Johnson Controls' CEO Discusses Q2 2013 Results - Earnings Call Transcript

Apr.23.13 | About: Johnson Controls, (JCI)

Johnson Controls, Inc. (NYSE:JCI)

Q2 2013 Earnings Conference Call

April 23, 2013 11:00 AM ET

Executives

Stephen A. Roell - Chairman, President and CEO

Alex A. Molinaroli - Vice Chairman

R. Bruce McDonald - EVP and CFO

Glen Ponczak - VP, Global Investor Relations

Analysts

Ravi Shanker - Morgan Stanley

Brian Johnson - Barclays Capital

Christopher Ceraso - Credit Suisse

Rod Lache - Deutsche Bank AG

John Murphy - Bank of America Merrill Lynch

Timothy Denoyer - Wolfe Trahan & Co.

Richard Kwas - Wells Fargo Securities, LLC

Joseph Spak - RBC Capital Markets

Patrick Archambault - Goldman Sachs

Brian Sponheimer - Gabelli & Company, Inc.

Matthew T. Stover - Guggenheim Securities

Joe Vruwink - Robert W. Baird & Co

Ryan Brinkman - JP Morgan

Operator

Welcome, and thank you for standing by. All participants are in a listen-only mode until the question-and-answer session of today’s conference call. (Operator Instructions) Today’s conference is being recorded. If you have any objections, you may disconnect at this point.

Now I will turn the meeting over to your host Mr. Glen Ponczak. Thank you. Sir, you may proceed.

Glen Ponczak

Thank you, Mica. Good morning, everybody, and thanks for joining us. Before we start, I'd like to remind you about our forward-looking statements. Johnson Controls will be making statements in this presentation that are forward-looking and therefore are subject to risks and uncertainties. All statements in this presentation other than statements of historical fact are statements that are or could be deemed forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

In this presentation, statements regarding future financial position, sales, costs, earnings, cash flows, other measures of results of operations, capital expenditures or debt levels and plans, objectives, outlook, target, guidance and goals are forward-looking statements. Words such as may, will, expect, intend, estimate, anticipate, believe, should, forecast, project or plan, or terms of similar meaning are also intended to identify forward-looking statements.

Johnson Controls cautions that these statements are subject to numerous important risks, uncertainties, assumptions and other factors some of which are beyond the Company’s control that could cause Johnson Controls’ actual results to differ materially from those expressed or implied by such forward-looking statements.

These factors include the strength of the U.S. or other economies, automotive vehicle production levels, mix and schedules, energy and commodity prices, availability of raw materials and component products, currency exchange rates and cancellation of or changes to commercial contracts, as well as other factors discussed in Item 1A of Part 1 of Johnson Controls’ most recent Annual Report on Form 10-K for the year ended September 30, 2012, and Johnson Controls' subsequent quarterly reports on Form 10-Q. Shareholders, potential investors and others should consider this factors in evaluating the forward-looking statements and should not place undue reliance on such statements.

The forward-looking statements included in this document are only made as of the date of this presentation and Johnson Controls assumes no obligation and disclaims any obligation to update forward-looking statements to reflect events or circumstances occurring after the date of this document.

I’d like to talk a little about our agenda that we have this morning before we get started. Our Chairman and CEO, Steve Roell, will give us an overview of the quarter and provide some market highlights. Afterwards Vice Chairman, Alex Molinaroli will talk about results for Power Solutions and Building Efficiency. Then Executive Vice President and Chief Financial Officer, Bruce McDonald, will talk about our mode of experience and then provide a more detailed review of our financial results. And then we will do questions-and-answers until the top of the hour.

And with that, I will turn it over to Steve.

Stephen A. Roell

Okay. Thank you, Glen. Well, good morning and thank you for joining us. As Glen mentioned, I’m going to make some general comments about the business environment and our outlook and then Alex and Bruce will provide highlights on each of the business segments.

Entering the quarter we had modest expectations for our growth due to the depressed economic conditions in Europe and the softness in the non-residential building market. And while growth was hard to define, I think there are some signs we can point you today that conditions are improving in our markets. Looking first at the automotive industry, North American industry production was up 1% on the strength of passenger cars, which were up 4% and they were offset by a slight decline in light trucks.

Industry production was up 10% in China, consistent with our view that the market will have high single-digit growth at this fiscal year. As many of you know that follow the European automotive industry, it was a difficult quarter were production declined 8%. In terms of the near-term outlook for the auto industry, in Europe we expect the upcoming quarter to be down about 3% versus the 8% decline we encountered in this past quarter, comparisons continue to improve in the second half of the year in Europe, in fact by the fourth calendar quarter the current projections are that the build will be slightly higher than the prior-year.

North American production will rebound with growth of 4.4% and 6.8% respectively in the upcoming third and fourth fiscal quarters. Then finally, China production will be up 9% in the next six month period consistent with the comment I made earlier about the prospects for the full fiscal year.

Non-residential markets will improve over time. Some of you watched the recent AIA billing index and showing signs of recovering, and our pipeline activity in systems and solutions has accelerated over the last quarter. Our year-over-year comparisons for our backlog will improve throughout the remainder of the fiscal year, although admittedly we are dependant on the timing of several large solution contracts.

Power solution’s doesn’t really see any unusual trends. We don’t see anything unusual there in terms of inventory levels or stocking patterns, core prices have stabilized and therefore we expect a fairly predictable shipping pattern over the remainder of the fiscal year.

So now turning to our second fiscal quarter sales of $10.4 billion we’re 1% lower than last year, FX accounting for that decline. Our European operations in automotive and building efficiency accounted for about another 400 basis point decline in revenues. This has been offset however by the power solutions in certain business -- building efficiency businesses.

Segment income was $463 million in the quarter down from the $581 million a year ago. This was consistent with the expectations we provided in our January 2013 earnings conference call. The decline is associated with our automotive business segment which Bruce will address in his comments. And net income and EPS then reflects the decline in the segment income.

Well based on the conversations we’ve had with our various businesses, recent forecast and the market outlook, we’re confirming our previous guidance range for EPS of $2.60 to $2.70 for the fiscal year, and in addition in our press release you’ll note that we confirmed – that we’re comfortable with the current sell-side consensus estimate for our third fiscal quarter.

Last quarter I highlighted five factors that are key to our second half of the year, and I just want to review those – each of those with you. The first item is that we will benefit from the restructuring actions that we announced in the third and fourth fiscal quarters of fiscal 2012. If you recall, we took restructuring of $52 million back in Q3 of late last year and $245 million in Q4 and those benefits accelerate in the second half of our current fiscal year.

The second item is the comparison for Power Solutions business which benefits from the avoidance of, if you recall the impact of high core cost last year of the inventories we had as well as the ramp up of our South Carolina Smelting Plant.

The third item is our Building Efficiency group which will see higher margins as their cost containment efforts more than offset the impact of softer volume. If you recall Building Efficiency from a seasonal standpoint there’s much higher volume in the second half and if you recall it was the second half of last year where we saw this significant margin improvements year-over-year, we expect that to be true again in this fiscal year.

The fourth item was that we continue to see improvement in our South American and metals business in automotive. We’ve taken some aggressive restructuring actions in South America with the closing of several facilities and in the metals operations the improvement is a combination of commercial negotiations, lower material cost, operational improvements, lower launch cost and lower SG&A in engineering. Now that may sound like a laundry list, but really those are the cost changes that we actually monitor and have been monitoring since the beginning of the fiscal year. And they probably – our efforts will probably be evenly distributed amongst that, so you can just assume the commercial negotiations, our operational benefits, our lower SG&A in engineering and our purchasing each of those contribute about 25% of the improvement in the third and fourth quarter.

And last item that we have, which is simply the improvement in the European and stronger North American auto builds. So obviously for North American it's the higher build rates in the third and fourth quarter and in Europe it's the fact the declines are of less severe, the year-over-year comparisons are easier, okay. So those are the five items that we are confident that will provide the second half performance for us.

So with that, I’m going to turn it over to Alex, who will start going through the Power Solutions Business. Alex.

Alex A. Molinaroli

Okay. Thanks Steve, good morning. Power Solutions sales were up 10%, and if you adjust for FX and lead, sales were up 7% in the quarter. OE volumes were up 7%, and the aftermarket volumes globally were up 1%. The overall quarterly shipments were up 2% in the Americas, up 14% in Asia and it was offset -- those gains were offset by a weaker Europe.

The results were favorably impacted by some strong operational performance and the ongoing benefits associated with our vertical integration or in-house lead recycling. We’ve improved our pricing, and we also had a one-time favorable legal settlement in the quarter for $24 million. Just to make sure that you note that last year, we had a one-time gain of 9 million in the same quarter related to our joint venture transactions.

Segment income was up to $221 million. That's 11% from $200 million in 2012. And if you normalize the results for the legal settlement and the prior year gain, the segment income was up 3%. Lead core prices remain elevated, but they're in line with what we expect. In the third quarter, we expect to see a favorable year-on-year comparison, because if you recall last year just about when we started seeing the high lead prices.

Let's switch to building efficiency, which posted slightly higher earnings. And that's really despite some tough markets both in the institutional and construction markets which impacted the top line. For the quarter, sales were 3.5 billion. It's down 3%, down 2% if you adjust for FX. We saw revenue growth in North America Systems, it's up 2% but it was more than offset by weakness in Europe, Asia and our North American service business.

Overall, at the end of the quarter, our unexecuted backlog was 4.9 billion. That's down 6% from a year ago, higher demand in Asia offset by our energy solutions, Europe and the Middle East. Order intake in the quarter was down 10%. Let me give you a rundown geographically; 12% in the Middle East, down 12% in Asia, down 10% in North America, down 13% in Europe and that's with one region Latin America up 5%. So overall it was a tough quarter for orders. I'll come back to that in just a minute.

The segment income of 139% was 1% higher than 2012. That's 3% if you exclude the FX. The good news here is that year-over-year margins continue to increase by 10 basis points to 4%. Margin expansion in service and GWS were unfortunately offset by the market pressures that we're seeing at systems Asia and in Europe.

Some of the positive signs we are seeing is our pipeline is increasing. Steve mentioned that in his comments earlier, and so we do see that although the backlog is under pressure, we do see orders picking up in the second -- our third and fourth quarter.

With that, I'll turn it over to Bruce.

R. Bruce McDonald

Okay. Thanks Alex. Start on page 9 here in terms of auto experience, for the quarter or generally speaking our results were in line with our expectations. As some of the analysts' notes out there have reflected volumes on a global basis came in a little bit stronger than we had thought coming into the quarter, so we're pleased to see this sort of outlook in Europe stabilized and we feel pretty good about where we're headed here in Q3 and our Q4 to start to see some sequential improvements.

On the upside that we got from extra volume however was offset by a payment that we had to make to exit a distressed supplier which I'll comment on later. So just looking at revenues, we were down about 3%. That's the same with or without exchange. In terms of seating, we were down %, interiors down 3%, electronics business our sales were down 13%. That business was much more heavily exposed to Europe and in particular to some of the French OEs, so that business was overexposed to a weaker part of the market.

Look at geographic, sales versus the production levels, North America were up 7% versus the 1% increase in the market, so good over performance there. In terms of Europe, we were down 11% versus the market being down 8%. If you sort of peel that back a little bit of underperformance that we had, what you would see in there is it's really attributable to our interiors and electronics business. Electronics being more heavily exposed to the French customers and also our exposure to Volvo, which had a weak revenue quarter for us.

In terms of China, we continue to see very strong momentum here. Look at our sales in the quarter and I'm talking about both non-consolidated and consolidated, up about 31% on a year-over-year basis to 1.3 billion and we think that compares to passenger car production being up about 10%.

In terms of segment income you'll see we had a down 58%, to just a $103 million. Main issue here obviously being a lower level of profitability of our European business where we continue to struggle with some operational difficulties and lower production volumes.

Couple of things I may be sort to point out in here. If you look at the last quarter call, we talked about delays in our restructuring programs in Europe, not unplanned delays, but just the time it was taken to sort of get heads out. If you look at where we’re in an overall restructuring basis, we got about 45% of our heads that we’ve targeted to take out in Europe, the headcount on a year-to-date basis its down about 2,000 heads. So we’re generally pleased to see how we’re doing in terms of taking the actions that we committed to.

And then if you look at some of our leading launch indicators, we probably in better shape and we’ve been in a long, long time. So, pretty comfortable that the initiatives that Steve referred to that we’re tracking in our metals business are going to produce sustainable results we’re looking for here, we’re not going to slip back with some problematic launches that we have in the pipeline.

Couple of things I’d – also note in the quarter, if you look at automotive we had higher engineering and launch cost. That’s not really a full-year issue for us, but in the quarter its more of a timing how it faces out, that was about $17 million and we also have these distressed supplier costs about $22 million in the quarter, most of which was in our North American business.

Looking at margins, about 1.9% or 240 basis points lower than last year. Looking at our margins on a geographic basis, what you would see is North America we came in at 5% versus a 6% level last year, if you were to adjust it for the non-recurrence in these distressed supplier charge, we’d be coming around 5.8% versus that 6%. Europe, we had a loss of $74 million, that represents a $31 million sequential improvement versus last year, but it’s a $100 million deterioration versus where we were in the second quarter of last year and lastly Asia margins about 9.9% versus 13% last year.

Turning to the financials here, you will – you note that in our press release we talked about three non-recurring items, which in aggregate resulted in a net charge of $21 million. And in the comments that Alex just gave, we sort of talk through our – the business results excluding those, but maybe just highlight what those were we – three items as we referred to, one was a gain on the consolidation of an automotive joint venture in India. We had incremental restructuring charges which were targeted at our South America seating business, our European interiors business. We want to do more to get those businesses to a breakeven level quicker. And we took a non-cash charge to set up some tax valuations allowance against some of our operations in Brazil and Germany.

In the prior-year we also had a few non-operational items that we talked about in terms of an act on EPS, however they offset one another. So backing all those charges and talk into the columns excluding items here, we can see our revenues were down about 1%, foreign exchange generally speaking had very little impact on in terms of our top line. In terms of our gross profit we were down about 40 basis points on a year-over-year basis. What we sort of saw in there as we did see stronger margins in both Power Solutions and Building Efficiency, though these were largely offset by deterioration in our margins in our auto business in Europe.

In terms of SG&A, see SG&A level was up about 4%, about half of that is the distressed supplier payments. The rest of the increase would be around investments that we’re making at innovation and some of the infrastructure in that emerging markets.

Equity income you see down, both $13 million year-over-year and you recall and as Alex comment, we had $9 million one-time gain in prior year’s level. So generally speaking equity income is kind of inline with what it was last year and you can see our segment income margins at 4.4% were down about 110 basis points versus year-ago levels.

In terms of our net financing charges, they tipped up a little bit, $66 million, was 3 million higher than last year really reflecting just a little bit higher level of overall average debt levels. Tax rate in the quarter when you adjust out for the one-time items was in line with our guidance of 20% and consistent with last year. And then in terms of income attributable to non-controlling interest of lower charges, as we've talked about for the last two or three quarters, that really reflects the buyout of our minority partner in plastic that we did in the third quarter of last year. So we have one more sort of quarter of favorable year-over-year comps on this line and it will start to normalize out for us.

A few comments before we open it up for questions. I guess I'd just like to summarize some of the key messages and sort of reflect back on the quarter. So for us, Q2 really represents an inflection point. It was a tough first half of the year in terms of the year-over-year comps. We're pleased with the progress that we've made in terms of our restructuring and so pleased – we've sort of announced some other actions in Brazil and in European interiors. So we feel good about that. We confirm in our guidance here of 260 to 270 for the year and we're introducing – comfortable with that third quarter analysts' consensus estimate of $0.75.

Reasons why I think we feel so confident in terms of our outlook here in the second half is when you sort of look at it, it's really – it's going to be influenced by things that we have 100% control internally on. So we're not counting on any uptick in the back half of the year in terms of our markets. The restructuring initiatives that we need to pay dividends for us in the second half, we're tracking those closely and they're on track. If you look at our European automotive business, it's still not obviously where we like it to be but we are seeing good momentum on a monthly basis and as I referred to in the comments here, we made a $31 million improvement a quarter. We're pretty confident in terms of our outlook that we'll be able to get our European auto business to a breakeven level by the end of this year.

Look at our balance sheet, again significant year-to-date improvement in terms of our free cash flow. We've taken down our CapEx outlook. It's going to be about $1.2 billion. We've got some targeted working capital actions that we're implementing here. So if you look at between now and the end of the year, we expect to see about $1 billion reduction in net debt before we end the year. In addition to that, we're making good progress in terms of the divestiture of our electronics business. We're in the very early stages of that process. We do have multiple expressions of interest from several strategic buyers. We're not really going to comment a lot more about that, but in thinking about the next three to four months, we ought to be in a position where we can provide a little bit more clarity around what's going on there.

So with that, Glen I'll turn it over to you to open it up for questions.

Glen Ponczak

Great. Thanks, Bruce. Mica, we're ready to take the questions here. I've just been told that there's a lot of folks in the queue here wanting to ask questions, so would like to ask you to limit your questions to one and a follow-up at most. And I think everybody who's calling are professional financial analysts and you're good with numbers, so the number to think of is one. With that Mica, we'll take some questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). Our first question is from Ravi Shanker of Morgan Stanley. Your line is open.

Ravi Shanker - Morgan Stanley

Thanks. Good morning. I wouldn't want to incur Glen's wrath so I'll keep it strictly one. Steve or Alex, can you elaborate a little more on the decision to divest or potentially explore the divestiture of automotive electronics? I thought you actually sounded pretty enthusiastic about the opportunities in that business at your Analyst Day in December, so what changed there and also what does that mean for some of the other businesses that you have that you may potentially consider non-core? Thanks.

Stephen A. Roell

Sure. I think we'll leave our discussions specifically, Ravi, to electronics. I think we had a meeting in the September timeframe where we talked about looking at our – we just completed our strategic reviews of our businesses with the Board and we had concluded that two things. One is if you recall even at the management meeting or the analyst meeting we had in December, I think it was pretty well recognized that that we're a niche player in the industry and that in order to participate in a bigger way and sustain that business we were going to have to make investments in navigation and other types of technologies. And we just had to make a decision whether or not that was the business we wanted to allocate capital to. And we concluded at that point in time that there were other opportunities for us in other businesses that we felt were better long-term bets where we had leadership positions. And so really the decision was to pursue that divestiture for purposes of being able to use that capital for other business growth opportunities and really a decision that we would not invest in electronics and maintain a niche position. It's really that straightforward, Ravi.

Ravi Shanker - Morgan Stanley

Great. Thank you.

Operator

Thank you. Next question is from Brian Johnson of Barclays. Your line is open.

Brian Johnson - Barclays Capital

Good morning. So sort of continuing on that theme, are there other areas of automotive in particular the interiors business, it looks the market reacted very positively when there was a mistaken leak that, that would be for sale or would be upper and then sort of retreated when it looked like electronics. I understand you’re thinking electronics, but interiors doesn’t seem like particularly a business that has a lot of scale advantages, it doesn’t seem to have any interesting technologies doesn’t tie to your broader themes of energy efficiency in you other business units. So, do you have any kind of thinking on that?

Stephen A. Roell

Yeah, let – Alex and I’ll talk. Alex, go ahead.

Alex A. Molinaroli

So I think if I remember that day that the market responded interiors retreated and then it responded positively to electronics if I recall, and I think that it's a fair observation. The best thing that we can say at this point is what we talked about electronics is that we’re looking at everything, but the decision for electronics I think the way Steve described that is we can’t afford to invest in everything to be a winner in everything and electronics decision was made based off of that. So, I don’t think we really want to comment on anything we’re going to do in the future, but just to let you know that as we’ve talked about it as we recognized that we have strong positions and lots of opportunity and we need to make sure we invest in those opportunities.

Brian Johnson - Barclays Capital

And in terms of the proceeds, would you see that going into organic acquisitions or dividends or share repurchases?

Stephen A. Roell

From my standpoint, I guess we’ve targeted some potential acquisitions but they would be – they had still a long ways to be determined yet, okay. So initially we probably would use it to pay down some of our debt, but we probably we then look to augment some of the investments we’re going to make in other businesses, okay. If I could just go back to the interiors comment, two things happened, Brian to be honest with you. One was the fact that the information that was out there was really inaccurate regarding the amount of proceeds and the market reaction it just was real, I wouldn’t put a lot of credence on how the market reacted based on proceeds people felt we can get from that business or anything else. But that business has a lot of opportunity for us too in terms of our – we have seen our ability to engage with customers and what we can do in total interiors with them. Some of our interior designs, there’s some real value in that business in terms of customer relation. So, I wouldn’t speculate that, that’s on our list right now.

Brian Johnson - Barclays Capital

Okay. Thanks.

Operator

Thank you. Next question is from Chris Ceraso of Credit Suisse. Your line is open.

Christopher Ceraso - Credit Suisse

Thanks, good morning. Bruce, I was wondering if you could take us through maybe a somewhat more detailed bridge for the automotive business where revenues were down $180 million, but EBIT was down $130 million, you highlighted the supplier payment which was $20 million and a couple of other items, a normal decremental margin on that lost revenue was maybe $40 million or $50 million worth. So how do you plug the rest of the gap? Can you give us some big buckets, how much is South America? How much is metals? How much is launch cost et cetera, so we can think about how and when those items diminish and profitability starts to get better?

R. Bruce McDonald

Yeah, well there’s a lot in there, but I guess like I said -- I mean just to sort of quantify, about $22 million was distressed supplier, one the launch and engineering is a $17 million. So, let’s say there’s nearly $40 of the reduction. And then I think if you were to look at our metals business in the quarter we still, it's still a -- not much of an improvement. In fact I think if you look at the overall level of profitability there it would be down slightly. Like you said, if you look at our profitability in electronics negatively impacted by some of the investments that we're making in infotainment. But I think maybe just to sort of help you out, volume was probably worked maybe 35 million, pricing on the year-over-year basis worked maybe 30 million and I think the other thing that I touched on would sort of bridge that.

Christopher Ceraso - Credit Suisse

Okay.

R. Bruce McDonald

I think, Chris, there's a lot of moving pieces here so I think maybe what we can do is set up a time and Glen and I can get on the phone. Maybe we can spend a little bit more time and maybe you can probably ask me five more follow-ups on that.

Christopher Ceraso - Credit Suisse

Yeah, probably. Okay, but I'll let that go.

Stephen A. Roell

Okay. Thanks, Chris.

Christopher Ceraso - Credit Suisse

Thanks.

Operator

Thank you. Next question is from Rod Lache, Deutsche Bank. Your line is open.

Rod Lache - Deutsche Bank AG

Good morning, everyone. In that automotive experience business, could you talk a little bit about what we should see as we moved into the June quarter? Was there around $60 million maybe of non-qualifying restructuring in the fiscal second quarter that goes away, was that distressed supplier issue a one-timer in that engineering thing unusual? I assume you're going to get a disproportionate amount of that 200 million of cost savings in the back half?

R. Bruce McDonald

Yeah, that's right, Rod. I think I'm not sure I'll answer them all, in terms of the distressed supplier payment, that was a one-time event. So that is not – I mean not to say we don't have charges, but if you – I would say on average that number maybe 4 million or 5 million a quarter, so it's exceptionally high with one large amount in the quarter. So that's non-recurring. The restructuring item that you referred to, like we said on the [call] [ph], generally speaking it's right in line with what we were expecting for that. That's very consistent with what I think we told you in Q1. The benefits are going to start to flow through like you said, a couple of 100 million is in the annualized number, so it gets some good leverage in the back half of the year. Just to be a little more specific if you look at the European profitability that we're looking for, in Q1 it was 105 million loss here. In the second quarter, we were at 74 million. That number we're anticipating for the third quarter here should be in that 30 million-ish range it'd be sort of where we see that and get into a breakeven in the fourth quarter.

Stephen A. Roell

The only thing I can add, Bruce, is that engineering will continue higher in the third quarter and then by the time we get to the fourth, it looks pretty cut flat to the prior year, okay.

Rod Lache - Deutsche Bank AG

Okay, thank you. And just my second question is a clarification on power solutions. Did you say that the volume was up 7% but the earnings were up 3% ex the settlement? I'm not sure if I misheard that?

R. Bruce McDonald

That sounds right.

Rod Lache - Deutsche Bank AG

Okay. And why would you not be getting the operating leverage on the additional volume.

R. Bruce McDonald

I think that where the volumes are increasing as in Asia and our fixed cost structure is higher there as we ramp up.

Rod Lache - Deutsche Bank AG

Okay. But shouldn't there be some savings from the smelter and some of the other actions that you were taking to mitigate that.

Stephen A. Roell

Yeah. So we're starting to see that. The smelter will ramp up through the summer, so we should start seeing more and more favorability, but that's sort of where the offsets were.

R. Bruce McDonald

I think Rod what you'll see is in Q3, you'll see the margins pop up here in power.

Stephen A. Roell

Particularly with pricing and everything else that takes place, so we're expecting power to be a big contributor to our third and fourth quarter.

Rod Lache - Deutsche Bank AG

Okay. All right, thank you.

Stephen A. Roell

Thanks, Rod.

Operator

Thank you. Our next question is from John Murphy, Bank of America Merrill Lynch. Your line is open.

John Murphy - Bank of America Merrill Lynch

Good morning, guys. To keep it one question, I just wanted to focus on Europe and just get your thoughts as we look at that – through that improvement sequentially that you're looking at in your losses to breakeven by the end of the year, I'm just curious as we think about that, how much of that is coming from stabilization and a potential recovery in volumes and how much of it is your internal actions? I'm just trying to really gauge what's micro versus macro in the improvement? And really the crux of the question is there is such risk to the downside in European volumes and maybe another 10%, I just kind of want to understand the sensitivity there, to that potential risk?

Stephen A. Roell

Yeah. Well, I would say by far the majority of what we're projecting for the third and fourth quarter comes from our internal actions and not from volumes. If I look at the current projections that we have for our Q3, we’re still expecting as I mentioned, Europe to be down about 3% year-over-year. Now you can take that range going to be down 10, but far John the majority of our improvement year-over-year is coming from the actions I described to you. Our commercial negotiations which, if you want to translate that, that’s getting paid for our engineering changes, it's our purchasing initiatives and moving our tools use, it’s a function of our launch cost and our efficiency in our manufacturing operations and its lower SG&A as we get into that fourth quarter, particularly from engineering…

R. Bruce McDonald

And the restructuring.

Stephen A. Roell

... and the restructuring benefit, yeah.

John Murphy - Bank of America Merrill Lynch

And you’ve identified all the actions that you think you need to take even if volume were weaker, would there be incremental actions that you could take in response to potentially weaker volumes?

Stephen A. Roell

There’s some, but I wouldn’t want to say I could cover a full 10%. If its down 10%, John I would have – if we got some exposure we have to run hard at, okay?

John Murphy - Bank of America Merrill Lynch

Yeah, absolutely. But would there be more opportunities to maybe structurally shift the business further East or take other restructuring actions it might set you up better for the long-term?

Stephen A. Roell

Not in a quarter’s timeframe. Longer term, but not in a quarter, it cant move in that quick, okay?

John Murphy - Bank of America Merrill Lynch

Okay.

Stephen A. Roell

Okay.

John Murphy - Bank of America Merrill Lynch

All right. Thank you. Thanks a lot.

R. Bruce McDonald

I think one thing that’s worth commending on though is, if you look at the European production levels if it were to go down another 10% in the back half, I think we have to sort of step back and think when are they coming back because we’re already at sort of 20, 25 year lows here in terms of volume and we’re not going to incur several $100 million of cost to take some actions that we’re going to regret when the volume start to bounce back here a little bit. So, I think I’m more optimistic that we’re starting to see the bottom and I’d be -- maybe I will be proven wrong, but I would be surprised to see it down that level.

Stephen A. Roell

Hey Mica?

Operator

Thank you. Our next question is from Tim Denoyer of Wolfe Trahan. Your line is open.

Timothy Denoyer - Wolfe Trahan & Co.

Hi. Good morning.

Stephen A. Roell

Good morning, Tim.

R. Bruce McDonald

Hi, Tim.

Timothy Denoyer - Wolfe Trahan & Co.

Good morning. Just wanted to ask about the competitive dynamics in the U.S. battery market, I’m wondering if you’re seeing any changes based on some competitive issues, especially as it relates to the market share and prices for lead cores?

Stephen A. Roell

I will take that. I think that there is a lot to change as most of you know going on with our competitors. So I think there is lot of activity quoting activity, but I don’t know that we’ve seen anything happen yet. Probably the biggest phenomena right now is not due to our competitors it’s just the fact we haven’t had our spring yet and we’re looking to hopefully get the spring orders out, so the people can get out and ride their lawnmower but unfortunately that hasn’t happened yet. But from a competitive standpoint its fairly stable although there is -- there are people that are checking to see what capacities in the marketplace in case something happens.

Timothy Denoyer - Wolfe Trahan & Co.

Okay. And did it -- sorry, just one quick follow-up on that, did the spring -- the late spring helped, end it with pretty lean inventories the prior quarter?

Alex A. Molinaroli

Well, inventories are more – I would put it as more normal. So they’re lower than they were a year-ago. I’d put it at a more normal level, what the inventories are in the channel.

Stephen A. Roell

We’re just talking really about lawn and garden, so that will all recover itself here as the spring unfolds in the quarter, okay.

Alex A. Molinaroli

Eventually that will happen.

Stephen A. Roell

Yeah.

Timothy Denoyer - Wolfe Trahan & Co.

Okay. All right. Thanks.

Operator

Thank you. Next question is from Rich Kwas of Wells Fargo Securities. Your line is open.

Richard Kwas - Wells Fargo Securities, LLC

Hi. Good morning, everyone.

Stephen A. Roell

Hi. Good morning, Rich.

Richard Kwas - Wells Fargo Securities, LLC

Switching gears on to Building Efficiency, so orders down pretty much across the board regionally speaking and somewhat similar to last quarter. I noticed the seasonal pickup in the second half, but doesn't this kind of indicate that the growth rate is going to come in a bit as we move through the next few quarters and I know you’re going to give your ’14 outlook six months from now or there about, but what do you – in terms of growth rate for ’14 it just seemed like its going to have to be more modest, so I’m just curious on your thoughts here given the order rates of the decline for two quarters in a row?

Stephen A. Roell

Yeah, my guess is what we will see, Rich if I had to play out the quarters, I think you will see a backlog recover here in between now and the end of the year. And that will be driven though as I mentioned by what we see in the pipeline. And so that will come primarily from two areas. It will come from systems work in North America, it will come from Asia and to a greater extend maybe even the Solutions Business that we see the pipeline picking up. So I think our volume issue is really one right now that we’ve got to address in terms of our cost containment for the remainder of this fiscal year. Then I think we need to check back and see where our backlog ends up at the end of this calendar – this fiscal year relative to 2014 and that will dictate it. But I do think what Steve and Alex are working on is making sure that we go in with a fairly conservative view of our cost structure into '14 until we get a better view of that. But what we do like is the fact that and I can just tell you our systems pipeline's up about 10% and our solution's up 20%. And we're seeing good growth across a lot of verticals. So that makes us feel good. We're doing good things in Asia. We don't expect much from Europe. So that's sort of how we see the [lamp]. But I would say that '14 will be based on what kind of orders and backlog we have at the end of the next few quarters.

Richard Kwas - Wells Fargo Securities, LLC

And just a quick follow-up on the federal government state governing, what are you seeing early read on sequester and impact on the business at all?

Alex A. Molinaroli

That's good questions, Alex. So first I'll reinforce what Steve said. I think the business has done a great job of managing costs and they have to continue that because we're at the – what I think is going to be the low point of our backlog. We'll see if I'm right, but the order intake should pick up as the pipeline in some of our segments has historically high levels but the backlog is under a lot of stress. So hopefully that picks up over the next few months. But one caveat and I'm glad you're asking is we're not sure what the sequester might mean as it relates to funding. We haven't seen anything yet, but that will show up probably late in our fiscal year to find out if there is any ramifications. Our customers aren't telling us that there are, but we're trying to make sure we understand that. So that's a good question. Right now, we don't see an impact.

Stephen A. Roell

As we've said that the federal backlog is one of our strongest movers right now.

Alex A. Molinaroli

Yeah, the federal and state actually.

Richard Kwas - Wells Fargo Securities, LLC

Okay, thanks. I'll pass it on. Thanks.

Operator

Thank you. Next question is from Joe Spak of RBC Capital Markets. Your line is open, sir.

Joseph Spak - RBC Capital Markets

Hi, good morning. Thanks for taking my questions. I just want to get back to the statement made about comfortable with third quarter estimates and really the reiteration of the full year guidance. Is there any shift internally between the segments and the reason I ask is if you look at auto or seating per se, seating more specifically, you did about 2.3% margins in the first half and to hit the full year number that you initially got it to, it seems like something over 6% in the back half which even if you add up all the factors, you mentioned it seems a little bit aggressive. So I'm wondering if you guys internally have shifted expectations between the segments for the year?

R. Bruce McDonald

Not really. I'm not sure I'd agree with that mass, so maybe we have to take that offline. But I think if you look at – just talk about going from Q2 to 3, I think we have a significant step up in building efficiency. That is very much in line with our historical pattern in terms of the seasonality. It's sort of high margin as our service business starts t pick up when people initially turn their [air-conditioning on]. We see a big ramp up of Q2 to Q3 in terms of building efficiency. I touched on some of the issues earlier in terms of pickup that we expect to see in auto and Europe in particular. And we also expect, like I said to see margins pick up strongly in power solutions here in the third quarter.

Stephen A. Roell

I can't add much more. I guess I would tell you if you had to look at business and say where are we dependant in terms of improvement, clearly it's -- year-over-year it's automotive. I think that we should say BE, we expect improvement, but that – we also had the seasonal factor that comes in the BE. It's just a bigger contributor in the second half of the year.

R. Bruce McDonald

I guess our residential business too picks up.

Stephen A. Roell

…picks up too, yeah. I guess those are the two factors, but that's probably the only color I can provide you.

Joseph Spak - RBC Capital Markets

All right. And then just quickly on the quarter, you mentioned Asia margins 10%. I think under the old report, if you look back at the old reporting structure, that's down about 300 basis points from last year. Is there anything specific in the quarter out of Asia?

R. Bruce McDonald

No, it's really just the – we are down about 300 basis points in the quarter. It's just – as you know, that's where our equity income flows through and it's just timing of investments. Right now, if you look at kind of – a couple of our biggest joint ventures that are opening up several new plants in the west and so it's just sort of start-up costs of new facilities to come underneath the growth.

Joseph Spak - RBC Capital Markets

Okay, thanks guys.

Operator

Thank you. Our next question is from Pat Archambault of Goldman Sachs. Your line is open.

Patrick Archambault - Goldman Sachs

Yeah, thank you very much. My main question is more I guess, just on the industry side, and forgive me if you’ve said this, but you kind of have a constructive tone on the European market stabilizing. You had obviously the retail auto sales numbers have been pretty weak. Can you just tell us a little bit more about what you’re seeing in terms of near term production schedules at some of your big customers there and I’d be also particularly interested in your views of inventory, because if it's coming in better but the demand is worse, one would think that there might be some de-stocking to deal with into the back half sometimes, so just your views on that would be great.

R. Bruce McDonald

Yeah, I’ll take this one, it's Bruce. I think we don’t have as reliable information in terms of what sort of in the dealer inventories and things like that in Europe as we also do here in North America, but I think -- I’ve seen a couple of research reports that would suggest a fairly significant amount of inventory that’s come out of the channel, it's hard to say. But I think we feel pretty comfortable that with once you look at our schedules which generally are pretty firm for like the next four to six weeks, so we could say half, but we’re sort of already a month into the quarter and we have pretty good visibility in the next four to six weeks. I would tell you right now we see very little downside to the quarter. I think if you look at how the OEs have tended to flex and if sort of things weaken up it would be around taking some more time out around the shutdowns which would be kind of into our fourth quarter. So I think when we -- again to our confidence here in the third quarter month of it early in the bag and we got pretty good visibility here, so we don’t see a lot of downside risk for the current quarter and we’re just happening to keep our eye on whether any of our customers extend some of the shutdown timeframes. And that’s in Europe, I guess I would flip that and say on the other hand in North America our customers are asking us -- some of our customers are asking the supply base about shortening the summer shutdown. So, I think we maybe talked about some of the risk in Europe but I think in North America there is some offsets.

Stephen A. Roell

Maybe (indiscernible) and I mentioned the fact that the Q2 lower level from the first quarter is, going from a 8% decline to about a 3% decline, but the absolute production levels were about 4.8 million units for both periods, so we’re not anticipating any significant recovery. And then of course in Q3 we had the shutdown period. So we’re only projecting about 4.2 and that’s consistent with our (indiscernible). As Bruce mentioned, we’re well into this queue with our build, so we feel comfortable that those numbers are reasonable.

Patrick Archambault - Goldman Sachs

Okay, that’s very helpful. If I could just one housekeeping one on building efficiency. Can you just remind us in terms of the timeframe that both orders and backlog typically get translated into revenue?

R. Bruce McDonald

Okay. Well, I would say that backlog today, about 40% to 50% of that will flow this year. So when you talk about our backlog, when you look and it's skewed depending on what your solutions backlog they’re larger projects. So if you look at what we have to work with for the remainder of the year, for the most part we can see it. We will be determined to get some orders here in the third quarter in order to finish the year out, so the orders in the third quarter are important for the rest of the fiscal year. And then if you look going into next year I think when Steve talked about going into next year as the sales increase in our fourth quarter it will put a little bit of pressure in the first half of the year, but those -- because those orders will flow second and third quarter next year.

Patrick Archambault - Goldman Sachs

Okay, guys. Thank you very much. I'll turn it over.

Operator

Thank you. Our next question is from Brian Sponheimer of Gabelli & Company. Your line is open.

Brian Sponheimer - Gabelli & Company, Inc.

Hi, good morning. Thank you for taking my call. Just want to spend a second on the balance sheet looking at around 6.2 billion in that debt right now targeting 5.2 towards the back half – at September 30. Obviously CapEx is about 200 million of that. Talk about some of the levers that you can pull and where you expect that incremental $800 million to come from?

R. Bruce McDonald

Yeah, I think if you sort of want to do a high level bridge there, I think our earnings in the second half versus the first half is a big chunk. It's probably 40% of it. If you look at our net working capital outflow on a year-to-date basis, I think it's around – nearly 400 million. And within that what you would see if we typically have an outflow in the first half of the year associated with a lot of setup compensation and sales commission plans as well as some contributions to like our defined contribution employee plans. So those flipped from being uses of cash in Q1 to sources in the second half of the year. And then we've probably got, I'd say about $100 million of receivables that we didn't collect in the second quarter. That would be to name two specific issues, one was Good Friday was the last sort of day of the quarter, so we had a couple of customers that we were expecting the payment and we didn't get [receipted] and we had a few of our Japanese customers which have a March 31 year end kind of withheld payments from us. And then I guess the last thing would be we've got a couple $100 million and we've talked about this before of overdue VAT receivables, some indirect taxes that we're starting to make some good progress and I think we can bring most of that in, in the second half. So those would be sort of the main drivers.

Brian Sponheimer - Gabelli & Company, Inc.

Okay, great. And then just switching gears real quick. If I'm thinking about energy prices and how it relates to building efficiency, if we start to see oil come down a little bit more here, would that be a net benefit for you with some of your customers becoming a little more cash flow positive or should we think about the other way that high energy prices means that Johnson Controls becomes more valuable as a solutions provider?

Stephen A. Roell

Just to make sure we're talking about electricity, not gasoline prices, okay.

R. Bruce McDonald

Look, if you're talking energy prices, I think that it's – if you believe that energy prices are going to continue on the long haul to increase, I think that's the way our customers view the world. Most of our customers are looking at assets that are long life assets and a lot of the paybacks are also for deferred maintenance programs. So I'm not sure it will have a meaningful effect. I'd be more concerned about interest rates.

Brian Sponheimer - Gabelli & Company, Inc.

All right, thank you very much.

Operator

Thank you. Our next question is from Matthew Stover of Guggenheim. Your line is open.

Matthew T. Stover - Guggenheim Securities

Thanks for taking my question. I wanted to see if you can give us a little bit more color about what it is that you see driving the margin outlook for power systems in the second half, there's significant volume reduction, there's mix, there's some price and there's some core cost impact, but if you can kind of scope some of those things, it'd be helpful? Thank you.

R. Bruce McDonald

So I don't know if I can give you the dollar versions, but what I'll do is give you the things to be looking for. First off, we're going to see the benefits of the Florence Recycling Center. It's been something that we – as we ramp up, we're getting some benefits but we'll also have start up cost that we've had in the first part of the year. The second thing that's going to be very important is a year ago, we put some pricing in place, we're going to see that benefit of the pricing over the summer and we also have more pricing that's going to go in play in July. We've notified our customers about a 3% to 4% pricing increase across North America. So those things are significant. Our operational improvements have continued, our China operation is also getting up to scale in operations. So all these things added together along with more and more AGM coverage in Europe add up to the numbers. So the volumes – if the volumes happen, I feel pretty comfortable about our forecast.

Stephen A. Roell

The only thing I can add to that is the core – last year we had the core imbalance that we had and…

R. Bruce McDonald

Yeah, so the core costs are still high but one of the problems we had is that we were out of balance ourselves as it relates to our core inventories and we've been able to get that more in line with normal – that was a cost that we had last year that we hadn't incurred in the past.

Matthew T. Stover - Guggenheim Securities

Thanks very much.

Operator

Thank you. Our next question is from David Leiker of Baird. Your line is open.

Joe Vruwink - Robert W. Baird & Co

Hi. Good morning. This is Joe on the line for David.

Stephen A. Roell

Hi Joe.

Joe Vruwink - Robert W. Baird & Co

May be just a little more generally or broadly looking at Building Efficiency, you’ve really seen you go out and say we’re going to not do these things to improve margin, its follow through what’s the margin improvement Building has been able to post. Where are you may be in terms of like a baseball now, since we are in that season and in terms of innings into ticketing the improvement or is it the type of thing were you the pricing gains, the cost reductions carry through year-end and then you’re sort of more at a normalized level for that business?

Alex A. Molinaroli

Great question. I think that this was – so let's just say that this is a baseball game and maybe the first game is over but this is a double-header. And I think we have more opportunity. So, there is a lot of programs that BE group has been looking at both in North America and across the world, some of them are structural and some of them are pricing. I think we're going to see more and more of that. We have opportunities, it will come in small chunks, and little chunks, but I think that we're pretty excited about the opportunities we have in front of us in different ways in order to solve some of the current problems or the problems that we have with our customers that have had over the last few years. So I'm pretty confident that we're going to find more opportunities. I think we have more opportunities than we have heartbeats to go get them.

Stephen A. Roell

I think the other thing we got to mention with Joe is also we’ve got opportunities to invest in areas that we want to really drive future value with our customers in terms of product technology. So that’s the tradeoff that we’ve got is making sure we can sustain those investments and at the same time, continue to ratchet down our cost structure, but we’ve still got – as Alex mentioned, we got lots of room.

Alex A. Molinaroli

Yeah, and I actually think they go hand in hand. So there's good opportunity there.

Joe Vruwink - Robert W. Baird & Co

And if I can ask a quick follow-up, you’ve always talked about that business being 8.5% margin business, is the pricing sticking or any of these things maybe coming in faster than you were expected? I know the 8.5% kind of has allusive end date associated with that.

Alex A. Molinaroli

Well, I don’t know that – I don’t know there is an end date. I think that there is plenty of opportunity, a lot of that has to do with the mix of our business and how the – and how that’s going to -- how we’re going to make investments in the future, but I think that all of the targets we put in place are realistic.

R. Bruce McDonald

And Joe, just to clarify, our objective in this business is to get to a 10% without GWS. It's the way we've always phrased it, okay? That’s just to clarify that. And I think to Alex’s point, part of this cost structure a lot of it just growth and pricing, I mean I think we’ve got opportunities in the service area to grow. We know we’ve got some opportunities in our cost structure. So the margin improvements that you should see in the second half or it should be dramatic and help drive another step towards that improvement longer term, okay.

Joe Vruwink - Robert W. Baird & Co.

Great. Thank you.

R. Bruce McDonald

And we have time for one more.

Operator

Okay, thank you. Our next question is from Ryan Brinkman of JP Morgan. Your line is open.

Ryan Brinkman - JP Morgan

Hi, great. Thanks for squeezing me in.

R. Bruce McDonald

Hi, Ryan.

Ryan Brinkman - JP Morgan

You’ve touched on Europe a few times already, just throughout the Q&A here, but I am curious if there’s a level of European light vehicle production that you’re preparing the European business for through your restructuring program. Do you have a sense of what the threshold of production is necessary now for the automotive business to breakeven in Europe, and what might that threshold become after the restructuring program?

R. Bruce McDonald

Yeah, Ryan I would say that -- I would tell you that our business is sized to be profitable at the current level. Our issue is really the internal challenges that we talked about before. It's a lot of things that we’re doing to drive the improvements in the metals operation that Steve talked about. Our challenge that we have in interiors isn’t really so much around volume, it's around -- we’re overly exposed to Western European for manufacturing perspective rather than Eastern Europe in where some of our competitors are and that sort of set the market price. So, I wouldn’t really look at it like, we have a footprint that’s sized to breakeven at a level that’s higher than a market. I think most of the issues are around our operational performance, some product lines that we’re looking to exit and things like that.

Ryan Brinkman - JP Morgan

Okay.

Stephen A. Roell

I think Bruce made a comment earlier to – if you go back – kind of the fact that we're already at 20-year lows here, okay. And so I think we recognize that we'll take steps as our customers take steps and we know that some of those are coming, but I don't think there's a big structural issue here that we have to deal with relative to the fact that we need the plan for the production going much lower. I mean right now, we've got our Western Europe production and on a calendar year – on the calendar year, it's 20 million units. And that's still below 12.6 last year. So I think to Bruce's comment, I think we have hit bottom, I think we can plan for whole lot lower. I don't think that's not a sustained level that we'll see Europe drop to, okay?

R. Bruce McDonald

It wouldn't be like – like you sort of read the industry comments about capacity utilization in Europe for the industry at the OE level being at the 50% or 60%. We wouldn't be like that at all.

Ryan Brinkman - JP Morgan

Yeah. I appreciate the color. Thanks a lot.

Glen Ponczak

Great. Thanks a lot. Folks we'll be – Dave and I will be available through the balance of the day. Thanks for calling. Steve, is there any concluding comments?

Stephen A. Roell

No, I think that's – I think the way to view this quarter is Bruce used and stayed with and talked about the fact that I do think we have a point of reflection here and I do believe that we feel that internally, and I think that a lot of it is within our control as he also mentioned. So I think that this is just a function of our execution in the second half and hopefully by the time we meet at the end of the quarter, we'll be talking about our improved backlogs in BE and the fact that we'll start seeing some recovery in our end markets, okay.

Alex A. Molinaroli

Thanks everybody.

R. Bruce McDonald

Thank you.

Operator

That concludes today's conference. Thank you for your participation. You may now disconnect.

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Johnson Controls (JCI): FQ2 EPS of $0.42 in-line. Revenue of $10.4B (-1% Y/Y) misses by $0.06B. (PR)