While I understand that Wall Street is a discounting mechanism that looks forward more often than backward, I have a hard time reconciling the confidence that investors have shown in Johnson Controls (JCI) over the past three months with the likely trajectory of performance.
Johnson Controls said many of the right things at its recent analyst day, addressing issues like margin challenges in the automotive and building systems businesses and pointing to a promising future in batteries, but it seems like analysts are much too willing to reward the company with unprecedented operating improvements. A slight beat for the fiscal first quarter is certainly better than another miss, but back-loaded guidance and iffy auto margins leave me hanging on to some skepticism.
Steps Forward, And Back, In Fiscal Q1
Johnson Controls reported basically flat sales for this fiscal first quarter, and that was good enough for a slight beat relative to the average of sell-side estimates. Both automotive (down 1%) and building efficiency (FLAT) slightly outperformed expectations, while the battery business (up 4%) was just shy on 3% shipment growth.
Margins, where I'd argue Johnson Controls has the most work to do and the most to prove, were a bit disappointing. Overall segment EBIT fell by a low teens percentage (13% as reported by the company, or 11% on an adjusted basis), and this was a tiny miss as was the 10bp miss in operating margin (which declined from 5.8%, or 6% reported, to 5.2%).
The auto business was notably weak, with income down 50% and an 80bp margin miss. Income in the battery business fell 1%, but margins were solid (down 80bp from last year, but more than 100bp better than expected). In the building efficiency business, profits leaped 29%, margins improved 70bp, and the margin performance exceeded targets by about 40bp.
Admittedly, a 10bp miss on segment EBIT margin is not normally a big deal at all. In the case of Johnson Controls, though, I think it's important to view it in the context of a company that has long needed to deliver better performance, and where investors have already rewarded the expectation of improving performance. Johnson Controls needs to deliver a few straight quarters of good, clean beats and I'm not sure this really makes the grade.
Autos - Will China Pick Up Where Europe Leaves Off?
As it contributes about half of the company's sales, Johnson Controls absolutely needs better top and bottom-line performance to hit sell-side targets. While U.S. auto production is looking pretty solid for 2013, Europe is most definitely not. Chinese production should help pick up some of the slack (and JCI has good share in China), so investors need to keep a careful eye on this market. Investors may also want to monitor Harman (HAR) and Gentex (GNTX) given JCI's weak performance in auto electronics (down 8% this quarter).
On the margin side, there's a huge amount of work to do. The auto parts industry is a tough one in general, but JCI lags other seating rivals like Lear (LEA), Magna (MGA) and Faurecia by too much in margins to just ignore. The company is taking some logical steps - improving sourcing policies, learning from recent launch mistakes, and restructuring bad programs - but the high single-digit goal the company laid out seems tough to accept given the amount of capacity in the industry and the volume pressures in Europe.
Batteries And Building Hold Potential … But Also Rivals
I'm relatively more positive on Johnson Controls' prospects of better results from its other two businesses. While the stagnant commercial building environment hasn't helped, nor has a reduction in government-sponsored subsidies for energy efficiency, I believe the long-term future for solutions that reduce the environmental impact of buildings is a bright one - whether it's for "fuzzy bunny" environmental reasons in Europe or simply reducing the strain on the power grid in markets like China and India. The key here, though, is whether Johnson Controls can reinvest and stay with/ahead of the likes of Honeywell (HON), Siemens (SI), and so on.
On the battery side, JCI has done well maintaining its place in the auto battery business and introducing new products like absorbent glass mat ((AGM)) batteries for the stop-start market. I was a little disappointed that JCI didn't bid more for the assets and IP of bankrupt A123, but M&A price discipline is hardly a bad thing. With technology as a gating factory, I believe this can be an even higher-margin business down the road.
The Bottom Line
My skepticism on Johnson Controls comes down to the numbers. Although Johnson Controls' near-consistent double-digit returns on invested capital and high single-digit long-term owner earnings growth suggest quality, the company's free cash flow production has always been poor. I realize that free cash flow isn't a flawless metric in isolation (it does tend to punish investing for future growth), but an entire decade of sub-3% free cash flow margins bugs me. More to the point, I think it also creates a very high bar for the company, as many sell-side analysts are blithely predicting fiscal 2014 free cash flow production at a rate not seen in company history, with more growth to follow.
For me, I see a long-term CAGR of about 4-5% on revenue, but much less free cash flow leverage. I believe Johnson Controls' FCF will continue to bump along in the single digits, rising maybe to 5% far down the road. Discounted back, that suggests fair value of about $25. If these analysts are right, though, and JCI's free cash flow production ramps up and ultimately starts approaching the levels of companies like Honeywell, then all bets are off and maybe Johnson Controls shoots through the $30s and into the $40s.
Personally, I don't believe it, and there are too many good companies with strong track records trading at discounts to conservative fair values for me to take a chance on fixer-upper like JCI. Nevertheless, if you're a believer in JCI's vision of a substantially better future for itself, hang on because there's still a tremendous amount of improving to be done.