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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Good morning, ladies and gentlemen, and welcome to Modine Manufacturing Company's Fourth Quarter Fiscal 2018 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. You may begin.
Good morning, and thank you for joining us for today's call. I am here with Modine's President and CEO, Tom Burke; and Mick Lucareli, our Vice President of Finance and Chief Financial Officer.
We will be using slides for today's presentation, which can be accessed either through the webcast link or by accessing the PDF file posted on the Investor Relations section of our website, modine.com.
On Slide 2 of the presentation is an outline for today's call. Tom and Mick will present our fourth quarter and full year results and provide our revenue and earnings guidance for fiscal '19. At the end of the call, there will be a question-and-answer session.
On Slide 3 is our notice regarding forward-looking statements. This call may contain forward-looking statements as outlined in our earnings release, as well 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.
Thank you, Kathy, and good morning everyone.
On today's call, I will discuss our fourth quarter and full-year results including an update on our business segments and strategic initiatives. After that, Mick will provide a more detailed review of our consolidated financial results and will provide our revenue and earnings guidance for fiscal 2019. I will then provide a few closing remarks prior to opening up the call for your questions.
Fiscal 2018 was a very successful year for Modine, continuing the positive momentum from the prior year. Looking back over the past two years, we have increased our revenues by over 50% from $1.4 billion in fiscal 2016 to $2.1 billion today. This increase was jointly due to the addition of the CIS business in fiscal 2017 and meaningful sales growth in our vehicular and building HVAC segments.
Of particular note is our Asia segment, where our local team has executed very well and more than doubled revenues over the past two years increasing - increased operating earnings by almost $17 million. In total, we reported full-year adjusted operating income of $120.1 million, an increase of 66%; and adjusted EPS of $1.54, which is nearly double the prior year.
Moving to our fourth quarter results, I'm pleased to report another strong quarter with significant sales and earnings improvements. Overall, sales increased 16% with the largest contributions from the Europe, Asia, and CIS segments. Our fourth quarter adjusted operating income was $34.7 million up $4.8 million or 16% from the prior year, and adjusted earnings per share were $0.44 for the quarter, a $0.09 improvement from the prior year.
Now I’d like to briefly review the segment results for the fourth quarter. Turning to Page 6, sales for the Americas segment increased 4% on a constant currency basis to $150 million driven primarily by higher sales to off-highway and automotive customers. Gross margin declined 420 basis points to 14.8% as compared to the prior year. We anticipated we would have a tough comparison particularly due to the extremely strong fourth quarter of last year.
This decrease was driven by several factors including higher material costs which had a $2.6 million negative impact during the quarter. Material pass-through provisions in many of our customer contracts should alleviate this negative impact in subsequent quarters, as long as metal prices stabilize.
In addition, we had higher labor and benefit expense in our Nuevo Laredo, Mexico plant as we prepare for new business launches that will lead to future sales growth. Lastly, we had a negative currency impact from the stronger Mexican peso.
While we are subject to labor cost increases in addition to having to offset customer price downs. We are continually working to offset these impacts by controlling our supply chain costs and improving efficiency and productivity. We expect margins in the Americas to improve in the next one to two quarters.
As a result of these factors and the tough comparables, adjusted operating income for the Americas segment was $9.7 million, $4.9 million lower than the prior year primarily related to the decrease in gross profit partially offset by lower SG&A expense.
Our markets in the Americas segment continue to be strong with growth expected in all of our end markets. We're still working through some of the wind down on commercial vehicle programs but are launching new business in automotive, off-highway, specialty vehicle and new commercial vehicle customer programs.
Higher material prices continue to be a concern and will impact our margins in the short term, but the pricing mechanisms in our contracts will allow us to recover much of this cost increase over time as I mentioned earlier.
Please turn to Page 7. Sales for our Europe segment increased 5% on a constant currency basis to $162.9 million with improvements across all markets. Gross margin increased 70 basis points to 16.6%. The increase in margin was primarily due to higher sales volume, procurement cost savings and plant production efficiencies.
Adjusted operating income increased $4 million to $14.8 million due to higher sales and improved gross margin along with favorable foreign currency exchange rates. Our European team, as is the case in each region is managing high level of quote activity for electric vehicles leveraging our strong product portfolio and manufacturing footprint.
As you know, we have completed construction of our plant expansion in Hungary allowing us to expand our low cost country footprint for automotive oil coolers and charger coolers. We've seen the benefit of this investment in our income tax expense this year, as we're able to take advantage of development credits in Hungary. We're also transferring production of certain product lines from our Austrian plant to our facility in Hungary and those transfers have been going smoothly.
Please turn to Page 8. Our Asia segment continues to report significant sales and earnings growth. Overall Asia segment sales grew 35% compared to the prior year on a constant currency basis. We increased sales in China, India and Korea with the most significant increases in automotive and off-highway sales in China.
Higher sales volume led to a 70 basis point improvement in gross margin to 17.6%. This resulted in a $2.8 million increase in gross profit from $5.6 million last year to $8.4 million this year. Operating income for the Asia segment increased $2.2 million or 79% to $5 million due to higher sales volume.
As I mentioned last quarter, higher sales volumes have continued to stretch our capacity in China. To allow for further growth in the region, we announced our intention to construct the second building at our Changzhou site and the finalized design for facility had broken ground on construction. We anticipate that construction of the building will be complete by the end of calendar 2018.
Turning to Page 9, sales for our CIS segment increased 10% on a constant currency basis to $168.4 million primarily due to higher sales of precision cooling, mobile air conditioning and coatings products. Gross profit was $25.7 million which resulted in a gross margin of 15.3%, up 20 basis points on the higher sales volume.
The segment reported adjusted operating income of $11.6 million, a $3.8 million or 49% improvement over the prior year. This improvement evidences the synergy savings we've been able to obtain this year as we work towards our goal of obtaining $15 million in synergy savings over the first two years of operation which is on track. We’ve done a great job this year achieving the procurement synergy cost savings outlined in our plans and now we will turn to manufacturing cost savings to further reach our goals.
As a first step, we closed a plant in Australia and expanding our footprint in Serbia. Second, we will add an additional lease capacity to our facility in Juarez, Mexico to allow for production increases. Our goal over time is to enhance production capabilities at the Juarez plant and to continue its development to scaled coils manufacturing facility.
Please turn to Page 10. Sales for building HVAC segment increased 7% on a constant currency basis compared to the prior year to $43.3 million. The increase in sales was driven by a strong North American heating season.
Gross profit increased 21% and gross margin improved by 250 basis points to 30% [ph] driven by solid conversion due to a favorable sales mix and improved pricing. This resulted in adjusted operating income of $3.3 million up 18% from the prior year driven by higher gross profit on higher sales.
As part of our broader strategic portfolio analysis, we discontinued our geothermal product line during the fourth quarter. Sales growth in this product line was continually below our expectations and we were not able to reach a critical size to be competitive in this market with annual sales of less than $1 million.
In addition, we have decided to sell our South African business to a local entity, which will allow the business to have greater opportunities for success. Fiscal year 2018 sales for this business were less than $2 million.
And finally just as a reminder, this will be the last quarter that we report on five business segments. Starting with the first quarter of fiscal 2019, we will report on one particular segment called Vehicular Thermal Solutions or VTS that will include the current Americas, Europe and Asia segments. So our three segments going forward will then be BTS, CIS and the Building HVAC segment.
With that, I'd like to turn over to Mick for an overview of our consolidated financial results, as well as our outlook for guidance in fiscal 2019.
Thanks Tom.
Please turn to Slide 12. Reported sales increased $78 million or 16% which includes a positive FX impact. On a constant currency basis sales increased $42 million or 9%. Our topline benefited again this quarter from favorable market, foreign-exchange rates and pricing tied to metals pass-through, gross profit of $96.5 million was up 13%. Our results were positively impacted by the higher sales volume FX rate, than ongoing purchasing initiatives.
Gross profit and gross margin improved in our Europe, Asia, CIS and building HVAC segment. Total company gross margin was down slightly to 17% mainly due to the temporary challenges in the Americas as Tom just reviewed. SG&A of $63.6 million was up $3.5 million primarily due to the change in foreign exchange rates. Unfavorable exchange rates accounted for $2.9 million of the increase and on a constant currency basis SG&A increased just1%.
Please note at the bottom of the page we've included a table with adjustments to operating income which totaled $7.5 million for the quarter. The largest item represents our restructuring expenses which primarily relates to severance in Europe. We also adjusted 600,000 for acquisition and integration costs, along with 900,000 for strategy consulting fees, the 1.2 million impairment charge related to the building HVAC segment which discontinued its geothermal product line during the quarter. The remaining adjustments related to environmental expenses in the Americas for a plant that was previously closed.
Fourth quarter adjusted operating income of $34.7 million was up 16%. Our adjusted earnings per share was $0.44, an improvement at 26%. Note that our U.S. GAAP earnings per share of $0.34 was impacted again this quarter by tax reform legislation enacted in December. We recorded $2.3 million of provisional charges to income tax expense in the quarter. This included a U.S. deferred tax benefit of $1.7 million as a result of higher U.S. taxable 2018 earnings compared to our forecast.
Also a 4 million charge for the transition tax on foreign earnings that have not been previously taxed in the U.S. was recorded in the quarter. The U.S. tax environment is quite fluid, an additional legislative guidance is expected which will be monitoring closely.
As a reminder, we benefited during fiscal '18 from $9 million in development tax credits related to our Hungary expansion. This is a one-time benefit that will not carry-over into fiscal 2019. In addition, we reversed a portion of the valuation allowance on our deferred tax assets in China resulting in a $2.8 million benefit in income tax expense.
In our adjusted EPS, we made income tax adjustments related to tax reform and the reversal of the valuation allowance in China. Last, please note that our U.S. GAAP income statement is included in this presentation and in our earnings release including a full reconciliation.
Turning to Slide 13, fiscal 2018 operating cash flow was $123.8 million or $82.2 million higher than the prior year. Full year capital expenditures were higher than the prior year by $6.6 million. This is primarily due to capital spending in our new CIS segment in unfavorable foreign exchange rate changes.
In addition, we made equipment purchases to expand manufacturing capacity in Hungary and China to support new product launches. We reported free cash flow of $52.8 million in fiscal 2018. Please note that this includes a negative $26.1 million impact of cash payments for restructuring activities, strategy cost, acquisition integration costs, and environmental related expenses. Finally, our net debt declined by $37 million during the year and our leverage ratio is at 2.4 down from 2.9 at the end of fiscal 2017.
Now let's turn to our fiscal 2019 guidance on Slide 14. I'm pleased to report that we're expecting another year of good earnings growth driven by improving margins and continued market growth. To summarize our guidance, we project sales to be up 3% to 8%. We expect ongoing vehicular market growth as Tom described earlier partially offset by the wind down of multiple truck programs.
For our industrial and HVAC markets, we expect low to mid single-digit market growth. In addition to the revenue growth, we are planning to drive earnings through margin improvements across all business segments. We expect adjusted operating income to be in the range of $135 million to $145 million. This equates the year-over-year growth at 12% to 21%.
As usual, I want to briefly review some of our key assumptions, first metals prices have continued to increase and we anticipate that this will be an ongoing headwind. Second, we expect annual interest expense of approximately $23 million. Third, we are using current foreign exchange rates which will result in a slight benefit year-over-year. Also I want to spend a moment reviewing our very complicated and fluid tax environment.
To start, we added significant benefit in fiscal 2018 related to Hungarian development tax credit that will not repeat in 2019. Next, we have impacts from the change of our expected mix of earnings particularly related to those jurisdictions where we have valuation allowances. And last, we have the impact of the U.S. tax reform legislation which is causing a significant increase to our tax rate in fiscal '19.
We previously expected our U.S. tax rate to drop due to the lowering of the federal rate, however we are now expecting to have additional U.S. tax related to a specific provision in the new law. We estimate this to be about $6 million in fiscal '19.
Given all these factors, we expect our adjusted tax rate to be approximately 27% to 28% in fiscal '19 versus 12% in fiscal '18. Based on the expected tax rate, we anticipate our adjusted EPS to be between $1.50 and a $1.65.
So to wrap up, we finished a strong year. Closed out one of our best years in terms of financial results and increased shareholder value. I look forward to reporting back on our continued momentum throughout fiscal 2019.
Tom?
Thanks Mick.
Please turn to Slide 15. As I mentioned last quarter, we have focused significant resources this year on performing a strategic review of our product portfolio and as we assessed our strategic progress over this time, we kept coming back to strength and diversify and grow what we refer to as SDG, the strategy that is successfully guided our decisions over the past 2.5 years.
Although we will define new targets and new actions for reaching our long-term goals, the overall strategy will remain consistent. As we strive to become a more diversified global thermal management leader, I look forward to sharing details on next phase of SDG in the near future. But to be clear, we will continue to strengthen our business by optimizing our global manufacturing operational capabilities, working hard to continually improve our global business process.
Today I outlined many examples of how we're expanding our oil cost country footprint around the world in order to continue to competitively meet demand for our advantage products. Our global operations team recently coined the phrase One Modine to describe their approach on developing Modine operating system discipline deeply and consistently around the world. This has proven to be a powerful competitive advantage along with our growing size and scale.
Secondly, we’ll continue to diversify the business following on the success of our acquisition of the CIS business. We proved we can deliver on our promises by completing the biggest acquisition in the company's history having to be accretive earnings in the first year, allowing us to generate a sufficient free cash flow to bring our leverage ratio back down into our targeted range.
This success will allow us to look for other opportunities for acquisitions that will add to our industrial portfolio, increasing our diversification and decreasing our customer concentration and reducing our exposure to market cyclicality.
And finally, we will continue to grow by seeking those investments where we have the right to win in making wise choices with our capital. Whether the growth comes from new or inorganic opportunities or from our proven organic growth capability, we will continually seek high returns in our invested capital.
In some cases we may choose to deemphasize certain products or end markets as I described earlier in the building HVAC segment. But we've been making these types of decisions for the past several years, but this is a special time as we embrace technological advancement and societal changes that will be disruptive to our markets.
This is where Modine will thrive. As a technology leader we will be able to deliver the products that our customers need to meet higher energy and fuel efficiency requirements, enable the introduction of advanced refrigerants and provide thermal solutions for electric vehicles. This is Modine at its best.
And with that we will take your questions.
[Operator Instructions] Our first question comes from the line of Ryan Amberger of Seaport Global. Your line is now open.
This is Ryan Amberger on for Mike Shlisky. Just two quick ones. So looking at the segments, Asia was your leader for fiscal 2018. Margins were up nearly four points for the year and were above 10%. Do you still think there's more expansion ahead for margins in Asia, or is the 10% to 11% range a reasonable number going forward?
Ryan it's Mick. That’s the range we'd expect going forward. I would say - I’m the first to say they have surpassed our expectations, but I think at this point we’ve leveraged the existing scale, and now as you know we are starting to put in some additional capacity, so we’ll reach a natural level here, and I think it's probably in that 10% or 11% operating range.
And then one other one quick. In looking at your guidance, the incremental margins look like they are high teens for fiscal 2019. That's an improvement over the last year or two but still maybe could be a little better. Is it just a matter of raw material costs at this point? And if we were to see raw materials come back to more normalized levels, could we get a sense of where operating profits could be for fiscal 2019?
Yes, great question, and a lot going on there with regards to our guidance in this year and in next year. From a gross profit standpoint, if you look at our outlook for next year at a gross profit line we’re really planning to convert pretty nicely in a 25 plus percent range. And then I think you must have representing the operating income.
One of the headwinds we do have next year and that’s part of it is metals. We’re not as concerned about all the discussion on the tariffs and trade wars but it’s really on the LME and the raw material price. For most of this year we talked about it $10 million to $15 million headwind and we’re passing that through in the new year.
Really around the spring here we saw another run up in raw materials, especially copper and aluminum prices. And there we are looking at another $30 million to $40 million increase in costs in fiscal 2019, and we will start passing that through, but there will be a lag on that. So that would pull down the margin a little bit this year until we pass through the balance of the material change. Does that make sense?
And our next question comes from the line of David Leiker of Baird. Your line is now open.
First of all, great finish to the year. These numbers are great, the returns are great and look for more to go forward. On China, is there a way to break apart the revenue growth of how much of that is what's going on in the market as opposed to new contract awards, content, market share? Is there a way to separate those two?
Yes, they could kind of qualify, clearly our big markets there - are our traditional off-highway construction markets where we are really benefiting from a bounce back of construction sales with heavy excavators, so that is kind of market driven, but also [indiscernible] new awards. And again, when we talk about that, it's China that’s driving the bulk of that but also seeing a strong performance out of India and some out of Korea.
The real growth side as far as new wins is really around the automotive engine products, specifically supplying engine content as the lower displacement, boosted engine phenomenon takes place in China that has given this great opportunity for content and increase in business wins, so that's really how that breaks down. I’d quantify that - Mick, do you have any way of --?
Yes, I would say David, it’s less than half its market, maybe a third. So out of 35% or 40% growth, we look across the end markets in India, the construction market in Asia and auto in China. The excavator market by our external data was up 10% to 20% in Asia, most of the markets in India in the quarter were 10% to 15%, and just a pretty low growth rate by our data on auto in China.
And across all of our - so and then Modine sales up 40%, it was pretty across the board. Our auto sales were up 30% to 40%, our off-highway sales or construction sales were 20% to 40%. And then India sales were up another 20% to 40% depending on off-highway or commercial vehicles.
So I would say about a third of the growth would be market and then the balance is us winning new programs and launching new programs.
If we look at that, it seems like you are bumping up against some capacity constraints. Is that incremental growth opportunities slow down a little bit before it ratchets up again? How would you look at that?
Well, it clearly is driven the growth acceleration has kind of forced us to look ahead, and we looked at many options on how to solve that. We decided to build right on the same campus where our Changzhou facility is so we can leverage the management structure and other infrastructure there.
But yes, that’s completely driven by this growth that Mick said, the participation, the business wins that we’re taking on there are really looking positive, obviously those markets and also truck market in China as well that we’re looking for opportunity. So I’d say the continued growth, the percentage growth may not be like it has been the last year or two, but it is still going to be growing double-digit.
And David, it’s not prohibiting or limiting our quote activity or win rate, that’s for sure. I think in the last six months and probably the next six months, the challenge is just - as volumes ramp up in the existing facilities, the conversion and the productivity to keep up with it.
It’s kind of success - we have success for certain customers they kind of open the door for more opportunities so we’re getting more share wallet as well which is really encouraging.
[Operator Instructions] Our next question comes from the line of Matthew Paige of Gabelli. Your line is now open.
You had strong cash flow in the quarter. Does this change your thoughts on your leverage target? Does that go up at all?
No, we’re going to stay disciplined on the leverage, but I think what it does as it builds our confidence in two things. We will continue to look at acquisitions and now we’re getting the balance sheet back in a position where we have I'd say the right to go look at acquisition.
And then secondly, Tom commented on his comments that the Luvata integration has gone quite well with anything you always know where your tough points are and your opportunities. But everything we really set out to do we achieved.
So I think it's a combination of we’re building the cash flow, the balance sheet is in a reasonable position and we had good success with Luvata. So we don't want to go again, we’re going to stay long-term to the 1.5 to 2.5 leverage ratio. But if the right opportunity came, I think we would look at it again like we did with Luvata for a temporary spike with a strong commitment to get it quickly back under our target ratio.
And then I guess maybe along those lines could you provide a little color into your M&A pipeline? What areas are you looking to expand? And have you seen reasonable valuation multiples? Kind of along those lines.
Yes, so we set up an office - a new function of strategy and business development office and manned that up on a search that’s looking through key markets. As I mentioned in my comments that our focus is on diversification as to keep that momentum going. Right now we’re at a 60/40 split between vehicular and what we call industrial. We see the benefits of that, we think that improving that ratio to more parity between the two is a way to go because of again diversification with the solid focus on our core technical strength of thermal management gives us a lots of advantages both on earnings, quality of earnings, capital - intensity being less and again more diversification across markets and customer.
So look for us to be spending a lot of time in an industrial space which could - and we’re seeing opportunities and clearly we’re going to be shopping wisely.
And it took us - we talked quite few quarters about maybe a year or more about before we announced Luvata and valuations that really depends on each opportunity and there are some that are going to be quite reasonable and fit well with our competencies. And then there will be ones like we had before Luvata that we won't participate or we’ll pass either the multiples goes up or we don't see the synergy benefits to justify the cost.
So really answer will be it really depends on the particular company we’re talking about.
All right. And then one more question from me. Through the presentation it seems like you are forecasting continued end market improvements and you noted some expected margin expansion. How much conservatism is baked into your EPS guidance?
Well it will be CFO talking here. We stretched the team really hard and we always try to go forward with the shareholders and we always tried to deliver guidance that is right in line with what we’re pushing the teams for. With the metal’s headwinds this year and all of the volume launches, we really have pushed the teams hard. So I will leave it at, I don't think you ever have any management - no management team is ever going to say we can’t hit the numbers so they are sandbagged.
But I think we're trying to build an expectation with all of you that we're coming right down the middle in this year’s - the lever where we really pushed hard to deliver another year of strong growth and there is a lot of work to do to hit those numbers.
I'm showing no further questions at this time. I would now like to turn the conference back to Kathy Powers.
Thank you. Thank you for joining us this morning. A replay of this call will be available through our website in about two hours. We hope you have a great day.
Ladies and gentlemen, thank you for participating in today's conference. This does conclude our presentation. And you may all disconnect. Everyone have a great day.