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Morningstar | Johnson Controls to Sell Power Solutions for $13.2 Billion; Lowering Our FVE to $46 Per Share. See Updated Analyst Note from 13 Nov 2018

On Nov. 13, Johnson Controls announced it had reached an agreement to sell its power solutions business to a consortium of investors, including Brookfield Business Partners and Caisse de Depot Placement du Quebec, for $13.2 billion, which equates to 7.9 times power solutions' trailing 12-month EBITDA. While the deal multiple is commensurate with the one-year average EV/TTM EBITDA multiple for other automotive suppliers Morningstar covers, we think power solutions' relatively stronger profitability and outsize exposure to the more stable aftermarket warrants a premium over the average auto supplier valuation. In fact, our DCF-driven valuation range for stand-alone power solutions was $16 billion-$20 billion. However, we previously remarked that a sale price at the lower end our valuation range was more likely given power solutions' persistently lower EBITA margins in 2018 as compared with 2017. We think the combination of few logical buyers and management's motivation to sell the business kept our estimate of power solutions' intrinsic value out of Johnson Controls' reach. Furthermore, the institutional investors that will purchase power solutions are not the type of strategic buyers, in our view, that can produce enough deal-related synergies to support a higher valuation.

Johnson Controls expects to receive approximately $11.4 billion net of taxes and other expenses. The $1.1 billion expected tax liability is lower than we anticipated. The firm intends to use $3 billion-$3.5 billion to p ay down debt (maintaining net debt/EBITDA below 2.5 and an investment-grade credit rating). That leaves $7.9 billion-$8.4 billion that could be returned to shareholders.

We decreased our fair value estimate to $46 as we expect the sale to close in fiscal 2019. Johnson Controls' stock traded up about modestly after the announcement but still trades at an over-20% discount to our revised fair value estimate. We don't expect to change our narrow-moat rating for Johnson Controls.

Management noted that everything is on the table in terms of how the firm might use the remaining $8 billion of net sale proceeds; large share repurchase programs, special dividends, and acquisitions will all be considered. Johnson Controls' supplementary "power solutions strategic review" presentation included a chart that considered the EPS effect of using all remaining proceeds to repurchase stock. Excluding power solutions, management's prior fiscal 2019 EPS guidance of $2.90-$3.05 is reduced to $1.65-$1.75; however, that range increases to $2.40-$2.50 if management were to use all remaining proceeds after paying down debt to repurchase stock. We don't expect Johnson Controls to use all of that $8 billion to repurchase shares and instead expect a more balanced allocation of the remaining sale proceeds.

Many investors are probably wondering why Johnson Controls' stock didn't react more favorably to the announcement. We think part of it is that the sale price was in line with market expectations. But beyond that, we think Johnson Controls is still a "show-me story," maybe even more so now that management will be sitting on around $8 billion of excess cash after rightsizing the firm's balance sheet, and exactly how those proceeds will be used is not certain at this point. Aside from capital allocation uncertainties, we think the market has not yet given CEO George Oliver and team enough credit for improving the competitive positioning of the buildings business and for that business' improving fundamentals. As we noted in our Nov. 8 analyst note, Johnson Controls remains on track to achieve its over $1 billion synergy target, and the buildings segment's organic growth has accelerated, and its margins have expanded despite adding 950 heads to the sales team. 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 improves productivity. Power solutions was a more capital-intensive business as compared with buildings, so free cash flow conversion, a metric that has been closely monitored by the investment community, will now be stronger for Johnson Controls as a pure-play buildings technology company. Indeed, CFO Brian Stief noted that free cash flow conversion for the remaining business should be around 95% and could approach 100% if dividends from the Hitachi joint venture mirrored the amount of equity income recorded by Johnson Controls. We think a prudent capital allocation strategy in tandem with a simplified business model that is clearly showing improving fundamentals will help Johnson Controls close the gap between its current stock price and our estimate of its intrinsic value.

During the conference call following the news release, management noted that Johnson Controls' exposure to any power solutions legacy liabilities was relatively minor. CFO Brian Stief remarked that pension obligations, capital leases, asset retirement obligations, and environmental obligations are less than $100 million in aggregate. The company also expects pre-payment penalties related to the early retirement of debt to be less than $100 million.

According to a news release from Brookfield Business Partners (a subsidiary of Brookfield Asset Management), the transaction will be funded with $3 billion of equity (30% from Brookfield, 30% from Caisse de Depot Placement du Quebec and 40% from other institutional partners) and $10.2 billion of long-term debt.