Johnson Controls International plc (JCI) — Q1 2018 Transcript

Good morning and thank you for joining our conference call to discuss Johnson Controls first quarter fiscal 2018 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 have 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 restructuring and integration costs, as well as other special items. These metrics are non-GAAP measures and are reconciled in the schedules attached to our press release. GAAP earnings per share from continuing operations attributable to Johnson Controls ordinary shareholders was $0.25 for the quarter and included a net charge of $0.29 related to special items. These special items primarily relate to restructuring and impairment costs, as well as the net impact from U.S. tax reform, partially offset by the gain on sale from the Scott Safety divestiture which closed early in the quarter. Adjusting for these special items, non-GAAP adjusted diluted earnings per share from continuing operations was $0.54 compared to $0.53 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. I thought I would start today by providing you with an update on the progress we have made with respect to some of the strategic priorities I laid out for you last quarter. Beginning on Slide 3, first we made some additional changes to our Board in the quarter. At our most recent Board meeting in December, we formally welcomed our newest director, John Young, who currently serves as Group President of Pfizer Innovative Health. Additionally, we announced the retirement of two longstanding board members, effective as of the upcoming Annual Shareholders Meeting in early March. On behalf of my fellow board members and the executive management team, I would like to personally thank Natalie Black and David Abney for their many years of dedicated service to Johnson Controls and wish them all the best. We also nominated two new board members: Gretchen Haggerty, who served as CFO of U.S. Steel before retiring in 2013, and Simone Menne, who served most recently as CFO at Boehringer Ingelheim and as CFO of Lufthansa prior to that. Both nominees bring decades of senior leadership experience and a deep financial acumen. I look forward to their joining the board and to leveraging their expertise in the coming years. As we mentioned last quarter, we expected the Compensation Committee to make a number of changes to executive incentive plans in an effort to more closely align with shareholder expectations. Those changes have been made, and beginning in fiscal year 2018, executive’s annual incentive compensation plans are tied to three key performance metrics: organic revenue growth, EBIT growth, and free cash flow conversion. We are off to a strong start on our initiative to increase sales capacity. Net of attrition, we added 180 new sales team members during the quarter, and we are well on our way to reaching our target for the year of 400 net adds. Although we are still in the early stages concerning the changes we are making across the sales organization within buildings, I am very encouraged by the results we are seeing so far. We are also beginning to see the initial benefits of driving improved gross margins in backlog. Our field teams are more disciplined on pricing new projects and more focused on driving stronger service growth. As a result, we are improving our booked margin rate on new orders as well as accelerating service growth, which will help alleviate some of the margin pressure in the field organization as the year progresses. We saw solid organic top-line growth across the buildings platform which grew 4% organically in the quarter, admittedly on our easiest comparison of the year. But the underlying trends across each of our businesses are promising and should provide us some momentum as we go forward. I am very encouraged by the progress we have made in expanding our services. We have been adding both sales and technician capacity, and it is beginning to pay off with service growth accelerating to 3%. Next, we have implemented our internal cash management office and the team is actively engaged with the business units as well as external advisors in an effort to improve cash generation and management. I have made this our top priority for the company in fiscal 2018 and we have the right team in place to deliver. As I mentioned last quarter, we will continue to look at the portfolio ensuring we are allocating resources in areas where we can generate the highest returns and divesting businesses that are non-core. Lastly, I wanted to highlight a number of truly innovative new products recently launched. As I have been communicating with many of you over the last six plus months, Johnson Controls entered into a significant product development phase roughly three years ago. We are beginning to see some of the fruits of our labor here on Slide 4. I want to spend time on each one of these, but I do want to call your attention to the breath of product categories across building technologies launched within the quarter over the last few weeks. We have a steady pace of product launches planned for 2018 across the buildings portfolio with expanded AGM battery offerings within power solutions. Turning to Slide 5, I do want to spend a minute highlighting our New York YZ centrifugal chiller which was launched in early January. The YZ represents a significant milestone in our product development journey. It will become the new flagship in our chiller portfolio. Our engineers have spent the past three years analyzing, designing and optimizing each component, turning it around the next-gen low GWP refrigerant to create the highest efficiency centrifugal chiller on the market today. With its mag bearing driveline, variable speed drive, and our OptiView control panel, we have created what will be the new industry standard when it comes to reliability, energy saving, and service capabilities. I had the opportunity to spend some time with key customers and distributors at the AHR Expo in Chicago last week. I can tell you the feedback was overwhelmingly positive, not just about the YZ, but for the entire HVAC and controls products suite. I am extremely proud of the work our engineering and R&D teams are doing around the globe, and I am confident we are investing in the technologies and channels necessary to accelerate top-line growth over time. Let’s turn to Slide 6. The macroeconomic environment remains generally favorable across most of our key geographic regions supported by rising global GDPs. North American non-residential construction markets are growing steadily, led by the institutional vertical. Global demand for our commercial HVAC and controls products is strong, highlighted by recent strength in Asia, the Middle East, and North America. The sustained rebound in oil prices is helping to ease budget constraints, even releasing some large infrastructure projects, especially in the Middle East, and also driving demand for our fire protection and suppression products that serve the harsh and hazardous end markets. China remains one of the fastest growth regions, although pricing remains competitive, particularly in HVAC. We remain focused on developing innovative new products and expanding our channel presence, and we are gaining share as a result. In Power, we continue to see increased adoption of our start-stop technologies globally and are well-positioned to address the increased electrification in vehicles. OE production is a soft spot, particularly in the U.S. and Europe, and we would anticipate that to continue in the near term. That said, we are fully committed to serving our customers and channel partners worldwide, and our technology capabilities enable us to consistently outperform the market. Overall, I would say the economic landscape is supportive of continued order and revenue growth momentum throughout fiscal 2018. Moving to Slide 7, field orders accelerated in the quarter to 5% year-over-year organically compared to the low single-digit average we experienced in fiscal 2017. Underlying order strength was broad-based across the three regions as well as all domains, including installation and service. Brian will provide more color by segment in just a few minutes. Turning now to Slide 8, let me recap the results for the quarter. Sales of $7.4 billion increased 5% on a reported basis in the quarter and 3% organically, led by strong performance across our building platform. As expected, adjusted EBIT of $748 million declined 1% as the impact from the Scott Safety divestiture and anticipated headwinds from lower gross margins and incremental investments more than offset cost synergies and productivity realization. EBIT margins declined 60 basis points year-over-year on a reported basis or 30 basis points excluding the impact of the Scott Safety divestiture, FX, and lead. Despite the anticipated margin pressure in the quarter, we were able to deliver modest earnings growth of 2% year-over-year to $0.54. Adjusted free cash was an outflow of roughly $300 million, which is typical of our first quarter and in line with our expectations. Turning to our EPS bridge on Slide 9, you can see synergy and productivity savings adding $0.05 to the prior year. Volume and mix added an additional $0.05 driven by solid growth across buildings and a mixed benefit in Power Solutions. The cumulative benefit of synergies and volume mix was mostly offset by expected gross margin pressure and incremental investments we discussed on our last call. Overall, this resulted in $0.54 in adjusted EPS for the quarter. With that, I will turn it over to Brian to discuss the performance within the segments.

Thanks, George and good morning, everyone. Starting on Slide 10, we provided the breakdown of our buildings business, which is the same pie chart that we provided you last quarter when we thought this would be a useful reference point for you as we talk through our segment results. So, let’s move to Slide 11 and get into the details with a look at the performance of buildings on a consolidated basis. As you will see as I go through the results here, the Q1 headwinds, we talked about on our Q4 call came through pretty much as we expected, and we see good momentum building as we move into Q2. Total building sales in the quarter of $5.3 billion increased 2% year-over-year and 4% organically, with products growth in mid single-digits and field growth in the low single-digit range. Buildings consolidated EBITDA of $559 million declined 3%, but keep in mind the prior year included the results of Scott Safety. Buildings EBITDA margin decreased 60 basis points versus the prior year to 10.5%, but again, this includes a 40 basis point headwind from the Scott Safety divestiture. So, on a normalized basis, EBITDA margin declined 20 basis points as we expected. You can see in the margin waterfall that the combined benefit of 130 basis points from cost synergies and productivity savings, as well as volume leverage, was more than offset by 150 basis points of headwind from conversion of lower margin backlog, price cost pressure, and the incremental investments in product and sales capacity— all generally in line with the Q1 expectations we set for you last quarter. Looking to Q2, we do anticipate these headwinds will continue. However, these pressures should begin to abate sequentially as we move throughout the year. As George mentioned, total field orders increased by a very strong 5%, including improved margins with backlog up 4% year-over-year to $8.1 billion. Now, in order to provide more transparency on each of our reportable segments within buildings, let’s review each segment’s individual results. So moving to Slide 12, Building Solutions North America, their sales grew 3% organically to $2 billion, led by high single-digit growth in our commercial HVAC and controls businesses and mid-single-digit growth in our solutions businesses, fire and security. Field revenues declined modestly in the quarter. North America adjusted EBITA of $236 million was flat on a year-over-year basis, and EBITA margin declined 50 basis points to 11.7% as an 80 basis point headwind from lower margin backlog conversion and a headwind from sales force additions more than offset the benefits of synergies, productivity, and volume leverage. Orders in North America increased a solid 4%. During the quarter, we saw strong order intake led by our conventional HVAC business, integrated security, and retail, primarily driven by higher installation activity. Our solutions business, which as you know was primarily performance contracting, also had strong order growth, but this was against an easy prior year comparison. Given the underlying trends in North America and our opportunity pipeline, we expect to see continued solid order growth in Q2. Backlog at the end of Q1 was $5.3 billion, which was up 4%. So let’s move to Slide 13 in EMEA/LA. Sales of $915 million increased 4% organically, with solid performance in installation and service across our three primary regions. Europe grew modestly in the quarter across fire, security, and controls, and in the Middle East, we saw solid demand for commercial HVAC projects. Latin America experienced broad-based strength across fire, security, HVAC, and controls. Adjusted EBITA of $71 million grew 9%, and EBITA margin expanded 40 basis points to 7.8%, primarily driven by cost synergies and productivity, as well as modest volume leverage. Orders in EMEA/LA increased to a strong 6%, led by growth in Continental Europe and the Middle East, with backlog increasing 1% to $1.4 billion. Moving to APAC on Slide 14, sales of $597 million in the quarter increased 2% organically, primarily due to higher service activity versus the prior year. Adjusted EBITA of $74 million increased 3%, and adjusted EBIT margin declined 10 basis points, but this includes a 30 basis point headwind related to foreign currency. The underlying margin increased 20 basis points reflecting savings from cost synergies and productivity, as well as some modest volume leverage. One item that I would like to point out is that pricing does remain very competitive in China and did negatively impact margins in the quarter. We do expect continued pricing pressure in our China field businesses as we look into Q2, but we are going to work to offset that headwind with cost actions. Asia-Pacific orders increased 9% driven by strong growth in China, Northeast Asia, and India, including a solid increase in service bookings, with our backlog increasing 11% to $1.4 billion. Now let’s turn to global products on Slide 15, and again, sales increased a strong 6% organically to $1.8 billion with mid-single-digit growth across HVAC and refrigeration equipment, building management, and specialty products. In HVAC and refrigeration equipment, our applied HVAC business grew in the mid-single-digit range, with strong shipment growth across all geographies for both large and small tonnage chillers. Another bright spot that I would like to point out is our VRF business in Asia, where we saw mid-single-digit organic growth in the quarter. I would also point out that our unconsolidated Hitachi joint ventures in China also saw strong double-digit growth in the quarter. Moving to residential and light commercial HVAC equipment, we saw low single-digit growth versus the tough comparison in the prior year. Mid-single-digit growth in building management and specialty products was driven primarily by growth in buildings controls and fire and security products led by increased demand for special hazards and fire detection equipment. Segment EBITA of $178 million declined 13%, but remember this reflects the impact of the Scott Safety divestiture. The reported segment EBITA margin declined 140 basis points, but again 110 basis points of that decline was attributable to Scott Safety. So, the underlying segment margin in products declined 30 basis points to 10%, as the benefit of cost synergies, productivity, and volume leverage was offset by about 100 basis points related to incremental product investments and 160 basis points related to price cost pressure. So, let’s turn to Power Solutions on Slide 16. Our solution sales of $2.1 billion grew 1% organically, as favorable price mix was offset by decline in unit volumes. Global battery shipments declined roughly 2%, with declines in both OE and aftermarket. The 1% decline in OE was actually slightly less than declines in the overall auto production. Shipments to the aftermarket channel declined 2% on a tough prior year comparison, the warmer weather we experienced during the quarter and a bit of pull forward of demand that we saw in the fourth quarter of last year. Once again, the China market was a highlight with units up 20%, with strong growth in both OE and aftermarket channels. Global shipments of start-stop batteries increased 20%, with another quarter of strong growth in the Americas and China, and we saw EMEA start-stop up 3%. Segment EBITA of $384 million declined 2%, with margins declining 250 basis points to 18%, but this includes a 150 basis point impact of FX and the higher lead prices. Power's underlying margin declined 100 basis points as favorable mix and productivity savings were more than offset by planned product investments and startup and launch costs, and increased transportation costs and logistics costs were a bit higher than we expected in Q1. We are definitely seeing higher freight costs, particularly in the U.S. and Mexico, as well as higher fuel costs and unfavorable lane mix due in part to the ongoing impact of the hurricanes. Turning to Slide 17 quickly, corporate expense moved down 6% year-over-year to $101 million, and we continue to target a range of $425 million to $440 million for the entire year. So, let’s move to Slide 18 and free cash flow. Reported free cash was an outflow of just under $400 million in the quarter, which is in line with normal seasonal patterns and consistent with our plan on expectations. Excluding about $100 million of integration cost, adjusted free cash was an outflow of $300 million. As expected, we received a $200 million tax refund in the quarter, which was offset by the $200 million in tax planning payments that we talked about in our fourth quarter call. As George mentioned, the focus on improving cash flow is our company’s top priority and I am working closely with the newly established cash management office as well as our external advisors. In Q1, we have created a free cash flow roadmap and identified specific actions with clear accountability that will improve trade working capital and drive higher free cash flow conversion as we move through the year. For 2018, we are on track to deliver over 80% adjusted free cash flow conversion, excluding the net one-time items that we communicated to you last quarter.

Thanks, Brian. Before we open up the lines for questions, I wanted to reiterate that fiscal 2018 will be a year of change. We are intensely focused on driving execution to deliver our adjusted EPS 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 I mentioned on our last call, 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, the pace and timing of investment, as well as price cost and gross margin headwinds, all of which are heavier in the first half. Based on our current outlook, we would expect EPS to be weighted roughly 38% in the first half and 52% in the second half compared to our normal 40-60 split. As I think about the second half ramp, we are going to focus on controlling what we can control. Although I feel good about the underlying momentum we are seeing in the top line, organic growth begins to decelerate, you should expect that we will dial back the pace of investments. Cost synergies are on track and will give us about $0.03 more in the back half than in the first half. Price cost headwinds should begin to flatten out as some of our more recent price increases begin to take effect. We feel good about our price realization so far, but obviously, Asia and China specifically are still tough. We are taking additional productivity actions to help offset some of the areas we are seeing pressure. Our guide assumes price gets better, so that is one area we will have to watch. I am encouraged by the margin improvement we are seeing in backlog, the traction we are seeing on sales capacity and by the acceleration we are seeing in higher margin service and product sales. Ultimately, we are committed to delivering on profitability as we continue to manage our way through the integration and focus on reinvesting for growth. We have made the structural changes necessary to help ensure that the focus on execution is felt deep into the organization. With that, let me turn it over to our operator to open the line for questions.

Thank you. Good morning everyone.

Good morning Deane.

Good morning.

Hey, just speaking of the year of change, I would like the revamp slide deck, lots of good color, and especially like the bridges that are included, so I appreciate that.

Thanks Deane.

So first question, George, I was hoping you could expand on the strategic focus to improve to serve margins – secure margins in buildings and I can’t help but think that this sounds a bit like project selectivity and maybe there are some parallels there, but what are the initiatives and then for the 5% increase in orders this quarter, what’s that margin improvement over the implied margin?

Sure. Let me start Deane by saying that when I took over I set up a sales leadership team that I ultimately chair. We have been meeting monthly to ensure that we are executing on the commitments we have made to not only put the capacity in place from a sales force standpoint, but also to be able to execute on improved margins and ultimately deliver on the organic growth. We are making a tremendous amount of progress with this team. Not only have we been able to add 180 heads in the quarter that was in addition to the 50 that we added in the fourth quarter, but strategically now as we are segmenting our markets, understanding how we are deploying that capacity to go after where growth is occurring and making sure that from a pricing standpoint we are staying disciplined with the projects that we are taking on. That said, we have seen significant improvement not only in the pipeline generation but also how that’s converting to orders and setting us up to accelerate organic growth through the remainder of the year. When you look at the book margins in the quarter, our booked margins are now up 30 basis points. You can imagine we booked margins much better than that in the quarter, bringing the average up about 30 basis points. So I am feeling really good working with the sales team and how we are deploying the resources we are putting in place, the productivity we are getting from those resources, the book margins we are securing, the service growth we are accelerating, and that all will translate into improved growth in the second half as well as from a margin perspective with much higher margins.

So is this a bit of this project selectivity playbook that you are running?

So Deane, project selectivity is making sure that from a resource standpoint as we understand the markets and the opportunities we have, we are deploying our resources where we can accelerate and ultimately get the returns for the resources we are putting into these projects. We are beginning to execute. So certainly, from a discipline standpoint, we have implemented the discipline to make sure that as we plan these projects, we are doing so in a way that positions us to get the appropriate returns. Whether it’s project selectivity or just pure discipline in how we deploy our resources and set expectations for the type of margins we expect by executing on these projects, that's ultimately what we are doing.

Got it. And then just as a follow-up question, and this may just be competitive sniping with the second coming of ADT, but there have been some claims about taking share in light commercial and correct me if I am wrong, but non-competes all came off in 2014 and that really shouldn’t be anything new going on here, but would be interested in your perspective?

I would reinforce what you said, Deane. Our security business is executing extremely well in North America. We are continuing to grow, continuing to execute on margins, and ultimately delivering on performance. As you said, the non-compete went away back in 2014. Certainly, we respect our competitors, but as we are seeing now, we are continuing to execute on our business, continuing to grow, and continuing to maintain and grow the margins.

Great. Thank you.

Thank you. Good morning, everyone.

Good morning, Jeff.

George, just back to thinking about how that all plays out in margins. When you say margin is up and backlog up 30 basis points, that’s up relative to what it I guess was last quarter, is it tracking up relative to what you are reporting here today and can you give us some context on that?

Yes, absolutely Jeff. In the first quarter, when we looked at—let me just go back and reframe what the problem was when we gave guidance back in November. We had, when we looked at our North America backlog, we had 75 basis points of pressure in about a $5 billion business. We projected that there was going to be roughly about $40 million of pressure that would play out through the course of the year, and we would need to offset that with productivity and other initiatives so that we would be positioned to deliver on the commitments we made. We have seen about $16 million of that pressure in the first quarter, and so the remainder will play out a little bit less in the second quarter and then less in the third and fourth quarter. I would tell you that with what we have booked, we had an improvement of about 70 basis points, maybe a little bit better in the quarter. The projects that are going into backlog and how they will play out the remainder of the year will start to see improved gross margins. I project that in the second quarter, our margins will be relatively flat in buildings, and we realize that in addition to the backlog that’s converting, we also have price cost that we have experienced here in the first quarter, a little bit more in the second quarter – little bit less in the second quarter, and then we start to see it turn positive in the second half. Those combined topics—because we are executing, we are now seeing the margins flatten, and you will start to see them improve in the second half.

And then thinking about the sales force growth and initiative, how long does that remain a headwind? How long does it take for lack of a better term for a new salesman to carry his weight so to speak and be accretive to the equation?

What I would say, Jeff, it varies depending on what business you are in and whether it be a large installed project type business or a transactional service business. You could say that when we estimated the year, we said we were going to have about $15 million to $20 million of potential pressure for what I would say while we are adding the sales capacity, we would have less productivity per head with that new capacity. I would tell you that the way we are bringing them on board, we have been very process-driven in training, getting them educated and trained so that they can hit the ground running. There is still going to be that pressure, but I have confidence with the folks that we have brought on here not only in the fourth quarter and the first quarter. We are making really good progress in how we are deploying that capacity and making them productive through the course of the year, so you could average it probably takes around 6 months – 3 to 6 months depending on the type of business, but I am extremely encouraged by the progress we are making and what we can expect here going forward.

And then just one last one for me. So you did do some share repurchase in the quarter. Should we assume you are chipping away at repo or given your leverage you are on hold until the cash flow comes in later in the year-end or is there some asset sales or something else going on?

Yes, Jeff, this quarter was $100 million that we did in the month of October, and the thought is roughly $50 million a quarter for the remainder of the year, which is essentially offsetting option dilution. So, I don’t think at this point in time we are looking at any incremental share repurchase above and beyond that.

Right, thank you.

Hey, thanks and good morning all.

Hi Steve.

Hey, just wonder about the cash side. I know you referenced it in your prepared remarks. But a couple of things—one, when did the conversion addition to comp start to really hit the ground for management, sales force, etcetera? And then secondly, maybe just talk about that cash management office. I know this is a seasonally normal cash outflow, but maybe get into the biggest drivers of that and that we might expect to see improvement in over the next year.

Steve, I will take the first part of the question and then I will turn it over to Brian on the cash management office. Relative to the incentives, as we went through the succession with myself becoming Chairman and CEO, there was certainly a lot of focus on incentive compensation here, our executive compensation within the company. As we put the plan together for 2018, that was certainly something that was front and center with our Board. We worked through that very quickly so when we launched our incentives with our executive team and then had similar components that are embedded in the executive leadership incentive that are now pushed out into sales incentives and operational incentives, all that was done at the beginning of the year. We wanted to be positioned to hit the ground running. The right metrics were in place, the right incentives were in place so we could ensure that we execute on the commitments we made for the year. Now, Brian, you might want to talk a little bit more about the cash management office.

Yes. We set up during the quarter the cash management office, which is really a combination of roughly 8 to 10 people internally, and then we have got an outside advisor that’s working with us on this effort. I would just comment that we took one of our top finance people—the CFO of our buildings business—and have put him in charge of the cash management office, which I think is reflective of the importance we are placing on making sure that we deliver on the free cash flow conversion commitments we have got. As far as Q1 and why Q1 tends to be a bit of a cash outflow quarter for us, I think I would focus on a couple of things. First of all, as it relates to the fourth quarter, there was a huge push in Q4 and that tends to be our best cash flow quarter. There is a little bit of pull forward maybe in Q4 from Q1. Secondly, I would say our lowest income quarter tends to generally be the first or second quarter as well. There is some timing of working capital that I would put in the equation as well, and then we do pay our bonuses out in the first quarter of each year as well. Those are probably some of the items that really drive some of the timing, Steve. But I think it tends to be an outflow in Q1 and inflow in Q2, and then Q3 and Q4 tend to be our strongest quarters.

Okay. And then George, I see all the start-stop growth that you are mentioning in power, can you maybe comment on the progress of those factor investments in AGM, how are we in the ramp on those? And then I guess just one last one maybe Brian also I understand that with tax—you are going through portfolio review together, but any of the tax legislation changes with regard to asset sales or 338 H10 elections changed the view of tax leakage across the portfolio—does it give you more options?

Yes. So let me—starting with the AGM, like we said, we are up about 20% year-on-year, and that’s really a function of very strong penetration in Europe and that continues. We are kind of in line with the market. We are picking up a little bit of share. If you look at where the investments are being made, it’s mainly in China as well as North America. We are executing well on putting that investment in place and that’s contributing to the very strong growth we are getting in China, being up over about 50% or thereabouts, and continuing to see good progress in North America. That is going to be when you look at the mix that’s going to be extremely important for us to continue to execute on those investments and in the volumes from those investments.

Yes. As far as the tax rate impact, to the extent that any business that we would decide to divest from a non-core standpoint—if it has significant head U.S. operations, those tax rate reductions certainly would play into that.

Thank you.

Thanks.

Thanks, Steve.

Hi guys, good morning.

Good morning.

Hi Steve.

Good morning, Steve.

So I just wanted to clear what is the target for your incentive for this year in cash. I think the guide is 80% plus, and then $1.3 billion of or up to $1.3 billion of CapEx. I didn’t see kind of an explicit rehalf of that; just want to make sure that we were counting for any tweaks there, and is it based on conversion or absolute free cash flow?

It’s the adjusted free cash flow conversion is at 80% plus, as we have talked about previously. Then there are no adjustments above and beyond that we have communicated already that are necessary really for us to talk about here. So the 80% plus is our target.

Okay. And the CapEx guide?

CapEx $1.3 for the year, there is a little timing in the quarter, but still $1.3 for the year Steve.

Okay. And then just following up on I think it was Deane’s question on the security side. I mean you said that your security business is holding up in North America, I think the field business fire and surety field was a modest decline. Does that mean kind of fire was down and security is growing? Maybe you could just give us some idea of how kind of that core business did, the security business did in the quarter from a revenue perspective?

Yes. So in North America, where we have had a gap with our capacity has been fire. We talked about last year having some shortfall of putting the sales capacity in place, a lot of that was in the fire space. That has become a roll forward and why we are seeing a temporary decline within that business. We have been adding capacity both in sales as well as technicians, because the market is very attractive, and we are making progress. So it’s more, I would say, it’s more of a temporary situation because of the way that we were short on how we are staffing the fire business, but that’s going to continue to improve now with the work that we have done in the capacity that we are putting in place. The part of the security business I think overall was modest, I mean, year-on-year, they had a good year in the first quarter last year, and correct the low single-digits.

This year, this security business?

Correct.

And then one last question on commercial HVAC pricing, asking all these guys all the guys’ question—what are your assumptions embedded in for price this year for the business where it’s relevant? I think it’s probably mostly in the products business, yet a tough price cost spread of this quarter. What’s your pricing assumption embedded for commercial HVAC?

Yes. So if you look at our price cost pressure, we are in the first quarter, it was about $34 million, and a lot of that certainly was in HVAC. As we put our price increases, it’s at the beginning of our second quarter, so the beginning of the calendar year. There is a range from 5% to 7% type price increases that are being put into place. I think that compares similarly with our competitors. Certainly, we are going to be very disciplined with how we execute on these price increases given the pressure we had here in the first quarter. Some of the actions have already taken place, so the price pressure, price cost will be better in the second quarter, and as we get into the third and fourth, we believe that we will have a positive price cost. It’s really about executing and staying disciplined with all those price increases that are going into place because we are seeing, on the opposite side, we are seeing the commodity headwind coming through.

Yes, I guess I have seen a lot of letters around residential price, and I am sorry to prolong this, but I am just trying to get an idea of the magnitude in commercial markets—a lot more opaque for everybody—and Ingersoll made some positive comments on ability to get price. So is Carrier, but there is no number that has been around those. I guess are the magnitude of commercial HVAC price increases, I mean, is it low single-digits, is it mid singles hoping to capture low singles—is that TBD? Like I am just trying to get an idea of the magnitude that you guys are all kind of trying to put out there. Nobody seems to be giving a really good answer.

So Steve, I have been spending a lot of time in the field here over the last couple months, and this has been front and center with many of our discussions. I would tell you that it’s probably the range varies depending on market. Brian talked about China being a little bit more difficult right now with some of the pricing, but on average, I would say low to mid, probably low to mid-single-digits, still getting traction, which is certainly part of our ability to be able to now normally improve the projects we are putting in place and then ultimately expanding on margin improvement of those projects.

Great color. Thanks a lot for the detail. Appreciate it.

Thanks Steve.

Hi, good morning, guys.

Good morning.

Good morning.

Just going back to global products, the 6% organic revenue growth looks like the strongest it’s been in a while. While you mentioned fire security and VRS being highlights of the quarter, the former Tyco business has been a drag in the business for a while. Is that really the biggest change in the growth profile of the products business as we sit here today?

What I would say is we have had strength that is very broad-based. In Brian’s prepared remarks we are seeing it across all of the platforms. So we break it down into HVAC equipment, we break it into building management, which is all of our electronic equipment, and we break it into specialty, which is fire suppression business. When you look across the board, it’s broad-based, anywhere from about 5% to 7% growth across the board. Also, there are two key elements where we have been investing heavily over the last 3 years. We have actually increased our technology new product developments. If you look at our run rate of investments, they are up about $165 million on a run rate over the last 3 years. We are now seeing the products from those investments coming to the market, and we are positioned to be able to gain share and continue to accelerate our positioning. In addition to market recovery, we see the Middle East with oil and gas beginning to recover and we see industrial refrigeration we are up strong double digits 20 plus percent in our industrial refrigeration business with orders and backlog extremely strong. We have seen a significant recovery of fire and security products, and there is very broad-based execution across every one of our platforms.

That’s helpful, George. And I want to ask about power margin in the quarter. You identified transportation costs as a drag, which I am guessing really wasn’t as much in your initial guidance, so maybe you can give us a little more color on what do you expect going forward there, and if that cost is higher, what you can do to sort of get closer to the flat margin guidance that you had given for the year?

Yes. Overall, when you look at the total, when you look at the total company, we were down about 60 basis points in the first quarter, and about 30 basis points of that was the divestiture of Scott Safety. If you break it down into the two segments, buildings it was right in line with the lower margin on backlog conversion, again we were down about 60 basis; it was about 60 basis points, 40 basis points of which was driven by the Scott Safety divestiture. With the additional price cost we talked about in the quarter and then the acceleration of our sales force, the investments in sales force and the continued product investments is what ultimately contributed to that. So we got strong productivity and integration savings plus the volume were a little more than offset from the price cost and additional sales investments and continued product investments. So that’s the building side. On power, right off the top you got 150 basis points from the impact of FX and lead. When you look at the remaining 100 basis points, we got the volume leverage and mix on productivity was more than offset with the product investments, continued product investments as well as increased transportation costs that Brian talked about. Post-hurricane as well as with the overall pickup in the economy you can imagine transporting lead acid batteries, there is a cost of that. As we ramp up in the first quarter getting ready for the selling season, we certainly had higher demand. This created some of the increased costs we saw in the quarter.

So I think when you look at the power margins, as George said, there is 100 basis points in the first quarter that the transportation and logistics will probably continue with us into the second quarter, and I would think in terms of half what we saw in the first quarter. As we move throughout the year, through either cost actions we are going to take or pricing actions, we are going to take in the back half of the year, we will make effort to cover that, but there still will be some going into Q2.

That’s helpful guys. Thank you.

Hey everybody, good morning. I just had two quick follow-ups if you could. I guess first hit on the order growth in products. I'm not sure if I saw them, I might have missed this—if you will let me know what the order growth in the products business was in the quarter. And then secondly, just on the cost side of the price cost, what are you expecting or what are you putting into the back half of the year in terms of input costs around things like metals and refrigerants?

Yes. So on the first one…

So let me take that one. In terms of the orders, one of the things that we decided to do just to make sure that everybody is clear is when we are looking at forecasting our revenue going forward, the orders are now focused on the field side of the business because keep in mind that on the products side it tends to be more of a book-and-ship type business. There might be a little bit of variability from quarter to quarter and you may recall last quarter actually orders were a little higher than the revenue growth. This quarter, I would say that the orders were a little lower than the revenue growth, but think of products as more of a book-and-ship type business.

As far as this price cost, we are monitoring all of our commodities and projecting what each of them will do as we look at the mix of our commodities with the overall cost of goods. We are making sure that our pricing actions are not only in line but ahead of that to make sure that if there are any additional pressures going forward, we are going to be able to abate the overall margin pressure from that.

And the only thing I would add to that in terms of price cost, I know there is a lot of focus on that. We had about $0.03 in the first quarter that’s expected to moderate maybe $0.02 in the second quarter. Keep in mind as we get into the second half of the year, it will actually be a benefit for us. Particularly as you think about first half, second half that is another thing that flows into the second half of the year as the benefit.

Great. Thanks. Good luck.

Thanks.

Thanks.

Thanks and good morning.

We are getting a lot of feedback on the line.

Operator, you are going to have to…

Could you guys hear me?

Yes.

Alright, that was interesting. Maybe just circling back to this price cost question for a second. I just want to make sure that I may have not heard the answer, but we talked about a $34 million headwind in the first quarter. It seems like your guide is assuming that it gets better as the year progresses. What’s the implicit or explicit assumption on price cost for the outlook?

So as we laid out the year, and certainly this has been one of the headwinds we have been extremely focused on. We started off knowing that the first quarter was going to be the most difficult, which it was $34 million, mainly in global products as well as some of the pricing in China that we talked about. Most of the price increase will affect this quarter and as we have started the second half, we believe it will mitigate a lot of the pressure we had in the first quarter and the second not fully. So it will improve from first quarter to second quarter. With all of the actions in place, we then in the second half, we turn positive in price cost with the actions that are being taken. We are watching this very closely and making sure that we are staying disciplined in the market as we ultimately yield what we need to yield to be positioned to deliver on the commitments we made here through the year.

Got it, that’s helpful, George. I guess my following question in yield and thinking about those lower margin projects—I mean you talked about it a little bit last quarter—that had been basically been building for about the last 18 months. Fully recognize that your backlog typically isn’t that long cycle, I’m just trying to understand like when we start getting through these lower margin projects. Will we begin by the second quarter, or could they possibly bleed into the second half of your fiscal year as well?

Yes. Our projects you can look at projects. We turn some of the quick-term projects can be a few months, and then large projects can go multi-years, the average being somewhere 6 to 9, but probably 6 months to 12 months depending on whether it’s fire security or HVAC. We knew the turn that we saw coming through in the first quarter that that was going to be the toughest. As we said in North America, at the start of the year, we had 75 basis points of pressure that on a $5 billion plus backlog goes roughly about $40 million. About 40% of that turned in the first quarter. It was about $16 million. As far as we now project what’s in backlog and how it’s going to turn, it will be reduced in the second quarter and then minimal impact in the third and fourth quarter based on what’s being put into the backlog. Just another note on that would just be to say that in line with the compensation discussion, a big change has been making sure that not only from a sales standpoint, but from an overall comp standpoint margins is part of the compensation now for our sales team and for our operating teams in the field.

Got it. Thanks, George.

Thanks, again for joining our call this morning. As I hope you took away from our call today, we are building momentum and expect a very strong second half. I look forward to seeing many of you soon. Operator, that concludes our call.