MODINE MANUFACTURING CO - Quarter Report: 2021 June (Form 10-Q)

Note 1: General

The accompanying unaudited condensed consolidated financial statements of Modine Manufacturing Company (“Modine” or the “Company”) were prepared in conformity with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X.  Accordingly, they do not include all of the information and footnotes necessary for a comprehensive presentation of financial position, results of operations and cash flows required by GAAP for complete financial statements.  The financial statements include all normal recurring adjustments that are, in the opinion of management, necessary for a fair statement of results for the interim periods.  Results for the first three months of fiscal 2022 are not necessarily indicative of the results to be expected for the full year.  These financial statements should be read in conjunction with the consolidated financial statements and related notes in Modine’s Annual Report on Form 10-K for the year ended March 31, 2021.

On April 30, 2021, the Company sold its air-cooled automotive business to Schmid Metall GmbH.  As a result of this transaction, the Company recorded a loss of $6.6 million during the first quarter of fiscal 2022, which included the write-off of $1.7 million of net actuarial losses related to the business’s pension plan.  The Company reported this loss within the loss on sale of assets line on the consolidated statement of operations.  Upon transaction closing, $5.9 million of cash within the business transferred to the buyer.  The finalization of and payment for the purchase price adjustment for net working capital and certain other items, as defined by the sale agreement, is pending.  While the Company does not expect a material adjustment, it is possible that the loss on sale may increase when the purchase price adjustment is finalized.  Prior to the disposition, the Company reported the financial results of this business within the Automotive segment.  The air-cooled automotive business’s net sales were $63.0 million in fiscal 2021.

The Company has agreed to sell its liquid-cooled automotive business to Dana Incorporated.  In connection with the pending sale, the Company classified the assets and liabilities expected to convey to the buyer as held for sale on the June 30, 2021 consolidated balance sheet.  See Note 2 for additional information.

Note 2: Assets Held for Sale

On November 2, 2020, the Company signed a definitive agreement to sell its liquid-cooled automotive business to Dana Incorporated, subject to the receipt of governmental and third-party approvals and satisfaction of other closing conditions.  During the first quarter of fiscal 2022, the Company and the buyer withdrew the regulatory filing for approval of the transaction in Germany.  The Company and the buyer subsequently resubmitted a plan containing a modified sale perimeter for regulatory approval.  In accordance with the modified sale perimeter, certain manufacturing operations will no longer convey to the buyer.  In addition, the Company expects to inject additional cash into the business to counterbalance the impact of the perimeter modifications on the economic value of the pending transaction.  The Company and the buyer are currently working to amend the definitive sale agreement to reflect the transaction modifications.  The Company expects to record a loss on sale of approximately $30.0 million to $50.0 million upon transaction completion.  The loss on sale recorded will be impacted by the final negotiated terms with the buyer and other impacts such as changes in working capital, costs to sell and net actuarial losses in accumulated other comprehensive loss related to the disposal group’s pension plans.  It is possible that the loss on sale recorded could differ materially from the Company’s estimate.

The Company has classified and reported the assets and liabilities within the modified sale perimeter as held for sale on the June 30, 2021 consolidated balance sheet.  The Company believes it is probable that the sale will be completed within one year of the balance sheet date.  The Company ceased depreciating the long-lived assets within the disposal group beginning on November 2, 2020 when it first met the criteria for held for sale classification.  The Company has determined that this disposal group does not qualify as a discontinued operation for reporting under U.S. GAAP.  As part of its discontinued operations assessment, the Company considered anticipated future sales to automotive and light vehicle customers as well as sales to other vehicular customers with similar product offerings and using similar heat-transfer technology within the Heavy Duty Equipment and Automotive segments.  In addition, the Company will continue to operate in the same major geographical areas as it does today.

In fiscal 2021, upon classification as held for sale, the Company compared the disposal group’s carrying value with its fair value, less costs to sell.  Based upon the selling price for the transaction, the Company estimated implied losses in excess of the respective carrying value of the disposal group’s long-lived assets.  The disposal groups’ long-lived assets consist entirely of property, plant and equipment and right-of-use lease assets.  As a result, the Company recorded non-cash impairment charges of $138.3 million in fiscal 2021 to reduce the net carrying value of the disposal group’s long-lived assets to zero as of March 31, 2021.

The Company reassesses the liquid-cooled disposal group’s fair value less costs to sell at each reporting period that it is held for sale until the transaction is completed.  As a result of this evaluation for the first quarter of fiscal 2022, the Company recorded $5.3 million of additional non-cash impairment charges related to the Automotive segment’s held for sale assets.  The impairment charges reduced the net carrying value of property, plant and equipment additions during the quarter to zero as of June 30, 2021.

In connection with the modifications to the sale perimeter, the Company determined that the manufacturing operations that will not be sold to the buyer no longer meet the requirements to be classified as held for sale.  U.S. GAAP requires companies to measure asset groups that revert back to held and used classification at the lower of their (i) carrying value, as if held for sale classification had not been met; or (ii) fair value at the date of the decision not to sell.  As noted above, the long-lived assets within these businesses were previously impaired when they were classified as held for sale. As a result of its evaluation, the Company reversed $7.4 million of impairment charges to adjust the long-lived asset groups to their estimated fair value.  For purposes of its evaluation, the Company estimated the fair value of the businesses primarily using the income approach, which is a valuation technique that focuses on future cash flows anticipated to be generated by a business.  The Company’s determination of fair value involved judgement and the use of significant estimates and assumptions, including assumptions regarding future revenue projections and operating profit margins, risk-adjusted discount rates, business trends and market conditions.  The fair value measurements of these businesses are categorized as Level 3 within the fair value hierarchy.  Refer to Note 4 for the definition of a Level 3 fair value measurement.

During the first quarter of fiscal 2022, the Company signed a definitive agreement to sell a previously-closed manufacturing facility in the U.S.  As a result, the Company recorded an impairment charge of $0.3 million within the Commercial and Industrial Solutions (“CIS”) segment to write-down the property to fair value less costs to sell.  During July 2021, the sale was completed and the Company received net cash proceeds of $0.7 million.

As of June 30, 2021, the Company presented the assets and liabilities within the modified sale perimeter of the liquid-cooled automotive business and the previously-closed CIS facility as held for sale on its consolidated balance sheet.

As of March 31, 2021, the Company presented the assets and liabilities of the liquid- and air-cooled automotive businesses as held for sale.  See Note 1 for additional information regarding the sale of the air-cooled automotive business, which was completed on April 30, 2021.

The major classes of assets and liabilities held for sale were as follows:

Note 3: Revenue Recognition

The table below presents revenue for each of the Company’s business segments, Building HVAC Systems (“BHVAC”), CIS, Heavy Duty Equipment (“HDE”) and Automotive.  Each segment’s revenue is disaggregated by primary end market, by geographic location and based upon the timing of revenue recognition and includes inter-segment sales.

Contract assets and contract liabilities from contracts with customers were as follows:

Contract assets, included within other current assets in the consolidated balance sheets, primarily consist of capitalized costs related to customer-owned tooling contracts, wherein the customer has guaranteed reimbursement, and assets recorded for revenue recognized over time, which represent the Company’s rights to consideration for work completed but not yet billed. The $2.3 million increase in contract assets during the first three months of fiscal 2022 primarily resulted from an increase in capitalized costs related to customer-owned tooling contracts and, to a lesser extent, an increase in contracts assets for revenue recognized over time.

Contract liabilities, included within other current liabilities in the consolidated balance sheets, consist of payments received in advance of satisfying performance obligations under customer contracts, including contracts for customer-owned tooling. The $1.6 million increase in contract liabilities during the first three months of fiscal 2022 was primarily related to customer contracts for which payment was received in advance of the Company’s satisfaction of performance obligations.

Note 4: Fair Value Measurements

Fair value is defined as the price that would be received for an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants. Fair value measurements are classified under the following hierarchy:

When available, the Company uses quoted market prices to determine fair value and classifies such measurements as Level 1.  In some cases, where market prices are not available, the Company uses observable market-based inputs to calculate fair value, in which case the measurements are classified as Level 2.  If quoted or observable market prices are not available, the Company determines fair value based upon valuation models that use, where possible, market-based data such as interest rates, yield curves or currency rates.  These measurements are classified as Level 3.

The carrying values of cash, cash equivalents, restricted cash, short-term investments, trade accounts receivable, accounts payable, and short-term debt approximate fair value due to the short-term nature of these instruments.  In addition, the Company assesses the fair value of a disposal group for each reporting period it is held for sale.  See Note 2 for additional information regarding assets held for sale.  The fair value of the Company’s long-term debt is disclosed in Note 17.

The Company holds investments in deferred compensation trusts to fund obligations under certain non-qualified deferred compensation plans.  The Company records the fair value of these investments within other noncurrent assets on its consolidated balance sheets.  The Company classifies money market investments held by the trusts within Level 2 of the valuation hierarchy.  The Company classifies all other investments held by the trusts within Level 1 of the valuation hierarchy, as it uses quoted market prices to determine the investments’ fair value.  The Company’s deferred compensation obligations, which are recorded as other noncurrent liabilities, are recorded at the fair values of the investments held by the trust.  At June 30, 2021 and March 31, 2021, the fair values of the investments and obligations for the Company’s deferred compensation plans each totaled $3.0 million and $2.8 million, respectively.

Note 5: Pensions

Pension cost included the following components:

During the three months ended June 30, 2021, the Company contributed $2.8 million to its U.S. pension plans.  In connection with the American Rescue Plan Act of 2021, employer funding requirements have been reduced.  During the remainder of fiscal 2022, the Company expects to contribute approximately $2.0 million to its U.S. pension plans.

Note 6: Stock-Based Compensation

The Company’s stock-based incentive programs consist of the following: (1) a long-term incentive plan (“LTIP”) for officers and other executives that consists of stock awards, stock options, and performance-based stock awards granted for retention and performance, (2) a discretionary equity program for other management and key employees, and (3) stock awards for non-employee directors.

The Company calculates compensation expense based upon the fair value of the instruments at the time of grant and subsequently recognizes expense ratably over the respective vesting periods of the stock-based awards. The Company recognized stock-based compensation expense of $1.2 million and $0.7 million for the three months ended June 30, 2021 and 2020, respectively.

The fair value of stock-based compensation awards granted during the three months ended June 30, 2021 were as follows:

In lieu of performance-based stock awards, the Company granted performance cash awards to the LTIP participants during the first quarter of fiscal 2022.  The performance metrics for the cash awards are based upon a target three-year average cash flow return on invested capital and a target three-year average growth in consolidated net earnings before interest, taxes, depreciation, amortization, and certain other adjustments (“Adjusted EBITDA”) at the end of the three-year performance period ending March 31, 2024.

In fiscal 2021, the Company granted stock-based awards to officers and other executives during the third quarter of the fiscal year.

The Company used the following assumptions in determining fair value for stock options for the three months ended June 30, 2021:

As of June 30, 2021, unrecognized compensation expense related to non-vested stock-based compensation awards, which will be amortized over the remaining service periods, was as follows:

Note 7: Restructuring Activities

During the first quarter of fiscal 2022, restructuring and repositioning expenses primarily consisted of equipment transfer costs within the HDE segment and severance-related costs in the Automotive segment.

During the first quarter of fiscal 2021, the Company recorded $1.7 million of severance expenses related to plant consolidation activities in China within the CIS segment. The Company also implemented targeted headcount reductions, the most significant of which were in North America in the HDE and CIS segments.

Restructuring and repositioning expenses were as follows:

Other restructuring and repositioning expenses primarily consist of equipment transfers and plant consolidation costs.

The Company accrues severance in accordance with its written plans, procedures, and relevant statutory requirements. Changes in accrued severance were as follows:

Note 8: Other Income and Expense

Other income and expense consisted of the following:

Note 9: Income Taxes

The Company’s effective tax rate for the three months ended June 30, 2021 and 2020 was 40.4 percent and 2.3 percent, respectively.  The effective tax rate for the first quarter of fiscal 2022 is higher than the first quarter of the prior year, primarily due to changes in the mix and amount of foreign and U.S. earnings, partially offset by an income tax benefit recorded in the first quarter of fiscal 2022 for the release of a valuation allowance in a foreign jurisdiction, as further described below.

The Company records valuation allowances against its net deferred tax assets to the extent it determines it is more likely than not that such assets will not be realized in the future.  Each quarter, the Company evaluates the probability that its deferred tax assets will be realized and determines whether valuation allowances or adjustments thereto are needed.  This determination involves judgement and the use of significant estimates and assumptions, including expectations of future taxable income and tax planning strategies.  In addition, the Company considers the duration of statutory carryforward periods and historical financial results.

Based upon the Company’s analysis as of June 30, 2021, the Company determined it was more likely than not that the deferred tax assets in a foreign jurisdiction will be realized.  As a result, the need for the valuation allowance recorded thereon was eliminated and the Company recorded an income tax benefit of $4.8 million in the first quarter of fiscal 2022 upon release of the valuation allowance.  The Company’s analysis included consideration of the perimeter modifications for the pending sale of the liquid-cooled automotive business and the associated reversal of $7.4 million of impairment charges during the first quarter of fiscal 2022; see Note 2 for additional information.

As of June 30, 2021, valuation allowances against deferred tax assets in the U.S. and in certain foreign jurisdictions totaled $85.8 million and $9.5 million, respectively. These totals exclude the full valuation allowances recorded for net deferred tax assets classified as held for sale. The Company will maintain the valuation allowances in each applicable tax jurisdiction until it determines it is more likely than not the deferred tax assets will be realized, thereby eliminating the need for a valuation allowance. As further discussed in Note 18, the COVID-19 pandemic has resulted in risks and uncertainties for the Company.  Future events or circumstances, such as lower taxable income or unfavorable changes in the financial outlook of the Company’s operations in certain foreign jurisdictions, could necessitate the establishment of further valuation allowances.

Accounting policies for interim reporting require the Company to adjust its effective tax rate each quarter to be consistent with its estimated annual effective tax rate.  Under this methodology, the Company applies its estimated annual income tax rate to its year-to-date ordinary earnings to derive its income tax provision each quarter.  The Company records the tax impacts of certain significant, unusual or infrequently occurring items in the period in which they occur.  The Company excluded the impact of its operations in the U.S. and certain foreign locations from the overall effective tax rate methodology and recorded them discretely based upon year-to-date results because the Company anticipates net operating losses for the full fiscal year in these jurisdictions.  The Company does not anticipate a significant change in unrecognized tax benefits during the remainder of fiscal 2022.

Note 10: Earnings Per Share

The components of basic and diluted earnings per share were as follows:

For the three months ended June 30, 2021, the calculation of diluted earnings per share excluded 0.3 million and 0.2 million stock options and restricted stock awards, respectively, because they were anti-dilutive.

For the three months ended June 30, 2020, the calculation of diluted earnings per share excluded 1.4 million and 0.4 million stock options and restricted stock awards, respectively, because they were anti-dilutive.

Note 11: Cash, Cash Equivalents and Restricted Cash

Cash, cash equivalents and restricted cash consisted of the following:

Restricted cash, which is reported within other current assets in the consolidated balance sheets, consists primarily of deposits for contractual guarantees or commitments required for rents, import and export duties, and commercial agreements.

Note 12: Inventories

Inventories consisted of the following:

Note 13: Property, Plant and Equipment

Property, plant and equipment, including depreciable lives, consisted of the following:

Note 14: Goodwill and Intangible Assets

Changes in the carrying amount of goodwill were as follows:

Intangible assets consisted of the following:

The Company recorded amortization expense of $2.1 million for each of the three months ended June 30, 2021 and 2020.  The Company estimates that it will record $6.4 million of amortization expense during the remainder of fiscal 2022 and approximately $8.0 million of annual amortization expense in fiscal 2023 through 2027.

Note 15: Product Warranties

Changes in accrued warranty costs were as follows:

Note 16: Leases

The following table provides a summary of leases recorded on the consolidated balance sheets. The amounts exclude operating lease right of use (“ROU”) assets and liabilities, which each totaled $4.5 million and $6.1 million as of June 30, 2021 and March 31, 2021, respectively, that are classified as held for sale on the Company’s consolidated balance sheets; see Note 2 for additional information.

The components of lease expense were as follows:

Long-term debt consisted of the following:

Long-term debt, including the current portion of long-term debt, matures as follows:

At June 30, 2021, the Company’s revolving credit facility borrowings totaled $44.9 million and domestic letters of credit totaled $5.7 million, resulting in available borrowings under the revolving credit facility of $199.4 million.

The Company also maintains credit agreements for its foreign subsidiaries. The outstanding short-term borrowings related to these foreign credit agreements totaled $10.7 million at June 30, 2021, of which $10.1 million was classified as held for sale.  The $5.0 million of outstanding short-term foreign borrowings at March 31, 2021 were classified as held for sale.  See Note 2 for additional information.

Provisions in the Company’s credit agreement, Senior Note agreements, and various foreign credit agreements require the Company to maintain compliance with various covenants and include certain cross-default clauses.  Under its primary debt agreements in the U.S., the Company has provided liens on substantially all domestic assets.  Also, as specified in the credit agreement, the term loans may require prepayments in the event of certain asset sales.  In addition, at the time of each incremental borrowing under the revolving credit facility, the Company is required to represent to the lenders that there has been no material adverse effect, as defined in the credit agreement, on its business, property, or results of operations.

The leverage ratio covenant requires the Company to limit its consolidated indebtedness, less a portion of its cash balances, both as defined by the credit agreements, to no more than three and one-quarter times consolidated net earnings before interest, taxes, depreciation, amortization, and certain other adjustments (“Adjusted EBITDA”.)  The Company is also subject to an interest expense coverage ratio covenant, which requires the Company to maintain Adjusted EBITDA of at least three times consolidated interest expense.  As of June 30, 2021, the Company was in compliance with its debt covenants; its leverage ratio and interest coverage ratio were 2.0 and 10.8, respectively.

The Company estimates the fair value of long-term debt using discounted future cash flows at rates offered to the Company for similar debt instruments of comparable maturities. As of June 30, 2021 and March 31, 2021, the carrying value of the Company’s long-term debt approximated fair value, with the exception of the Senior Notes, which had an aggregate fair value of $152.8 million and $146.0 million, respectively.  The fair value of the Company’s long-term debt is categorized as Level 2 within the fair value hierarchy.  Refer to Note 4 for the definition of a Level 2 fair value measurement.

Note 18: Risks, Uncertainties, Contingencies and Litigation

The COVID-19 pandemic has broadly impacted the global economy and the Company’s key end markets, which were most severely impacted during the first quarter of fiscal 2021.  In connection with local government requirements or customer shutdowns, the Company suspended production at many of its manufacturing facilities in March and April 2020.  All of the temporarily-closed facilities reopened in the first or second quarter of fiscal 2021 and have generally returned to more normal production levels.  However, since reopening, production at certain of our plants has been negatively affected at times by employee absences due to COVID-19.  The Company is continuing to focus on protecting the health and wellbeing of its employees and the communities in which it operates, while also ensuring the continuity of its business operations and timely delivery of quality products and services to its customers.  Beginning largely in April 2020 and to mitigate the negative impacts of COVID-19, the Company took actions including, but not limited to, production staffing adjustments, furloughs, shortened work weeks, and temporary salary reductions at all levels of the organization.  While the Company withdrew most of the cost-saving actions in the third quarter of fiscal 2021 as production returned to more normal levels as markets recovered, it remains focused on controlling operating and administrative expenses.

The Company’s consolidated financial statements reflect estimates and assumptions made by management, including assumptions regarding the future impacts of the COVID-19 pandemic, that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and reported amounts of revenue and expenses during the reporting periods presented.  While the Company believes it used appropriate estimates and assumptions to prepare the consolidated financial statements, actual amounts could differ materially and future events or circumstances could have a potential negative effect on the assumptions used.  If the Company, its suppliers, or its customers experience shutdowns or other significant business disruptions associated with the COVID-19 pandemic, its ability to conduct business in the manner and on the timelines presently planned could be materially and negatively impacted, which could have a material adverse effect on the Company’s business, financial position, results of operations and cash flows.

The Company has recorded environmental investigation and remediation accruals related to soil and groundwater contamination at manufacturing facilities in the U.S., one of which the Company currently owns and operates, and at its former manufacturing facility in the Netherlands, along with accruals for lesser environmental matters at certain other facilities in the U.S.  These accruals generally relate to facilities where past operations followed practices and procedures that were considered acceptable under then-existing regulations, or where the Company is a successor to the obligations of prior owners, and current laws and regulations require investigative and/or remedial work to ensure sufficient environmental compliance.  In instances where a range of loss can be reasonably estimated for a probable environmental liability, but no amount within the range is a better estimate than any other amount, the Company accrues the minimum of the range.  The Company’s accruals for environmental matters totaled $19.3 million and $16.0 million as of June 30, 2021 and March 31, 2021, respectively.  During the first quarter of fiscal 2022, the Company increased its remediation accrual related to a former manufacturing facility in the U.S. by $3.4 million.  As additional information becomes available regarding the environmental matters, the Company will re-assess the liabilities and revise the estimated accruals, if necessary.  While it is possible that the ultimate environmental remediation costs may be in excess of amounts accrued, the Company believes, based upon currently available information, that the ultimate outcome of these matters, individually and in the aggregate, will not have a material adverse effect on its financial position.  However, these matters are subject to inherent uncertainties, and unfavorable outcomes could occur, including significant monetary damages.

In the normal course of business, the Company and its subsidiaries are named as defendants in various lawsuits and enforcement proceedings by private parties, governmental agencies and/or others in which claims are asserted against Modine.  The Company believes that any additional loss in excess of amounts already accrued would not have a material effect on the Company’s consolidated balance sheet, results of operations, and cash flows.  In addition, management expects that the liabilities which may ultimately result from such lawsuits or proceedings, if any, would not have a material adverse effect on the Company’s financial position.

Note 19: Accumulated Other Comprehensive Loss

Changes in accumulated other comprehensive loss were as follows:

Note 20: Segment Information

Effective July 1, 2021, the BHVAC segment assumed leadership of the Company’s business operation in Guadalajara, Spain, which was previously managed by and reported within the CIS segment.  This organizational change is integral to the Company’s strategic initiative to align its data center businesses under the BHVAC leadership team in order to accelerate organizational efficiencies and operational improvements.  The Company is focused on expanding its presence in the North American and European data center markets.  Beginning for the second quarter of fiscal 2022, the Company will report the financial results of its business in Spain as part of the BHVAC segment.

The following is a summary of net sales, gross profit, operating income, and total assets by segment: