There aren't too many auto or commercial vehicle component manufacturers doing very well in the market right now, as even popular names like BorgWarner (NYSE:BWA) and Cummins (NYSE:CMI) are getting sold on fears about waning global demand. That leaves Modine Manufacturing (NYSE:MOD) in a precarious position - the company serves both passenger and commercial vehicle manufacturers, it has a sizable exposure to Europe and it's trying to execute a restructuring of some of its operations.
Although there's definitely a risk that Modine's restructuring efforts will fail, as well as industry-wide risks regarding demand and sustainable free cash flow generation, the potential payoffs of success make this a name worth watching.
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Running Hot and Cold
I don't suppose that Modine is a household name with most investors, so a little background might be helpful. Modine specializes in heating and cooling systems for vehicle (passenger and commercial) OEMs, as well as providing some commercial heating and cooling products. Said differently, Modine sells radiators, heat transfer components and a variety of cooling products, such as engine oil coolers and EGR coolers - in fact, the company's history goes back to supplying the standard radiator on every Ford (NYSE:F) Model-T.
Modine has built itself into a globally diverse player with a long customer list of well-known names. While 10 customers accounted for about 60% of revenue in fiscal 2012, none of them were 10% or more of revenue (though BMW (OTC:BAMXY) often has been). The customer list is largely a "who's who" of quality OEMs - BMW, Daimler (OTC:DDAIF), Caterpillar (NYSE:CAT), Volkswagen (OTC:VLKAY) and Deere (NYSE:DE).
That said, North American passenger vehicles make up a relatively small portion of sales; for better or worse, this is company built largely around commercial vehicles and European passenger vehicles. And that's part of the problem today - companies like Caterpillar and Deere have been dialing back global construction, mining and agricultural equipment sales expectations, while a variety of European OEMs have likewise been projecting lower commercial vehicle and passenger vehicle sales.
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European Restructuring Carries Risks, but Makes Long-Term Sense
Like many other industrial/manufacturing companies, it seems like Modine has been in a state of near-perpetual restructuring. In addition to closing several plants around the world since 2006, the company is currently in the midst of restructuring its European operations.
These moves have included exiting non-strategic businesses and shifting more of the focus to commercial vehicles. That latter point, the shift to more CV, makes considerable sense given the differing margin structures of light vehicle versus commercial vehicle components, but it's not without risks. There is often less visibility and more volatility in commercial vehicle order trends, and Modine will still be a relatively small and specialized company (which may mean that margin improvement is more limited).
Likewise, the company's expansion efforts into markets like Brazil and China have yet to really pay off. I don't think anybody argues with the long-term necessity of having a strong presence in these markets, but the short-term effect is one of greater quarter-to-quarter volatility and less visibility (particularly as the construction market in China struggles).
The Bottom Line
Investors who are unwilling to take on a lot of risk would probably do better with BorgWarner, Cummins or Honeywell (NYSE:HON) (one of Modine's competitors in commercial vehicles), or skipping the vehicle sector altogether. After all, while a few well-run companies have managed to produce reliably solid free cash flow, it's more the exception than the norm.
When it comes to Modine, that industry-wide legacy of iffy cash flow production is one of my biggest worries. It's been more than seven years since the company has delivered what I'd consider good free cash flow, and even if the company's restructuring and growth initiatives work, there's probably always going to be cyclicality to the financial performance.
Nevertheless, Modine is relatively unusual in that its debt load doesn't obliterate its long-term discounted cash flow value. If Modine can continue to build share in commercial vehicles and improve its cost structure enough to deliver consistent free cash flow in the 2 to 3% of revenue range (and up closer to 5% towards the end of the next decade), these shares should trade in the double-digits, but that's a very big "if." Therefore, investors have to balance the rewards of a much better Modine with the risk that the company will continue to muddle along, struggling to deliver cash flow or value.
At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.