Modine Manufacturing Company (MOD) Earnings Call Transcript

Good morning, ladies and gentlemen, and welcome to Modine's Second Quarter Fiscal 2027 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Kathy Powers, Vice President, Treasurer and Investor Relations.

Hello, and good morning. Welcome to our conference call to discuss Modine's second quarter fiscal 2027 results. I'm joined by Neil Brinker, our President and Chief Executive Officer; and Mick Lucareli, our Executive Vice President and Chief Financial Officer. The slides that we'll be using with today's presentation are available on the Investor Relations section of our website, modine.com. On Slide 3 of that deck is our notice regarding forward-looking statements. This call will contain forward-looking statements as outlined in our earnings release as well as with our company's filings with the Securities and Exchange Commission. With that, I'm going to turn the call over to Neil.

Thank you, Kathy, and good morning, everyone. This morning, I'm going to start out with the segment updates and then turn it over to Mick to review the financial results for the quarter. Let's jump in. Starting with data centers, we delivered another impressive quarter with revenues increasing 95% from the prior year. We achieved our fourth consecutive quarter of record orders exceeding $1 billion in quarterly order intake for the first time in our history. Strong demand has pushed our backlog to another historic cut. In addition, we recently received a major new program award with a strategic hyperscaler customer. Through this partnership, we will supply more than $400 million of custom air handling units through calendar year 2027 to cool next-generation data centers. We have continually added manufacturing capacity to support the surging demand for our air handling products since acquiring the Scott Springfield business in 2024. To that end, we are currently launching production at our third dedicated data center facility in Calgary and are actively increasing throughput at our facility in Franklin, Wisconsin. Demand continues to be incredibly strong across our entire data center cooling portfolio, and we are strategically using 80/20 principles to manage this growth. Regarding our overall capacity expansion, we remain firmly on track, we currently have 13 chiller lines up and running and remain fully committed to reaching 20 operational lines by the end of the fiscal year. A massive part of executing this capacity expansion has been stabilizing our supply chain and I'm pleased to report that we have made significant progress during this quarter. Over the past few months, the reliability of our supply chain has steadily improved and we have entered into multiple LTAs with key suppliers to lock in volume for critical components in 2027. We've also continued to share our future volume requirements with our suppliers so that they can confidently increase their own capacity, but their expansions take time to ramp. This supply-demand imbalance is leading to higher prices, incremental to the material inflation of tariffs. We are working on cost sharing and pass-through mechanics, but that takes time as well. In addition, we occasionally get surprised to other smaller disruptions. While these may not result in material production impacts, they can still create delays in short-term inefficiencies. Furthermore, we continue to leverage the specialized capabilities of our commercial HVAC segment to support the rapid growth of our data center business. Commercial HVAC is already successfully producing vBlock subassemblies for our chillers, and recently passed testing for another critical component officially adding them to our qualified supplier panel. Scaling our supply chain as we expand capacity to meet demand, possess a number of challenges that need to be continually managed. That said, we are in a much stronger position than we were 90 days ago, and I'm incredibly proud of what the team has accomplished. Please turn to Slide 5. The commercial HVAC segment also delivered a strong quarter with revenues increasing 23% from the prior year. Our coils business continues to benefit from higher sales to data center customers. Our CHVAC segment has a significant opportunity to drive incremental growth in the data center market, and we are currently executing on several strategic fronts. First, we have been selling coils directly to various external data center cooling companies for some time, which was a primary driver of our revenue growth over the past several quarters. Second, we are capitalizing on a developing trend where hyperscalers are getting involved in downstream sourcing, specifically identifying qualified Tier 2 suppliers for custom data center cooling products. We are currently in active discussions with 1 of our strategic customers to become a key coils provider within their supply chain. This represents a major incremental opportunity for our commercial HVAC business that could lead to significant future orders. Additionally, our coil sales are creating a strong pull-through effect for our coolings business as many customers request specialized coatings to prevent corrosion in harsh environments. Our Coatings business had an outstanding quarter with revenues up 28% from the prior year. Finally, CHVAC has multiple opportunities to support our own data center business. As I mentioned, we're currently producing vBloc subassemblies for our chillers and plan to start supplementing our current supply needs with additional CHVAC manufactured products later this fiscal year. These are exciting opportunities that should drive revenue growth in the near term, fully supported by our disciplined 80/20 focus. We are also seeing excellent growth opportunities elsewhere in the segment. Specifically, we are expanding our product line for portable heating products that we acquired as part of the LB White transaction last year. Overall, there's a wealth of opportunities for both revenue growth and margin expansion within the CHVAC segment. Please turn to Slide 6. As you know, we successfully closed on the spin-off of our Performance Technologies business and merger with Gentherm on October 1 as planned. Preparing for this transaction of this scale is a massive undertaking for both teams, and I'm pleased to report that the initial phases of the transition are going smoothly. I want to extend my sincere gratitude to our internal team who tirelessly manage the complex work experience required to execute this transaction as well as to our external advisers. Gentherm has been an outstanding partner throughout this process, and we are confident they will provide a fantastic home for that business. For Modine, this milestone represents a clean strategic separation that allows us to focus 100% of our resources on our highest growth, highest margin thermal management opportunity. Finally, I'd like to remind everyone of our upcoming Analyst and Investor Day planned for November 18. We are holding the event in Chicago with a live webcast for those not planning to attend in person. We will provide an in-depth review of the company's strategy, including growth opportunities for both segments, along with our new long-term financial targets. It should be a great event. With that, I'll turn the call over to Mick.

Thanks, Neil, and good morning, everyone. Please turn to Slide 7 to review the Q2 segment results. Beginning with data centers, I want to highlight the exceptional rate of revenue and earnings growth which continues to outpace the rest of the market with a 95% increase in sales. Americas sales grew 132%, driven by strong demand from hyperscale customers and EMEA sales decreased 6%, mainly due to the timing of shipments. Adjusted EBITDA grew 66%, resulting in an adjusted EBITDA margin of 15.4%. As I discussed last quarter, we reported a nice sequential margin improvement from the first quarter. However, this was somewhat lower than we anticipated. On the positive side, we continue to see a lower impact from the fixed cost absorption and expansion costs. This was relatively in line with our expectations. However, the supply chain and material impacts were larger and are lingering longer than we had expected. These can be grouped into a few key baskets, including logistics with a negative impact from tariffs, raw material inflation and higher prices paid to our suppliers to secure volumes. We're working on commercial actions or recurring in future programs to address these additional costs, and we're confident that we can recover these costs. We remain excited about the overall positive momentum in this segment and anticipate further margin improvements through the second half of the year. Based on our updated revenue and margin outlook, we anticipate that the data center segment will generate earnings growth in excess of 80% this year. Please turn to Slide 8 to review commercial HVAC. Commercial HVAC also delivered strong revenue growth with a 23% increase in sales. HVAC Technologies sales increased 20% and Heat Transfer Solutions sales improved 16%. Adjusted EBITDA increased 22%, while the adjusted EBITDA margin was flat to the prior year at 15.1%. Similar to the data center segment, we anticipated a higher margin in the second quarter. The major driver of the flat margin was the mix of product sales, along with higher material and tariff costs. Commercial HVAC remains on track for the year as the leadership team focuses on driving both growth and margin expansion through 80/20 initiatives. We expect double-digit earnings growth and incremental improvements in the adjusted EBITDA margin during the second half of the fiscal year. Please turn to Slide 9. For Performance Technologies, I'll keep my comments relatively brief given the recently completed spinoff and merger with Gentherm. Sales were relatively flat with heavy-duty up 11% and on-highway down 5%. Adjusted EBITDA declined 3% from the prior year, and adjusted EBITDA margin was 14.2%. These results were generally in line with our expectations. As Neil covered, the separation plan and merger with Gentherm was completed on October 1. We are very proud of the improvement made these past few years by the Performance Technologies business and its legacy for Modine. Peter and Modine are a fantastic combination with a bright future, and we wish them all the best. Now let's review the total company results. Please turn to Slide 10. Second quarter sales increased 35%, and I want to point out that if we just look at our remaining data center and commercial HVAC segments, revenue growth was 59%. Gross margin declined by 160 basis points to 20.7%, driven by lower margins in all 3 segments and largely due to the material cost inflation. Although we continue to invest in incremental SG&A to support growth, we're controlling the spending as a percentage of sales. Reported SG&A also includes $14.1 million of expenses directly related to the spin-off of the Performance Technologies business. I'm pleased to report that adjusted EBITDA increased $32.4 million or 31%. Resulting in a 13.7% adjusted EBITDA margin. As I previously discussed, the actual margin was somewhat lower than we anticipated, but there continues to be sequential improvements as we launch more volume and recover material costs. In Q2, there was a 150 basis point improvement from the first quarter, and we expect to see further improvements in the second half of the year. Adjusted earnings per share was $1.35, 27% higher than the prior year. This excludes $29.5 million of income tax expense related to legal entity restructuring steps required to spin off the Performance Technology systems. Now moving to cash flow metrics. Please turn to Slide 11. Free cash flow was negative in the second quarter primarily due to the working capital and capital investments in data centers, along with expenses related to the Performance Technology spin-off. As expected, we're deploying cash for working capital to support our growing data center customer demand and protect our production from supply chain constraints. In addition, we incurred $27.7 million of cash payments, primarily for restructuring and disposition-related costs. Lastly, cash taxes were higher than normal due to some unique situations and significant customer LTA payments. Net debt was $211 million higher than the prior fiscal year-end, but we received approximately $200 million from Gentherm on October 1, which was used to repay debt. Based on our current outlook for earnings and cash flow, we expect the leverage ratio will decrease further by year-end. Now let's turn to Slide 12 for our fiscal '27 outlook. As announced in our press release, we're updating our fiscal '27 guidance to reflect our higher revenue outlook for our remaining businesses and the successful spin-off of the Performance Technologies business. Starting with the third quarter, we'll report historical results for this business as discontinued operations. So our current outlook now excludes Performance Technologies revenue and earnings for the full year. Table is available in the appendix providing a recap of financial information for net sales and adjusted EBITDA by quarter for fiscal '26 and year-to-date fiscal '27. We expect total company sales to be in the range of $3.1 billion to $3.2 billion, representing a 50% to 55% increase from the prior year, excluding Performance Technologies revenue for both periods. We expect data center sales to grow 80% to 90% and expect Commercial HVAC sales to grow 10% to 15% from the prior year. One highlight that both of these ranges represent an increase from our segment outlook last quarter. With revenue expectations increasing, we're still expecting continued margin improvement in the back half of the year. However, we believe that margins will improve at a lower rate than originally anticipated, mostly due to ongoing cost increases across the supply base. Given the revenue outlook, and ongoing improvements in margins, I'm pleased to say that we expect fiscal '27 adjusted EBITDA to be in the range of $470 million to $500 million, representing a growth rate in excess of 50% and Again, this outlook excludes Performance Technologies from the full fiscal year. From a free cash flow perspective, we expect to generate positive cash flow for the full year, making up for the use of cash in the first 2 quarters. And as I previously mentioned, we received approximately $200 million of cash on October 1. And while it is not included in our free cash flow calculation, it was used to repay debt. And to wrap up, we remain excited about our fiscal '27 outlook with outstanding revenue and earnings growth. Very few companies are generating earnings growth in excess of 50%. And I'm proud to say this would represent our fifth consecutive year of adjusted EBITDA growth in excess of 20%. We're looking forward to our next chapter as Modexus Solutions as we're truly a new company and have an exciting future to share with our shareholders. As Neil mentioned, we're holding an Analyst and Investor Day on November 18. Neil and the entire team are looking forward to providing a new strategic update on this next phase of our transformation, along with an exciting financial outlook for fiscal '28 and for fiscal '29. With that, Neil and I will take your questions.

[Operator Instructions] The first question is from Matt Summerville from D.A. Davidson.

Thanks morning. Can we maybe start with data center margins to keep it easy, if you did roughly 15% EBITDA in the first half of the year sort of implies you need to get to somewhere in the low 20s, let's say, in the second half of the year if data center profits are set to rise by 80% is indicated in the deck and in prepared remarks. Can you specifically spell out what gets you there? Why not maybe derisk that cadence more meaningfully? And I guess, why should investors feel that this is a dependable sort of outlook? And can you bridge how much of this gap between, say, 15% and 21% first half, second half. How much of that is sort of solved by price capture. And if you can comment on the cadence between the 2 quarters, that would be helpful. And then I have 1 follow-up.

It's Mick. So as we look at second half of the year, we continue to expect a step up each quarter sequentially. You're right in on the high-level math based on our public comments there. Q3, we'd expect to see 100 to 200 basis point sequential improvement and then another step up in Q4 with the target of getting to 20% or above in and Q4. 2 major drivers. So we've talked a lot about first half of the year around labor and overhead. Those have been as expected, those were coming in much in line with our outlook for Q2. So as we talked about, materials has been a significant increase, and in the quarter, that was about 375 basis points. So when we look to the second half of the year, there's 2 big drivers. One, volume is a big one. The conversion rate on incremental volume is quite high, way above, as you can imagine, it's at a variable level. So more volume we're putting through is coming through at a much higher margin than our targets of being at a 20% level. Secondly, we are going to recover material costs and we have contracts in place. We already have commercial negotiations. So that recovery of material cost is going to improve our material margin. Again, if you just look at first half, second half, again, Q2 was 375 basis points at a minimum between all of our material cost increases. This was kind of the headwind or the penalty in the quarter.

And then I'm sure you guys internally have been talking about potential election outcomes. And I would imagine if I don't ask it, it's going to get asked on the call. But does this outcome change the shape of your growth trajectory or the fundamental thermal backdrop for you in the United States? And putting that aside for a second, just given that we're looking at a stock price sub-$100, how are you thinking about potential aggressive share buybacks given the state of your balance sheet?

Matt, this is Neil. Yes, certainly, we we've all thought about the outcome of the elections, and I don't think there's really a big surprise here in terms of what shook out last night. I know that we're seeing a robust, healthy backlog that goes well beyond 2 to 3 years, and there's an immediate demand even today. So there's already many data centers that are in flight that have been permitted that are going to require multiple years of building and preparing. So those things are kind of in position and in place. For us, I believe that we're going to see even increased demand from this because as you remember, when we broke into the data center market, we broke in as a sustainability play. We broke in as our first data center customers were the only customers that offered a carbon-neutral data center. And when you offer a carbon-neutral data center, you have to have the best power use effectiveness and the best water use you have to be able to ensure that you are conserving energy and water. And that has been our niche and that has been our play. And I believe going forward with data centers, particularly in many local communities here in the United States, that that's going to be important for people to understand that you're using the best technology in order to drive down energy costs and drive down water usage. That's our play. That's our differentiation. That's how we broke into the market. I think that's going to continue to trend that way.

Matt, on the buyback, we're -- like everybody this morning, we're digesting the news to the elections and how the markets react to the data center space. But to your question, at the current share price, that will obviously be a big topic with our Board as soon as we meet with them. More to come there, but that will clearly be a topic with our Board.

The next question is from Noah Kaye from Oppenheimer.

Yes, I would like to follow up on the margin trajectory as well. Nick, I think you said maybe 100 to 200 bps step-up is what you'd contemplated for 3Q on data center margins. Is that correct?

Yes, correct.

Yes. So that would imply 4Q margins materially above 20%. I want to confirm that. And I understand what is sort of the -- if any, outsized margin benefit you get in that quarter. I don't know if there's a timing that's anticipated on material recoveries. Or is that kind of really the right level to think about as a jumping off point going into '28. Maybe you can comment on that. And maybe even following up on that point, the visibility you now have into the cost base through some of these LTAs that I know have been a big lift for the company over the last couple of months.

Yes. I'll go first to he's a lot to what you said there about trying to hit it all. Yes. The -- so Q4 would be another sizable lift from if we're in a 16.5%, 17.5% margin in Q3 and Q4, the big driver in Q4 besides continued improvement in our material cost ratios as the volume. So if we look at second half implied volume that's kind of in a 80%, 90% range. Q3, I would see in another like 80% type growth rate. And obviously, Q4 gets us 90% plus. So that level of volume going through is a big lift. Also, the more programs that we are quoting, launching and so forth are all adjusting pricing real time. what I kind of want to make sure we cover with all of you is when we've talked the last few quarters, we've started seeing some of the few key components, and we talked to all of you about that. And we've gone back to our customers to recover those. At the same time, there's just general inflation we're seeing across aluminum, copper, steel, 30%, core Q1, 30% Q2. These are things we didn't necessarily anticipate in the agreement, so they've had to go back. And Neil can comment our customers are very supportive about recovering those. So we have a little bit of a lag effect on that element. But then certainly, as we're quoting new programs and receiving new POs, we're negotiating that upfront, which is a combination of tariffs raw material costs and then purchase component costs. That's what's -- so that's the impact in Q2, but the opportunity set for us as we go into Q3 and Q4.

And to tie into that -- I'm sorry, Neil, I don't know if we're going to add anything else. But to tie into that, I mean, these 4 quarters of record orders, your book-to-bill was greater than 2 this quarter. I guess, how is the better pricing that you're talking about embedded in the orders in the backlog? And can we just get a sense of where this backlog coverage really puts you both for the back half and even into '28?

So just to build a little bit on what Mick was saying with -- obviously, when we at LTAs and we negotiate these program wins. We want to make sure that we can open up the agreements when there are things that are material in terms of margins. And we have been able to display that willingness to work with our customers, and that's where you're going to see some of this improvement in the back half to Mick's point. Certainly, to your other question, there'll be -- this will be very clear in the IR day update for FY '28, '29 next week. Few weeks.

The next question is from Chris Moore from CJS Securities.

Obviously, lots of noise out there. maybe just kind of how you would characterize 2 things from a customer kind of standpoint. One would be what you're hearing in terms of from availability from a cash flow perspective to build? And two, is the kind of certainty in terms of the final geographic destination? Is it still -- is that still up in the air on a lot of the work that you're doing at this stage?

I think for the work that we're working the work that we're considering that beyond '28 into '29 and 2030, certainly, there's some of that in terms of locations and exact size of gigawatt campuses, there's a little uncertainty there, but we're working through that in terms of how to close that gap. But in the immediate 24 months, it's there. Remember, Chris, we're 1 of the last products to go into the data center. So we can see a site that's been permitted and they start the construction of the site and that can take anywhere from 12 to 18 months. And then you start to bring our equipment in. So the equipment that we're preparing our inventories around that we're going to be building over the next several years are 4 sites that are permitted and are in place. So more of the backlog that we're working on in terms of size as well as locations where that may change from state to state, which we have seen that happen in the past and size, they can continue to get bigger rather than smaller, that's beyond 2 years for numbers.

Got you. Very helpful. And maybe just -- I know that with Gentherm, there's still I think $20 million to $25 million additional costs in the second half for the transition services agreement. Are these costs included in the EBITDA estimate or they will be adjusted out?

Great question. In our guide is about full year and when we do disc ops when we remove Performance Technologies from the full year, there would be about $10 million to $15 million of temporary stranded costs. Obviously, we had PT for half the year. But if you just back them out, the inner guide Ed includes that. And when we first announced the spin-off, we said we didn't anticipate much in the way of stranded and we still believe that where those costs will be reabsorbed is through the data center growth. So in other words, all those resources we had working on Performance Technologies at the rate of growth we're adding on data centers. Wells will be fully absorbed by next fiscal year is just more of an internal accounting. But to be clear, in this interim period, with now with PC gone to $15 million, and it's really half year's impact in the second half, about, I'd say, $7 million to $8 million here that we need to redeploy into the data center business. I hope that answers your question.

The next question is from David Tarantino from KeyBanc Capital Markets.

Maybe following up on the data center margins. Can you just take us through how these headwinds progress through the quarter? I'm particularly thinking back to last quarter's commentary around margins improving in June. So could you give us some color on how this evolved through the quarter and through October as you lock down more supply and worked on price with your customers?

Yes. Neil can add more color, David, but I would say that -- and I go back to what we talked about last quarter was what really started was we were surprised by some short shipments of a few key components. And Neil talked quite a bit about working through those. What's continued to happen, I'd say, through the quarter, it would be other suppliers coming forward either with shortages or their own volume challenges. And then what comes with that, what -- when I talk about material costs, we have expedited freight and logistics and tariffs. So a couple of things that -- what's happening as the quarter continued to go on. And I think Matt Summerville had asked a good question we're trying to get in front of it and make sure why we talked about reducing our outlook for the rate of margin improvement is expecting that this will linger longer. But in some cases, we had some sheet metal suppliers or something that don't weren't hitting their deliveries. Other cases, we're getting the deliveries that we ask for, but they show up on a Friday instead of a Monday. Or we're shipping parts that we have in Europe over to North America so we can utilize them. So a lot of inefficiencies getting the product in the door to keep the lines moving. I know it's a lot, but it isn't just that, hey, someone called us and we are negotiating a price increase or an LTA that we should have known about I think it's just almost a day-to-day evolution. Neil, any other color?

No, I think that's good color. I mean ultimately, we have a decision to make when we have these challenges in the operations environment or with the supply chain you can look at your customer and apologize and not do anything or you can react to it and try to continue to delight your customers. And sometimes that decision to react to it and do the best you can to meet their commitments and our expectations to meet our delivery schedules is it gets quite costly. When we have to -- when we have key components that are sourced locally, and they fall through, we have to then use their international sources to get the components in and to double that, you expedite the freight at the same time. So there are many instances where we had some suppliers prior to the LTA that we're not able to meet their commitments locally. We had to go with international shipments with expedited freight in order for us to keep the delivery schedules.

Okay. Great. And then maybe could you give us some color on the pricing discussions in data center. My understanding is there were pass-throughs for inflation, but securing supply at higher cost is somewhat unique. So what does the pricing look like in the LTAs from your suppliers? Where are the discussions at this point with your customers on price? And how much more work is there to do on these discussions?

Well, I think the important piece here, David, is that it's not fixed. We have -- we've got the agreement with our customers that pricing is variable, especially when we have challenges in the metals inflation as well as tariffs, expedited freight costs, those kind of things, there's a willingness to have a conversation and there's a willingness to help us in terms of making sure we can meet their delivery commitments and help share the cost in order to do that. That is a very -- those are very active conversations that take place on a sometimes weekly basis with some of our biggest customers.

The next question is from Neak Burk from UBS.

On the commercial HVAC guide, you guys have just done 2 quarters of pretty good double-digit organic sales growth. But I think the guide assumes a step down in the back half. Can you elaborate on that? Do comps get harder? Or is there some tariff that's just conservatism?

Yes. With the heating season, 1 thing that was positive here and help with HVAC in the really strong Q2, we've had a really good preseason for heating, preseason orders. So we are being a little bit cautious that for those that have been with us a while, we always -- you don't know what unfortunately, weather is going to be. So there's 1 element of we try to go in with a relatively conservative heat outlook. Secondly, the that new leadership team is really going through a heavy lift on 80/20, and we have planned exits, cost reductions and attrition, much like again, people have been with Modine for a while, we'll see because also implied in there is a pretty healthy second half margin lift again, from the first half, I think we'd probably be looking at least 300, 400 basis point plus improvement in the second half of the year, and part of that is from the 80/20 activities along with price recovery on material costs because there was also a little bit of that in the HVAC segment for Q2.

Yes, I wanted to follow up on that. I think I think last quarter, you were pointing to kind of maybe 200 basis points of margin expansion in climate for the year. And so can you kind of kind of update where we are now relative to that? I mean you kind of just guided back half, but was 2Q, how much worse than you expected? And what's the sort of ramp in the back half? How do you kind of break that out between cost recovery and price?

Yes. I see the full year being up, call it, 100 basis points or so. When we look to the back half of the year, I expect 50 to 100 basis points year-over-year improvement in Q3 and then another big lift in Q4. And again, where -- in as far as Q2, we were a little bit light, and that was also a majority was around material costs and mostly raw material costs on the coil business. really strong order intake. In fact, a lot of growth driven by data center business, but that's a lag in timing recovery of like copper, aluminum and steel.

The next question is from Brian Drab from William Blair.

Can you touch on that opportunity that you have with data center customer within the coils business with the timing of that? And how significant could that be for that segment?

Yes. That is definitely significant. We're going to have to do a lot of 80/20 work there to ensure that we're using the appropriate capacity for this key customer definitely is significant in terms of the revenue growth, and it would be helping them supply, helping them secure supply so that they can continue to navigate the shortages in the supply chain. We've talked about fans as a shortage in the supply chain. You've heard lots of companies talk about that. We've talked about things like evaporators and comparisons. Coils is now bumping up as to 1 of the areas where they're seeing a severe shortage in the industry, and the fact that we're the largest independent oil producer in the world is in our advantage. So we have a lot of opportunity there, and we can partner with them and we are partnering with them that will be a significant mix shift in that business going forward.