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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 2019 Earnings Conference Call. [Operator Instructions] As a reminder, this call is being recorded.
Now I would now like to turn the conference over to your host, Ms. Kathy Powers, Vice President, Treasurer, Investor Relations and Tax.
Good morning and thank you for joining our conference call to discuss Modine's fourth quarter fiscal 2019 results. I am 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 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. This morning, Tom and Mick will present our fourth quarter and full-year results for fiscal '19 and will provide our outlook for fiscal '20. 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 is my pleasure to turn the call over to Tom Burke.
Thank you, Kathy, and good morning, everyone. We finished fiscal 2019 with a strong quarter in our industrial businesses capping our second year in a row of record sales and earnings. As a matter of fact, since announcing our SDG strategy in fiscal 2016, sales have increased 63%, adjusted operating income increased 110% and our industrial businesses now make up 40% of total sales. Further, we're focused on accelerating our transformation to become a higher performing and more industrial company.
Looking at the fourth quarter, sales increased 3% on a constant currency basis, driven by strong growth in our building HVAC segment. Our fourth quarter adjusted operating income was $35 million fairly flat from the prior-year. Strong performances in the CIS and Building HVAC segments were unfortunately offset by challenges in the VTS segment. Material costs have continued to have a negative impact on margins in our VTS segment due to the direct and indirect impact of tariffs on our raw material purchases. Overall, fiscal 2019 was a very successful year for Modine.
We reported another solid year of revenue and earnings growth despite the significant headwinds resulting from a negative impact of tariffs on our vehicular business. Fiscal 2019 sales increased 7% on a constant currency basis and adjusted operating income of $132 million, increased 10% from the prior year. Overall, I couldn’t be happier with the industrial side of the business and I’m excited about our future, especially as we complete the strategic review of our automotive business that was announced early in the fourth quarter.
I’m pleased to report that we’ve made significant progress and we will provide additional details after Mick reviews our fourth quarter results and our outlook for fiscal 2020.
Turning to Page 5. Sales for the VTS segment were down 5% from the prior year, but were slightly higher on a constant currency basis. Growth in sales to commercial vehicle customers in the Americas region and higher sales to the off-highway and automotive customers in Asia were offset by lower automotive sales in the Americas and lower sales in Europe.
Adjusted operating income for the VTS segment was $20 million for the quarter, which was $9 million lower than the prior year. Adjusted operating margin was down 210 basis points to 5.9%. Throughout fiscal 2019, the margins in our VTS segment were negatively impacted by the direct and indirect impact of tariffs on our raw material cost.
As mentioned last quarter, some of our suppliers are leveraging the imbalance of supply and demand created by tariffs and have increased our fabrication cost by more than 20%. In one specific case, a major supplier decided to exit the heat exchanger business altogether. We’ve worked diligently during the quarter to resource the supply in order to continue meet our customer demand, which has increased our cost.
We're also working to offset the direct cost of tariffs by negotiating cost sharing agreements with our key customers. While it's hard to predict how quickly we can recover these costs, we did reach cost sharing agreements with several customers this quarter and we will be able to recover a portion of our cost moving forward. The situation remains somewhat fluid, but we’re working diligently to service our customers and mitigate some of the supply chain volatility and cost pressure.
Please turn to Page 6. Sales for our CIS segment decreased 2% from the prior year, but increased 2% on a constant currency basis, primarily due to a 9% increase in sales to data center customers. The segment reported adjusted operating income of $14 million, up 17% from the prior year. The adjusted operating margin was up 130 basis points year-over-year to 8%. This improvement was driven by higher sales volume and favorable mix.
The sale of coolers into the data center market continues to drive benefit for our CIS segment. This has been a strong market for us this fiscal year and we expect this market to remain strong in fiscal 2020.
Please turn to Page 7. Sales for our Building HVAC segment increased 21% or 25% on a constant currency basis, driven primarily by a very strong performance by our U.K business. Adjusted operating income increased 79% from the prior year to $6 million and adjusted operating margin increased 360 basis points to 11.2%. This increase was driven by higher sales volume and lower SG&A expenses.
This was an exceptionally strong quarter for sales of air-conditioning products in our U.K business. We've been winning significant new business for both precision cooling products and chillers in the U.K and are now seeing the benefit of these wins in our results.
With that, I would like to turn over to Mick for an overview of our consolidated results and to provide our outlook for fiscal 2020.
Thanks, Tom, and good morning, everyone. Please turn to Slide 9. Fourth quarter sales decreased $10 million or 2% largely due to a negative FX impact of $25 million. On a constant currency basis, sales were up 3%. Gross profit of $92 million was slightly lower by 5% resulting in a gross margin of 16.4%. CIS and Building HVAC had strong gross margins in the quarter. On the VTS side, we incurred a sizable decrease in gross margin due primarily to flat sales, combined with the negative impact of tariffs and tariff related costs. In addition, VTS experienced higher labor and warranty cost in the quarter compared to the prior year.
To help offset the volume and material cost challenges, we were extremely focused on SG&A costs, which were relatively flat in the quarter. The $64 million of SG&A costs included $6 million of consulting and advisory fees related to the automotive business review and $1 million for environmental charges. Excluding these items, SG&A was down significantly.
Adjusted operating income was $34.6 million, which was relatively flat to the prior-year. As Tom reviewed, the earnings growth in CIS and Building HVAC was offset by the decline in VTS. The appendix includes an itemized list of adjustments and a full reconciliation to our U.S GAAP results. These adjustments totaled $16.1 million and pertain to restructuring expenses, strategy consulting fees and environmental charges related to previously owned manufacturing facilities.
The restructuring expenses are mostly severance costs at a European manufacturing location. I also want to point out that we recorded $4.2 million of income tax expense, which is significantly higher than the prior year. Our adjusted effective tax rate was 23% compared to 16% for the same period in the prior year.
As we previously discussed over the last year, the lower adjusted tax rate in the prior year was due to a development credit in Hungary. Our adjusted earnings per share was $0.40, which is down $0.04 or 9% from the prior year due to the higher tax rate.
Turning to Slide 10. Fiscal '19 operating cash flow was a $103 million and our free cash flow was $29 million. As I explained in previous calls, this year's cash flow was negatively impacted by a number of items, including higher incentive compensation payments and working capital levels. In particular, we’ve been carrying higher inventory levels primarily due to program launches and the impact of tariffs on our domestic supply of materials along with preparing for potential Brexit issues.
I would also like to note that our free cash flow of $29 million included the negative impact of about $17 million of cash payments, primarily related to restructuring activities. Finally, our net debt decreased $32 million during the year and our leverage ratio was 2.1, which is within our target range of 1.5 to 2.5.
Now let's turn to our fiscal 2020 guidance on Slide 11. I'm pleased to report that we're currently forecasting another year of earnings growth, despite some challenging market. To summarize our fiscal '20 guidance, we project sales to be flat to up 5%. First, we expect the strong growth to continue in our Building HVAC segment.
Next with regards to CIS, we're expecting a more moderate level of growth this year due to leveling off of data center sales combined with a negative foreign currency impact. Last, we anticipate lower growth in our VTS markets and we expect sales will be flat to down versus the prior year, the largest challenges in Europe due to a slowing automotive market and the continued wind down on certain commercial vehicle programs.
We expect continued growth in Asia and for the Americas region to be generally flat. We anticipate earnings growth in all three segments with adjusted operating income to be in the range of $135 million to $145 million. This equates to a year-over-year growth rate of 2% to 10%.
With regards to other key assumptions, we expect annual interest expense of approximately $21 million and we expect our adjusted tax rate to be approximately 25% in fiscal '20 compared to 20% in fiscal '19. Based on the expected tax rate, we anticipate our adjusted EPS to be between $1.55 and $1.70.
Before wrapping up, I want to run through how we see quarterly earnings and the overall run rate for the year. With regards to the first half of the year, we're expecting some significant challenges, which will result in difficult comparisons, especially in the first quarter. One of the main drivers is that we're expecting a very weak first quarter on both the top and the bottom line from VTS as compared to the prior year.
In addition to lower volumes, we expect the margins of this business to be in line with the most recent quarters, reflecting the significant impact of tariffs and the increase in our domestic fabrication cost that Tom mentioned earlier. We expect the CIS segment to have lower revenue year-over-year in the first half, primarily due to a very robust data center sales in fiscal 2019. The second half will be more favorable on easier comparisons and projections for orders ramping up later in the year.
Lastly, I want to point out that our full-year outlook fully includes our automotive business. If a transaction is completed this fiscal year, it will obviously have an impact on our fiscal '20 financial results. Once we’ve certainty regarding the outcome, deal, details and timing, we will address this further.
Before passing back to Tom, I would summarize by saying we're pleased to report another record year in fiscal '19, and anticipate additional growth in earnings and cash flow in fiscal '20. I look forward to reporting our results throughout fiscal 2020.
With that, Tom, I will turn it back to you.
Thanks, Mick. Please turn to Slide 12. As I said at the beginning of the call, fiscal 2019 was another success year for Modine. Few years ago we laid the groundwork for our Strengthen, Diversify and Growth strategy, which has led us to we’re today, a stronger more diversified thermal management company. Although we’ve clearly made great progress, we are not at the end of this journey.
We will continue to improve our business and our competitive position moving forward with strategic actions. This includes the strategic review of the automotive business that we announced early in the fourth quarter, which has progressed significantly.
The history of Modine is tied to the automobile, from supplying radiators for the Model T to providing battery chillers for electric vehicles, automotive sales have always been a significant portion of our business. However, this market has changed and is fundamentally different from our other vehicular end markets and from our industrial businesses. The level of capital investment required to remain competitive significantly hampers our returns in this segment.
As I've discussed before, Modine's automotive business has a lot of positive aspects. We have a fantastic brand name and IP portfolio. In addition, we're a leader in engine cooling, leading to a lot of development work and new business on electric vehicles. However, in reviewing the market dynamics and our corporate strategy, we believe that the value of this business may be maximized through another owner.
The automotive business is approximately 25% of our revenues, representing more than $500 million. Although we don't report margins by customer end market, the margins on total auto sales are lower than margins in VTS segment as a whole. In addition, the automotive industry is significantly more capital intensive than our other end markets. In fact, 40% to 50% of our total CapEx is generally spent on automotive programs in a given year.
We’ve made significant progress on our strategic evaluation of our automotive business and are moving forward with the sale process. As you can imagine, the car route and separation will be extremely complicated given the size and scale of the business. Although some of our manufacturing facilities are dedicated to automotive sales, others are co-mingled. In some cases, we’ve multiple buildings on our manufacturing campus where the automotive programs can be concentrated in one building. This separation will be complex, but our teams are working on a comprehensive plan.
Currently our VTS segment has 18 manufacturing locations and we anticipate the separation of the auto business would include approximate 10 of these locations. So far we are pleased with the level of interest in this business and are confident in the process, we cannot guarantee any particular outcome, but are committed to complete the process as quickly as possible by still taking the steps necessary to maximize value for our shareholders.
If the process is successful, Modine will look quite different. It will be temporally smaller from a revenue standpoint, but would have improved operating margins. Our overall capital expenditures would decrease and free cash flow would increase significantly, resulting in higher return on capital. We will maintain a balanced approach to capital allocation. We will consider a number of options for the use of the proceeds. We will continue to invest organically in our growing platforms, manage our balance sheet through the repayment of debt and opportunistically consider share repurchases are other ways to return cash to shareholders as appropriate.
In addition, we will continue to look for accretive acquisitions that would further grow our industrial businesses in markets where Modine maintains industry-leading positions and/or other adjacent opportunities. We see this as a key component of future growth. It is clear that Modine's performance in our industrial markets as well as our off-highway and commercial vehicle markets within VTS are performing well. And the goal of our strategic review of the automotive business is to increase returns and drive shareholder value.
We believe that a future focus on these markets is the best option for the company and our shareholders. Once complete, we expect Modine to emerge as even a stronger, more diversified industrial thermal management company. Since announcing SDG platform in October of 2015, Modine's market cap has increased by 85%. We're confident and excited that even more shareholder value will be created with this next phase as we are further able to demonstrate the potential of our industrial businesses.
With that, we would like to take your questions.
[Operator Instructions] And our first question is from the line of David Leiker from Baird. Go ahead please. Your line is open.
Hi. Good morning. This is Joe Vruwink for David.
Hi, Joe.
I was wondering if we could do a bit of a retrospective on fiscal 2019. So you ended up generating $132 million in EBITDA guidance started the year at $135 million to $145 million. But in thinking about bridging those two numbers, there was a much more substantial material cost headwind that arose as fiscal '19 went on. Can you quantify what that ultimately ended up being and then discuss some of the actions in Modine's control operational actions that allow you to mitigate that impact?
Yes. Hey, Joe, it's Mick. I will kind of take a stab at the material cost impacts and then let Tom comment on the operations side. So in fiscal '19 it was the combination just as a reminder of several items for often I think others. The first was the direct impact of the tariffs and net of any recovery that we got from customers that was about $2 million approximately. In addition, the tariffs started to create some cost challenges and Thomas talked about in the past, particularly with one or two domestic suppliers that increase prices towards the end of the calendar year that had a net impact of about another million. And then while the LME was the -- the underlying metals, were only up about 4% or 5% last year. The transaction premium on aluminum more than doubled, it's up about a 115% and that was about a $5 million impact. So from where we started the year, where we finished, at least $8 million of material cost increase that we needed to absorb or try to step -- offset from the operation standpoint.
Yes, from other actions, clearly CIS and Building HVAC over performed versus the plan where we started the year. So again it was a demonstration of being the diversified focus if we could leverage that growth and convert that effectively. Our procurement team did a fantastic job on over performing last year as well on the -- beating our expectations for our budgeted amounts for procurement savings by a significant amount. And then as you know we dug ourselves into a hole coming into the year with launches specifically one plant in China, one plant in North America, where we had significant launch ramp up activity kind of 24/7 type of coverage that we had to offset as well at the beginning of the year we made progress through the year, significant progress, I’m pleased to say that we are back nearly where we should be. Specifically in China, feel very strong where we’re at our plant near Shanghai. It’s operating at -- with KPIs at our expected level. And in North America, again, with a lot of change focus and discipline we’ve got the trend reversed there going in the right direction. So, let's say, CIS, Building HVAC offsetting some of those challenges that Mick described, procurement effectiveness with what we've invested in, with resource and talent and then turning starting at the momentum turned around towards the end of the year to help us get back as well.
And then -- that was helpful. Can we have a similar conversation just in terms of what's contemplated in the 2020 outlook. It sounds like vehicular operationally should be better in 2020 relative to 2019. Unfortunately it seems like later in the year we’re going to see a receding in volumes from some of the commercial vehicle and off-highway markets really if that’s a possibility, so maybe cyclically you're dealing with new pressures in vehicular. Do you think that's pretty much contemplated and could CIS and HVAC be the offset again, so you feel -- it's always tough to call, but you feel like the 135 to 145 range, ultimately that includes some buffer in the projection?
Yes. Joe, it's Mick. Yes, I think we will run through that. There's a lot there you covered, but its good. Just kind of lay it out as we see it. So back to VTS, yes, I think we see the same market dynamics you guys are seeing the challenge -- biggest challenge in the VTS area right now is not seeing that market lift from a volume standpoint. We do have the full-year impact of the tariffs, the direct and indirect tariffs. So while operations is improving in a normal year, we like to see some margin improvement and you'd expect to see that the tariff will be about an incremental $7 million or so cost to us as we go to the full-year impact of the direct and indirect tariff. The actual traditional metal exchange numbers are neutral to slightly positive for us this year. So the biggest headwind is lower volume and the tariff impact. And then from the other side, we will continue -- we ended Q4 obviously really strong on the Building HVAC side and across all of our markets. The indications are we're off to a really strong start and we feel good about the run rate heading into the year on Building HVAC both in the U.S and in the U.K and in Europe. From a CIS standpoint, we've got first half of the year probably a little bit more difficult comps. We have record level sales of data center business last year. We are expecting the second half and good indications from our markets and customers about some pickup in the second half of the year from a CIS standpoint. So, I guess, before I turn it back to Tom, the way I’m thinking about it is a little bit tougher comps from the CIS standpoint, but we feel like the dynamics and the markets there and data centers globally. Building HVAC seems to have a tailwind as we head into this year, when we think about whether its cushion or just comfort, that’s feeling good. And then biggest challenge we have is more flat markets on VTS combined with tariffs that we need to find a way to offset. Tom, would you add anything?
Yes, I think you said it right. I -- about 180 maybe a little bit higher of our sales now are directly tied to data centers. That’s with the whole megatrend on digitalization. Really pleased that we have some really good engagement both in North America and onto the U.K with those two businesses that we want to make sure that we take advantage of and grow when we see good indications as Mick said in both regions that continuing this year. We will continue to focus on our procurement efficiency, which again I’m very pleased with, and I expect productivity to be gaining in VTS significantly this year, so to be offset to some of those challenge that Mick laid out. So I think that’s the best summary we can put together for that.
Okay, great. Specifically on HVAC, based on lot of your commentary, it seems like the share gains that took place in fiscal '19 that that’s sticking based on the order book and you’re maybe continuing to grow market share. Is that a fair characterization of what's happening in that business?
Yes, we definitely gained market share in fiscal '19 over '18, which was also strong year specifically on heating. And we’re really seeing that pick up on U.K from a precision cooling and chillers standpoint as well, where we are gaining a share in those regions with the data center business and the related products there. So, moving forward, we have a heavy focus on continuing with that, on concentrating on regions where we see share gain possible in North America as well as capitalizing on potential transatlantic opportunities that may develop from chiller and chiller sales from U.K needed in the U.S by certain customers. So, again, really good momentum across all segments within -- all sub-segments within Building HVAC.
And so thinking of the trend for that business when you start to compare against 15%, 20% revenue growth in the second half of 2020. If you're maintaining that market share, even though of course there is probably growth moderation, would you expect to be down year-on-year? It doesn't sound like if you maintain market share and you’re continuing to grow, you would necessarily be down?
Yes, we think we will up slightly maybe not quite the jump that we had last year to your point because of the share gain and we have that same look forward, but we expect to be up.
Okay, great. And then my last question, more of a housekeeping item. How much of commercial vehicle business is still left to roll off in Europe?
Yes, Europe and there's a little bit in the U.S on service approximately $40 million, Joe, in fiscal '20.
And that is …
Go ahead.
No, sorry. Go ahead, Tom.
I was just going to say, and of course, we’ve some new model launches that are starting to prepare for North America with recent business wins and good quote activity still going on with European customer. So I -- yes, this is going to be a roll off year this year yet, net roll off, but yet with gains coming in behind it.
Okay, great. I will get back in queue. I might have another one, but I wanted to turn it over to someone else. So thanks very much.
Joe, you’re actually I think the only one in queue right now. So if you have other questions, why don’t you keep going?
Okay. If you humor me with one more, my two last question. On the automotive business, so you've obviously communicated this to the market. I would imagine you are having conversations with customers, what has been the feedback on the decision? Is it having any ramifications on bookings activity that might influence ultimately the value you are able to get for the business? And then, any spillover effects to what Modine ultimately intends to retain in the VTS segment?
Well, let me handle the first part and I will make sure I understand the second part later. So the first part is, yes, we are in discussion with customers, and obviously they are very curious as to how this is going to proceed. Clearly they’re staying close, nobody is necessarily taking us off any supplier platforms. But I would, say we are kind of in close watch. It will -- and we think that there's a prospective buyers that could add value with this valuable asset that we have as they think of subsystem integration and being able to put that together with maybe people are thinking of diving into thermal management. So still I think it's just like a close watch and not really being -- not hampering this at the moment, but one that we stay in close contact with customers. And what was your second part of the question, Joe?
I think -- yes. I think you’ve been very transparent and explicit about what you intend to retain in VTS and the fact that you’re fully committed to commercial vehicle off-highway?
Great point. Yes, I was thinking clearly from an automotive customer standpoint. On the commercial vehicle off-highway side, very positive feedback from customers. I personally visited several and make sure it's clear that our focus is to be able to do this to give us more resource capability, whether it's capital or human resource, to focus in on not just the industrial portion of the business, but we think the off-highway commercial vehicle tucks in very nicely within industrial business. I want to make sure they saw that, there's a long-term strategy we have. So very positive feedback from truck and off-highway customers.
Okay, great. I appreciate your time. Thank you very much.
Thank you.
[Operator Instructions] And I'm showing no further questions at this time. I would now like to turn the conference back to Kathy Powers.
Thank you and thank you for joining us this morning. A replay of this call will be available through our website in about two hours. We hope that you have a great day.
This concludes today’s conference. You may now disconnect.