niphon
Investment Thesis
Modine Manufacturing Company (NYSE:MOD) has outperformed the S&P 500 (SPY) since our last article and has gained ~50%. The company is experiencing healthy demand from its end markets, which has led to a strong order book. Along with this, the pricing actions taken by the company to offset the inflationary cost pressures are supporting revenue growth. Modine has been expanding its distributors’ network and developing new products to position itself to benefit from the grant passed by the U.S. government to improve air quality at schools. The company recently laid out its multi-phase transformation program to grow its revenue and improve its margin. This program focuses on implementing the 80/20 strategy, geographic expansion, and M&As.
MOD’s Q1 FY23 Earnings
Modine recently reported better than expected first quarter FY23 financial results. The net sales in the quarter grew 9.4% Y/Y to $541 mn (vs. the consensus estimate of $494.1 mn). The adjusted EPS in the quarter was up 60% Y/Y to $0.32 (vs. the consensus estimate of $0.12). The sales growth was driven by strong double-digit growth in the Climate Solutions segment, partially offset by unfavorable currency translation of 5.6%. The adjusted EBITDA margin in the quarter was up 110 bps Y/Y to 7.8% due to higher sales volume and improved pricing. The improvement in adjusted EBITDA margin benefited the adjusted EPS growth in the quarter.
Revenue Growth Prospects
The primary drivers of the revenue in the quarter were pricing and higher volume. Pricing contributed $41 mn whereas higher volume contributed $32 mn, partially offset by $27 mn of negative FX impact. The Climate Solutions segment grew 18.4% Y/Y to $244.4 mn driven by 19% Y/Y growth in the sales of heat transfer products, 40% Y/Y growth in the data center business, and 11% Y/Y growth in the sales of HVAC&R. The Performance Technologies segment grew 2% Y/Y due to flattish volume growth and a positive pricing impact, partially offset by negative FX translations and COVID-related shutdowns in China. Within the segment, Advanced Solutions sales grew 18% Y/Y, and sales in the air-cooled business grew 8% Y/Y, whereas the liquid-cooled business sales dropped 7% Y/Y.
In the HVAC & Refrigeration business, Modine is experiencing strong demand for its heating products for warehousing, distribution centers, and greenhouse projects. The company improved its services, outperformed its competitors, and gained market share. Preseason stocking orders were up 10% Y/Y and MOD has onboarded nine new distributors in the quarter. The company is expanding its distributor network in the U.S. to increase its market share targeted at school ventilation. Projects related to school ventilation are supported by significant government funding opportunities. The Biden Administration launched a $500 mn grant program under the Bipartisan Infrastructure Law to improve the air quality at schools. In Indoor Air Quality, the company is simplifying its product line and renewing its focus on product development to build next-generation school products that meet the regulations and new refrigeration requirements. The revenue for the rest of FY23 should increase partly due to the seasonality in the heating business and pricing.
The order book in the data center business remains strong, and the company is further expanding its presence in North America. The capacity at the newly opened chiller facility in Virginia is getting rapidly filled with the current order book. The heat transfer products business is benefiting from the European heat pump market and is continuing to gain market share in the region. Within the Performance Technologies segment, the Advanced Solutions business is experiencing strong development activities for zero-emission mobility, driven by government and business commitment to aggressive climate goals. In response, the company is expanding production of its EVantage battery thermal management system into its existing footprint in Europe. Modine is also heavily involved in pursuit activities with three OEs for the last-mile delivery application.
I believe, despite the concerns about softening in the economy, Modine should benefit from the strong tailwinds in its end markets and the pricing actions taken by the company. Additionally, the COVID-related shutdowns in China have been lifted and the company has resumed its production at its plants, which should benefit in Q2 FY23 and beyond. Management has guided for revenue growth in the range of 6% to 12%.
At the recent investor day, the company laid out its multi-phase transformation programs which are expected to benefit the company’s revenue and profitability in the near term as well as long term. The first phase is focusing on the organization which is completed now. In this phase, the company focused on building its capabilities around 80/20. It includes simplifying the business, segmenting businesses, and reallocating both people and financial capital. This benefited the company, generating $2.1 bn in revenue in FY22. The first phase is expected to support the second phase of the transformation, which will have a heavier focus on growth and will include more acquisitions and potential divestitures. The second phase of transformation is Perform and Deliver, which will be implemented over the next 12 to 24 months. In this phase, the company plans to maximize its share of targeted markets by focusing on growing existing products and markets. This should be done by leveraging its existing footprint and channels and pursuing planned acquisitions in these markets. This should increase the revenue in FY23 and FY24 by 6% to 8% CAGR. The last phase of the transformation is to accelerate profitable growth by expanding its geographic presence. This should be done by expanding Modine’s data center business from the U.K. to North America and expanding its IAQ, heating, and EV systems from North America to the EMEA region. The company also plans to pursue opportunistic M&As to expand in the niche product business, and new geographies, and improve its manufacturing scale. The company is targeting revenue growth at a CAGR of 8% to 10% from FY25 to FY27.
Margins
In Q1 FY23, the commodity metals, freight, and packaging increased Y/Y but the majority of these costs were offset by price hikes. This led to the adjusted EBITDA margin growing by 110 bps Y/Y to 7.8% in the quarter. Furthermore, momentum from various 80/20 actions has resulted in significant Y/Y improvements. In the Climate Solutions segment, the adjusted EBITDA margin improved 510 bps Y/Y to 13.3%, driven by higher sales volume, commercial pricing initiatives, and operational improvements. The Climate Solutions segment was the first business to implement an 80/20 strategy, which benefited the segment’s margins. The adjusted EBITDA margin in the Performance Technologies segment declined 140 bps Y/Y to 5.6% due to higher material costs and supply chain disruptions.
In the Performance Technologies segment, the company is working to recoup the majority of the raw material costs through pass-through agreements on a lagged basis. The company is also working to lower the cost structure within the segment. The restructuring actions taken by the company in Europe are expected to save $20 million by the end of this fiscal year, with most of the benefit coming in FY24. The company has started implementing the 80/20 strategy in the Performance Technologies segment after witnessing the benefits in the Climate Solutions segment. This should improve the margins of the segment later in the fiscal year. Along with this, the PT segment should also benefit from the pricing actions, the decline in material costs, and weaker material cost comparisons. In addition to 80/20, the segment is focused on operational improvements by reducing scrap, reducing packaging costs, consolidating SKUs, and improving throughput at plants.
The recent decline in the raw material costs should bode well for the remainder of the fiscal year. The margins should improve sequentially in FY23, with the majority of the improvement in 2H FY22. The company is targeting an adjusted EBITDA margin of 10% to 12% over the next two years and 13% to 15% beyond FY24.
Valuation & Conclusion
The stock is currently trading at 9.20x FY22 consensus EPS estimate of $1.70 and 7.05x FY23 consensus EPS estimate of $2.21, which is below its five-year average forward P/E of 11.91x. The company has a healthy order book and the tailwinds from its strong end markets should support the volume growth in FY23 along with the pricing actions. The company has laid out its multi-phase transformation program, which is all set to improve revenue and margins over the next few years through an 80/20 strategy, M&As, and expansion within the existing market and other markets. The strong revenue and margin prospects, along with cheap valuations, make Modine a good buy.
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