Johnson Controls: How to Overcome Trends in Cyclical Buildings Segment

Johnson Controls International (JCI) was established in 1885 to manufacture, install and service automatic temperature regulation systems for buildings. The company offers a global diversified technology and industrial solutions. JCI provides air conditioning, heating systems, industrial refrigeration products, HVAC controls, fire safety, security, and building management solutions. JCI has operations in approximately 60 countries and employs around 121,000 people (about 44,000 in the US, and 77,000 outside the US). The company reported USD 30.2 billion revenue and USD 3.2 billion operating income as of September 30, 2017.

JCI operates two distinct operations; building technologies and solutions, and power solutions.

Overview

The company completely reorganized its businesses in 2016 and 2017 fiscal years. In September 2016, Johnson Controls merged with Tyco. This acquisition is expected to create a less cyclical business. Tyco acquisition also increases fire, security and HVAC service capabilities. In October 2016, JCI completed the spin-off of its automotive experience business with transferring shares to Adient. In October 2017, the company sold its Scott Safety business to 3M for approximately USD 2 billion. In October 2015, JCI formed a joint venture with Hitachi to expand its building technologies and solutions operations. As of March 2017, the joint venture generated approximately USD 2.2 billion revenue and USD 175 million EBITDA. These acquisitions and divestitures provide synergies, efficient production and increased market penetration.

Building technologies and solutions provide fire-detection, security systems, and services. The sales of the segment are mostly generated through distributors of residential air conditioning and heating systems, industrial refrigeration products, security products, anti-theft devices, fire detection systems. In 2017, the segment generates 76% of the company’s total sales, and around 27% of its sales originated from service revenues.

Power solutions supply aftermarket batteries to large merchants. JCI use private labels and large battery brand names for auto batteries, and automobile manufacturers use as original equipment. JCI is the largest producer of lead-acid automotive batteries in the world, producing and distributing approximately 154 million lead-acid batteries annually in 17 countries worldwide. The segment accounted for the remaining 24% of the company’s sales. Nearly 75% of unit sales were aftermarket sales, and the remaining revenue is from original equipment market.

JCI’s chairman and CEO of George Oliver succeeded the role of chairman and CEO from Alex Molinaroli. Mr. Oliver was CEO of Tyco, stand-alone fire and security business during the acquisition process of the two companies. After that, he took key roles in the integration of Johnson Controls and Tyco.

According to his interview with Journal Sentiment, Mr. Oliver said that one of his priorities is to create clarity for the company and its products. JCI’s acquisitions and divestitures currently appear to be in line with Mr. Oliver’s clarity strategy.

Building technologies and solutions provide fire-detection, security systems, and services. In 2017, the segment generates 76% of the company’s total sales, and around 27% of its sales originated from service revenues. Power solutions use private labels and large battery brand names for auto batteries, and automobile manufacturers use as original equipment. JCI is the largest producer of lead-acid automotive batteries in the world, producing and distributing approximately 154 million lead-acid batteries annually in 17 countries worldwide.

Investment Characteristics

JCI’s gross profit is increased to 31% from 16% in the 2014-2017 period with help of spinning off and acquisition activities. The financial history of pre-merged and divided company is less suitable than that has not had this kind of financial engineering measures. The company’s debt-to-equity levels are high 50% to low 60%, showing a relatively stable trend in the 2015-2017 period. However, the company’s long-term debt levels are accumulating to 24% in the balance sheet, which may indicate a minor risk of credit or a solvency risk. Also, decelerating interest coverage of 6.5 supports the interest risk. Johnson Controls has interest expense-to-debt ratio of approximately 3.5% in the current period, indicating that the debt levels are priced in an acceptable range.

The company’s operating margin is increased to 10.5% from 7% in 2017. JCI’s accelerating revenues and relatively stable sales, general and administrative expenses result in the improving trend of operating margin. Management assesses the performance of its business units based on EBITA (income from continuing operations before income taxes and noncontrolling interests, without amortization of intangible assets, interest expenses, impairments). The building technologies segment has approximately 61% revenue and 98% EBITA increase in the current period. Johnson Controls denoted that the main increase was due to one-time purchase accounting adjustment of Tyco merger. The power solutions segment has nearly 10% revenue and 7.5% EBITA surge in 2017. JCI’s annual report states that sales increased due to favorable pricing and growing battery volumes in China and lower selling, general and administrative expenses help to improve the segment’s ratios.

The company’s 3-year average revenue growth rate in 2017 is approximately –8% due to recent divestitures. However, the 3-year average operating margin is around 14%. On the other hand, the revenue growth and operating margin levels are positively correlated and improving in recent periods.

Johnson Controls' long-term debt levels are accumulating to 24% in the balance sheet, which may indicate a minor risk of credit or a solvency risk. JCI's accelerating revenues and relatively stable sales, general and administrative expenses result in the improving trend of operating margin.

Valuation

Our fair value estimate for Johnson Controls is USD 48.00 per share. JCI is one of the leaders in power solutions and has an opportunity to deliberately is its growth and EBITDA margins in the future. The divestiture of power solutions may create possible additional value for the company. Johnson Controls has generated more than 75% of its revenue from building technologies and solutions. According to Clarivate Analytics Top 100 Global Innovators list, the company ranks three times consecutively among the most innovative companies in the world. Johnson Controls’ research and development spending for energy-efficient and smart city integrations may increase competitiveness in the industry. The company has 44.80% revenue growth in 2017; however, JCI’s one-time purchase accounting adjustment affected the current rate. We are being conservatively hedged side and used 3.5% revenue growth rate as opposed to Wall Street analysts’ higher growth rate estimates. We gradually decelerated the growth rate to approximately 2% over the long-run in our estimates. Our EBITDA margin estimates are about in 12% to 14% range due to the company’s estimates of USD 1.2 billion of merger-related cost-saving and cross-selling strategies. Still, we keep the conservative assessment because merger-related targets may not be realized as we experienced previous acquisition events, even the company has successful merging activities in its history. Our expected enterprise value is approximately 20% higher than the current levels. The company’s expected enterprise value-to-sales ratio is 4.29.

Risks to consider

The company expects to benefit from operational and general and administrative cost synergies and calculates approximately USD 1.2 billion cost-synergies due to Tyco merger. However, JCI needs to reach the expected savings without negative future growth and revenues. If the company fails to reach its cost-saving target, JCI’s value may materially decline. The company generating approximately 76% of its revenue from the building solutions segment. The building solutions segment reflecting relatively cyclical trends comparing to the power solutions segment. The building solutions producing cyclical products of HVAC, security products, and fire detection systems, which heavily rely on general economic conditions. Also, declines in real estate values could lead reduction of new construction demand.

If the company fails to reach its cost-saving target, JCI’s value may materially decline. The building solutions segment reflecting relatively cyclical trends comparing to the power solutions segment.

Other considerations

Johnson Controls headquartered in Cork, Ireland and is treated as non-US corporation for tax purposes. However, the US government’s current protectionist approach may affect the company’s tax status. The government may link the Tyco’s former subsidiaries as the US company in the future. Currently, this risk may seem remote; however, this type of risk may have a material impact on future financial statements.

As company denoted in its annual report, Johnson Controls has most of its 44% revenue increase due to one-time purchase accounting adjustment. However, key executive compensations are increased by 194%. The former CEO and chairman, Alex Molinaroli’s compensation package help to increase the total remuneration levels, but the total compensation increase is still relatively high.

Conclusion

JCI and its peers graph as of July 2018
Source: Yahoo! Finance

High dividend yields, expected stable growth rates and decelerated and relatively constant current price-to-earnings ratio indicate that the company has shown value characteristics. Also, the size of JCI implies large-cap investment. Johnson Controls has its highest share price of more than USD 45 per share in November 2016 due to the high expectations from the Tyco merger. The current declining trend of the share price may represent buying opportunities to investors. We think investors need to consider current economic uncertainty in construction and risks of cost-saving synergies in their decision process.

Disclosure: I do not have any of the securities mentioned above. This article expresses my own views, and I wrote the article by myself. I am not receiving compensation for it. I have no business relationship with any company whose security is mentioned in this article.

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Covers investment, financial analysis and related financial market issues for BrightHedge. He has extensive experience in portfolio management, business consulting, risk management, and accounting areas.

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The investment information, comments and recommendations contained herein are not subject to investment advice. The comments and recommendations contained herein are based on personal views. These views may not fit your financial situation and your risk and return preferences. For this reason, based only on the information contained herein, investment decisions may not have the appropriate outcome.