Modine Manufacturing Company

Modine's third quarter fiscal 2022 results. I'm joined on this call by Neil Brinker, our president and chief executive officer, and Nick Luccarelli, our executive vice president and chief financial officer. We will 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 three 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 is my pleasure to turn the call over to Neil.

Thank you, Kathy, and good morning, everyone. As I mentioned last quarter, we are undergoing a great deal of change at Modine. We have transformed our organizational structure and have significantly strengthened our management team. Over the past few quarters, we have begun applying 80-20 to guide our decisions and as we actively manage our portfolio businesses. This includes implementing responsible pricing activities, simplifying product line offerings through skew rationalization, and driving operational efficiencies. We expect these efforts to continue as we work to optimize profit margins and cash flows by shifting our focus towards those products and markets where we have true, sustainable, competitive advantages and the right to win. These strategic plans are helping us develop long-range targets that will better measure and drive our success as we continue to transform the company. We're also beginning to make changes to our automotive business. As previously discussed, we are thinking about our vehicular businesses differently, focusing more on technology rather than in markets. This means reprioritizing resources and capital away from legacy internal combustion solutions and towards system-focused platforms. Along those lines, our new EV organization is focused on providing smart thermal system technologies to specialty and commercial vehicle customers. This technology is advancing rapidly, and we are providing significant resources to those applications where we can provide a value-added system solution. Our strategy for this business is to leverage our thermal and mechanical expertise to provide a turnkey solution to fast-growing niche markets. These markets include the last mile delivery, school and transit bus, and specialty vehicles. Our goal is to design and manufacture a complete thermal solution for any EV chassis. By controlling the temperature of the vehicle's key components, we can improve the battery's range and life. We are making good progress with staffing this function and have a great deal of inbound activity engagement, including refrigerated trucks, specialty vehicles, and rail applications. As we increase our investment in products and technologies that will feel profitable revenue growth, we're also taking actions to improve the profitability of other parts of our business. Our objective is to optimize profit margins and cash flows while focusing resources on the products where we have technical competitive position and where we can provide value to our key customers. In order to meet our return targets, we will reduce SG&A expense and limit capital expenditures in low margin areas where we do not have a competitive position. As I mentioned last quarter, we are working on restructuring plans to improve profit margins across all business units, particularly within our automotive business. For the full company, we are targeting approximately $20 million in annualized savings with these actions. While we're too early in the process to precisely estimate the associated costs, we expect to record approximately 20 to 25 million of restructuring expenses for these plans. We expect most of these costs will be severance-related for headcount reductions. We will finalize our plans in the fourth quarter and will provide more details in terms of timing, levels of cost savings, and related charges at that time. Please turn to slide five. Now, I would like to provide some business highlights for the quarter. While we continue to manage through a challenging business environment, Commercial actions taken earlier in the year are beginning to have a positive impact. We are aggressively managing our supply chain and adding resources to address specific challenges and decentralizing the decision-making structure where possible. Our most significant supply chain challenges are being felt in our North America business. To address this, we have instituted a critical supplier management process, which includes designating a dedicated point of contact for critical suppliers, taking a project management approach. This includes daily communication, site visits, and escalation protocol. We are building recovery plans to meet our requirements and implementing dual or resourcing strategies where appropriate. From a labor standpoint, we have been dealing with both an increase in COVID cases and the ongoing impact of the labor shortage. But I'm happy to report that at the current time, numbers seem to be improving. At the peak, we had over 350 employees in North American Europe, out of work with positive COVID cases or due to quarantine requirements. We are currently seeing these numbers decline, but that could change as new variants emerge and spread. We therefore continue to maintain strict protocols to mitigate the risk of internal spread of the virus in our facilities. In addition, we had over 300 open positions at our peak vacancy rates in 2021. However, creative recruiting solutions, enhanced benefit offerings, modifications to our wage structures, and hiring incentives have allowed us to make significant progress in filling our open positions. Now moving on to the segments. In building HVAC, demand remains strong for our heating, indoor air quality, and data center businesses. That said, as of the third quarter, we were not able to fully offset inflationary pressures with price increases, causing our margins to decline year over year. The team is aggressively working through corrective actions regarding both cost and pricing, as evident by the strong sequential earnings improvement. We anticipate the DHVAC will be back to historical margin levels in the next few months. In addition, production volumes have been constrained by the lack of labor, but this does appear to be improving. In December, our heating plant in Virginia produced 20% more units than its previous single-month record. This was possible in part due to employees that traveled to Virginia from our Racine, Wisconsin headquarters and our Lawrenceburg, Tennessee plant so that we would have sufficient labor resources to meet demand. In data centers, we continue to make progress on our Rockbridge, Virginia facility, where we are repurposing an existing warehouse into a dedicated chiller manufacturing and testing facility. I'm pleased to report that we've received our first purchase order for chillers in North America during the quarter, in addition to the orders for computer room air handlers and fan walls produced at our Grenada, Mississippi facility. This investment in capacity expansion will allow us to meet our aggressive revenue growth targets in the future. Moving to our CIS segment, our focus during the quarter was primarily on pricing and supply chain management. This included expediting raw material purchases, which impacted our freight costs. That being said, we had less overtime during the quarter as the labor situation improved. This allowed us to reduce our order backlog while market demand has held steady. We saw a significant improvement in the margins this quarter versus the prior year due to higher sales volume despite the supply chain challenges. In addition, we're using 80-20 in our coils business to take targeted pricing actions, simplify our product offering, and improve operations efficiency by maximizing setups to eliminate bottlenecks on the plant floor. In our HDE and automotive segments, our focus has shifted to improving profitability, utilizing 80-20. deep within our processes. This includes strict quoting guidelines for new programs, including capex and payback limits. The improvements made in this business are a critical component to the transformation of Modine. The EV transition is enabling a new play for Modine with thermal systems. The thermal system technology can be leveraged into new market spaces for Modine that are opening up with the EV market inflection. As we think about our business, there's a common thread. We provide trusted systems and solutions that improve air quality and conserve natural resources. We do this by reducing water and energy consumption in data centers, improving air quality in schools and businesses as we continue to battle global pandemic, lowering harmful emissions and enabling more efficient electric vehicles as internal combustion engine transitions to alternative power trains, all while innovating more environmentally friendly refrigerants that will meet future regulatory requirements. It is clear that all of our key growth areas support our purpose of engineering a cleaner, healthier world. This is the cornerstone of unlocking the value in Modine, driving our decisions as we invest in our future. Now, I'd like to turn the call over to Mick, who will review our results for the quarter and provide segment financial updates.

Thanks, Neil, and good morning, everyone. Please turn to slide six. I'm pleased to report good sequential performance from the previous quarter as we continue to work through the supply chain challenges, rising input costs, and labor shortages. The organization's hard work is beginning to pay off, and we expect the trends to continue. Third quarter sales were up 4% or $18 million as Building HVAC and CIS experienced significant gains. It's important to point out that our revenue increase was positively impacted by approximately $31 million of material pass-throughs and other price increases. While this is positive from a material cost recovery standpoint, it does not drive higher unit volume. Sales volume, excluding the impact of price increases and foreign exchange, was down $8 million. The lower volume was primarily driven by the auto segment, with declines due to the semiconductor shortage and the Austrian divestiture earlier this year. Adjusted EBITDA declined 16% or $7 million year-over-year, but showed significant improvement from the previous quarter. A portion of the decline was due to the lower volumes, but that was offset with higher plant productivity. The main driver of the earnings decline relates to the current inflationary environment, especially around material costs. During the quarter, we experienced approximately 39 million in commodity metals, freight, and packaging increases. However, we were able to recover 29 million of the cost increases, which resulted in a net negative EBITDA impact of 10 million. Like many companies, we've been battling significant cost increases throughout 2021 and now into 2022. As previously discussed, we expect the cost recovery gap to narrow with time, and I'm pleased to report that the negative materials impact was reduced by 50% as compared to the prior quarter. Last, we are closely managing our SG&A costs, which favorably impacted adjusted EBITDA by $3 million. Although adjusted EBITDA margin was below the prior year, we're seeing positive momentum from our recovery actions, which resulted in sequential margin improvement from Q2. Adjusted earnings per share of 31 cents was 3 cents above the prior year. Before moving on, I'd like to point out that we had a few earnings adjustments that occurred during Q3. The largest was in connection with the termination of the automotive divestiture. as we reclassified those assets to held and used. This resulted in a reversal of held for sale impairment charges of $57.2 million. The balance of smaller adjustments can be found in our press release and appendix, which includes additional information, U.S. GAAP results, and complete reconciliations. Now let's review the segment results. Please turn to slide seven. Building HVAC reported sales growth of 23% from the prior year. This includes approximately $5 million related to pricing actions, mainly in our heating business. The main driver of the volume growth was a strong increase in data center sales. Heating product sales were up 9% over the prior year, while indoor air quality finished 8% higher. As anticipated, we experienced strong sequential margin improvement. but our EBITDA margin remains below prior year levels due to several factors. First, results were negatively impacted by the higher material and freight costs, as it's taking us a little longer than anticipated to fully offset the rising costs. Second, our heating products carry shorter lead times, and the extremely tight labor market resulted in higher labor costs. This is important because maintaining and protecting lead times is one of several key competitive differentiators in this market. Finally, we've made some temporary investments in SG&A to support aggressive growth plans. Return on this investment will begin to show along with the higher revenue and the eventual recovery of all material costs. Before I move on, I'd like to point out that we're excited about the growth opportunities with building HVAC. Despite the recent headwinds, our gross margin was over 30 percent, which is a large improvement from the first half of the year. Please turn to slide eight. CIS reported a good quarter with strong revenue growth and year-over-year margin improvement. Early signs of 80-20 progress are evident within this segment. Third quarter sales for CIS were up 19 percent or $24 million, with $13 million of the increase coming from pricing Revenue was up double digits in most markets, including 30% in commercial HVAC, 14% in refrigeration, and 10% in coatings. Adjusted EBITDA was $10.1 million, or 87% higher than the prior year. Most importantly, the adjusted EBITDA margin improved 250 basis points. The earnings and margin increases were driven by several factors, including increased volume, realization of key pricing initiatives, and a focus on operational improvements. Given the steady market demand, a reduced backlog, and our 80-20 work, we anticipate finishing the fiscal year with further margin improvement in Q4. Please turn to slide nine. Sales in the HDE segment were up 8% or $15 million. Similar to building HVAC and CIS, the sales increase was partially driven by increased pricing. Pricing in foreign exchange resulted in a $9 million increase, while sales volume was up $6 million or 3%. With regards to our markets, we experienced strong revenue growth in the bus and specialty vehicle market, particularly in the Americas region. In addition, the off-highway market experienced double-digit increases. Adjusted EBITDA declined $4 million, driven by a reduction in gross profit that was partially offset by lower SG&A. As is typical for this segment, commodity costs have a large impact on bottom line results. Net material costs increased by $9 million, as we were able to pass through approximately $10 million of a $19 million increase. On a more positive note, SG&A was $2 million lower than the prior year. As I mentioned last quarter, we implemented additional pricing adjustments in January, which should result in further margin improvements. The supply chain remains highly uncertain, including the metals markets, but we are benefiting from market demand and new program launches. Given all of these activities, we're pleased to deliver the sequential margin improvement in Q3 and expect a further increase in Q4. Please turn to slide 10. As expected, our auto segment was heavily impacted by volume declines tied to semiconductor shortages and other supply chain issues within the auto industry. In addition, we sold our Austrian business earlier this year, which also contributed to the year-over-year decline. As a result, third quarter sales declined 42 million, including an 18 million impact from our Austrian sale. Adjusted EBITDA was significantly lower, largely from the sales decline. Lower volume accounted for nearly all of the $13 million EBITDA decline, along with some material cost increases. SG&A was up with general inflationary pressures. We are moving swiftly to improve the automotive business through pricing initiatives, restructuring activities, and optimizing our plants. As Neil previously discussed, we've begun taking aggressive profit improvement actions through commercial negotiations and SG&A cost reductions. We generated some sequential improvement in Q3 and believe we are past the low watermark for this business. Based on the 2022 market outlook and our restructuring plans, we anticipate further improvements in Q4 and even larger steps in the new fiscal year. Now, moving to the balance sheet, please turn to slide 11. As anticipated, our Q3 free cash flow was a positive $16 million. On a year-to-date basis, free cash flow remains negative but is improving. As I mentioned earlier this year, the first half of fiscal 22 would be challenged in terms of cash flow with improvements in the second half. Over the last three months, we've focused on improving our working capital. Inventory levels continue to be a challenge as material costs have gone up and supply chain issues have forced us to maintain safety stock. We're also working hard to reduce backlog, which will help us further reduce inventory in the fourth quarter. Our net debt of $330 million is slightly lower than the prior quarter. And our leverage ratio is 2.5 times, which is within our targeted range, and we expect a further decline by fiscal year end. Now let's turn to slide 12 and our fiscal 2022 outlook. I'm pleased to report that after analyzing the current economic conditions and the actions we're taking as a company, we're maintaining the fiscal 2022 outlook. We anticipate the final quarter will build on third quarter's momentum, with sales and adjusted EBITDA to increase sequentially in all segments. Material costs continue to be our largest headwind, and volatility over the last several weeks has made the outlook even more uncertain. Our plans have been very aggressive, driving favorable performance to offset the tight labor and difficult labor markets. End market demand continues to be a tailwind, and the growth outlook is relatively consistent with the prior quarter's projections. While year-over-year comparisons have been challenging to the economic climate, I'm very encouraged by the sequential improvement and trends heading into our new fiscal year. With that, Neil and I will take your questions.