Johnson Controls International plc (JCI) — Q3 2019 Transcript

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

Thanks, Antonella, and good morning everyone. Thank you for joining us on today's call. I'm going to start with a few strategic highlights from the quarter beginning on Slide 3. Looking at our results for the quarter as a whole, we remain encouraged by the ongoing progress we've seen over the last several quarters. We delivered another strong quarter of organic revenue, order, and backlog growth, and also delivered on our commitment to generate $600 million in adjusted free cash flow. These results reflect the continued emphasis on driving underlying fundamentals focused on innovation and new product development, talent management, enhancing commercial excellence across the organization, and optimizing our cost structure. As I think about the reinvestments we have made and continue to make to support future growth, I am confident that we are strategically strengthening our market position. As we highlighted in the examples we provided to you last quarter, our objective to lead the evolution of smarter, more efficient, and more sustainable buildings and infrastructure is coming more into focus every day. In pursuit of developing our strategy in connected buildings, we are actively partnering with our customers, technology providers, and integrators to create comprehensive digital solutions with attractive value propositions that assist our customers in achieving their goals and missions. Our broad portfolio of smart edge devices, connected equipment, and systems in cloud-based data analytics capabilities provide Johnson Controls the unique competitive advantage as the industry begins this transition.

Thanks, George, and good morning everyone. So starting on Slide 6, let's take a look at our year-over-year EPS bridge. Operational performance including synergy and productivity savings contributed $0.10, which was partially offset by $0.02 of continued product investments in the fiscal 2018 run rate sales force additions we have talked about in prior quarters. Other below the line items contributed a net $0.03 to our Q3 results of $0.65, which was up 20% year-on-year. Moving to Slide 7, let's review our segment results on a consolidated basis. Sales of $6.5 billion increased 6%, led by 7% growth in products and 5% growth in our field businesses. During the quarter, we saw solid service growth in North America and tempered growth in EMEA/LA and APAC. Overall service growth was 2% in Q3, and we continued to convert our project backlog with installation revenue up 6% led by solid growth across all regions. Segment EBITDA of $992 million grew 7%, driven by volume leverage from our field and products businesses as well as productivity and synergy savings. Q3 segment EBIT margin provided 20 basis points to 15.4% as volume leveraged across our businesses, favorable mix in global products, and synergy and productivity savings were partially offset by a 30 basis points headwind related to mix in North America that George mentioned. As you can see in our margin waterfall, underlying operational improvement contributed 60 basis points which was partially offset by continued product and run rate sales force investments. Now let's take a look at each of the segments in more detail, starting with North America on Slide 8. Sales grew 4%, driven by continued strength in both installed and service, which were up 4% and 3% respectively. Q3 growth was led by strong high single-digit growth in our applied HVAC and controls businesses as we saw double-digit increases in Applied Equipment sales. Our Fire & Security service and installed businesses grew low single-digits on a tough prior year compared to 7%. Our performance solutions business declined high single-digits in the quarter. Adjusted EBITDA declined 3% and EBITDA margin decreased 90 basis points to 13.3%. Benefits from synergy and productivity savings as well as volume leverage were more than offset by unfavorable mix within the individual platforms and the year-over-year impact of our run rate sales force additions. So just to comment on mix as this was a primary driver of the North American margin headwind we saw in the quarter. You may remember that in Q3 last year we benefited from very favorable mix in our North America segment. This was a result of our higher margin Fire & Security businesses growing at a faster pace than our HVAC business. Additionally, within Fire & Security, our high-margin retail business had a very strong Q3 last year driven by several large shipments to big box retailers.

Thanks, Brian. Before we open up the line for questions, let me provide you an update on our 2019 guidance starting with our EPS walk on Slide 18. Just a couple of changes versus what we shared with you last quarter; there is no change to the EPS benefit from operations, synergies, and investments in sales force additions. You can see the impact of our capital deployment on net financing charges and share count. Compared to our EPS guidance range last quarter, there's $0.04 of additional benefit at the midpoint of the range. This primarily relates to a benefit in net financing charges due to favorable interest income rates and less interest expense given our significant debt paid down activity during the quarter, as well as a start to right size corporate costs resulting from the sale of Power Solutions. As a result, we are tightening our EPS guidance to the high end of our previous range and now expect the EPS before special items to be in the range of $1.93 to $1.95, representing EPS growth of 21% to 23% year-over-year. This includes an expected Q4 adjusted EPS range of $0.76 to $0.78. Turning to Slide 19, we have updated some of our operational assumptions as well as the below the line items to reflect our year-to-date performance and current outlook for Q4. For the full year, organic growth is now expected to come in at the high end of our previous range, up 5% to 6%. Given the higher expected revenues coupled with the Q3 mix in North America, our segment EBIT margin expansion is now expected to be approximately 30 basis points for the year. As I mentioned earlier, we are continuing to see top line momentum across the businesses, and our focus remains on driving the fundamentals both from a P&L and cash perspective. With that, let me turn it over to our operator to open the line for questions.

Hey, thank you, good morning everyone.

Good morning, Jeff.

Good morning. Just on cash use and kind of the outlook for that, clearly on the repurchase it looks like you're holding back, and Brian actually used the term like if we see the need to preserve cash, so can you just give a little bit of color on what you're thinking? Do you see something more worrisome from a macro standpoint, or are there some particular reasons you're kind of keeping $1 billion in your back pocket here?

No, I think what I was trying to communicate there, Jeff, was simply that we've got a formal program right now for $3.1 billion, and our plan is to make sure that gets executed during fiscal 2020. As we move through the year, we could very well use that other $1 billion for share repurchase as we move into the back half of next year, but we are going to just maintain a bit of flexibility both from a macro standpoint to see how things play out, and we might also consider some product line gap fillers or other M&A that we want to look at as well. So we just didn't want to fully commit right now to the entire $4.1 billion, but we're going to do the $3.1 billion, and we'll keep you updated on the remaining $1 billion as we move throughout fiscal 2020.

And then maybe as a follow up on that, George, what are you thinking on the M&A front? Do you have an active bolt-on pipeline, anything moving through that pipeline?

Yeah, let me start, Jeff, by saying relative to our performance as we've communicated, we're continuing to focus on execution, delivering our commitments, and delivering results. That all being said, we continue to look at M&A with bolt-ons that, as we're reinvesting, we're making sure we're supplementing that with strategic bolt-ons. So there is a pipeline that we've been working on; a lot of that is in building management systems as we build out our capabilities within our digital solutions, and so we are continuing to pursue acquisitions. As Brian said, we believe that the environment we still see is very good across our markets. We're continuing to capitalize on that as we're converting not only the pipeline to orders but now the orders to growth. We're going to stay focused on execution and ensure that we're also tracking what's happening in the M&A front, and as we go forward we want to continue strengthening what we're doing organically.

Great, thank you.

Hey, good morning guys.

Good morning, Andy.

George, we know you had a relatively significant mix issue that you talked about in Building Solutions North America. You mentioned that Fire & Security is growing slower than HVAC & Controls, but it did slow down a little bit in Q3 versus Q2. You mentioned a difficult comparison on retailers this quarter, but is any of the store growth a little slower in U.S. retail economy, and how much would you expect a 90 basis points mix headwind on the business to improve in the quarters ahead?

Yes, so as we look at what took place in third quarter, as you said, it was mainly driven because last year we had very strong growth in Fire & Security, and within that, very strong growth in retail. And then year-on-year, although we are outperforming the market in Fire & Security in 2019, it's at a much lower growth than our HVAC business, which we're continuing to execute very well. As we now project North America going forward, we see in fourth quarter roughly about 30 basis points with the mix going to come through in third quarter. For the year, it will be relatively flat. Now when you look at the year, it suggests that our productivity and synergies are offsetting the investments we're making in sales force as well as the pension headwind. The volume that we are achieving now is offsetting some of that negative mix. But we're very confident with the fundamentals we have in place, the way that we're driving improved fundamentals to be able to see improved leverage as we go into 2020.

George, maybe if I could follow-up on that. The incrementals in your products business were much stronger than usual. We know that pricing versus costs are strong, but did you actually have lower investment than usual in the quarter in that segment? And you talked about incrementals in products getting up to 30% over time. I know you mentioned operational investment in Q4, but are you actually ahead of schedule on improving the execution on the products in that segment?

Yeah, when you look at our product business year-on-year, this is where a lot of the work that we've done around price-cost has come through. As you know, we had significant commodity headwinds as well as tariffs. We've done a nice job ultimately driving price as well as productivity to get positive price-cost, and that within the quarter is about 40 basis points. Overall, that has been a big strength for us. With the leverage when you look at our investment profile, it was pretty much spread through the year, and as Brian said, we'll see some additional reinvestment in fourth quarter based on the timing of our product launches. But it's in line with what we expected. So as we look at these businesses, what I would say is we're building the fundamentals, we're getting the lift with the reinvestments we're making and that's coming through the growth, and that we're executing very well on the price cost, which is adding to the overall margins. On a go-forward basis, we believe with the continued performance with growth and with the work we're driving on fundamentals, we're going to be in a position to be able to leverage the product. The leverage margins will be 25% to 30%.

And you see that 40 basis points being pretty stable going forward for the price-cost?

Yeah, I mean based on what we see today, I mean you can't predict all of what's going to happen in the future, but I feel confident now that we have a good understanding of what's happening from a cost standpoint, and that from a pricing standpoint we're now factoring that into account on a go-forward basis.

Thanks, guys.

Hey guys, good morning.

Good morning.

Can you maybe talk about what you are seeing on the global applied markets? What your order pipeline looks like for the next several quarters including in China?

Yeah, what markets are you referring to, Steve?

Global applied. Applied equipment, just the order pipeline there, HVAC applied.

So, let me just give you a perspective on our overall HVAC businesses globally. When you look at our performance, our orders are up 6% globally. Our revenues we converted revenues at 7% and when you look at our pipeline, we're continuing to build pipelines pretty much across the globe that are up kind of mid to high single digits both in our commercial and residential businesses. So overall, I feel very good about the work that we've done to be able to take advantage of that market. When you break out into segmentation, you see our commercial HVAC businesses are growing 7%, and that's been driven by applied as well as with the service that we're getting and as a result of the installed base that we're putting in place. And then when you look at revenue, we're up kind of mid-single digits, and that's a combination of our UPG business up kind of mid-single digits in North America and our business up high-single digits globally. So overall, Steve, we still feel very good about the pipeline, how we're converting the pipeline, and then how that's setting us up here as we go forward in 2020.

Okay, and any specific comments on China, what you're seeing in China commercial HVAC?

Yeah, so China, when you look at the China market, it continues to perform. I mean we're seeing kind of orders in the mid-single digits, we're seeing a little bit better in service which is high single digits. So we're watching this closely, but as you know, we have a strong presence there. We have strong positions from a market share standpoint, and we've been making sure that we've got the right product. We're ultimately capitalizing on the growth that's occurring. So we have not seen any significant change in the activity or the pipeline that we are building, and as I said, we're continuing to build our service business, which over the cycle is very important to make sure that we're getting the recurring revenues.

Steve, the only thing I would add is that China specifically orders were very strong; although APAC was up 1%. China orders were really strong and it was a mix between install and service.

Great, thanks for the color guys.

Thanks, good morning.

Good morning.

Just wanted to go back to North America and the retail headwinds. You have obviously covered that already, but can you just recap how big is the retail exposure there? It does feel like the physical footprint of the retail effect is starting to shrink at an accelerated pace. I'm just wondering how you think about that business going forward in light of this online transition that seems to be occurring?

Globally, Nigel, the retail business is about a $1 billion business. It is a global business with a significant piece of that in North America. What happened last year, we had very strong growth in the quarter last year which was mainly driven by some significant product shipments in the quarter which obviously didn't repeat this year. Overall, as you know, we got multiple businesses there; we have the anti-theft security business as well as we've been building a digital traffic business, and also our inventory management business. Those businesses are performing well. Certainly with the slowdown in some of the challenges in retail, some of the projects have been pushed out which we've seen here in the third quarter, and we're watching that closely for the fourth quarter. But as you know, overall this is a good business. We've had a lot of growth, and we're going to watch this closely.

Okay, great, and then just a quick one on the NPI line; it's up quite a bit from your prior guides, and I'm just wondering what's driving that?

So those would be the Hitachi businesses where we own 60% of those ventures, and they continue to perform very strong in Q3 and Q4. Even into fiscal 2020, we're going to continue to see that NCI line move up simply because of the strong performance of Hitachi.

And then just, Brian, quickly, is that better revenue or better margin, and where do we stack up right now on getting cash out of those JVs?

So you probably saw in the quarter, if you look at the cash flow statement that was attached to our release, we did get a big dividend in the quarter as we expected. As I think I've mentioned on this call in the past, the second calendar quarter of each year is when we have certain board meetings related to the Hitachi entities, and we did receive a large dividend in the third quarter as we had planned. So the good news is it's at a larger amount than we've gotten in prior years, and we continue on a go-forward basis. We'll have to work on getting out a similar level of dividend. As I've talked about in the past, it may require some reinvestment in the Hitachi business to support the growth. So on a go-forward basis, we're just going to have to monitor the level of dividends that we get out of the Hitachi joint venture, but in the quarter, we got a large one.

Okay, thanks, Brian.

Hi, good morning. Maybe just the first question on the corporate expense; very good progress there again. And when we think about the sort of go-forward run rate, I think we've been thinking maybe another $50 million or so reduction into next year. Does that sound about right? So the sort of go-forward run rate is closer to $330 million, like that?

Yeah, that might be a little heavy. I would just say that I was very pleased with the actions that our corporate team took immediately after the Power sale to begin taking costs out to right size. I would say this year, there's probably going to be $10 million taken out. Realistically as we transition through fiscal 2020, I would say that costs will be taken out during the course of the year. So if you assume we take them out pro-rata, that's going to probably give you another $20 million minimum, and if we can accelerate some of that, maybe $30 million to $35 million would come out next year. The full run rate of $50 million we would see as we move into 2021. So I think more along the $30 million to $35 million is probably a better number to work with.

That's helpful, thank you. And then just a quick follow-up, I'm not sure how specific you can get, but you did book that $140 million environmental reserves in the quarter, so maybe just give us a mark-to-market of where the environmental reserves sit now in total at present at JCI and if this charge obviously cleaned up that Wisconsin issue you mentioned in the Q and the noise on a triple S around municipal and individual actions, any upcoming events you think we should watch for, all points on that as they pertain to JCI?

Well let me comment on your first question regarding environmental reserves. I think we are appropriately reserved for the Marinette issue based upon all the work that we did in the quarter. Incremental of that $140 million reserve, I believe we've got reserves globally for other matters less than $100 million. I want to say between $50 million and $100 million. There's a footnote disclosure on that in the Q's and K's, but this particular matter in Marinette at $140 million is the largest one that we will manage over the next several years. So I think from an environmental research standpoint, we feel comfortable with where we are.

And Julian, let me address the other part of the question on the civil litigation. I think we need to put this in perspective. Tyco and Chemguard make life-saving firefighting foam, PFAS chemicals. They purchased the compounds that contain trace amounts of PFAS which they then blend to make the foam. The firefighting foam is made to exacting military standards. The majority of the foam at issue is specified and used by the U.S. government and military and therefore subject to the government contractors' defense. Tyco and Chemguard have always acted responsibly in producing these firefighting foams, and we feel very confident in our ability to defend these clients.

Great, thank you.

Hey, good morning guys. So you made a comment earlier, George, about some of the channel inventories in the unitary side just still being high at the end of the quarter. How long do you think it takes to work those down, and then have you seen any pushback or softening in the price environment just as other folks in the system as well are trying to move inventory along a little bit in the back half of the cooling season?

I think we should see a normal bring down of that inventory during Q4, and I don't think it's going to have any impact on our pricing in the market at all. So I think it's more seasonal that will come down here as we move through the fourth quarter.

And we've been managing the inventory as this has played out over the last quarter. Some of the impact of weather and the like, we've been managing that appropriately. We are watching that closely as we get into the latter part of the season here but we are positioned as we have planned.

Got it, that's helpful. And then just a follow up on the retail Fire & Security exposure there. I guess I knew mix was strong last year; I didn't appreciate exactly where that came from. But just thinking about the pipeline in that piece specifically, does that tend to be lumpy over time? Are there any other quarters that we should keep in mind over the past several that have had outsized mix there as you compare that could be a challenge?

Having been part of the business for several years, I can say that when we examine the business profile, we occasionally see year-on-year comparisons due to how projects are executed with retailers. There is a seasonal aspect to the business across the four quarters. Therefore, I don't believe there is anything unusual based on our observations. We remain well-aligned with all the major retailers given our strong presence in retail, and we are closely monitoring their plans regarding investments and other related activities. Consequently, I do not see anything significantly unusual at this time.

Great, thanks for the color.

Thank you. Good morning everyone.

Good morning.

Hey, I would like to get some color as you see it in North America non-res construction, just kind of trends. There's some anxiety in some sectors that the macro uncertainty is weighing on project releases. Are you seeing anything along those lines? And just to be clear on the retail push-outs that you've seen, is that more retail sector specific, or would that be attributed to some of the broader macro ones certainly?

So let me start with your first question, Deane, relative to the environment. I think when we look at all of our industries whether it be ABI, Dodge forecast and what the overall activity is, it's still given where we play, and a lot of that is in the institutional space we see continued expansion. Now we've also expanded our sales force and our footprint, so I think at this stage, you could suggest we are picking up some share. Our pipelines are continuing to grow; we're converting those into orders. Our North America orders are up 6%, but HVAC was up double digits. We're performing well and creating a backlog, and we feel confident that we're going to see that continue at least in the near term. As it relates to retail, the discussion around retail is retail specific. This is project by project as we look at our customer base and what their plans were and what ultimately played out. It's specific to each of the retailers, and so as I have said, we have pretty good visibility especially with the large retailers, what their plans are, and we're going to monitor that as we go forward.

Great, and then just what's embedded in the Q4 guide? You typically see during summer months some verticals make bigger project implementations like K through 1 colleges. Are you seeing that those projects going through as expected?

Absolutely. I mean when we look at our growth, as we suggested, we're going to grow mid-single digits in Q4, and that will get us to 5% to 6% organic growth in total. When you look at the compare that’s over a 7.6% growth last fourth quarter. So we look at our current pipeline of projects that we're executing to deliver on that, those are all moving forward as planned.

Thank you.

Hi, good morning.

Good morning.

Hi, so we were actually talking to a couple of integrators and they were really excited about a new product release you guys had put out, Enterprise Management 2.0, and what they were basically intimating to me is it seems like JCI and Honeywell are really taking the lead on smart buildings AI and really bringing additional capability to occupants. Is there anything you can point to around metrics you've seen, not necessarily specific to this product, but other control products? Obviously, there's been good growth there that we're actually going to see building owners willing to upgrade and pay for some of these newer services that you're offering?

So this is core to our overall strategy for the company as you think about our portfolio leading in our HVAC equipment and then leading in building management. And building management, it's how this is on top of what we're doing to integrate all of our digital platforms, create a data layer with our Digital Vault, and then to be able to create new solutions on top of that data to create value for our customers. So what you're referring to, the Enterprise Management, is what we call our jump, which is John's controlled enterprise management, taking all that data and positioning that data to be able to deliver and execute for our customers, things that they ultimately see value in. We've got that deployed now across a number of installations and very successfully, and as we think about not only that, but we've got a number of other digital solutions that we're deploying today that we can take our installed base that we have with our service business to be able to add these digital solutions and be able to accelerate our service growth with the customers that we're currently supporting. It's core to the strategy and how we ultimately create more value for our customers and leverage all of our digital capabilities to do that.

Yeah, I guess maybe as a follow on, do you have any numbers around the size of the business? Either what your pure software component is, things like that if you can share?

We don't segment our revenues today, but as you know, across our business, we have a lot of software embedded in the products as well as the solutions that we bring to the market. So when you look at that, we have software within our building controls, within our security platform, and within our fire platform. What we're doing now is taking all of that, integrating that as well as building a data platform that enables us to create apps and be able to create new outcomes that will create service growth for us. We don't segment it that way, but as we go forward, that's something as we look at how we're taking our building management solutions forward that we will focus on and how we can create some metrics so you can track the progress that we're making with the investments we're making.

Great, thank you.

Good morning, thanks. Just going back to China; you talked about service maybe outpacing install. Just your thoughts on I guess one install coming back, reasons for any kind of delays there, and then your confidence and ability to drive price and favorable mix on the business you quoted?

Yeah, the comment on the low single-digits was in order as I think overall our orders were somewhat flat on the install side with the service being a little bit higher. But as we project what we're going to do there when you look at the overall growth in the pipeline, we suggest that we're still going to see kind of mid-single digit growth in both orders as well as revenue. From a service standpoint, we're continuing to put resources in place to be able to accelerate the service off the installed base that we've got in place there. This for us is a big market; it represents about 6% of our revenue and in the field business in APAC it's about 35% to 40% of our APAC business. So obviously a very important market for us.

Can you discuss some of your initiatives to increase recurring revenues, not just in APAC but overall? Your earlier comments on software suggested there are tools available to enhance customer retention. How should we consider the growth of recurring revenue as a proportion of the total?

So in total, when you look at the overall company, service represents a little bit better than 25% of the revenue, and about 60% of that is recurring and how we contract that revenue. A lot of that is supported by software, and so as we've been driving our service strategy, there are a couple of key components. We're making sure we get the right sales force that we're deploying globally. We've made tremendous progress over the last year, year and a half with the sales force getting the right footprint in the key markets that we're looking to grow within, which we've been expanding our footprint. It's a combination of all three. We've been able to achieve our run rate overtime that's roughly been about mid-single digits, and our goal is obviously to continue to grow at the same rate that we're growing installed but also grow with a higher percentage of recurring revenue. So that 60% that we contract that's recurring and then creating more stickiness with the digital solutions that we can deploy that becomes more recurring longer-term with the solutions that we put into place; and that's the overall strategy.

Perfect, thanks George.

Good morning everyone. I have a question about the investments you are currently making. What is the appropriate level of ongoing incremental investment we should consider for the coming years? Last year, it was a 60 basis point headwind to margins, and I believe it's likely closer to half that this year. How much of that can decrease over time, and how much will continue to be an incremental cost each year?

Well, there are two elements that drive that reinvestment. The first is the sales increase that we were adding ahead of the growth actually coming through, and that's been the headwind for the last two years. We are now adding at a rate that is sustainable, so the cost as a percent of revenue now has flattened out. We shouldn't see any additional headwind going forward relative to our sales cost. The other big bucket is our reinvestment in R&D in new products, and as you know, we've been ramping that up over the last three to four years. We're now ending as we get through this year, and we project going forward; we should be able to maintain that level of reinvestment as a percent of product revenues more flat. So we shouldn't see any significant headwind there on a go-forward basis.

Okay, so if we kind of look into 2020, the investments that you've seen over the last couple of years, you'd actually think that would be more kind of flat on a year-over-year basis versus a headwind?

That's correct.

As a percent of revenue, so we'll be spending more dollars, but as a percent of revenue, we won't have the headwind on the EPS bridge.

Right, right, exactly. Okay, and then Brian, just on the debt pay down, what's the average cost of the remaining debt now?

About 97% of that is fixed, and it's at an average rate of just a little bit above 3%.

Okay, great. Thank you.

Operator, I would like to turn the call over to George for some closing comments.

So again, I want to thank everyone for joining our call this morning. As you see, we're pleased with our continued momentum in growth, orders, and backlog. As I mentioned earlier, we are keeping a close eye on the macro environment, but overall our end markets are remaining healthy and our order pipeline is robust. I certainly look forward to seeing many of you soon. So operator, that concludes our call.