Description

MOD – Investment Thesis

April 2019

Situation Overview

Modine Manufacturing Company (“MOD” or the “Company”) has historically been a manufacturer of heat transfer products serving the automotive, commercial vehicle and off-highway vehicle markets.  Over the past seven years, the Company has completed two acquisitions which have dramatically shifted its mix of business from 9% industrial in 2012 to 47% industrial today.[1] The industrial business primarily serves the commercial HVAC market.  On January 29, 2019 the Company announced its intention to divest its auto heat transfer business. Following the divestiture, the business mix will be 39% vehicle and 61% industrial. We believe the Company trades at a substantial discount to its SOTP value after giving effect to the proposed divestiture.  We believe the auto business divestiture serves as a catalyst to re-rate the stock.

Overview

We recommend Modine Manufacturing Company as a long with a target price of $19.44 (~30% upside).

Modine, headquartered in Wisconsin, is a provider of thermal management systems and components to automotive, commercial and off-highway vehicle, industrial and HVAC markets.  The Company operates through three segments[2]:

The Vehicular Thermal Solutions (“VTS”) segment (47% of PF LTM 12/31/18 revenue) designs powertrain and engine cooling products for end users in the automotive, commercial vehicle and off-highway vehicle markets.

Within the VTS segment, demand for auto customers is driven by longer-term changes in fuel efficiency standards, in-vehicle technology enhancements and growth in emerging markets.  The auto business is currently being divested. Demand for commercial vehicle customers is driven by growth in heavy-duty and medium-duty trucks, changes in emission standards and vehicle efficiency.  Demand for off-highway customers is driven by production of agriculture, construction and mining machinery which are generally tied to macroeconomic conditions in each respective end market.

The Commercial & Industrial Solutions (“CIS”) segment (41% of PF LTM 12/31/18 revenue) designs coils, coolers, and coatings for end-users in the heating, ventilation, air conditioning, refrigeration, data center and broader industrial end-markets.  Management estimates that roughly 2/3 of CIS sales are related to replacement products, with the balance related to new construction.

Demand for the CIS segment is driven by 1) more stringent efficiency regulations; 2) increasing heat density in data centers as a result of the increasing data traffic; 3) increasing urbanization resulting in evolving food consumption trends and the need for refrigeration infrastructure; and 4) required infrastructure upgrades in more mature markets.

The Building HVAC Systems (“BHVAC”) segment (12% of PF LTM 12/31/18 revenue) manufactures a variety of OE and aftermarket heating, ventilation and air conditioning products for end-users in commercial buildings and data centers.

Demand for the BHVAC segment is driven by demand for building renovations, commercial construction, growth in data centers and higher efficiency requirements.  Consistent with industry forecasts for HVAC systems broadly, AOF estimates that approximately 2/3 of MOD’s BHVAC products are related to replacement products.

Investment Thesis

Management has successfully executed on its plan to streamline operations and diversify its revenue into higher growth end markets

Modine began its expansion beyond its legacy vehicular and BHVAC products in late 2015 with the announcement of its Strengthen, Diversify and Grow (“SDG”) strategy.  The plan focused on 1) cost reductions of $40-50mm within 18 months; 2) reducing customer concentration and cyclical exposure through increased investment in BHVAC, coils and other industrial products; and 3) acquisition of $100mm in incremental industrial revenue.  The Company also announced a $50mm buyback program.

Over the next 12 months, the Company reduced its SG&A spend to ~$170mm from levels that exceeded $240mm prior to the recession.[3]

In September 2016, the Company announced the acquisition of Luvata Heat Transfer Solutions (“Luvata”), the largest global manufacturer of coils, and a leading player in coolers and coatings for commercial and industrial applications.  Luvata was acquired for $422mm, representing ~7x LTM EBITDA of $59mm. At the time of the acquisition Luvata had $530mm of revenues. After the acquisition, MOD vehicular revenues as a percentage of the total decreased from 83% to 60%.  Since the acquisition, the Company has achieved cost synergies in excess of $19mm, exceeding the estimated $15mm of synergies announced at the time of the acquisition. Additional revenue synergies also materialized through expansion into markets where legacy Luvata did not have a presence, such as Brazil.

When Luvata was acquired it was growing revenues at 2-3%, which compares to YoY growth in the past four quarters of 7-10%[4], largely due to a mix shift towards data centers end-users.  Given the enhanced growth profile of the business and increase in multiples generally, we believe an 8x multiple is appropriately conservative to use in a SOTP valuation.

The Company is conducting a sale of its auto business, which will result in improved growth and margins, while reducing cyclicality and materially lowering ongoing capital requirements

Ahead of the Company’s FQ3 ‘19 call, management announced the proposed divestiture of its auto business.  Proceeds are expected to be re-deployed towards share repurchases, debt paydown and re-invested in growth opportunities / acquisitions.

We believe the sale of the auto business should generate interest from strategic buyers particularly due to higher fuel efficiency standards and growth in electric car demand.  Baird estimates that MOD’s auto content on electric vehicles is $300 vs. $100 on an internal combustion engine vehicle today.[5]  In addition, the MOD auto business will benefit from the secular trend of additional electrical content per vehicle across all propulsion types of vehicles.

Baird has estimated that a sale of the auto business could be valued at $350-$400mm[6], which would represent an 8.4-9.6x EBITDA multiple based on our build of EBITDA of $41.5mm.  We have used a more conservative valuation of 5.0x or $207.5mm. Our conversations with management indicate minimal tax leakage from a sale of the auto business.  Based on the Company’s filings, we have analyzed the asset’s tax basis and believe the basis is approximately $284.6mm, which would result in zero leakage. We have also modeled 50bps to account for M&A fees.[7]

Management has also indicated that of the $75mm in LTM capex spend, $40mm is attributable to the auto business.  As a result, the divestiture would yield a substantial increase in go-forward free cash flow. While the Company’s current FCF yield is 12.4%, we believe that a FCF yield at ~8% pro forma the transaction is reasonable for an industrial asset, which would yield a share price of $24.33, ~60% above the current trading price.

HVAC is an attractive industry and MOD’s BHVAC business is an attractive asset

HVAC Industry

The HVAC market is a $100bn+ market consisting of equipment and services products.  It exhibits GDP+ growth characteristics with moderate capital intensity. HVAC purchases are largely replacement purchases (roughly 2/3)[8], which are discretionary in the short-term, but necessary in the long-term.  As a result, the industry is inherently less reliant on new construction, though weather dislocations may create short-term volatility.

The longer-term secular trend towards HVAC systems is driven by energy efficiency.  HVAC systems account for 30-50% of global commercial building energy use, which encourage the replacement rather than repair of HVAC systems as newer generations of systems yield improvements to energy efficiency.  JP Morgan estimates that the payback economics of HVAC replacements to be in the range of 3-4 years.

As a result, we believe that the payback economics for an HVAC unit provides some degree of insulation from broader cyclical pressures, particularly when compared to traditional industrial markets.

MOD’s BHVAC Segment (12% of PF MOD)

MOD’s BHVAC segment principally serves end-customers in data centers, commercial buildings and schools either as a direct supplier or through distributor.  The Company also provides branded supply for selected OEMs such as Carrier, as well as components and secondary products for niches where the large OEMs don’t have existing product.

Relative to the conglomerates in the space, we expect MOD’s LTM operating margins of 11% to remain structurally below peers, but anticipate continued margin expansion as the data center business grows.

UTX, while discussing its proposed spin of the Carrier division, indicated that they believed the asset would trade for 12-12.5x on a standalone basis.[9]  Carrier reported full year 2018 sales of $18.9bn and 16% operating margins while reporting an increase in organic sales of 6%. Carrier expects HVAC revenues to increase in the mid-single-digit range this coming year, which is consistent with industry growth.

Lennox and Carrier, two of MOD’s larger OEM competitors, have both stated that they view industry consolidation positively and are actively seeking acquisitions within the HVAC market. Precedent HVAC transactions have ranged in the 8-15x LTM EBITDA range, which indicates that there is additional value to be unlocked for MOD’s HVAC business.

Nortek, a manufacturing asset with 2/3 of its business comprising of air solutions, was acquired by Melrose for 10x EBITDA in 2016.  Under its ownership EBITDA margins expanded >400bps, further supporting our thesis that MOD’s BHVAC asset should be financially compelling to a strategic acquirer.

Given the incremental scale, growth and margin profile of peers above, we believe a valuation range of 8.5–9.5x is reasonable for MOD’s business, which based on an EBITDA of $27.2mm would yield a value of $230.9-$258.1mm.[11]

Trading comps also support this valuation range, with publicly traded conglomerates trading well in excess of ~10x, albeit with greater scale and higher margins.

The remaining VTS segment post auto business divestiture (47% of PF MOD) will have incrementally superior return on capital characteristics

Following the sale of the auto business, VTS will retain its higher value-add business focused on the commercial vehicle and off-highway segments.

Products in this segment are primarily related to heavy-duty trucks and medium-duty trucks, school buses, transit buses, motor homes and motor coaches within the commercial vehicle end-market, and construction, agricultural and mining equipment and engine manufacturers.  Specific products for the commercial vehicle and off-highway end-markets include powertrain cooling (engine cooling modules, radiators, charge air coolers, condensers, oil coolers, fan shrouds and surge tanks), on-engine cooling (EGR coolers, engine oil coolers, fuel coolers, charge air coolers and intake coolers) and auxiliary cooling products (transmission and retarder oil coolers and power steering coolers), and battery thermal management systems.

Despite strong recent revenue growth trends, the Company’s VTS segment margins have been temporarily depressed due to raw material and trade-related cost pressures and operating inefficiencies at the Company’s plants.  The Company is working through alternative sourcing strategies and customer cost sharing arrangements to help mitigate the impact. Management estimated that tariff-related headwinds resulted in $10-13mm of adverse financial impact to fiscal 2019 earnings and has indicated to us that the headwinds are largely related to the non-auto VTS segment.

Valuation

Based on the SOTP multiples outlined below, we have arrived at a base case target price of $19.44, representing a ~30% premium to the Company’s current share price of $14.98 (as of 4/26/19).

We have also modeled a scenario in which the auto business reflects $10mm of additional EBITDA upside as a result of prospective strategic buyers being willing to compensate MOD for G&A savings.  The upside case value of ~$260mm remains substantially lower than Baird’s estimate of $350-$400mm for the auto business’ transaction value. The SOTP also makes no assumption that the management-estimated $10-$13mm tariff headwind abates.

Risks

A failure to monetize the auto business

As multiples trade down in the auto sector, prevailing concerns around a slowdown in SAAR might lead to subdued interest in the asset.  A failure to monetize the asset or a divestiture below the asset’s intrinsic value may lead to lost value.

Cyclicality, particularly in the commercial vehicle and off-highway segments

While divesting the auto business will substantially de-risk MOD’s cyclicality, the commercial vehicle and off-highway segments have in recent history experienced significant growth that may be indicative of the tail-end of a cycle.

Tariff negotiation with China loses momentum

A lack of progress on trade negotiations with China would continue and perhaps even exacerbate margin pressure for MOD.

Raw material pricing

MOD is exposed to raw material pricing in aluminum, nickel and steel.  While pass-through pricing is in place for some products, these are often with a 3-12 month lag, leaving the Company exposed to variations in commodity prices in the interim.

Slowdown in data center business

The very strong recent growth to the data center end-market is likely unsustainable beyond the next few quarters.  While management has indicated to us that they expect margin stability even as growth slows, moderating data center growth may adversely impact operating income for MOD’s CIS segment.

Substantial competition, particularly in HVAC products, with competition that includes well-capitalized, scale players

The HVAC market consists of large, well-capitalized players with substantial scale and superior margins.  MOD’s HVAC peers may seek to more aggressively displace MOD’s products with its end-users.

[1] Based on disclosed FY 2012 Commercial Products revenue segmentation and FQ3 ‘19 end market segmentation.

[2] PF LTM revenue segmentation is PF divestiture of auto business (25% of LTM 12/31/18 sales).

[3] Compares fiscal year ending 3/31/08 to fiscal year ending 3/31/16.  Financials are pro forma for spin-off of Aftermarket business, as per Baird research, 12/6/16.

[4] Growth rates are in constant currency, as reported.

[5] Baird Equity Research, 5/25/17.

[6] Baird Equity Research, 2/1/19.

[7] Based on 12/31/18 VTS assets of $711.4mm multiplied by auto business revenue as % of total VTS sales of 40% as per the Company’s FQ3 ‘19 investor presentation.

[8] JP Morgan HVAC Industry Research Report, 4/18/17.

[9]  UTX Conference Call, 2/20/19.

[10] Source: Company filings, JP Morgan HVAC Industry Research Report, 4/18/17.

[11] BHVAC segment EBITDA of $27.2mm based on BHVAC LTM Operating Income of $22.7mm plus segmented D&A (based on fiscal 2018 D&A segmentation).

[12]Auto business EBITDA based on operating income of $21.1mm (3.8% margin) and D&A of $20.4mm (3.7% % of sales).

RemainCo VTS EBITDA based on operating income of $58.4mm (7.2% margin) and D&A of $29.8mm (3.7% of sales).

CIS EBITDA based on operating income of $51.2mm (7.2% margin) and D&A of 27.9mm (3.9% of sales).

BHVAC EBITDA based on operating income of $22.7mm (11.2% margin) and D&A of $4.5mm (2.2% of sales).

Net Intercompany / Adjustments reflects the net of LTM intercompany eliminations of ($35mm) plus total EBITDA adjustments of $18.1mm less $5mm overstatement of D&A when calculating D&A as a % of sales based on F2018 D&A compared to total LTM 12/31/18 D&A.

Catalyst

Monetization of auto business

We expect the sale of the auto business to serve as the principal near-term catalyst.  Following the divestiture, the overhang around cyclical pressures should largely subside, which we expect to lead to a multiple re-rerating based on the SOTP values outlined above.

Activist engagement pushes for a sale of the remaining business to strategic buyers

PF MOD will be comprised of a collection of stable industrial assets that we expect should attract strategic and financial interest.  We are encouraged by management’s willingness to date to pursue value creating strategies.