Johnson Controls International plc (JCI) — Q4 2017 Transcript

Good morning, and thank you for joining our conference call to discuss Johnson Controls fourth quarter and full year fiscal 2017 results. The press release and all related tables issued earlier this morning as well as the conference call slide presentation can be found on the Investor Relations portion of our website at johnsoncontrols.com. With me today are Johnson Controls Chairman and Chief Executive Officer, George Oliver; and our Executive Vice President and Chief Financial Officer, Brian Stief. Before we begin, I would like to remind you that during the course of today’s call, we will be providing certain forward-looking information. We ask that you review today’s press release and read through the forward-looking cautionary informational statements that we’ve included there. In addition, we will use certain non-GAAP measures in our discussions, and we ask that you read through the sections of our press release that address the use of these items. In discussing our results during the call, references to adjusted EBITA and adjusted EBIT margins exclude transaction and integration costs as well as other special items. These metrics are non-GAAP measures and are reconciled in the schedule attached to our press release. All comparisons to the prior year are on a combined basis, which excludes the results of Adient and includes the results of Tyco, net of conforming accounting adjustments and recurring purchase accounting. GAAP earnings per share from continuing operations attributable to Johnson Controls ordinary shareholders was $0.93 for the quarter and included a net benefit of $0.06 related to special items. These special items primarily related to mark-to-market pension and postretirement gains and discrete tax items partially offset by restructuring, impairment and integration costs. Adjusting for these special items, non-GAAP adjusted diluted earnings per share from continuing operations was $0.87 per share compared to $0.76 in the prior year quarter. Now, let me turn the call over to George.

Thanks, Antonella, and good morning, everyone. Thank you for joining us on today’s call. Let me begin with a look back at our first year as a combined company. And the message that I hope you walk away with is although our financial results came in at the low end of where we would have expected in fiscal 2017, we made significant progress on the integration of a historic merger with Johnson Controls. I’m extremely proud of the work our teams around the globe have done and what we have accomplished throughout the year. We completed a major reorganization of our operating structure across the globe, most recently in North America. We made significant strides in aligning our cost structures, generating $300 million in incremental cost synergies and productivity savings, driving 90 basis points of margin expansion for the year. Despite the substantial amount of integration taking place, we also maintained rigor around optimizing our portfolio and capital structure. We completed the spin-off of Adient and divested ADT South Africa and Scott Safety as well as several other small noncore assets. We redeployed the proceeds from those divestitures into paying down a substantial portion of the merger-related TSARL debt. Additionally, we pursued opportunistic share repurchases in an effort to offset the coming dilution related to the Scott Safety transaction, and we finished the year with approximately $650 million of share buybacks. That said, as we have identified on the right side of Slide 5, there are areas in our performance where we need to improve as we move forward: accelerating organic growth in orders and Buildings, expanding gross margins in Buildings, improving free cash flow conversion and consistently delivering on our commitments. If we turn to Slide 6, I’ll tie those areas of improvement to the changes we have already implemented to enable us to put shareholder value creation at the forefront of everything we do. First, as you may have seen in a press release this morning, we announced a change in our General Counsel with the departure of Judy Reinsdorf. I’ve worked with Judy for well over a decade. She was instrumental in my time as CEO of Tyco and has been a crucial voice throughout her transitional role for the past year here at Johnson Controls. I’d like to sincerely thank Judy for her many years of service and wish her all the best. I’d also like to take this opportunity to welcome John Donofrio to the team who’s joining us from Mars Incorporated. With this and a few other recent appointments, our senior leadership team is coming together and will be held accountable for driving execution. Beginning in fiscal 2018, we plan to change our compensation incentives to be more closely linked to our performance and aligned with shareholder expectations. Specifically, we plan to tie compensation incentives to the key performance areas that we are focused on: organic revenue growth, EBIT growth and free cash flow conversion. When it comes to accelerating organic sales and orders growth in the field businesses, tracking sales capacity and sales productivity metrics are essential. Growing the field businesses requires a strong and expanding sales force by business and by region with continued productivity. It sounds simple but demands intense focus and consistent monitoring by our business leaders, including myself. With the combination of reorganization of the Buildings businesses, we have remixed the sales force and reinvested in areas of growth. For the full year, we were short of the increased capacity required to accelerate growth. However, in the fourth quarter, we enhanced the process and achieved net adds of 50 salespeople. As we move forward in our new structure, we are targeting 400 net sales adds in fiscal 2018, which will be core to accelerating orders in organic revenue growth. This investment is in response to a strong positive feedback from our customers with respect to how our technologies and solutions are helping our customers enhance their businesses. This will put a bit of pressure into the first half of the year as the new salespeople ramp up, but the increase in capacity will ultimately drive improvements in execution and higher growth. As we move through the course of fiscal 2018, we will keep you posted on our progress. Additionally, not all revenue growth is created equal. And similar to how I operated at Tyco, we will be focused on profitable growth. This starts with going after the right projects, remaining disciplined on pricing to ensure that we are being paid for the value that we provide to our customers and rigorous project management down to driving change orders. With the installed base we create, it is critical that we continue to accelerate our service growth, which enhances our margin profile. As we look at the underlying fundamentals of our backlog, there is some gross margin pressure we expect to see as the backlog turns in our North America field business. To put this in context, the size of backlog in our North America field business is $5.2 billion, and I would say we are entering the year with roughly 75 basis points of gross margin pressure. We have put in place a more strict approval process for large installation projects and are realigning the incentive compensation structure for the entire sales organization. We plan to weight sales incentives more towards gross margins and sales growth so that we can ensure our teams are targeting more profitable growth. With more discipline on price, sales productivity, project management and service acceleration, we expect to drive both improved margins and increased profitability. When it comes to improving free cash flow conversion, we had an intense focus in the fourth quarter to ensure we met the expectations set. I, together with Brian, established a weekly meeting to drive the importance of this metric and closely monitored our free cash flow generation. Additionally, we are in the process of establishing a cash management office reallocating internal talent to solve some of our working capital challenges and focus solely on achieving the targets we have set out. While we saw improvement in our free cash flow generation in the fourth quarter, we know we have a lot more work to do to increase our cash flow conversion. As we move forward, we will also be more selective in our CapEx spending, focused on high return projects and reducing our reinvestment ratio. In terms of capital allocation, you can expect us to remain disciplined when it comes to returning cash to shareholders with a near-term focus remaining on opportunistic share repurchases and overtime, a more balanced approach between accretive M&A and buybacks. We have leading market positions and are strongly positioned to win across our core businesses. That said, we will continue to look at the portfolio both within Power and Buildings, ensuring we are allocating resources in areas where we can generate the highest returns and divesting businesses that are noncore. With all of these key business fundamentals I have discussed, we have established discipline and accountability from which we set grounded expectations. We know where performance needs to improve. And as a management team, we are entirely focused on executing on the actions I have outlined. I am humbled and honored to be leading this organization, and I want to reiterate that this team is intensely focused on driving execution and creating shareholder value. My personal mission as CEO of Johnson Controls is to lead with clarity, simplicity and confidence, and my intent is that those same values permeate beyond the executive management team throughout the entire organization. I remain confident that, with the organizational changes over the past year, we are well positioned to lead the evolution of Building Solutions and battery technologies. Turning now to Slide 7. Let me recap the results for the quarter, and Brian will provide more detail in a few minutes. Overall, another quarter of solid earnings growth with strong EBIT margin expansion driven by continued progress on synergy and productivity actions. Sales of $8.1 billion increased 4% on a reported basis in the quarter. Excluding the impact from divestitures, FX and lead pass-through, sales increased 2% organically, led by strong performance in our Power Solutions business as well as our Global products business within Buildings. Adjusted EBIT of $1.1 billion grew 10%, driven by cost synergy and productivity realization. EBIT margins were up 80 basis points year-over-year on a reported basis or up 110 basis points excluding the impact of FX and lead.

Thanks, George, and good morning. Let’s start with our new segment structure within Building Technologies & Solutions on Slide 10. As you can see, Buildings has two main components: Building Solutions and Global products. Building Solutions, which has annual revenue of about $15 billion, is our field business and direct channel. We operate in a regional structure and report 3 segments: North America, EMEA/LA and Asia Pacific. Global products has $8 billion of annual revenue and will be reported as our fourth segment within Buildings. I will speak to the new segments as I go through the results for Buildings. Now let’s get into the details of the quarter on Slide 11. Total building sales in the quarter of $6 billion declined 1% year-over-year on a reported basis. However, excluding the impacts from FX and divestitures, sales grew 1% organically. The impact of the hurricanes, the earthquake in Mexico and some final sales-related purchase accounting adjustments impacted sales growth by approximately 60 basis points in the quarter. So let’s start by unpacking the 1% organic decline in Building Solutions, which again represents our project and service-based field business. In North America, our largest region, sales declined low single digits. Our fire and security field business, which comprises about half of the revenue in North America, is relatively flat year-over-year. HVAC and controls installation and service activity, which typically accounts for about 35% to 40% of sales in North America, grew low single digits. However, this growth was more than offset by a decline in large projects within our solutions business, which declined low double digits in the quarter. And I’d just point out that about half of that decline was driven by weaker sales to the U.S. federal government. Turning to EMEA/LA, we saw low single-digit growth in the quarter. Growth in Europe was led by solid project activity in fire and security. In the Middle East, sales inflected to positive growth in the quarter driven by HVAC. Latin America also grew low single digits with balanced growth across fire and security, HVAC and controls. In Asia Pacific, organic growth was flat in the quarter as strong growth in service was offset by lower project installation spend year-over-year, particularly in China. Turning to global products. Sales increased 3% organically year-over-year with growth across building management, HVAC and refrigeration equipment and specialty products. Building management, which is about 15% of global products revenue, includes controls, security and fire detection, and we saw a nice growth across all 3 of these product lines. HVAC and refrigeration products, which comprises about 65% of global products revenue, includes unitary and applied HVAC equipment and products, our Hitachi joint venture products, as well as industrial refrigeration and marine equipment. Within these businesses, residential and light commercial HVAC grew low single digits where a low single-digit decline in residential HVAC was more than offset by low teens growth in light commercial where we saw significant growth in our national accounts business. I would point out that the residential HVAC decline was impacted by a tough prior year comparison with fiscal ‘16 Q4 growth north of 20% as well as lower cooling degree days. For the full year, our residential HVAC business grew high single digits organically, benefiting from new product launches in the spring of 2016. Our applied business grew in the mid-single digits range in the quarter with strong performance from North America and larger projects in the Middle East. Finally, we continue to see solid growth in our Hitachi joint venture as well as a pickup in our industrial refrigeration businesses led by the improving natural gas and food and beverage markets. The remaining 20% of revenue in global products is specialty products, which includes fire suppression and Scott Safety. This platform saw low single-digit growth in the quarter and, as you know, Scott Safety was sold to 3M in early October. So let’s turn to EBITA. Buildings grew 5% year-over-year in both the reported and adjusted basis to $904 million with margins expanding 80 basis points year-over-year to 15.1%. This growth was led by cost synergies and productivity savings, partially offset by price cost pressure as well as continued investments we’re making in new products in our channels. Over the course of 2017, we launched 14 new chiller products globally and expanded our factory direct distribution business by adding 17 new storefronts across North America. And I just point out that for the full year, Buildings EBITA margin expanded 50 basis points. So let’s turn to Slide 12. Orders grew 2% organically year-over-year, led by the 5% growth in our products business. Field orders were flat as high single-digit growth in Asia Pacific was offset by a low single-digit decline in North America and EMEA/LA. Backlog of 8.5 billion at year-end grew 4% year-over-year on an organic basis. So let’s move to Power Solutions. Sales of 2.1 billion increased 18% year-over-year on a reported basis, but this includes a significant tailwind from lead pass-through. Excluding lead and FX, sales grew 9% organically, led by strong shipments to the aftermarket channels across all regions. Global battery shipments increased 5% year-over-year with aftermarket unit growth of 8%, partially offset by a 5% decline in our lease shipments, which is consistent with the lower auto production in our two biggest markets, the U.S. and Europe. China rebounded nicely versus last quarter with total shipment growth of nearly 40% with strength across both OE and aftermarket. Global shipments of Start-Stop units increased 30% led by strong growth in China and the Americas. EMEA Start-Stop units increased 7% due primarily to strong aftermarket growth, which is more than offset by a low single-digit decline in OE. Segment EBITA of 431 million increased 4% on a reported basis or 5% excluding the impact of FX and lead. Power’s margins declined 260 basis points year-over-year to 20.2% on a reported basis, but this includes 170 basis point headwind from lead. Excluding the impact of FX and lead, Power’s margins declined 80 basis points. In the quarter, leverage and higher volumes, favorable mix and productivity savings were more than offset by ongoing product investments, start-up and launch costs and increased logistics and distribution costs, including the disruptions related to the hurricane. For the full year, Power’s margin declined by 60 basis points to 19.5% on a reported basis, but this includes 150 basis point headwind for lead. Excluding the impact of lead and FX, Power’s margins expanded a strong 100 basis points for the year.

Moving to Slide 14, corporate expenses decreased by 25% year-over-year to 107 million, benefiting from ongoing synergy and productivity savings, along with reduced compensation expenses compared to the previous year. For the full year, corporate expenses totaled 465 million on an adjusted basis, which is better than the 480 million to 500 million guidance range we provided last December. I am pleased with our progress in lowering overall corporate expenses, and we expect further improvements in fiscal '18. Now, let's look at free cash flow on Slide 15. In this quarter, we generated $1 billion in reported cash flow. After excluding 100 million in transaction and integration costs, adjusted free cash flow was 1.1 billion. This exceeded our 900 million target for Q4 outlined in July, primarily due to strong volume growth in Power Solutions, which enabled us to manage a portion of the inventory buildup from the end of Q3, along with a reduction in receivables across our businesses. As George mentioned, we are in the process of establishing an internal cash management office, which will focus on enhancing our overall cash management and forecasting processes, reporting directly to me. This will be one of our top priorities for fiscal '18, and we are committed to achieving adjusted free cash flow conversion of over 80%, excluding one-time cash outflows of 800 million to 900 million mainly related to integration, restructuring, and income tax payments. Let me pause for a moment to outline the components of these one-time items. We have approximately 500 million in restructuring and integration costs, likely about 100 million higher due to accelerating some actions into Q4 of '18 that were initially planned for fiscal '19. Additionally, there is about 100 million for executive severance and an unfavorable arbitration award that occurred in Q4. We also have 50 million in Scott Safety tax payments, along with around 350 million in tax-related items that are split into two parts. One is a 200 million outflow due to a new Mexican tax law change that disallows consolidated filings, requiring a deconsolidation that will result in cash outflows in the first quarter of fiscal '18, and the other is a 150 million outflow tied to specific tax planning in the U.S. In total, these amount to about 1 billion, and while we initially anticipated a 300 million tax refund in the first quarter of fiscal '18, that figure is now revised to 200 million. Conversely, the expected tax refund in 2019 has increased from 600 million to 700 million. Essentially, we now project about 1 billion in cash outflows and 200 million relating to the tax refund in the first quarter, totaling that 800 million figure. Also noteworthy, as we move into '19, we expect 700 million of tax refunds associated with the Adient tax paid in the first quarter of '17. Similar to previous years, we project our adjusted free cash flow to be more heavily weighted towards the second half of the year, with an outflow in Q1 and our largest inflow in Q4. Moving to Slide 16, we concluded the year with a net debt-to-cap of 39.3%, down from 41.2% on June 30. During the quarter, we capitalized on the low interest rate environment for foreign debt, issuing 310 million in yen-denominated five-year notes and 175 million in euro-denominated one-year notes. We utilized the strong cash flow generation, along with the proceeds from these debt issuances, to pay down 1 billion in commercial paper and 150 million in bond maturity. Additionally, we paid back 165 million in TSARL debt using Tyco-related cash flows. As you may know, the Scott Safety sale to 3M closed in early October, which allowed us to repay 1.9 billion of TSARL debt with the net proceeds. Together with the ADT South Africa sale earlier this year, these actions reduced our initial 4 billion in TSARL debt down to a current balance of 1.8 billion. During the quarter, we repurchased 225 million in stock, which is about 5.5 million shares. For the year, we bought back just under 16 million shares for a total of 650 million. I would also like to mention that we completed an additional 150 million in buybacks in October. As we go through fiscal '18, we plan to at least buy back enough stock to counter the effects of option dilution. On Slide 17, we provided details in the appendix related to the special items for Q4, all of which have been excluded from our adjusted results. I previously mentioned that the building segment change took effect in the fourth quarter, and the revised figures for fiscal '17 are included in the appendix as well. Lastly, the House U.S. tax reform proposal was released last week, and the Senate proposal is anticipated shortly. Interest deductibility and repatriation taxes on foreign earnings will pose challenges for us, but we are just beginning to assess the overall implications for Johnson Controls and explore other available tax planning opportunities. Thanks, Brian. As I mentioned earlier, we have made significant progress over the past year related to the merger integration, but we still have plenty of work to do. Fiscal 2018 will be a year of change. We will intensely focus on driving execution. Turning to Slide 18. We expect total sales to be in the range of $30.1 billion to $30.7 billion. Based on current exchange rates, this includes a $265 million tailwind related to changes in foreign currency as well as a $70 million tailwind related to lead prices. Additionally, the impact of recent divestitures is expected to be a $700 million headwind to sales. We expect overall organic sales growth to be in the low single digits. Going through our expectations for Buildings and Power, let me start with Buildings. Based on current backlog, we expect organic growth in the low single digits as we begin to ramp our sales capacity in fiscal 2018. From an adjusted EBITA margin perspective, we expect the benefit from synergies and volume growth to be partly offset by gross margin pressure within our North American field business backlog, which I spoke to earlier, as well as continued incremental investments in our products and channels. Overall, we expect adjusted EBITA margin expansion in Buildings of approximately 10 to 30 basis points, including a 40 basis point headwind related to the divestiture of Scott Safety. Underlying margins are expected to increase 50 to 70 basis points. In Power Solutions, we expect organic sales growth in the low to mid-single digits, driven by volume growth in the aftermarket. We expect volume mix and productivity benefits to be offset by higher lead prices and incremental investments including launch costs. We expect adjusted EBITA margins to be relatively flat on a year-over-year basis. As Brian mentioned earlier, we expect to see continued reductions in corporate expense and are targeting an incremental 5% to 9% reduction, which would bring our adjusted corporate expense down to a range of $425 million to $440 million. Overall, we expect adjusted EBIT margins to increase 30 to 50 basis points to 12.2% to 12.4%, which includes a 30 basis point headwind related to the divestiture of Scott Safety. Underlying adjusted EBIT margins are expected to increase 60 to 80 basis points. As we move to the below-the-line items, we expect to see a tailwind to interest expense related to the pay down of the TSARL debt from the Scott Safety proceeds. This decrease is expected to be mostly offset by an increase in variable interest rates. In total, we expect net financing charges to be in the range of $460 million to $475 million. Additionally, we have seen very nice growth from our joint ventures, particularly Hitachi over the last few years, and expect to see our noncontrolling interest increase to $200 million to $210 million. Based on these items, we expect adjusted EPS to be in the range of $2.75 to $2.85, which represents a 6% to 10% increase in earnings per share versus fiscal year 2017. As Brian mentioned, we expect adjusted free cash flow conversion of 80-plus percent, which includes CapEx of up to $1.3 billion. Consistent with prior years, we expect our earnings per share to be stronger in the second half of the year due to the normal seasonality of our businesses. We expect our quarterly EPS cadence to be similar to last year with a slightly lower percentage of earnings in the first quarter, given the ramp-up of our sales force and lower margin backlog in Buildings and the lead price movements in Power. With that, let me turn it over to our operator to open the line for questions.

George, just first on the portfolio and maybe putting Power aside, which is a whole other discussion. You’ve only been in the CEO seat for 2.5 months or so but obviously, you’ve been evaluating the portfolio as COO all along. I wouldn’t expect you to name names on what might be a candidate to be divested, but can you give us a general assessment of your view? Is there 5%, 10%, 15% of the portfolio that’s kind of a question mark in your mind? Just some way to kind of frame how you’re thinking about that. And if you do have some additional thoughts on Power, would love to hear them, too.

So what I would say, Jeff, starting out is certainly over the last couple of months the opportunity to really take a fresh look at the portfolio. I’ve been working very closely with the business leaders and really understanding the core businesses, adjacencies and complementary type businesses. We’ve got incredible platforms in both Power Solutions and Buildings. But as we look at the portfolio, there are opportunities for potential divestitures where we could take those proceeds and double down on some of our core businesses. And as I’ve always demonstrated in the past, as we do this, we certainly will continue to focus on how do we create the most long-term shareholder value in the remix of the portfolio. So what I would say is starting out here, just with the type of businesses that you’ve seen us looking at here, in that kind of high single-digit, mid- to high-single digits potentially as some opportunities here that we see that are kind of outside of our core that would raise capital and be able to position us to be able to double down from an investment standpoint in our more core HVAC and building system businesses within our Buildings portfolio.

Mid- to high-single digits within Buildings not relative to total?

That is correct.

Yes. And I was wondering also, just shifting gears on tax and cash flow and the like, really kind of a couple questions, or related anyhow, for Brian. How do we get comfortable that it’s Mexico next year and it’s not something else the year after, so to speak? And I wonder if you could just elaborate a little bit more on the magnitude of pressures you see on U.S. tax reform relative to your initial analysis.

Yes. So let me start with U.S. tax reform. And I think the two areas that I commented on providing the most headwind are probably the limitations on interest deductibility as well as the repatriation taxes on foreign earnings. And we are in the early stages, Jeff, of taking a look at the implications of the proposal, and we’ll see what comes out from the Senate as well. But those two items certainly do put pressure on our effective rate in the mid-teens where it is today. But I’d also say that until we really sit back and study all the provisions of it, we really aren’t in a position today to comment on what the ultimate effect will be because I’m sure there’ll be tax planning opportunities that we’ll have in front of us as well. So I think this is one we’re going to probably just have to keep front and center with you and everyone on the call. And the more information we get and as ultimately the regulations come out, we’ll address it at that time. As far as your comment on Mexico, the calculations that were completed on the specifics around deconsolidation of Mexican returns, I mean the tax law changed, just to give you a little bit of color here, was that in Mexico, no longer can you file a consolidated return and get group tax relief, but you’ve got to file individual returns. And that payment is required to be made for us in our first quarter of fiscal ‘18, and we didn’t finish the calculations on what that net payment was going to be after unpacking all of these individual returns until just recently. And so the one thing I would point out there is that the payment that we’re going to make of $200 million, the way these regulations are working in Mexico, we will recoup that payment over a period of time of up to seven years. So it’s something we’ll get back over time, but it was a one-time payment that’s large enough that we called out in our commentary here.

I would like to explore the margin dynamics from the first half. You mentioned the addition of new salespeople and a decrease in backlog margins. Can you provide some insight on how these factors will affect the operating margin in the first half, so that everyone has a clear understanding of the expectations as we see these costs and the lower margin revenue come into play?

Sure. Let me start with North America. We have approximately $5.2 billion in backlog there. As we progress, there’s likely to be about 75 basis points of headwind, combined with the investments we are making in sales, which are showing good progress. This will create some pressure in the first half as we ramp up orders and begin converting them to revenues. That’s a significant aspect. Additionally, regarding our reinvestment, last year we invested about $0.06 into our products. This is starting to show positive performance in our products' organic growth and will continue through 2018. We estimate reinvesting around $0.06 to $0.08 into our products. These two factors are key as we consider our guidance for 2018. Brian, perhaps you would like to add your comments?

I would just comment on Buildings, that’s correct, George. And then when you look at Power Solutions given the spike up that we have seen in lead over the last few months here, there’s probably a bit of headwind as we look at just Q1 impact. But as we’ve kind of commented on before, when it spikes like that, we can have an individual quarter impact based upon the arrangements we’ve got with our customers to pass on those lead increases over the course of the year that tends to normalize, and we wouldn’t expect that to be a big number for the year. But there could be a little bit of an impact in Q1 from the spike in lead prices as well, Steve.

Got it. When I consider this EPS growth trajectory for the year, from $0.06 to $0.10 off of the $0.48 in the first quarter or $0.53 in the first quarter of 2017, will you be growing earnings in the first quarter?

Yes, I think the way to think about this is we’ve historically been around 20% in the first quarter. And then it’s probably been maybe slightly less than that in the second quarter. And so I think, for the first quarter, you can probably dial it in maybe a little less than where we’ve been before, but that’s kind of the general guidance we’d give.

Okay. And then one last question for you. The whole compensation discussion around what you’re getting paid for, like EBIT, organic growth, and conversion—if tax rates go up and your net income is affected by that, leading to an impact on your free cash, that shouldn't affect the incentive package you have. Is that correct?

On the AIPP side, that’s correct. On the long-term side, it could have some impact. But the short-term bonus here, it would be 1/3 on EBIT growth, 1/3 on organic revenue growth and 1/3 on free cash flow conversion. And then there could be some modifiers that might also address things like EBIT margin improvement to ensure that we aren’t just chasing revenue dollars, that we’re chasing profitable growth.

This is David Lu on for Deane. So on the cash flow for 2018, could you parse out sort of what the increase or the ramp-up from 2017 and 2018 will be? Is it more on the working capital side? I know you gave some color around CapEx, but how should we think about the different buckets that leads to the sequential increase in cash flow?

CapEx is expected to remain around $1.3 billion. To understand this, consider our performance this year and adjust for the factors we discussed in the third quarter, particularly what transpired in the fourth quarter. We managed to reduce inventory by approximately $100 million, and we also saw a $100 million decrease in receivables. During the third quarter, we estimated we could eliminate a couple of hundred million dollars in inventory and $100 million in receivables. In the fourth quarter, we successfully reduced these by $200 million to $300 million. Therefore, we anticipate another $100 million in inventory reduction. This would bring us up to over 80%. Beyond this, our cash management team will work to enhance trade working capital and examine payment and billing terms with our customers. Currently, we are targeting above 80%.

Great. And then for my follow-up, can provide an update on the nonresidential sector either in the U.S. or globally, how has it trended? How do you expect it to trend in 2018, is it accelerating or decelerating? Just any color around that would be great.

Yes, when we assess our nonresidential sector, we have a strong presence across all regions. In North America, we see many opportunities and are expanding our sales team to take advantage of that. Although there have been some fluctuations in metrics recently, we maintain a robust growth pipeline, which we aim to accelerate throughout the year. In the EMEA/LA regions, our performance has been solid, with positive developments in Continental Europe offsetting some challenges in the U.K. Looking ahead to 2018, we expect continued low single-digit growth. Latin America has been particularly strong, benefiting from our investments and expansions, performing better than the EMEA region. In the Asia-Pacific region, our business is also making progress in 2017, thanks to new products and expansion efforts. We anticipate mid-single-digit growth opportunities as the market develops as expected, supported by our investments. Overall, we are in a strong position from a market perspective and are well-prepared to take advantage of these opportunities moving forward.

Building Solutions experienced a 1% decline in the quarter, and orders remained unchanged. Can you provide your outlook for the Building Solutions business within the context of low single-digit organic growth for the overall Buildings sector?

When you look at our business here, let’s looks at fourth quarter in Buildings, we are seeing some nice progress in our products businesses pretty much across the board. And that’s an output of some of the fire and security markets coming back and those businesses performing well in the fourth quarter. And then with the investments we’ve been making in HVAC and controls and the regionalization of some of those products, we’re beginning to see the pickup, and that also would include the work we’ve been doing with Hitachi. So we see that with those investments continuing in 2018. When you look at the field businesses, that’s where the pressure has been. We were down about 1%, and that was driven by our performance solutions business in North America as well as we did see some timing of some of our projects in Asia, we saw a little bit of slowdown there, but we got a very robust pipeline of opportunities and we’re seeing the orders coming through there. So don’t believe that that’s a longer-term concern. So when you look at what we’re doing from a sales capacity standpoint, where we fell short in 2017, we’ve now, over the last few months, picked up our activity in being able to add salespeople not only driving projects but also service. And so as we now project what that’s going to mean, we’ll see accelerating orders through the course of the year and start to see better conversion of the backlog that we have in place. Backlog was up 4% year-on-year so that does give us confidence that we’ll begin to see the acceleration of revenue through the course of 2018. And while we’re driving increased secured orders, that also gives us confidence that, as we plan for 2018, we’ll be in a much better position to continue that acceleration of growth.

And then in terms of synergies, can you talk about any progress you’re seeing on the revenue synergies with any cross-selling opportunities that continue to progress?

Sure. Within our business, we have strong relationships with our historical customers, whether in HVAC controls or fire and security. We've made good progress in the first year with developing pipelines and converting those across the board. Most of these projects range from less than $1 million to $10 million. These customers are executing on expansions where we are leveraging our combined capabilities to effectively meet their needs in the new space, and we're starting to see solid traction. Looking ahead, when we outlined our longer-term plan, we mentioned that the first year would focus on securing orders, while the second and third years would focus on revenue conversion. That’s what we expect will happen. As we start to see orders, we will observe an acceleration in turning those orders into revenue throughout 2018.

I would like to add that we have a lot of momentum in the latter half of this year. While we are not experiencing benefits from revenue pull-through in 2017, the activities in the third and fourth quarters will contribute to our top line in 2018.

On CapEx, so up to 1.3 billion, what does that imply for the Power CapEx? I thought there was some expansion of facilities in China. So what’s the latest on that?

So for Power Solutions next year, we’ve got 500 million in the plan, and that would include the construction of the facility that will be part of our Bohai Piston joint venture. The other facility that we’ve talked about in China will be starting late in ‘18, maybe even into ‘19. So the second facility in China will probably not have a big impact on the cash flows in fiscal ‘18.

So Brian, I know as we think about ‘19, is this still kind of the peakish year for CapEx as you look out the next couple of years or is there still bit of a ramp in ‘19?

No, I would say this is the peak. I mean, I could see depending upon levels of the Buildings investments, I would say that we’re probably looking at the 1.3 billion being a peak. I mean, it would have to be something very opportunistic for us to not have a peak at the 1.3 billion. Even at that level, we end up with the reinvestment ratio that’s 1.4, 1.5, something like that. So we’re working to get that down into the more 1.1, 1.2 range.

Okay, good. And then just on the synergies, so 300 million for ‘17. It was better than expected. The guide includes 250 million. Is that a conservative number? Or is it a reasonable number? I mean, how should we interpret that, considering you had upside last year? And I know there’s moving parts with regards to projects and whatnot, but how do you feel that in terms of potentially delivering some upside to that later in the year?

I’d say we guided 250 million to 300 million last year. We ended up at the high end. I would tell you the 250 million is a number that’s pretty much what we’ve got road map for fiscal ‘18. I mean as we go through the year, could there be some upside? Maybe. But right now, we’ve got the teams focused on the 250 million, which is exactly what we’ve got in our trackers, and we’re working toward delivering that. So I think that’s where we are, Rich.

Okay. And then quick last one. What’s the lead price assumption for the year?

2,100.

Congratulations, George, on the new job. I have two questions. First, could you explain why pricing in the backlog is softer in North America? Is it due to pursuing less desirable projects or is it a response to market demand conditions? Additionally, could you comment on pricing in the applied market internationally? For my second question, Brian, will the actual free cash flow for 2019 surpass the adjusted free cash flow? If so, by what amount considering the $700 million Adient tax recovery? Any insights on both of these questions would be appreciated.

Sure, Gautam. I'll address the margin pressure. As I mentioned earlier, the incentive systems previously focused solely on sales. We've made changes going forward to emphasize both sales and margins. This concept wasn't applied consistently, leading to a decline in book margins over the past 18 months. Consequently, that backlog has impacted gross margins during this time. Despite this, we have implemented measures and accountability that will drive improvement. Along with various cost actions, we expect to see benefits in both pricing and gross margin enhancement throughout the year. Additionally, service growth is crucial. In 2017, our service growth was very low, and we're actively working to accelerate it, as it is a key profit driver in our field businesses. These two factors will significantly influence our overall margin rate. I'm confident that with our current strategies, we will be well-positioned to execute effectively.

Pricing outside the U.S. as well? Just on pricing outside the U.S. as well?

We have experienced some price increases related to certain HVAC equipment, which you may have noticed with some of our competitors. We have maintained a disciplined approach to pricing and focused on driving down costs. In the fourth quarter, the price impact was about $20 million or 30 basis points within our building segment, and we expect to see a bit more of this in the first quarter. However, after reviewing the situation and considering the price and cost actions we’ve implemented, I believe we will start to see improvements in the second quarter and thereafter in 2018.

Gautam, so on cash flow for ‘19, I mean it’s a bit early to talk about ‘19, but I guess I’ll give you my thoughts as we sit here today. That $600 million refund from the Adient tax payment is now $700 million that we’re going to get in ‘19. And I think we’ve talked in the past, we hope to get that in fiscal ‘19. Whether it’s fiscal ‘19 or calendar ‘19 really depends upon how quickly we can get it through a joint committee because, given the size of the refund, it’s got to go to joint committee. But obviously, we’re targeting to get it in fiscal ‘19. So that $700 million, when we look at the other onetime items that could be out there, it’d be restructuring and integration, and I would expect those to be well below that $700 million number as we move into fiscal ‘19, there’s probably a bit of a wildcard, right? Relative to tax reform and what that might mean. I guess we just need to sort through that. But I guess the short response is I would expect adjusted free cash flow or reported cash flow to exceed adjusted free cash flow in fiscal ‘19.

Just to continue on some of the comments that you guys made on the margin pressure, gross margin pressure in the backlog. George, I think at Tyco, you went through a similar phenomenon when you took over there trying to bring up backlog margins and enhance some bidding discipline. I think there was a period of time where that selectivity showed up in growth. Is that something that you guys are anticipating in the current outlook? Is that something that over the next couple of quarters could be kind of a slow or uneven handoff as you just work that through the system?

Not at all. We’re doing both. I think what’s different is that during that time, the markets weren’t as strong. The selectivity we employed resulted in a net decline, but margins significantly improved. In the current environment, the market is quite strong. We’re adding salespeople and engaging with our customers. We're receiving great feedback indicating that there’s much more we can do for our customers, and we have the capacity to pursue those opportunities while focusing on projects that generate the most value. From a pricing perspective, we seek the appropriate return for the projects we deliver. This situation differs from what we experienced at Tyco, although some of the same principles apply. It requires more focus and discipline, ensuring that our incentive systems align with our objectives for both growth and margins.

Got you. That’s helpful. Regarding cash flow, the growth mix projected for 2018, particularly with increased growth in Asia and in the Power and building sectors, seems to involve your lower cash-generating businesses. Since Hitachi is a significant part of the growth in Asia and Power tends to consume working capital, does this influence a less optimal cash flow growth mix this year, potentially resulting in something below 80%? I’m just trying to understand the situation better. It appears that the current growth mix may not be ideal for generating free cash flow.

I don’t think that’s going to have a major effect. Right now, we’re examining the Buildings business on a global scale. Target is around 85% free cash flow, while Power Solutions is currently at approximately 70% due to the growth investments we’re making. As we progress with the growth initiatives discussed in this call at Power, we are still aiming to reach the 90% target set for 2020. However, I don’t believe that the geographic mix you're mentioning will have a significant impact on that.

Operator, I’d just like to turn the call over to George Oliver for some closing comments.

Thanks, Antonella. And again, thanks, everyone, for joining our call this morning. As I mentioned earlier, I’m even more excited about the future opportunity as we look at 2018 and beyond and certainly look forward to engaging with many of you here over the next coming weeks. So, operator, that concludes our call today.