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Good morning, ladies and gentlemen and welcome to Modine Manufacturing Company's Second Quarter Fiscal 2021 Earnings Conference Call. [Operator Instruction] 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 thank you for joining our conference call to discuss Modine's second quarter fiscal 2021 results. I'm joined on this call by Mick Lucareli, 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, modine.com. On Slide 2 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 Mick Lucareli.
Thank you, Kathy, and good morning, everyone. We have a lot of good news to reward 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 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, given our improved liquidity position and provides additional flexibility to manage our future cash flows. And finally, I'd 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 4. 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 the 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 7 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 in future liabilities along with pension and other employee-related costs. Also, I want to highlight that this is a leverage-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 condition. Please turn to Slide 5. I would like to provide some additional details on both the liquid-cooled business that we're selling and the air-cooled business that we're planning to address next as part of our overall auto strategy. Starting with the liquid-cooled 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 the 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 investment, the liquid-cooled business carries a significant amount of net asset. 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 investments. Now, moving on to the air-cooled business, which is the remaining business in our automotive segment and includes the plants in Austria and Germany. This business represents approximately $100 million of revenue and is 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 breakeven on an adjusted EBITDA basis and will require minimal capital going forward. We're 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 properties 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 the second quarter segment results on Page 6. 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 have 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 our next-generation product and are encouraged by the recent order outlook for next year. We continue to invest in our coating 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 coils 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 7. 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 plans. Looking forward, we expect continued growth in our data center sales in the coming quarters and projects 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 for the hospitality market have been hard hit by COVID-19 causing us to shift focus to both the schools 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 in brand in the U.K. to produce data center products in mainland Europe. And equally exciting are the increasing opportunities in the U.S. We're industrializing computer room air handlers and chillers in our existing U.S. manufacturing sites and are planning to be in production next fiscal year. Please turn to Slide 8. 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 the 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 impact of higher material costs and recently announced tariff. Please turn to Slide 9, 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% 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 maintain strict cost controls over spending and benefited from previous FTG savings. Some of the reductions should be viewed as largely temporary, representing about 1/3 of the SG&A savings this quarter. Another driver of lower SG&A was the 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 U.S. 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 $0.43, 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 6 months of fiscal '21 was $73 million, which represents a $97 million improvement over the prior year. The positive cash flow is driven by numerous items, including lower spending on the automotive exit strategy, favorable working capital and nominal capital spending. We used 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 million 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 the 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 and our fiscal '21 outlook. Like many companies, we're hesitant to provide full-year guidance, especially given the ever-changing dynamics prior of COVID. Based on the recent results, our full-year outlook has 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 31. 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 million 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.
[Operator Instruction] Our first question comes from Matt Summerville with D.A. Davidson.
A couple of 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?
Matt, good question. So we've been on, as you know, the last few quarters have unfortunately been year-over-year decline than we've been entering a period here where in the quarter, we had very little in the way of actual sales to the customer. And Q4 as well, we'll have very little in the way of 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 forget the actual timing of shipments and revenue, but we see that being the inflection point. And then from where we come from we're running significantly below this year where we were 2 years ago. Last year was cut in half, and this year was again cut in half. So without going into too much detail, and detail I can't provide in a public setting, what I can tell you is next year -- next 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. We're talking to that customer about an opportunity. From there, about another significant increase to get back to where we peaked out probably more than a year, a 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 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.
Yes, yes, for sure. So 2 things as we think about the second half of the year and I'll try to quantify it for you. One, as we've seen recently a rise in raw material prices that you referenced, we estimate for the second half versus first half that those metal prices will be $4 million to $5 million net cost increase impact to us against second half. And then a few weeks ago, maybe just a couple of weeks ago are 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 that for now in the second half would be about $3 million from tariffs and $4 million to $5 million from net metal.
Your next question comes from Michael Shlisky with Colliers Securities.
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 value what is the sort of the true value of what you're receiving for this division?
Yes, Mike. So a couple of things that as we know has made it more of a complex story since the day 1. We know, and a part of our automotive exit strategy, that this business has been a low EBITDA business of 4% or 5% type in total margin business and very high capital spending. We've spent 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. The $300 million-ish-type business, the liquid-cooled that we announced the sale of, that's been historically, neutral to negative free cash flow business, depends on the year and exactly and all the different calcs going into it that as I said on the -- 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 costs 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, this business, the liquid-cooled, 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 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 profile that drives value for our shareholders.
And it's that plus the pension that you also discussed?
Yes. So, yes, and with it, part of that came with, I mentioned, $15 million of pension and then on top of that I mentioned if -- 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 the amount of management time -- the last year the amount of management time and money we've 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 a go-forward CapEx for Modine, and in the next few quarters prior to the sale closing, will that area have any CapEx associated with it in the very near terms.
Yes, so good question. We mentioned that balance of the year for Modine, 2 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, I'll assume that those are -- 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 2 quarters for us average about $15 million a quarter of capital spending. That may be a little bit high. We'll just see how in the next few months shake out and through the 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 done $70 million to $80 million. So very well could be a little bit -- running a little below $50 million, maybe a little bit ahead just depending on the year. But in totality, going from a company spending $70 million to $80 million. And again, I'm excluding restructuring, which would make it even higher to more like a $50 million run rate, Mike.
And does that $50 million run rate include -- exclude the liquid part that's still left to sell?
Yes. The air side, no -- yes, we anticipate very little future capital spending. Basically the majority of that volume has run out of one plan that's fully capitalized. So I'd say an immaterial amount of capital spending tied to air-cooled.
Okay. I also wanted to turn to some of the Building HVAC business. You had mentioned some good heating business in your slides, and 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 shifting to dining outdoors?
Yes. 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 as you enter a hotel or something. We have seen a nice increase in the heating market 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 Dawg 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 opportunities. We're doing some additional product development and we're getting in-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 will you be able to give us kind of one pinpoint number for the quarter. Obviously, it was a great performance on EBITDA level. I'm just kind of curious if you could give us some sense of how much of that, in total, would you attribute to some temporary stuff going on around COVID.
Yes. That's a good question. I would say when we look at the quarter, there was about $11 million or so of benefit between cost of goods and SG&A that I would classify as temporary in nature. They are things -- everything from salaries to short work weeks and furloughs. So I view it -- I call it normalized EBITDA margin more in the 9.5% rate for the quarter, Mike. Clearly, well above what we did last year at just under 8% and on lower volumes. So kind of like you said, I view it as 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 volumes and we had all the cost savings, so we won't be able to continue that at least in the next couple of quarters until we see a significant rebound in revenue.
Maybe I could just throw one last one in there, and that is the question on the EV outlook. Can you just give us a little bit of sense as to what your engineers are kind of working on in the EV world. Are some of these models coming faster than expected in the second half of '21, somewhere in '22 and '23 launches. But I was curious what Modine seated at that table and some of your development projects and some of the outlook for that in your business.
Yes. The answer is probably twofold. On the commercial vehicle side, I can tell you that Modine continues to have a seat at the table with all of those discussions and development work. There is a lot of request for development time and resources to work on electrification projects on truck. 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 in commercial trucks. The other side, which has been really exciting is on the bus and specialty vehicle side, where we had a tremendous quarter to hear and it's continuing to grow with the rate that it looks like buses that are converting to full EV 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. We see soft specialty vehicle coming first, and then in the next -- in the near term, I'd say a year or 2, Mike, this is more developmental work on the truck side.
[Operator Instruction]. Your next question comes from Chris Hillary with Roubaix Capital.
I just wanted to ask, we had a couple of questions around it, but there's such a focus on air quality currently given the health crisis, but this may catalyze longer-term thinking about the need to have cleaner indoor air. As you're looking at your HVAC segment, it's not your biggest revenue source but it's a good profit source, how do you see this focus you're talking about shifting the ventilation for school and the healthcare market? Can you give us any sense of how large that business is in this segment now and where do you think it might be able to go in the median term? And 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.
Yes, great. I appreciate the question. The -- for Modine, right now ventilation is about 4% or 5% of 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 -- starting with the announcement to exit auto but even ramping up the last 6 months, even pre-COVID, we see this area and it's a big area. I think it's -- the way we would define it, the products we sell in market and channels, $900 million to $1 billion market. And then on top of it, you add in COVID-related concern and we think this is a great opportunity. Again, we're focused on commercial applications. Previous to this, we then have -- 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 is 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 just -- we 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 if I just say over the top of that is the exciting part for us and I mentioned with Mike in the call a little while ago there's been so much effort spent in the last year -- monumental effort of the company to take a billion dollar segment, a vehicular segment, and split it into 2 pieces between automotive and heavy duty, and then go through a year sale process. The more we can continue to focus our resources and our capital on these opportunities I think is a huge opportunity for the company.
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 2 hours. We hope you all have a great day. Bye.
This concludes today's conference call. You may now disconnect.