EUR 850.00 For Business Accounts Only

Morningstar | Organic Revenue Growth Picks Up for Johnson Controls; Buildings Segment Drives 3Q Margin Expansion

Narrow-moat Johnson Controls turned in another solid quarter highlighted by accelerating organic revenue growth and continued margin expansion. We remain confident that our investment thesis will continue to play out. Johnson Controls' stock has persistently traded at an unwarranted discount to close peers, in our view, because the market has been unable to see the forest for the trees. That is, near-term noise related to the integration of the Tyco merger has overshadowed Johnson Controls' improving fundamentals and future potential. We strongly believe that Johnson Controls is one of the best-positioned firms within commercial buildings technology, offering a one-stop shop for HVAC, refrigeration, building automation and controls, and fire and security products and services. We've maintained our $53 per share fair value estimate.

Sales grew 6% organically to $8.1 billion, which was 2% above the consensus estimate. Adjusted EBIT margin expanded 10 basis points to 13.1%, and GAAP EBIT margin expanded 150 basis points to 12.5%. Adjusted EPS increased 14% year over year to $0.81, beating the consensus estimate by $0.02. Based on data from Capital IQ, Johnson Controls has now beat consensus revenue and EPS estimates for four consecutive quarters.

In early March, the company disclosed it was exploring strategic alternatives for its power solutions business. Management now expects to announce a decision by the firm's fiscal fourth-quarter earnings release, which will likely be in early November (for a September year-end).

The buildings segment, which will be Johnson Controls' sole business if it divests power solutions, reported 5% organic revenue growth as product revenue was up 7% and field revenue was up 4%, driven by a 5% increase in service revenue. Buildings adjusted EBITA margin was up 20 basis points to 15.2%, but up 70 basis points excluding the divested Scott Safety business and foreign currency exchange.

The buildings segment appears well positioned for continued growth into 2019. Order growth has been accelerating, organic field orders were up 8% year over year during the quarter versus up 7% last quarter, and up 5% during the first quarter. The backlog stands at $8.5 billion, up 7% on an organic basis. Johnson Controls' realization of Tyco-related synergies continues to support margin improvement for the buildings segment. As previously noted, excluding the contribution from the divested Scott Safety business in the year-ago quarter, as well as foreign currency exchange, buildings' adjusted EBITA margin expanded 70 basis points year over year entirely because of synergies and productivity gains as 60 basis points of margin improvement from favorable volume and product mix was offset by investments in the business, such as significant salesforce head count additions. In our view, this quarter was a prime example of how beneficial these synergies can be. Indeed, the buildings segment was able to show margin expansion despite reinvesting for growth. We've long told investors that we believe the buildings segment can continue to expand margins while peers struggle to do the same. Case in point, Ingersoll Rand's climate segment reported flat adjusted operating margin relative to the year-ago quarter despite strong top-line growth, and United Technologies' climate, controls, and security segment saw an 80-basis-point year-over-year decline in adjusted operating margin.

After reporting a 2% year-over-year decline in organic revenue last quarter, power solutions' fiscal third-quarter organic revenue growth improved significantly, up 10% year over year due to higher volumes, better pricing, and favorable product mix. Volumes sold to automakers was up 6% year over year, and aftermarket volume was also up 6%. Unfortunately, unfavorable foreign currency exchange, higher lead and freight costs, and investments prevented power solutions from realizing any operating leverage, and segment EBITA margin contracted 200 basis points year over year to 16.9%. Excluding the impact of lead and foreign currency exchange, segment EBITA margin contracted 50 basis points. As a reminder, the power solutions segment passes through lead costs to customers, but the time lag in doing so can cause margin volatility.

Only July 25, Bloomberg reported that several private equity firms are in final discussions with Johnson Controls to purchase the firm's power solutions segment. The report named Apollo Global Management, Brookfield Asset Management, Clayton, Dubilier & Rice, and a consortium consisting of Onex Corp. and the Canada Pension Plan Investment Board as potential acquirers. The Bloomberg report also noted that the deal "could fetch more than $12 billion in a sale, according to people familiar with the matter." However, we're hopeful that if power solutions is sold, its purchase price is considerably more than $12 billion. As we noted in our May report "Can a Power-Less Johnson Controls Unlock Shareholder Value?" we value power solutions' enterprise value at approximately $19 billion, but we think $16 billion-$20 billion is a reasonable valuation range for the business. Given that power solutions' adjusted EBITA margins have been persistently lower this year relative to last year, due in part to higher lead and transportation costs, the lower end of our valuation range may be a more likely outcome than the higher end of the range if power solutions is indeed sold.

Johnson Controls bears have pointed to the firm's free cash flow conversion as a cause for concern. However, our analysis shows that one-time cash outlays related to the Tyco merger and Adient spin-off are mostly to blame for weak free cash flow conversion. We continue to believe that Johnson Controls' true free cash flow conversion potential will shine through as integration charges abate. Fortunately, fewer one-time charges are flowing through Johnson Controls' net income and free cash flow. Indeed, during the fiscal third quarter, Johnson Controls reported only a $0.03 adjustment to EPS versus $0.12 during the year-ago quarter. Furthermore, year-to-date, Johnson Controls has generated $0.5 billion of free cash flow (defined as operating cash flow less capital expenditures) this year versus a $2.3 billion outflow last year. On an adjusted basis, which excludes one-time items, year-to-date free cash flow stands at approximately $1 billion versus $0.2 billion last year. Management still expects to achieve an adjusted free cash flow conversion rate of at least 80% this year. If the powers solutions segment is divested, we think the remaining buildings segment can sustainably convert at least 90% of its earnings into free cash flow.

In terms of fiscal 2018 guidance, management now expects full-year revenue of about $31.3 billion versus previous guidance of $31 billion-$31.5 billion, and adjusted EPS of $2.80-$2.82 versus $2.75-$2.85 previously.