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Morningstar | Johnson Controls Ends Its Fiscal 2018 With Strong 4Q Results; No Decision Made on Power Solutions

Johnson Controls' fiscal fourth-quarter results continued the company's trend of improving fundamentals. The narrow-moat rated company's organic revenue grew 6% year over year to $8.73 billion, adjusted EBIT margin expanded 10 basis points to 14.0%, and adjusted EPS increased 7% to $0.93. Johnson Controls' fourth-quarter revenue slightly beat Wall Street estimates while its adjusted EBIT margin and adjusted EPS were in line with consensus estimates. Johnson Controls' cash management initiatives have been effective as the firm generated an 88% adjusted free cash flow conversion ratio in 2018, well above management's 80% target. Johnson Controls exited 2018 with a stronger balance sheet, and the firm appears poised for improved financial performance in fiscal 2019.

We were surprised that the firm didn't announce the fate of its power solutions segment. During the earnings call, CEO George Oliver noted that the strategic review is "in the final stages," and the firm is focused on "making the right decision versus keeping to a set time line." Based on multiple media reports, it appears that Johnson Controls is planning on selling the business. While we had hoped for an announcement in tandem with the firm's earnings release, we'd rather Johnson Controls take its time rather than rush a sale, which would give a potential buyer more bargaining power. We're maintaining our $53 per share fair value estimate until a decision regarding power solutions is announced. If a sale is announced for $13 to $14 billion as speculated by the media, our fair value estimate would likely decline to the mid-$40s. Still, based on our valuation work, we believe Johnson Controls' stand-alone buildings business is worth in the low to mid $30s--about where Johnson Controls' stock is currently trading--therefore, the monetization of the power solutions business would be a positive for shareholders, in our view, even if the sale price is below our estimate of power solutions' intrinsic value.

Johnson Controls remains on track to achieve its over $1 billion synergy target. The company realized $257 million of synergies in 2018 versus its $250 million goal. The firm has now achieved over $550 million of synergies since it merged with Tyco in late 2016. The value of these synergies continues to shine through. These cost savings have allowed the firm to invest in 950 additional sales personnel while still improving margins. Indeed, consolidated adjusted EBIT margin expanded 10 basis points year over year (up 50 basis points if foreign currency translation and the Scott Safety divestiture are excluded) to 14%. We expect further margin expansion over the next several years as additional synergies are realized (the firm is still targeting an incremental $550 million in 2019 and 2020), and the recently added sales capacity matures and improves productivity.

Johnson Controls' building technologies and solutions segment reported 8% organic revenue growth as product sales were up 9%, service revenue was up 6%, and installation revenue was up 7%. The field business reported a 9% increase in orders and its $8.4 billion backlog is up 8% year over year. Buildings EBITA margin expanded 10 basis points year over year (up 60 basis points excluding foreign currency translation and the Scott Safety divestiture) to 15.2%. A 120-basis point gain from synergies and favorable volume and mix, were partially offset by the aforementioned salesforce additions (50-basis-point headwind) and a 10-basis-point headwind from other factors.

The power solutions segment reported 2% organic growth as a 5% increase in volume to automakers offset a 2% decline in aftermarket volume. Start-stop unit volume was up 20%. The segment's EBITA margin declined 80 basis points year over year to 19.4% as an 80-basis-point gain from productivity was not enough to offset unfavorable mix, higher transportation costs, incremental investments, and higher lead costs.

Management unveiled its fiscal 2019 guidance that calls for revenue of $33.2 to $33.7 billion, which assumes mid-single-digit organic growth; 50 to 80 basis point EBIT margin expansion; and EPS of $2.90 to $3.05, which, excluding the affect of a higher expected tax rate in 2019 (16% versus 13% in 2018), implies earnings growth of 7% to 13%. We're modeling Johnson Controls to slightly beat the high end of its earnings guidance; however, this guidance will of course drastically change if power solutions is divested.

Johnson Controls announced two notable corporate actions in early October. First, on Oct. 1, Johnson Controls announced a partnership between its energy storage business and Con Edison Solutions. Johnson Controls' director of media relations told the Milwaukee Business Journal that energy storage is a separate unit from the company's building technologies and solutions and power solutions segments. This leads us to believe that Johnson Controls will maintain it interest in the partnership following a divestiture of power solutions. According to a press release from Con Edison Solutions, it will be the majority owner and "exclusive provider of battery energy storage to customers of Johnson Controls." Energy storage is currently a nascent business for Johnson Controls now, and we're hopeful this partnership will help grow this business. On Oct. 2, Johnson Controls announced its acquisition of Lux Products Corporation for an undisclosed price. Lux sells residential thermostats and smart home products, which fits into Johnson Controls' heating, ventilation, and air-conditioning controls business.