Modine Manufacturing Company

THE END Good morning, ladies and gentlemen, and welcome to Modine Manufacturing Company's second quarter fiscal 2021 earnings conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question and answer session, and instructions will follow at that time. If anyone should require assistance during the conference, please press star then zero on your touchtone phone. As a reminder, this conference call is being recorded. I would now like to turn the conference over to your host, Ms. Cathy Powers, Vice President of Treasury and Investor Relations and Tax. Please go ahead.

Good morning, and thank you for joining our conference call to discuss Modine's second quarter fiscal 2021 results. I'm joined on this call by Mick Luccarelli, our Interim President and Chief Executive Officer. We'll be using slides with 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, Mojeen.com. On slide two is our notice regarding forward-looking statements. This call may 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 is my pleasure to turn the call over to Michael Zarelli.

Thank you, Kathy, and good morning, everyone. We have a lot of good news to report, so I'll start with a brief summary of the highlights. Q2 results were significantly ahead of our expectations, including higher earnings, margins, and cash flow. Better market conditions combined with significant cost control resulted in a 40% adjusted EBITDA increase. In addition, we generated 73 million dollars of year-to-date free cash flow bringing our leverage ratio back to pre-pandemic levels next we made significant progress on our strategic initiatives this quarter including an agreement to sell our liquid cooled automotive business which makes up the majority of our automotive segment our board authorized a 50 million share repurchase program This is timely, giving our improved liquidity position and provides additional flexibility to manage our future cash flows. And finally, I would like to make a quick comment on the CEO search. The process has been going very well with very good outside candidates. We are in the final stages of the search and anticipate completing the process within the coming weeks. Now, before turning to the quarterly results, I would like to provide some more details about our automotive announcement on page four. Earlier this week, we announced an agreement to sell the majority of our automotive business, which is a significant step in our strategic transformation. This transaction provides our company with a number of benefits, including reallocating capital and resources to higher returning industrial businesses, especially those within our building HVAC segment. eliminating significant liabilities relating to future restructuring, along with pension costs and additional cash investments. And finally, this transaction will lower our future capital spending, improving our cash profile. The transaction includes seven manufacturing locations around the globe, including several in Western Europe and our headquarters in Germany. It also includes the assets and liabilities associated with these locations. While not expecting significant proceeds, we are foregoing significant future cash investments, including ongoing capital spending and future liabilities, along with pension and other employee-related costs. Also, I want to highlight that this is a leveraged neutral transaction from a covenant standpoint, consistent with the provisions in our credit agreement. And last, we expect the transaction to close in the first half of calendar 2021, subject to regulatory approvals and customary closing conditions. Please turn to slide five. I would like to provide some additional details on both the liquid cool business that we are selling and the air cool business that we are planning to address next as part of our overall auto strategy. Starting with the liquid cool business, it's averaged about $300 million in revenues over the last several years and has been recently running below that level due to general economic conditions. As we've discussed in the past, this has historically been a negative cash flow business with annual capital spending offsetting cash earnings. In addition, this business has required significant restructuring and would require additional investments going forward. Given the large amount of historical investments, the liquid-cooled business carries a significant amount of net assets. Based on the transaction, we anticipate a large non-cash impairment charge in Q3. Our view is then that this business is best in the hands of a strategic owner that has the size, scale, and desire to make the required investment. Now, moving on to the air-cooled business, which is the remaining business in our automotive segment and includes a plant in Austria and Germany. This business represents approximately 100 million of revenue and it's currently running at a lower rate due to the global pandemic. The majority of this business is comprised of automotive condensers, which are produced in Austria. Again, as previously discussed, this business runs much closer to break even on an adjusted EBITDA basis and will require minimal capital going forward. We are actively exploring alternatives for portions of this business and are currently engaged in discussions with interested strategic buyers. For the right partner, this business has value due to a relatively new facility, industry-leading products, and intellectual property, along with a solid order book. We have some more work to do, but much of the heavy lifting is complete with the automotive separation done and the recent sale announcement. We're optimistic about addressing the small amount of remaining business and further reducing future liabilities and cash needs. Now let's cover our second quarter segment results on page six. CIS sales were down 14% from the prior year, primarily due to COVID-related declines in our commercial HVAC and refrigeration markets, along with lower data center sales. Approximately half the decline relates to lower sales to our largest data center customer. As we've previously discussed, the pullback is due to one customer's reduction in construction and is expected to continue through Q4, after which we will begin to see the recovery. We're actively working on the testing of their next-generation product and are encouraged by the recent order outlook for next year. We continue to invest in our coding business, where we're receiving positive feedback from our OEM customers on a new coding process. Adjusted EBITDA was down 7% on lower sales, but I'm pleased to report the margin improved 70 basis points despite lower revenue. Good downside conversion was due to cost savings initiatives taken earlier in the year and a good trend with regards to COIL's margin improvement. In fact, If we adjust for the negative effect of lower data center sales, the margin would have improved by approximately 300 basis points versus the prior year on lower sales. Please turn to slide seven. The building HVAC segment had another great quarter, with sales up 11% from the prior year. This was primarily driven by a significant increase in data center sales due to our aggressive growth plan. Looking forward, we expect continued growth in our data center sales in the coming quarters and project we'll finish the fiscal year up more than 50%. In addition, we also had a strong preseason orders of heating products, which was partially offset by lower sales of ventilation and air conditioning products. On the ventilation side, sales to the hospitality market have been hard hit by COVID-19, causing us to shift focus to both the school and healthcare markets. We see future growth opportunities with our ventilation products, given the growing focus on the benefits of proper ventilation. I want to highlight that adjusted EBITDA increased 42% from the prior year, primarily due to higher sales volume and favorable product mix. This resulted in a 500 basis point improvement in EBITDA. The recent performance of this segment also demonstrates the potential for Modine after we complete the exit of the auto business and continue to reallocate capital. For example, We're leveraging our success and brand in the UK to produce data center products in mainland Europe. And equally exciting are the increasing opportunities in the US. We're industrializing computer room air handlers and chillers in our existing US manufacturing sites and are planning to be in production next fiscal year. Please turn to slide eight. Sales in the HDE, or heavy-duty equipment, were down 12% from the prior year, but a significant improvement from Q1 as markets continue to stabilize. Although sales decreased to most of our major end markets, we actually had higher sales to commercial vehicle and off-highway customers in Asia, partially offsetting the declines in North America. Adjusted EBITDA was up 42%. on a 460 basis point margin improvement despite lower sales hde significantly benefited from temporary cost reductions along with permanent actions including headcount reductions taken earlier in the year procurement savings and improved operational performance we're cautiously optimistic about further market recoveries in this segment while balancing the impacts of higher material costs and recently announced tariffs. Please turn to slide nine, and I'll shift to the automotive segment. Sales were down 5% from the prior year, which also represents a large sequential improvement from the first quarter. Auto sales recovered faster than most people anticipated as we saw lower sales in North America and Europe, partially offset by higher sales in Asia. Adjusted EBITDA improved significantly, up $5.7 million from the prior year, primarily due to cost reductions and other temporary COVID-related savings actions. Given the large amount of temporary cost reductions, we expect that the auto segment margins will return to more normal levels in the second half of the year. I want to point out that we do not anticipate that the recent announcement will change how we report our earnings in this segment. Obviously things can change, but for now we expect to report segment sales and earnings in a consistent manner until the transaction closes. Please turn to slide 10. As I mentioned at the beginning, Our team adjusted to the challenging economic environment earlier in the year by quickly implementing significant cost reductions. We prepared for the worst case, but we were pleased to see sales rebounded somewhat more quickly than expected. Second quarter sales declined by 39 million, or 8% as compared to the prior year, driven mostly by the global pandemic and associated economic conditions. Overall, our results benefited from a combination of markets recovering better than we anticipated and aggressive cost-cutting measures resulting in both temporary and permanent savings. I'm very pleased to report our gross profit was $81 million, which was higher than the prior year by $5 million on lower sales, and the gross margin increased by 240 basis points to 17.5%. SG&A was $17 million or 25% lower than the prior year. Given the significant uncertainties surrounding the pandemic, we maintained strict cost controls over spending and benefited from previous SDG savings. Some of the reductions should be viewed as largely temporary, representing about a third of the SG&A savings this quarter. Another driver of lower SG&A was a significant reduction in auto separation costs. Adjusted EBITDA of $55 million was better than the prior year by $16 million, or 40%. Please see our appendix for itemized list of adjustments and a full reconciliation to our US GAAP results. Our second quarter adjustments totaled $7.6 million, including $5.5 million from CEO transition costs, mostly related to severance and benefit-related expenses owed to the previous CEO. Most of these will be paid over multiple years. We also incurred $1.5 million of restructuring expenses related to plant consolidation activities, and our adjusted earnings per share was 43 cents, higher than the prior year by over 200%. Let's turn to cash flow and debt on slide 11. I'm pleased to report our free cash flow for the first six months of fiscal 21 was $73 million, which represents a $97 million improvement over the prior year. The positive cash flow was driven by numerous items, including lower spending on the automotive exit strategy, favorable working capital, and nominal capital spending. We use cash in the quarter to repay debt, increasing our available liquidity. And I'm very pleased to report that our resulting leverage ratio was 2.2, back to pre-pandemic levels and within our target range. We expect slightly positive cash flow for the remainder of the year, resulting in full year free cash flow of 70 to 80 million. The anticipated lower second half cash is due to a number of timing factors, including the deferral of certain cash items. For example, we have approximately $20 million in pension contributions, along with a phase-out of payroll tax deferrals under the CARES Act. We also expect higher capital spending in the second half of the fiscal year, along with some working capital growth in line with the recovery. Overall, the cash and debt position is a great story for Modine, especially given the current economic environment. Now let's turn to slide 12 in our fiscal 21 outlook. Like many companies, we're hesitant to provide full-year guidance, especially given the ever-changing dynamics tied to COVID. Based on the recent results, our full-year outlook is clearly improved, but we want to be careful not to extrapolate all of the Q2 upside through the balance of the year. We have a reasonable amount of visibility into our third fiscal quarter ending December 31st. Our Q4 is more uncertain, especially as it spans into calendar 2021. We expect our net sales to be down between 7% and 12% from the prior year. and for adjusted EBITDA to be in a range of $155 to $165 million. While the markets are changing continuously, we expect sequential revenue improvement in the third and fourth quarters. Positives include good momentum as we enter the heating season and a solid data center order book, plus strong vehicular market trends in Asia. We also see some higher costs in the second half, particularly related to employee compensation expenses as we reverse some of the temporary cost control measures taken earlier in the year, as well as higher metals prices, including the negative impact of the newly announced tariffs in the U.S. I also want to point out that our outlook includes the automotive business that is subject to the recent sale announcement. Our full year results could be different if this or another transaction is completed before fiscal year end. And finally, I want to thank our employees who have made numerous sacrifices this year and to the many shareholders who have fully supported our transformation. With that, we'll now take your questions.

If you have questions at this time, please press the star, the number one key on your touchtone phone. If your question has been answered or you wish to move yourself from the queue, please press the pound key. Our first question comes from Matt Somerville with DA Davidson. Your line is open.

Thanks. Good morning. A couple questions. First, with respect to your large data center customer within CIS, Can you talk about how you expect that revenue to ramp up during fiscal 22 and what you think the overall potential book of business could look like on an annual basis for that customer compared to prior peak levels?

Yeah. Good morning, Matt. Good question. We've been on, as you know, uh, the last few quarters have unfortunately been, uh, year over year, you know, declines. And we've been entering a period here where in the quarter we had, uh, very little in the way of actual sales to this customer and Q4 as well, we'll have very little, uh, in the way of, uh, in sales in total. And then, As I mentioned, we're working now on the testing and development of what they're going to use in the next generation for the next generation product. We're starting to see those purchase orders and construction plans come in place with a ramp in our Q4. We'll actually start building products in our March quarter as well, a little hard to predict the actual timing of shipments and revenue. But we see that being the inflection point. And then from where we've come from, we're running significantly below this year where we were two years ago. Last year was cut in half, and this year it's again cut in half. Without going into too much detail and detail I can't provide in a public setting, what I can tell you is next year, ex-fiscal year, would be a significant increase in planned volumes in production at almost about like a double run rate, so a real significant rebuild. And even at that run rate next year would be well below our high water mark. So we're optimistic in talking to that customer about an opportunity from there about another significant increase to get back to, you know, where we peaked out probably more than a year, year and a half ago. So, again, probably another quarter here of slow sales, and then the activity is really ramped up. and production beginning in our Q4. Next year, we see a significant jump in sales. And at that point, we're still well below where we kind of peaked out with them and an opportunity to go significantly higher from there.

Got it. And then just as a follow up, can you talk about what you anticipate the impact to be as it pertains to steel prices moving higher, as well as you mentioned some sort of tariff action, maybe if you could provide a little bit more detail on that. But if you could sort of parse that out and be a little bit more granular about what that impact is going to look like. Thank you. Yeah, yeah, for sure.

So two things as we think about the second half of the year and try to quantify it for you. One, as we've seen recently, a rise in raw material prices, as you referenced. We estimate from the second half versus first half that those metal prices will be 4 to 5 million net cost increase impact to us. Again, second half. A few weeks ago, maybe just a couple weeks ago, the new set of tariffs announced on aluminum products, and one of the highest tariffs was products coming out of Germany at almost a 50% tariff rate. We do have some material coming out of Germany, and we've got plans in place now to adjust for that, but we anticipate in the second half of the year that that's about another $3 million cost impact to us. For that one, we think we have a path forward to between different logistics and procurement strategies of eliminating or reducing that cost. But for now, in the second half, we see about $3 million from tariffs and $4 to $5 from net metals.

Thank you. I'll get back to you.

Your next question comes from Michael Schiske with Kohler Security. Your line is open.

Hey, good morning, everybody. So can we first start with the auto sale that was announced? Can you give us just kind of a full view on what are the avoided cash costs that are part of the deal in total? Just to kind of put the true value of what you're receiving for this division?

Yeah, Mike. So a couple of things that, as we know, made it more of a complex story since day one. We know, you know, and a part of our automotive exit strategy that this business has been a low EBITDA business, a 4% or 5% type in total. margin business and very high capital spending. We spent an average of $40 million a year just on capital expenditures in auto as a segment, not to mention other restructuring costs in the last few years. We've had almost $25 million of restructuring costs and tens of millions of dollars of impairments, as we painfully know well. 300 million-ish type business, the liquid cool that we announced the sale of, that's been historically neutral to negative free cash flow business. Depends on the year and exactly all the different calcs going into it. As I said at the beginning, generally the lower margin and low level of EBITDA that this business has been throwing out has been all consumed by a large amount of capital spending. So just as an ongoing basis, we've had struggles to generate positive cash flow. And then our biggest strategy going forward and belief on this business, as I also mentioned, is that we think the right owner, the right place for this business is for a strategic buyer or a company that will make the investments required to improve that margin profile, reduce the cost profile. So to your question, a big part of liabilities and cost and future cost investments we're avoiding all relate to what we would view as additional plant moves, plant expansion, severance charges. and ongoing capital investments that, in this business, the liquid cool has been averaging around $25 million a year. So that's the biggest value driver of the business, if you want to think about it that way, or a challenge in selling it. But also the opportunity for Modine as we go forward is avoiding all the additional cash investments we would need to put this into a – a profile that drives value for our shareholders.

And that plus the pension that you also discussed.

Yeah. So, yeah, with it, you know, part of it came with, I mentioned, it's about $15 million of pension. And then, you know, on top of it, I mentioned all along we've always talked about since we had first announced it, if we don't feed that engine – the amount of potential social costs and social liabilities that could come our way are enormous. So we view it as a huge step forward for us. And I even mentioned amount of management time. The last year, the amount of management time and money we spent also on separating and running this business has been enormous.

Okay. Can you also just maybe give us the broad outline of what is the go-forward CapEx for Modine and in the next few quarters prior to the oil sale closing, will that area have any capex associated with it in the very near term?

Yeah, so good question. We mentioned that, you know, balance of the year for Modine, two things, where our guidance, our outlook is based on the assumption that we still have the liquid cooled automotive business and the air cooled, even though We're looking at alternatives there. And so earnings and cash flow all assume that those stay with Modine. There's always a chance that the transaction closes before our fiscal year. And the other issue is we clearly have a responsibility to run that business between the signing of a deal and closing in a normal course of business for us. I would say the next two quarters, For us, average about $15 million a quarter of capital spending. That may be a little bit high. We'll just see how the next few months shake out and through year end. I'm talking total company. After the automotive divestiture, We see Modine running more in a 50 million-ish type capital spending run rate annually. We've been 70 to 80. So very well could be a little bit running a little below 50, maybe a little bit ahead, just depending on the year. But in totality, going from a company spending 70 to 80, and again, I'm excluding restructuring, which would make it even higher, to more like a 50 run rate, Mike.

And does that 50 run rate include or exclude the liquid part that's still left to sell?

Yeah, we anticipate very little future capital spending. Basically, the majority of that volume is run out of one plant that fully capitalized, so I would say an immaterial amount of capital spending tied to air-cooled.

Okay. I also wanted to turn to some of the building extract business. You had mentioned some good heating business in your slides, but also weak hospitality. I was curious whether the heating business strength was anything to do with outdoor heating or areas for outdoor dining or anything. Have you gotten any kind of positive orders or sales from people shipping to Downing Outdoors?

Yeah, we've seen a lot of those opportunities. We don't make a product that's the standard standing heating unit that you would think of. We do make some infrared products that you'd see hanging often, you know, as you enter a hotel or something. We have seen a nice increase in the heating market and on our side as well. But we think that's a lot tied to what's going on across the market in general, home construction and home repair, remodeling. In fact, our hot dog units have been selling quite nicely. We're also optimistic about our win rate on school products. There's been some good news coming out recently there. And so I mentioned on the call, Lots of opportunity. We're doing some additional product development. And we're getting inbound calls, as you can imagine, for our ventilation side of equipment. Commercial applications and school applications for improved ventilation and filtration we think could be a good opportunity for us going forward.

Got it. And also, would you give us kind of one pinpoint number for the quarter. Obviously, it was great performance on the EBITDA level. I'm just kind of curious if you give us some sense of how much of that was in total, which you attribute to some temporary stuff going on around COVID.

Yeah, that's a good question. I would say when we look at the quarter, there was about 11 million or so of benefits between cost of goods and SG&A that I would classify as temporary in nature. They are, you know, things, everything from salaries to short work weeks and furloughs. So I view it, I call it normalized EBITDA margin more than nine and a half percent rate for the quarter, Mike, clearly well above what we did last year, you know, just under eight and on lower volume. So kind of like you said, I view it as You know, the 12%, really good. But we actually had volumes better than we were planning for the worst. And we got a little bit better on the volume. And we had all the cost savings. So we won't be able to continue that at least in the next couple quarters until we see a significant rebound in revenue.

Thanks for that, Mick. Maybe I can just throw one last one in there. And that is a question on the EV outlook. Can you give us a little bit of a sense as to what your engineers are kind of working on in the EV world? Some of these models are coming faster than expected in the second half of 2021. Some are over 2022 and 2023 launches. But I'm curious, you know, what Modine's seated at that table and some of your development projects and some of the outlook for that in your business.

Yeah. So the answer is probably twofold. Commercial vehicle side, I can tell you that Bodine continues to have a seat at the table with all of those discussions and development work. There is a lot of requests for development time and resources to work on electrification projects on trucks. There is some concern we have, or I'd say we're monitoring, and along with some of our customers that we talk to, about the actual timing, and it may be a longer run rate to see significant volumes on commercial trucks. The other side, which has been really exciting, is on the bus and specialty vehicle side, where We've had a tremendous quarter or two here, and it's continuing to grow with the rate that it looks like buses are converting to fully V hybrid, even thinking about fuel cell type vehicles. And those are not only development activities, those are real in production orders. And so that's exciting. spot specialty vehicle coming first, and then in the next, you know, in the near term, I'd say a year or two, Mike, this is more developmental work on the truck side.

Okay. Well, thanks very much. I'll leave it there.

Yeah, thanks.

Again, to ask a question, please press star, then the number one on your telephone keypad. Your next question comes from Chris Hillary with Rolex Capital. Your line is open.

Hi. Good morning. Good morning. just wanted to ask we had a couple questions around it but there's there's such a focus on air quality currently given the health crisis um but you know this this may catalyze just longer term thinking about the need to have cleaner indoor air as you're looking at your hvac segment you know it's not your biggest revenue source but it's it's a good profit source um how do you see you're talking about shifting to ventilation for school in the healthcare market. Can you give us any sense of how large that business is in the segment now and where do you think it might be able to go in the median term? And, you know, as you mentioned, you're getting some inbound calls. Can you just maybe share some color about the products that you're selling and what, where the interest is and how you think that's going to develop over the next couple of years?

Yeah, great. Appreciate the question. For Modine right now, ventilation is about 4% or 5% sales of the company. And you're right, it historically hasn't gotten as much attention, obviously, as the vehicular side. I can tell you in the last, you know, starting with the announcement to exit auto, but even ramping up the last six months, even pre-COVID, we see this area and it's a big area. I think it's, you know, the way we would define it and products we sell in markets and channels 900 to a billion dollar market. And then on top of it, you add in a COVID related concern. And we think this is a great opportunity. Again, we're focused on commercial applications. Previous to this, a big part of our growth plan this year was in the hospitality side, and we've been making a lot of inroads. But from a product development side, what the team is mostly focused on now is there's a combination of alternatives and debates out there. How much of it is putting more air into a building or a room? And how much of it then is recirculating or filtrating air in that same space? And we have products that can kind of fill both avenues. So we're super excited about this is becoming a bigger deal for schools. We've won some significant business in a large community, and the referendum was just passed. So we're excited about seeing those orders come through. And then, secondly, in the office space, as you lined up, I think I'd just say over the top of that is the exciting part for us, and I mentioned it with Mike in the call a little while ago, there's been so much effort spent in the last year, a monumental effort of the company to take a billion-dollar segment, a vehicular segment, and split it into two pieces between automotive and heavy-duty, and then uh go through a year sale process the more we can continue to uh focus our resources and our capital on these opportunities i think is a huge opportunity for the company great thank you i'm showing no further question at this time i would now like to turn the conference call back to kathy powers

Thank you, and thank you to everybody for joining us this morning. A replay of the call will be available through our website in about two hours. We hope you all have a great day. Bye.

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