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Executives

Susan Fisher – Director, IR and Corporation Communications

Tom Burke – President, CEO and Chief Technology Officer

Bob Kampstra – VP, Corporate Controller and Chief Accounting Officer

Analysts

David Leiker – Robert W. Baird

Walt Liptak – Barrington Research

Gregory Macosko – Lord Abbett

Dennis Scannell – Rutabaga Capital

Sean Nicholson – Kennedy Capital

Modine Manufacturing Company (MOD) F3Q10 (Qtr End 12/31/09) Earnings Call Transcript February 2, 2010 11:30 AM ET

Operator

Good day, ladies and gentlemen and welcome to the third quarter 2010 Modine Manufacturing Company earnings conference call. My name is Ann and I will be your coordinator for today's call. (Operator Instructions) As a reminder, this conference is being recorded. At this time, all participants are in listen-only mode. We will be facilitating a question-and-answer session following the presentation.

I would now like to turn the presentation over to Susan Fisher, Director of Investor Relations and corporate communications. Please proceed.

Susan Fisher

Thank you for joining us today for Modine's third quarter fiscal 2010 earnings call. With me today are Modine's President and Chief Executive Officer, Tom Burke, as well as Bob Kampstra, Vice President, Controller and Chief Accounting Officer. Our format for today's call will be approximately 20 to 25 minutes of prepared remarks, followed by a Q&A session.

We'll be using slides with today's presentation. Those slides are available through both the webcast link as well as a PDF file posted on the Investor Relations section of our company's website at modine.com. Also, should you need to exit the call prior to its conclusion, a replay will be available through our website beginning approximately two hours after this call concludes.

Before we begin, I would remind you that this call may contain forward-looking statements as outlined in today's earnings release, as well as in our company's filings with the Securities and Exchange Commission.

And with that, it is my pleasure to turn the call over to Tom Burke.

Tom Burke

Thank you, Susan and good morning everyone. We are very excited to present to our investors and shareholders the third quarter results for Modine. Bob Kampstra and I will jointly provide a detailed summary with the quarter. We'll also highlight important factors as we look forward. We will of course provide ample time to answer all questions from our investors and analysts at the end of our presentation.

On slide four, we summarize the highlights of the third quarter, which are significant, especially considering the impact of the economic challenges that still negatively impact most of our served markets. Simply put, we had a great quarter. It was our best performing quarter in 18 months despite the continued sales pressure in our largest markets. We attained a gross margin of 15.8% for the quarter. This was our highest level gross margin in six quarters and up 36% on a year-over-year basis and a sequential improvement in our solid performance in the prior quarter. We attribute our performance to our significant cost reduction initiatives year-over-year as well as some modest tailwind from our lower materials cost, a trend which is beginning to reverse as we finish out the fiscal year.

During the quarter, we earned 25 million in adjusted EBITDA, by far our strongest quarter of the year and again, demonstrating solid sequential improvement. Bottom line, we earned our first pre-tax profit in six quarters, an accomplishment that underscores a tremendous commitment of everyone on the Modine team and a clear of our Four-Point Plan restructuring strategy.

The results are driving value through our Four-Point Plan strategy were again evident in the third quarter as follows. First, we successfully completed the sale of our South Korea vehicular HVAC business, resulting in positive cash flow from the proceeds but more importantly resulting in a further refinement of targeted product portfolio. This will enable our Asia leadership team to place more emphasis on accelerating sales growth in our critically important Asia segment where we are focused on the off-highway and commercial vehicle markets in China, India and Korea.

It is also important to note that post the sale we are maintaining a critically important engineering and sales presence in Korea to serve our highly value great customers in our focused markets. We also announced in the third quarter an additional plant closure in North America, accelerating our plans to improve our manufacturing footprint. This plant consolidation is part of our overall plan to have fewer but larger scale facilities. This will help to create cost advantage relative to our competitors while still enabling us to deliver the high-quality thermal management solutions our customers have come to expect from Modine.

We are now well positioned to overcome the economic recession and emerge as a stronger company. Our recent secondary share offering combined with strong cash flows enabled us to dramatically reduce our debt. Bob will take you through the details but I would like to note that our delevered balance sheet not only provides Modine with strong liquidity to see our way through these economic challenges but also to accelerate our plans to reposition the company for future growth and sustained profitability.

Our actions to date have resulted in a 30% reduction in fixed cost. This provides a strong operating leverage with a substantial positive sales conversion opportunity as our end markets recover. Building strong customer partnerships is a top priority for the company. Our recent strengthening of our balance sheet helped lift a cloud of uncertainty within our customer base that has existed over the past 18 months.

Our customers know that we are fully committed to their thermal management needs for the long term. On the next slide, slide five, we have updated the third quarter action in the framework of our Four-Point Plan. But I would like to spend a minute first to remind everyone about our Four-Point Plan that was put in place over two years ago as a framework to focus our strategies and to achieve our 11 to 12% return on capital objective. This framework consists of four key elements.

First, product portfolio rationalization, manufacturing realignment, capital allocation discipline and SG&A reduction. Concerning our product portfolio, we made a strategic decision to exit the vehicular HVAC business. We took some major steps forward this quarter with the divestiture of our South Korean HVAC business. This along with the announced closure of another North American plant will complete our transition out of the vehicular HVAC business, globally.

In stark contrast, high interest from the market in our patented Origami technology makes it an important component of our product portfolio that continues to present new business opportunities. Commercialization of the technology is progressing on schedule, profitable growth opportunities in the European vehicular market in radiator and condenser heat exchanger applications are accelerating.

We are on track to support the production for calendar 2012 models in the commercial and light vehicle markets. Another positive development in our product portfolio lies within our commercial products group in the industrial HVAC market. We continue to invest in this business. Bringing to market 10 new product offerings over the past year. This includes products such as affinity ninety three family of unit leaders which is the most energy which are the most energy efficient in the market. It also includes a new parallel flow or PF aluminum long coil heat exchanger designed to replace the traditional copper coil that is both expensive and inefficient for the very large building HVAC market.

We believe this market's conversion to the PF long coils industry-wide represents an estimated $2 billion available market within North America and Europe over the next few years. In addition, the continued focus on new product offerings in the computer data room cooling market continues to grow is resulting in continuing strong sales for our business in the U.K. serving Europe and the Middle East. I am very pleased with the results of our CBG team and their plans to grow their business.

We continue to realign our manufacturing footprint. Over the next two quarters, we will complete the closure of our Logansport, Indiana and Harrodsburg, Kentucky facilities. By the first quarter of the next fiscal year, we will have closed and consolidated five manufacturing plants in North America and Europe over the previous 18 months, resulting in significantly reduced fixed cost as we increase the scale of our factories globally.

The results are a 60 million reduction in our fixed cost manufacturing overhead structure from 260 to approximately $200 million. We will continue to be aggressive in driving our manufacturing footprint forward toward our objective of a leading competitive cost position in our markets.

Our investments in China, India, Hungary and Mexico were all providing great opportunities as we ramp up production with many new business awards. New plant teams and their advantaged cost positions are winning the confidence of both our global and regional customers. The timing of these plants coming online coupled with the focus on our redefined product portfolio are resulting in business wins that will provide significant growth in the latter half our five year planning horizon.

For more than three years now, we have been driving a leadership structured model toward accelerating operational excellence in our business. We call this the Modine Operating System or MOS.

Our worldwide leaders are focused on learning and teaching the fundamental principles of MOS. In recent plant business I am growing more confident that we are accelerating the rate of learning, leading to a higher rate of continuous improvement and reduction of waste. As important, we're building an improved culture of involvement that will benefit us and our stakeholders long into the future.

With the more advantaged product portfolio in place and accelerating improvement in our manufacturing footprint, we are now better able to allocate the critical resources of our financial and human capital in a much more strategic and controlled manner.

We have made tremendous progress in reducing our capital intensity for our investments. We are below our targeted levels of $65 million for expenditures for the fiscal year. Standardizing designs and maximizing capacity utilization will enable us to sustain a lower level of capital investment going forward.

In relation to SG&A costs, with we have achieved our near-term objective of 33% reduction. We have brought the business to an approximate $40 million per quarter run rate of SG&A. While SG&A is subject to inflation and will also grow in time as growth opportunities present themselves, it will do so in a highly controlled manner. Again, the Four-Point Plan framework continues to serve us well keeping us aligned with our longer term return on capital target of 11 to 12%.

Turning to slide six, I would like to take you through a few slides that clearly display the positive results that our teams have achieved. The upper left hand graph shows the drastic reduction in sales by quarter that have resulted from the economic crisis.

On a year-over-year basis, sales were down 7% but have shown modest sequential growth over the last two quarters. The line graph on the same chart shows how well we as a company reacted by reducing our SG&A cost in line with the drop in sales over the past five quarters. Again, we have established a clear run rate of $40 million per quarter which we are working to leverage as market volumes recover.

The lower left chart shows a strong progress we made in our gross margin. We now have attained three sequential quarters of improvement with a 420 basis point improvement year-over-year in the third quarter and again the highest gross margin performance in six quarters. The upper right hand chart tells a similar story for adjusted EBITDA which at $25 million marked our third sequential quarter of improvement.

At this time, I'd like to turn it over to Bob to take you through further detail on the financial results for the third quarter. Bob?

Bob Kampstra

Thanks, Tom and good morning everyone. I'm going to walk through a few slides which summarize our financial results for the third quarter as well as our current liquidity position.

So starting with turn to slide eight, which is a summary of our P&L for the third quarter of fiscal 2010, as compared to our P&L for the third quarter of fiscal 2009. Turning on top of the slide you see net sales, declining 23 million year-over-year. That decline really is related to the fact that last year's third quarter was only partially impacted by the full extent of the recession whereas in the current year we're looking at a post recession fairly number.

When you look over to the box in the upper right hand corner, we show that volume declined by segments. As you can see, the majority of that decline is noted within our North American segment. Within the segment, we haven't seen any dramatic recovery yet from commercial vehicle volumes or the off-highway business post the recession.

In South America, Asia and Europe, we do show a slight increase year-over-year, largely due to foreign currency exchange rate changes as opposed to growth within those markets. However, despite this reduction in sales, we did see a 10 million improvement in gross profit year-over-year.

Gross margin improving from 11.6% last year to 15.8% in the current year. Improvement in gross margin was largely due to the manufacturing cost reduction actions which the company put in place over the last year under its four point restructuring plan. In addition, we did see some year-over-year lower raw material prices as well as some one-time recovery of engineering design costs in the current year.

Looking at our gross margin further by segment, in the table on the right you can see that our gross margin within our South America, Asia, Europe and CPG businesses all improved quite substantially year-over-year. The only decline in gross margin was noted within our North America segment. However, the prior year was positively impacted by a one-time Fuel Cell revenue that we received with cash of 8.7 million. If you exclude that from last year's numbers, we actually show a similar increase for North America, similar to our other segments. Clearly what we're seeing is the impacts of our cost reductions across the business and across our segments.

Looking at the SG&A expense line, we show SG&A holding relatively consistent at approximately a 40 to $43 million range year-over-year. Restructuring and impairment charges, we saw very little in those charges this year whereas in the prior year, we had relatively significant charges related to our cost reduction activities as well as related to some impairments in Europe and North America.

So as a result of the gross profit improvement and the lack of the restructuring and impairment charges in the current year, we show dramatic improvement in our earnings and loss from operations as well as our pre-tax earnings both showing income m the current year versus relatively large losses in the prior year.

Similarly, our adjusted EBITDA shows improvement largely driven by the gross profit improvement and we generated 38 million of free cash, quite improved due to our improved operating results as well as the proceeds from the sale of our South Korean business.

So if we turn to slide nine, this is a slide that we've shown the last several quarters to try to back off the unusual or one-time adjustments that we can make under our covenants, under our covenants, such as restructuring charges and impairment charges.

So the top of this chart shows the fiscal 2010 third quarter results and then adjusted for those one-time items to come to adjusted results and similarly for the prior year. And as you can see, when you look at gross profit, gross margin, pre-tax and adjusted EBITDA, you can see similar trends of improvements year-over-year in all of those results.

So if we turn to slide ten, what we've shown is sequential snapshot of certain aspects of our P&L over the last seven quarters. If we start with the sales line, what you can see starting in Q1 of '09 and then declining through Q4 of '09 was really the dramatic impact of the recession that the company felt. Really the bottom of the recession noted in about Q4 of '09 and slightly into Q1 of 2010.

Since that point we've shown modest growth sequentially into the second quarter of 2010 and on into the third quarter. Still have a long ways to go to get back to pre-recession levels but we are encouraged by the slow and steady increase that we've seen in our sales.

Gross margin also shows a similar trending with the sales declining to the bottom of the recession and then improving sequentially each of the last three quarters to 15.8%, our highest gross margin since the first quarter of 2009. SG&A was running at about $60 million a quarter pre-recession at which point we took a number of cost reduction actions starting in the third quarter of last year and since that point have held us in a relatively consistent at approximately 40 million a quarter.

We look at pretax adjusted EBITDA and free cash flow similar trending to the other categories. Decreasing to the bottom of the recession in Q4 with three sequential quarters of improvement since that point. Pre-tax and adjusted EBITDA we're showing the highest levels since the first quarter of 2009 and for free cash flow the highest for all periods presented.

We the take a little bit further dive into our sequential numbers on slide 11 by segments. Start with our sales by segments sequentially.

First, I'll note as it relates to Asia that Asia really is in startup mode. We still show very nominal sales within that region. Moving on to Europe, you can see the Europe decline from Q1 '09 to the bottom of the recession in Q4 of '09. Since that point, we've shown modest improvement in sales in Europe.

North America, North America shows similar decline to the bottom of the recession but since that point we really haven't seen a tick-up yet in the North American markets. South America, similar to Europe, shows the decline to the bottom of the recession and then slow but steady improvement in the last three quarters and CPG also shows the decline to the bottom of the recession. But then nice return to near pre-recessionary fairly levels at this point, really due to the impact of new product offerings as well as some market penetration that we've been able to achieve in that business.

Looking at the bottom of the slide at the adjusted operating income again, we adjusted this for the typical covenant type adjustments for impairments and restructuring which you can see when you a lot at Europe, South America and CG you can see when you look at Europe, South America and CPG is the operating income decreasing as we moved into the recession and then for the last three sequential quarters nice improvement.

If you look at the CPG line in particular, in Q3 of fiscal 2010, we earned 7.9 million within that segment. That's the highest profitability of any of our segments during the quarter and highest profitability that that business has achieved over the seven periods. They had a very nice quarter.

On notes about North America. What you see in North America is that they were already at a pretty depressed profitability level prior to the recession in Q1 and Q2 of '09. Starting in Q3 and Q4, we have the impact of cost reduction activities showing a nice improvement in that business which improved sequentially into Q1 and Q2 of fiscal 2010.

However, in Q3, you do see a reduction going from 6 million, down to $2 million in Q3 of fiscal 2010. What we're starting to experience in this business is the impact of some rising raw material prices driving that quarter-over-quarter deterioration. We'll spend a little bit more time talking about the impact of raw materials a few slides further when we get into our outlook.

So finally, turning to slide 12, is a summary of our free cash flow. What we've shown on this slide is our first quarter, second quarter and third quarter of fiscal 2010 free cash flow by quarter and then our year-to-date numbers and then our full year for the prior year for comparative purposes.

So we look at the Q3 of 2010 column, what you can see that with our net cash earnings during the quarter, plus some working capital improvements, we generated $31 million of operating cash flow. Certainly, that number has improved from the prior two quarters with the improvement in our operating results.

Capital spending you'll note we spent approximately $7 million during the quarter and $41 million for the first three quarters of fiscal 2010. That number is substantially beneath the prior year and well within our goal of achieving $60 to $70 million of capital expenditures in the current year.

Disposition of assets line of $15 million includes the sale of our Korean business, approximately $11 million of those proceeds. So ultimately what this results in is our free cash flow for the quarter of $39 million which we used to pay down indebtedness. If you look in the upper right hand corner at our net debt graph, which is our total debt less cash on hand which you can see is our net debt was increasing into the recession up to the first quarter of 2010, when we had $229 million of net debt.

Since that point, we've seen a dramatic decline in the second quarter, with the results of the secondary stock offering and then a further decline to $88 million in the third quarter with the results of our free cash flow generation. So at this point, our net debt-to-capitalization ratio is 19% which is well within our targeted range.

We have available borrowings of $175 million, plus we have cash on hand of $44 million. So we believe that this is more than sufficient liquidity to fund our future growth opportunities. So at this point, I'll turn it back to Tom who will spend some time talking about our future outlook for the next quarter.

Tom Burke

Thanks, Bob. As I mentioned in my opening comments there remains significant uncertainty in most of markets we serve. One thing we've learned during these uncertain times is you have to plan conservatively and then react quickly to the changing factors in the marketplace.

We know there will be unforeseen factors and volatility as we move forward but we have proven to ourselves that we can adapt as necessary and we will continue to do so. Turning to slide 14, we have spelled out our current assumptions for the calendar year 2010 as compared to the calendar year 2009.

In North America, we expect the following. Class A truck sales reach approximately 103,000 units or 15% increase for calendar year 2010. We expect medium truck sales which is Class five to class seven vehicles to rebound by as much at 40% to 115,000 units. In North America, off-highway which is the ag and construction markets, we anticipate a flat market based on lower gain prices and a depressed housing construction market.

In Europe, we expect the commercial truck to increase about 5% while the off-highway is anticipated to remain flat. Both of these are coming off a very low base. The light vehicle market in Western Europe where customer base has fared relatively well through the economic crisis is expected to be flat to slightly down this calendar year.

In South America, the truck and bus market is forecast to increase 10% in the calendar year, but we have the agricultural market at a flat expectation. Following the divestiture of our south Korean vehicular HVAC business, our remaining sales in Asia are small but are growing rapidly as we launch over 80 programs this calendar year in China and India.

Our commercial products group which serves several segments in the industrial HVAC market continues to be a bright spot in our portfolio. Our core markets are expected to grow modestly next year. However, our new technology offerings are being well received, resulting in increased sales through share gain in year-to-year market as well as the coil conversion opportunity I referenced earlier.

Overall at this point we're planning for modest overall sales improvement for our next 12 months. Turning to slide 15, we have stated that we do expect some headwinds as we look forward that could impact our fourth quarter gross margin. As I mentioned earlier, we're prepared to take these head-on as we have a great number of challenges over the 18 months.

Some have a one-time impact that we fully expected such as with plant shutdowns. Over the next two quarters, we will complete the previously announced closures of the Logans Port, Indian and Harrodsburg, Kentucky facilities. These closures will result in incremental one-time cost associated with the product transfer and shutdown activity.

The second headwind we anticipate is the seasonality which exists in our commercial products business. The heating season usually comes to a close near the end of January which results in a typical gross margin decline as sales of higher margin heating products decline.

The most significant factor anticipated to exert pressure on our near-term gross margin is raising commodity metals pricing. In view of the steep rise of metal cost over the past year, we anticipate commodity prices will have a near-term impact on our gross margin. The impact very much depends on the magnitude and duration as we manage the material pass through agreements with the customer.

Bob will now provide you more detailed summary on the detailed summary on recent trends of capital and raw material prices and how this volatility may impact the performance in the near term.

Bob Kampstra

Thanks, Tom. Turn to slide 16, take a little bit deeper dive into the impact we expect from the commodity trends that we've recently been experiencing. Two factors, we're anticipating are going to put pressure on our margins. First is rising purchase costs and then second is decreasing pass-through price to our customers.

I'm going to walk through each of these separately. If you look to the left side of this chart, you see two graphs. The top graph is a 24 month history of aluminum prices and the bottom is 24 month history of copper prices. These are two of the largest commodities that the company purchases. What you can see is both commodities were running at relatively high prices in 2008, prior to the recession and then with the recession there was a dramatic decline in the prices to some lower levels that we were experiencing earlier in 2009.

Since that point, both commodities have shown a steady rise in prices. Aluminum up 55% in calendar 2009 and copper up 160% in calendar 2009. We're anticipating that these higher prices will have an adverse effect to our gross margin in the near term. At the same time, we have decreasing pass-throughs with our customers under the contractual arrangements.

We have contractual pricing arrangements with our customers that vary. Some are quarterly, some we price semiannually and some annually. So if we use an example of an annual repricing in November for example and we look at this graph over the on the right, we tried to show how this is impacting our results.

So let's say we had an annual price that repriced in November of 2008. That would have set the pricing at the higher commodity prices we were experiencing in the prior year. So for the first, second and third quarters of 2009, we were able to charge a higher pass-through to our customers under our contractual arrangements.

Then in November of 2009, when that annual contract reprices, it reprices at the very low prices we experienced earlier in 2009, resulting in a decrease in our customer pricing that we're anticipating starting in the fourth quarter. So what you have is with customer pricing decreasing in the fourth quarter, while at the same time our material costs rising, you actually get a double impact which is being caused by the changing metals.

We are expecting this to have a near-term pressure on our margins. The extent and duration of this though is not known because it really is dependent on the LME trends. If the LME trends stabilize, what we will expect is that with the timing of our repricing agreements, quarterly, semiannual and annual to slowly catch up and slowly decrease that gap. So at this point, I want to tint back to Tom who will make some concluding remarks.

Tom Burke

Thanks Bob. Summary, turning to slide 17, we are confidently focused on delivering on our near-term objectives of converting our established operating leverage while at the same time preparing for future growth and with it long-term shareholder returns.

We believe the worst is behind us, we still have more work to do. We will continue to accelerate our plans to improve our performance and competitiveness every day. We will manage any near-term challenges quickly and effectively while remaining laser-focused on delivering on our long-term commitments.

The Four-Point Plan remains our strategic framework to drive and guide us forward. Our global product organizational structure and leadership model is continuously challenging our offerings to ensure that we can provide competitive solutions in each region of the world.

Our renewed and increasingly advantaged product portfolio is now concentrated to provide high value to our targeted markets and customers. Our research is more targeted than ever on projects that will bring innovation to our current customers as well as new market opportunities.

A good example is our extensive focus on waste heat recovery for which we recently received a $5.7 million grant from the Department of Energy to fund additional research in this promising technology to improve fuel efficiency for commercial trucks. We will continue to accelerate improvements in our manufacturing footprint. Our focus is to attain the lowest global manufacturing cost versus our competition through improved scale, low-cost country utilization and continuous improvement in operating excellence through MOS.

Our capital allocation discipline and methods are driving us to a leaner asset base that will be highly utilized in conjunction with our future manufacturing footprint strategies. Our aggressive SG&A actions have been affective in lowering our SG&A by 33%. But we've also protected the vital resources required to maintain a strong product offering and research focus.

In addition, we're well prepared to effectively manage our SG&A needs as we move forward through our growth plans. Bottom line, with the execution of our Four-Point Plan framework, we will emerge as a much stronger company well positioned to achieve future growth. We’ve attained a much stronger balance sheet and liquidity position with a successful secondary share offering and cash generation within the business.

This gives us the needed liquidity to fund growth opportunities. We have made significant improvements to our cost structure and committed to accelerate further changes. We have positioned Modine to capitalize on the significant operating leverage and lower breakeven levels we have attained as market volumes return to near – over the near and intermediate term.

Regulatory and technology changes in our end markets will continue to drive future growth opportunities for Modine. This includes future changes in emission laws, fuel economy standards and development of alternative energy solutions. These are all positive opportunities for Modine.

Finally, I would like for all of our shareholders and customers to know that the leadership team and our entire global workforce is fully committed to drive value, innovation, which together will enable profitable growth for the future. And I would like to add that with all of the trials of the last 18 months which have been significant, we are now more confident than ever in our long-term outlook and ability to deliver ongoing shareholder value.

With that we'd like to invite your questions and comments.

Question-and-Answer Session

Operator

(Operator Instructions) And our first question comes from the line of David Leiker with Robert W. Baird. Please proceed.

David Leiker – Robert W. Baird

Hi. Good morning, everybody.

Tom Burke

Good morning, David.

Bob Kampstra

Good morning, David.

David Leiker – Robert W. Baird

As we – while we're seeing that a lot of other commercial vehicle related companies here in calendar fourth quarter, the pre-buy activity pretty strong numbers, better than expected in the top line. Did you see much of that at all or not?

Tom Burke

No. We really didn't see. There was a lot of talk in the industry with the numbers that came in late in the fourth quarter but that didn't really flow through for us as you can see from our quarter-by-quarter analysis, David.

David Leiker – Robert W. Baird

What's the explanation for that? Because (inaudible) they just built every engine that they could in December.

Tom Burke

You know, our patterning, our sourcing is with – near 50% of the market. Just the way that balanced out with our content for whatever reason, it didn't flow to the top line.

David Leiker – Robert W. Baird

Okay. And then as we look at your commercial truck business, particularly here in North America. Do you have a particular mix spread there between medium duty and heavy duty? Does one matter more than the other?

Tom Burke

Well, we have – I would say it's a pretty balanced focus on share between the two, medium and heavy right now. So I don't think there was any impact on that. Obviously, I don't anticipate any relative change as I can think of the numbers here, David.

David Leiker – Robert W. Baird

What about your content? You have more content on 13 or 15-liter engine than you do on nine or 11 or…

Bob Kampstra

It varies by customer again. As I think about it there's pretty even content with the module and EGR applications that go in both Royal coolers and the like so I think it's, again, pretty evenly distributed, my guess. We can follow up on that.

David Leiker – Robert W. Baird

Okay. And then the other item kind of similar but a little bit different vein, when we look out, all those engines, when we look at production in Q1 versus Q4, calendar Q1 versus calendar Q4, there's a pretty significant increase in production sequentially. Seems like you're indicating that things are more flat sequentially. I'm just trying to understand the difference there. You show North American production up 10 to 15%.

Bob Kampstra

Right.

David Leiker – Robert W. Baird

Q1 versus Q4.

Bob Kampstra

I guesses guess in the Q1 to Q4 you're asking.

David Leiker – Robert W. Baird

Calendar Q4 to calendar Q1, there's about a 10 to 15% increase in North America.

Bob Kampstra

We thing that's going to be back half loaded on those sales increases. Data read coming in that the sales still remain at a pretty low level compared to that kind of coming out of the last fiscal year from our standpoint and the indications from our contacts is it's going to be a back half loaded because as people anticipate the engine model changes and not wanting to buy in until they're proven out.

David Leiker – Robert W. Baird

These are the production numbers. Are you shipping to the engine maker or the truck maker?

Bob Kampstra

We do both.

David Leiker – Robert W. Baird

Okay. And then one last item here and I'll cycle back. When we look at the 2010 engines versus the 2009 engines, what kind of increase in content do you have on those engines? Is there a big difference?

Bob Kampstra

Well, the biggest increase came with the opportunity of EGR content on the F 10. With the calendar year 2010 changes on emission, that's where we see most of our content increase was on EGR.

David Leiker – Robert W. Baird

Okay. What kind of a content is that – is that 5% more, 10% more or 50% more content?

Tom Burke

Well, as the – on a revenue basis, I can't put a percentage on it. I know the opportunity for revenue as we stated for EGR business, it grows to a significant amount of revenue that comes up off the total EGR applications, we have across the market. We stated publicly that we're out there at 80 to $100 million worth of sales, once that fully matures online with all engines in place.

David Leiker – Robert W. Baird

What are you currently expecting the time line for that to start to roll through? In 2010, when do you start shipping on that in your guidance of revenues staying relatively flat here?

Tom Burke

I think you have different factors as the engines come online depending on what OEM it is, both on commercial truck and off-highway by the way, so therefore that is delayed a little bit more versus the commercial truck deadline of January 10.

David Leiker – Robert W. Baird

How are you expecting that, is that something you start to see in calendar first quarter or is it calendar Q2, calendar Q3, where do you thing that starts to ramp up?

Bob Kampstra

I think, David, I think it's slowly ramping up at this point. We've got a number of launches in our Joplin facility over the third and fourth quarters. Actually they are slowly starting to ramp you are starting in the first quarter and I think you will see a little bit steady increase in these volumes as we look to calendar 2010.

David Leiker – Robert W. Baird

Okay. Thanks. I'll come around if there's no one else. Thanks.

Tom Burke

Thank you.

Operator

Our next question comes from the line of Walt Liptak with Barrington Research. Please proceed.

Walt Liptak – Barrington Research

Hi, thanks. Good morning everyone.

Tom Burke

Hi, Walt.

Margaret Kelsey

Hi, Walt

Walt Liptak – Barrington Research

Hi. Not to beat a dead horse on the pre-buy thing but when you ship out something that's like maybe a higher priced product like a cooling module or a radiator, does that typically go to the truck OEM or the engine OEM?

Bob Kampstra

The module will typically go to the truck OEM.

Walt Liptak – Barrington Research

Okay. So is it safe to say that most of your product is sold to the truck OEM. There is some things maybe EGR coolers or transmission coolers or something that are…

Tom Burke

The majority goes to truck OEM either via the assembly point or engine build-up. Now there are different engine, manufacturers that supply the market. I would say that's a minority of our sales. Most are to the OEM.

Walt Liptak – Barrington Research

So you wouldn't expect to see a pre-buy because the pre-buy was with the engines, not with the trucks.

Tom Burke

Right.

Walt Liptak – Barrington Research

Okay. I wonder if I could ask about the gross margin and you didn't give – thanks for the charts and some of the clarity, but can you help us with just a data point on what gross margin degradation might be in the fourth quarter versus the third in basis points?

Tom Burke

Yeah. Yeah. We laid out the, kind of the three items, the metals, kind of the launch inefficiencies and plant closures and then the seasonality. When we look at all three of those factors, it's tough to completely predict the future but our estimate at this point is a combination of those three could be as much as about a 300 basis point decline in our gross margin when you look at third quarter to fourth quarter.

Walt Liptak – Barrington Research

Okay. And is it possible we could get a shot at what 2011 gross margin might be considering the continuation of some of these gross margin impacts?

Bob Kampstra

It’s not something that we can give to you. We're still in the process of completing our planning process for next year and so at this point we're just not in a position to be able to give quantitative guidance to fiscal 2011 as it relates the to our margin. We certainly – the plant closures we anticipate will be completed by the end of the first quarter of fiscal 2011. So that is certainly something that will impact Q4 and Q1. The seasonality is really a Q4 type impact, only with CPG business and their heating season. And then the metals, that one's probably the most difficult to really predict. If the markets would, if the copper and aluminum markets would settle and certainly in the month of January we saw a little bit of that, then that helps with the catch-up. If they don't, then that catch-up is a little bit longer. So, we don't really know if we're talking and we don't though how long we're talking about impacts in the next several quarters.

Walt Liptak – Barrington Research

Okay. Thanks for that. Fair enough. And for your fourth quarter, what kind of cash flow quarter should that be? Are there still inventory draw-downs and other things that can happen, or where do you expect to end the year for net debt?

Tom Burke

Yeah, we're at – anticipating our net debt isn't going to change all that significantly from where it is at, at this point in Q4. So what you have is you saw the working capital improvement in Q3, really due to some of the seasonal shutdowns that we experienced right around the holiday. So you get a little bit, so you have a little bit of that coming back in the fourth quarter in terms of spends.

So, our view at this point is net debt's going to hold relatively consistent, maybe slightly down or net debt might be slightly up a million or two but generally speaking we're just being relatively consistent.

Walt Liptak – Barrington Research

Okay. All right, thanks. And I guess I was a little bit surprised by the off-highway outlook of flat to slightly down. I guess my question is how did you formulate that outlook?

Tom Burke

I mean we pick up data from all sorts of points and obviously there's some that are stronger than others, depending on specific submarket, if it's construction, heavy construction or mining or whatever. But with housing starts where they are, we still feel that there's going to be a down market in light construction.

Obviously we have expectation of things kicking in and wherever the heavier mining, industrial equipment might go would be more of an opportunity possibly. But right now, again, we're kind of planning conservatively.

Walt Liptak – Barrington Research

Okay. All right. Thanks very much, guys.

Operator

And the next question comes from the line of David Leiker with Robert W. Baird. Please proceed.

David Leiker – Robert W. Baird

Just of couple of other items here, you talk about on slide 14 about your Asia business and that you're launching 80 new programs. Are all those programs going to run through Asia in the revenue line?

Tom Burke

Yes, they will.

David Leiker – Robert W. Baird

Is that how we should look at that?

Tom Burke

That's how you should look at that, yes.

David Leiker – Robert W. Baird

And is there any way you could frame the revenue opportunity that, that where that revenue base in Asia goes to?

Tom Burke

Okay. Well, it's pretty much balanced as far as ramping up through the course of the year, okay, that we're looking at that. Clearly, we have a heavy focus on the off-highway business, okay. We still have some light industrial and beginning to look at some opportunities on the commercial truck. But it's really the growth is with the off-highway focus and the market growth opportunity.

David Leiker – Robert W. Baird

So, that's a $9 million a quarter business today. Is that something that as you launch all those programs, all this business? Does that become a $15, $20 million a quarter business?

Tom Burke

Well, there is significant growth. We don't have that dimension for public information yet, David. And that obviously as we gain a handle on our next fiscal year and are planning through the five-year process, we'll give more definition of that. Right now, I'm not in a position to publicly disclose that.

David Leiker – Robert W. Baird

And then how should we look at the profitability of that relative to segment or the business overall? As that new business launches, what happens with margins within that business segment?

Tom Burke

Yeah. As you know, we have a strong focus on our gross market contribution, what we're going after and that's right inside of that expectation that we have for 18 to 20% gross margin we are probably talking about. We feel that this is definitely accretive to the business.

David Leiker – Robert W. Baird

And then the last item, can you talk a little bit, you mentioned in your comments but can you talk a little bit about what you're working on specifically as it relates to cooling systems for hybrid electric vehicles?

Tom Burke

Yeah, we've got more or less kind of development projects going on mostly for Eastern Europe. We have talked about this before, okay. As far as commercialization of that, yeah, we are not in a position to make a statement on anything, obviously we're kind of doing a lot of sorting out, trying to find out where these technical trends are going and where the biggest value for heat transfer technology support is required. So, it's a lot of shifting developments there.

Our focus is to build design platforms, David. I think we walked through that before. Ones we can really substantiate and put a long-term plan on and there's still a lot of shifting around, exactly what the platforms are needed to support the OEMs that are looking at this, are pressing quickly.

And we've actually looked at some and decided that we don't see a design platform opportunity to invest in because it would be just kind of short-term one-off type of investment that we don't see the kind of return that would be the best use of our resources. So we're still kind of searching and working with OEMs on development side to find that foothold.

David Leiker – Robert W. Baird

Are you working with automakers or with battery companies?

Tom Burke

We're working with both. We work with OEMs, battery companies and let's say Tier 1 suppliers. So it's a combination of all three.

David Leiker – Robert W. Baird

And are you working on both liquid cooled and air cooled solutions or is it just liquid?

Tom Burke

We are working on and you're testing me now, David. And I would say I think we're working mostly on liquid cooled applications.

David Leiker – Robert W. Baird

Okay. Great. Thank you.

Operator

And our next question comes from the line of Gregory Macosko with Lord Abbett. Please proceed.

Gregory Macosko – Lord Abbett

Yes, thank you. We should get a question from the other side of the street here. Could you talk about the – that slide you had with regard to the change in price on, I think 16, yes, 16. Now, clearly you have an understanding of how the pricing is, it's falling and I guess it's hitting bottom in a sense in the fourth quarter. Can you given us a sense of when, given the prices that have come through in the past, when that price, those contract pass-throughs might start to go the other way?

Tom Burke

Yeah. I mean, we have quite a mix of different pricing arrangements with our customers, really on a global basis. There are several that are on quarterly. There are several that are on semiannual and some that are annual. So, the quarterlies, those certainly within the next quarter re-price and the semiannuals within the next six months and then we do have a few contracts that will be a while.

Now, one of the things, things I want to know is that one of the focuses that we really have with this volatility in this marketplace, the semiannual and the annual re-pricing, you certainly get this lag impact. And one of the things, we're trying to do is standardize our arrangements with our customers and our suppliers to try to get more toward a three month repricing basis.

And certainly that helps manage that lag but that's going to take us some time. So, it's really going to be a mix, depending on all of the different arrangements we have over the next three to 12 months.

Gregory Macosko – Lord Abbett

Okay. But right now, there's six and 12 months time frames?

Tom Burke

There's three, six and 12 month time frames.

Gregory Macosko – Lord Abbett

Okay. And would you say that at this point or in the fourth quarter that we've hit bottom in terms of the pricing and, I mean, given obviously you're looking behind yourself and knowing what the prices were, so have we come all the way down at this point?

Tom Burke

I could tell you that the contracts that re-pricing now, were pricing off of the bottom of these two graphs. So with those prices you were seeing in the June, July, August, September time frame was when those prices were being reestablished off of. I can't expect to get that.

Gregory Macosko – Lord Abbett

I guess so that there will be some annual contracts, perhaps that will also price down in the next couple quarters as well, then?

Tom Burke

Yes. And annual contracts that re-priced here late in our third quarter, so they re-priced at the bottom of these charts. Now, where these charts go from this point I can't speculate, but we are at this point priced with some of these annual re-pricings lower than where the current LME is at.

Gregory Macosko – Lord Abbett

I understand that. So the point being that we're probably not all through, I mean, obviously some will change depending upon the time frames but there could be even past the fourth quarter a little bit, some more pricing down is possible?

Tom Burke

Well. Our next round of pricing primarily is in the April 1st time frame and so that pricing would be based generally on the prices we're seeing in the late fall November, December type prices, so that would actually, those prices would actually price up at that point.

Gregory Macosko – Lord Abbett

Okay. And you mentioned as pressure on the gross margins from the CPG group, the seasonality of it from your just looking at it, how is that seasonality and is it typical? Or Is it less than normal? More than normal?

Tom Burke

It's very typical. In fact, if you look back at the last several years, what we've always had in the fourth quarter is a seasonal decline from our CPG business. The heating products tend to be higher margin products and so as that season really comes to an end at the end of January, we do have less sales of those heating products and so just a natural seasonality just due to the product mix. What you have happening in prior years where you may not have seen it quite as significant is the CPG business was a smaller piece of the total Company. So if you remember on that earlier slide where I showed that CPG was our most profitable piece of our Company in the third quarter, that is exacerbating that impact and it's seen much larger this year than maybe you've seen other years.

Gregory Macosko – Lord Abbett

I see. But the point being that we're kind of moving forward sequentially and you make the point about sequential growth in all your product areas and I assume this one as well. If we're seeing a sequential shift, in other words, from the bottom of the cycle wouldn't you suggest that the seasonality might be a little less this time around or is that not, that's not the case?

Tom Burke

No. In fact, I think we're seeing it's a little bit higher, just with, CPG had a very, very good quarter with 31% gross margin and that's not the type of margin that they get all year, certainly and so just with CPG being the biggest piece of our profit driver right now and the normal change in their gross margins through the seasons, as we come out of the heating season, we will see a decline just off of their gross margin.

Gregory Macosko – Lord Abbett

I see. Okay. Okay. Well, sounds as oh and then, with regard to Asia, 80 new launches, I assume those are small OEMs in China and in Asia so they're I mean, 80, that's in the space of a year?

Tom Burke

Yeah. That's in a year, just shows the aggressive ramp-up we have in those plants. We've had had a little bit of impact in India with some delays of launching which pushed that back a little bit as I mentioned in the earlier answer. That's why we haven't been public yet with the quarter by quarter impact. We know there's significant growth. We're happy with it. Yes, a lot of smaller off-highway customers in some cases that don't bring the big revenue stream to the top line but we are very comfortable that we're on the right path and excited about filling those facilities up with good, quality business.

Gregory Macosko – Lord Abbett

And do you see additional launches following that? I mean, are there still things in the pipeline in Asia?

Tom Burke

There are more things the pipeline in Asia, okay, both, we've had great success with our global customers that have a growing presence in both India and in China. Of course, we're really focusing on regional customers as well which provides an opportunity yet that's really hard to define because we're starting to make those relationships and establish those. We feel very positive with the growth opportunity and I feel extremely positive now that we've got the Korea divestiture behind us and our leadership team is focused on that sales strait question strategy and building those relationships in the near term there.

Gregory Macosko – Lord Abbett

The development projects for cooling projects for the electric vehicles in Europe and I guess Asia, is there any time frame on those in terms of when they start delivering revenue?

Tom Burke

Well. A lot of this, my estimation, okay. Is customers are pressing to get new vehicle platforms out there and specifically in the hybrid or full electric, there are certain manufacturers that are rushing for the near term gain and there are those that are really looking for the long-term opportunity. That's what we're trying to lock in on. I can't give you a defined time frame, Greg, although we're going to make sure we find value because again you can get a lot of you get pulled into a lot of different directions, okay, as you chase one-off type projects. I won't go with any specifics we decided to pull away from but there are have been some we have made those decisions simply because we see them as one our project in our long term platforms so we are still on that position looking for those and feel confident they'll develop but we're not committing anything yet.

Gregory Macosko – Lord Abbott

All right. Well, thank you very much.

Operator

And our next question comes from the line of Dennis Scannell with Rutabaga Capital. Please proceed.

Tom Burke

Hi Dennis.

Bob Kampstra

Hi Dennis.

Dennis Scannell – Rutabaga Capital

Yes. Good morning. Tom, just maybe follow up a little bit on Greg's question and I think David was there too. When you talked about fiscal year 2010 early in the fiscal year, you had said look, we're adding this year current fiscal year about $100 million in net new business, I think a lot of it was EGR and there was a big chunk of automotive in Europe. Is there any way to give us a similar feel for what you'll be looking at for fiscal 2011, generally speaking? Sounds like the biggest chunk will be coming from Asia, but I am just trying to get a sense of the overall.

Tom Burke

I can't give you any details yet kind of as I answered before, Dennis. But we feel that we're going to plan conservatively and that includes making sure that we are below but we're really focused on as we said a modest overall sales improvement for the next 12 months. If things come rushing back, there's projections for medium duty being 40% in North America and 15% in commercial truck and we aren't seeing those releases yet. As I do my research, everybody says maybe back half of the year. Some of the reading the fleet sales they're really going to test these 10 engines out before they start making commitments and there is still lot of capacity on the class 8 side but yet more demands on the mediums because of the fuel efficiency opportunities and the service they need. So we hear all that but we're going to planning modestly. And I just think that's an important theme our shareholders should know. We're not going to get ahead of ourselves here. We're going to plan that way and take things on as them come.

Dennis Scannell – Rutabaga Capital

Fair enough. Again not looking for a number here but just in terms of where the launches are, is it safe to say that for fiscal 2011 the largest place for incremental new business, I'm not thinking where build rates are but just incremental new business, new modules, is in Asia or are there other – ?

Tom Burke

You meant as a percentage over –?

Dennis Scannell – Rutabaga Capital

Yeah.

Tom Burke

As a percentage of our current state Asia will be ramping up with the percentage of growth higher. The absolute dollars of that will be less. Obviously, North America on a 2010EGR is going to be a ramp-up spot. Brazil, Europe, just estimation, pretty stable depending on what volumes do there. CPG, despite the seasonality, we're starting to look at this PF long coil business with opportunity that starts having an impact this year as well as the computer room data cooling business which is showing signs of growth for our Airedale business. So the order book there is strong. Again, we see good indications coming into different areas across our portfolio which we're happy about, again, diversified. But we're going to be modest in our estimation.

Dennis Scannell – Rutabaga Capital

Yeah. Fair enough. One last thing on the repricing of pass-throughs, so they're annual, quarterly and semiannual. Do they – in general, does your contracts kind of roll evenly throughout the year or does the December contracts, is that kind of half of the contracts because yearend plus it's also the semi-annual?

Tom Burke

I'm going to turn this over to Bob. But I think it's important that we are really focused on working with all of our customers to find what I would say a very balanced and fair methodology for managing these pass-throughs. And of course it takes a while, it's program by program that you have to go through to set these up. But we are well positioned with our teams and having in some cases some pretty hard discussions with what we need to have going forward and making sure that's part of that we can protect ourselves from the volatility. But as far as specific timing, Bob, you want to add to that?

Bob Kampstra

Yeah. Our contracts, while they do vary, they tend to fall at quarter-ends type things. So April 1st, July 1st, October 1st, January 1st time frames. So looking at the – in Europe we tend to be more quarterly. In North America we tend to be – we have a mix of quarterly, semiannual and annual. I would say that there is I don't see a weighting toward any one time of the year or any one part of the year at this point.

Dennis Scannell – Rutabaga Capital

Yeah. I just wanted to make sure that while since unfortunately December that's repricing it's not that half of them are being repriced in an unfavorable time. Okay. That's – you answered my question. Thank you very much.

Bob Kampstra

Thank you.

Operator

And the next question comes from the line of David Leiker with Robert W. Baird. Please proceed.

David Leiker – Robert W. Baird

Just one last item, of this 80 to $100 million of revenue.

Tom Burke

Yeah.

David Leiker – Robert W. Baird

That's an annualized number when everything's up and running, correct?

Tom Burke

That's right.

David Leiker – Robert W. Baird

And do you think, 12 months from now that that's all up and running that?

Tom Burke

Yes. I do.

David Leiker – Robert W. Baird

And is there any way you can give us a sense of how much of that would be EGR versus Europe versus Asia, any breakdown in that at all?

Tom Burke

I just, I guess, I would say that again, I'm trying to quantify in my mind. I would say if you put that as a whole bunch, you would say North America EGR is a majority of that, I would guess and Asia kind of represents a smaller piece and throughout the rest is balanced across what I described in the CPG markets whether it's – air conditioning or long coil business that we're growing over time, as well as some new launches on the condenser business in Europe that we haven't really talked about with Origami that has an opportunity to start coming online. So we will have the opportunity to start coming online, so but I would say that's how I would break it down very qualitatively, David.

David Leiker – Robert W. Baird

Okay. Great. Thank you.

Operator

(Operator Instructions). And the next question comes from the line of Sean Nicholson with Kennedy Capital. Please proceed.

Sean Nicholson – Kennedy Capital

Hi, Just a quick question on Origami. Can you get a sense of what the scope of that launch will look like, how quickly that ramps up with that area?

Tom Burke

For the commercial truck in Europe it's out a few more years, so we haven't define as going to go euro six standards for compliance for emissions in Europe. So heavily – kind of as we said, kind of the back half of the five year horizon, strong influence with that. There will be some condenser applications that are sooner than later that we're starting to work on and we have not quantified that will be part of this annual plan for fiscal '11 and the five year plan going forward that we'll be able to define that better. But right now, I can't quantify that.

Sean Nicholson – Kennedy Capital

Is there any other technology that is out there that you guys will be competing with other OEs that may use a competitor is this something you can take pretty much in the market at this point in time?

Tom Burke

We feel that – again the distinct advantages of what they're looking forward the market in Europe from the standpoint of commercial trucks both the because of the higher operating pressure and fuel efficiency has a big draw of value there, which is what we have the aggressive targets that we do for objective for market share in Europe. The same thing applies in the condenser application because of smaller engine packages and weight opportunities and the like. We also feel, it's going to be strong there, but that's the biggest factor there.

Again, the EGR '10 has been a proven technology that we've been successful with in this region and we're looking at the same EGR opportunities for Europe as they grow, because they're going to need that added capacity for gas recirculation in Europe with euro six standards. Those are really kind of the largest factor PF long coil, as mentioned there is a new technology that we are out there with just a few people that we'll be working to really gain the opportunity of that large, large available market as the industrial HVAC business starts to convert and that's looking pretty exciting for us, quite frankly. So there's a good half a dozen technologies that we feel that we're going to serve us well over the next couple of years.

Sean Nicholson – Kennedy Capital

Thanks, guys.

Tom Burke

Okay.

Operator

Ladies and gentlemen, this concludes today's question-and-answer session. I would now like to turn the call over to Susan Fisher for closing remarks.

Susan Fisher

Thanks for joining us for our discussion on Modine's Q3 fiscal '10 results. Look forward to apprising you of our progress going forward. Thank you.

Operator

Ladies and gentlemen, we thank you for your participation in today's conference. This concludes the presentation and you may now disconnect. Have a good day.

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Source: Modine Manufacturing Company F3Q10 (Qtr End 12/31/09) Earnings Call Transcript
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