- Modine Manufacturing's stock price has gained 20% post its recent earnings beat.
- While the market is excited about the company's 21% year over year growth in Europe last quarter, a closer look suggests that this growth is not sustainable.
- Back in the US, agriculture end-market has started showing the signs of weakness and growth in light vehicle sales is slowing as well.
- Sell side is estimating growth to accelerate to 8.70% in FY2015 (Mar.) which is unlikely.
- The stock is likely to give up most of its recent gains as market expectations reset to a more reasonable level post March quarter earnings.
Modine Manufacturing (MOD) is involved in manufacturing of heat exchangers (radiators, condensers etc.) for use in on-highway (truck, bus, automobile) and off-highway (agriculture, construction) OEM vehicular applications, and also in building, industrial and refrigeration markets.
The company's stock has seen over 20% gains in the last couple of weeks. This upside has been driven by the company's better than expected results and analyst upgrades. In particular the company's results were very strong in Europe (21% increase in year over year sales). Modine derives 36% of its sales from Europe and therefore any strength in its European end market is a big positive for the company. Hence, investors rewarded the company post its recent results.
However, if we dig deeper into the company's European growth numbers, this pace of growth doesn't seem sustainable. Also, the company's North American business is likely to see headwinds from decline in agricultural equipment demand. Here's a look.
Europe accelerating, but are the underlying trends really that strong?
The company reported 21% year over year increase in its Q3 (ended December) sales which positively surprised the street. However, if we try to dissect European gains we will see that one of the major drivers for them was the currency. In the quarter ended December 2013 average EUR/USD rate was 1.36 while in 2012 it was hovering around 1.29. So, this resulted in 540 bps of the tailwind. Going forward, this currency tailwind will diminish.
Another important driver of Modine's strong growth in fourth quarter was the pre buy of Euro 5 vehicles. Europe implemented Euro 6 norms requiring all new trucks and buses registered in EU member states to comply with new emission norms from January 2014. Since Euro 6 compliant vehicles are significantly more expensive than Euro 5, it resulted in surge in Euro 5 sales before January 1 deadline. At the same time Modine benefited from ramping up of Euro 6 compliant product as well. If we go by European Automobile Manufacturer Association's reported figures, commercial vehicle registrations were up 8.1% in October, 8.9% in November and 34.7% in December - this compared to a total of just 1% year over year increase for the full CY2013. Given Commercial Vehicles account for 25% of the company's European sales, I believe this contributed to ~500 bps increase in growth rate. Going forward, I expect this bump to vanish and instead become a headwind in CY2014 (FY2015). For example, truck sales in Britain dropped by a whopping 37% year over year in January 2014.
If we assume mid teen growth in European light vehicle sales (generous), currency tailwinds to reduce to 250 bps (still positive) and 4%-5% decline in commercial vehicle sales; we will have ~11% growth in the Europe for the next fiscal.
North American headwind
In addition to European growth decelerating, the company's prospect in North American market also doesn't look good. Unlike the European end market which primarily comprise of light and commercial vehicles, Modine's North American revenues are much more diversified with Agriculture/Construction (23%), Industrial (14%) and Services (19%) end markets contributing significant revenues.
In the last three quarter, the company's North American revenues have been relatively flat. However, going forward, weakness in agriculture end market might cause decline in the company's North American business. Wheat and corn prices are significantly below their mid 2012 highs and adversely affecting farm incomes.
According to projections by the US Farm equipment giant Deere and Company (DE) US farm cash receipts, which reached an all time high in 2012 and 2013, are expected to decline in 2014. This will adversely affect US and Canadian agriculture equipment sales which, according to Deere, will decline by 5%-10%. Other agriculture equipment companies like AGCO Corporation (AGCO) are also giving similar commentaries and indicating looming slowdown in the US sales. Modine is likely to see a derivative impact of slowdown as it supplies parts to agriculture equipment OEM.
Now one might ask - grain prices are on a downward trend for last year and a half, why has it suddenly become an issue for Modine now? While grain prices started declining from mid 2012, balance sheet of US farmers were still strong in 2013 coming out of 2012 (which was a record year in terms of profitability). Companies like Deere and Co. reported around 5% increase in the Us equipment sales in 2013. It was not until the late fourth quarter of 2013 that the first signs of cracks in this end market started emerging. Unless there is any meaningful upturn in agricultural commodities prices, this market is likely headed south from here onwards. So, it poses an incremental risk going forward that is not already priced in.
In addition to decline in agriculture end market, the US light vehicle sales may also see a slowdown in growth from 2013 levels. In the first three quarters of the CY2013, US auto sales increased ~8%. In fourth quarter, this growth slowed to 4.4%. While I am still anticipating growth in 2014, I am expecting it to be 300 to 400 bps lower than 2013 levels given the fact that we are just 9%-10% below the 2006 US auto sale highs.
Last quarter, the company reported 1% increase in its North American revenue which was slightly lower than 2% increase it saw in September quarter. As impact of declining agriculture OEM sales and reduced growth in Light Vehicles sales sets in, I expect the company North American sales to decline next year.
Another thing which worries me about Modine is its small size which puts it at a competitive disadvantage against its larger competitors with better distribution foot prints (eg. Visteon Corporation, Denso Corporation, Delphi Corporation, Honeywell Thermal Division). A couple of years back, BMW used to be the largest customer of Modine's powertrain cooling modules and Modine used to supply the power train cooling module for all the three series and one series model. However, the company couldn't compete with bigger players particularly when it came to supplying its product globally. This resulted in winding down of this account.
Management maintains that they decided to pull back because they wanted to focus on bringing higher level solution to the truck market. However, I believe letting your biggest customer go because you lack the distribution footprints indicates significant risk to the business in the longer term, particularly when you see larger competitors expanding their product portfolio and geographic foot prints.
Forecast and valuation
Currently sell side is estimating 5.70% growth for FY2014 (ending March) and 8.70% growth for FY2015. The company is trading at 18x FY2015 EPS estimates which is quite high for a cyclical industrial company, but bulls seems to be excited about growth re-acceleration in 2015. I believe their optimism is misplaced and the company can disappoint them going forward. Here are my assumptions and forecast for FY2015.
North American revenues are likely to be flat to slightly down in FY2015 as agriculture end market declines and growth in light vehicle sales slows. European growth at 11% as pre-buy of Euro 5 trucks which was a big tailwind last year turns into a headwind and FX comparison becomes tougher. Asia to grow at 30% in line with the last year, HVAC to grow at 5% (as impact of temporary disruption from Airedale Facility fire reduces) and South America segment sales to remain flat. This gives 5.66% growth for the next year versus 8.70% growth sell side is modeling. I believe the biggest delta between my estimates and sell side estimates is coming from difference in our European growth estimates. The company will need to post ~20% year over year growth in Europe next year in order to meet sell side estimates, which I believe is unlikely.
This 300 bps miss in the topline will result in ~5% reduction in EPS (0.78 my estimate versus 0.82 sell side). However, the bigger downside is likely to come from multiple compression as hopes of growth re-acceleration fades. The stock is very volatile and its PE multiple is significantly dependent on growth expectations. Last time, when Modine disappointed investors on growth, it lost two-third of its market cap from mid 2011 to mid 2012. I believe when bulls realize that growth re-acceleration is unlikely for Modine in FY2015, its PE multiple can easily compress to 15-15.5x (inline with S&P500). This implies $11.7 -$12.09 target price or 18%-21% downside from the current levels.
Upside risks and mitigation
One of the near term upside risk for Modine is the positive dataflow on European Light Vehicles sales recovery. Modine derives 20% of its revenues from European light vehicles sales and it is possible that the stock may see positive reaction on the macro data points coming out of Europe in the short term (before the company's FY2015 guidance is out in April or May). One way to mitigate this risk is hedging Modine short with Gentherm (THRM) long. Gentherm derives 15% of its revenues from passenger car sales in Germany and United Kingdom. Gentherm has better long term growth prospects as compared to Modine, yet it is trading at similar forward PE as Modine. So, pairing Modine short with Gentherm long can mitigate some of the market/macro related risk.
- Guidance for FY2015 in the next earnings call
- Negative data point on commercial vehicle sales in Europe and agricultural equipment sales in the US