Johnson Controls International plc (JCI) — Q4 2020 Transcript

Thanks, Antonella, and good morning everyone. Thank you for joining us on today's call. As the effects and impacts of COVID are still fresh in our minds, I hope you and your families are continuing to stay healthy and safe. Before we get started with the prepared remarks, I wanted to take the time to officially welcome Olivier to the team. Olivier is on the call today and will be actively participating in our guidance discussion and in Q&A. Many of you have already had the opportunity to speak with him briefly at a few of our investor conferences in early September. And if not, we look forward to speaking with many of you over the next several weeks. From my perspective, the transition couldn't be going any better. And it's clear to me that Olivier is already having a positive impact on the organization in his first 10 weeks. As we said at the time of his announcement, Olivier will formally assume the role of CFO immediately following the release of our 10-K in just a few days.

Thanks, George, and good morning, everyone. So let's get started with our year-over-year EPS bridge on Slide 6. As you can see, operations, net of mitigating actions, was an $0.11 headwind. Despite continued volume pressure and some unfavorable mix, freight costs were again positive, and we achieved significant cost savings during the quarter. In total, Q4 benefited from approximately $200 million in mitigating cost actions in response to COVID-19. Ongoing synergy and productivity savings was a $0.04 tailwind as anticipated, and net financing costs were a $0.02 headwind. Our lower share count, given the significant share repurchase activity over the past 12 months, benefited us $0.05. Moving to our segment margin bridge on Slide 7. As I mentioned, despite continued volume pressure across all four segments due to the pandemic, we did remain very disciplined on price in an increasingly competitive environment. As a result, we delivered another quarter of strong gross margin expansion, up 70 basis points year-over-year to 34.3%. With the full quarter of run rate permanent cost savings in Q4 and the incremental benefits from our cost mitigation efforts, we were able to hold decremental margins to 20% at the segment EBITDA level and as planned, 13% at the consolidated EBIT level. Overall, segment EBITDA margin declined 20 basis points on an organic basis to 15.6%. So let's turn to Slide 8 for a look at our segment results in more detail, and my comments will also focus on the segment end-market performance that's included on Slide 9. For North America, revenues declined 6%, with install down 9% and service down 3%. We saw strong retrofit activity, particularly from our enterprise customers requesting solutions to enhance the health and safety of their facilities. However, demand in our conventional installed business related to new construction remains under pressure.

Thanks, Brian. Please turn to Slide 13. As we have come to the end of our original full year integration period, we are at a point now where the difficult work around our internal transformation, portfolio rationalization and leadership changes is now largely complete. While there is always more work to do in an organization of this size, we are very excited about the growth opportunities in front of us. Our portfolio is very well aligned with the strong secular trends, including sustainability and energy efficiency, urbanization in smarter and safer buildings and infrastructure. We are uniquely positioned to serve these trends with a holistic approach that leverages the most comprehensive product portfolio in the industry, combined with the largest installed base and broadest direct channel footprint to enable extensive go-to-market advantages. Our vision for this merger five years ago was to ultimately lead the evolution from managing traditional building systems and becoming an outcome-based solutions provider, supporting more intelligent, connected spaces and places. Given the improvement in our growth and operational fundamentals over the last few years, we are very well positioned to accelerate and leverage our unique competitive advantages. As I mentioned earlier, we have developed three growth priorities, all designed and calibrated around gaining share, scaling OpenBlue, accelerating new product introductions and driving higher service attachment rates and sales growth. At the same time, in some respects enabled by these growth priorities, we will remain focused on driving improved margin performance, attacking the cost structure with the same intensity we have over the last four years. With the steps we've taken to strengthen the balance sheet over the past two years and the improvements we've made to our liquidity position and cash generation capabilities, we are now in a better position to pursue a more balanced but disciplined capital allocation plan. Please turn to Slide 14. The launch of OpenBlue represents the next stage in our journey. Although it is still very early, we have achieved significant success in creating momentum with customers and partners. OpenBlue is immediately compelling to a wide variety of customers looking to connect, plan, and manage space for enhanced security, sustainability, and experiences. This platform addresses a series of solutions for a variety of environments. Worldwide, we saw engagement with a range of customers from one of the largest and most respected real estate developers in Asia to multiple sports venues across the world and everything in between. For example, let's look at universities. We began OpenBlue engagements at Stanford, Brown, Tulane, Kent State, University of Arkansas, and others. Our work with the National University of Singapore demonstrates our deep collaboration with Microsoft, creating a living laboratory for a new breed of customizable, contact-free applications built on Johnson Controls' unifying digital technology suite, OpenBlue. From a technology perspective, I mentioned our collaboration with Microsoft. We've also begun new work with a portfolio of technology companies including Accenture, Cisco, and Intel. OpenBlue is also fueling some of the most ambitious projects in the world such as BEA and the next World Cup. Over the last several months, we have had numerous releases under OpenBlue. For example, in August, we launched our comprehensive suite of digital solutions under the OpenBlue Healthy Buildings label, bringing together intelligent, connected hardware, software-based analytics in dashboards, as well as mobile applications aimed at accelerating building occupancy by instilling confidence and assisting in the management of COVID-19 risk. We remain focused on creating the world's best technologies and are proud that we received over 600 patents, and we earned the highly coveted ISA, Secured Development Life Cycle Assurance Certification, the highest standard in product security. Let's turn now to Slide 15. As we have mentioned to many of you over the last few months, one of the biggest benefits of OpenBlue will be our ability to tailor our service offerings to individual customers based on their unique needs. This platform enhances lead generation; improves attachment rates; increases average revenue per user; and over time, should sustainably accelerate our service growth rate by 2 to 3 percentage points with a very attractive margin profile. In late September, we launched a new flexible tiered service offering powered by OpenBlue, which increases our capabilities around real-time remote service and monitoring, as well as predictive analytics. Lastly, turning to Slide 16. Demand for indoor air quality and healthy building solutions remain a key focus area. And we have seen significant uptick in interest from our customers since the beginning of the pandemic. For example, year-to-date sales of our YORK MERV 13 filters are up over 400% year-over-year. Our second half residential indoor air quality products were up 84% year-over-year. And in most cases, the revenue dollars for any one of these products individually are smaller, but in aggregate, have been enough to partially offset some of the weakness we are seeing. In addition to some of our core offerings that have always served these markets, we have also rapidly innovated or redeveloped several new products for customized applications. I won't spend time on each one listed on this page, but this collection represents why we believe we are uniquely positioned to fulfill the different customer needs regarding healthy buildings. This focus on targeted innovation is one facet of our goal to accelerating new product introductions. Over the next three years, we expect to gain significant share and plan to launch over 150 new products in fiscal '21 alone. With that, I would now like to turn things over to Olivier to provide you with his initial impressions and our thoughts on fiscal '21.

Thank you, George, and good morning, everyone. I'm pleased to be with you on the call today, and I'm thrilled to be part of the Johnson Controls team. I've been in the office for about 10 weeks now and have fully immersed myself in learning the business and, with the help of Brian and the finance team, understanding the strengths and opportunities we have in front of us as an organization. I cannot thank Brian enough for his guidance and alliance through this transition. I thought I might quickly share with you my initial impressions and perspective, before I get into our forward outlook. I've been asked by some of you why I was drawn to this role at Johnson Controls, and I would tell you there were a number of reasons. From a personnel standpoint, how we do things is incredibly important to me. I wanted to be part of an organization where culture, diversity, and inclusion matter. We are focused on the environment and developing people, where meritocracy matters. I'm impressed by what the team has achieved over the last two years, its strategic vision, and the operational discipline that has been established. I also recognize there is still work to be done, particularly around optimizing the cost structure of our business model. I am very positive about the growth opportunities of the end markets we serve, smart, safe, healthy buildings, and by our vision around services, digital, and product innovation. Finally, I'm excited about the ability we have to drive above-market growth with best-in-class margins. That seems like a natural point to transition to our outlook, starting on Slide 17. I mentioned my optimism about our served markets, and I think this depiction of our business mix shows a very balanced revenue profile, roughly split one-third each for products, install, and service. We have one of the largest installed bases of buildings globally with an unmatched direct channel footprint, both of which we can leverage to generate very attractive service opportunities. As George mentioned, service powered by OpenBlue is expected to be an attractive vector of profitable growth for the Company. Looking at our installation portfolio, we are roughly evenly split between new construction and renovation retrofit, although many parts of this business remain challenged by the effects of the ongoing pandemic. Our portfolio of LC building solutions and retrofit activity can moderate the weakness in new builds. Turning to Slide 18. This slide provides our end-market exposure as well as a few economic indicators on the fiscal year basis we utilize as an input to our planning process. Construction outlook is a barometer for the new construction portion of our installation business in North America, which is about 15% of our total sales. GDP tends to be the barometer for service market growth. As the market forecast indicates, the global macro environment remains uncertain. However, given the attractiveness of our portfolio and the elements of our go-forward growth strategy George discussed, we feel very confident that we are positioned to outgrow our end markets. Now let's turn to Slide 19 with our views of fiscal '21 and our Q1 guidance. Current forecast for market recovery suggests a stronger second half of the year. We will continue to manage costs over the course of the year, keeping tight controls on the amount and timing of temporary cost reversals as volumes continue to normalize. We also have the carryover benefits from the permanent cost actions we took in the back half, which will partially offset the return of temporary costs. This, along with our focus on higher-margin revenue growth, is expected to result in ongoing EBIT margin expansion. Regardless of the presidential election outcome, we are very confident in our ability to maintain a 13.5% tax rate in fiscal '21. Free cash flow on a reported basis will approximate 95% for the full year and should follow a fairly normal cadence, with the majority of our cash being generated in the back half, in line with our traditional cash flow seasonality. With the majority of the large cash adjustments now being behind us, we are transitioning to an unadjusted cash flow metric. As part of our disciplined capital allocation, we expect to deploy the remaining $1 billion of proceeds from the Power Solutions sale to share repurchases. Now for our Q1 guidance, we expect to start the year off with organic sales decline in the range of 5% to 7%. The continued focus on the cost side will allow us to expand our EBIT margin by 20 to 40 basis points, and EPS should be in the range of $0.39 to $0.41. Overall, continued strong performance in a challenging environment. With that, operator, we can open the line for questions.

To begin with the forward outlook and guidance, we believe that many companies will likely continue to suspend their annual guidance. However, you have provided sufficient data regarding free cash flow and its conversion implications for EPS. To confirm our calculations, we are estimating a range of $2.45 to $2.50, which aligns with consensus. I want to verify that our math is correct. Is the ongoing heightened uncertainty the reason you have not yet provided official guidance?

So let me give you a bit of color before answering specifically to your question. We have, as you sense from the call, very confident about the position of the Company, and we believe we're going to be able to navigate this uncertain environment as we did last year. Now, as you alluded to, at this point in time, there was a lot of uncertainty regarding what is happening in the pandemic. We have had, particularly over the last few weeks, additional lockdowns and restrictions in Europe, and we have a second wave in the U.S. So in this context, we believe we have a solid plan. We have momentum building, and we'll be agile. As you said, we have stress-tested our plan, and we believe that despite the uncertain environment, we're going to be able to deliver very good EBIT margin expansion and strong cash flow performance. Now let me answer your question specifically. Based upon the current market trajectory and all of that is still a bit unknown regarding where that would go, we were looking at organic revenue growth in the low to mid-single digits range. Our salesforce today is targeting growth parts of the market, focusing on indoor quality and LC buildings, and in verticals such as data centers, warehouses, and institutions. And as George indicated, we're investing heavily in new product launches. Now if you look at your EPS range today, we believe it's not an unrealistic expectation.

That's really helpful. I appreciate all the updates on OpenBlue. Several of your HVAC competitors have started providing some insight into what the indoor air quality market might look like. I was hoping you could provide more details. You mentioned that filtration orders are increasing, but could you clarify what the overall market opportunity looks like? We're starting to see some activity in the retrofit business in North America, and I would like you to highlight that opportunity as it currently stands.

Deane, let me just kind of frame up what we're doing on indoor air quality, how important it is, and then I'll kind of frame up what we see here within the pipeline. So I would start by saying it's clear that this is front and center with all of our customer engagement. So the education that has been had around air quality and the impact that has in mitigating the impact of the virus is certainly front and center. Now there are many critical elements to delivering clean air. It includes ventilation, filtration, disinfection, and then isolation. It's also combined with sensors around temperature, humidity, occupancy, and ultimately ties to building controls. Our clean air strategy has been focused on finding the right balance between air quality as well as energy efficiency. It's based on science, backed by recommendations on clean air delivery rate, which is ultimately clean air changes per hour. We're performing a number of assessments at starting points to align our solutions and services to each customer's application and ultimately, their clean air delivery rate target. We're not simply making product recommendations, and there's really no one better positioned now to be able to help our customers operate healthy, safe buildings. It really is built on the combination of our HVAC portfolio with our security and building software platforms that uniquely enable us to provide more powerful solutions based on specific customer outcomes. In addition to that, Deane, we've got over 16,000 service experts around the globe, which is the size and strength of our direct channel footprint, which we believe creates a significant competitive advantage. As we look at this today, with all of this activity right from assessments to deploying capabilities, we're looking at a pipeline of a couple of hundred million dollars for 2021. Long-term, we think the focus on clean air and striking the right balance between proper ventilation, filtration, disinfection, and energy efficiency will ultimately lead to increased service activity, system replacements, and other emerging solutions. We think clean air, the market itself is multibillions of dollars in incremental market. With that, not only our strong position, but we've been expanding our partnerships to be able to accelerate our penetration in our go-to-market.

Best of luck, Brian. Two for me. First, George, and this maybe picks up a little bit on what you were talking about. But you were kind of talking about OpenBlue adding one to two points to your sales growth, and now you're saying two to three. Your confidence level is clear in your voice this morning, but interesting that you're already thinking a higher number before we're too far into this. So I just wonder if you could elaborate a little bit more on your thinking around that incremental growth rate and how the customer conversations are going.

Yes. Let me start, Jeff, by talking about the strength of our OpenBlue platform. For everyone on the call, it is a complete suite of connected solutions that enables the delivery of more impactful sustainability, new occupant experiences, and enhanced safety and security. This does combine our long-standing expertise in buildings with cutting-edge technology. It enables us, along with our customers and partners, to fundamentally transform how spaces and places are experienced, making them safe and protected. It combines everything that we do in a building and, through leveraging connectivity and data, allows us to create new outcomes. We truly believe that this differentiates what we do through our direct channel footprint with the significant installed base of equipment and service we have today, and we can amplify this now with digital solutions. Let me talk a little bit about the progress we've made in the last 90 days, as I said in my prepared remarks, we've had significant engagement, right from the start. We've kept the momentum going with the release of several new solutions, including OpenBlue Workplace, new tiered flexible service offerings under OpenBlue, OpenBlue Enterprise. Many, many more are coming over the next several months, including five that are planned in the first quarter. Let me move to customers. When you look at the customer wins, we're very excited. One example I talked about was one of the largest real estate developers in Asia, a leader in facility management. They ultimately selected our OpenBlue enterprise manager solution, which is a software solution that helps customers manage large portfolios of properties. They've now deployed that across 42 of their buildings in Singapore. We're embedding OpenBlue in everything we do and enhancing our go-to-market strategy. Our multiyear pipeline is well over $1 billion of opportunity when you consider what OpenBlue does, not only as a stand-alone but how that combines with our core capabilities in how we go to market. We have supported that with partnerships with Microsoft, Accenture, Cisco, and Intel. These partnerships are integral on many levels to ultimately deliver a complete outcome-based solution that our customers are asking for.

Just on the cost headwinds and tailwinds, you gave a very explicit table and chart on the Q3 call. I'm wondering if all those numbers are basically the same, the $240 million to $260 million tail on permanent and kind of what you gave us on the temporary. And I guess whether the answer is yes or no, can you give us a little bit of color on how these kind of feather in and out over the course of this year?

So Jeff, before I answer the specifics of your questions, we have said that in the past, but we want to repeat it because it's very important. We believe we have the opportunity to improve the return on sales of our business going forward. We believe we have opportunities in both gross margin and OpEx management. If you look at the prepared remarks from Brian, improving the margin rate by about one full point year-on-year last year despite the environment was remarkable. That says a lot about the execution discipline of the Company. We have done some modeling lately and believe that the 30% incremental is an achievable and required goal for the Company. Now to answer specifically to your question, the net $40 million that Brian mentioned before is still valid. We would expect those costs to come back mainly in the second half of the year. So we believe that it's the best way to plan for those costs. We're still looking at levers to mitigate those costs, but it's too early for us to commit, Jeff, at this stage.

Just wanted to come on the back of Jeff's question there. Obviously, the temporary costs are coming in towards the back end of the year. The structural costs, is that more linear through the year? Or are we seeing some of those coming through in the 1Q guide?

So at the moment, for the first half of the year, we have a net benefit to the P&L when you look, Nigel, at the permanent and temporary costs coming back. The headwind will come in the second half, and more in the Q3 fiscal quarter, Nigel.

Great. And then obviously, the service kind of acceleration is really encouraging and also a $1 billion pipeline. Is that $1 billion, that funnel, has that been built since you sort of soft launched OpenBlue? I think it was mid-2000. I can't exactly remember the date, but I think in the last seven months, has that all been built in that time frame? Do you have any indication on the sort of the timeline to the service revenue acceleration?

Yes. Let me go back, Nigel, to the pipeline. That pipeline is when we do, as we're doing installations and now taking our digital capabilities with OpenBlue and combining that with our core capabilities and ultimately then deploying that as a solution. So that isn't just service; it is ultimately creating a much bigger installed base with our digital capabilities that will then spin off services from that. What I talked about there with the digital blue pipeline. As far as the services, what we get with OpenBlue, it allows us to not only differentiate the core of what we do with our services, making everything connected, utilizing data to optimize our delivery of service and then adding new services on top of that. OpenBlue enhances our ability to be able to attach service contracts. We're starting to see a nice pickup in our contractual services, and that will continue to improve as we go forward. From a revenue per customer standpoint, it ultimately allows us to build on that base of service, add new capabilities, and deliver enhanced value, which we ultimately get paid for. It's really about expanding our installed base with OpenBlue and then mining that installed base with additional services on a recurring basis.

Just curious, how much does one of the big differentiators versus you guys in your HVAC equipment peers, at least, is your control system, the kind of Metasys platform. Maybe that brand has changed. But how much of a differentiator is having that controls legacy, if you will, the building controls legacy over and above the kind of HVAC and Fire & Security?

Yes, Steve, let me just start by talking about commercial HVAC and the importance of not only the equipment but also the digital capabilities. When we look at these markets, they're very attractive with long-term secular drivers that ultimately align with our core capabilities in both equipment and digital. The secular trends of energy efficiency and sustainability enable us to mine a much larger installed base with the connectivity of our digital offerings. The ability to take a holistic solution with our equipment plus our digital platforms, which includes Metasys and connects every device and system within a building, gives us a competitive advantage. We'll continue to differentiate what we install and also how we capitalize on the service opportunity, which will contribute to accelerating our service growth.

The control system is crucial. Additionally, you acquired a joint venture, and the cash flow statement indicates some activities there. Was there any impact on the profit and loss statement from that? Some companies report gains on their ownership when they acquire joint ventures. Did that occur in this case?

Steve, that was related to the buyout of Qolsys. We had a majority interest in Qolsys already, and we bought out, during the quarter, the remaining 42% of those shares. So the activity that you're referring to was an entity that we historically have consolidated, so there was no unique P&L in Q4 related to that.

I had a couple of questions, George, maybe if you could elaborate on the IAQ opportunity. Carrier had talked about it at like $9 billion to $10 billion in aggregate. I wondered if you would agree with that assessment. Secondly, maybe if you can talk about whether you think IAQ sort of becomes a table stakes for some of these commercial building operators, because it seems like there is a conflict between energy draw going up when you utilize some of these solutions and what has been the compelling case to renew applied systems, which is the energy consumption drops with the new technology. Just how you kind of frame that. Do you think it's table stakes? Do you think it's kind of a short-term blip while we have COVID and then maybe you revert back or just your opinion on that topic?

Yes. When we talk about indoor air quality as part of the market, and so you've seen numbers from Navigant where there's about 1.7 trillion square footage, and about a quarter of that is ultimately non-residential space. Today's level of air purification is well below what is now perceived as acceptable in this environment. So, as I talked about, there is a key element of providing the right solution. It includes maintaining or maximizing the ventilation, bringing the highest level of filtration, like MERV 8 to MERV 13, deploying potential disinfection technologies, and isolation in healthcare. What we do is provide the best solution to achieve what we call the clean air delivery rate, which is clean air changes per hour while optimizing the energy required to perform that outcome. We work to provide a higher standard while delivering on the sustainability goals of our customers.

I just wanted to focus a little bit on the first quarter guidance. It looks like you guys are kind of projecting organic revenue decline similar to what you saw in Q4. Just curious if that reflects kind of stabilization in organic trends throughout the quarter or if you did see improvement into the later parts of the quarter and into October?

So Nicole, we are seeing today, you're right, a gradual improvement in our business environment, both for our field business and our global product segment. If you look at our order book, and I'm not talking about revenue for now, we'll give you the specifics in a second. Orders velocity for our field business are sequentially better by one or two points relative to Q4. You have our installed business, which is booked now, but the orders were recorded about two quarters ago. Thus, you're seeing this installed business because of this lag, being still down. As George mentioned, there is an acceleration in our service business, which is largely offsetting what's happening in installed. For our Global Products, again, we see today that we are gaining shares in the product we sell.

Got it. That's really helpful and then maybe just a follow-up also on the first quarter. When we think about the 20 to 40 bps of expected margin improvement, can you just talk about any divergences between the segments? I know global products faced some unique challenges this quarter. Does that continue into the first quarter? And anything on the field businesses that we should make sure we think about?

We believe that without going into too much detail, we will still see some negative impact on our Global Products business for two reasons: one, exception of fixed costs and two, product mix, while our field business is keeping its momentum from a margin improvement standpoint.

A couple of questions. But first, George, is M&A still a possibility in 2021?

Yes. Absolutely, we're going to be very disciplined. As we look at our capabilities and enhance some of our positions in technology and as we build out OpenBlue, there are opportunities we're going to pursue and have been pursuing. We've done some in the past year, some bolt-ons like the acquisition of Qolsys, which has helped us from an interactive technology capability that we're leveraging more broadly. M&A will be part of our capital deployment going forward.

Okay. And then on OpenBlue, George, and I know there's been a ton of questions, but just to clarify. When you do an install, I imagine there's a fair amount of upfront customization. Do you charge for that? Or is that part of the SaaS pricing you expect over time to have perhaps a breakeven period and then a more profitable period after that? Is that a way to think about it?

Yes. When you think about our installed business today, it is an applied business where we apply engineering. We configure solutions, we deploy those solutions with install, and ultimately, we look to attach and get the life cycle service. Today, we incur a lot of engineering upfront before we ultimately get a contract, and then we take the contract and continue to pursue that. OpenBlue changes the level of engagement with our customers significantly. With OpenBlue, we can change the outcomes we provide with the installations or solutions proposed. That is incremental to what we historically would have done and certainly get paid for that upfront, with the ability now to attach recurring revenue onto that service over time.

Yes. Just to wrap up here, I want to thank everyone again for joining us this morning. I'm incredibly proud of how our teams responded during the global pandemic and the progress that we've made as an organization. I'm extremely pleased with our continued strong performance and very excited about the future opportunities which we discussed today. I hope that you and your families remain safe, and I look forward to speaking with many of you soon. So operator, that concludes our call.