Johnson Controls (JCI) Alex A. Molinaroli on Q1 2016 Results - Earnings Call Transcript

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Johnson Controls, Inc. (NYSE:JCI)

Q1 2016 Earnings Call

January 28, 2016 11:00 am ET

Executives

Glen L. Ponczak - Vice President-Global Investor Relations

Alex A. Molinaroli - Chairman, President & Chief Executive Officer

Brian J. Stief - Chief Financial Officer & Executive Vice President

Robert Bruce McDonald - Vice Chairman & Executive Vice President

Analysts

Robert Barry - Susquehanna Financial Group LLLP

Jonathan David Wright - Nomura Securities International, Inc.

Julian Mitchell - Credit Suisse Securities (NYSE:USA) LLC (Broker)

Mike Wood - Macquarie Capital (USA), Inc.

Joshua Pokrzywinski - The Buckingham Research Group, Inc.

Colin Michael Langan - UBS Securities LLC

Patrick E. Nolan - Deutsche Bank Securities, Inc.

Noah Kaye - Oppenheimer & Co., Inc. (Broker)

Operator

Welcome, and thank you all for standing by. At this time all participants are in a listen-only mode until the question-and-answer session of today's conference call. Today's call is being recorded, if you have any objections you may disconnect at this point.

Now I will hand the meeting over to your host, Mr. Glen Ponczak, sir you may begin.

Glen L. Ponczak - Vice President-Global Investor Relations

Thanks, operator and welcome, everybody, to the review of Johnson Controls First Quarter 2015 Earnings. If you didn't already receive it, the slide presentation can be accessed at the Investors section at johnsoncontrols.com. This morning, Chairman and CEO, Alex Molinaroli, will provide some perspective on the quarter as well as some updates; and he'll be followed by Executive Vice President and Chief Financial Officer, Brian Stief, who will review the results of the individual businesses as well as the company's overall financial performance. Following those prepared remarks, we'll open up the call for questions, and we're scheduled to end at the top of the hour.

Before we begin, just want to remind you that today's conference will include forward-looking statements that are subject to risks, uncertainties and assumptions that could cause the actual results to be materially different from those expressed or implied by such forward-looking statements. These factors that could cause results to differ are discussed in the cautionary statement included in today's news release and the presentation document. We also remind you to review the extended disclosures related to the proposed transaction with Tyco, which can also be found in the earnings document today.

And with that, I'll turn it over to Alex.

Alex A. Molinaroli - Chairman, President & Chief Executive Officer

Great. Thank you, Glen. I first want to acknowledge that this is probably the first time in years that Bruce McDonald hasn't been on the agenda, but just for everyone's sake, he's here, so when we get to the Q&A, we'll make sure that Bruce gets an opportunity to keep his string alive.

What I'd like to do before we get started is just remind everyone, it's been a while since we had an opportunity to talk, and I wanted to remind everyone that in December when we had our Analyst Day there's some themes that I want to hit on. We talked about execution, and over the last couple years, I continue to be completely satisfied with our teams' ability to stay focused, particularly as we transform our portfolio. Our teams within the business units have been focused on reinvesting in growth, but most importantly, being able to improve margins and continue to meet our commitments.

As we talked in December, we've made a lot of progress around our operational excellence, our Johnson Controls Operating System, and it continues to bring and yield results for us as a company within our business units. And I think after the Auto spin, we talked a lot about that, and Bruce had an opportunity to meet with a bunch of you in January in Detroit about the Automotive business, about Adient, and we'll be well-positioned along with the Automotive business to be two great companies after the end of this fiscal year, and I'm pretty excited about that.

And then as it relates to the path of the remaining Johnson Controls, I think that particularly as we talk about our announcement earlier this week and the portfolio changes that we made up to this point and how we've invested within our businesses, I think we're really on a path to achieve our multi-industrial status and make sure that we are in a position to reinvest in the business and continue to increase shareholder value.

So with that, I'll start on slide seven. I won't spend a lot of time on this, but I just want to break a few things down for you to make sure that you understand that from an organic standpoint, although we're not exactly where we want to be, I am seeing some momentum in the business. If you sort out some of the numbers, you see that our FX has impacted us negatively along with a drop in lead prices within our Power Solutions business, and Brian will talk about that when he gets into each one of the businesses.

Also, you have to take Hitachi and you have to make sure that you know that we now have that consolidated within our quarter and it's over $0.5 billion of increased revenue, but then you have to take the deconsolidation of the Interiors joint venture out, and it's over $1 billion.

So if you look inside our businesses, what you see is Automotive business really exceeded our expectation around production levels across the board, and that would include China, by the way. And then BE is up organically 1%, and that excludes Hitachi and FX, and we have higher revenues, particularly in North America and the Middle East. And we'll talk later about North America, but we're seeing some real momentum in that business that we saw earlier, and I think last quarter, we had a little bit of a hiccup because some of the federal government work, but the secured sales continues to come, and our top line I think is in a position to continue to grow. And then Power Solution, if you take out the unit volume and you just take out lead and FX, we had a 3% growth, and I'm particularly happy with some of the sales increase we have in China.

Once again, we continue to see margin expansion in the business at 130 basis points across the board. In Auto, we had record performance. We've never seen this kind of performance before in our first quarter, and we continue to see improvements within that business, and so we're setting that up for success. And then Power Solutions, again, with margins that are almost 20%. A little bit benefit from the low – the pressed lead position, but still we're seeing margin improvements within the business. And now we're seeing BE with the reinvestments into that business with a real position to – in a real position to grow.

If you go to slide eight, let's talk about a couple of things here that I think are pretty important. You know that I'm pretty proud of how our team is accomplishing, and as I said earlier, and with the segmented income margins up 130 basis points and EPS 11% versus last year, even with a little softness in the top line versus where we wanted it to be, we've got a lot of headwinds in the business that are outside of our control, we continue to deliver on the bottom line despite that.

And of course, as I said earlier, operational excellence across all of our functions continues to improve. And I would say that it includes everything from our procurement, our manufacturing operations, our supply chain and the productivity we're getting out of our sales force. We have a challenging macroeconomic environment, but we are gaining some momentum.

If you look at our SSNA, our North American branch business, we saw orders grow in Q1 and we see the pipeline are up. If you look within North America and you just go to North America, you can see that orders are up 13%. Our chiller market share is up 170 basis points. Our hit rate is up; this is historical highs. And then within Q2, we see the pipeline continuing to grow. And so the institutional market focus that we have I think is starting to pay off. It's been a long time coming, but hopefully we'll continue to see that happen. And so we expect to see revenue growth and the pipeline continue to increase.

Actually, in Asia, orders were up significantly in the quarter. Now in the context of things that we saw three quarters of orders being down prior to that, so we were happy to see Asia orders being up. And if you look at Hitachi, we're pretty happy with where we were. Now it exceeded our plan, we've got a long way to go with Hitachi and the integration, but the integration is going well. And as it relates to what our plans were for Hitachi, we had more profitability and better operational performance than what we planned, so off to a good start there.

Power Solutions, great quarter; some real milestones, I was reflecting on Power Solutions and some of the growth. We're going to be adding some more capacity as we speak. Within 2017, we'll have another 6.5 million of units in a new plant in Power Solutions in China. And we hit a record of 1 million units of batteries shipped in China during December, and a little bit less than 3 million units for the quarter, and I was reflecting on that, because you know over the past few years, when I was at Power Solutions when we had our problem with the Shanghai plant, that plant was a 3 million unit plant. And so as we've moved through the past few years, we're now selling in one quarter of total capacity what we had when we first entered China with our Shanghai plant. And then AGM growth continues to be something that's accelerating. Our biggest challenge here is keeping up with capacity. We had a 41% growth in AGM, so the mix is working in our favor.

You go to slide nine, we'll talk about the Auto separation, the Adient spin-off here in a few minutes, and then as you all know, we introduced the fact that we will merge with Tyco earlier this week. And I'm incredibly excited about what I've seen so far, the reaction by our customers, by our employees and by the folks that follow us, our investors. I do think it's going to be a win-win for both companies, certainly for our customers and our shareholders. And so I look forward to working with our partners at Tyco over the next few months as we work toward close. And I think that it's just going to be more exciting times to come for both companies.

Back in December, I think there was a little bit of a disappointment. We talked about the fact that we were just a little unsure of ourselves as it relates to our share repurchase program and we wanted to pause that while we really understood what the costs and the cash flows were going to be associated with the Automotive spin. And I got a lot of feedback there at the meeting that there was a little bit of a surprise. I think it was the right thing to do, but we now understand how this is all going to come together, and so we're going to reinstate our repurchase program in the second half of this year. I think the stock price is at a place where it's a really good buy, and so we're going to – we plan to repurchase 0.5 million shares by the end of the fiscal year in the second half of the year. So I'm happy to report that.

Go to slide 10, you know that Bruce announced earlier this month, and I found out just right before you did the name of the new company, Adient, and it's a real exciting step forward. A lot of things that are on this slide are consistent with what you saw if you were – if you either had the presentation or you were at the presentation that Bruce gave in Detroit, but there's only one real significant difference is that since that time, we've actually received another piece of business, a Hyundai Kia replacement business and a VW metals program, and so that moves from the $650 million of replacement business to $750 million. And of course we already had talked about $850 million of new business that we've seen in the business essentially since we made the announcement. So the team is working hard around separation. We're not seeing any hiccups in the business itself. And in fact, we're seeing momentum. The team is really excited about their future.

You'll get some more information. The Form 10 should be out late March, early April, and then when that comes out, I think you'll get some of the details that you're probably looking for as we work toward getting that complete. I don't want to jump ahead of ourselves. And so I think when that comes, I think a lot of the questions that you might have and some of the things we're still working through will be answered.

And then I think that as we talk about our capital structure, Bruce talked about that, and nothing has really changed as it relates to how we're thinking about the capital structure for Adient.

On slide 11, I'm not going to spend a lot of time on this. This should look familiar; the Tyco and Johnson Controls merger, if you look at the key points on this particular slide, I just want to talk about a couple of things and make sure that it's absolutely clear, and we've gotten a lot of feedback over the last week.

We see $650 million of synergies including operational and the tax synergies that we're going to get from the deal. That's something that we've taken to the bank and we feel very comfortable that we'll be able to achieve. What we don't have in that is any revenue synergies. One of the things that you can expect from us over the next few months as we fully understand how that is going to come together and how we're going to integrate specifically, you can expect for us to update these numbers to include revenue synergies and the timing for that.

So that's – we've positioned that as all upside to make sure that we didn't set some expectations that we couldn't meet. But I can tell you internally, our teams are incredibly excited about this opportunity, and I spoke with George Oliver, and his team is too.

Post-merger, prior to any of the synergies, we're talking about a company with $4.5 billion of EBITDA, so I think the financial flexibility we'll have as a combined company certainly will be much enhanced from what we have today and what RemainCo would have had without the merger.

If you go to slide 12, we've gotten a lot of feedback over the last week, and so we tried to put a slide together that I think is going to be very helpful. There's been a lot of feedback that we've gotten to make sure that people can understand because we are merging and then spinning, what is the value to the JCI shareholder and what are the mechanics and what's included what's not included.

And so I think this slide certainly goes through some of the questions that we've gotten in particular. I'm not going to go through the entire slide because I think most of this stuff is something that we've talked about and that you've been able to understand. I think that the share repurchase helps you understand how we get from the current 650 million shares outstanding to the future combined company of 940 million shares outstanding after the repurchase program. So if you go back into the appendix, there is a slide that I think can help you get from the 650 million to the 940 million of shares, and that might close some gaps for some of the folks that are on the phone that were trying to understand some of the metrics around this deal.

The $10.5 billion net debt is an important number, and if you look at what our – you look at our net debt-to-EBITDA is we'll be in a strong position, as I said earlier, to be able to have some flexibility moving forward.

So with that, I think that as we move forward, we look forward to your feedback to make sure that we're as transparent as we can and make sure that you can – it helps you put together your models. I do know that it's a little bit of a challenge with a couple of the moving parts that we have here.

With that, I'm going to turn it over to Brian and let him go through the businesses.

Brian J. Stief - Chief Financial Officer & Executive Vice President

Okay. Thanks, Alex, and good morning, everyone. Before we move into page 13, just a couple housekeeping things. As you saw in the press release, our Q1 results from continuing operations are adjusted for the $87 million in separation cost, primarily related to the Adient spinoff that we incurred in the quarter. And as I talk through the business unit results and the financials, I'm going to exclude the $87 million in costs from my comments consistent with what we guided to previously to exclude those type of costs. And I'll also comment on just continuing operations as we go through the slides here.

As you know, the formation of the Automotive Interiors joint venture in July 2015 and the closing of our Hitachi joint venture in October 2015, does impact the comparability of the quarter-to-quarter results, and so I will also refer to that as I go through the commentary here.

And then lastly, we did file Form 8-K today, and that Form 8-K will break out for you the fiscal 2015 results with our new reportable segments for BE. It will give you annual fiscal 2014 results as well. And then as we move through 2016, you'll have the comparable quarter amounts for the four new business segments of BE. And those four new business segments are Systems and Services North America, Products North America, Asia, and Rest of World, and we have outlined kind of the mapping as to our old segments to the new segments in an appendix to the slide deck.

So with that, let's go through slide 13 on Building Efficiency. Their sales in the quarter were $3 billion, which were up 18% from the prior year. If you adjust for Hitachi and FX, sales grew by 1%. Revenues in our Systems and Services North American business were up 4% year-over-year, and as Alex mentioned, we continue to see good momentum in the North American branch business. And the Middle East was up 31% quarter-over-quarter, and that was due primarily to several large jobs that closed here in the first quarter. However, Asia, excluding Hitachi, was down 3%, Europe was down 4%, and Latin America was down 31%, although the 31% is off a pretty small number.

Orders secured in the quarter, excluding Hitachi and FX, were up 5%. We're very pleased with the share gains we saw in the North American region where orders increased 8%. As Alex mentioned, Asian orders were also strong in the quarter, up 10%, and we did see a bit of softness in the Rest of the World.

Backlog is consistent at $4.5 billion, and we continue to see strength in the Systems and Services North American business, as far as the new business opportunities pipeline for the next six months, which is up 7%.

If you look at segment income, year-over-year, up 10%. Ex-Hitachi and FX, it's up 2%, primarily due to the higher North American volumes. And as expected, with the Hitachi consolidation, our margins were down to 6.1% versus 6.6% in the prior year. But if you adjust out for the negative impact of Hitachi, we're flat year-over-year.

And we'll comment that for the remainder of the year, we still are confident that the margins will be in line with the guidance that we provided in December, which is a 30 basis point improvement. So overall, a very solid Q1 for Building Efficiency.

If we turn to slide 14, Power Solutions, their sales were down 6% compared to last year. But again, if you adjust for FX and the impact of lower lead prices, their sales were actually up 3%. And just to kind of put a little bit of color around the lead prices, the average price in Q1 of this year was $1,681 as compared to $1,999 in the first quarter last year, and that reduced price of lead finds its way through our top line.

In terms of units, overall first quarter shipments were up 3%, with growth in all regions. Americas up 1%, Europe up 8%, and Asia was up 7%. And as Alex mentioned, we had a record 1 million units shipped in China in the month of December.

We continue to see very strong AGM growth, with quite honestly demand outpacing our current capacity, and year-over-year volumes are up 41% to 3.2 million units. And we saw strong global volumes with the OEs up 4% and aftermarket up 3%.

Segment income in the quarter was $342 million versus $315 million last year, an increase of 7%, primarily the result of the higher volumes, improved product mix and productivity improvements. The segment margin improvement was 260 basis points, but you really have to look at that exclusive of the impact of lead, and ex-lead, it was still up a solid 70 basis points in the quarter. So again, Power Solutions just continued to deliver strong quarters for us.

So turning to the Automotive business, their sales were down 20% compared to last year, but as Alex mentioned, you've got to factor in the deconsolidation of the Interiors business with the joint venture that was formed in July of last year and FX. And if you consider those two items, sales were actually up 4% on across-the-board strong global production.

China sales, which are primarily unconsolidated, as you know, improved 58% in the quarter to $3.3 billion, but that's inclusive of the Interiors joint venture. If you strip that out, China sales were up 11%. So again, very strong performance.

For the quarter, segment income of $266 million was up 15% year-over-year, and Auto margins of 6.3% were up 180 basis points. Again, we get the benefit of the Interiors equity income being picked up with the sales not in the denominator, so if you adjust for that, the Automotive business still showed a 70 basis point improvement in the quarter versus last year. So Automotive simply continues to deliver excellent results for us.

So if I take you to page – slide 16, overall first quarter revenues were down 7% to $8.9 billion. As Alex mentioned, you really kind of need to unpack that in three pieces. There's just short of $1 billion in Interiors revenue that we lost, and then we had headwinds with about $0.5 billion of foreign exchange, and then additive to that would be the Hitachi revenues of north of $500 million. So if you look at it that way and exclude those items, you end up that sales were actually up 2% on a consolidated basis and up across all three of our businesses.

Gross margin for the quarter was 18.3%, up 160 basis points, and I think that's really reflective of the benefits we're continuing to see from the Johnson Controls Operating System.

SG&A was level with last year. Really the way to look at that is the increases that came from the Hitachi JV were substantially offset by the deconsolidation of Interiors and ongoing cost savings and restructuring initiatives that we have across our business.

Equity income was up strong, 37%, to $140 million, and that's really attributable to two pieces; the Interiors JV, which contributed about $20 million in the quarter, and then there were several JVs that came with the Hitachi business and they contributed between $15 million and $18 million as well. So that really is the entire gap there.

So, overall, first quarter segment margins of 8.8% were up 130 bps versus 2015, and 80 basis points excluding the impacts of Hitachi and Interiors, so very strong performance as it relates to our segment margins.

On slide 17, net financing charges were pretty level with last year. We did have a slight increase in our effective tax rate from 18.4% to 19%. And there were a few joint ventures that came with the Hitachi transaction that added about $10 million to the minority interest line in the current quarter.

So, overall, we're very pleased with strong first quarter results and diluted EPS of $0.82, which is up 11% from last year. And I would just echo what Alex said, we're pretty proud of the management teams that are able to deliver these type of results quarter-to-quarter with all of the portfolio transformation that's really going across the company and could be potential distractions for us. But it simply hasn't been and we continue to deliver strong results.

So, quickly, I'd like to hit the highlights in the balance sheet. At quarter end, we've got a net debt to cap of 39.1% versus the prior quarter of 40.5% and year-end at 36.7%. And our net debt of $6.7 billion is up from $6 billion at 9/30/15. And if you look at those ratios and the net debt position, it's really a function of the Hitachi investment we made in Q1.

Capital spending at $300 million is in line with expectations and relates primarily as we've talked in the past about Power Solutions' growth investments. And then cash flow we made some good progress in the quarter. It's normally a cash outflow quarter for us, as you know. It was $300 million in the quarter, which was $100 million better than last year and we had $100 million of separation costs – roughly $100 million in the quarter as well, so stronger free cash flow performance this quarter than planned.

So let's turn to guidance on slide 19. For the second quarter, we expect earnings per share of $0.80 to $0.83, which would be up 10% to 14% from the prior year level of $0.73. And then consistent with our prior guidance, this will exclude the transaction and separation costs in the second quarter, and I note that again simply because we expect those costs to ramp up in the second quarter as we move toward a July 1 operational separation date with full legal separation in early October.

The other thing we've done on page 19 is kind of lay out for you a chart that shows what our December analyst guidance was for sales growth by business and then our sink margin targets by business for fiscal 2016, and I would highlight a couple of things.

As it relates to BE, we are seeing revenue softness in that business primarily in three areas; China, where it seems to be taking a bit longer to number one, secure orders, and then number two, to get the orders executed from a revenue recognition standpoint. So, that's causing a bit of softness for us as we look through the rest of the year. The Middle East, although strong in the first quarter, it looks like with oil prices where they are that there could be some softness in the back half of the year. And then the third area that I'd just point to is there were three or four federal jobs, one in particular, that we thought at the end of the year fiscal 2015 that we were going to secure in early 2016, and for a variety of reasons, those jobs have not been secured yet. And if they aren't secured, that'll provide a bit of downward pressure on our previously provided guidance as well. So, some softness we see in BE as it relates to the 9% to 11%.

In Power Solutions, although unit volumes remain strong, the decrease in lead prices that Alex and I have talked about, as well as the FX impact in the year, could put a little pressure on the 9% to 11% at Power Solutions.

Auto, on the other hand, continues to be very strong, and we would expect them to exceed the revenue guidance that we provided. As far as margins, despite the top line pressures that we see at BE and Power Solutions, we continue to be committed to that margin improvement as well as delivering on the $3.70 to $3.90 per share annual target that we provided in December, and that would be 8% to 14% improvement from the $3.42 that we delivered in fiscal 2015.

So with that, Glen, we can open it up for questions.

Glen L. Ponczak - Vice President-Global Investor Relations

Thanks, Brian. Thanks, Alex. Operator, we're ready to take questions.

Question-and-Answer Session

Operator

Thank you. We'll now begin the question-and-answer session. Our first question comes from the line of Mr. Robert Barry with Susquehanna. Sir, your line is now open.

Robert Barry - Susquehanna Financial Group LLLP

Hey, guys. Good morning.

Alex A. Molinaroli - Chairman, President & Chief Executive Officer

Hi, Rob.

Robert Barry - Susquehanna Financial Group LLLP

Wanted to follow up on the comments on commercial HVAC in Asia, both China and elsewhere. It looks like orders were actually pretty good in the quarter, but you also cautioned that China weakness is kind of weighing on the outlook. So, could you maybe unpack a little more of kind of what you're seeing in commercial HVAC in Asia, China and elsewhere?

Alex A. Molinaroli - Chairman, President & Chief Executive Officer

Yeah, so I think that – and you're right, I caution because you look across our businesses and just because you asked the question, I'll go ahead and answer it, but I'll also point out that we're really surprised with the strength in Auto and Power Solutions continue to gain share and grow dramatically there in China. But when we look at the Buildings business, there does seem to be some delays and some stickiness, and it's been pretty lumpy. If you remember, we had a couple of quarters where we were down. We had a real strong quarter, I think it was fourth quarter sales secured, and so it's pretty lumpy.

And I think from our standpoint, it's probably just best for us to be cautious, and that's why when we talked about our guidance, we report on the top line. It's just become pretty hard to predict as it relates to the commercial business. I would tell you, though, that one of the real surprises we had, I was looking at the Hitachi sales and our VRF sales through Hisense, our – it's an unconsolidated joint venture in China, were up dramatically versus our plan. So I think it's more of a mix issue, and I think at the high-end infrastructure level some of the commercial projects we're doing moving a little slower than we thought. But our VRF sales are higher than what we expected. So, I think we're just going to have to continue to watch it. Thank goodness that North American market just seems to be kind of chugging along and gaining a little momentum.

You didn't ask the question, but I looked inside our secured for North America, and it's truly institutional. If you look at within the institutional and also commercial, which we're seeing some benefit from the CB Richard Ellis relationship, within commercial and institutional, we're seeing that outpace some of the losses that we're seeing within the, essentially the manufacturing and retail segment.

Robert Barry - Susquehanna Financial Group LLLP

Got you. Got you. Just sticking with BE on the margin side, you talked about seeing improvements in the remaining quarters after some pressure in 1Q. Is that just about investment spending moderating, or what's driving that?

Alex A. Molinaroli - Chairman, President & Chief Executive Officer

So as you look – and I'll let – get Brian get into some of the details, but if you look at the margins and you get into the new segments, you'll see that our product margins are under pressure, and that's where the investments are showing up. I think what our expectation is that we had some costs that won't repeat, but we certainly have reinvested in that business purposely, and you're going to see that pressure. It'll get offset, but you'll see that pressure is going to continue to be a little bit on the product side because that's where the investments show up.

Brian J. Stief - Chief Financial Officer & Executive Vice President

Yeah, Rob, I would just add to that. I mean, if you recall, in Q4 we took a pretty good size restructuring charge in BE. And if we look at the timing of those actions, some of those are occurring during the first quarter and we'll just get full run rate benefit for the year in the back half. So there's some improvement in margins just as a result of the timing of some of the restructuring actions we had.

Robert Barry - Susquehanna Financial Group LLLP

Got you. And then just one last one for me. The resumption of the share repurchase, does that add to the EPS target for this year versus what was factored in at the Analyst Day? Thank you.

Brian J. Stief - Chief Financial Officer & Executive Vice President

Yeah, at Analyst Day we had an average share outstanding of 652 million, and at that time, we indicated we were going to pause it for six months and then reevaluate. We had built into the guidance that we had given that repurchase program coming in for the entire $1 billion in the back six months of the year, and now we're doing $500 million, but instead of doing $1 billion at $50 a share, which was what we had built into our plan, we're doing $500 million at $35 a share let's say, just to pick a stock price. And the net effect of that is about a penny or so in the guidance that we gave, Rob.

Robert Barry - Susquehanna Financial Group LLLP

Got you. It benefits it by a penny.

Brian J. Stief - Chief Financial Officer & Executive Vice President

Actually, it's the other way, right, because we had $1 billion in shares at $50 in what we guided, and it's going to be $535 million. So I think the net effect of that's a penny going the other way.

Robert Barry - Susquehanna Financial Group LLLP

Got you. Great. Thank you.

Brian J. Stief - Chief Financial Officer & Executive Vice President

Yeah.

Alex A. Molinaroli - Chairman, President & Chief Executive Officer

Thanks, Rob.

Operator

Thank you. Our next question comes from the line of Mr. Jonny Wright with Nomura. Sir, your line is now open.

Jonathan David Wright - Nomura Securities International, Inc.

Hi, guys. Good morning.

Alex A. Molinaroli - Chairman, President & Chief Executive Officer

Hi.

Brian J. Stief - Chief Financial Officer & Executive Vice President

Good morning.

Alex A. Molinaroli - Chairman, President & Chief Executive Officer

Good morning.

Jonathan David Wright - Nomura Securities International, Inc.

So just going to the Auto side maybe, I mean you guys are actually putting up some strong results despite certainly from some of the investors we've talked who seem more and more concerned about the Auto cycle. I know China's benefiting a little bit from the incentives that have been put in place there. But maybe you can talk about in developed markets what you're seeing, what you're hearing from companies and kind of your outlook for the remainder of 2016?

Robert Bruce McDonald - Vice Chairman & Executive Vice President

Yeah, it's Bruce McDonald here. Yeah, I think if I just sort of run through it regionally, you're right. The incentives that we've put – that got put in place in China that last till the end of the fiscal year have been pretty effective. If just look at the production throughout our quarter, and it accelerated and it continues to be pretty strong. I think there are some questions whether or not after the Chinese New Year's here in early February whether that strength is going to continue. But for now, the production schedules that we have for China look pretty good, and I think people are feeling fairly optimistic and probably much more optimistic than people looking outside into China are feeling.

The Auto sector is doing well and the stock market impact in terms of the how widespread that is, is much lower than people think. So I feel pretty good about the outlook for China for the balance of the year, probably more so than most people.

In Europe, I would say, after a long period of soft volumes, we're seeing sort of double-digit increases in some of the more mature markets like, Spain, France, Italy, the UK, and Germany. Those are holding up pretty well. Our customers are doing better there. A lot of us have taken big restructurings in Europe and so I think we are positioned well, and you'll have seen that in our margins, we're positioned well to benefit from the better volumes.

I'd also point out that in Europe, it's primarily where all the luxury vehicles are made for Audi, BMW, Mercedes and the demand globally for the luxury is strong and that's helping us particularly in our Interiors business and seats because there's a lot more content there. And then in North America, things are looking pretty good. We're, I would say, doing better than the industry because of the enhanced content in larger SUVs and pickup trucks, which as you know are sort of hard to keep in stock here right now. So, I don't think there's a lot of extra growth in the tank for North America this year, but we are seeing a richer mix on larger vehicles and that will be a good thing for Johnson Controls.

Jonathan David Wright - Nomura Securities International, Inc.

Great. Thanks for that, Bruce. And on Power Solutions, 3% growth excluding FX and the lead impact, I think you guys are looking at close to double digits. But some of the key drivers in that business, you have the China record order – record shipments in the month, the AGM up 41% – look pretty robust. Maybe what's different there versus your prior expectation and kind of how do you see that playing for the rest of the year?

Alex A. Molinaroli - Chairman, President & Chief Executive Officer

Yeah, well, the numbers are so big when you get to Europe and North America. When you start talking about AGM growth at 41% and China being record sales, it doesn't – we can't get to the 9% to 10% without both mix and growth within primarily North America, I mean that's really where we need to see it. And so I think that, I mean, I think we feel good about where things are, but it's a little bit out of our control. Particularly when you start talking about the aftermarket and what the weather's going to be and what the timing of that is going to be, but that's what moves the needle when you look at North America. So I think we feel like we're in good position. A lot of it has to do with what our customers are seeing. We're not in a position we're going to gain any more share in North America and so what we really need to see is some – we need to see the weather help us out here little bit so...

Jonathan David Wright - Nomura Securities International, Inc.

Okay, guys. Just, Brian, reported free cash flow this year is $1 billion still the target?

Brian J. Stief - Chief Financial Officer & Executive Vice President

Yes. Yeah, the guidance hasn't changed.

Jonathan David Wright - Nomura Securities International, Inc.

Okay. Thanks guys

Brian J. Stief - Chief Financial Officer & Executive Vice President

Thank you.

Alex A. Molinaroli - Chairman, President & Chief Executive Officer

Thanks, Jonny.

Operator

Thank you. Our next question comes from the line of Julian Mitchell with Credit Suisse. Sir, your line is now open.

Julian Mitchell - Credit Suisse Securities (USA) LLC (Broker)

Hi. Good morning. Thank you.

Alex A. Molinaroli - Chairman, President & Chief Executive Officer

Good morning.

Brian J. Stief - Chief Financial Officer & Executive Vice President

Good morning.

Julian Mitchell - Credit Suisse Securities (USA) LLC (Broker)

Just first a question on pricing within building efficiency. I guess firstly around – you talked about some of the private sector commercial activity maybe being a bit uneven. Have you seen any change in the ability of HVAC manufacturers to price? And then also on your margins what sort of affect do you see for price net of cost this year in BE?

Alex A. Molinaroli - Chairman, President & Chief Executive Officer

You're talking about based on commodities?

Julian Mitchell - Credit Suisse Securities (USA) LLC (Broker)

Yeah and your pricing net of commodity costs, yes.

Alex A. Molinaroli - Chairman, President & Chief Executive Officer

Yes. So I actually don't have that in front of me, so I will have to get back with you and make sure I understand our net hedge position, primarily around copper. We certainly are seeing some help as it relates to our transportation costs, but I don't have an update on that. So we'll follow up on that specifically just so I don't misrepresent it. As it relates to pricing, I was talking to Bill Jackson, our President at Building Efficiency and he seems to feel pretty good that pricing has been rational and probably because we're starting to see orders increase a little bit that we're not under as much pressure, particularly in North America. I think the opposite is the truth when you get to places like China though. I think there's some pricing pressure in China.

Julian Mitchell - Credit Suisse Securities (USA) LLC (Broker)

Understood. Thanks. And then just on Hitachi, you highlighted that it's off to a good start on growth as well as perhaps margins. I just wondered when you look at that business right now, how you think about the priorities there in terms of maximizing say VRF growth in the U.S. versus making sure that you can pull up the margins through cost synergies. And maybe how much higher do think you can push those margins at Hitachi over the next couple of years?

Alex A. Molinaroli - Chairman, President & Chief Executive Officer

Yes. So I think if you were going after the most important things, I mean strategically we need to be able to get our position strengthened in North America in VRF, because we're going to market now, and Hitachi wasn't in the market. So I think that strategically is going to be important.

As it relates to margins, our biggest lever on margins is going to be the business that's in Brazil, and the business that's in Japan and Iraq business, which is a residential business, and that's going to be more around cost than it is going to be around growth. So there's really two answers. One the long-term, it's going to be very important for us to continue in investing. So if you looked inside we should see we're investing in our distribution, and investing in places like North America to set up our channels and our training and our support system. And then if you look at our cost plan, it really is around the residential business and focused in Japan and Brazil.

Julian Mitchell - Credit Suisse Securities (USA) LLC (Broker)

Very helpful. Thank you.

Brian J. Stief - Chief Financial Officer & Executive Vice President

On the commodity question, just to address that quickly, I do have some data here. So as it relates to BE in the quarter, we did get a commodity benefit of about $3 million, $3.5 million in the quarter, and we're forecasting for the year that that number could be around $14 million but based upon current FX levels across the two or three main countries that they do business in that are impacted negatively, it's pretty much offset as it relates to our plan. So there's really no commodity benefit net-net coming through if you consider FX as well.

Julian Mitchell - Credit Suisse Securities (USA) LLC (Broker)

Perfect. Thank you.

Operator

Thank you. Our next question comes from the line of Mr. Mike Wood with Macquarie. Sir, your line is now open.

Mike Wood - Macquarie Capital (USA), Inc.

Hi. Thanks for taking my question. First, are Hitachi sales still expected to be about $3 billion for the full year? And is the lower run rate in fiscal first quarter just seasonality or is there something else there?

Brian J. Stief - Chief Financial Officer & Executive Vice President

Yeah, so a couple of things there. The first quarter was $525 million, and it is seasonal to some extent. I would tell you that we had guided at about $3 billion of sales and $120 million a sync and in that $3 billion of sales there was an entity that's got about $250 million of sales that we were planning on consolidating. And as we got in and looked at the underlying agreements related to the joint venture itself, we determined from accounting standpoint that we weren't going to be able to consolidate that entity. So, instead of $3 billion for the year, our revenues related to Hitachi are going to be $2.75 billion or so, and that correspond where there's about $70 million in the quarter that was impacted as well. So that $525 million was originally targeted to be about $600 million. So, we are now looking at Hitachi for the year about $2.75 billion. And, yes, the $525 million in the first quarter reflects some seasonality in that business.

Alex A. Molinaroli - Chairman, President & Chief Executive Officer

I'd like to point out that the strong [exposed] you saw in China is in unconsolidated. So if you look at the topline growth, where we had the strongest sales, it happens to be – and where we saw the strength in China that was – representing earlier happens to be with Hisense which is unconsolidated.

Mike Wood - Macquarie Capital (USA), Inc.

Great. Then approximately when should we expect to begin to see benefits of the restructuring in that resi business that you were planning?

Alex A. Molinaroli - Chairman, President & Chief Executive Officer

That's a great question. I think the next time we get together I'll be able to update. In fact I'll be at a steering committee meeting tonight. So I'll be able to report on that. So I'm anxious to be able to tell you what the plan is, but I want to make sure that I get it hot off the press.

Mike Wood - Macquarie Capital (USA), Inc.

Great. Thank you.

Operator

Thank you. Our next question comes from the line of Mr. Josh Pokrzywinski with Buckingham Research. Sir, your line is now open.

Joshua Pokrzywinski - The Buckingham Research Group, Inc.

Hi. Good morning, guys.

Alex A. Molinaroli - Chairman, President & Chief Executive Officer

Hi, Josh.

Brian J. Stief - Chief Financial Officer & Executive Vice President

Good morning.

Robert Bruce McDonald - Vice Chairman & Executive Vice President

Good morning.

Joshua Pokrzywinski - The Buckingham Research Group, Inc.

Just to follow up on some of the BE order momentum and maybe unpacking that growth algorithm to 10%.

Alex A. Molinaroli - Chairman, President & Chief Executive Officer

I'm sorry. We can't hear you.

Joshua Pokrzywinski - The Buckingham Research Group, Inc.

Can guys hear me?

Alex A. Molinaroli - Chairman, President & Chief Executive Officer

Yeah, go ahead.

Joshua Pokrzywinski - The Buckingham Research Group, Inc.

Okay. Perfect. Just to come back to that 10% outlook for BE, obviously some puts and takes internationally, and it sounds like the bottom line is North America is still pretty solid. I guess, Alex, how do you think about North America underneath that 10%, and where does the bridge from here really need to get better to start to move closer to that? Maybe the 10% number is more aspirational just given where we started, but what needs to get better or chilled from here to start looking more achievable?

Alex A. Molinaroli - Chairman, President & Chief Executive Officer

If we continue to see the kind of momentum we have in the quarter, particularly the end of the quarter, I mean I think that at some point, in North America, I think that we can get there. I just get a little bit nervous about things that are outside our control. I mean it seems like the actual market is doing better than the financial markets, but at some point the financial markets will make their way to the investors and that – investments and that's what worries me.

I'm pretty bullish on what I see in North America, with one caveat is that there is this cloud hanging around as it relates to the financial markets that just what you hope is it doesn't get our customers spooked as it relates to investments. But the institutional markets are gaining steam, which is our strength. So knock on wood, I'm hopeful to be able to report that we will continue to see that growth. Unfortunately the one thing that we were counting on that did not come back, at least didn't come back at the pace we wanted was, if you remember we got sidetracked at the end of Q4 with the federal government work, it was huge projects, and a lot of them. And we had significant impact to our backlog and to our topline because of that, and we haven't seen that come back, hopefully we'll see it at the end of this year, when it comes to that time again, but it's always been something we can count on, and I'm just not sure if we can count on it now or not.

Joshua Pokrzywinski - The Buckingham Research Group, Inc.

Would that branch business look even stronger ex government this quarter?

Alex A. Molinaroli - Chairman, President & Chief Executive Officer

Absolutely. The federal government – in fact earlier when I said that, I apologize, I said something about industrial – industrial and federal government together are the two ones that are off, not only where our backlog is, but we've seen that continue through the second quarter.

Brian J. Stief - Chief Financial Officer & Executive Vice President

Yes, I mean just to put it in perspective, the government jobs that I referred to that are really out there that we aren't sure if they're going to now be able to execute or even if they will be awarded to JCI given some of the deferrals that are going on are in the $125 million to $150 million range in aggregate. So that certainly is a piece that we need to work through for the rest of the year here.

Joshua Pokrzywinski - The Buckingham Research Group, Inc.

Got you. As I think about how that 10% broke down initially in December, it seemed like there were, if I'm recalling it right, about maybe three or four points of product – new product growth and channel penetration. How would you mark yourself against that bogie today? On track or there may be a bit of a gap there too?

Alex A. Molinaroli - Chairman, President & Chief Executive Officer

There's a gap there and when you talk to the teams, I mean there's two things that when you look at the new segments you'll be able to see that. The product growth wasn't what we expected, and the margins because the investments were a little lower. One of the things that was a challenge for us in the first quarter was that when we were going through the integration of ADTI, one of our brands, our significant brands, we relocated one of the production facilities, and I think we had a hard time catching up with deliveries. So hopefully that will fix itself a little bit, but that was one of the problems we had in the quarter.

Brian J. Stief - Chief Financial Officer & Executive Vice President

I think with some of the product investments that we made in the first quarter, hopefully we will start to see some of that benefit in the back half of this year. But I mean just to kind of frame that you, between product investments and investments in sales resources, that number was almost $20 million in the quarter for BE, and you'll see that when you see the products North America segment data that's in the 8-K.

Joshua Pokrzywinski - The Buckingham Research Group, Inc.

Got you.

Alex A. Molinaroli - Chairman, President & Chief Executive Officer

The other thing that this kind of a – to kind of pile on a little bit, the Hitachi channel work will show up in that number, too, which was – which is an investment that we have to put in place in order to get ready for sales for that particular product. So there was a significant amount of investments in the product North America business.

Joshua Pokrzywinski - The Buckingham Research Group, Inc.

Okay. And just flipping over to Adient real quickly, it might be a little premature for this. I'll take a flyer. I guess with the new structure with Tyco one would imagine that Adient now comes out maybe a bit more tax advantaged than it would have otherwise pre-merger. Any way to maybe handicap what kind of tax synergies maybe versus the former imaginary case.

Alex A. Molinaroli - Chairman, President & Chief Executive Officer

It's a great question. It's a really good question, and I think as we work through that, we've talked about where we are and we just don't have it finally worked out. We will have it worked out by the time we get the Form 10 and the question you have is a great question, and I think that we are sorting through that now and we certainly will have that prepared between now and the Form 10 and so at the latest we will be able to have that then which is late March, early April.

Joshua Pokrzywinski - The Buckingham Research Group, Inc.

Great.

Alex A. Molinaroli - Chairman, President & Chief Executive Officer

Good question.

Joshua Pokrzywinski - The Buckingham Research Group, Inc.

Thanks guys.

Operator

Thank you. Our next question comes from the line of Mr. Colin Langan with UBS Securities. Sir, your line is now open.

Colin Michael Langan - UBS Securities LLC

Great. Thanks for taking my question. Can I just clarify – I just want to understand the power solution outlook. I mean if we take out the impact of lead prices, does the outlook on your – for that segment actually really change? I mean is the sales-that's creating a sales headwind, but dollar margins seem like they're going to look better on a percentage basis, or is there some other underlying headwind there that we should also be considering.

Alex A. Molinaroli - Chairman, President & Chief Executive Officer

That's the way you should think about this business. So one of the things we wanted to make sure that we pointed out was that don't give us all the credit for the 260 basis points of margin improvement, because that's not all operational because as things move around, we may not be able to continue at that level. So that's why we point that out, that we are – because that's such a big part of that pass through that it does impact our margin. But you got it right. As lead prices go down, the margins go up. It doesn't impact us. There is a timing issue that flows through our books, but other than timing, it's kind of a net zero effect dollars wise.

Colin Michael Langan - UBS Securities LLC

And in terms of the outlook for Building Efficiency sales being at risk, you named three items, you quantified some like the federal jobs are maybe 1% of your growth. I mean if all of those items are issues what is sort of the bare case that you are looking at for that from that 9% to 11%? How bad do you think it will get if all of them come together at the same time.

Alex A. Molinaroli - Chairman, President & Chief Executive Officer

Probably half that number.

Colin Michael Langan - UBS Securities LLC

Okay.

Alex A. Molinaroli - Chairman, President & Chief Executive Officer

I mean I think that's probably what we see now. I mean I guess it could get worse, but if we see – kind of if you look at where we are, when we talked about it, our backlog was actually down going into the year because of the federal government work. And so what you have to – what gets a little bit difficult to predict is if the product business doesn't grow, then we are really suspect to the revenue recognition of meeting a backlog and the flow-through to the work. So even if we are secured starts moving at the rate it's been growing at, we'll still have a revenue issue, and so we need to get those orders in now.

Colin Michael Langan - UBS Securities LLC

Okay. Very helpful.

Brian J. Stief - Chief Financial Officer & Executive Vice President

But I would tell you, we've got a contingency plan as it relates to, if that were to happen, we've got actions that we can take to ensure that we still deliver the segment income and the margins and what we've kind of put out there for our full-year guidance. So, we're working the issue relative to top line and adjusting our cost structure accordingly.

Alex A. Molinaroli - Chairman, President & Chief Executive Officer

Yeah, absolutely. So our investments will certainly mirror our top-line prospects. We have not changed our commitment regardless of where we fit in that revenue as it relates to our bottom line, because the other part of this is, it's not like you can't see it coming as it relates to revenue. If our backlog doesn't improve, we're certainly not going to be able to make the investment as quickly as we planned.

Colin Michael Langan - UBS Securities LLC

Thank you very much.

Operator

Thank you. Our next question comes from the line of Mr. Rod Lache with Deutsche Bank. Sir, your line is now open.

Alex A. Molinaroli - Chairman, President & Chief Executive Officer

Hi, Rod.

Patrick E. Nolan - Deutsche Bank Securities, Inc.

Good morning, everyone. It's actually Pat Nolan on for Rod.

Alex A. Molinaroli - Chairman, President & Chief Executive Officer

Hi, Pat.

Patrick E. Nolan - Deutsche Bank Securities, Inc.

Just a similar question on Power Solutions the organic growth, the 9% to 11%. I know it's not the biggest quarter this quarter but how are you – if things are tracking pretty much in line with what you're seeing at the end of the quarter, where do you think that 9% to 11% ends up for the year? And just a housekeeping. What was the actual revenue impact from lead in the quarter?

Brian J. Stief - Chief Financial Officer & Executive Vice President

I'm sorry, the...

Alex A. Molinaroli - Chairman, President & Chief Executive Officer

Revenue impact on lead?

Brian J. Stief - Chief Financial Officer & Executive Vice President

Revenue impact on lead was about $50 million in the quarter. And as far as where the 9% to 11% could go, I guess based upon what we've seen, it could go down to 7% to 8%, yeah, but again, I would tell you that if it goes down to that level, we've got plans in place to cover. So at this point in time, whatever shortfall we might see at BE and Power, we think Auto is over-performing, and so we're very comfortable with where we are for full-year guidance.

Alex A. Molinaroli - Chairman, President & Chief Executive Officer

Yeah, and remember, as it relates to any of the lead impact to top line, it's not something that we should feel from a bottom line perspective.

Patrick E. Nolan - Deutsche Bank Securities, Inc.

Thanks, guys.

Alex A. Molinaroli - Chairman, President & Chief Executive Officer

Okay. Operator, we've got time for one more.

Operator

Thank you. Our last question comes from the line of Noah Kaye with Oppenheimer. Sir, your line is now open.

Noah Kaye - Oppenheimer & Co., Inc. (Broker)

Yeah, thanks for taking the question. So with the Tyco merger now another major integration to manage, just wondering how, if at all, does that change your thinking about the capital allocation strategy once all these ducks are put in a row? Thank you.

Alex A. Molinaroli - Chairman, President & Chief Executive Officer

Do you mean as it relates to after the...

Noah Kaye - Oppenheimer & Co., Inc. (Broker)

Yes after the spinoff and the dividend receipt, the influx of cash, how could all of this change any of your thinking about capital allocation say between M&A, share repurchase?

Alex A. Molinaroli - Chairman, President & Chief Executive Officer

So I don't know that it changes anything except that we're going to have an awful lot going on. And so depending on where we are, and if you look at the cash flows that we look at, I mean, it's going to ramp up because we'll still have some trailing costs as it relates to integration moving into next year even the separation. So I think as our cash flows improve, depending on where we are with the integration, I would expect that we're going to make the right decision as it relates to whether we return that to the shareholders or make investments.

I don't know that we've gotten that far, but one thing I can tell you for sure is around our dividend policy, we're both, at this point, we're both committed to making sure that at a minimum we continue the current dividend policies of both companies. And we have – just to make sure that you understand where we in the process, there's an awful lot of the stuff that we really have to continue work through. We haven't really had a lot of those conversations yet as a team. But we're going to have significant cash flow, that's for sure.

Noah Kaye - Oppenheimer & Co., Inc. (Broker)

Yeah, if I have time for one quick follow-up just to come back to Power Solutions and specifically to AGM, 41% growth in shipments. Maybe at a high-level could you talk about your level of, let's call it, medium-term visibility over the next few years, you're significantly expanding capacity. How much of that visibility related to design-ins and customer commitments and what's sort of the right mix of aftermarket versus OE to think about? Thank you.

Alex A. Molinaroli - Chairman, President & Chief Executive Officer

Well, that – so a great question. It's still going to be a lot more OE than aftermarket because the OE business is growing so fast. And our visibility to that is pretty high because usually it's program driven. A lot of the AGM capacity that we're talking about adding has been in China, but what we're seeing is across the board. I mean we'll be adding capacity in Europe. A lot of that is because the aftermarket is starting to happen there because we've been at it much longer. And in North America, there's actually more than aftermarket that's already there surprisingly. It's not necessarily for start-stop. It's just for enhanced performance, and in China it's really – it's an OE story. So I think it's still going to be a heavy mix for OE and I think that what we see is that most of the capacity if not almost all of it is already subscribed that we're putting in.

Noah Kaye - Oppenheimer & Co., Inc. (Broker)

Excellent. Thank you.

Alex A. Molinaroli - Chairman, President & Chief Executive Officer

Thank you.

Alex A. Molinaroli - Chairman, President & Chief Executive Officer

So let me close out. I mean I just want to comment again. I'm not sure if you were sitting in my shoes how you couldn't feel good about the ongoing performance of the business. We continue to meet the expectations that we set not only as an overall business but within the segments, continue to improve our margins and I think our investments, particularly in BE, we're starting to see the shoots of growth and I'm pretty proud of all that that everybody's accomplishing.

And hopefully you feel the same way that I do that our strategic position is improving. I think Adient is going to be an incredible competitor within the Automotive space and we're setting up to be successful. That's our plan and then if you look at the remaining Johnson Controls, not only the investments we're making now, but you look at the transformational merger that we talked about, we have an opportunity to be something really special and I think that we'll actualize that. So I hopefully have the same confidence I have and we look forward to continue reporting, achieving our near-term and our long-term plan, so thanks a lot. Have a great day.

Brian J. Stief - Chief Financial Officer & Executive Vice President

Thanks, everybody.

Operator

Thank you. And that concludes today's conference. Thank you all for participating. You may now disconnect.

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