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0:10 Good morning, ladies and gentlemen, and welcome to Modine Manufacturing Company's Third 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. [Operator Instructions] As a reminder, this conference call is being recorded.
0:36 I would now like to turn the conference over to your host Ms. Kathy Powers, Vice President, Treasurer, Corporate Communications, Investor Relations.
0:49 Good morning and thank you for joining our conference call to discuss Modine's third quarter fiscal 2022 results. I'm joined on this call by Neil Brinker, our President and Chief Executive Officer; and Mick Lucareli, 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.
1:16 On Slide 3 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.
1:27 With that, it's my pleasure to turn the call over to Neil.
1:31 Thank you, Kathy, and good morning, everyone. As I mentioned last quarter, we are undergoing a great deal of change of Modine, we have transformed our organizational structure, and it's significantly strengthened our management team. Over the past few quarters, we have begun employing (ph) 80/20 to guide our decisions as we actively manage our portfolio businesses. This includes implementing responsible pricing activities, simplifying product line offerings through secure 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.
2:14 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 end markets. This means reprioritizing resources and capital away from Legacy internal combustion solutions and towards system focused platforms.
2:43 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, the fast growing niche markets. These markets include the last mile delivery school and transit bus and specialty vehicles.
3:17 Our goal is to design and manufacture a complete thermal solution for any EV chassis. By controlling the temperature of the vehicles 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.
3:50 Our objective is to optimize profit margins and cash flows, while focusing resources on the products where we have technical competitive position, and what 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 and low margin areas where we do not have a competitive position.
4:12 As I mentioned last quarter, we're 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 annual savings with these actions. While we're too early in the process to precisely estimate the associated costs, we expect to record approximately $20 million 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 we'll provide more details in terms of timing, levels of cost savings and related charges at that time.
4:51 Please turn to slide 5. Now, I'd 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.
5:42 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 America and Europe, out of work with positive COVID cases are due to quarantine requirements. We're currently seeing these numbers decline, but that could change as new variants emergence 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, enhance benefit offerings, modifications to our wage structures, and hiring incentives have allowed us to make significant progress and filling our open positions.
6:32 Now moving on to the segments and building HVAC, demand remained 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 evidenced by the strong sequential earnings improvement. We anticipate that the HVAC will be back to historical margin levels in the next few months.
7:04 In addition, production volumes have been constrained by the lack of labor, but this does appear to be improving. In December, our heating plan in Virginia produced 20% more units than previous single-month record. This was possible, in part due to employees that travelled 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. Well, we are repurposing an existing warehouse into a dedicated chiller manufacturing and testing facility. I'm pleased to report that we've received their 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 and capacity expansion will allow us to meet our aggressive revenue growth targets in the future.
8:01 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, 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.
8:44 In our HD 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 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 EV market inflection.
9:14 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 and 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.
9:59 Now, I'd like to turn the call over to Mick who will review our results for the quarter and provide segment financial updates.
10:08 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. Your 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.
10:41 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 semiconductor shortage and the Austrian divestiture earlier this year.
11:19 Adjusted EBITDA declined 16% or $7 million year-over-year that 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.
11:42 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.
12:10 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 SG&A cost, 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.
12:44 Adjusted earnings per share of $0.31, was $0.03 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 if 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 a press release and appendix, which includes additional information, US GAAP result and complete reconciliations.
13:26 Now let's review the segment results. Please turn to slide 7. 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 sale. Heating product sales were up 9% over the prior year, while indoor air quality finished 8% higher.
13:58 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 in the extremely tight labor market resulted in higher labor costs.
14:25 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 raw material costs.
14:48 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% which is the large improvement from the first half of the year.
15:03 Please turn to slide 8. CIS reported a good quarter with strong revenue growth in year-over-year margin improvement. Early signs of 80/20 progress are evident within this segment. Third quarter sales for CIS were up 19% or $24 million, with $13 million of the increase coming from pricing. Revenue was up double digits in most markets, including 30% of commercial HVAC, 14% on refrigeration, and 10% in coatings.
15:35 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, the reduced backlog and our 80/20 work, we anticipate finishing the fiscal year with further margin improvement in Q4.
16:09 Please turn to slide 9. Sales in the HD segment were up 8% or $15 million. Similar to building HVAC and CIS, the sales increase is partially driven by increased pricing. Pricing and 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 box and specialty vehicle market, particularly in the Americas region.
16:41 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.
17:18 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 these activities, were pleased to deliver the sequential margin improvement in Q3 and expect a further increase in Q4.
17:45 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.
18:30 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 negotiation, 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, in our restructuring plans, we anticipate further improvements in Q4, and even larger steps in the new fiscal year.
19:14 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 that 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.
20:18 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 quarters 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.
20:50 Our plants 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 quarters 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.
21:17 With that, Neil, and I'll take your questions.
21:22 [Operator Instructions] Our first question comes from Steve Ferazani with Sidoti and Company. Your line is open.
21:40 Good morning, everyone. Nice job with the cost cuts in the quarter. I'm trying to get a sense [Indiscernible] in particularly to the SG&A with heavy duty equipment and automotive. I'm trying to think of, you're talking about $20 million of cost cuts in the future. I'm trying to think about near-term what you think you can do on the SG&A line and how much of that's related to the weakness in those segments margin wise recently or more, is this part of your long-term 80/20 initiatives or combination?
22:12 Yeah. Hey, Steve. Good morning. It's Mick. The – so the target that Neil laid out the 20 million savings target. It will be a heavy, heavy piece in the automotive segment and then a smaller portion in HDE and a little bit across some other areas of the company. From short-term nature, long-term nature of it, it was gonna take us probably the next quarter to finalize all of those plans and then still a little early, but I think it's a fair target to capture about half at least half of that in the new year. And then the balance after that, if that helps you out at all.
23:02 It does. Thanks. Then when I think about, how we should think about pricing, clearly, it was CIS, you seem to have an easier time of [Indiscernible] necessarily building HVAC and trying to get a sense of, is that based on the products, you're selling the customers. You're selling to the contractual terms, why it was that much easier to get the margins back up on CIS and then also whether we would see greater pass throughs just contractually with HD and automotive in this current quarter, although you got quite a bit this quarter.
23:35 Yeah. Now that's a good question. Hey, Steve, this is Neil here. Regarding the difference, there's, CIS had implemented those price increases pretty early on a backlog that wasn't as strong or robust as on the HVAC side. So we needed to get through some of the backlog on HVAC side of the business in order for the price increases to be realized. We just recently announced our fourth price increase in HVAC. So we've done more incremental price increases on the HVAC side, while we're burning through a larger backlog than on the CIS, on the CIS backlog.
24:11 So we should see more of it on the building HVAC?
24:15 Correct.
24:15 In the next couple of quarters. Gotcha. That's fair. Just even get one more in the 92% growth on data center sales, was there one large order there? Was there something in terms of timing? We shouldn't expect that every quarter?
24:31 Yeah, I think last year was a little bit of a dip, Steve. It wasn't one large order. These are in series. These are all generally big orders and sometimes they are – they can be lumpy, depending on just the timing of the actual shipment or when the customers ready to receive it. Well, we're on track this year, still, too, we're still targeting that $100 million range of data center revenue on a full year basis.
25:06 Great. Let me turn it over. I'll get back in queue. Thank you.
25:09 Your next question comes from the line of Matt Summerville with D.A. Davidson. Your line is open.
25:19 Thanks. A couple of questions. First with the guide, that's kind of, that’s pretty wide range with two months to go. So help me understand what kind of define the low end versus the high end and how do you risk, do you feel that bottom end would be at this point? Again, given that we have just two months left?
25:50 Yeah. I will take it. I think that's a good question. We decided and typically, we won't adjust guidance with a quarter to go, even though we could have thought about maybe narrowing that band a little bit. But as we went through the, the segment by segment results, Matt, I think we're clearly feel really good about where we sit in that range. Very hard to, if we deliver on our sequential improvement really the low we're – we're net, we're well outside of the low end of the range, right? So I would say, as I went through it, we expect sequential improvement in earnings and in margins in Q4 and if you just take that from the $102 million, we've done year-to-date. I'll leave it at that. But we feel secure within that range and we probably, the math would simply say we'd have to go backwards to get at the low end.
26:49 Yeah, great. Okay, so I want to talk a little bit about price and first, I want to talk about the price capture you experienced in Q3. How much of that was structural versus formulate pass through, and how we should be thinking about structural pricing looking forward.
27:15 Yeah, and you when you talk about structural I think, it's really margin improvement. It's, you know, longer-term margin capture, right, Matt?
27:28 Yeah, that's exactly right.
27:31Yeah, so maybe I'll go through segment by segment a little bit and Neil can add up now let Neil add color over the top, clearly across the total company in the quarter, this was same as last quarter. Our largest gap is in the HDE segment. It tends to have longer lags, the auto side, frankly, is more tied to quarterly. But we have a lot more large module, a lot more components we pass through as well on the heavy duty equipment side. So that is pass through there, we have more to catch up from a lag and a lot more commercially, to go back to the customers with their. So that is and we pass through a huge amount of pricing in those vehicular spaces. That is drives revenue, right. But it also doesn't attach margin to it. So it can actually be a little margin dilutive. So we have a lot of work to do, commercially, strategically using 80/20, to not only recoup those costs increases on the vehicular side, but then think about even different ways to manage that business going forward to get structural improvements. On the CIS and HVAC side as you can imagine a lot, I think, cleaner, I won't say easier. And Neil was just talking about CIS, they were able to jump out in front of that very quickly and you could see that in the numbers. A lot of the CIS improvements. I would like to answer your question, I would say is in that structural category. And then on the building HVAC side and Neil talking about that. The first three quarters of this year, there was a, they did a series of price increases, two or three to catch up on material pass through level, what we see beginning in Q4, and beyond will be more pricing on a structural level and building HVAC. Let me pause. Neil, if you want to add anything?
29:45 Yeah, the only other thing I would add to that. Hi, Matt, this is Neil. Is that we have more liberty on the HVAC side as well as on the CIS side. We're not hindered with some of the contractual obligations that we have across other parts of the business.
30:04 Got it? And then just as a follow up, if you look at the data center piece of the business $100 million platform for you guys this year. Do you have any thoughts? I'll be able to relate on what that business does in fiscal ‘23 and if you can speak to both the hyper as well as the cola (ph) market there and that would be great. Thank you.
30:33 Yeah, Matt, I think that's a good question. We're in the process of developing our strategic plan, we should expect to see some of the outputs relative to our, our outlook relative to hyperscale, as well as colocation. We're also in the throes of our ALP planning, and we should start to see some of that forecasting come to fruition soon.
30:55 And then the only thing I would add is, yeah, I think the target for us is to continue to go greater than the market, I think it'd be hard to have another continue, obviously, at a 50% clip, that if the markets are going to be up another 15% or 20%, next year, our goal is to outpace that market growth. And as Neil said, once we wrap up our plan and provide updates, Q1, Q4, we can be a little more specific.
31:27 Got it? Thank you guys.
31:30 Your next question comes from Steve Ferazani with Sidoti and Company. Your line is open.
31:37 [Technical Difficulty] A couple of questions. I wasn't able to get to the first time around, really about the automotive and plans on restructuring. I think you've touched on a couple of the points in your presentation, but I'm trying to think about in terms of and we certainly know some of the larger automakers over the last one or two weeks is the assumption with the chip shortage could be alleviated significantly this year more, but more back end loaded. Your automotive business does can do well, in a growing market, how you're thinking about, how that affects thinking about shrinking that business, potential divestitures and longer-term, how that might affect your short of restructuring plans with automotive?
32:20 Yes, Steve. That's a good question. So as we think about automotive, we're looking at it in terms of technologies where we have a competitive position where we see evolution in the market towards EV products, where we have good strong customer relations. Those are the areas that we're going to continue to rally around other areas where we don't have a competitive advantage, regardless of the vehicle recovery. If there's margin compression and margin issues and challenges, those are going to be areas that we're going to continue to have conversations commercially, as well as looking at the other options.
33:00 For these initiatives, and how much of it is controlled by the market itself?
33:06 Can you just repeat that, Steve, one more time?
33:08 What's your, what's your timetable for some of the bigger plans in terms of maybe individual facilities in the automotive market in terms of what you might do with them and how much of it's controlled by the market itself? Is it easier to potentially divest in a recovering markets and it would be when the market still remains weak?
33:29 Yes, back to the restructuring plans and the savings Neil targeted by first. So first and foremost, those numbers are nearly all tied to SG&A cost reductions, really refocusing on the areas that Neil said that we think, drive value for us, so not plant restructurings in there. And then we talked a little bit about this last quarter out of the automotive business and Neil talked about looking at as a technology. There's a smaller piece of that now. So the last couple of years, we – it's – we've shrunk it, we executed the sale in Austria. There's a third or so that is non-strategic. It isn't tied to the technologies, emissions changes fuel economy EV that Neil was describing and that we will probably have a long tail to it and then the balance of it is the core stuff that Neil was covering. We think A, already today has good margin or margin potential, and B, leads to the EV transformation.
34:48 Great, thanks. Thanks for letting me have these follow ups.
34:55 I'm showing no further questions at this time. I would now like to turn the conference back to Kathy Powers.
35:03 Thank you and thanks to everyone for joining us on the call this morning. You will be able to access the replay of the call through our website in about two hours. We hope you have a great day.
35:14 This concludes today’s conference call. You may now disconnect.