Our Q1 leverage ratio was 2x, comfortably within our target range, and we expect our free cash flow to show sequential improvement as the year progresses. As a result, we anticipate that full year free cash flow will be positive, but below the record levels produced last year. This is mostly due to the increase in working capital required to support the sales recovery along with the higher capital spending.

Now let's turn to Slide 11 for our fiscal '22 outlook. We are holding our full year outlook based on the continued strengthening across our core markets. While the higher sales volume is adding more supply chain challenges, it's helping offset the related inflationary impacts. As I covered last quarter, our largest challenge remains the raw material cost within the vehicular businesses. Key metals are up significantly over the prior year with aluminum and copper up 40% to 50% and most steel up over 100%. We currently anticipate the total net impact of material and supply chain inflation could exceed $25 million this fiscal year. I would also like to remind everyone that our guidance includes a full year of our Auto segment, including the business that is pending a sale to Dana.

With regards to other key assumptions, we expect the annual interest expense in the range of $14 million to $15 million and the adjusted tax rate to be in the mid-20s. Based on all these factors, we continue to anticipate consolidated sales growth of 12% to 18% and adjusted EBITDA range of $170 million to $185 million. We anticipated that our first quarter would represent a low watermark from an earnings and a margin perspective due to the inflationary challenges and the time it takes to fully pass through these cost increases. It's important to point out that we do not expect a step function change in our earnings between quarters due to the nature of our commercial agreements. Rather, we project slow steady improvement in both margins and earnings as each quarter progresses.

With that, we'd be happy to take your questions.

[Operator]

[Operator Instructions]

Our first question is from Matt Summerville of D.A. Davidson.

[Matt Summerville, analyst]

Mick, to get back to the $25 million you just referenced, is that a gross or a net number in terms of offsets? And is it possible to try and split that out a little bit across the businesses just to give us a feel for how that impacts the vehicular side versus the other pieces?

[Michael Lucareli, executive]

Yes. Matt, when we go through the details of that $25 million I gave you, the vast majority of it sits within our vehicular businesses, probably about $20 million or more of that will sit within HDE and Automotive. And that's primarily based on the lag effect based on our pass-through arrangements and agreements with those customers. It is the net number. So we are clearly -- there is a significant number I talked last time about based on the amount of material we buy in pounds -- millions of pounds of aluminum, copper, steel, the gross cost increases are well greater that the gross costs are probably in the $50 million to $100 million range. And that net number, it isn't a loss number, it's going to be a catch-up still. When we look through the fiscal year, assuming once metals eventually level out, we will catch up to that, but we're anticipating now that there will be that lag. So it's -- $25 million is a net number and a vast majority of it sits in HDE and Auto.

[Matt Summerville, analyst]

Got it. And then as a follow-up, Neil, I was hoping you could just do a little bit more of a deeper dive now that you've been here for a couple of quarters, what you've been doing with 80/20, specifically in data center, but across the company more broadly? So looking for a deeper dive there. And then Mick, if you can also comment on free cash in terms of what should be a realistic conversion rate this year.

[Neil Brinker, executive]

Sure. Matt, as you know, we piloted and started 80/20 in data center deliberately. That is an area where we have the highest potential of growth. We have a strong market position, a good customer base and products that differentiate. And as we've evolved over the last couple of quarters, we've reorganized, and we're starting the consolidation of our engineering efforts, our commercial efforts. And most recently, as we announced today on the operations side, where we've moved the Spain plant from CIS into the Building HVAC group to help increase our overall capacity globally.

Also through our 80/20 work, we're dialed in with some of our customers, particularly in the colocation market and especially, the ones that are thinking about single tenant usage. And we're doing this through further capacity expansion, not only in Europe, but in North America as well, in Virginia, particularly where we're utilizing our HVAC plant to expand capacity. So a lot of effort and energy at the beginning of 80/20 has been focused on data centers because that's where the growth is. And we're doing quite well. And we're to the point now where it's around capacity expansion because we have a strategy in place that supports our 80/20 initiatives and we're moving forward.

Now with that said, we -- with the success of this so far, we are now starting to roll into other areas of the organization where we've started to segment around our market-based verticals. And in order to do that, we needed to get some leaders in place that have strong P&L experience, and that's where Adrian and Eric come into play that are going to be extremely important. The next level is bringing in general managers and additional P&L support so that we can roll out the data center type 80/20 approach with other parts of the business. So we collected the data. We're well with on our way. We've seen the success of data centers, and we're going to continue to cascade that throughout the organization.

[Michael Lucareli, executive]

Matt, I'll jump in on, too. You had asked the question just about cash flow. So as we look full year, the CapEx we talked about being higher this year, and part of that will depend on where we end up with timing of the Automotive divestiture, but we're planning on higher CapEx this year in that $60 million to $70 million range. And then with the volume coming back, higher working capital as well from a -- as the year progresses, we're anticipating each quarter will get sequentially better from a cash flow standpoint, improving in Q2 over Q1. And then a much stronger second half of the year based on 2 things, as you can imagine, though, the working capital will level out, plus as we work through a lot of the supply chain logistics challenges we're planning to work down some excess working capital.

And then from a conversion standpoint, we're going to be positive free cash flow this year below last year. Last year was just an awesome year based on the combination of the COVID, cash preservation and some other items going on. But probably the way to think about it would be the ratio to sales will probably be in the 2.5% to 3% range is a good target for us to shoot for this year.

[Operator]

Our next question is from Steve Ferazani from Sidoti & Company.

[Steve Ferazani, analyst]

I Do want to ask about the guidance because certainly, it's worth the latter stages of earnings season. I think there's been an acknowledgment that materials costs and supply chain issues are less transitory than were expected 3 months ago, and everyone sort of adjusting their outlook for the year based on acknowledging that maybe there is more pressure there in the back half of the year than were expected. I'm trying to think, one, if you agree with that? And then two, if you do, are there other things you've seen that are more positive in the last 3 months that enables you to maintain that guidance?

[Michael Lucareli, executive]

Yes. Steve, it's Mick. I'll go first just to kind of give you some quantitative view from the forecast standpoint. And Neil's got a lot more color around the operations side of it and from the business side.

So a couple of things we see going on and as what we're talking about in our guidance was, we see sequential improvement. One is, as I talked about at the beginning, we have a significant amount of contractual price-throughs to manage and put through in our process on the vehicular side, which is customary as part of our LCA. That's one positive element of it.

The second one is, we -- frankly, in our mix of business, we start moving into a much heavier mix than our Building HVAC business and CIS. So some of the issues we're seeing around copper, aluminum, steel are heavily impacting the vehicular business. We talked about the chip shortage on the Auto side. On the data center growth, the HVAC growth, there are challenges there, but what we see there is a much better ability for us to manage the cost real time and also manage the supply chain. It isn't that there isn't global headwinds. And I'll let Neil comment on that, but I think from our side, we see a combination of passing through prices and how our mix of business changes through the year, which will be favorable or help us manage through this.

Neil, you want to add more ?

[Neil Brinker, executive]

Yes. No, that's a good answer. Yes, we're seeing this as well with the supply chain and primarily, with the logistics. Logistics have been extremely challenging for us, and we put together a tactical team in order to manage this and monitor it on a daily basis. So that is part of our daily management process in terms of making sure that we have the right parts in the right place and the right plan at the right time.

And then on the supply chain side, their lead times are extending. We thought we would see improvement previously, but with the labor constraints not only that we're experiencing, we're seeing that with our supply chain as well. And with these expanded lead times, we're having to do unique things in terms of managing our pipeline with the inventory, and sometimes that includes increasing our inventory levels for safety stock. So it is a bit of a challenge. It's extremely tactical right now, and it's something that's at the forefront of us, how we're managing daily and weekly.

[Steve Ferazani, analyst]

That's helpful. I did want to -- I'm not sure what you can add for detail in terms of the resubmitted divestiture proposal. Is there anything -- color you can add in terms of the changes you made and why you think that was necessary? And why you think -- any comment on that.

[Michael Lucareli, executive]

Yes. Sure. This is Mick. I'll give the best update I can. So the -- we can't give details now and give you a little color around it as it links to our previous announcements that as we looked at concerns with the German regulatory authorities, we get together with Dana and agreed on some changes on the perimeter, and the perimeter is, what's basically included and not included in the transaction. And we think based on discussions and feedback from the regulatory authorities, that's why both parties thought it was the right approach, given how far we were in the process.

We are not going to give more detail than that right now for 2 reasons: one is, we're clearly in a regulatory review process; and two, we're working through those details with Dana as well in parallel. As you can imagine, prior to this, there is a lot of work and effort into a lot of agreements between the parties. And then with the change in that, it takes time to flow those completely through. So as soon as we get feedback on regulatory process and/or a updated definitive agreement with the 2 parties, then we'll provide a more detailed update.

[Steve Ferazani, analyst]

Great. That's helpful. And then just wanted to ask about -- you announced the leadership changes. And just thinking about the 80/20 process and bringing in additional leaders, is it reasonable to think that there is additional costs before you start seeing the margin improvement that can be driven by 80/20?

[Neil Brinker, executive]

So additional costs. Can you elaborate on the question?

[Steve Ferazani, analyst]

Sure. You just announced 2 pretty senior level executives.

[Neil Brinker, executive]

Of course. Understood. Well, maybe temporarily, right? But at the end of the day, what we can do with strong P&L ownership, individuals that are driving strategy and helping us win on a day-to-day basis, it will pay for itself multiple times over. So maybe in the temporary, you're correct, but the long-term payback in this investment is exactly where we want to be.

[Steve Ferazani, analyst]

And then I guess adding to that would just be, if we back out those environmental costs on that SG&A line, Mick, would that SG&A be a reasonable run rate for the year?

[Michael Lucareli, executive]

Yes, that's a good point. The only items in there -- yes, that's the right run rate to use, Steve.

[Operator]

I'm showing no further questions at this time. I would now like to turn the conference back to Ms. Kathy Powers.

[Kathy Powers, executive]

Thanks for joining us this morning. A replay of the call will be available through our website in about 2 hours. We hope everyone has a great day. Thanks.

[Operator]

This concludes today's conference call. Thank you for participating. You may now disconnect.