Modine Manufacturing Company (NYSE:MOD) Q2 2024 Earnings Call Transcript

Modine Manufacturing Company (NYSE:MOD) Q2 2024 Earnings Call Transcript November 3, 2023

Kathy Powers: Good morning, and thank you for joining our conference call to discuss Modine’s Second Quarter Fiscal 2024 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’ll be using slides with today’s presentation, which can be accessed either through the webcast link or by accessing the PDF file posted on the Investor Relations section of our website, modine.com. On Slide 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. With that, it’s my pleasure to turn the call over to Neil.

Neil Brinker: Thank you, Kathy, and good morning, everyone. I’m pleased to report another strong quarter with both solid revenue growth and earnings improvements that came in ahead of our expectations. Sales increased 7% from the prior year, driven by increases in both the Climate Solutions and Performance Technologies segment. In addition, we reported adjusted EBITDA of $81.2 million, an increase of 59% from the prior year. EBITDA margin was 13.1%, a 430-basis point improvement from the prior year. As a reminder, last year we set a goal to significantly improve our EBITDA margins, targeting a range of 10% to 12% by the end of the fiscal year, and reaching 13% to 15% range by the end of fiscal 2027. We are clearly ahead of these targets, driven by a combination of key factors, including using 80/20 principles to guide decision-making throughout the organization, allocating additional resources to targeted higher-margin businesses, and focusing on the value we bring to our customers and leveraging that to drive margin improvement and profitable growth.

I’m very proud of what the organization has been able to accomplish in a short period of time. I continue to believe that we remain in the early stages of our transformation as we see medium to long-term opportunities for sustainable growth that will continue to improve our financial profile. Please turn to Slide 5. The Climate Solutions segment delivered an excellent quarter with revenue of 8% from the prior year. We are benefiting from the planned diversification of our businesses, as strong growth in the data center vertical is helping offset some weaknesses in the other HVAC markets. The segment reported adjusted EBITDA of $50.4 million, a 31% increase from the prior year. This resulted in an adjusted EBITDA margin of 18.3%, up 330 basis points from the prior year.

Revenues in our data center business were $79 million, more than double the prior year. Our order intake continues to grow. That said, this business can be quite lumpy due to the timing of product shipments on large data center projects. So we’re not expecting growth to continue at a linear rate. We have projected a dip in the third quarter data center volume since the beginning of the year, and then expect volumes to pick up again in Q4. We have significant backlog to work through over the next 12 months to 18 months, which should provide some stability in the business despite the quarter-to-quarter fluctuation in revenues. Our commercial team continues to win orders with key relationships in our pipeline and add new opportunities to the sales funnel as we evaluate and develop high-quality prospects.

Our goal is not to be a high-volume products part of the data center market. Instead, we’re focusing on relationships with key customers, supporting them with system solutions and ongoing services as they grow globally. This includes new and existing customers that value our engineering and service model. We have great products in the space and the expertise to advance the technology to address the higher heat loads that will be required in the future. For example, we are internally developing a cooling distribution unit or CDU. A CDU is integral to liquid cooling, providing critical cooling capacity and heat removal for high-density data center environments. The CDU offers controlled contaminant-free coolant for heat exchangers, direct-to-chip, and immersion cooling devices, integrating between the server and the external heat rejection.

The CDU will further strengthen our global data center systems offering, as we’ll be able to offer hybrid, liquid, and air-cooled systems. Our CDU is being developed with the full voice of the customer and is planned to be commercialized early next year. This marks our first dedicated development into liquid cooling systems. In addition, we are also working on other advanced technologies and our product roadmaps, so we can continue to provide our data center customers with efficient, connected systems, elevating their performance, while helping them meet their sustainability targets around power and water usage. Moving to our HVAC&R businesses, we recently announced the expansion of our electrical heating line with two new product launches.

Our new electric infrared line provides a low-emissions heating product that can be used in a wide variety of commercial and residential applications. In addition, our new AmpDawg is the electric version of our popular Hot Dawg line of residential garage and workshop heaters. This line provides an electric alternative with the same quality and performance that Modine is known for. These are just a few examples of our product development efforts and there are more to come. Regarding heat pumps, earlier this year we announced our plans to expand capacity at our plant in Serbia in response to the strong order intake from heat pump customers. Growth expectations for the heat pump market have been fueled by regulations driving a conversion from natural gas to electric to increase the use of renewable energy.

Recently, the enforcement date of these regulations has been delayed, specifically in the German market, where the adoption date was pushed from 2027 to 2029. This has resulted in a reduction of our forecast based on the latest information from our customers. We’re still planning on growth but expect lower growth in the near-term while we adjust our overall production ramp. We still believe that this is an important market for Modine and are nearing completion of the first phase of our Serbian plant expansion. We had planned the investment in phases so that we could bring on the necessary production capacity as needed. This is providing us with the flexibility to respond to regulatory changes like these and allows us to take more measured approach to our investment.

We will continue to monitor this market along with regulatory drivers that are creating this volatility. And our Climate Solutions business is having an incredible year, and I’m very proud of what we’ve been able to accomplish. We are investing in new products and technologies now to make sure we can continue to have profitable growth in the future. Please turn to Slide 6. The Performance Technologies segment also delivered excellent results this quarter, with revenue up 7% from the prior year, driven by off-highway commercial vehicle and specialty vehicle customers. Adjusted EBITDA increased 73% to $42 million, resulting in an adjusted EBITDA margin of 11.9%, an improvement of 450 basis points. Similar to last quarter, much of the increase was due to improving commercial terms in our long-term contracts, including some additional retroactive recovery.

The PT business made a couple of important announcements this quarter that I would like to highlight as a prime example of our 80/20 work. First, we announced the divestiture of three businesses in Germany that produce products for internal combustion diesel and gasoline engines for the European automotive market. I’m pleased to report that this transaction closed on October 31. We have been very clear with our intention to exit non-strategic businesses, and these divestitures are firm actions towards that goal. We will continue to pivot our resources towards strategic, high-growth businesses, and will quickly exit or wind down business that is not meeting our margin targets. Many of these actions have already been identified and are underway.

As a reminder, exiting lower-margin businesses is a critical element of 80/20 as we remain focused on the earnings growth over revenue growth. We have anticipated this as part of our transformation strategy in the PT segment, understanding that it could initially result in lower revenue. However, we also have plans for growth in our EV systems and GenSet businesses that will replace the businesses we are exiting with product profiles aligned with our long-term goals. This is all part of the 80/20 process. In addition, as we exit certain businesses, we need to examine our cost structure to make sure that it’s appropriate for the size of the business. There could be some additional costs as we realign our manufacturing footprint. One of the businesses where we’re investing is our EV Systems business.

Last month, we announced our plans to expand production of our EVantage Thermal Management Systems to Europe. Beginning next year, we’ll produce battery thermal management systems and electronic cooling packages for our European customers at our plant in Pontevico, Italy. This is in addition to our existing product lines in Lawrenceburg, Tennessee, where we are in the process of adding additional capacity to accommodate increased volumes as we launch more programs. Overall, our Performance Technologies segment is firmly on track, and I’m proud of the work being done by this team. Material costs continue to be favorable, and we have had significant success negotiating contractual improvements. We’re making great progress on the 80/20 journey in the segment, focusing the organization on both capitalizing on growth opportunities and optimizing non-strategic product lines.

Now I’d like to turn the call over to Mick, who will review our results for the quarter and provide segment financial updates.

Mick Lucareli: Thanks, Neil, and good morning, everyone. Please turn to Slide 7 to review the segment results. Climate Solutions had another excellent quarter with a 31% increase in adjusted EBITDA. Revenue grew 8%, including a $7 million favorable FX impact. The growth was driven by data center increasing 117% or $43 million. We continue to see strong demand for our products in North America and Europe, including those supporting both hyperscale and co-location customers. As Neil mentioned, the timing of these sales can be somewhat unpredictable, and shipments in the quarter once again exceeded our expectations. Based on the timing of our current customer schedules, we anticipate lower shipments in Q3 than ramping significantly in Q4.

I want to highlight that while the timing can be hard to predict between quarters, our full year outlook has not changed, with growth expected to exceed 60%. HVAC&R sales were down 2% or $2 million. The heating market remains soft but has improved sequentially from Q1. We expect to see further rebound as we enter the heating season, but the weather will ultimately factor into the strength of our sales for the balance of the year. Sales of heat transfer products decreased 16%, or $21 million. As discussed in previous quarters, we’ve experienced a decline in market demand with commercial refrigeration, along with commercial and residential HVAC&R customers. We believe many customers are continuing to work down excess inventory that was created during the previous supply chain shortage.

Additionally, we’ve continued 80/20 product rationalization activities to drive further margin improvements. We’re pleased with the strong earnings conversion as adjusted EBITDA increased 31% with a 330 basis point margin improvement to 18.3%. The earnings and margin improvements were driven by higher sales volume and benefits from ongoing 80/20 initiatives. Climate Solutions clearly had a very strong first half of the year. The growth in data center sales was driven by a favorable market along with the investments we made to grow this business. With regards to HVAC&R and heat transfer products, we’re still maintaining a cautious outlook for the second half of the year. Given our assumptions on the heating market and the lighter data center shipments in Q3, we would expect sequentially lower earnings in Q3, then close out the year with a strong Q4.

To wrap up on Climate Solutions, we’re remaining cautious in a few key markets, but fully anticipate further year-over-year improvements in the next two quarters to wrap up another great year. Please turn to Slide 8. Performance Technologies also had a great quarter with 7% sales growth, including an $8 million favorable FX impact. Revenue benefited from 80/20 initiatives as we continue to focus on higher margin businesses. While underlying sales volume declined by $5 million or 2%, the average selling price per unit was higher. As a reminder 80/20 efforts in Performance Technologies are focused on driving rapid earnings growth and not revenue growth. Therefore, we expect to see earnings growth at a more rapid rate than overall sales volume.

Advanced Solutions sales were up 30% or $10 million with continued growth of our EV Systems and component sales along with higher sales to specialty vehicle and coatings customers. Liquid cooled application sales increased 6% or $7 million due to higher demand from our commercial vehicle customers along with benefits from 80/20 initiatives. Lastly air-cooled application sales increased 2% or $4 million primarily due to higher sales to off-highway and genset customers, along with gains from 80/20 initiatives. Performance Technologies’ earnings conversion was excellent, with adjusted EBITDA of 73%, resulting in an 11.9% margin and a 450 basis point improvement. Similar to the previous quarter, earnings temporarily benefited from several million dollars of retroactive payments that may not repeat in future quarters.

As Neil mentioned, we’re pleased to report that the divestiture of three businesses in Germany was completed on October 31. As previously disclosed, the annual revenue impact from these businesses is approximately $80 million to $90 million and will result in a revenue reduction the second half of this fiscal year. While these divestitures represent lower margin and non-strategic business, we’re reviewing action plans to further align our cost structure to the lower revenue. We anticipate that these plans will be launched in Q3, with savings to begin in Q4. We did not experience any material impact from the UAW strike, but expect that some of our major OE customers may take extended holiday shutdowns this year. Based on all of these factors for the balance of the year, we anticipate ongoing 80/20 progress and further year-over-year improvements, with a sequential dip in earnings in Q3 and a step up again in Q4.

And on a full-year basis, we expect Performance Technologies will report another excellent year and be within our targeted margin range. Now let’s review the total company results. Please turn to Slide 9. First quarter sales were up 7% or $42 million, including a $15 million favorable FX impact. As previously discussed, the higher revenue was driven by growth in both business segments. The gross margin improved 520 basis points, primarily driven by increases in volume, higher average selling prices, and numerous other improvements tied to our 80/20 initiatives. SG&A increased $10 million, driven primarily by higher employee compensation expenses, including incentive comp and higher product development costs. I’m happy to report that adjusted EBITDA was very strong in the quarter with an increase of 59% or $30 million.

This equates to an adjusted EBITDA margin of 13.1% and a 430-basis point improvement from the prior year. This also represents the seventh consecutive quarter of year-over-year margin improvement. In addition, adjusted earnings per share was $0.89 and 85% higher than the prior year. Before moving to the balance sheet, I’d like to reiterate that we’re pleased with the exceptional performance in the quarter, and there were a few areas that were better than expected. First, our shipments of data center products were somewhat stronger than expected with a little pull forward from Q3. Second, we had some additional benefits in the quarter for Performance Technologies, including favorable material ratios and product mix. And as I mentioned on the previous slide, we also benefited from some commercial negotiations and settlements.

While maintaining a cautious view for the second half, we’re again raising our earnings outlook based on some of the first-half progress. In a few minutes, I’ll further review how all this will impact our sequential results in the full year guidance. Now moving to cash flow metrics, please turn to Slide 10. We generated $58 million of free cash flow in the second quarter, which is a nice improvement from our first quarter. This puts year-to-date free cash flow at $85 million, which compares very favorably to $33 million generated in the prior year. Net debt of $222 million was $63 million lower than the prior fiscal year end and $43 million lower than the last quarter. Net debt coupled with strong earnings resulted in a leverage ratio of 0.8. During the quarter, we restarted our share repurchase program and purchased 200,000 shares.

As a reminder, our program is currently focused on offsetting the dilutive impact of our share-based incentive compensation program. This fiscal year, we expect continued growth in free cash flow, driven by higher earnings and a continued focus on working capital. We continue to anticipate full-year free cash flow will fall in our targeted range of 3% to 5% of sales. Modine’s balance sheet remains quite strong, which we plan to maintain in the current economic climate and stand ready to support both organic growth and acquisition initiatives. Now let’s turn to Slide 11 for our fiscal 2024 outlook. As announced in the press release, we’re raising our full year earnings outlook for fiscal 2024. The second quarter exceeded our expectations, leading to another increase in our profitability outlook for the fiscal year.

In the Climate Solutions segment, we continue to expect data center revenue growth of 60% to 70%. Moving to HVAC&R, we expect modest revenue growth in the low single digits, maintaining the range from last quarter as we remain cautious and approach the prime heating season. With regards to heat transfer products, we now anticipate a sales decline in the mid-single digits, which is a reduction from our previous guidance. This is primarily due to concerns over a general economic slowdown, especially in residential and commercial refrigeration applications, and a slower ramp schedule for the heat pump market. Moving to Performance Technologies. We expect continued benefits from our 80/20 rollout, and now that we’ve completed the German divestitures, we’re adjusting the second half revenue outlook accordingly.

We expect advanced solutions to grow in the 25% to 35% range, which did not change from last quarter. This growth is driven by program launches, continued demand for EV systems and components. We anticipate modest growth for liquid and aircooled products as we implement 80/20 across the segment, including the impact of the divestitures. From an SG&A perspective, we’re anticipating that we’ll finish the full year between $260 million and $270 million, including higher incentive and compensation expenses. Let’s move to adjusted EBITDA. Based on the recent results and market trends, we’re raising our adjusted EBITDA outlook for the year while maintaining a somewhat cautious position with half of the fiscal year left in front of us. We now expect our adjusted fiscal 2024 EBITDA to be in the range of $285 million to $300 million, up from $280 million to $295 million, and representing an increase of 34% to 41% versus the prior year.

Consistent with our previous update, we anticipate that the second half will average approximately $70 million of a quarterly adjusted EBITDA. We expect that Q3 will be sequentially lower based on my previous comments on the business segments with a step up in Q4. The sequential lift in Q4 will be driven by typical seasonal patterns and a strong order book and data centers, advanced thermal solutions, and other key growth businesses. Shifting back to the full year, I want to reaffirm that our full year outlook is well aligned with our transformational earnings and margin targets, and we expect to deliver another year of record results at Modine. In addition, we anticipate that free cash flow will further improve with the higher earnings outlook with capital expenditures expected to be around $70 million.

Other assumptions including interest expense, taxes, depreciation, amortization are included in appendices attached to this presentation and our press release. To wrap up, we’re extremely pleased with the results from the second quarter and our ability to maintain momentum towards our interim and long-term financial targets. As Neil said, we’re in the early stages of our transformation, but the progress has been tremendous. And we have a lot of hard work and opportunity in front of us. With that, Neil and I will take your questions.

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Q&A Session

Operator: Thank you. [Operator Instructions] Our first question comes from Matt Summerville with D.A. Davidson. Please go ahead.

Matt Summerville: Excuse me. Thanks, good morning. I wanted to maybe start with a question on the data center business. The growth cycle you’re in fiscal 2024, what does that suggest about fiscal 2025 in the context of the backlog and order comments you made and what were in the slides here? And then I’m curious if you have any update on customer diversification initiatives within the hyperscale market and any early feedback on the CDU? And then I have a follow-up. Thank you.

Neil Brinker: Do you want to go first on CDU?

Mick Lucareli: Yes, Matt, thank you for the question. Yes, so as you know, we continue to experience growth and we continue to grow the backlog in data centers. A lot of that was driven by the fact that we’ve expanded our ability to manufacture globally. The CapEx investment that we made in our labs and our factories in the United States as well as in Europe to support this growth, to allow us to build the capacity to keep up with this demand that we’re seeing. We’ve been able to expand our product portfolio on the air cooling side as well. An integral piece of this growth was being able to develop and manufacture a chiller in the United States and North American market. So we will continue to expand our product portfolio and data centers, and the next evolution of that is with the CDUs. So these CDUs are going to get us into a different area of the data center to allow us to provide liquid cooling, and that’s the VOC that we’ve collected from both our hyperscaler and colos.

They pivot into more of a liquid cooling approach for areas where they have high heat density and heat loads. They’re leaning on us in order to help them provide that solution. And you know, this isn’t new to us, Matt. We’ve recognized this and we’ve realized this. We actually produced the CDU back in 2016. And, you know, this was before there was a market. And now that we see that there’s favorable trends where we can complement our current product portfolio of cooling products and data centers, adding the CDU piece just makes a lot of sense.

Neil Brinker: Yes, and Matt, on your question about next year, we’re in the middle of our planning process, so a little bit early to give a definitive number for you. But I think the way we thought about it for quite a while is the ability, obviously, to grow 60%, 70% a year is not going to be sustainable over the long-term as the business gets much bigger. But we’ve talked about longer-term growth rates in the 20%, 30% level, maybe even a little bit higher. So still really high. We’d expect very high revenue growth next year, but it won’t continue at a 60%, 70% pace.

Matt Summerville: And then I asked about any progress on hyperscale customer diversification.

Neil Brinker: Yes, we continue to have conversations and advance our conversations there. It takes time. We started the process about 18 months ago, and we’re much further along in line with where we would expect to be. Again, adding our capacity across the globe, having the global manufacturing footprint, increasing our product portfolio with liquid cooling technologies, all is in favor of us being able to continue to advance those conversations with the hypers.

Matt Summerville: Got it. And then, just as a follow-up, as I kind of think about the guidance framework you gave coming out of Q1, thinking about Q2, pretty much everything you just delivered bucked all of that guidance in a good way. And I’m just curious about the go-forward guidance. Have you really seen a step function change in the demand environment? Or are you looking at this saying, macro is a little choppy. There’s a few myths here and there in the business. Geopolitical environment is unfortunate as it is what it is, so to speak. So, maybe some conservatism here is understandable. I’m just trying to sort of more dig at kind of your guidance philosophy as we think about the second half in the setup, given how you performed in 1H?

Mick Lucareli: Yes. Hey, Matt, it’s Mick. I think really fair question. And I think it’s much more of the latter. We’re not seeing a step function change in the business or any level of profitability levels. The latter, which you went through that list of the uncertainties kind of across the market, geopolitical environment, a number of things in a few markets like the heating season coming up. So I know we had thought Q2 would be a little bit of a step down from Q1, and we had another strong quarter. In there is the other thing I guess I’d add, and Neil could add any color, but as we continue to go through this transformation, the amount of complexity that we have in the organization, we’re asking the leaders to manage through businesses that we are divesting product lines we’re exiting, pricing adjustments we’re pushing through growth volumes and timing.

It’s turned out for us in a positive way, the momentum is great, but our ability to predict in one quarter to the next, with that level of accuracy, there’s a large amount of complexity in the company right now. That’s just making it, we’re trying to be cautious of how we project for the next six months. Neil, do you want to add any other color on it?

Neil Brinker: Yes, I mean, when you think about how difficult it is to predict change in a stable environment when we destabilize it, through a lot of our 80/20 activities intentionally for the right thing to do, we’re transforming the company. When you’re in a destabilized mode, we’re changing many, many things all at once. It does become a little bit more difficult to predict. So we’re continuing to manage it the way we do and we want to make sure that we keep consistent with our approach in terms of how we guide.

Matt Summerville: Great. Thanks, guys.

Operator: Thank you. Our next question is from Chris Moore with CJS Securities. Please go ahead.

Chris Moore: Hey, good morning, guys. Thanks for taking a couple of questions. Maybe I’ll just start with a quick follow-up on the data center side. The current backlog, is that all air cooling technology?

Neil Brinker: Correct.

Chris Moore: Got you. And the time frame on the CDU development, is that a couple of years? What does that look like?

Neil Brinker: Great question, Chris. We expect to have the ability to commercialize that in the beginning of next year. And it’ll grow at the rate that we see, or we potentially could predict the market adoption of this. So it’s a nice compliment in terms of what we’re doing on the air cooling side. We’ve got multiple technologies here with the CDU. We can do liquid to liquid, we can do air to liquid. There’s just different ways to solve for the challenges that our customers see. So we’re going to be able to move and deploy product at the rate that they rate that they see that growth inside of the data centers that support high density hilos.

Chris Moore: Got it. Very helpful. Does the competitive landscape change much as you move on to the liquid cooling side?

Neil Brinker: It’s a natural extension of what we do. The competitive landscape is similar. The technologies are different. Some of our competitors have partnered with some companies that have this technology and they position themselves well with joint ventures and other things, but it’s similar space. We’re familiar with it. We’ve been waiting for the time to make this investment when we actually start to see this market start to stabilize and has the potential to grow. Like I said earlier, we’ve developed CDUs in the past. We did this six years ago. There just wasn’t a market for it. So we believe the time is right.