Modine Manufacturing Company

Good morning, ladies and gentlemen, and welcome to Modine Manufacturing Company's fourth quarter fiscal 2022 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 touch-tone for telephone. 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.

Please go ahead.

Good morning, and thanks for joining our conference call to discuss Modine's fourth 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'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 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 Neal.

Thank you, Kathy, and good morning, everyone. Before covering our quarterly results, I would like to go over some changes that we've made to our segment structure at the beginning of our new fiscal year. We have reorganized into two separate reporting segments and will begin reporting under this structure in the first quarter of fiscal 23. Our first segment is performance technologies, which is comprised of our heavy-duty equipment, automotive, EV, and coatings businesses. We are now managing this business by technology and product groups and will report revenue based on three sub-segments. The first sub-segment contains our air-cooled applications, which includes components that are traditionally attached to the powertrain. These include radiators and condensers sold to our traditional vehicle end markets, commercial vehicle, off-highway, and automotive. The second sub-segment focuses on liquid-cooled applications. including components such as oil coolers and exhaust gas recirculation coolers sold to these same end markets. The third subsegment is advanced solutions, which includes EV systems and components and coatings. The focus here is rapid growth, and we are allocating a significant number of strategic resources to advanced solutions. Our second segment is climate solutions, combining our building HVAC and CIS segments. There is significant overlap between the end markets served by these businesses, So consolidating allows for better focus on growing in our key target markets. This segment also has three subsegments, heat transfer products, HVAC and refrigeration, and data centers. Heat transfer products is our coils business, which primarily sells into HVAC and refrigeration end markets. HVAC and refrigeration includes our heating and indoor air quality products, along with refrigeration and industrial coolers. The final subsegment is our data center business, including data center systems and services. We believe that simplifying our segment structure provides us with numerous benefits. This leaner, more focused organization optimizes our ability to coordinate global strategies and ensure our employees can act quickly and decisively. It also allows us to simplify and improve our external messaging and financial reporting processes. Please turn to slide five. Now, I would like to provide some business highlights for the quarter. I'm pleased to report that we have had strong earnings growth driven by higher revenues in key markets and also due to the actions taken earlier this year to improve our business, including implementation of 80-20 actions. One of our key challenges this past year was keeping up with the continued inflationary pressures created by the rapidly accelerating rise in metal prices and logistic costs throughout the year. We have spent much of this past year strengthening our commercial organization and we definitely saw the positive impacts of those changes this quarter, particularly in our building HVAC and CIS segments. We have implemented multiple pricing adjustments and have improved our commercial agreements with our customers using 80-20 as a guide to ensure that we are focusing on the most impactful areas. By simplifying our processes and working to grow and resource our best performing businesses, we expect to continue to see margin improvements into fiscal 2023 and beyond. Now moving on to the segments. In building HVAC, demand remains strong for our heating, indoor air quality, and data center products. Growth in our heating businesses continues to be above market, and sales of our school ventilation products are benefiting from federal funding targeted at improving indoor air quality. Across the industry, On-time delivery continues to be an issue with shortages of critical components creating production delays. However, we've been able to take advantage of this situation through superior product availability and shorter lead times, allowing us to continue growing our market share and creating a competitive advantage for our products. I would now like to take a moment to give an update on our school ventilation products, which has been a small business for us historically, but one where we are now dedicating additional resources and project strong future growth. There have been three separate government programs with funding available for improving indoor air qualities in schools. So it's critically important that we capture our share of this major infrastructure spend over the next several years. We currently estimate that over 40% of the K through 12 schools in North America require upgrades to their HVAC systems. And given that market demand, we believe this business is likely to double over the next three years. We have shifted engineering resources to these product lines and have growth targets for both product sales and service revenue. We are increasing production capacity for this business by consolidating production of these products in our West Kingston, Rhode Island plan and simplifying our product line through SKU rationalization. This market presents an incredible opportunity for us, and we plan to take full advantage by increasing the focus and resources dedicated to supporting this market in a time of supply and demand imbalance. In our heating business, we are also focused on growth. We continue to increase market share by converting distributors and strengthening our marketing activities with targeted campaigns and development for both residential garage heaters and for our high efficiency products that go into greenhouses and warehouses. Finally, we are working on refreshing our product line with new offerings in the works for the next heating season. In our data centers business, we are still seeing strong demand from key accounts as the data center market continues to expand. We are also experiencing supply chain challenges, particularly with fans and controllers. This has created a production backlog, which we'll continue to work through, but that could negatively impact our first quarter, particularly after our strong Q4. Progress continues in our new production facility in Virginia, and we are developing a strong pipeline of orders that will start shipping by the end of this calendar year. From a technology standpoint, Our engineers are focused on how our products can contribute to our customers' sustainability goals, in particular, reducing the water and energy consumption of our products and lowering the global warming impact. As we enter our new product development cycle, this will help contribute to our competitive advantage. Please turn to page six. Our CIS segment had a very strong quarter with significant growth in both revenue and earnings. We continue to see the benefit of commercial actions taken earlier in the year, with our revenue growth driven by both volume gains and pricing improvements. This segment is an early indicator of the potential benefits of 80-20, as we have the most flexibility to make rapid business decisions and see the benefits. For example, in our coils business, this included introducing filters into our order entry system to block inactive or low-volume part numbers and introduce minimum order quantities and extend lead times where appropriate. We have implemented several price increases in our coils business, which is seeing pockets of growth, particularly in European heat pumps and North American pool heaters. We have also targeted certain areas of the business to exit as we focus more on margin improvement and less on top-line growth in this area of the business. In our coolers businesses, we are dedicating more capacity for the production of CO2 coolers as we expect this market to continue to grow. In addition, we are benefiting from the post-COVID growth in the hotel and restaurant markets. The biggest issue is the availability of certain components, namely fans, which is limiting production. Overall, I'm very pleased with the progress that is being made in this segment. In our HPE and automotive segments, our focus continues to be on improving profitability through price realization and cost reduction. As we mentioned last quarter, we are implementing restructuring actions intended to reduce SG&A and operational expenses, particularly within our European automotive business. Although demand remains strong for our heavy duty products, we're still dealing with issues on multiple fronts, including cost inflation and supply chain disruption. The recent COVID outbreak in China has added additional uncertainty to an already weak market. As a result of government mandated lockdowns, we shut down production at our Chinese manufacturing facilities for portions of March and April. While our plants in China have reopened, they are currently producing at reduced levels due to supply chain challenges and labor availability. This will definitely impact our first quarter results. We are working to address the supply chain obstacles and expect to increase production levels at our Chinese plants this summer. We continue to work with our customers to better offset cost increases with pricing and have had some successes in our HDE business. The automotive business remains challenged with ongoing volume pressures due to supply chain issues. We are still working with our customers to obtain price increases outside of the contractual LME-based pass-through agreements. Now I would like to shift to our EV systems business. As you know, we separated out this business in fiscal 22 and have built a strong, energized EV team. Last week, we launched the marketing campaign for our EVantage brand of thermal management systems, which are designed to improve battery performance, range, and life on the wide range of electric vehicles, including commercial, specialty, and purpose-built products. We continue to reallocate engineering, commercial, and operational resources to this team and are making important connections with the innovators that are driving the transition to EV. We are currently engaged in 75 system-oriented programs with prototype orders on 46 and production orders on 12. At this point, we are actively selecting which programs to engage in as demand for our engineering expertise continues to be strong. 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 seven. I'm pleased to report solid revenue growth this quarter, which was driven by a combination of pricing and volume increases. Fourth quarter sales were up 12% or $60 million as building HVAC, CIS, and HDE experienced significant gains. $41 million of the increase was driven by higher volume, which is a significant improvement over the last few quarters. Pricing and material pass-throughs accounted for $33 million of the increase, while FX was negative, offsetting these gains by $14 million. Adjusted EBITDA increased 34% or $15 million year-over-year. Conversion on the higher sales volume plus increased pricing accounted for the majority of the earnings increase. Through the hard work of our various teams, we're recovering material cost inflation and addressing the lowest margin areas of our businesses. During the quarter, commodity metals, freight, and packaging increased $32 million from the prior year. However, our pricing mechanisms recovered more than $33 million, which resulted in a net positive EBITDA impact. Last, we're closely managing our SG&A costs, which favorably impacted adjusted EBITDA by $2 million. Clearly, we're seeing momentum from our various actions, which resulted in both sequential margin improvement from Q3 and a year-over-year improvement of 170 basis points. Adjusted earnings per share of 57 cents was six cents above the prior year. Before moving on, I'd like to point out that we had 21.7 million of Q4 earnings adjustment. The largest was a 21 million charge, primarily related to previously announced plans to implement targeted headcount reductions in the European automotive business. The balance of smaller adjustments can be found in our press release and appendix, which includes additional information, US GAAP results, and complete reconciliations.

Now let's review the segment results. Please turn to slide eight.

Building HVAC reported sales growth of 52% from the prior year. The main driver of the volume growth was a strong increase in data center sales, which more than doubled compared to the prior year. Heating and ventilation product sales also contributed, both up over 30% from the prior year. Adjusted EBITDA increased 58% from the prior year, resulting in a 70 basis point improvement to 17.1%. We're pleased with the further margin improvement as the team works through the impact of higher material costs, along with overall supply chain inflation and disruptions. SG&A was slightly higher than the prior year, partly due to higher commissions, but significantly lower as a percentage of sales. The investments we're making to support our aggressive growth plans are clearly having a positive impact in this segment. Please turn to slide nine. CIS also reported an exceptional quarter with solid revenue growth and outstanding earnings improvement. With regards to 80-20, CIS represents an early indicator regarding the results that the 80-20 process can bring across all of our businesses. Fourth quarter sales for CIS were up 20% or 29 million. Revenue was up significantly in most markets, including 27% in commercial HVAC, 21% in refrigeration, and 20% in coatings. Adjusted EBITDA increased 12 million to 24 million, nearly double the prior year. Most importantly, the adjusted EBITDA margin improved 560 basis points to 14.1%. The earnings and margin increases were driven by several factors, including higher volume, commercial pricing initiatives, improved mix, and a focus on operational improvement.

Please turn to slide 10. Sales in the HDE segment were up 9% or 19 million.

Approximately half of the sales increase was driven by higher volume. The balance was due to pricing and metals pass-through adjustments. With regards to our markets, we experienced strong revenue growth in the off-highway and the bus and specialty vehicle market, especially in the Americas region. Adjusted EBITDA declined by 5 million, driven by a reduction in gross profit and slightly higher SG&A. Unfortunately, our material, labor, and overhead costs continue to increase further through Q4, including higher freight, packaging, and metals fabrication costs. We were not able to fully offset those increases in HDE during the quarter. The team is diligently addressing all commercial agreements and working with our customers to address this unprecedented inflationary environment. While it's difficult to quickly offset cost increases in this environment, we believe that we'll be able to recover a majority of the higher costs. In addition, we're further encouraged by the recent downward trend in the metals markets, which should have an additional positive impact in the coming quarters. The HDE team is laser-focused on margin improvements, and we expect all of these actions will have a positive earnings and margin impact in the new fiscal year. Please turn to slide 11. Similar to HDE, the auto segment has been impacted by supply chain issues, plus volume declines tied to the semiconductor shortages and other disruptions to the overall auto industry. As many of you know, the auto manufacturers have been impacted by supply chain shortages tied to the chip shortage, and more recently, the Ukrainian conflict and the COVID lockdown in China. In addition, we have a difficult year-over-year comparison due to the sale of our Austrian business early in fiscal 2022. Collectively, these factors contributed to a fourth quarter sales decline of 23 million, including an 18 million impact from our Austrian sale. Adjusted EBITDA was 2 million lower than the prior year, due to the lower sales volume, partially offset operational efficiencies, and lower SG&A. As part of our plan to optimize this business, we're implementing cost savings initiatives across the organization, moving swiftly to improve our automotive business through pricing initiatives, restructuring activities, and plant optimization. The team is well on track with our targeted $20 million of SG&A savings with the first portion beginning later this year. We believe all of these actions will begin to generate higher margin improvements in the new fiscal year. Now, moving to the balance sheet and cash flow, please turn to slide 12. Our Q4 free cash flow was slightly negative at $6 million. This resulted in a full year free cash flow of negative $29 million. However, This includes 20 million of cash payments, primarily for restructuring and reorganization activities. This has been a difficult year from a cash flow perspective, partly due to COVID-related savings last year, along with the supply chain challenges that have been impacting our inventory levels. We're anticipating positive free cash flow in fiscal 23, driven by earnings improvements, working capital management, and ongoing cost control. This includes approximately $20 million of anticipated cash restructuring payments, mostly tied to our cost reduction plans in Europe. I'm happy to report that due to the anticipated positive cash flows for the next year, we plan to restart our share repurchase plan in the next quarter. The actual amount of shares to be repurchased will depend on a number of factors, including monthly cash needs and the timing of cash flow, along with the daily trading volume. Net debt of $333 million as of March 31 was slightly higher than the prior quarter. We finished the fiscal year with a leverage ratio of 2.3, which is within our targeted range and improved from the prior quarter. Now let's turn to slide 13 for our fiscal 23 outlook. As we look forward to the new fiscal year, we're encouraged by the positive trends in our markets and the early benefits from the actions taken this past year to improve our business. That said, it remains an extremely volatile environment with many factors to consider, including ongoing inflationary pressure in material, labor, and overhead costs, plus supply chain shortages, COVID shutdowns in China, and the Ukrainian conflict. Considering all these factors in our current market outlook, we anticipate revenues to be up 6% to 12% in fiscal 23, with sales increasing in most end markets. We also anticipate that adjusted EBITDA will be in the range of $180 to $195 million. This represents an increase of 13% to 23% versus the prior year. EBITDA improvement will be driven by pricing and volume gains, and favorable sales mix, partially offset by anticipated cost inflation and higher SG&A, including higher labor and incentive compensation. Before wrapping up, I'd like to take a minute to share how we see the quarterly results ramping up through the year. First, I'll point out that over the last few years, we've seen a somewhat seasonal pattern with quarters three and four representing the high water mark, and then a dip in Q1. A portion of that is tied to the strong seasonal pattern in the building HVAC segment, and we expect this to continue. In addition, we're experiencing some temporary headwinds in our vehicular businesses that we expect to improve over the next few months. The largest impact relates to the ongoing lockdown in China, which impacts the availability of parts and labor. In addition, we experienced additional material cost increases between January and March that we expect to recover. Therefore, we anticipate that our first quarter will represent a difficult comparison to the prior year, then improve sequentially and year over year in the next three quarters. This is a similar pattern to what we experienced in this last fiscal year. Beyond this, We're very encouraged by the revenue and margin outlook for our building HVAC and CIS businesses. In addition, we expect full-year margin improvement in the vehicular businesses as we eventually recover the significant material cost increases experienced in fiscal 22.

With that, Neil and I will take your questions.

If you have a question at this time, please press the star then one key on your touch-tone telephone. If your question has been answered or you wish to remove yourself from the queue, please press star one again. Thank you. Our first question comes from Matt Somerville from DA Davidson. Please go ahead. Your line is open.

Thanks. A couple questions. First, just with CIS and where you're at, with the 80-20 process there. Maybe, you know, talk inning baseball analogy with where you're at with implementation. And, you know, that was a pretty striking margin performance in fiscal Q4. How should we think about that in the context of sustainability moving throughout fiscal 23?

Yeah, thanks for that question, Matt. I appreciate it. Good morning. We've moved a long way in the CIS business. It's just proof to show that segmentation is working. We have a strong leader in place there that has executed on the strategies that are deployed through 80-20, and we expect to see this positive trend as we move forward. I'll let Mick comment in terms of where we see it in the next fiscal year.

Yeah. Hey, Matt. So, you know, for quite a while that business had been operating in the more in the mid, sometimes upper single digits. And with the early wins here on the 80-20, you saw that, you know, pop to a 14% type margin. Our goal all along has been to get this into first the low double digit range and then longer term, see if we can push above there. I think Q4 was kind of a perfect storm for us in a positive way. We had a lot of catch up on price, which helped really, really strong volume as well, which was a positive surprise for us. So short answer is I would expect that we won't be able temporarily to keep that level of margin, but certainly well above where we've been, I think, running that more in a 10 to 12% in the short run. And then certainly Neil and I'd like to see it get to a 14 or 15 more long term.

Got it. And then as a follow up, can you be a little more specific around how much revenue and or profit was impacted in fiscal Q4 and what you expect the impact to be in fiscal Q1 with respect to the COVID, you know, mandated COVID-related lockdown in China. And then how should we be thinking about, Mick, the roll forward of that $20 million in savings in the auto business? Thank you.

The 20, what was the last part, structure? Oh, yeah, great. And the restructuring. Yeah, so in Q4, sales in Asia were down about 20%. I'll let you do maybe the math on that, Matt, but it is a profitable business for us and really above the vehicular average margin. So it was a a decent impact in Q4, probably about the same amount in Q1. And then by all indications, both what we see externally and what our teams are telling us, we're expecting that by the end of Q1, we should be back to more normal capacity and operations. So probably think about it as about a 20% revenue impact in Q4 and Q1. on the Asia business. Then on the SG&A reduction in Europe, our target is at least $20 million in annual savings. That will start to kick in in the second half of this year. My expectation would be we'd love to get half of it, but I think somewhere maybe a third to half of it would be the goal this year, just based on the timing of how those processes work.

Just as a quick follow-up, and then I'll get back into you. With respect to that restructuring initiative you're deploying in Europe, have you already received all the needed workers' council approvals and all that stuff?

Yeah. So, I mean, it's a process that we are – well into it and fully engaged with the Works Council right next to us. I'd say, Neil, we're pleased with how it's working, and now we're into the heavy lifting of it, the hard work, but it's absolutely side-by-side with the Works Council.

Understood. Thank you, guys.

Once again, if you would like to ask a question, please press star followed by the number one on your telephone keypad. Our next question comes from Steve Farazani from Sidoti and Company. Please go ahead. Your line is open.

Thank you. Morning, Neil, Mick. I do want to ask about guidance. I know how challenging that is in this kind of environment, particularly to put out full year numbers and given the various end markets you operate in. But clearly we're running into a situation where the expectation is the economy cools a bit at minimum growth slows, maybe flattens out. I'm trying to think about how you're incorporating that into guidance and what portions of your business do you think can grow through that type of an environment?

Yeah, that's a great question, Steve. Thanks. This is Neil. You know, we've, we've, Through 80-20 in our segmentation process, we've targeted growth areas for the business. And those areas that we've targeted, we believe we have opportunity to expand in those places and spaces. We've invested heavily into data centers. We've invested into IAQ, our indoor air quality group. We've invested into EV. And we believe that there's expansion there. We can gain more market. even in a challenging economy, potentially a challenging economy coming up. So we're going to stay focused there. We're invested. We're going to resource it. We're going to provide a capital. And those are the areas where we think we can continue to grow. And that's a major driver in terms of how we've forecasted our guidance.

When I think about the sales guidance, can you give any sense? I know it's kind of hard to break out. pricing versus volume versus mix when you're thinking about that?

Yeah, Steve, that was the one point I would add to what Neil said was based on our guidance, I won't give you the specifics, but we have a heavy mix, I call it mix, of price recovery that's contractually owed to us, another component of price negotiations with customers, whether we attribute that to 80-20 or recovery, and then volume. So our guidance has a good portion is a heavy balance, I would say, of price recovery versus volume. And then if you spread the volume across the areas Neil walked you through, I would say a lot of our growth businesses have a very strong order book, which is good. And then a lot of our business is also replacement. And so we feel good about that. I think the thing Neil and I are watching the most more than volume would be inflation and cost.

When I think about that increase in CapEx expected, I'm assuming you've talked a lot about the investment in the growth segments. Can you kind of walk through the CapEx and how you're sort of allotting that?

Yeah, for the first time in my years at Modine, we're going to have a bigger portion of our capital spending in our growth businesses, specifically in that climate solutions area to support data center growth, ventilation, indoor air quality, heating. And then the balance is a very small amount supporting the old automotive segment. and then more maintenance capital in the other areas of the business.

Okay. It sounds like you're very bullish on the indoor air quality, particularly related to schools. I would have expected you would have seen the strong surge in that, and the folks that needed it did it, and then we'd start seeing slowing. That doesn't sound like that's what you're expecting or indicating.

No, that's a fair question. No, we don't expect that because of the amount of infrastructure that needs to be put in place. It's going to take several years for that to be deployed, and typically the peak season is in the next three to four months because schools are going to be letting out, and this is where you see the maintenance and the installations occurs during the summer times.

Okay, perfect. Thanks, everyone.

Our next question comes from Matt Somerville from DA Davidson.

Please go ahead. Your line is open.

Just to follow up on 80-20 and what I think you referred to on slide 13 is some planned revenue reduction. Can you maybe quantify that and what we should be considering as we attempt to model that? Is CIS the only legacy reportable business segment that is going to be impacted by what I would just call deliberate revenue attrition?

Yeah. Hey, Matt, it's Nick. I'll give you the first kind of quantitative answer, and then Neil can give you some other color by segment. In the near term, and really in the upcoming six to 12 months, the heaviest impact we see is in CIS. And again, we'll fold that into the new segment. But since you've got historical data, we really see that flat to maybe down 5%. So, and I mentioned at the beginning, that's really, as far as innings go, they're the furthest along. So they're well into product rationalization and those elements of 80-20. So I think for my guidance and a modeling, the only material impact we would see in that, and I'll just leave it with a flat to modestly down in CIS, I'll let Neil comment because I know there's a lot going on even on the building HVAC side with product rationalization.

Yeah, that's a good question, Matt. Certainly we go through each one of these segments and there's going to be a mix, right? Sometimes you have some price and some commercial excellence that offsets some of the volume decline. Sometimes we're working through the SKU reductions and you'll see some volume decline. You know, we've spent a lot of time in terms of SKU reductions and eliminating product lines that are below our target margin thresholds. So we're working through each one of the segments one by one, and we spend most of the time in climate solutions. We're starting to pivot now into performance technologies. We're going to get into that in a pretty big way over the next three to six months. And as we shift our energy from climate solutions, because we've We're in motion and we're happy with the progress that we've made. We can now start to really focus on the performance technologies segment. And I would expect as we go through the same process as we did in climate solutions that we're going to see some of that. We're going to see some product lines that we're going to want to exit. We're going to see some areas that we're not going to want to continue to fund. So we just need to get a little bit further into the process in performance technologies, which is the HDE and automotive group. We're starting to do sub-segmentation in that business.

and then we're really going to start to get into the data.

Got it. And then I would assume, if you let that business attrit in CIS, that's going to have a natural margin benefit to that as that unfolds. I assume that would be a correct assumption there.

That's a correct assumption as we continue to reduce complexity and simplify in that business. Got it. Okay. Thanks, guys. That's all for me.

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

Thank you, and thanks to everyone for joining us this morning. You'll be able to access the replay of this call through our website in about two hours. We hope that you have a great day. Goodbye.

Ladies and gentlemen, this concludes today's conference call. Thank you for your participation. You may now disconnect.