I have previously written about Johnson Control's evolution (NYSE:JCI) from an auto parts manufacturer into a multi-industrial with a focus on energy efficient buildings and energy storage and this past Tuesday I wrote about the mechanics of the JCI merger deal with Tyco (NYSE:TYC) that will take effect at the end of September (and please feel free to read either or both!). Sometime next week I am hoping to provide some additional analysis as to how a combined JCI and Tyco would fit together and function, but today I want to take a look at the Johnson Controls 1Q16 earnings call that took place on Thursday. (click here for JCI 1Q16 Corporate presentation) (click here for JCI 1Q16 earnings transcript)
Here are the highlights, broken down by category:
(In this article, "Post-spin JCI" means the merged JCI and Tyco after the spin-off of Adient)
Overall First Quarter Results
JCI CFO Brian J. Stief: "… overall first quarter revenues were down 7% to $8.9 billion… There's just short of $1 billion in (Automotive) 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."
- Some analysts and observers have been underwhelmed by the announcement of $650 million in operational and tax synergies the post-spin JCI is expected to achieve in its first three years. For a company expected to generate $32 billion in revenue, $216.67 million in savings per year is certainly welcome, but far from overwhelming.
However, JCI CEO Alex Molinaroli provided some additional color during the 1Q16 earnings call. "We see $650 million in 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's 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."
- The post-spin JCI is expected to generate $4.5 billion EBITDA and carry approximately $10.5 billion in debt. The debt will consist of (all numbers approximate): 1) $7 billion in JCI debt; 2) $2.2 billion in Tyco debt; 3) $4 billion of new Tyco debt related to the $3.9 billion cash payment to JCI shareholders. This aggregated debt will be partially offset by a $2.5 to $3.5 billion dividend payment from Adient to post-spin JCI.
The $3.9 billion cash payment from Tyco to JCI shareholders looks like a clever way to give the JCI shareholders a significant accelerated future payment from Adient (that Tyco shareholders will not participate in) before the spin-off and merger as a counter-balance to the equity in Adient the Tyco shareholders will receive. Even though Tyco is initially incurring the debt on its balance sheet, the Adient dividend payment to post-spin JCI will offset a good portion of this debt (and put it onto Adient's books if Adient takes on debt to pay it, which is likely), with the remaining amount shared by both sets of shareholders in the post-spin JCI.
- The equity structure of JCI currently consists of approximately 653 million shares. In December, the JCI Board re-authorized a $500,000,000 buyback of stock which had originally been authorized as a $1 billion buyback that had been placed on hold pending re-examination of certain market conditions. The buyback will commence in the second half of the fiscal year (April-September) and is expected to retire approximately 13,000,000 shares. (This would hypothetically leave about 640 million shares of JCI).
- The $3.9 billion cash payment from Tyco to JCI shareholders will be used to retire approximately 111 million shares of JCI, leaving approximately 529 million JCI shares pre-merger. (There was no word as to whether these 111 million shares will be bought on the open market, if they are JCI treasury stock or some combination of both). These 529 million shares of JCI will be merged with 411 million shares of Tyco, for a total of 940 million shares of post-spin JCI.
The $3.9 billion cash will be shared pro rata to the 542 million remaining shares of JCI. These numbers are not precise- market share price will have an impact on the total number of shares retired and any of the $3.9 billion used to purchase shares on the open market (rather than to retire treasury stock) will not be available for distribution to shareholders. In essence, though, Tyco is permanently cashing out about 17 % of JCI as a part of the merger, which helps in understanding the 56%-44% equity split a little better.
Automotive Experience (Adient)
- Sales in Automotive Seating (SE) were down 20% year over year. However, this was almost totally driven by issues related to the deconsolidation of the division from JCI in anticipation of the spin-off. Net revenue for the quarter was $4.2 billion, a decrease from $5.3 billion year over year, BUT income was UP 11% year over year, to $266 million from $240 million.
- Costs associated with the deconsolidation of the Automotive Experience have topped $1 billion from the overall JCI bottom line. These costs are in line with expectations, but they are having a short term impact on profitability.
- The Automotive Experience (Seating) spin-off is proceeding on track and has gained $850 million in new (unspecified) business.
- Adient's initial 10-K will be out in late March or early April and will provide detailed information on the organizational and financial structure of the company. Adient will be operationally independent from JCI by mid-summer and fully independent by October 1.
- Power Solutions (PS) overall first quarter shipments were up 3%; in the Americas, up 1%; Europe up 8%; and Asia up 7%. Segment income was $342 million for the quarter, which was up 7% year over year. The results were somewhat skewed to the upside due to the significant decrease in the price of copper year over year, but even factoring this out of the analysis, income was solid.
- PS shipped 1 million batteries in China during December and almost 3 million batteries for the quarter. CEO Molinaroli said in regard to these numbers, "…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 (per year) plant. And so as we've moved through the past few years, we're now selling in one (fiscal) quarter of total capacity what we had when we first entered China with our Shanghai plant".
- Sales of Absorbent Glass Mat batteries (i.e. "stop-start" batteries for automobiles) have increased 41% year over year to 3.2 million units. The limiting factor for JCI is manufacturing capacity, not demand. Sales to Original Equipment Manufacturers (OEM) were up 4%, and sales to After Market (AM) were up 3%.
- A new 6.5 million unit plant is under construction in China that will be operational in 2017.
- In looking at the combined entity that JCI and Tyco will form after spinning off the Automotive Experience division, Power Solutions doesn't seem to fit with the rest of the company… the post spin JCI Building Efficiency division is expected to generate $25 billion in revenue and Power Solutions is expected to generate $7 billion in revenue. Is it possible that post-spin JCI will look to grow the Power Solutions division for a couple of years and then sell or spin it as well? I think it's definitely possible.
- Orders were up a total of 5% quarter over quarter: 8% quarter over quarter in North America; 10% quarter over quarter in Asia; down significantly in the rest of the world. Revenue was up from $2.5 billion to $3.0 billion year over year for the quarter and income was up from $164 million to $180 million. The Building Efficiency division has an order backlog of $4.5 billion.
- In October, 2015, JCI and Hitachi formed a JV, of which JCI owns 60%, to sell Hitachi's line of air conditioning products through the JCI Building Efficiency division worldwide. The products include Hitachi's VRF (Variable Refrigerant Flow) technology, residential air conditioning, and high efficiency chillers that are paired and integrated with JCI's HVAC technology. The JV is expected to generate $2.8 billion in sales annually. The integration and consolidation of the Hitachi operations has caused some headwinds in the first quarter of 2016, driving margins down from 6.6% to 6.1%. However, this is expected to be a temporary issue and, once consolidation is completed, margins are expected to significantly improve.
- BE lost some federal government business that they thought they had in hand in December 2015 ($125 million to $150 million aggregate). It is unclear, but appears that the funding for the projects may have fallen through. Sales to industrial customers are also down. However, institutional and commercial sales are good (ex. CB Richard Ellis).
- CEO Molinaroli on the BE division: "As it related to BE, we are seeing revenue softness in that business in primarily three areas: China, where it seems to be taking a bit longer to number one, secure order, 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 the area that there could be some softness in the back half of the year. And then the third area that I 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 (sic) 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."
What struck me listening to this report was the amount of change JCI management is dealing with across the entire organization. While the changes are (in my opinion) driven by rational, well-thought out decisions that have been (mostly) well executed and have the potential to drive significant value, the sheer amount of organizational change-management required across semi-related industries (within JCI) and multiple (global) cultures in multiple (again, global) economic environments leaves plenty of opportunity for error, even for a competent and skilled management team.
Is Johnson Controls management biting off more than they can chew?
Are they taking on too much reorganization at one time? Headwinds from the Hitachi integration, deconsolidation activities for the Automotive Experience (Adient), the potential loss of material government contracts for the Building Efficiency division, demand outpacing manufacturing capacity for AGM batteries, and managing and shepherding the merger with Tyco are just some of the issues management must effectively orchestrate, not in isolation, but in a unified manner that drives overall organizational momentum. It seems like a tall task. But one of the traits that drew me to Johnson Controls in the first place was the fact that it is basically three companies in one, and if those entities can be unpackaged from each other effectively I believe there is a ton of value for those who don't mind living through significant changes such as the ones JCI is currently going through.
Disclosure: I am/we are long JCI.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The author is not a professional or licensed investment or financial advisor and the preceding article is intended for informational purposes only. It is not to be taken as ”buy, sell, hold”, or other specific investment or financial advice of any type. Before making any investment/financial decisions, investors are advised to conduct their own research to their own satisfaction and are solely responsible for the decisions and actions they take- the author bears no responsibility for any gains or losses of any investment decision made of any type based on this or any other article written by the author.