Modine Manufacturing Co

NYSE:MOD

Earnings Call Transcript 2019-Q3

[Operator]

Good morning, ladies and gentlemen, and welcome to Modine Manufacturing Company's Third Quarter Fiscal 2019 Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to turn the conference over to your host, Ms. Kathy Powers, Vice President, Treasurer, Investor Relations and Tax.

[Kathy Powers, executive]

Good morning, and thank you for joining our conference call to discuss Modine's third quarter fiscal 2019 results. I'm here with Modine's President and CEO, Tom Burke; and Mick Lucareli, our Vice President, Finance, and Chief Financial Officer. We will 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. This morning, Tom and Mick will present our third quarter results and update our outlook for the remainder of fiscal '19. At the end of the call, there will be a question-and-answer session. 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's my pleasure to turn the call over to Tom Burke.

[Thomas Burke, executive]

Thank you, Kathy. Good morning, everyone. We recorded another strong quarter with significant increases in both sales and earnings. Sales increased 6% or 8% on a constant currency basis. Each of our segments recorded higher sales this quarter as compared to the prior year, led by the off-highway, data center and commercial HVAC markets. Third quarter adjusted operating income was $34.8 million, up 29% to prior year. Similar to last quarter, strong performances from CIS and Building HVAC segments were partially offset by lower earnings from the VTS segment. Mick and I will provide more details, but we continue to be negatively impacted by the direct and indirect impact of tariffs on raw material purchases within the VTS segment.

After reviewing the segment results for the third quarter, Mick will provide an update on our consolidated results and our outlook for the rest of fiscal 2019. I will then provide an update on our strategic initiatives, including our review of the strategic alternatives for the automotive business that was announced earlier this week. Please turn to Page 5. Sales for the VTS segment increased 3% or 6% on a constant currency basis, driven primarily by increase in the Americas and Asia, partially offset by lower sales in Europe. Growth in the Americas region was across all end markets, while growth in Asia was primarily driven by higher off-highway sales. Adjusted operating income for the VTS segment is $15 million for the quarter or $5 million lower than the prior year. And adjusted operating margin was down 180 basis points to 4.6%.

Over the past couple of quarters, we have mentioned the direct and indirect impact that tariffs continue to have on our raw material cost at VTS. Although we source much of our raw material domestically, our raw material suppliers are using tariffs to apply leverage for the cost increases. In fact, some of our suppliers have increased their fabrication cost by more than 20%, and some are choosing to exit the heat exchanger business altogether, resulting in our having to resource supply in order to fulfill our commitments to our customers. These changes are unplanned and are resulting in a significant cost burden to the VTS segment. In addition, we're also bearing the direct cost of tariffs on certain imported items from certain countries, primarily China.

Overall, the negative impact of tariffs on our margins has been greater than we originally expected. We are therefore attacking this issue from many angles and exhausting all tools at our disposal to address these market pressures. Our procurement group is working tirelessly to secure the supply of raw materials that we need. And our commercial teams are working with our VTS customers to reach cost-sharing arrangements to help cover these higher costs. In addition, we continue to monitor the status of the exclusion request that we filed with the government. We are also still experiencing some operating inefficiencies in a few of our VTS plants but are starting to see some significant improvements. We have made leadership changes at the affected plant locations within the segment, and we are confident these changes will accelerate improvements. Please turn to Page 6. Sales for our CIS segment increased 5% or 7% on a constant currency basis, primarily due to a 36% increase in sales to data center customers. The segment reported adjusted operating income of $13.6 million, more than double the prior year. The adjusted operating income margin was up 460 basis points year-over-year to 8.1%. This improvement was driven by higher sales volume, favorable sales mix and improved performance. We continue to benefit from both the strength of the data center market and higher market share, which is driving both top line growth and margin improvement. In addition, we are benefiting from operational improvements and from the restructuring actions taken in Europe last year. We continue to be very pleased with the performance of this segment. Please turn to Page 7. Sales for our Building HVAC segment increased 14% or 16% on a constant currency basis, driven both by a strong North American heating season and higher air-conditioning sales in the U.K. Operating income increased 41% from the prior year to $13 million, and operating margin increased 380 basis points to 20.3%. This increase was driven by higher sales volume along with improved pricing and a decrease in SG&A expense.

As I mentioned, this has been an exceptionally strong heating season for us. In addition to benefiting from strong market conditions, we've also gained market share in both the U.S. and Canada. There was clearly a great deal of momentum in this segment. We always benefit from a strong heating season, but we're also working to build our reputation as an industry leader in data center cooling as we are winning significant new business both in precision cooling and chillers out in the U.K.

With that, I'd like to turn it over to Mick for an overview of our consolidated results and an update on our outlook for the remainder of fiscal 2019.

[Michael Lucareli, executive]

Good morning. Please turn to Slide 9. First, I want to say that we're pleased with the quarterly sales and earnings growth within our 2 primary industrial segments. Total company sales increased $28 million or 6%, including a negative foreign currency impact. Revenue improved in all business segments this quarter, with the highest rate of growth in the off-highway, data center and commercial HVAC markets. Gross profit of $92 million was up 7%, and our margin was up 20 basis points. The Building HVAC gross margin was higher than the prior year, and CIS showed a significant improvement as well. On the VTS side, we had positive impacts from higher sales volume and ongoing purchasing initiatives. However, this was more than offset by higher tariff and tariff-related costs. As Tom described, these costs relate to tariffs on imported materials and large price increases from certain domestic suppliers that are leveraging their current position. We're working hard to recover these cost increases from our VTS customers, but this is proving more difficult than we anticipated.

With regards to CIS and Building HVAC, we are generally able to pass through these cost increases in the normal course of business. In addition to the material costs, we incurred a number of incremental costs related to rapid volume increases, program launches and a facility expansion. To help offset the material challenges, we continue to tightly manage SG&A. At $57 million, SG&A improved 130 basis points as a percentage of sales. The 6% decrease in SG&A includes a $1.1 million recovery of environmental costs. Adjusted operating income was $34.8 million, up 29%, due primarily to the gross margin improvement in CIS and Building HVAC segments. The appendix includes an itemized list of adjustments and a full reconciliation to our U.S. GAAP results. These adjustments totaled $1.2 million and relate to strategy consulting fees, restructuring expenses, impairment charges and environmental charges related to previously owned manufacturing facilities. I also want to point out that we recorded an $8.6 million income tax expense, which is significantly lower than the prior year. Last year, we recorded a significant income tax expense related to U.S. tax reform. In our adjusted taxes and adjusted EPS, we have excluded these impacts. After these adjustments, our effective tax rate was 23% compared to 9% for the same period in the prior year. The low adjusted tax rate in the prior year was due to a Hungary development credit.

And last, our adjusted earnings per share was $0.42, which was up $0.07 or 20% from the prior year. Turning to Slide 10. Our year-to-date operating cash flow of $67 million benefited from a solid third quarter, which was $31 million. After a slow start in Q1, our free cash flow has improved with third quarter free cash flow of $10 million. Year-to-date free cash flow is $9 million, but we are running below the prior year. Please note that this includes about $15 million of cash spent on restructuring and related activities. The other large impacts on free cash flow are inventory and capital spending. We are running higher inventory due to program launches and the tariff impact on domestic supply. Year-to-date capital spending is about $4 million higher than last year. Based on the current trends and outlook, we expect our full year free cash flow to remain positive, but we'll finish below the prior year. Our leverage ratio was 2.2, which is within our target range of 1.5 to 2.5. And as we announced last quarter, our Board authorized a $50 million share repurchase plan. We have purchased 50,000 shares in December at an average price of $11.37. We'll follow our capital allocation strategy and balance share repurchases with our priorities on investments that support diversification and growth. In addition, we remain committed to delevering our balance sheet and keeping the leverage ratio within our targeted range. Let's turn to Slide 11 with our fiscal 2019 outlook. We adjusted our outlook based on our most recent quarter and the evolving tariff situation. In summary, we tightened our sales and EPS range. In addition, we tightened our adjusted operating income range and reduced the low end by $2 million. With regards to revenue, we are lowering the top end of the range and project sales to be up 3% to 7%. From a VTS perspective, the tariff situation is creating cost challenges within the supply chain that our teams are working through, but it's proving more challenging than we anticipated. We now expect our adjusted operating income to be in the range of $128 million to $134 million compared with our previous range of $130 million to $140 million. Despite the adjustment, we continue to see year-over-year growth of 7% to 12%. With regards to other key assumptions, we expect the annual interest expense of approximately $24 million. As usual, we're using current foreign exchange rates. And last, we expect our adjusted tax rate to be approximately 21% to 22% in fiscal '19. Given these factors, we're tightening our adjusted earnings per share range to be between $1.50 and $1.60. And to wrap up, we're happy with the earnings growth this quarter but anticipate some pressure in our fourth quarter, mostly in the VTS segment. Even with some temporary cost challenges, we have an opportunity to deliver another record year of sales and earnings. So with that, Tom, I'll turn it back to you.

[Thomas Burke, executive]

Thanks, Mick. Please turn to Slide 12. As we've been discussing over the past several quarters, our strengthened, diversified and growth strategy is driving our focus on areas targeted for improved organic and inorganic growth and on the areas of our business that we plan to deemphasize. Soon after completing the Luvata acquisition, we began a strategic analysis of our portfolio of businesses, including our major end-market drivers and the performance of our current product portfolio in those markets. You may have already seen us take some strategic action by selling our South African business and exiting the geothermal product line. What has been clear, however, is that even though some of our highest growth rates are within our automotive engine products, there are significant and persistent competitive forces in the industry that we believe will limit our long-term return on capital, given the high capital intensity and ever-increasing competitive pressures in this business. Last quarter, we specifically mentioned that we had identified approximately $200 million of sales to automotive markets that were undergoing a strategic review. As we further evaluated this business, we widened the scope of the review to include our entire automotive business, which accounts for approximately 25% of our total company revenues. As discussed in a separate press release we distributed earlier this week, we are now exploring strategic alternatives to find the most successful path for this whole business in order to best serve our customers and provide the greatest return for our shareholders. Let me be clear: we have great products, technology, customer relationships and a very talented team that service this market. Further, we have been producing products for the automotive customers for nearly 100 years. This is an incredible legacy, but at this point, we need to determine what it will take to expand our portfolio with the necessary adjacencies to be a global full-system supplier in the automotive market. This investment would be significant and needs to be carefully evaluated, along with other strategic alternatives under consideration. We believe that Modine and our shareholders could be better served by more appropriately allocating our capital in higher-return opportunities that will drive profitable growth and further business diversification. I want to be very clear that we remain fully committed to the commercial vehicle and off-highway markets in VTS, which share many characteristics with the rest of our industrial portfolio. We have full -- we have and will continue to make the necessary investments in people and capital to ensure this global business is successful. In addition, we aim to grow our global market-leading positions in the rest of our industrial market segments, both organically and inorganically, building on the momentum and success of the CIS and Building HVAC segments. We will complete this assessment of strategic alternatives over the next several months, and we'll provide more information once complete. I understand there may be questions about the potential outcomes of this process and about the future financial impact to Modine. However, at the current time, we can only comment on the status of our assessment, and we'll provide more information when there is something more definitive to share. And with that, we'd like to take your questions.

[Operator]

[Operator Instructions] Our first question comes from David Leiker with Baird.

[Joseph Vruwink, analyst]

This is Joe Vruwink for David. I wanted to start on the topic of tariffs. Could you maybe just walk through what got worse relative to your thinking a quarter ago? I'm wondering, is it the inflationary pressures from your suppliers that worsened? Or did some of the Modine mitigation actions maybe just take a little bit longer to go into effect, and so there's maybe a benefit still to come on the horizon?

[Thomas Burke, executive]

Let me give you a couple of points, then I'll let Mick chime in. The indirect impact of tariffs has been much greater than we anticipated, okay? As I highlighted in my comments, that the domestic suppliers have been very aggressive in using the opportunity for rising cost and higher demand to leverage their capacity against us. That's been very significant and forcing us to then -- and one example, as I mentioned, I mentioned it's up over 20% in one case. And that's pretty much -- it varies across the board, but just about everybody that is impacted by this [ supply growth ] is taking advantage of that. One supplier has actually said, "Hey, look, I'm going to send my capacity someplace else other than heat exchanger raw material."

So that has then had a knock-on effect of having to bring on new suppliers that are from outside the country, quite frankly, that has then a tariff impact potentially, still better than what -- the price gouging that we were going through, and then having to go through the cost of running that material and testing it and getting it approved through the system. That is a full-court press, okay? So you're flying in materials, you're spending overtime, you're [ bidding ] parts, you're getting tests done, working with customers to keep our customers in product. So that's been very -- something that we didn't quite anticipate last quarter.

The rest of the kind of planned tariffs, okay, is going along as planned. And clearly, as Mick mentioned, negotiation with our customers, which, again, with the contract terms we have, have to be kind of walked back in and discussed, okay? And they have the ability to kind of say, do they support a negotiation or not? That has been a little more difficult as well. And -- but I will say that overall, we -- from a procurement standpoint, the contracts we had, we've got those, for the first round of the tariffs, besides negotiations, had things long-handed, this indirect impact has been worse. Mick, do you want to add anything to that?

[Michael Lucareli, executive]

Two other things to add with regards to the sharing that we've talked about. We assumed there would be a sharing, and that's proving out to be the case, so that -- no surprise there. But I mean Tom was on the road in January personally, and what's taking a long time is to get the agreements in writing. So we actually had one customer that we're able to get everything buttoned up for Q3, and we've got a lot of progress with other customers. Those contracts or legal agreements do have to be buttoned up. Obviously, they want to protect themselves if these go away.

The second point would be the exclusions. The government shutdown didn't help us at all. We had comment periods expiring. And so we believe strongly, we have valid exclusions from certain tariffs, and that was taking a longer progress -- or process than we expected, Joe.

[Joseph Vruwink, analyst]

So that's helpful. So a quarter ago, you kind of tweaked the fiscal year guidance by $5 million. This quarter, you're tweaking it by $6 million, so let's call it an $11 million EBIT adjustment the last 2 quarters. And over that period of time, I would imagine that the contribution from the industrial business has been a lot better than you would have originally assumed as well. So are we talking about something that's maybe $15 million, plus or minus, adversely impacting you relative to 6 months ago? And then how much of that, if I'm right, $15 million, give or take, can maybe be mitigated into fiscal 2020?

[Michael Lucareli, executive]

Yes. I'll take a stab at it first, Joe. It's Mick. So I'm not going to comment specifically on your math. It's probably just -- I can help you with the direction. From -- the magnitude that you're laying out is much -- is higher than we have seen. But from a material standpoint, we talked about, in fiscal '19, about a $6 million to $7 million challenge, cost increase this fiscal year. And on top of it, at the time, we were talking about potential risks of domestic suppliers.

If you roll in the indirect or the domestic price increases, a lot of those came, Joe, late in the calendar year in a lot of frantic moving over the holidays, frankly, with price increases coming January 1, another $4 million to $6 million. So somewhere between $10 million and $13 million, $14 million, just price increases. And then it gets to the sharing that I've talked about. The $4 million to $6 million that has come in from domestic suppliers, there is no sharing there. That's a renegotiation or resourcing that Tom walked you through, and we'll find a way through that. I'll let Tom comment. But we will -- we are vetting, evaluating and resourcing where appropriate on those, and we are getting sharing agreements even though it's slower. So I think probably $10 million to $13 million in total tariff-related headwinds. And absolutely, we should be able to make progress on closing that gap as we head into fiscal '20.

The other challenge in there, if you think, in the last 6 months, Tom talked about some of the program launches and inefficiencies. We are seeing improvements, but honestly, they've been, frankly, a little bit slower than we anticipated. And again, when we look to fiscal '20, we -- these are things, both on the material and the launch costs, that we should be able to work through. Tom?

[Thomas Burke, executive]

No, I think you hit that squarely. I'll just add, on the performance, as far as launch performance and inefficiencies, we are improving. I'm not satisfied with the rate of improvement. I noted we've made some leadership changes as a result, and I expect that to significantly improve at a higher rate. So that's the other portion that we're getting through.

But Joe, they're great questions. We -- from a quarter, this thing got much more complicated quickly with the indirect impact. We are managing the direct impact, as we talked about before, in a very structured way. But this -- kind of the dam broke loose a little bit here with the challenges with our domestic suppliers. Very unfortunate and, quite frankly, not acceptable on how -- we've had long-term relationships with a lot of these suppliers that we're talking about. And to see them react this way has been very disturbing, but we are managing through that, focused on making sure, number one, we keep our customers in supply, which we're confident we will; and then making sure that we get the best deals possible. But it's been a full-court press from nearly every function in the VTS world.

[Joseph Vruwink, analyst]

Okay. So focusing on the good news now. CIS profitability was pretty remarkable this quarter. And I seem to remember that seasonally, the December quarter should actually be the weakest of the quarters for CIS, so even more remarkable in that regard. Maybe walk through some of the things that surprised you on the upside. And then in thinking about upcoming quarters, does this become a new high watermark where you kind of build from here? Or are there certain things to contemplate where maybe there's a bit of moderation in upcoming quarters?

[Thomas Burke, executive]

Well, as mentioned in my comments, Joe, we were benefiting from several factors in CIS. First off, we were a focused leadership team on building levers in their strategy that are important to improve operating performance, manage opportunities with the restructuring that we did in Europe last year that we invested in with the plant in Austria to give them a better performance there. And clearly, the data center market has been -- the surge in orders there has been very positive for us, both in the market and in gaining share, okay, that we feel across different -- throughout the different channels in the data center market.

So I can only say that I'm very pleased. The cash flow predictability in this segment is great. The ability to not be in hammerlock because of tariffs because of our ability to price and pass through is very refreshing. So overall, I'm just very pleased. Mick, you want to quantify anything more to that?

[Michael Lucareli, executive]

Yes, Joe. I think as much as we love it, I think this business will regress to what we talked about when we bought it. I think we should all be thinking about this as a low single-digit top line grower, and the margins are just going to plateau here and stabilize. We've got a lot of benefit from everything from the synergies fully coming through, operational improvements, mix. But I think we -- this is going to start to level off, which is fine because it's also a very nice cash generator. And we want to build off of it, both organically and inorganically. But booyah, there -- this is a -- several good things have gone our way, favorable from a market standpoint. And I think we still think of this business, long term, as a low single-digit top line and a nice margin, cash flow generator going forward. And then we can supplement that growth through other strategic and acquisition kind of measures.

[Joseph Vruwink, analyst]

And then my last question, and I'll turn it over. The growth in Building HVAC was also very remarkable this quarter. Do you have a sense -- this would, I guess, apply only to your U.K. business, but a sense of stocking ahead of some uncertainties in Q1, thinking about Brexit primarily? But anything that would indicate that not only was end demand strong but stocking as well, so there's some moderation due into coming quarters?

[Thomas Burke, executive]

Yes. Well, as far as orders, we're right now in very good shape as far as the order book. I mentioned the real focus on data center business there with the expansion of data center -- colo centers in Ireland, England, the Netherlands and Germany, which we're receiving nice orders and really gaining share. So the order book looks fine -- not fine, it looks great. So I'm really pleased with that. And the performance -- operating performance of our U.K. business, as you recall from a couple of years ago, has really improved as well with focused leadership and really driving improvement.

As far as the -- what was the second part? Oh, Brexit. As far as Brexit is concerned, it's -- clearly, we're preparing. We have about 40% of our parts that we supply, that we get, comes from the mainland in Europe. So we -- what we're doing to counter that a little bit is we've built some inventory, banked up on those parts just to have some flexibility there, okay, depending on what happens here. But we're staying really close, but that's really the one countermeasure we put in place right now as well as staying close to what the latest developments are. But very good question.

[Operator]

[Operator Instructions] I am showing no further questions at this time. I would now like to turn the conference back to Kathy Powers.

[Kathy Powers, executive]

Thank you for joining us this morning. A replay of this call will be available through our website in about 2 hours. We hope you have a great day. Goodbye.

[Operator]

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