Modine Manufacturing: Unreasonable Expectations And Poor Fundamentals

| About: Modine Manufacturing (MOD)
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Overview

Modine Manufacturing (NYSE:MOD) develops, manufactures and markets various heat exchangers and systems for on and off-road vehicles as well as various industrial and refrigeration applications. With 90% of its revenue coming from various types of vehicles, MOD finds its shares heavily levered to automobile sales in the US and Europe. Last quarter's earnings sent the stock flying and shares have doubled over the past year. With a forward multiple of 17 and a huge rally behind it, investors may be ready to take profits in the name. I'll argue here that ludicrous growth targets and an automobile market that may be near topping out will derail the rally in MOD shares and send the stock lower. I'll also take a shot at assigning a fair value to shares based on my views.

Earnings Model

Before we take a look at the business I feel it is instructive to understand what analysts think of the company's earnings prospects. I'll use these and other inputs in my earnings model, which you can read about here in greater detail, in order to compute a fair value for shares. My inputs and sources are as follows: 1) reported earnings, 2) earnings growth rates, 3) current dividend and 4) current book value, all from Yahoo! Finance, 5) perpetual growth rate of 3% and 6) discount rate of 10%, both of which are my numbers.

 

2013

2014

2015

2016

2017

2018

2019

Earnings Forecast

             

Reported earnings per share

$0.40

 

$0.62

$0.84

$1.18

$1.65

$2.31

x(1+Forecasted earnings growth)

 

55.00%

35.50%

40.00%

40.00%

40.00%

40.00%

=Forecasted earnings per share

 

$0.62

$0.84

$1.18

$1.65

$2.31

$3.23

               

Equity Book Value Forecasts

             

Equity book value at beginning of year

 

$5.77

$6.39

$7.23

$8.41

$10.05

$12.36

Earnings per share

 

$0.62

$0.84

$1.18

$1.65

$2.31

$3.23

-Dividends per share

 

$0.00

$0.00

$0.00

$0.00

$0.00

$0.00

=Equity book value at end of year

$5.77

$6.39

$7.23

$8.41

$10.05

$12.36

$15.59

               

Abnormal earnings

             

Equity book value at begin of year

 

$5.77

$6.39

$7.23

$8.41

$10.05

$12.36

x Equity cost of capital

10.00%

10.00%

10.00%

10.00%

10.00%

10.00%

10.00%

=Normal earnings

 

$0.58

$0.64

$0.72

$0.84

$1.01

$1.24

               

Forecasted EPS

 

$0.62

$0.84

$1.18

$1.65

$2.31

$3.23

-Normal earnings

 

$0.58

$0.64

$0.72

$0.84

$1.01

$1.24

=Abnormal earnings

 

$0.04

$0.20

$0.45

$0.81

$1.30

$1.99

               

Valuation

             

Future abnormal earnings

 

$0.04

$0.20

$0.45

$0.81

$1.30

$1.99

x discount factor(0.1)

 

0.909

0.826

0.751

0.683

0.621

0.564

=Abnormal earnings disc to present

 

$0.04

$0.17

$0.34

$0.55

$0.81

$1.12

               

Abnormal earnings in year +6

           

$1.99

Assumed long-term growth rate

           

3.00%

Value of terminal year

           

$28.45

               

Estimated share price

             

Sum of discounted AE over horizon

 

$1.90

         

+PV of terminal year AE

 

$16.06

         

=PV of all AE

 

$17.96

         

+Current equity book value

 

$5.77

         

=Estimated current share price

 

$23.73

         

At first glance, a stock trading at $14 would appear to be quite the bargain with a fair value of nearly $24. The only problem is the assumptions that are used in order to produce that price. Take a look at the growth rates that analysts are expecting for MOD over the next five years; do you think it's reasonable for a company that produced $19 million in operating income last year to then produce $40 million next fiscal year, followed by $153 million in fiscal 2019? If this were a startup of some sort with tremendous operating leverage I'd concede that was a possibility but MOD is no startup. In fact, MOD's operating leverage is terrible due to very low gross margins (~16%) so in order to produce the delusional growth rates that are represented here, MOD would have to grow revenues at 30% to 40% per year just to have a shot. With management guiding fiscal 2014 to a three to eight percent increase over 2013, color me skeptical.

Causes for Concern

This brings us to the first issue with MOD; its expectations are simply too high to be possible, setting investors up for disappointment. Companies with terrible operating leverage like MOD have to have commensurately higher increases in revenues in order to produce large amounts of profit growth. Conversely, companies with very high operating leverage can produce relatively small increases in revenue but produce much larger profit gains due to high margins.

As an example, in fiscal 2012, MOD produced $1.577 billion in sales and $70 million in operating income. In fiscal 2013, MOD's revenue fell 13% to $1.376 billion but operating income collapsed 40%. This is the problem with a low margin business like MOD; when operating leverage is so low it makes losing money very easy and making money very difficult. MOD is being priced like it is producing 60% gross margins when reality is one-quarter of that number. MOD simply can't produce revenue increases commensurate with the amount of profit gains that are expected in the coming years with its thin margins.

Next, the company has a significant amount of debt on its balance sheet. As of the end of the last quarter long term debt stood at $132 million, a number that has been steadily declining, to management's credit. However, interest expense is still an enormous portion of MOD's operating profits each year at roughly $12.5 million in each of the last two years. MOD is paying down its debt so hopefully that number will be zero at some point in the future but right now, MOD has to sell almost $80 million of products in order to produce enough gross margin just to make its interest payments, irrespective of SG&A and all the other costs it is responsible for. For a company that produced a 40% drop in operating income last year (and a GAAP loss) that can be crippling.

In addition to this, MOD produces significant operating cash flows but fails to cover the amount of investments it must make to maintain and grow its business. This results in the extremely undesirable choice of having to stop maintaining and growing the business or borrowing. Based on the balance sheet discussion we know that management's modis operandi in the past has been to choose the latter. Unfortunately for MOD even borrowing wasn't enough to stem the tide of negative cash flows as the aggregate net change in cash and equivalents for the past three full fiscal years comes to a nearly $20 million drop despite borrowing nearly $26 million in the same time period. The point is that MOD has a cash generation problem, and a big one at that, because it cannot produce enough cash to both run the business and pay down its debt. Thus, when choices have to be made regarding capital allocation, something is going to suffer. This may seem elementary but when you are looking at a business that cannot produce enough cash to fund itself you've got a big problem.

Finally, auto sales from around the world, particularly in the US, are at or near all-time high run rates. With the US posting the highest annualized rate since before the financial crisis I'd caution that MOD will likely see peak demand at some point in the near future. Even if it doesn't see demand peak the idea that this company can continue to grow its top line enough to support a 40% earnings growth rate with its primary customers already running near capacity is laughable. Where is this growth going to come from? Are we going to see 20 million units sold in the US next year and 24 million in 2015 and so on? I highly doubt it and any bull case for MOD based upon such unreasonable growth rates is highly suspect. I'm fully aware that MOD has other businesses it is involved in but the bulk of its revenue comes from automobile customers and with the market already booming, I'm failing to see the growth catalysts. In fact, if anything, it would support the bear argument for MOD.

Valuation

Now that we've established that I'm not particularly bullish on MOD, what is a fair value? Given what I've laid out, including management's guidance for mid-single digit revenue growth for 2014, I believe earnings growth rates of perhaps eight to 10 percent are more reasonable. If we use those growth rates in my earnings model we get a fair value of about $4. Now, MOD's book value is higher than that at just under $6 so I don't think we'll see $4 any time soon. However, the point I wanted to make is that the fundamentals simply don't support a $14 price for MOD shares. I see the prices we witnessed last year at this time, in the $7 range, to be far more reasonable. I suspect that is exactly the reason shares were trading that low in the first place; investors buoyed shares near their book value based upon otherwise poor fundamentals. I suspect we'll see this again and that is a long way down from current levels.

Conclusion

MOD is a decent business but it is simply at the mercy of global auto demand and accepts terrible margins as a result. Given that it has many earnings headwinds including auto demand, no discernible competitive advantage, moderate leverage with high interest expense, anemic revenue growth and no material catalysts and negative free cash flow each year, there isn't much to like in terms of the stock. Just because a business is viable doesn't make it a good investment and we see that with MOD. I'm not saying the company is going out of business but what I am saying is that the fundamentals support a $7 stock but we are seeing prices now that are twice that much.

With mid-single digit revenue growth and razor thin margins I just don't see any way this company will possibly match up to analyst expectations. Thus, investors are setting themselves up to be disappointed and I think we will see MOD move down violently once investors realize the pie-in-the-sky growth rates that are currently priced in are never going to happen. Before that happens, take a hard look at unloading your shares.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.