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Year Ended March 31, 2017 Compared with Year Ended March 31, 2016:

Europe net sales of $524 million in fiscal 2017 were consistent with the prior year, as higher sales volume to automotive customers was offset by lower sales volume to commercial vehicle and off-highway customers and a $3 million unfavorable impact of foreign currency exchange rate changes.  Gross profit increased $13 million and gross margin improved 240 basis points to 15.4 percent in fiscal 2017, primarily due to cost savings resulting from procurement initiatives, favorable sales mix, and improved production efficiencies, partially offset by unfavorable material costs.  SG&A expenses increased $3 million in fiscal 2017, primarily due to higher compensation-related expenses.  In fiscal 2017, we recorded $3 million of restructuring expenses, primarily consisting of severance expenses.  In addition, we sold a manufacturing facility in Europe and recognized a gain of $1 million as a result.  Operating income of $37 million in fiscal 2017 increased $24 million compared with the prior year, primarily due to higher gross profit and the absence of a $10 million impairment charge in the prior year.

Year Ended March 31, 2016 Compared with Year Ended March 31, 2015:

Europe net sales decreased $54 million, or 9 percent, in fiscal 2016 compared with the prior year, primarily due to a $76 million unfavorable impact of foreign currency exchange rate changes and lower sales volume to off-highway customers, partially offset by increased sales volume to commercial vehicle and automotive customers.  Gross profit decreased $1 million, yet gross margin increased 110 basis points to 13.0 percent in fiscal 2016.  The gross margin increase was primarily due to higher sales volume and lower material costs.  In addition, gross profit was negatively impacted by $9 million from foreign currency exchange rate changes.  Fiscal 2016 SG&A expenses decreased $5 million from the prior year, primarily due to a $6 million favorable impact of foreign currency exchange rate changes.  In fiscal 2016, we recorded $6 million of restructuring expenses, primarily related to severance expenses.  In addition, we recorded a $10 million asset impairment charge.  These restructuring expenses and impairment charge primarily related to a manufacturing facility in Germany, which was generating pre-tax losses, resulting in management deciding to exit a certain product line.  Operating income of $13 million in fiscal 2016 decreased $13 million compared with the prior year, primarily due to higher restructuring expenses, an impairment charge, and the absence of a $3 million gain on the sale of a wind tunnel in the prior year, partially offset by lower SG&A expenses.

 

 

Year Ended March 31, 2017 Compared with Year Ended March 31, 2016:

Asia net sales increased $33 million, or 42 percent, in fiscal 2017 compared with the prior year, primarily due to higher sales volume to automotive and off-highway customers in China and incremental sales from our recently-formed joint venture in China, partially offset by a $4 million unfavorable impact of foreign currency exchange rate changes.  Gross profit increased $7 million and gross margin improved 130 basis points to 16.8 percent in fiscal 2017, primarily due to higher sales volume. Fiscal 2017 SG&A expenses were consistent with the prior year.  Operating income of $8 million in fiscal 2017 increased $7 million compared with the prior year, primarily due to higher gross profit.

Year Ended March 31, 2016 Compared with Year Ended March 31, 2015:

Asia net sales decreased $2 million, or 3 percent, in fiscal 2016 compared with the prior year, primarily due to lower sales volume to off-highway customers in China and Korea and a $4 million unfavorable impact of foreign currency exchange rate changes, partially offset by higher sales volume to automotive customers in China and increased overall sales in India.  Gross margin improved 130 basis points to 15.5 percent in fiscal 2016 compared with the prior year, primarily due to favorable sales mix.  Fiscal 2016 SG&A expenses decreased $1 million from the prior year, primarily due to cost-control initiatives, partially offset by acquisition-related costs associated with a joint venture that we formed in late fiscal 2016.  Operating income of $1 million in fiscal 2016 increased $1 million compared with the prior year, primarily due to lower SG&A expenses.

 

 

Year Ended March 31, 2017 Compared with Year Ended March 31, 2016:

BHVAC net sales decreased $9 million, or 5 percent, in fiscal 2017 compared with the prior year, primarily due to an $11 million unfavorable impact of foreign currency exchange rate changes and lower school ventilation and heating product sales in North America, partially offset by increased air conditioning product sales in the U.K.  Gross profit decreased $6 million and gross margin decreased 210 basis points to 27.8 percent in fiscal 2017, primarily due to unfavorable sales mix, unfavorable material costs and higher depreciation expense in the current year resulting from replacement assets associated with the Airedale fire, which we started to depreciate in the fourth quarter of fiscal 2016.  In addition, gross profit was unfavorably impacted by $2 million from foreign currency exchange rate changes.  Fiscal 2017 SG&A expenses decreased $5 million from fiscal 2016, primarily due to lower commission costs and compensation-related expenses and a $2 million favorable impact of foreign currency exchange rate changes.  In fiscal 2017, we recorded $1 million of restructuring expenses consisting of severance expenses.  Operating income of $13 million in fiscal 2017 decreased $1 million compared with the prior year, primarily due to lower gross profit, partially offset by lower SG&A expenses.

Year Ended March 31, 2016 Compared with Year Ended March 31, 2015:

BHVAC net sales decreased $5 million, or 3 percent, in fiscal 2016 compared with the prior year, primarily due to a $6 million unfavorable impact of foreign currency exchange rate changes and lower sales at our businesses in the U.K., as unfavorable currency conditions resulted in increased competition from other mainland European suppliers, partially offset by increased ventilation product sales in North America.  Gross profit decreased $2 million in fiscal 2016 compared with the prior year, primarily due to a $1 million unfavorable impact of foreign currency exchange rate changes.  Gross margin decreased 10 basis points to 29.9 percent in fiscal 2016 compared with the prior year.  Fiscal 2016 SG&A expenses increased $2 million from the prior year, primarily due to the absence of $5 million of recoveries from business interruption insurance for the Airedale fire received in the prior year, partially offset by lower engineering and development costs and a $1 million favorable impact of foreign currency exchange rate changes.  In fiscal 2016, we recorded $1 million of restructuring expenses consisting of severance expenses.  Operating income of $14 million in fiscal 2016 decreased $5 million compared with the prior year, primarily due to lower gross profit and higher SG&A expenses.

 

Liquidity and Capital Resources

Our primary sources of liquidity are cash flow from operating activities, our cash and cash equivalents at March 31, 2017 of $34 million, and an available borrowing capacity of $153 million under lines of credit provided by banks in the United States and abroad.  Given our extensive international operations, $32 million of our cash and cash equivalents are held by our non-U.S. subsidiaries.  Amounts held by non-U.S. subsidiaries are available for general corporate use; however, these funds may be subject to U.S. tax if repatriated.  We have not encountered, and do not expect to encounter, any difficulty meeting the liquidity requirements of our global operations.

Net Cash Provided by Operating Activities

Net cash provided by operating activities in fiscal 2017 was $42 million, a decrease of $30 million from $72 million in the prior year.  This decrease in operating cash flow was primarily due to payments for acquisition- and integration-related costs, unfavorable net changes in working capital, and higher payments for restructuring activities.

Net cash provided by operating activities in fiscal 2016 was $72 million, an increase of $8 million from $64 million in the prior year.  This increase in operating cash flow was primarily due to favorable net changes in working capital, including lower incentive compensation payments during fiscal 2016 and the timing of value-added tax payments.

Capital Expenditures

Capital expenditures of $64 million during fiscal 2017 increased $1 million compared with fiscal 2016.  In fiscal 2017, our capital spending primarily occurred in the Americas and Europe segments, which totaled $26 million and $25 million, respectively.  Capital projects in fiscal 2017 included tooling and equipment purchases in conjunction with new and renewal programs with customers, as well as expansions of our manufacturing capacity in Mexico and Hungary.

At March 31, 2017, our capital expenditure commitments totaled $18 million.  Significant commitments included tooling and equipment expenditures for new and renewal programs with customers in the Americas, Asia, and Europe segments.

Dividends

We did not pay dividends in fiscal 2017, 2016, or 2015.  We currently do not intend to pay dividends in fiscal 2018.

Debt

Our total debt outstanding increased $348 million to $511 million at March 31, 2017 compared with the prior year, primarily due to new long-term debt and borrowings under our revolving credit facility used to finance a significant portion of the $364 million cash consideration for our acquisition of Luvata HTS.  See Note 15 of the Notes to Consolidated Financial Statements for additional information regarding our new credit agreements.

Our debt agreements require us to maintain compliance with various covenants.  The term loans require prepayments, as defined in the credit agreement, in the event the Company’s annual excess cash flow exceeds defined levels or in the event of certain asset sales.  In addition, under our primary debt agreements in the U.S., we are subject to a leverage ratio covenant, which requires us to limit our consolidated indebtedness, less a certain portion of our cash balance, 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”).  As permitted by the credit agreements and in connection with our acquisition of Luvata HTS, the leverage ratio covenant limit has been temporarily raised to no more than three and three-quarters times Adjusted EBITDA through the second quarter of fiscal 2018, and thereafter to no more than three and one-half times Adjusted EBITDA through the first quarter of fiscal 2019.  We are also subject to an interest expense coverage ratio, which requires us to maintain Adjusted EBITDA of at least three times consolidated interest expense.

 

Our leverage ratio at March 31, 2017 was 2.9, which was below the maximum permitted ratio of 3.75.  Our interest expense coverage ratio at March 31, 2017 was 7.0, which exceeded the minimum requirement of 3.0.  We were in compliance with our debt covenants as of March 31, 2017 and expect to remain in compliance during fiscal 2018 and beyond.

Off-Balance Sheet Arrangements

None.

Contractual Obligations

Our liabilities for pensions, postretirement benefits, and uncertain tax positions totaled $139 million as of March 31, 2017.  We are unable to determine the ultimate timing of payments for these liabilities; therefore, we have excluded these amounts from the contractual obligations table above.  We expect to contribute $13 million to our U.S. pension plans during fiscal 2018.

 

Critical Accounting Policies

 

The following critical accounting policies reflect the more significant judgments and estimates used in preparing our consolidated financial statements.  Application of these policies results in accounting estimates that have the greatest potential for a significant impact on our financial statements.  The following discussion of these judgments and estimates is intended to supplement the significant accounting policies presented in Note 1 of the Notes to Consolidated Financial Statements.  In addition, recently issued accounting pronouncements that could significantly impact our financial statements are included in Note 1 of the Notes to Consolidated Financial Statements.

 

Acquisitions

 

From time to time, we make strategic acquisitions that have a material impact on our consolidated results of operations or financial position.  We allocate the purchase price of acquired businesses to the identifiable tangible and intangible assets acquired and liabilities assumed in the transaction based upon their estimated fair values as of the acquisition date.  We determine the estimated fair values using information available to us and engage third-party valuation specialists when necessary.  The estimates we use to determine the fair value of long-lived assets, such as intangible assets, can be complex and require significant judgments.  While we use our best estimates and assumptions, our estimates are inherently uncertain and subject to refinement.  As a result, during the measurement period, which may be up to one year from the acquisition date, we record adjustments to the assets acquired and liabilities assumed, with the corresponding offset to goodwill.  Upon conclusion of the measurement period or final determination of the values of assets acquired or liabilities assumed, whichever comes first, any subsequent adjustments are recorded to our consolidated statement of operations. We are also required to estimate the useful lives of intangible assets to determine the amount of amortization expense to record in future periods.  We periodically review the estimated useful lives assigned to our intangible assets to determine whether such estimated useful lives continue to be appropriate.  During fiscal 2017, we acquired Luvata HTS.  See Note 2 of the Notes to Consolidated Financial Statements for additional information regarding this acquisition.

 

Revenue Recognition

 

We recognize revenue, including agreed-upon commodity prices, when the risks and rewards of ownership are transferred to our customers, which generally occurs upon shipment.  Revenue is recorded net of applicable provisions for sales rebates, volume incentives, and returns and allowances.  At the time of revenue recognition, we also record estimates for bad debt expense and warranty expense.  We base these estimates on historical experience, current business trends, and current economic conditions.  We recognize price increases that are agreed upon in advance as revenue when the products are shipped to our customers.

 

Impairment of Long-Lived Assets

 

We perform impairment evaluations of long-lived assets, including property, plant and equipment, intangible assets and equity investments, whenever business conditions or events indicate that those assets may be impaired.  We consider factors such as operating losses, declining financial outlooks and market conditions, when evaluating the necessity for an impairment analysis.  When the net asset values exceed undiscounted cash flows expected to be generated by the assets, or the decline in value is considered to be “other than temporary,” we write down the assets to fair value and record an impairment charge to current operations.  We estimate fair value in various ways depending on the nature of the assets under review.  Fair value is generally based upon appraised value, estimated salvage value, or selling prices under negotiation, as applicable.

 

The most significant long-lived assets we evaluated for impairment indicators were property, plant and equipment and intangible assets, which totaled $459 million and $134 million at March 31, 2017, respectively.  Within property, plant and equipment, the most significant assets evaluated are buildings and improvements and machinery and equipment.  Our most significant intangible assets evaluated are customer relationships, trade names, and acquired technology, the majority of which are related to our recent acquisition of Luvata HTS.  See Note 2 of the Notes to Consolidated Financial Statements for additional information regarding this acquisition.  We evaluate impairment at the lowest level of separately identifiable cash flows, which is generally at the manufacturing plant level.  We monitor manufacturing plant financial performance to determine whether indicators exist that would require an impairment evaluation for the facility.  This includes significant adverse changes in plant profitability metrics; substantial changes in the mix of customer products manufactured in the plant; changes in manufacturing strategy; and the shifting of programs to other facilities under a manufacturing realignment strategy.  When such indicators are present, we perform an impairment evaluation.

 

Impairment of Goodwill

 

We perform goodwill impairment tests annually, as of March 31, unless business events or other conditions exist that require a more frequent evaluation.  We consider factors such as operating losses, declining financial and market outlooks, and market capitalization when evaluating the necessity for an interim impairment analysis.  We test goodwill for impairment at a reporting unit level.  Reporting units resulting from recent acquisitions generally represent the highest risk of impairment, which typically decreases as the businesses are integrated into the Company and positioned for future operating and financial performance.  Our first step in the goodwill impairment test is to compare the fair value of the reporting unit to its carrying value.  We determine the fair value of a reporting unit based upon the present value of estimated future cash flows.  If the fair value of the reporting unit exceeds the carrying value of the unit’s net assets, goodwill of that reporting unit is not impaired and further testing is not required.  If the carrying value of the reporting unit’s net assets exceeds the fair value of the unit, then we perform the second step of the impairment test to determine the implied fair value of the reporting unit’s goodwill and any impairment charge.  In estimating the implied fair value of goodwill for a reporting unit, we assign fair value to the assets and liabilities associated with the reporting unit as if the reporting unit had been acquired in a business combination.  Any excess of the carrying value of the reporting unit goodwill over its implied fair value is recorded as an impairment charge.  Determining the fair value of a reporting unit involves judgment and the use of significant estimates and assumptions, which include assumptions regarding the revenue growth rates and operating profit margins used to calculate estimated future cash flows, the risk-adjusted discount rate, business trends and market conditions.  We determine the expected future revenue growth rates and operating profit margins after consideration of our historical revenue growth rates and earnings levels, our assessment of future market potential and our expectations of future business performance.  The discount rate used in determining discounted cash flows is a rate corresponding to our cost of capital, adjusted for country-specific risks where appropriate.

 

 

Warranty Costs

We estimate costs related to product warranties and accrue for such costs at the time of the sale, within cost of sales.  We estimate warranty costs based upon the best information available, which includes statistical and analytical analysis of both historical and current claim data.  We monitor and adjust our warranty accruals, which totaled $10 million at March 31, 2017, if it is probable that expected claims will differ from previous estimates.

Pension Obligations

Our calculation of the expense and liabilities of our pension plans is dependent upon various assumptions.  At March 31, 2017, our pension liabilities totaled $122 million.  The most significant assumptions include the discount rate, long-term expected return on plan assets, and mortality rate tables.  We base our selection of assumptions on historical trends and economic and market conditions at the time of valuation.  In accordance with U.S. GAAP, actual results that differ from these assumptions are accumulated and amortized over future periods.  These differences impact future pension expenses.  Currently, participants in our domestic pension plans are not accruing benefits based upon their current service as the plans do not include increases in annual earnings or for future service in calculating the average annual earnings and years of credited service under the pension plan formula.

For the following discussion regarding sensitivity of assumptions, all amounts presented are in reference to our domestic pension plans, since our domestic plans comprise all of our benefit plan assets and the large majority of our pension plan expense.

To determine the expected rate of return on pension plan assets, we consider such factors as (a) the actual return earned on plan assets, (b) historical rates of return on the various asset classes in the plan portfolio, (c) projections of returns on those asset classes, (d) the amount of active management of the assets, (e) capital market conditions and economic forecasts, and (f) administrative expenses paid with the plan assets.  The long-term rate of return utilized in fiscal 2017 and 2016 was 8.0 percent.  For fiscal 2018, we have assumed a rate of 7.5 percent.  This 50 basis point decrease in the expected rate of return on assets, as compared with the prior year, resulted in an increase of less than $1 million in our estimated fiscal 2018 pension expense.

The discount rate reflects rates available on long-term, high-quality fixed-income corporate bonds on the measurement date of March 31.  For fiscal 2017 and 2016, we used a discount rate of 4.1 percent.  We determined these rates based upon a yield curve that was created following an analysis of the projected cash flows from the affected plans.  See Note 16 of the Notes to Consolidated Financial Statements for additional information.  A change in the assumed discount rate of 25 basis points would impact our fiscal 2018 pension expense by less than $1 million.

Income Taxes

We operate in numerous taxing jurisdictions; therefore, we are subject to regular examinations by federal, state and non-U.S. taxing authorities.  Due to the application of complex and sometimes ambiguous tax laws and rulings in the jurisdictions in which we do business, there is an inherent level of uncertainty within our worldwide tax provisions.  Despite our belief that our tax return positions are consistent with applicable tax laws, it is possible that taxing authorities could challenge certain positions.

Our deferred tax assets and liabilities reflect temporary differences between the amount of assets and liabilities for financial and tax reporting purposes.  We adjust these amounts to reflect changes in tax rates expected to be in effect when the temporary differences reverse.  We record a valuation allowance if we determine it is more likely than not that the net deferred tax assets in a particular jurisdiction will not be realized.  This determination involves significant judgment.  In performing this assessment on a jurisdiction-by-jurisdiction basis, we consider historical and projected financial results along with other pertinent information.

We have not recorded a provision for U.S. income taxes on undistributed earnings from our non-U.S. subsidiaries that we have determined to be permanently reinvested in our foreign operations.  If management’s intentions or U.S. tax law changes in the future, there could be a significant negative impact on our provision for income taxes.  See Note 7 of the Notes to Consolidated Financial Statements for additional information regarding income taxes.

 

Other Loss Reserves

We maintain liabilities and reserves for a number of other loss exposures, such as environmental remediation costs, self-insurance reserves, uncollectible accounts receivable, regulatory compliance matters, and litigation.  Establishing loss reserves for these exposures requires the use of estimates and judgment to determine the risk exposure and ultimate potential liability.  We estimate these reserve requirements by using consistent and suitable methodologies for the particular type of loss reserve being calculated.  See Note 18 of the Notes to Consolidated Financial Statements for additional information regarding contingencies and litigation.

 

Forward-Looking Statements

 

This report, including, but not limited to, the discussion under Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains statements, including information about future financial performance, accompanied by phrases such as “believes,” “estimates,” “expects,” “plans,” “anticipates,” “intends,” and other similar “forward-looking” statements, as defined in the Private Securities Litigation Reform Act of 1995.  Modine’s actual results, performance or achievements may differ materially from those expressed or implied in these statements, because of certain risks and uncertainties, including, but not limited to, those described under “Risk Factors” in Item 1A. in Part I. of this report.  Other risks and uncertainties include, but are not limited to, the following:

 

Market Risks:

 

·

Economic, social and political conditions, changes, challenges and unrest, particularly in the geographic, product and financial markets where we and our customers operate and compete, including, in particular, foreign currency exchange rate fluctuations, tariffs, inflation, changes in interest rates, recession and recovery therefrom, restrictions and uncertainty associated with cross-border trade, and, in particular, the continuing recovery and/or instability of certain markets in which we operate in China and North America, the still-weak forecasts for the Brazilian economy, and the general uncertainties about the impact of potential regulatory and/or policy changes, including those related to tax and trade, that may be implemented in the United States, as well as continuing uncertainty regarding the longer-term implications of “Brexit”;

·

The impact of potential increases in commodity prices, including our ability to successfully manage our exposure and/or pass increasing prices of aluminum, copper, steel and stainless steel (nickel) on to customers, as well as the inherent lag in timing of such pass-through arrangements; and

·

The impact of current and future environmental laws and regulations on our business and the businesses of our customers, including our ability to take advantage of opportunities to supply alternative new technologies to meet environmental and/or energy standards and objectives.

 

Operational Risks:

 

·

Our ability to integrate the former Luvata HTS operations into Modine, realize cost and revenue synergies in accordance with our expectations, and effectively manage any unanticipated risks that arise, while also maintaining stability within the acquired business and appropriate focus on the rest of Modine’s business;

·

The overall health and continually increasing price-down focus of our vehicular customers in light of economic and market-specific factors, and the potential impact on us from any deterioration in the stability or performance of any of our major customers;

·

Our ability to maintain current customer programs and compete effectively for new business, including our ability to offset or otherwise address increasing pricing pressures from competitors and price reduction and overall service pressures from customers, particularly in the face of macro-economic instability;

·

Unanticipated product or manufacturing difficulties or inefficiencies, including unanticipated program launch and product transfer challenges and warranty claims;

·

Unanticipated delays or modifications initiated by major customers with respect to product launches, product applications or requirements;

 

·

Unanticipated problems with suppliers meeting our time, quantity, quality and price demands, and the overall health of our suppliers, particularly in light of some continuing economic challenges in areas of the world in which we and our suppliers operate;

·

Our ability to consistently structure our operations in order to develop and maintain a competitive cost base with appropriately skilled and stable labor pools, while also positioning ourselves geographically, so that we can continue to support our customers with the technical expertise and market-leading products they demand and expect from Modine;

·

Costs and other effects of the investigation and remediation of environmental contamination;

·

Increasingly complex and restrictive laws and regulations, including those associated with being a U.S. public company and others present in various jurisdictions in which we operate, and the costs associated with compliance therewith;

·

Work stoppages or interference at our facilities or those of our major customers and/or suppliers;

·

The constant and increasing pressures associated with healthcare and associated insurance costs; and

·

Costs and other effects of unanticipated litigation, claims, or other obligations, including those associated with our acquisition of Luvata HTS.

 

Strategic Risks:

 

·

Our ability to successfully take advantage of our increased presence in the “industrial” markets, with our Building HVAC and Commercial and Industrial Solutions businesses, without shifting attention away from our vehicular business, where we enjoy and desire to preserve a leading position; and

·

Our ability to identify and execute additional growth and diversification opportunities in order to position us for long-term success.

 

Financial Risks:

 

·

Our ability to fund our global liquidity requirements efficiently for Modine’s current operations, particularly those in our Asia business segment, and meet our long-term commitments in the event of an unexpected disruption in or tightening of the credit markets or extended recessionary conditions in the global economy;

·

The impact of potential increases in interest rates, particularly in LIBOR and EURIBOR in relation to our variable-rate debt obligations;

·

Our ability to bring our leverage ratio (net debt divided by Adjusted EBITDA, as defined in our credit agreements) back into our target range of 1.5 to 2.5 in an efficient manner following our acquisition of Luvata HTS;

·

Costs arising from the integration of Luvata HTS and the timing and impact of potential purchase accounting adjustments;

·

The impact of foreign currency exchange rate fluctuations, particularly the value of the euro, Brazilian real, and British pound, relative to the U.S. dollar; and

·

Our ability to effectively realize the benefits of tax assets in various jurisdictions in which we operate.

In addition to the risks set forth above, we are subject to other risks and uncertainties as identified in our public filings with the U.S. Securities and Exchange Commission.  We do not assume any obligation to update any forward-looking statements.

 

ITEM 7A.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

 

In the normal course of business, we are subject to market exposure from changes in foreign currency exchange rates, interest rates, commodity prices, credit risk and economic conditions.

 

Foreign Currency Risk

 

We are subject to the risk of changes in foreign currency exchange rates due to our operations in foreign countries. We have manufacturing facilities in Brazil, China, India, Mexico, South Africa, and throughout Europe.  We also have joint ventures in China, Japan and South Korea.  We sell and distribute products throughout the world and also purchase raw materials from suppliers in foreign countries.  As a result, our financial results are affected by changes in foreign currency exchange rates and economic conditions in the foreign markets in which we do business.  We attempt to mitigate foreign currency risks on transactions with customers and suppliers in foreign countries by entering into contracts that are denominated in the functional currency of the entity engaging in the transaction.  In fiscal 2017, we recorded realized and unrealized foreign currency gains and losses that netted to a loss of $2 million, which we reported in other income and expense in the consolidated statement of operations.  In addition, our consolidated financial results are impacted by the translation of revenue and expenses in foreign currencies into U.S. dollars.  These translation impacts are affected by changes in exchange rates between the U.S. dollar and European currencies, primarily the euro, and changes between the U.S. dollar and the Brazilian real, and between the euro and the British pound.  In fiscal 2017, more than 50 percent of our sales were generated in countries outside the U.S.  A change in foreign currency exchange rates will positively or negatively affect our sales; however, this impact will be offset, usually to a large degree, with a corresponding effect on our cost of sales and other expenses.  In fiscal 2017, changes in foreign currency exchange rates negatively impacted our sales by $13 million; however, the impact on our operating income was less than $1 million.  Foreign currency exchange rate risk can be estimated by measuring the impact of a near-term adverse movement of 10 percent in foreign currency exchange rates.  If these rates were 10 percent higher or lower during fiscal 2017, there would not have been a material impact on our fiscal 2017 earnings.

 

We maintain foreign-denominated, long-term debt obligations and long-term intercompany loans that are subject to foreign currency exchange risk.  As of March 31, 2017, we did not have any long-term intercompany loans for which changes in foreign currency exchange rates could materially impact our net earnings.  From time to time, we enter into currency rate derivative contracts to manage the foreign exchange rate exposure on these types of loans.  These derivative instruments are typically not accounted for as hedges, and accordingly, gains or losses on the derivatives are recorded in other income and expense in the consolidated statements of operations and act to offset any currency movement on the outstanding loans receivable or payable.

 

Interest Rate Risk

We actively seek to reduce the potential volatility of earnings that could arise from changes in interest rates.  We generally utilize a mixture of debt maturities and both fixed-rate and variable-rate debt to manage exposure to changes in interest rates.  Interest on both our term loans and borrowings under our primary multi-currency revolving credit facility is based upon a variable interest rate, primarily either the London Interbank Offered Rate (“LIBOR”) or Euro Interbank Offered Rate (“EURIBOR”), plus 137.5 to 250 basis points, depending on our leverage ratio.  We are subject to risk of fluctuations in LIBOR and EURIBOR and changes in our leverage ratio, which would affect the variable interest rate on our term loans and revolving credit facility and could create variability in interest expense.  As of March 31, 2017, our outstanding borrowings on the variable-rate term loans and revolving credit facility totaled $269 million and $40 million, respectively.  Based upon our outstanding debt with variable interest rates at March 31, 2017, a 100 basis point increase in interest rates would increase our annual interest expense in fiscal 2018 by approximately $3 million.

Commodity Price Risk

We are dependent upon the supply of raw materials and supplies in our production processes and, from time to time, enter into firm purchase commitments for aluminum, copper, nickel, and natural gas.  We maintain agreements with certain customers to pass through specified raw material price fluctuations in order to mitigate commodity price risk.  The majority of these agreements contain provisions in which the pass-through of the price fluctuations can lag behind the actual fluctuations by three months or longer, and typically the arrangements are limited to the underlying material cost based upon the London Metal Exchange and exclude additional cost elements, such as fabrication.

 

Credit Risk

Credit risk represents the possibility of loss from a customer failing to make payment according to contract terms.  Our principal credit risk consists of outstanding trade accounts receivable.  At March 31, 2017, 35 percent of our trade accounts receivable balance was concentrated with our top ten customers.  These customers operate primarily in the automotive, commercial vehicle, and off-highway markets and are influenced by similar market and general economic factors.  In the past, credit losses from our customers have not been significant.

We manage credit risk through a focus on the following:

·

Cash and investments – We review cash deposits and short-term investments to ensure banks have acceptable credit ratings, and short-term investments are maintained in secured or guaranteed instruments.  We consider our holdings in cash and investments to be stable and secure at March 31, 2017;

·

Trade accounts receivable – Prior to granting credit, we evaluate each customer, taking into consideration the customer's financial condition, payment experience and credit information.  After credit is granted, we actively monitor the customer's financial condition and applicable business news;

·

Pension assets – We have retained outside advisors to assist in the management of the assets in our pension plans.  In making investment decisions, we utilize an established risk management protocol that focuses on protection of the plan assets against downside risk.  We ensure that investments within these plans provide appropriate diversification, the investments are monitored by investment teams, and portfolio managers adhere to the established investment policies.  We believe the plan assets are subject to appropriate investment policies and controls; and

·

Insurance – We monitor our insurance providers to ensure they have acceptable financial ratings.  We have not identified any concerns in this regard based upon our reviews.

Economic Risk

Economic risk represents the possibility of loss resulting from economic instability in certain areas of the world or downturns in markets in which we operate.  We sell a broad range of products that provide thermal solutions to customers operating primarily in the automotive, commercial vehicle, off-highway, and commercial, industrial, and building HVAC&R markets.  We operate in diversified markets as a strategy for offsetting the risk associated with a downturn in any of the markets we serve.  However, risk associated with market downturns is still present.

We monitor economic conditions in the U.S. and abroad.  As we expand our global presence, we also encounter risks imposed by potential trade restrictions, including tariffs, embargoes, and the like.  We continue to pursue non-speculative opportunities to mitigate these economic risks, and capitalize, when possible, on changing market conditions.

We pursue new market opportunities after careful consideration of the potential associated risks and benefits.  Successes in new markets are dependent upon our ability to commercialize our investments.  Current examples of new and emerging markets for us include those related to waste heat recovery, coils and coolers outside of North America and the U.K., and coatings.  Our investment in these areas is subject to the risks associated with business integration, technological success, customer and market acceptance, and our ability to meet the demands of our customers as these markets grow.

We anticipate that recovery within some of our geographic and end markets may put production pressure on certain suppliers of our raw materials.  In particular, there are a limited number of suppliers of aluminum, copper, and steel material.  We are exposed to the risk of suppliers of certain raw materials not being able to meet customer demand as they may not increase their output capacity as quickly as customers increase their orders, and of increased prices being charged by raw material suppliers.

In addition, we purchase parts from suppliers that use our tooling to create the parts.  In most instances, and for financial reasons, we do not have duplicate tooling for the manufacture of the purchased parts.  As a result, we are exposed to the risk of a supplier being unable to provide the quantity or quality of parts that we require.  Even in situations where suppliers are manufacturing parts without the use of our tooling, we face the challenge of obtaining consistently high-quality parts from suppliers that are financially stable.  We utilize a supplier risk management program that leverages internal and third-party tools to identify and mitigate higher-risk supplier situations.

 

In addition to the above risks on the supply side, we are also exposed to risks associated with demands by our customers for decreases in the price of our products.  We attempt to offset this risk with firm agreements with our customers whenever possible, but these agreements often contain provisions for future price reductions.  In addition, customers occasionally link price reductions to future program awards, and we must assess the overall implications of such requests on a case-by-case basis.

Hedging and Foreign Currency Forward Contracts

We use derivative financial instruments as a tool to manage certain financial risks.  We prohibit the use of leveraged derivatives.

Commodity derivatives: From time to time, we enter into futures contracts related to certain forecasted purchases of aluminum and copper.  Our strategy is to reduce our exposure to changing market prices for future purchases of these commodities.  In fiscal 2017, 2016 and 2015, net gains and losses related to commodity derivative contracts, which are reported in cost of sales in the consolidated statements of operations, were less than $1 million in each year.

Foreign currency forward contracts: We use derivative financial instruments in a limited way to mitigate foreign currency exchange risk.  We periodically enter into foreign currency exchange contracts to hedge specific foreign currency-denominated assets and liabilities.  We have not designated these forward contracts as hedges.  Accordingly, we record unrealized gains and losses related to the change in the fair value of the contracts in other income and expense.  Gains and losses on these foreign currency forward contracts are offset by foreign currency gains and losses associated with the related assets and liabilities.

Counterparty risks: We manage counterparty risks by ensuring that counterparties to derivative instruments have credit ratings acceptable to us.  At March 31, 2017, all counterparties had a sufficient long-term credit rating.

 

MODINE MANUFACTURING COMPANY

CONSOLIDATED STATEMENTS OF OPERATIONS

For the years ended March 31, 2017, 2016 and 2015

(In millions, except per share amounts)

The notes to consolidated financial statements are an integral part of these statements.

 

MODINE MANUFACTURING COMPANY

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

For the years ended March 31, 2017, 2016 and 2015

(In millions)

The notes to consolidated financial statements are an integral part of these statements.

 

MODINE MANUFACTURING COMPANY

CONSOLIDATED BALANCE SHEETS

March 31, 2017 and 2016

(In millions, except per share amounts)

The notes to consolidated financial statements are an integral part of these statements.

 

MODINE MANUFACTURING COMPANY

CONSOLIDATED STATEMENTS OF CASH FLOWS

For the years ended March 31, 2017, 2016 and 2015

(In millions)