Johnson Controls International plc (JCI) — Q2 2019 Transcript

Good morning and thank you for joining our conference call to discuss Johnson Controls second 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.

Thanks, Antonella, and good morning everyone. Thank you for joining us on today’s call. Let me start with some of the high level strategic highlights from the quarter, beginning on Slide 4. We delivered another quarter of solid results with continued improvement across a majority of our underlying fundamental metrics. The investments we’ve made throughout the sales organization and into new product development, combined with our ongoing efforts around commercial excellence, continue to drive strong organic top line growth across the board. We continue to grow our service business, a key element of our overall strategy in enhancing value for our buildings customers. And as I will share with you in just a second, these efforts are increasingly being acknowledged by our customers. With the exception of Asia Pacific, margins were higher in each segment as we remain focused on driving productivity, optimizing our cost structure, and improving our pricing discipline across our product categories as well as in our project businesses. Operational leverage is improving, which will become more evident over the next several quarters as the pricing we’ve built into the system over the last 12 months fully matures and raw materials and tariff impacts have stabilized.

Thanks, George, and good morning, everyone. So let's start on Slide 7 and look at our year-over-year EPS bridge. As you can see, operational performance including synergies and productivity contributed about $0.10. And this was partially offset by $0.02 of continued product investments and the carryover run rate of our fiscal '18 sales force additions. We also saw some other items create $0.02 worth of headwinds related primarily to FX and its below the line items. But as George mentioned, overall EPS in the quarter was up 23%. So moving to Slide 8, let's take a look at buildings on a consolidated basis. Sales of $5.8 billion increased 6% organically led by continued strength in our shorter cycle product segment, which was up 7% and 6% growth in our field businesses where we saw continued strength in service and project installation, which were up 5% and 6%, respectively. The continued strength in our field business is a reflection of the strong backlog we've been building over the past several quarters. Total segment EBITDA of $671 million grew 11% organically, driven by strong growth from our field and product businesses as well as ongoing productivity and cost synergy savings. Total segment EBITDA margin expanded 50 basis points on an organic basis to 11.6%. And as you can see in the waterfall, underlying operational improvement contributed about 100 basis points and this was partially offset by the product investments and run rate sales force additions.

Thanks, Brian. Before we open up the lines for questions, just a quick update on our 2019 guidance starting with our EPS walk on Slide 17. The only change to our bridge versus what we shared with you last quarter is the EPS benefit associated with the use of proceeds related to the Power sale. With the earlier close, we've updated all of our assumptions with respect to net interest savings associated with our planned debt reductions as well as the reduction in share count we should be able to achieve with our planned share tender. There are no changes to any of our operating assumptions or other below the line items. The additional $0.10 benefit from use of proceeds results in an increase to our adjusted EPS from continuing operations range to $1.85 to $1.95. This represents year-over-year EPS growth of 16% to 23%. Just to reaffirm some details of our underlying operating assumptions on Slide 18, again you will see there are no changes with the exception of the two items we’ve boxed for you. And just a few final comments before we get to your questions. We are encouraged by our performance year-to-date and feel very confident in our outlook for the second half. Our end markets do remain healthy. Our competitive position is strong, and we are well-positioned. As we close an important chapter in the history of Johnson Controls with the Power Solution sale, we're extremely excited to capitalize on the opportunities we have in front of us as one of the industry's leading building solution providers. With that, let me turn it over to our operator to open the line for questions.

Thanks. Good morning and congratulations on closing the deal early.

Thanks, Nigel.

Good morning, Nigel.

Good morning, everyone. I'm not very familiar with the modified Dutch auction process. Could you explain why the figure is set at $4 billion? Is there a reason it couldn't be closer to $8 billion? Also, once it’s completed, does that affect your ability to continue buying back shares in the market, through ASRs, or in other transactions?

The modified Dutch auction will be launched this week with a floor price of 36 and a top price of 40. We expect the tender process to be completed in early June after building the book over the next 20 business days. After discussions among management and advisors, we have decided on a limit of $4 billion for share buybacks at this time. There's also a possibility to increase that by $500 million if we choose to. For now, we are focusing on the $4 billion level and will assess demand. What was the second part of your question, Nigel?

Yes, Brian, so thanks for the detail. Just does it in any way bind you from a time period on further repurchases, so M&A any restrictions following the close of the deal?

No, not at all. Not at all. The implications of the tender really provide us more optionality after the tender is complete to decide if we move forward with share repurchases on what approach we may use.

Great. And then just my follow-on is, George, here, obviously, you’re expressing a high degree of confidence in your end markets and the order flow. Turning to your short cycle businesses within products, I mean, in '15, '16 we did see some pressure from the channel from oil and gas pressures in some of the businesses. Have you seen any signs of pressure in some of the shorter cycle businesses?

Not at all, Nigel. In fact, we've observed a very strong market within these businesses. Specifically, in our Fire & Security product divisions, we have seen low double-digit growth across all three key platforms: fire detection, security, and specialty products, including our fire suppression segment. Furthermore, the field has shown growth above mid-single digits, and this performance is quite widespread globally. Therefore, there are currently no indications in the short cycle metrics that suggest any significant slowdown.

Great. Thanks very much.

Good morning. This is Jeff on for Gautam. Thanks for taking my question here.

Good morning, Jeff.

Can you clarify what is included in your guidance assumption for debt reduction from the Power proceeds? Is it based on the $1.5 billion or the $3.4 billion? Additionally, what repo assumption is reflected in that guidance, specifically regarding the tender dollar amount for 2019?

Yes. So the debt pay down, so $11.6 billion is net proceeds. Debt pay down is $3.4 billion. The $1.5 billion is actually a tender that's part of the $3.4 billion to buy back that debt. The remaining $1.9 billion will be taken out over the next several weeks through either normal maturities of debt or commercial paper pay down. So $3.4 billion of debt, which will generate $40 million in savings this year in annual run rate of $100 million. As far as the share repurchase, what’s baked into the guidance we've given you is $4 billion in a tender that will be taken out by early June. And then the remaining $4.2 billion, we had to make some assumptions relative to what we were earning to calculate our guidance based upon. So we've assumed the remaining $4.2 billion for now will be put on our balance sheet in some interest-earning investment. And then as we make final decisions on what approach in share repurchase we’re going to use, we will update the guidance accordingly.

Okay, that’s clear. Could you provide some details on the order pipeline? You mentioned that Q3 orders are tracking in the mid to high single digits. Can you break that down by HVAC product categories like unitary, applied, and residential, and indicate which ones are the strongest? Any insights would be appreciated. Thank you.

Yes, in Q2, we saw strong product growth across the board, particularly with double-digit increases in our building management systems. Our HVAC platform experienced mid to upper single-digit growth, and our specialty products also achieved solid double-digit growth. This trend is ongoing. Our field operations, installations, and services are showing broad strength across all areas, supported by a developing project pipeline. We expect to convert many of these opportunities in the third and fourth quarters. Overall, we are performing very well in the HVAC sector globally, with our performance accelerating and increasing volumes. Although this growth is putting some pressure on our gross margins due to mix, our overall performance remains strong. In summary, this growth is widespread across all domains and regions, with a healthy balance between project-based and service-oriented business, and service growth exceeding 5%.

Thank you. Good morning, everyone.

Good morning, Jeff.

Good morning. George, you made a comment in your opening remarks about I think operating leverage really picking up or kicking in the higher gear or words to that effect in the back half. I just wondered if you could elaborate on that a little bit more right from our seat, kind of the observed incremental just that the segment levels 28%, which is solid underneath that its actually better, right, with the currency and other noise. But it's not clear to me from the guide that we would observe much more than high 20s, maybe it's 30-ish or so in the back half. But any other color on all those dynamics, the leverage, how price cost is playing through, and how to think about how that scales up into the back half will be helpful.

Let me start by mentioning that our incremental margins today are in the low 20s before considering productivity and investments. The composition is largely driven by high teens in our field businesses and mid to upper 20s in our product-based businesses. Looking ahead, we have a plan to increase those incremental margins to mid 20s, aiming to push our field businesses above 20% and our product-based businesses above 30% over the next couple of years. This year, we have made significant progress with our pricing strategy compared to last year, where we fell behind and ended up negative by approximately $35 million. With the actions we took in the latter half of last year, and continuing into this year while accounting for inflation and tariffs, we are optimistic that our margins will improve throughout the year across the board. We expect to see growth in the mid-single digits overall, which translates to about 30 basis points of leverage for the year and about 60 basis points from productivity and synergies, somewhat offset by reinvestments in our sales force and technology. While we do face a minor pension headwind, we anticipate achieving about 40 to 60 basis points for the year across all businesses.

Great. Thanks for that additional detail. And then just back to redeployment, as I’m sure you know, HVAC consolidation speculation has been ramped for the better part of six months or so. Can you just update us on your view on that? It would seem going ahead with plan A on the tender and the debt reduction would be a fairly clear indication that in the near-term you don't see an opportunity there, but I don’t want to put words into your mouth. Just what do you see kind of the optionality moving forward for this pure play building efficiency company that you’ve created?

Yes. So, I mean, when I look at where we are, it's been as I’ve communicated multiple times, we are very much focused on execution. We have an incredible portfolio that has historically underperformed. We are beginning to accelerate our performance, beginning to get more consistent performance, and delivering on our commitments. As I said, there's tremendous runway here as we continue to improve. And that’s been the focus. And so when we announced that we were going to redeploy the proceeds not only in the debt pay down but also the buybacks, it's believing that we’ve got a lot of opportunity here in front of us. We did announce the $4 billion tender. And as Brian mentioned, we'll see how that plays out and we have every intent here to continue with the plan that we have to buy back up to roughly $8.2 billion in buybacks. Now relative to the industry, certainly a lot of speculation. I’m not going to speculate on it. Certainly, when I stepped up to take over, we recognized that the building space is a very attractive end market and we had tremendous opportunity to reinvest and be able to deliver on growth. And that’s what we’re focused on doing. And as you’ve seen others, they’re doing similar, right? They’re streamlining their portfolios and positioning to do the same. But at this stage, I think we have a tremendous opportunity with the investments we've made and the continued investments we're making to be able to deliver a strong performance.

Great. Thank you for the color.

Hey, good morning.

Good morning, Steve.

Good morning, Steve.

Can you maybe just talk about what you're seeing in China? You put up some pretty good growth there. Obviously, the order slowed a little bit, but maybe just delve into a bit of the dynamics there on HVAC?

Yes, let me start by saying that it's roughly 6% of our total revenues, divided into about two-thirds from the field and a third from products. We are monitoring this closely due to the trade discussions and some signs of slowdown that raised concerns for the year. However, as we progressed through the second quarter, we felt a bit more optimistic. As Brian mentioned during the segment, we are experiencing good order growth and pipeline development. From a revenue perspective, we performed better than initially expected in converting revenue this quarter. We will continue to monitor this to ensure our investments yield the anticipated results. Additionally, from a service standpoint, it's crucial to increase our market share in the install base, and we are focused on boosting service revenues. Currently, service revenue is ramping up and accounts for about a third of our revenues in China. We see this as a significant opportunity moving forward, especially if we experience a downturn, as this segment would become very appealing for us.

Thanks for that. Following up on Jeff's question, how do you view the market share dynamics of commercial? I know there are really only three major suppliers in the U.S. for applied work, but applied can be a loose term since it's customized work. When you look at the market structure, do you see it as three major players in the U.S. that are pretty consolidated, or do you see various verticals within the market that have a range of competing solutions? Does that question make sense?

Yes. Let me give it a shot. Let me start with the residential, because I think it builds into the commercial. Residential is a space that we’re obviously not in the top two or three. And this is based that we’ve been reinvesting in North America with new product and as well as expanding our distribution, and that’s playing through pretty nicely. Our residential North America business was up 11% and that’s to a tough prior year comp. And a lot of that not only is the technology and the product, but also, of course, would be the pricing increases that we've seen here over the last 12 to 18 months. Now if we talk about commercial, this is where we’ve been relatively strong and then there are three key players here in this space. Certainly, we had over the last decade had underinvested. Over the last two or three years, we’ve significantly ramped up that investment. And I believe with the products that you see coming to market now are going to be very well-positioned to be able to gain more of that share. A big focus, our strength here is in national accounts, so there might be some segmentation of the market with how we serve customers. But I think when you look at our commercial HVAC equipment, it's up 13%.

I’m inquiring about market structure. To be more specific, is it consolidated or are we possibly misunderstanding it? Should we consider that there are various solutions for these buildings, which may indicate that it isn't as saturated or consolidated as it appears when we focus solely on chillers, which primarily involve Carrier, York, and Trane? That's my main question.

Well, I mean, when you look at the commercial space, what I would say, it's similar. When you look at the landscape within the market, its similar to the applied space where we have five or six key players. Now there's differing footprints and different product mixes within that, but there's mainly five or six key players within the commercial space.

Okay. Would you consider that that saturated and consolidated or not?

I’m not going to speculate at this stage about each of the players in the market positions. What I can say is that we're focused on our investments and ensuring we have the right approach in how we operate to gain market share and grow in the key end markets we serve.

Okay, fair enough. Thanks a lot.

All right.

Hey, good morning, guys.

Good morning, Andy.

Good morning.

George, despite the slowing in field order in the quarter, you obviously seemed quite positive about your pipeline. You made a comment in the presentation, I think for the first time around your field backlog that you now have some visibility into fiscal '20? Could you elaborate on what that means? Do you have enough projects now in backlog where you feel that field sales growth has a good chance of continuing to grow in the mid single-digit range in 2020?

Yes, I want to start by mentioning that our project durations can range from three to six months for shorter projects, and some can extend over several years. Typically, the average duration for our projects is about a year, depending on the type of projects we undertake. We are currently developing a strong pipeline, which has seen an increase in the high single digits. We are also continuing to grow our sales force while maintaining our sales costs as a percentage of revenue due to the productivity gains from the sales staff we added last year. As we move forward, we are focusing on converting our pipeline into actual projects. Although some of our current projects will help contribute to the second half of the year, many of them are laying the groundwork for our backlog in 2020. This gives me confidence that as we work through 2019, we will continue to make progress and set up for success in 2020.

Okay, George. At this point though in the year, you would say above the average visibility into the next year versus what you've seen?

Absolutely. We are halfway through the year, and I'm encouraged by our pipelines, which are tracking well across various segments, regions, installations, and services. After our regular monthly reviews, I feel confident in our ability to support our execution throughout the second half of 2019 and, more importantly, to set ourselves up for success in 2020.

And Brian, I just wanted to ask you about cash flow. Obviously, you’ve kept the guide at 95% conversion. Seasonally, we'd expect a bigger ramp up in the second half of the year. You talked in the past about needing to go after pockets of inventory that you have in your business, maybe standardizing cash collection in some of your smaller markets and collecting more from your JVs. So can you give us the confidence level that you have to get more cash out of your business in these areas, and how important are they to reach the goal for the year?

Last year in the third quarter, our free cash flow, adjusted free cash flow, was $0.5 billion. We expect around $600 million in Q3 this year. Last year, Q4 was about $900 million, and we're anticipating approximately $1 billion or slightly more in Q4 this year. With these figures, we are targeting a 95% free cash flow. When looking at improvements, year-over-year trade working capital as a percentage of sales has improved by 40 basis points from March of last year to March of this year. Sequentially, we moved from 12.1% at the end of Q1 to 12% at the end of Q2, showing progress in trade working capital as a percentage of sales. Observing trade working capital globally and the advancements from our cash management office over the past 15 months, we have standardized payment terms with our vendors, and this is working well in most major locations for payables. In inventory, there are a few areas, particularly in Japan and North America, where we can improve, representing a potential of $50 million to $100 million in opportunity. We see significant room for improvement in accounts receivable, and our team is fully focused on that now. This improvement will contribute to the year-over-year growth we expect in the latter half of this year compared to the last half of last year. Regarding joint venture dividends, we are actively discussing with our partners whether to distribute current dividends or reinvest them back into the business, and we will provide updates as the year progresses. Most of these discussions occur in the latter half of our fiscal year, when decisions will be finalized. We are hopeful for positive developments in our joint venture dividends in the coming months, which are included in our 95% guidance.

Appreciate all the color. Thanks, guys.

Good morning, everyone. This is David Lu on for Deane. I just have one question. I know you mentioned orders tracking on mid to high-single digits for the third quarter, but did you see any level of pull-in of customer spending from the second half of the year into the first half to get ahead of tariffs or price increases? Any material impact there?

No, I think we saw a normal flow in the quarter and we track these year-on-year, but nothing unusual or significant as far as that.

David, the only thing we talked about last quarter remember is in North America we did see some pull-forward from Q2 to Q1, but nothing from second half into first half.

Got it. And then, if I can just sneak one more in. Any update on tariff headwinds? I know the list three tariffs kind of stay at the 10% range, but you were projecting for I think 130 to 140 of total headwinds between 2018 and 2019. Could we potentially see some upside from lower cost increases here?

That’s about the range that on a 2-year basis the impact that we are seeing, and as I've said earlier that we are well positioned from a pricing standpoint to offset those. Certainly, we’ve been planning our supply chain so that on a go-forward basis, we can mitigate some of that. But our plan right now is we are planning for these tariffs and that’s what's ultimately in our guidance.

Great. Thank you very much.

Thank you.

Hi, everybody. Good morning.

Good morning, Tim.

Good morning, Tim.

I would like to revisit pricing and ask you, George, if you could frame the current pricing in backlog and orders compared to what is reflected in the P&L and how that looked about a year ago.

Yes. So, the easiest way to frame it up is a year ago pricing on our revenue was impacted our revenue by 1% to 2% and then pricing this year is going to be 2% to 3%. And so, think about it as an order of magnitude what’s coming through on price. And so that is in our product businesses, it's shorter cycle. So you see the realization quicker. You will see realization on service increases quicker and then the one that's been more of a cycle time impact is the work we are doing around our installation project-based business.

Okay, great. I think you mentioned this, but I missed it. Are the gross margins down slightly year-on-year and year-to-date mainly due to a mix relative to price cost or other factors?

Yes, the two areas where we've experienced pressure are APAC and North America. In APAC, we've been anticipating challenges this year due to our backlog, which will affect the second half of the year. However, with the efforts we're making, we expect improvements to start showing in 2020. In North America, while we're performing well in HVAC, the gross margins in Fire & Security are lower. Aside from that, we're seeing price increases and margin expansion across all sectors and regions as we move forward into the second half.

Great. Well, good luck on the second half. Thanks.

Thanks.

Thanks.

Hi. Good morning, guys.

Good morning.

Good morning, Josh.

Hey, Josh.

We’ve discussed a lot regarding the quarter, and now I’d like to shift our focus to the current phase of the cycle. It seems that one of your competitors mentioned that we may be in a golden age for HVAC and overall building investments, with increased spending and attention on energy efficiency and greenhouse gas emissions, which benefits the JCI portfolio. In this context, do you think you are gaining market share, or have you noticed new entrants or product lines emerging in the industry? That's my first question.

You are absolutely right. The opportunity we have in sustainability and energy reduction aligns with our strengths. I mentioned a couple of recent projects we’ve secured, including one with the University of Hawaii and another focused on creating the smartest building in the Middle East. We are well positioned mainly because we lead in HVAC, which is a major energy consumer. Coupled with our building management systems, we can optimize not just the equipment but also the overall building usage, which helps fulfill our customers' visions. In our building management systems, we experienced double-digit growth and saw low teens growth this quarter. This is how we serve the market now. As we advance, our capabilities are converging, allowing us to use our proprietary cloud-based data solution, which we call our digital vault, to facilitate energy reduction. Therefore, despite the current cycle, we believe this will continue to be an attractive space for us and one where we are well positioned.

Got it. So you don’t see anything competitively changing or new entrants or anything like that?

No, what I would say is that it's a combination of having leadership product, having technology platforms and then having a footprint in the key markets that you're serving that is close to customers and being able to take their vision with ours and convert it into what the next generation solution is going to be and that’s what we are doing.

Got it. And then just to pivot a little bit off of that, how pleased are you today with your mix, George? I think looking at some of the other folks in the HVAC landscape or in the buildings landscape, you do a bit more your own installation and you have kind of a wider range of service from the super high-end stuff to I think the things that would be maybe a bit more locally competitive. Within this kind of new regime for building investment, do you think JCI's organization does too much, too little, or the right amount as it pertains to kind of product mix and what that ultimately means for operating leverage?

Let me simplify this. Looking at our portfolio, approximately 40% is installed, around 30-35% is service, and about 25% is product. The investments we are making in our product aim to position us as leaders across all platforms. We are making good progress towards our goals and are on track with our reinvestment plans. This approach is essential not only for our direct channel but also to utilize all distribution channels to lead in the industry. Additionally, we have a strong global presence in our field-based businesses, which not only leverages our products but also our technology platforms to provide compelling solutions that drive sustainability, energy reduction, and efficiency for our customers. Although we have performed well during this cycle, we have seen significant growth in our installed business, and since I've taken over, I have focused on expanding our service offerings for that installed base. This area has substantial growth potential, attractive margins, and will be a significant contributor to our long-term success.

Great. Thanks. I will leave it there.

Great. Operator, I'd like to turn the call over to George for some closing comments.

So, thanks again all of you for joining our call this morning. As I said earlier, our end markets remain healthy. We are strengthening our competitive position, and I believe we are well positioned not only for the remainder of this year but setting up 2020. We are very excited now with the sale of Power Solutions to capitalize on the opportunities that we have in front of us and truly position Johnson Controls as the industry's leading building solutions provider. So on that, I look forward to seeing many of you soon, and operator that concludes our call.