Modine Manufacturing: Not A Buy, But Keep It On Your Watchlist (NYSE:MOD)

Firm Snapshot

Modine Manufacturing (NYSE:MOD), a small-cap inventory (~1bn market cap) gives thermal administration options to fulfill the heat-transfer wants of their clients. These clients are sometimes primarily based within the business, constructing, industrial, and HVAC&R (Heating, Air flow, Air-conditioning, and Refrigeration) markets and embody constructing contractors, architects, heating tools wholesalers, car OEMs, industrial OEMs, and so forth.

The corporate experiences beneath two divisions:

• Local weather Options (~45% of group gross sales) – Primarily centered round gross sales of warmth switch merchandise, HVAC&R, and knowledge heart cooling options.
• Efficiency Applied sciences (~55% of group gross sales) – Air and liquid-cooled merchandise for industrial purposes, vehicular and stationary energy.

Why Modine Manufacturing Ought to Be On Your Watchlist

MOD has fairly a couple of encouraging narratives going for it:

Knowledge-center publicity – Firstly, we just like the prospects of the business HVAC market, pushed primarily by the excitement round knowledge facilities. While, MOD has publicity to a variety of markets, observe that business HVAC gross sales account for the most important element of its group gross sales, at 38%.

The complexity and the ticket measurement of economic HVACs are sometimes extra pronounced than home HVAC methods, and the function these methods play in knowledge heart cooling shouldn’t be underestimated. MOD is prone to have loads of takers on this market, significantly in North America because it is without doubt one of the few firms that may regionally produce all of the HVAC parts required for knowledge facilities. You’d have an interest to notice that in Q3 (pushed primarily by demand for chillers), their knowledge heart enterprise grew by a formidable 68% and administration believes it will solely get higher in This fall, stating that “the info heart enterprise goes to have one in every of its strongest quarters of the 12 months in This fall”. The HVAC market additionally sometimes receives loads of fiscal advantages and tax rebates, which helps push its adoption.

Ongoing margin enchancment by FY24 – Traders also can nonetheless get excited concerning the ongoing outcomes from the 80/20 ideas that had been put in place by MOD administration to enhance pricing and optimize working margins. We have seen the affect of this play out within the Local weather Options a part of the enterprise (in Q3 EBITDA margins had been up by a formidable 300bps) however the results on the larger segment- Efficiency Applied sciences (which accounts for 55% of group gross sales) remains to be but to largely come by (despite the fact that this division noticed 200bps margin enchancment in Q3) and can be mirrored extra keenly within the quarters forward. It is because the 80/20 technique was solely carried out in Efficiency Applied sciences (PT) in direction of the second half of 2022.

For example, one promising final result of implementing 80/20 is what they’ve carried out with their business agreements. Earlier, MOD may solely cross on the affect of upper steel costs, however not the affect of ‘different prices’, which prevented them from defending their margins adequately. Underneath the brand new technique, MOD is making a concerted effort to insert clauses of their contracts that allow them to cross on even ‘different prices’.

The consequences of this are prone to persist for the foreseeable future, and that is evident within the development of sell-side consensus numbers. For FY23, consensus expects EBITDA progress to be 2.5x the income progress (which is stable sufficient working leverage in itself) however subsequent 12 months, analysts anticipate EBITDA progress to return in at 3.6x the extent of income progress! Additionally, from an annual EBITDA margin vary of seven.7% on the finish of FY22, analysts expect an extra incremental margin enchancment of 250bps by FY24.

Engaging Valuations – When you think about the enhancing diploma of working leverage and EBITDA margin enchancment, you possibly can argue that MOD deserves to commerce at a a lot superior ahead EV/EBITDA than its present a number of of 5.7x (primarily based on the FY24 numbers), which represents an 8% low cost to the inventory’s 5-year EV/EBITDA average.

FCF poised to enhance – MOD’s FCF technology within the latest quarter was fairly underwhelming (-$0.4m), however this could enhance within the March quarter as administration works its manner round extra stock ($20-$30m in extra of pre-pandemic ranges). The picture beneath exhibits you the way the times in stock have now hit 60 days, round 22% better than what they usually preserve. We will additionally see that it hardly ever ever stays at these ranges.

The excessive stock place has consequently weighed on working capital conversion, which is at present at 5-year lows. This isn’t sustainable, and it ought to begin trending nearer to the common of round 12x.

Dangers

The subsequent time MOD experiences (for the March quarter), buyers should not anticipate nice issues from the Local weather Options division as sure sub-segments inside that division must take care of a really troublesome gross sales and margin base impact from the March-2022 quarter. Along with that, heating merchandise and coils offered to the residential markets and HVAC markets are anticipated to be fairly weak and this too ought to adversely affect this division.

Then, the impacts of aggressive tightening are being felt in numerous pockets of the economic system, and this has definitely dampened threat sentiment and weighed on the broader markets. Throughout tough occasions like these, you do not need to get too cozy with shares which are too delicate to actions within the broader markets. Observe that MOD’s sensitivity to the broader markets has solely continued to extend over time, and a beta of just about 2x is definitely not comforting at this juncture.

Lastly, we might additionally like to focus on the unfavorable risk-reward dynamics on the charts.

Do take into account that over the previous 12 months, MOD’s inventory has already loved its time within the solar, delivering stable returns of 133% and in addition trouncing the Russell 2000 which has been a supply of wealth destruction. After a protracted interval of outperformance, we surprise if MOD may do with a breather.

Nicely, when you examine the value imprints of the MOD chart because the GFC, we will see that it has largely taken the form of a wedge, with some fairly apparent pivot factors (highlighted in blue). It was no shock to find that the candles of February and March noticed lengthy wicks (indication of shopping for fatigue) as they got here near hitting the higher boundary of the wedge. The inventory might resume its uptrend as soon as once more, however till it sees extra of a pullback, I am not too enthused with the risk-reward on provide at these ranges.

It is also honest to say that buyers fishing for good risk-reward alternatives from the Russell 2000 are unlikely to plump for MOD, as its relative power ratio versus the previous is now properly previous the mid-point of its long-term vary.

To conclude, we predict there are loads of admirable sides to the Modine story, however that is most likely not the most effective time to get in.