Since I first argued that Johnson Controls (JCI) was substantially undervalued here despite past volatility in free cash flow, the stock has appreciated by 28.5%. This beat the S&P 500 by around 1,770 bps and the best part is, namely, that the bull run is not over yet. Based on my multiples analysis and DCF model, I find that the company will outperform its peers and the broader index.
From a multiples perspective, Johnson Controls appears at reasonable levels. It trades at a respective 14.9x and 9.9x past and forward earnings while Lear (LEA) trades at 7.8x forward earnings and Honeywell (HON) trades at 12.7x forward earnings. The last of these firms offers the higher dividend yield of the three at 2.6%, as well as the lowest volatility with a beta of 1.4. Within this backdrop, there is room for continued multiples expansion, but even if there is some contraction, earnings growth is still geared to drive value creation.
On the third quarter earnings call, Johnson Controls' CEO, Steve Roell, noted the strong performance:
"As I look at full-year results, record sales and earnings, I'm pleased with the fact that we overcame a really mixed macro environment. We did benefit from some global growth in the automotive business industry, but to be honest, there were times throughout the year that we thought it would even be stronger. But nevertheless, we did benefit from that.
The building markets did not recover the way we expected. We assumed and it did get good growth in the interim in the emerging markets, but certainly, things like the residential market were much weaker than what we expected coming into the year. And of course, we had that mid-year disruption with the Japanese earthquake and tsunami and all the inefficiencies that created.
But despite that, the fact that we - despite those conditions, we outperformed our underlying markets, we have double-digit top line growth in earnings in all three of our businesses, and we believe we gained share significantly in every one of those 3."
Going forward, the company is well positioned to take advantage of the drive for energy efficiency. A major sustainable driver of profit comes from automotive batteries, which it ranks No. 1 in the market globally. Management has consistently returned free cash flow to shareholders and I do not see any reason to anticipate a change. Johnson Controls booked $4B of net new business in auto and has a backlog in building efficiency that ended 2011 at record levels of $5.1B. Two problems, however, add a significant amount of risk. First a majority of revenue, 51%, comes from Europe and, second, margins are at a historical trough in buildings efficiency.
Consensus estimates for Johnson Controls' EPS forecast that it will grow by 22.3% to $2.96 in 2012 and then by 20.3% and 21.1% more in the following two years. Assuming a multiple of 13.5x and a conservative 2013 EPS of $3.44, the rough intrinsic value of the stock is $46.44, implying 32.5% upside. Modeling a CAGR of 21.2% and then discounting backwards at a WACC of 9% yields a fair value yet higher at $54.05. Safe to say, this company merits its "strong buy" rating on the Street.
Lear is also attractive, but has meaningfully lower upside. Management guided for 2012 EBITDA of between $995M and $1.045B, which was below consensus. What was way below expectations, however, was guidance of $275M for free cash flow - the drive of value creation. With that said, management has boosted its buyback program and cleared up $2B worth of debt through bankruptcy restructuring. It divested its interior businesses in both Europe and North America. The company gained $2.4B worth of new business wins, which continues to rise. Again, the main problem is over exposure to Europe, where the company gets a plurality of its business from at 42%. General Motors (GM) and Ford (F) also contribute 40% to the top-line.
Consensus estimates for Lear's EPS forecast are that it will grow by 19% to $5.26 in 2011 and then by 1.5% and 13.3% more in the following two years. Assuming a multiple of 9.5x and a conservative 2012 EPS of $5.21, the rough intrinsic value of the stock is $49.50, implying 19.7% upside.