Johnson Controls: A Business Transformation Play And A Rising Dividend

Jul.24.14 | About: Johnson Controls, (JCI)


Management focused on transforming the company to increase profitability in the intermediate term.

Divesting of low-margin businesses and acquiring of higher-margin businesses should increase profitability.

A rising dividend payout and substantial share repurchases will reward shareholders while waiting for the business transformation to lift profitability.

Most major stock market indexes have repeatedly set records in 2014. Johnson Controls (NYSE:JCI) shares, however, are down about 3 percent year-to-date. Stocks failing to participate in the market indexes' record run are worth looking into to see whether they provide an investment opportunity over the long-term horizon.

JCI indicated earlier in 2014 that it had been having mixed results as it relates to top line revenue growth, even though the company had shown operational improvements across all of its businesses. In addition, in the company's commercial buildings segment, JCI has indicated it has been struggling because the overall market has been struggling. In particular, the most significant challenge that JCI has been having is within the federal government business. Given such circumstances, JCI's earnings growth is below that of its competitors, and, as such, the market is assigning a price-to-earnings multiple to JCI that is lower than the price-to-earnings ratio assigned to its competitors.


JCI is a company that is composed of three divisions. JCI's largest business division is its automotive division, which currently includes an interiors group, as well as seats, doors, and instrumentation panels. This division accounted for 51% of its 2013 revenue of $42.7 billion and 43% of its $3 billion in pretax income. The second-largest division of JCI is its building efficiencies division, which manufactures and services the infrastructure for forced-air heating and cooling in office buildings. This division accounts for 34% of 2013 revenue and 32% of pretax income. The third power solutions division manufactures batteries, including standard lead car batteries and energy-efficient stop/start systems. The power solutions unit accounts for 15% of revenue and 33% of income. JCI management indicates that each division will account for essentially a third of overall revenues in the next few years.

Divestitures and Acquisitions

Over the last few years, JCI has worked to exit its low-margin industrial businesses and move towards faster-growing markets or sub-markets and away from more capital-intensive and less-profitable markets. JCI sold its low-margin auto-electronics unit to Visteon (NYSE:VC) in 2013, and its low-margin HomeLink garage-door opening business to Gentex (NASDAQ:GNTX) also in 2013. JCI then purchased a higher-margin company named Air Distribution Technologies in 2014, which makes heating and cooling and security systems for residential and commercial buildings. By selling off its auto-electronics unit and its garage-door-opening business and buying a company that makes heating and cooling and security systems for residential and commercial buildings, JCI exited two relatively small, capital-intensive businesses to enter a business that has margins nearly double its overall net margin. Through such actions, JCI is working towards managing its capital more efficiently and increase its earnings.

More recently in May 2014, JCI announced its plan to spin off its low-margin, slow-growth auto interiors business into a joint venture with a division of the Chinese company SAIC. JCI will own 30 percent of the joint venture and receive an annual dividend as well. This spin-off into the joint venture changes the profile of JCI's interiors business from being a disadvantaged business that was in low-growth regions with a high cost base to a global company, whereby the spun-off joint venture has access to low-cost tooling, manufacturing equipment, and low-cost engineering skilled workers.

Earnings Announcement

Last week, JCI reported adjusted earnings of 84 cents per share in third-quarter fiscal 2014. Such earnings represented a 16.7% increase over 72 cents in earnings in the comparable quarter for 2013. The financial results for 2013 were revised, as JCI has classified the automotive electronics business as a discontinued operation.
This past quarter's results, including restructuring and non-recurring items, show JCI's net income as $238 million, or 35 cents per share. JCI's earnings guidance for its 2014 fourth quarter is in the range of $1.00-$1.02, an 11 percent increase from the earnings recorded in the fourth quarter of 2013.

JCI reaffirmed free cash flow guidance of about $1.6 billion. The indicated cash flow will provide opportunities for JCI's future capital expenditures, strategic acquisitions, share repurchases and dividend payouts. Finally, margins are expected to improve across all operating divisions in fiscal 2014. In regard to the current overall business environment for JCI's 3 business divisions, the CEO indicated:

"Let's start and talk about the environment. What we see in the automotive business is the market remains strong. I am really pleased to see that Europe continues to incrementally get better and we are seeing some benefits from that. [O]verall we are very happy with how the markets improving.

We talk about demand for the battery business. We are obviously seeing the high OE demand and we are gaining share. So, we are following the strength in the market. And our aftermarket demand is finally picking up in North America, Indonesia, specifically China and outside of Asia. And in Europe, we are still having demand problems, but I think that what we have seen is that the inventory levels with our distributors is starting to decline. So, hopefully, we are getting through the worst of that.

In the commercial buildings segment, where we have been struggling or the market has been struggling on our own pipelines, but our improvements in our pipelines that we are seeing forward-looking mirror the marketplace. The biggest challenge that we have is within the federal government business, because of the marketplace. And then in China, the market remains strong. It's not the same as it was a few years ago. It remains strong in each one of our markets."

JCI shares initially sold off sharply on the earnings release, and have trended downward slightly since the announcement of its earnings. With JCI's share price sinking in the days after the earnings announcement, the market is failing to appreciate the divestitures and acquisitions JCI has been making recently to exit low-margin businesses and to enter higher-margin businesses. In addition, JCI's transformation will serve to take advantage of future trends, such as the energy cost controls in office towers and energy-efficient battery technology.

Analysts' Views and Our Views

Some analysts believe that investors are failing to appreciate the divestitures and acquisitions JCI has been making recently to exit low-margin businesses and enter higher-margin businesses. Further, such analysts believe that JCI's slow but steady transformation will capitalize on future trends, such as the energy-efficiency concerns of office tower owners and energy-efficient battery technology.

Analysts expect JCI to earn $2.5 billion in fiscal year 2015, which is $3.73 a share on revenue of $44.4 billion. Such 2015 expectations would be up from 2014 estimates of $3.14 per share on $43 billion in revenue. JCI's current price-to-earnings ratio based on fiscal year 2015 earnings is 13.4. As JCI's margins increase, analysts believe that its forward price-to-earnings ratio should rise to a forward price-to-earnings ratio of 15. A price-to-earnings ratio of 15 is more in line with the price-to-earnings ratios of JCI's competitors, Emerson Electric (NYSE:EMR), Honeywell (NYSE:HON) and United Technologies (NYSE:UTX). Analysts believe that JCI could reach a share price between $60 and $65 in about 18 to 24 months from now, given JCI's recent transformative actions. In addition, JCI has been increasing its dividend on an annual basis and engaging a substantial share buyback.

We tend to agree with analysts and their intermediate-term outlook for JCI. Management of JCI is working to transform JCI by exiting low-margin businesses and acquiring higher-margin businesses. This transformation is ongoing, and the results will become more appreciated by Wall Street and individual investors in the next 18 to 24 months. That said, with most stock market indexes at or near record highs, an individual investor might want to wait for JCI to drop to a share price between 42.50 and 47.50 to establish a full position. Over the long term, JCI will reward investors with increasing dividends, substantial share repurchases and a rising share price.

Disclosure: The author is long JCI, HON, EMR. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.