Madison Air Solutions Corporation (MAIR) Earnings Call Transcript & Summary

I think we'll get started. So to start, for any important disclosures, please see the Morgan Stanley research disclosure website at morganstanley.com/researchdisclosures. And if you have any questions, please reach out to your Morgan Stanley representative. We're excited to have Madison Air here with us, President and CEO, Jill Wyant; and CFO, J.J. Foley. I think to start it off, would you like to make some opening remarks

Great. Thank you, Toby, and thank you, everyone, for joining us. And for those of you joining us on the live stream, we do have pages available on our investor website, madisonair.com/investors. So what I wanted to do is just to level the playing field on the understanding of our company, just open with a few remarks, as Toby said. So we are Madison Air. Our mission is to make the world safer, healthier and more productive through the power of better air. And we often talk about the 3 strengths that underlie the company. The first is we are differentiated by return on air. So whether it be residential markets or commercial end markets, we provide highly engineered custom and semi-custom solutions that drive a tangible improvement in the environments of the customers we serve. And we call that Return on Air, delivering -- moving the needle for our customers. We lead in growth markets. So we chase -- we are an 1/8 share in a $40 billion addressable market that is distinct and complementary to what the global OEMs do. And really, we sell into mission-critical end markets where air is a vital aspect of essential infrastructure. And these markets are disproportionately benefiting from strong secular tailwinds. And then last but not least, we are powered by a very unique value creation model. We are decentralized, meaning we are very customer-focused, agile locally with the customers we serve at enterprise scale with unique philosophies around value selling, value pricing, mergers and acquisitions, people, culture and the like. And you see that not only in our growth profile, but in our margin and cash profile as well. We believe we are building a very balanced and resilient business. So through -- on an LTM basis through June of this year, the company has about $3.75 billion in sales, an adjusted EBITDA margin of 26.6% or roughly 27%, and generated north of $430 million of free cash flow. All of this on a very asset-light model, low single-digit CapEx as a percentage of sales. We are balanced in the sense that 2/3 of the company's sales are in the commercial segment, the balance in residential. 50% of demand is replacement and upgrade demand, 10% services and aftermarket, an area of real strategic emphasis for us and then the balance of 40% in new builds and about -- on a today basis, 95% of sales domestically in North America, where we think that the secular tailwinds are quite strong. We are -- we operate in 2 distinct but very complementary segments, the first of which, as I mentioned, is commercial. June LTM sales of about $2.4 billion. Here, we bring highly engineered custom and semi-custom solutions in the area of air movement, custom air handling, air liquid and hybrid cooling, energy efficiency, heat solutions, again, into a diversified set of upwards of 15 end market verticals: logistics, manufacturing, pharmaceuticals, life sciences, chip fabs, hospitals, health care and the like. And in the residential segment, about $1.3 billion of sales or roughly 1/3 of total company sales through June. Here, we are in a fundamentally different game than the traditional global players. We are not in residential heating and cooling. We are in residential healthy air, purification, ventilation, humidification, dehumidification, sensing and controls with an enormous white space opportunity. 92% of U.S. homes have nothing. And that solution penetration opportunity, coupled with the contractor conversion opportunity that we have, I think we penetrated less than 20,000 of 75,000 HVAC contractors in the U.S. We have enormous channel and solution penetration potential. And maybe before I turn it over to J.J. for a couple of comments, I would just talk about the announcement a few weeks ago of our intention to acquire ebm-papst, a leading provider of integrated airflow technology founded in 1963, headquartered in Mulfingen, Germany, for a purchase price of $5 billion or roughly 10x '26 estimated adjusted EBITDA, inclusive of cost synergies. This more than doubles our -- or nearly doubles our addressable market to $70 billion. It affords us more commercial opportunity. And so we are really excited about the potential. Really, the strategic thesis here, this is a company we've been following for many years. It really is the unlock of Return on Air. So the fan is the enabler of every commercial HVAC system out there, whether that be a chiller or which -- an air handler or a piece of commercial refrigeration equipment, it is less than 10% of the upfront capital cost, but drives more than 80% of the operating cost over the life cycle of that asset and has very superior energy efficiency gains, a great sound profile and ebm-papst has more than 250 million fans in its air technology installed base. So lots of reputational reliability proven in the field. We believe this strengthens our ability to bring differentiated solutions, taking their integrated EC fan technology, our applications know-how and customer reach to become a provider of differentiated technology and a partner of choice. So in addition to $160 million of cost synergies as we exit the third year after closing and EPS accretion, moderate EPS accretion starting in year 1 after close, we see substantial and exciting revenue synergies, which are not in the model that we shared a few weeks ago, but are very much in the management plan as we seek to bring, again, that enabler, the best lines in EC fan technology, combined with our applications expertise to win and grow and expand growth, margins and the cash profile of ebm-papst. So maybe I'll turn it to you to give a little visibility, and then we'll close and take some questions.

Very good. Good morning, and thank you all for being here. I wanted to give you a little bit of an update on visibility here for the third quarter performance. Revenue growth in the third quarter is ahead of our prior expectations. So we're raising our third quarter revenue growth outlook to the high teens. And alongside that, now see low double digit or about 10% adjusted EBITDA growth. The market demand really remains solid overall, and it's broad-based commercial strength and continued outsized growth, particularly in data center cooling that gives us the confidence to be able to give that update today. Residential, I would say, broadly remains in line with our expectation and continues to perform well against a quite tepid market backdrop. Speaking to the third quarter revenue, we previously expected the third quarter revenue growth to be in the high single-digit plus range. And based on today's visibility, as I said, now expect growth in the high teens. Commercial driving much of that increase, and our teams are executing both strong orders as well as backlog converting that into revenue, beating the prior expectations, strong data center demand and executing against those major hyperscaler customer programs as well as solid performance across a broad range of other commercial businesses and end markets. And that just reinforces much of what Jill highlighted earlier in terms of our confidence in the demand environment and the relevance of the solutions. Speaking to the third quarter adjusted EBITDA, we expect low double-digit adjusted EBITDA growth in the quarter. That's faster than what was implied in the second quarter call with broad-based volume strength. There are a few relationship items here between revenue and adjusted EBITDA, and that growth reflects a few near-term dynamics. The most notable is the success-based mix impact from the outsized growth in the data center cooling business that is earlier in its scale up. And here, we're making big investments as well as investing into the ramp with cost there as we add that capacity and scale that production for strong support of customer demand. And while the data center business is already at healthy industrial EBITDA margins and contribution, there's still work to do there. We're investing and have a very clear path here to drive expansion over time as programs mature, productivity improves and volume scales. And the second but less notable item is around price/cost as inflation and tariff recovery actions continue to work across the portfolio, and we can talk more about that in Q&A. But particularly in the longer cycle parts of the business, as you all know, that takes time. So the EBITDA contribution from strong volume growth more than offsets these 2 near-term dynamics, which supports the higher quarterly growth outlook. And then just while we're on the topic of price/cost execution and why this really gets better over time, for us, we work through inflationary dynamics with a very disciplined -- and it's a surgical business-by-business approach. The teams are actively executing their coverage plans with clear ownership and operating cadences in each of the businesses. And you can imagine the host of actions we've talked about in the past, the combination of price and value selling as well as project level commercial actions and productivity improvements, material cost reduction and sourcing savings. Our first priority continues to be covering on a dollar basis and then following that with rate coverage exiting the year. And then I would just say, as it relates to the fourth quarter and the full year outlook, we'll expect to give a full update here on the year in the third quarter call as usual. We expect healthy book-to-bill in the fourth quarter and positive year-over-year revenue growth as we noted that on tough comps, probably a more moderate rate than this high teens growth that you're seeing in the third quarter. So overall, just sort of in closing on those comments, third quarter demand and execution are strong, stronger than we had previously expected and that support a higher revenue and adjusted EBITDA growth outlook for the quarter. And the upside continues to be broad-based with strong commercial growth, both within and beyond data centers, and we like the quality of the growth and the value that we're going to be able to create here as these businesses mature and scale. And for the fourth quarter, I don't really see conditions changing all that much. No grand update there, and we'll hit that in the full year update at the third quarter earnings. So those are a few updates on near-term visibility.

So that's us, differentiated by Return on Air, this idea that our engineered -- highly engineered custom and semi-custom solutions drive tangible improvements in our customers' environments, really leading in growth markets, mission-critical markets where the cost of failure is high and our solutions keep air operating as critical infrastructure and then really a unique value creation model, I think, further strengthened over time once we close the ebm-papst deal, which is anticipated later this year to continue to compound growth and cash flow.

That's great.

There you have it.

I appreciate you sharing that, and it's always great to hear how the quarter is trending very well. I guess kind of zooming out off of that, how would you characterize demand across Madison Air today? And looking at data center has clearly been a very significant driver, but where else are you seeing strength across the broader commercial portfolio?

Yes. And thank you again for having us, Toby, and to everyone in the room for joining us. I would say for us, and we talked about this in the second quarter call, and J.J. just gave some preview, demand is very healthy and remains balanced. Our -- particularly in the commercial segment, where we sell into 15 end market verticals, there is very diversified growth, both by end market and by customer. And so we are not a one-market company here, a diverse array of end market opportunities. And so spaces for us like logistics and health care, advanced manufacturing, and the like remain really healthy for us. Orders were up 70% in the second quarter. So healthy demand, very broad-based.

And then as you start to think about the durability of that demand, I think more than half of your record backlog goes to 2027 and beyond. What does that tell you about the durability of this growth outlook?

Yes. I think for the back -- $2.9 billion, as you said, on backlog exiting the quarter gives us very strong visibility both for the balance of the year, but well into 2027. And as Jill said, a nice diverse array of both customer and different end markets. And so I think our focus really will be on converting that backlog in a profitable manner and continuing to fuel the growth outlook. Pipelines are very strong right now across a number of the different businesses. And so we still see strong orders momentum and pipeline management.

And data center, of course, has been a key part of that growth story. How does Madison Air participate across air, liquid and hybrid cooling? And as that business scales, what does that say about the path for margins?

Yes. Good question, Toby. I think customers need a partner that's going to help meet them where they are and where they want to go. So for us to be able to offer air, liquid and hybrid cooling solutions allows us to be relevant to that customer regardless of what their cooling platform is or what their technology play is. I think for us, we feel good about where we are and really love serving these great customers, whether it's hyperscalers or colocators, very balanced on that front. And I think for us as well, when you think about the revenue outlook for the business, a good balance of air, liquid and hybrid cooling. And as it relates to the margins, I would say it's a very healthy industrial EBITDA business today. And we will continue to invest in the ramp. We'll continue to invest in technology, and we see a clear path for that to continue to move up and to the right over time as we execute our growth and margin playbook for the business.

And kind of following up on a point you mentioned earlier when it comes to price cost, how does that factor into that margin algo?

Yes. I think for us, we feel and manage price cost, as we said, very surgically. I think we have an ability to partner with customers to make sure that we deliver for all stakeholders, both in terms of delivering for customers, but also making sure that as that business scales, we are covered from a price/cost standpoint. We get rewarded for the innovation and the value that we bring, that we open up that services and aftermarket, really that margin playbook that allows us to grow those margins as the business scales.

And then I guess kind of shifting gears here, looking at the residential side of the business. How has your residential business been able to grow despite softer housing market and softer HVAC markets? What's been driving that resilience? And how much runway remains in the contractor conversion and healthy air system penetration?

Yes. So we are in a fundamentally different game than the global OEMs from -- within the residential space. So we're not, as I mentioned, in residential heating and cooling. Instead, we really specialize in the pillars of healthy air. And so this is purification, ventilation, humidification, dehumidification, sensing and controls. And that market, we estimate, we believe it to be more than 90% unpenetrated. So 92% of U.S. homes have nothing. And that's against the backdrop of people spending more time inside, this wildfire phenomenon that is as present in the Midwest where I live as it is here on the West Coast and wildfire is very small particles, really horrible for human health and wellness in terms of air quality. And so it's a fundamentally different game that is complementary to what the global OEMs do. And from a solution penetration perspective, a ton of white space in front of us. And so -- and you've seen that in our AprilAire business, which we acquired in May of last year, which has just continued to have attractive low double-digit growth here because of that solution penetration opportunity. We also, as you mentioned, have spent a lot of time educating and converting contractors. And really, that helps us create demand because they have more than 40 million homeowner touch points every year between regular service and warranty checks in your home and then to some extent, maybe 20%, 25% of those 40 million interactions per year on an HVAC system replacement. So even when HVAC system replacements are down, 75% of the commercial touch points are really routine visits each year. And so that helps us create and convert demand through those 40 million homeowner interactions or what we call our commercial at-bats. And then of those HVAC contractors, I think we are not even 20,000 converted in of a contractor base of 75,000 HVAC contractors in this country. So you have white space in terms of solution penetration, more than 90% of U.S. homes have nothing. And you have white space in terms of contractor conversion, 70%, 80% of contractors yet to be converted. So we think that's what has made our residential segment and our AprilAire business in particular, a strong performer.

And could you speak a little bit on that contractor conversion process? Why does Madison Air win? How do you make that pitch to those customers?

Well, I really -- yes, great question. I think of us more as a business services provider to our HVAC contractor partners as opposed to we swoop in, we sign a rebate agreement and we say, we'll see you at the end of the year when it's time to true up on how many units you've sold and we'll write you a check. So it really is we are wholly vested in the success of our contractor partners. And quite honestly, when we've seen the kind of 18 to 24 months that we've seen here, they need us more than ever, because they're in homes upwards of 40 million times a year. And so we spend a lot of time educating them on what is healthy air and what is the importance of healthy air. And it's really around health and comfort and home preservation for their customer. We educate them on the product. What is the product? How easy is it to install? And what are the opportunities? We converted -- there are 40 million basements and crawl spaces in this country. And to install dehumidification equipment in those spaces was historically very challenging for the HVAC contractor and less than ideal for the homeowner. You literally had to crawl under homes, crawl into tight spaces in order to get a sense for how well the dehumidification solution was working. So in partnership with those HVAC contractors, we made those systems easier to install and WiFi connected to the Healthy Air app. So suddenly, they don't have to crawl in that space. It's faster, it's easier and it's more seamless to install the solution. So it's really fanatical focus on the user who's then equipped to take that 1 of 40 million at-bats and help it to grow the -- grow their business with a higher margin, sticky solution. So every air purification system we sell has a 9x tail in terms of bespoke filtration solutions that they can sell over the life of that asset. So we're really embedded and indispensable partners with our contractor partners, not a "here you go, sign a deal and we'll see in a year."