Johnson Controls International plc (JCI) — Q1 2019 Transcript

Good morning and thank you for joining our conference call to discuss Johnson Controls first quarter fiscal 2019 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 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, and in the appendix to the presentation posted on our website. Given the announced sale of our Power Solutions business, the results of Power are reported as discontinued operations. The focus of this call will be on continuing operations. GAAP earnings per share from continuing operations attributable to Johnson Controls ordinary shareholders was $0.12 for the quarter and included a net charge of $0.14 related to special items. These special items primarily relate to integration costs and discrete tax items in the quarter. Adjusting for these special items, non-GAAP adjusted diluted earnings per share from continuing operations was $0.26 per share compared to $0.21 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 our call today. What I thought I'd do is start with a brief strategic overview then turn it over to Brian to review the financial results and end with an update on 2019 guidance. As we discussed with you on last quarter's call, 2018 was a year of significant progress for Johnson Controls, having set and achieved several ambitious goals to improve the operational performance with a bottoms-up and top-down approach. This included harmonizing our various legacy policies, establishing better processes around cash generation, and better aligning our top executives to drive the fundamentals of our businesses while concluding the strategic review of Power Solutions. Although I said it last quarter, I really can't thank our employees around the globe enough for all of their hard work, extra hours, and in many cases assuming new responsibilities. As we've entered into 2019, our goals remain the same: to continue to build upon the success in 2018 to further improve the operating fundamentals of our businesses and across all of our key initiatives. We have dedicated teams in place working on the power separation, and I can tell you at this point everything is progressing well, and we are on track to close no later than June 30. We continue to see the return on investment from several years of elevated R&D spend and engineering spend as a percent of sales aimed at refreshing our product portfolio. For those of you who joined us at this year's AHR Expo in Atlanta, I am sure you walked away with a good sense of some of the new products we are bringing to the HVAC and building controls market. New product introductions are continuing to ramp in 2019, and we are well-positioned to continue gaining share across our product categories. We have built a complete global portfolio of proven solutions to help our customers design, build, retrofit, and manage the next generation of safe, smart, and connected buildings. As a global leader in sustainability and energy efficiency, our approach to innovation focuses on enabling our customers and communities to reduce energy consumption, lower operating costs, and minimize the environmental footprint of their facilities. We achieved this with tools and technologies that make those facilities smarter by using sensor-based automated monitoring of environment and security systems, as well as data mining and artificial intelligence, whether that be the latest release of our Metasys software platform, our smart connected chillers, or our cloud-based digital solutions offerings. We were able to offer compelling value propositions across all of our key verticals. As we continue to drive top-line growth, we will remain focused on improving returns and increasing our operating leverage. We continue to strengthen our processes around large project approvals to ensure we are achieving appropriate margin rates. We have enhanced pricing desks and have set consistent productivity metrics across sales, service, and installation to drive improved performance. Turning to slide four, orders in our field businesses increased 7% organically. As you can see on the slide, although we are beginning to lap more difficult prior year comparisons, our momentum increased sequentially. The increase in orders was driven by mid-teens growth in global commercial HVAC and mid-single-digit growth in fire and security, partially offset by a significant decline in our North America solutions business. Brian will provide you with some order details in his segment review, but we continue to see broad-based strength in our order books across all three regions and across most of our core product platforms. Our backlog ended the quarter at $8.5 billion, up 7% organically versus the prior year, which puts us in a much better position in 2019 with strong visibility to execute on our revenue expectations. Our project pipeline remains robust, and we expect continued order momentum across our end markets over the course of the year. Taking into consideration the increasingly difficult comps as we move throughout the year, we expect continued strong order growth in the mid to high single-digit range. Before I move to the summary of our first-quarter results, just a quick comment on the macro environment; as evidenced by the continued strength in our orders and revenue, our end markets remain healthy. Generally speaking, we are not seeing a notable slowdown in any of our internal leading indicators, as our short cycle book-to-bill trends and service growth in both small and large project bookings remain robust. We continue to monitor global economic conditions, and although it seems clear that GDP growth rates in some key regions are beginning to moderate to some degree, we feel good about our position. We have made the right technology investments and have expanded our sales force as well as distribution footprint. We have been expanding capabilities in our service business, which is over $6 billion in annual revenue with roughly two-thirds recurring in nature. In addition to leveraging our industry-leading installed base, we have developed new technologies enabling us to create new value propositions for our customers. We are focused on execution and are continuing to take our costs and drive productivity. Turning now to slide five, let me recap the financial results for the quarter. Sales of $5.5 billion increased 6% on an organic basis, led by 7% growth in products and 5% growth in the field businesses. Adjusted EBIT of $400 million grew 10% on a reported basis and 15% on an organic basis despite the anticipated pressure in our Asia-Pac business and the carryover impact of sales capacity investments driven by solid growth in segment profit as well as lower corporate expense. Overall, underlying EBIT margins expanded 60 basis points year-over-year, excluding the impact of FX and M&A. Adjusted EPS of $0.26 increased 24% over the prior year driven by solid top-line performance and a modest benefit from below the line items. Adjusted free cash flow was an outflow in the quarter of approximately $200 million, better than the historical use of cash in Q1. The cash management office continues to execute well, driving improvements across our cash fundamentals. With that, I will turn it over to Brian to discuss our performance in more detail.

Thanks, George, and good morning everyone. So, let's start on slide six and take a quick look at the year-over-year EPS bridge. As you can see, segment operating performance stands at $0.08 versus the prior year quarter. This was partially offset by $0.02 of continued product and channel investments and the carryover run-rate impact from our fiscal '18 sales force investment. I would also note that net financing charges provided a $0.02 benefit primarily driven by favorable interest rates and some FX gains. This was more than offset by a slightly higher year-over-year tax rate and some pension amortization and FX headwinds. So let's move to slide seven. Buildings on a consolidated basis had total sales of $5.5 billion, which was up 6% organically. This was led by strength in products of 7% and field businesses which were 5% driven by continued strength in both service and project installation activity, which grew 6% and 4% respectively. Segment EBITDA of $590 million grew 9% organically driven by strong growth in both our field and shorter cycle products businesses despite some continued high investment levels. I would note that fiscal Q1 is typically our lowest quarter from a volume leverage standpoint given the seasonally lower revenues in our buildings business. Our segment EBITDA margin expanded 30 basis points on a reported basis to 10.8%. And as you can see in a vertical chart, this includes 90 basis points of underlying operational improvement, partially offset by continued product investment as well as the run-rate sales force investments and indirect channel cost expansion. Now, let's review each segment within buildings. Starting with North America on slide eight, you can see that sales grew 6% organically to $2.1 billion with install activity up 6% and service up 5%. We saw another quarter of strong performance in our applied HVAC and Controls platforms, which grew in aggregate mid-single digits organically, led by 5% growth in core applied HVAC equipment installation and service. We also saw fire security grow mid-single digits led by high single-digit growth in fire and our solutions business, which was up 30% in the quarter. I just want to highlight that the Solutions business can be quite choppy on both an order intake and revenue standpoint. Adjusted EBITDA of $253 million grew 8% on an organic basis. North America EBIT margin expanded 30 basis points to 12% as we saw the benefits of volume leverage and synergy and productivity saves, partially offset by the year-over-year impact of our run rate sales force investments and unfavorable mix as install revenue growth outpaced service growth in the quarter. Margin was also impacted by mix within the individual platforms. Orders in North America increased 5% organically, driven by applied HVAC orders of mid-teens. We do think this benefit is partly from some equipment pull-forward ahead of prices, and fire security was up mid-single digits including strength in project installation and service. This growth was partially offset by a significant decline in large orders and solutions, which as I mentioned earlier, can be quite choppy. Backlog of $5.4 billion increased 4% year-over-year. Now let's move to EMEA/LA on slide nine. There we saw sales of $907 million, which grew 4% organically with continued strength in service, partially offset by a modest decline in project installations. Growth was positive in most regions and across most lines of business. Europe grew mid-single digits led by continued recovery in IR and HVAC, which combined are roughly one-third of the revenues for the segment. Orders in Europe increased 10% organically, led by strong demand in IR security and HVAC. In the Middle East, we saw revenue decline low double-digits as continued growth in service activity was more than offset by softness we’re seeing in HVAC project installations, but this was also driven by a tough compare with the prior year, which was up strong double-digits. Latin America revenues increased mid-single digits led by strengthening our security long-term position business and solid growth in IR on fire suppression. Adjusted EBITDA of $77 million increased a strong 17% organically, and our EBIT margins expanded 70 basis points to 8.5%. This includes 30 basis points headwinds from FX. The underlying margin increased 100 basis points as favorable volume and mix and productivity and synergy saves more than offset the run rate impact of other sales force investments in '18. Orders in EMEA/LA increased 9%, led by solid growth in Europe and Latin America across both service and installation. In the Middle East, orders declined low double-digits again driven by a tough compare with the prior year. Overall backlog ended at $1.6 billion, up 15% organically. So let's move on to Asia-Pac on slide 10, sales of $613 million grew 6% organically driven by an acceleration in project installations, which grew 8% in the quarter. Growth in install was led by HVAC. Adjusted EBITDA declined 9% on an organic basis. And as expected, EBITDA margin declined 160 basis points to 10.8%, as the benefit of the favorable volume was more than offset by the higher install mix, run rate, sales force investments, and the expected competitive pressures in China. Asia-Pac orders increased a strong 9% in the quarter, driven primarily by service, and we are beginning to see some improvement in year-over-year secured margins, particularly in service, which should benefit the latter half of this year. Overall backlog increased 12% to $1.5 billion. Turning to global products in slide 11, sales increased 7% organically, totaling $1.8 billion for the quarter. Buildings Management Systems grew low double-digits with strength across all three of our platforms: control, security, and fire detection. Sales across our HVAC and IR equipment businesses grew high single-digits collectively, and global residential HVAC, which includes sales to our consolidated Hitachi Joint Ventures in Japan and Taiwan, grew mid-single digits in the quarter. North American revenue HVAC grew high single-digits benefiting from favorable weather trends and strong price realization. Our global light commercial HVAC grew mid-teens in the quarter with North America up low-teens. IR equipment revenues declined low double-digits in the quarter due to a very difficult prior-year compare, which was up a strong double-digits. Our applied HVAC equipment business grew high-teens reflecting strength in our indirect channels in both North America and Asia. We saw specialty products grow mid-single digits on strong demand for fire suppression products, which was broad-based across all regions, particularly in APAC. Segment EBITDA of $194 million was up 15% organically, and the margin expanded 60 basis points driven by higher volume leverage and mix, positive freight costs in the quarter, and the benefit of cost synergies and productivity saves, partially offset by our continued product and channel investments. So let's move to corporate on slide 12, corporate expense was down 11% to $93 million as we continue to see the benefits of our cost reduction initiatives. For the full-year on a continuing ops basis, we expect corporate expense in the range of $380 million to $395 million. This does not include any take out like the Power Solutions divestiture, which will begin post transaction close. As a reminder, we expect to reduce corporate expense by about $50 million over time. Moving to cash flow on slide 13, as George mentioned, reported cash flow was an outflow in the quarter, slightly above $200 million. If you exclude a little less than $100 million of integration and transaction costs, adjusted free cash flow in the quarter was an outflow of a couple hundred million. As you know, our first fiscal quarter is typically a cash outflow, but we will take with the continued year-over-year improvement we're seeing in the cadence of our cash generation. For fiscal 19, we expect adjusted free cash flow conversion of approximately 95%. As I mentioned on the Q4 call, this excludes special cash outflows of $300 million to $400 million related to some special integration costs, and a $600 million tax refund that we expect either in Q4 or in early fiscal 20. Moving to the balance sheet on slide 14, you can see that our gross and net debt increased to $1 billion sequentially as planned, which reflects a higher CP balance to support Q1 trade working capital needs as well as a more aggressive share buyback program that we implemented. Assuming a June 30 close for Power Solutions, we expect to pay between $3 billion and $3.5 billion of its outstanding debt in Q4 with a portion of the net proceeds. This will result in a reduction of financing costs of about $25 million or $0.02 in the fourth quarter, which is included in the full-year guidance that George will provide. Our net debt to cap increased to 36.6% from 33.7% in Q4, related primarily to the share repurchases as well as a reduction in equity related to a Q1 adoption of a new income tax accounting standard. Given our current stock price, we are being very aggressive with our buyback program. We made significant progress toward our full-year share repurchase target of $1 billion, which will be completed before the closing of the Power Solutions transaction. In Q1, we purchased just over $14 million shares for approximately $465 million. I would also note that we expect to utilize a portion of the power sale proceeds later in the year to purchase additional shares, which is expected to contribute about $0.03 in incremental earnings for the year. Given our planned share repurchase strategy for fiscal 19, we now expect our diluted weighted average shares to be approximately $905 million for the year. Finally, let me touch on a couple other items on slide 15 before I turn it back over to George for fiscal 19 guidance. First, based upon some additional tax planning that's been done in part related to the pending sales of Power Solutions, we now expect our effective tax rates in continuing ops in fiscal 19 to be approximately 13.5%. As Antonella mentioned, the results of Power Solutions are now reported as discontinued operations and all historical financial information is presented on a comparable basis. We are well underway with the separation activities and expect the sale to close no later than June 30, and also mentioned the Power Solutions adjusted free cash flow in the quarter of about $100 million, which is right in line with expectations. Lastly, all the guidance that we provide will be on a continuing ops basis. We have provided normalized financials in the appendix for competitive purposes, so you can update your models. And with that, I'll turn it back over to George.

Thanks, Brian. Before we open up the line for questions, I want to provide you with our outlook for 2019 continuing operations. Let's start by walking through the year-over-year impact of the significant items embedded in our 2019 guidance on slide 16. As I mentioned on the fourth quarter call, we expect mid-single digit organic growth in buildings, which will drive approximately $0.20 of earnings. We expect this growth to be primarily driven by improved volumes and price. We will also have the continued benefits of synergies and productivity savings in buildings and corporate, which we will realize over the course of the year, contributing an additional $0.19 of earnings. Additionally, as Brian discussed, the benefit in fiscal 2019 related to the deployment of a portion of the Power Solutions sale proceeds is expected to add about $0.05 of earnings. The carryover impact of the sales force investments as well as a few cents of incremental investments in our product businesses are expected to total about $0.07. As you are all aware, the U.S. dollar has continued to strengthen. Based on quarter-end rates, we expect this to result in a $0.06 foreign currency headwind year-over-year. Lastly, as you can see, there are various other items, which led to a $0.10 headwind with the most notable being a $0.03 headwind from tax and a $0.02 headwind from both pensions and amortization. All these factors contributed to our fiscal 2019 EPS guidance range before special items of $1.75 to $1.85. This represents growth in the range of 10% to 16%. The full detail of our guidance is included on slide 17. Lastly, as a significant portion of the benefit related to the deployment of the Power Solutions sale proceeds will benefit fiscal 2020, I wanted to provide a framework for how our earnings are expected to progress as we move forward. As you can see on slide 18, the incremental benefit of proceeds deployed in 2019, additional share repurchase in 2020, and a reduction in corporate costs is expected to contribute an incremental $0.50 to $0.60 of earnings, which takes our fiscal 2020 EPS in the range of $2.25 to $2.45. This would be prior to any operational growth or benefits from additional capital deployments. Recognizing that we will not receive the full benefit of our reduced share account in fiscal 2020, there will be an incremental benefit of $0.10 to $0.20 in fiscal 2021. Over the last two years, we've been merging two businesses into one and have made a significant amount of progress. During that time, we have reinvested heavily back into the businesses. Now, it's about capitalizing on those investments with how we are going to market. We have been building backlog, which provides us visibility in our field businesses. We've been strengthening our service business, which tends to be more resilient, and our short cycle products business is seeing good growth across all three platforms. We are watching closely what is happening economically around the globe, and our focus is on execution and delivering for our customers. We feel good about our position in a very attractive market, and we expect to grow our underlying operations at or above the market for industrial peers as we look ahead. With that, let me turn it over to our operator to open the line for questions.

Yes, thanks, good morning, and I appreciate the detail.

Good morning, Gautam.

Good morning.

Good morning, Gautam.

I was wondering, George, if you could just maybe directly address the capital allocation with the proceeds of the Power Solutions sale. Just to be clear, we should expect or we should model in that besides the $3 billion to $3.5 billion of debt repayment, it's all going to be directed at share repurchase. Is that a fair conclusion?

That is correct. As I said, we're very much focused on executing on the strategy, delivering on the growth, delivering the operational performance, and ultimately delivering results. Our plan today is to take the proceeds from the Power Solutions sales and, as we have said, deploy those as quickly and as efficiently as we can once we complete the transactions.

Got it, that's very helpful. And just in terms of M&A appetite, I mean, do you guys have any interest in North American residential HVAC as an area of acquisition growth?

Well, Gautam, as you know, we've been investing heavily back into our products over the last three or four years. We feel very good about our portfolio and the progress we've made with the new products we are bringing to market. Although we are not a leader in that space today, we feel very good about the progress we're making with the share gains that we're achieving and how we're positioned for the future. So at this stage, we're continuing to focus on executing on the investments we've made and ultimately delivering the results.

Thanks a lot, guys, appreciate it.

Thanks.