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Morningstar | Johnson Controls' Fundamentals Continue to Improve; Large Share Repurchase Program Looming

We're maintaining our $46 fair value estimate after Johnson Controls' fiscal first-quarter earnings release. Johnson Controls' trend of strong organic growth and improving margins continued during the quarter. As a reminder, Johnson Controls announced the sale of its power solutions business in November; therefore, that segment will be reported as a discontinued operation until the sale is finalized, which management expects will occur by the end of June. Johnson Controls' continuing operations, which consists of its building technologies and solutions business, increased revenue 3% (6% organic) year over year to $5.5 billion, which missed Wall Street's expectations by a mere $8 million. However, adjusted EPS from continuing operations of $0.26 (up 24% year over year) beat the consensus estimate by $0.01.

Global demand for Johnson Controls' products and services remained strong during the quarter. The firm's global products business increased organic sales 7% year over year, with strong demand for residential, light commercial, and applied heating, ventilation, and air conditioning products more than offsetting a decline in industrial refrigeration sales. Johnson Controls' field business grew organic revenue 5% and enjoyed a 7% increase in organic orders during the quarter, which helped push the backlog 7% higher to $8.5 billion.

Adjusted EBIT margin expanded 50 basis points year over year to 7.3% as continued synergy realization, favorable volume and mix, and corporate cost containment more than offset investment spending, pension-related expenses, and slightly higher amortization.

The power solutions sale should net the firm approximately $8 billion of cash after the firm uses $3 billion to $3.5 billion to reduce its debt load. During the earnings call, it was clear that management intends to use the remaining cash to repurchase shares. At Johnson Controls' current stock price ($33.25), the firm would be able to repurchase approximately 240 million shares.

When Johnson Controls announced the power solutions sale in November, the firm provided 2019 pro forma EPS from continuing operations guidance of $1.65 to $1.75. Management now expects to outperform its previous guidance, raising the range to $1.75 to $1.85. Johnson Controls' ability to realize cost synergies following the Tyco merger is critical to our investment thesis, and the firm's synergy realization continues to play out like we expected. In 2019, management expects to realize an incremental $200 million of cost and productivity synergies, which will add $0.19 to the bottom line.

Johnson Controls' free cash flow conversion was poor in the quarters following the consummation of the Tyco merger; however, as we noted in our May 2018 report, "Can a Power-Less Johnson Controls Unlock Shareholder Value?," we saw the firm's underwhelming free cash flow conversion as mostly the result of integration-related disruptions and one-time cash outflows that were not indicative of any structural issues with the business model. If 2019 turns out like management expects, Johnson Controls cash flow woes could be a thing of the past. Indeed, management expects the firm to achieve an adjusted free cash flow conversion of approximately 95% in 2019 versus 88% in 2018. During the earnings call, CFO Brian Stief noted that the company will continue to focus on optimizing its working capital in an effort to improve free cash flow conversion to 100% or better.