Johnson Controls F1Q08 (Qtr End 12/31/07) Earnings Call Transcript

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 |  About: Johnson Controls, Inc. (JCI)
by: SA Transcripts

Operator

Welcome and thank you for standing by. At this time all participants are in listen-only mode. (Operator Instructions) I will now turn the meeting over to Ms. Denise Zutz. You may begin.

Denise Zutz

Thank you and good morning everyone. Welcome to our conference call on our financial results for our first quarter of fiscal 2008. Joining me on the call this morning is Steve Roell, our Chairman and Chief Executive Officer. Steve is going to have some overview comments for you. Keith Wandell is also on the call. Keith is our President and Chief Operating Officer. He is going to be reviewing our financial results for the quarter for each of our three businesses. And then Bruce McDonald, our Executive Vice President and Chief Financial Officer will conclude our comments with some consolidated, as well as, some business financial highlights.

We will then be pleased to take your questions as usual. And we do have available about 60 minutes for the call today.

Before we begin and I turn this call over to Steve, I do need to remind you that we will be making forward-looking statements during the call pertaining to our financial results for fiscal 2008 and beyond that are based on preliminary data that are subject to risks and uncertainties. All statements, other than statements of historical fact, are statements that are or could be deemed forward-looking, and include terms such as outlook, expectations, estimates, or forecasts.

For those statements, the company cautions that numerous important factors such as automotive production levels and schedules, energy prices, the ability to mitigate the impact of raw material costs, the strength of the US or other economies, currency exchange rates, cancellation of commercial contracts, changes to domestic and foreign tax rates, as well as other factors discussed in our most recent form 10-K, dated November 29 of last year, could affect the company’s actual results. And could cause our consolidated results to differ materially from those expressed in any forward-looking statement may by or on behalf of the company.

And now, Steve.

Stephen A. Roell

Okay, thanks Denise. Good morning everyone. Just a few comments first about the quarter on a consolidated basis, first of all we were very pleased with our results. All three of our business units performed, had strong performance in the quarter. And in line with what we expected coming into the period.

Our consolidated sales were up 16% to a record $9.5 billion. Some markets were strong, some were challenging. But in terms of the market themselves, pretty much in line, again, with the market conditions that we expected in the quarter.

Segment income was up 25% to $374 million. And our income from continuing operations was a record $235 million. Which then resulted in an earnings per diluted share of $0.39 compared to $0.28 a year ago in the quarter, up 39%.

On this call I know that our management team and a number of employees around the world are listening. And we would just like to thank them for their contributions to our success in the period.

I just wanted to talk a little bit more about the business environment. And first talking about our automotive experience group, as we look at the industry of North American production, our outlook has been revised downward from what it was at the time that we met with the analysts back in October. We now are projecting and our plan is based on $14 million. Again I would like to remind you that is for our fiscal year that ended in September.

European production, we see it unchanged from what we guided to in our meeting in October. We are seeing some strengthening in Eastern Europe, which is offsetting just a slight weakening in Western Europe. Emerging markets are strong, and we expect them to stay strong for our fiscal year.

Power solutions, the only thing that I can say there is that I think the replacement market demand is stable globally. Certainly in the US we have seen weather conditions be very supportive of our demand in the month of December, early January.

Building efficiency, international construction markets remain robust. What I am referring to there is we are seeing continued growth in China, the Middle East, South America, aided by industrial refrigeration. And so the international markets are good for us, the [inaudible] of North American construction we do see a slight slow-down. I’m sure that I will get a chance to talk more about that later in the call.

But as we indicated going into this year, the strength in our primary sectors, healthcare, education, and government continue to be supported by the industry and economist forecasters. So we feel good about what the industry expectation is.

The non-residential market, as we indicated coming into this year, we don’t expect a recovery in 2008, not until 2009. And if anything, in the quarter it was probably softer than what we expected from an industry standpoint.

On the commodity front, we are seeing increases in energy prices on global basis. We are seeing modest increases in petrol based chemicals such as resin, and chemicals that we use in our foam plants.

We are seeing an increase in logistic costs tied to fuel. And that has been bouncing up and down. I know that oil is down again today and there is speculation that gasoline prices will decline, but in general we are seeing upward pressure on our logistics. Offsetting that is of course the fact that higher energy cost do provide us with opportunities in our energy efficiency group.

And we of course see increased demand and discussion around hybrid technology. I know that many of you were at the Detroit auto show and you had to be impressed by the number of hybrid vehicles that were being showcased at that event.

Lead was very volatile in the quarter. In the middle of the quarter it spiked to the highest that we have seen in a long time, probably 25-30% above our plan. But then it came down very quickly and at the end of the period actually was well within the original [substance] that we provided to you.

Turning specifically to then our view of our budgets to sustain our profitable growth, a couple of highlights for you, first of all we continue to see significant growth opportunities in each of our businesses.

We continue to invest in innovation. And again, I saw many of you at the North American auto show where we showcased over 50 new innovations. We will have over 3000 of our customers, employees, and professionals go through our booth by the end of this week.

We continue to benefit from strong customer focus and relationships that we enjoy. I think our account management processes are very strong in terms of the disciplines that we use. Strength, and our presence in the international markets is certainly a plus for us, and the whole theme around sustainability, and our strength in terms of providing energy conservation solutions to our customers is certainly at a growth opportunity for us.

For a long time we have talked about the importance of diversification in the context of both business, our geographic base, and our customer mix. And that clearly continues to be what makes us different. As we enter this year, we told you that almost 50% of our earnings would come from building efficiency. And if you look at our geographic diversification, those of you that have the graphs, charts that we are using on the right-hand side, you will see that we have a good diverse base relative to the North American and European market.

We continue to have a mix which is supported by our retrofit and service business, and building efficiency. And our solutions group, just to remind you, over 80% of our revenue is assigned to the aftermarket.

Probably the most important thing though is in a market like this, there is a fair sense of uncertainty. You can certainly sense that the continuous improvement culture that we have at Johnson Controls is critical to us. It allows us to respond to changes in those markets as well.

As Bruce will describe to you later, I’m sure that we also benefit from the strength of our balance sheet, which allows us to continue to invest, continue to drive our footprint, make investments that reduce our costs, and also support our growth objectives.

This morning in the press release, we also reaffirmed our guidance that we provided back in October 9th of 2007. Which called for sales growth of 10% to$38 billion, and this will represent our 62nd consecutive year of record sales.

A couple of the key assumptions that I have already mentioned to you that we are assuming that the North American vehicle production will be lower than what we assumed coming into the period. And the residential construction market is slightly weaker.

Our offsets has clearly been our grow-to-gain share and continue to improve in our cost base and take cost out of the business, while at the same time not really impacting the investments that we need to insure the continued growth.

Our earnings growth of 18% is still intact. We are looking for $2.45 to $2.50 per year, which would represent our 18th consecutive sales year of earnings growth. And we are still projecting that our free cash flow for fiscal 2008 will be between $1.1 billion and $1.3 billion.

So with that I am going to turn it over to Keith, who will talk to us about each of the businesses, Keith.

Keith E. Wandell

Okay, thank you, Steve. I’d like to just walk through each of the three businesses here, hopefully and just give some comparisons first quarter ’07 to ’08. And then talk about some of the highlights in the quarter for each one of those businesses.

Starting with building efficiency, our net sales quarter-to-quarter were up 11% from $2.9 billion to $3.2 billion. We enjoyed double-digit increases in our North American systems and services, as well as global workplace solutions businesses.

As Steve mentioned, the North American residential was down about 21%. Segment income was up 33% from $123 million to $163 million on higher volume, and cost structure improvements that more than offset our investments in growth.

And our commercial backlog was up 13% to $4.4 billion with double-digit growth in North America, Europe and the rest of the world, and a higher pipeline in both healthcare, higher education, and the government vertical markets.

Some of the highlights in the quarter were that we did gain market share globally specifically in our HVAC equipment, where we had particular strength in the small tonnage chillers in North America and Asia. We had strong growth for our large tonnage chillers in Asia and especially China.

Our technical services business, we had double-digit increases in North America, Europe, and Asia. And we mentioned residential, and although it is a down market we did gain share, primarily as a result of our increased relationship with the largest residential HVAC dealer in the United States, US Air.

In the quarter we also completed an acquisition of an HVAC equipment manufacturer in Canada, which will help us to build and fill out some of our product offerings in the mid-market. And we concluded two acquisitions of local mechanical service companies, which give us new market share in specific geographic regions.

The building industry’s largest trade show, ASHRAE is going to be held next week in New York. And we are going to be introducing both new rooftop units as well as new residential HVAC systems that are more energy efficient. So we will really showcase our whole theme around energy conservation and sustainability to more than 20,000 potential customers who will be attending that show.

Additionally in the quarter, we won a $7 million contract for controls and HVAC equipment at two hospitals, one new construction and the other a major retrofit. And the reason I bring this up is because it is an example of our customer demand for our one-stop shop offering as we see the benefits from the combination of both the mechanical equipment and the software. And it has enabled us, in this case, to displace the customer’s long-time preferred HVAC equipment provider. We also had several wins in our global workplace solutions business in the quarter, including a new contract with OfficeMax for over 900 locations throughout North America

Looking at our power solutions business, net sales were up 55% from $1.1 billion to $1.7 billion. Really higher unit prices driven by the pass-throughs on lead, and Steve mentioned that lead was volatile in the quarter. Was actually averages at around $3350 for the quarter and excluding the lead impact, sales were actually up 18%?

The replacement market globally was stable as Steve mentioned. Relatively flat in the original equipment market, we were able to see some significant share gains. Segment income was actually down 6% from $142 million to $133 million. But last year in the first quarter in 2007 we had a one-time benefit of $11 million, which did not reoccur in the first quarter of this year.

Lead was really neutral in the quarter. We continued to invest in our hybrid technology as Steve mentioned. And our underlying business performance continues to improve in that business. We expanded our Volkswagen relationship in Europe in batteries.

We’ve PowerFramed the technology that we have introduced in North America which has really allowed us to differentiate our product from both the quality and the cost in life perspective has now been rolled out and is being rolled out in Europe, and is on track.

We have announced some non-lead price increases to recover higher commodity cost such as sulfuric acid, and polypropylene. And then in relationship to our hybrid batteries, we’ve been awarded contracts for both Chery and SAIC in China. And our new factory in Nersac, France has just recently opened.

When we look at our automotive experience business, net sales were up 9% for the quarter from $4.2 billion to $4.6 billion. North America was up 5%, with higher volumes in the GM Lambda, the Toyota Tundra, the Chrysler Voyager and Caravan, the Ford Edge and the F250/350, as well as the Honda Accord. Sales were up 14% in Europe, specifically with the Kia Cee’d, Fiat 500 and the Ford Freelander. And our unconsolidated sales in China were up 43%.

Segment income in automotive was up 123% from $35 million to $78 million. And North America was profitable in Q1 of ’08 versus a loss that we experienced in Q1 of ’07. We have seen in the quarter significant new orders for our react headrest systems business and innovation that we developed which is really an anti-whiplash head-like headrest system. We continue to win new orders. With that particular innovation, as a matter of fact, 10 out of 13 automotive companies think our technology best in class in that particular innovation.

We’ve won new electronics business with Ford, Nissan, and Volkswagen, particular for our instrument cluster technology. And we expect this business to continue to grow. We continue to gain share in Europe with both Peugeot and Volkswagen.

And as Steve mentioned, over 3000 customers have viewed this week our technologies at the 2008 Detroit auto show. We showed more than 50 new innovations that were on display and we have had very, very positive customer responses.

A year ago this past October, we also announced the formation of joint ventures with Chery in China. We continued to make the investment in those joint ventures to insure that the launches next year will be on track and we expect that to happen as we planned.

And lastly I would like to just say that, and Steve already mentioned it as well, we just continue to really focus on cost and quality improvements in all three of our businesses. And I think that it really shows very well in our automotive business the improvements that we have been able to make year-over-year.

With that, I would like to turn it over to Bruce who will go through some of the financials.

R. Bruce McDonald

Okay, thank you, Keith. Turning to slide ten, as we have already mentioned our first quarter results were another record and represent an excellent start to the 2008 fiscal year with the earnings coming in about $0.02 better than the top end of the guidance that we provided last October.

Really reflecting both our business diversification, our geographic diversification, and the successful implementation of many of our growth strategies, sales were up to $9.5 billion, or 16% increase versus the prior year. If we exclude the impact of foreign exchange, which was a significant benefit to us in the quarter, our underlying sales growth was up and is still in front with 90%.

We are pleased to see, as Keith talked about, building efficiency sales up 11% reflecting the implementation of our growth strategies, and importantly our exposure to several high-growth international markets.

Power solutions was up 55% so exclusive of lead price pass-throughs that was 18% as compared to 2007. And lastly in automotive, we saw sales up 9%, although once we back out foreign exchange, sales were up about 2%. And that really needs to be looked at in the context of a quarter where North American production volumes were up 1%, and European production was up an estimated 5%.

Look at our gross profit line we saw an increase to 13.8% from 13.1% in the previous year. And as we have talked about in the last few quarters, net material economics is not really a significant factor on a year-over-year basis. We have a little bit of head wind but it is not a significant factor for us. And that is really because of the commodity hedging program is helping to insulate our short-term earnings from the run-up in commodity cost, and what I am really talking about there is lead. So we have hedged away all of the short-term exposure through financial derivatives.

Turning next to SG&A, about $950 million in the quarter, up about 18%, for the quarter that increase is due to foreign exchange and the balance is attributable to investments that we’re making in key growth initiatives, our global expansion, and increasing our investment in some of our innovation activities across each of the three businesses.

Turning to equity income, you will see about $17 million in the quarter. And as we have talked about in previous quarters that has sort of been trending down versus the year-over-year comparison. We look at sort of the $12 million reduction that we saw this quarter, it’s really attributable to higher engineering costs; and the North American automotive joint venture, and the specific North American joint venture that supplied the transplant customer; higher expenditures in our hybrid battery joint venture with Saft, and the initial acquisition; accounting charges in the US Air Conditioning joint venture that Keith talked about earlier.

If we look at our underlying equity earnings from our businesses in China, they are essentially flat with improved profitability our mature joint venture offsetting the startup costs in the six new joint ventures that we have versus this point in time last year.

Starting in Q2 we are going to see that trend reverse, so in the balance of the year you will see higher equity income in a year-over-year basis. Our overall segment income, as Steve talked about, is 25%. And importantly for me, we saw our margins grow about 20 basis points and that’s a theme that we will see again for the balance of this year.

Turning to slide eleven, talk about financing charges, flat year-over-year. Really the story here is higher interest rate on a year-over-year basis are more than basically offsetting the impact of lower net borrowing levels.

For the quarter, our tax rate was 21%, exactly in line with our guidance, but below the 23% rate that we had in Q1 of last year. Again, continuing the trend that we have seen in the last few quarters we are experiencing a short-term decline in the earnings in our unconsolidated joint ventures and so we have a lower minority interest deduction here. And that is really related to the non-recurring charges in a couple of our European components joint ventures and lower levels of profitability in a few power solution entities where we have got some lags in recovery of lead.

Earnings per share of $0.39 represent a record for us and up a very respectable 39% versus the prior year. Flat when you look to the outlook, and as Steve referred to earlier, we are reconfirming our full year guidance so I am just going to talk about the second quarter.

A little bit of detail here, for Q2 we are forecasting earnings of $0.46 to $0.48 a share, an underlying improvement of about 24-30% on sales of about $9.4 billion. I guess that I would like to note that in Q2 of last year we reported some non-recurring tax benefits of about $0.06 and a $0.01 benefit from the Q in a reduction of our effective tax rate to 21%. So the year-over-year comparable number for 2007 was $0.37 per share, so going from $0.37 to a range of last year to the $0.46 to $0.48 this year.

We expect to see each of our three businesses report earnings growth in the second quarter, and building efficiency is really driven by top line growth. And we expect margin expansion to continue in that business. In power solutions, it’s really our strong earnings growth that is going to be really driven by slightly higher volumes but more importantly improvements in our cost base.

And then in automotive, our turnaround in the North American business is gathering momentum despite the difficult conditions, and we expect to see that as we carry on to into the second quarter and beyond. Europe continues to perform very well for us, and for the balance of 2008 we expect to begin to report sequential improvement in the profitability of our Asian business.

So with that I will turn it back over to Denise.

Denise Zutz

Thank you, Bruce. And actually, Robin, if you could open the line for questions we would appreciate it. Thank you.

Question-and-Answer Session

Operator

Thank you. We will now begin the question and answer session. (Operator Instructions) Chris Ceraso your line is open. Please state your company name.

Christopher Ceraso – Credit Suisse

Thanks, Credit Suisse. Can you hear me okay guys?

Stephen A. Roell

Yes, we can Chris.

Christopher Ceraso – Credit Suisse

Okay, first question is on the growth in the building business at 11%, I think that I remember that you said for the full year you were looking 15%, Bruce, is that right? And then if it is, why was Q1 weaker than that and should we expect it to be better for the balance of the year and why?

R. Bruce McDonald

I’ll take that one, Chris its Bruce here. If you look at our Q1, our building efficiency revenues came in at about exactly in line with where we were planning. We’re sticking to the 15% full year target that we gave you and we are very comfortable that beginning in Q2 and Q3, and Q4 you will see numbers of at least 15% coming through.

Stephen A. Roell

I think that one thing that I could add to that, Bruce, is the fact that if you were to extract the residential decline and in particular the weakness in this quarter, our segment growth was up close to 14%, Chris. And so we don’t expect to see those same, I mean it is going to improve and this is a tougher quarter for the industry in terms of cost. So I think that we won’t have that level of drag on the non-residential or from the residential piece, okay.

Christopher Ceraso – Credit Suisse

Okay and I think that you just answered the next part which is the comparisons. Is that why Q2, 3, 4 it gets better. Not because revenue gets better, but because the cost is easier.

Stephen A. Roell

It gets better but certainly against the first fiscal quarter that we just had, okay. It’s part of the seasonal as well.

Christopher Ceraso – Credit Suisse

Okay, on the flip side it looked like the margin was a little better than we thought in the building business. Was there anything special or favorable about the mix in the quarter?

R. Bruce McDonald

Nothing that I would call of note.

Stephen A. Roell

I would say that as we look at the business that we are booking, we are booking at a higher profitability than last year. So that will probably answer the question regarding any pressure from a cost standpoint or pricing standpoint in the industry. We don’t see it right now.

Christopher Ceraso – Credit Suisse

Okay, you’ve cut your expectations for North America build, but overall your guidance is the same. Where are you making it up?

R. Bruce McDonald

A little bit in exchange, Chris, I think that in our guidance last year that we gave, we assumed year of about 135, and we are currently tracking a little bit ahead of that.

Christopher Ceraso – Credit Suisse

Okay, and then the last one, on the resins do you have any kind of protection or hedging there or any kind of pass-throughs? Or what is the risk there for the margin in the auto business from resins this year?

R. Bruce McDonald

We don’t hedge resin because there is not an economic product. We do have some longer-term, like I’ll say multi-quarter prices locked in terms with our suppliers. And generally speaking the past passing through resin prices in the OE side is generally pretty difficult.

Christopher Ceraso – Credit Suisse

Okay, thank you very much.

Operator

And thank you. Our next question comes from Himanshu Patel. Your line is open, state your company name.

Himanshu Patel – JP Morgan

Himanshu Patel calling from JP Morgan, I wanted to just ask a question on building efficiency because I think Bruce you mentioned that in Q2 and Q3 we should see the growth rate reaccelerate to 15%. Is that all because of the cost or are you actually seeing some sequential strengthening as well in the underlying business.

R. Bruce McDonald

It’s a combination of both, Himanshu. It’s not just the favorable cost on the residential side. The business is accelerating.

Stephen A. Roell

Himanshu let me give you some information here, okay. But let me give you if I could two external points of reference and I will talk specifically about what we are seeing, okay. Dodge puts out their data in October and we didn’t have that at the time that we talked to you, okay. But we have talked to them. We have seen the data now. We have subsequently talked to their economist in December, and what they are projecting is that the education market for new construction building up 7%. And they are also expecting, as we would expect, healthcare to be flat to slightly up. And then confirming what we thought, which was softness was primarily going to be confined to the retail, the hotel or lodging industry, and some extent industrial.

But it is interesting to me, yesterday or two days ago I guess, the American Institute of Architects went out and they have a forecast that they put together that is made up of a panel of seven different forecasters in the new construction industry in North America. And that forecast for ’08, they indicated that they though healthcare would be up almost 6%, education would be up 5.5%, that office would be up 1.7%, and the softness would be declined to retail and industrial. Now that is two industry sources, okay.

Now let me go back, when Keith went through his description of our backlog we talked about being up 13%. And again just to back that, it is up in every one of our geographic segments. We have what is known as a pipeline. I think that I have talked to some of you in the past about the fact that we look at our quoting activity, and when we look at our quoting activity across various segments, whether it would be in the K-12, or the healthcare, we see upward momentum, double-digit levels in those categories. And that is consistent with what we have said.

And we also see the double-digit growth in our solutions business, and in our retrofit activity. The part that may be surprising to you is that we are seeing good strength in the government sectors. We are seeing good growth yet in office. So that is the part that we are saying at this stage we are cautiously optimistic because our data is supporting the fact that we are seeing good quoting activity.

And when I say ‘quoting’ that is the work that we are bidding on which will turn into an order over the next three to six month timeframe. And in addition to again what we have been concerned about is whether or not we were seeing a push-up in awards. I know that somebody had asked that question of us, and you get anecdotal data that says that “Yes, this job got delayed, this one got deferred”. But our index of our total pipeline would indicate that in the October through December timeframe, that there was very little that the re-estimating in terms of when the awards would take place was at very much at historical norms.

So that is the data that we have that we are banking on, and it is the best that I can give to you. And like I said, I think that the term is probably cautiously optimistic. We continue to invest in our sales force, and that’s critical to us as well. So hopefully that answers some of the question.

Himanshu Patel – JP Morgan

Okay, separate question, did I hear someone say that battery revenues excluding lead were up 18% in the quarter?

R. Bruce McDonald

Yes.

Himanshu Patel – JP Morgan

Can you give a little bit more color on that, Bruce, like where was that? Was that on the Volkswagen OEM business that you mentioned?

R. Bruce McDonald

Well, there is an exchange in there as well, Himanshu. I think if you strip out lead and you strip out the impact of foreign exchange, I’m trying to find that number but I think that it is in the 4-5% range.

Himanshu Patel – JP Morgan

Okay. That’s fine. Then two housekeeping questions, could you quantify, Bruce, what the accounting charge was for the US Air Conditioning acquisition that you took through the numbers. And I think that you also mentioned there was a non-recurring charge that affected your minority interest in some of your European component JV’s.

R. Bruce McDonald

Yes, the two of them combined were $7 million or $8 million.

Himanshu Patel – JP Morgan

Pretax?

R. Bruce McDonald

Yes.

Himanshu Patel – JP Morgan

Okay great, thank you guys.

Operator

Thank you, your next question is from Rich Kwas, please state your company name.

Rich Kwas - Wachovia

Wachovia, good morning, everyone. Could you comment on the change to 14 million units from 14.28, I assume the biggest chunk of that is coming out of trucks. Is there any disproportionate change between manufacturers or for model types or segment types that stood out to you?

Steve Roell

Sure, yes, probably rather than going by segment, let me just go back differently. If you recall Chrysler announced the fact that they were discontinuing a number of models, and also cutting shifts. Over half of that from an industry standpoint, in our fiscal year, is tied to the Chrysler changes of both schedule and their models. Then after then I would say it’s pretty well distributed across a number of OEs.

That’s the best I can do, Rich. Just focus on the Chrysler piece, that would be the biggest piece by far.

Rich Kwas - Wachovia

Okay, then the middle market for billing efficiency, I know that’s an opportunity for you. What are your expectations for market share mid-market for fiscal 2008, if you wouldn’t mind sharing kind of your initial thoughts for fiscal ’09.

Steve Roell

Let me try something, then I’m going to flip it over to Bruce here, okay? I think that right now our primary focus is going to be looking at how we can expand our product offering in that space. As you recall, we talked about that at the October meeting, that one of our areas of M&A was going to be in that product segment. Why don’t I flip it to Bruce now and let him talk a little bit about what that means.

Bruce McDonald

I think, Rich, first of all, this is a long-term strategy that’s going to take a long time to play out. There’re a few different tacks. First of all, we have some internal work to do to clinch some of our products, our equipment to get more lower price points so we can be more competitive in that market. We’ve talked about some of the things that we’re doing in terms of footprint and some product inter-relation to do that.

Secondly, in that space we need to have factory-centered controls. We need to develop a lower cost control that we can fit in the factory. Those are nearly finished and will be rolling across our products in the next couple of quarters. We’re really starting off with a positions where we’ve done the comp work on the product, and we’ve done the work in terms of developing the controls. We’re just getting to the point where we’re able to launch those into the marketplace.

What Steve’s talked about is how we can accelerate that organic growth. It’s really one: look into expand into other related product areas so that we can offer more one-stop shopping than just the products that we have; secondly, by having more products we are a more attractive supplier to the independent distributors that are sort of the primary channel in that market place.

That’s a bit of a long answer. But what we’re looking to do in the mid-market sites. In ’08 and ’09, especially when you’re talking about the total JCI level or even at the building efficiency level, it’s a modest thing for us, but it’s something that’s very important in terms of accelerating our growth as we move forward.

Rich Kwas - Wachovia

Finally, how do you feel about your sales force in that area?

Steve Roell

I guess there are two things. I think the sales force that we have has been targeting that market. Number two is we do these acquisitions and in the product categories, that’s one of the advantages we get is we get a sales force. We did one, if you recall, a little over a year ago. That was really the key, that sales force called on the independent distributors, they had those relationships. Part of our ability to be effective there is attracting and through acquisition, a sales force that has those relationships.

Rich Kwas - Wachovia

Great, thanks so much.

Operator

Thank you, your next question is from Jairam Nathan, your line’s open, please state your company.

Jeff Speck - Banc Of America Securities

Hi, this is actually Jeff Speck for Jairam. On the production again, I know that’s sort of a top headline number, and your mix looks good, as well as geographically looks good. You do mention the cost savings, I was wondering if you could give a little bit more granularity on that. Is that stuff that’s being accelerated?

Keith Wandell

This is Keith. We’ve actually been focused on these cost initiatives for the last several years. These aren't things that you can just flip a switch and do overnight. It’s really all around the globalization of our product structure, the commonality of our components, whether it’s in our seat structure, our seat tracks. It’s really about the rationalization of our capacity and our footprint in each one of the regions.

We’ve really done a lot of work in North America over the last several years, in rationalizing our capacity and really driving the utilization of the facilities that we leave open. Also then in Europe, we were early to move a significant portion of our manufacturing footprint from Western Europe to Eastern Europe so that we not only realized the lower labor costs, but also the logistic savings as a lot of the OE customers move their production there.

We have a lot of momentum here. We still have a lot of things to do and there’s still a lot of opportunity. We do have, as was mentioned before our BBP analysis where, in every one of our facilities around the world we understand what our gaps our to our best practice. We have clearly defined and measurable goals in each one of those facilities to drive that improvement.

We just expect that to continue to happen. Most importantly we just have an operations team in place around the world that are really focused and driving these initiatives. We think that will continue.

Jeff Speck - Banc Of America Securities

It ticked up in lieu of the lower production? That sounds like stuff that, like you say, has been going on for years and years and is done continuously.

Keith Wandell

As I said if you think about what occurred in Europe in the last couple of years, that was really driven by all those initiatives. North America was probably a little bit later in terms of the up tick. We’re just seeing the benefit of all those initiatives.

Jeff Speck - Banc Of America Securities

Okay, on the power solutions, given the revenue growth and the related earnings, and you stated a significant hybrid battery investment, I was wondering if you could quantify that. Also does that continue for the next couple of quarters as you head into the launch later this year.

Bruce McDonald

I’ll take that one, it’s Bruce. A couple of things maybe. You should recall that last year we had a couple of non-recurring gains within power solutions that were worth probably 11 million. So when you look a the year-over-year comp, you’ve got to take that into consideration.

In terms of the hybrid investment level. Yes, it is accelerating and it will continue to be a headwind when we look at the activity for the next few quarters. That was in the guidance. Hybrid expenditure was not any higher than we had anticipated it. It’s growing as expected.

Management Representative

I think, Bruce, we just want to remind people that you can get more disturbed if you look at the change in the margin in the quarter year-over-year. But a good portion of that is also due to that higher lead price flowing through.

Bruce McDonald

If you look at the power solutions and strip out the impact of lead, and strip out the one-time items, then what the true comparison is last year, we would have had margins about 12% in power solutions. If you take out the incremental impact of lead in this quarter, our margins were 11%. On an underlying base level 1% deterioration, that’s primarily due to the higher investment that we’re making in hybrid.

Does that help you?

Jeff Speck - Banc Of America Securities

Yes, thanks a lot.

Operator

Thank you, your next question is from Pat Osterbaum, your line’s open.

Pat Osterbaum

Thank you, morning. Can I just first recap a little bit on the building efficiency. I know you guys have gone over it. But I guess some of the information came out in several questions. It sounds like the reason you lowered your outlook for North America, yes the backlog was able to increase in North America is due almost entire to the kind of customers you have exposure to, hospitals, government, that sort of thing, right?

Bruce McDonald

I think you’re a little bit mixed up here. We’re lowering our North American automotive industry function form 14.8 to 14. the only down track we see in North America in building efficiency is the residential side which is softer than we had anticipated at the beginning of the year.

I would just remind you, residential is roughly 8% of the total building efficiency business. That’s the part that we see as being softer.

Pat Osterbaum

Okay, so North America construction down slightly, that’s literally almost entirely driven by residential.

Steve Roell

The North American, again, we’re not taking our number down at all in North American Systems business. What we’re saying is the industry softness again appears to be in sectors we don’t have much exposure in. That’s really the message we wanted to send. What we’re saying is, where we have a strong market share presence in education, healthcare, government buildings, those sectors are holding up as we expected they would.

Bruce McDonald

Our book for revenue growth in building efficiencies, just to be clear is 15% this year and we’re not changing that.

Pat Osterbaum

Right, that I understood I just wanted to make sure that it was just the residential piece that was slower relative to where you thought it was in October. The other thing to clarify, and it sounds like even thought you didn't give specific numbers, it sounds like new orders are tracking upwards inline with your backlog and I guess the follow up I had on that, is it keeping pace with it or again or tracking at a little bit of a softer growth rate?

Steve Roell

I think the order rate that we have, again, I’m going to start with a global backlog statement, we have mixed efficiencies here. Our backlog is double-digits across all our businesses, from a regional standpoint. What we’re suggesting is that in addition to that if you look within North America, we’re seeing double-digit growth in segments of our business that we track which would be in terms of orders. Further in terms of the pipeline that we see, which is a precursor to the orders, we’re also seeing double digits.

Pat Osterbaum

Okay, thank you. One quick last one here, in terms of cash flow, it seems like you had a pretty significant change in payables. That was a significant use of cash this quarter, is there anything unique about that? I know Q1 is kind of a weak cash flow quarter seasonally anyway. Was there anything special behind that this quarter?

Bruce McDonald

No, if you look at our overall working capital mix between receivables and payables. One factor, we did talk about lead. Lead ended the quarter at about 2,600, I think. At year end we were in the lower to mid 3,000, say 3,300 to 3,400. Lead drops, that tends to have short payable terms. So that tends to have short payable terms, that produces an outflow on the balance sheet when we have slated purchases coming through the system. That would be the only thing I would point to.

And last year when lead went up, you saw that we used working capital. The first place it hits is with getting lower payables, then the inventory will start to come down so we’ll pick that up in the other quarters here.

Pat Osterbaum

Alright, thanks a lot, guys.

Operator

Thank you, your next question is from George Nissan, you line’s open.

George Nissan

Thank you very much, guys, congratulations, always a great job well done. A couple of things, what are you guys looking at doing in terms of improving operational initiatives for LEAN manufacturing, GPM and Six-Sigma?

Keith Wandell

This is Keith again, I sort of alluded to that a little bit earlier. Those initiatives are well in place. We’ve had Six-Sigma and LEAN in place for I’d say the past 10 years. Again, through our BBP initiative, we identify all the opportunities that exist by product line around the world. We actually then take about a third of those and put them into our financial plan on a yearly basis, and then really hold ourselves accountable for driving those improvements. That’s something we’ve been doing for some time, and it’s really become institutionalized in our company.

George Nissan

What metrics are you using to measure that, are you using OE or Roanoke? What specific metrics are you using to measure your success?

Keith Wandell

The way we really drive internal productivity is we internally benchmark and we quantify what that means in dollar terms and we focus on what are the actions that need to be put in place to close that gap on an annual basis. We talked about that a lot in the past. That’s how we measure our success. We see performance of the plants, operations improving, the quantified amounts of that gap between where that plant is and the best in class. That’s how we track if we’re making progress or not.

Steve Roell

George, maybe another way to think about it, this is Steve. What we put in place, is that we track all of the products under a lot of those estimates that Keith just gave to you. Monthly we have an operations review with each of our businesses and we often meet in other parts of the globe to talk about specifically how they’re performing against each one of those tracks versus their annual projection. Underlying that we have a tracking system that looks at each project, it’s signed off by the controllers and we track all that directly into our profit plans to make sure we have it tracked against what our expectations are.

George Nissan

Are you looking at specific plants in general in terms of operational improvements?

Steve Roell

There are several cuts. We look at it by business, by product line and by plant. Then typically, what we’ll do is we’ll have the five or six most important drivers in each one of those businesses. Then we’ll parade allow all the cost drivers associated with those, whether it be productivity, whether it be product cost, whether it be inventory turns, whether it be working capital management, logistics costs, et cetera.

You can look at it at different cuts, but it gets down to the plant level, it gets down to the department level within plants, and we have tracking measures in place to see exactly where those improvements are being made and again, they’re all tied into our financial plans.

George Nissan

What I have noticed in the past, a lot of guys in the industry seem to be emulating your initiatives. How long would you say your continuous improvement program has been in place and what systems are you using to continue to accelerate these programs?

Steve Roell

Again, we’ve been focused on continuous improvement in all three of our businesses for many years. I think the way to categorize it, the way we look at it is, we call it BBP, Best Business Practice. That’s really the umbrella, if you will. Beneath that, we do have a toolbox that we train all of our people in. It includes Six-Sigma, it includes LEAN, it includes Just Do It as an example. What we do again, is we’re really focused on identifying those best practices, identifying our gaps and then driving accountability through the organization to make sure that everyone of our businesses are making the improvements that are expected.

Again, we’ve institutionalized this. It’s part of our management philosophy and how we run our businesses. We expect that to continue into the future.

George Nissan

Final question, guys, as we go into the next year, our economy obviously is going through a lot of challenges. What are you going to say, Steve, is your top goal as CEO for 2008 to improve on overall group [inaudible 00:03:40] and make sure that Johnson Control stays a leader in the industry?

Steve Roell

There are two things. When we talk about my goals, one is the growth objective, we’re a growth culture and we want to make sure we’re making the proper investments and the proper moves to make sure we can grow this business.

Secondly, given the environment we’re in we have to ensure that we’re achieving what Keith just described to you, which is lowering our costs, become more productive, part of that would be not just productivity, but we’re focused on what we can do to improve our time compression and speed. That’s something that our customers are expecting from us.

George Nissan

Great, thank you very much, continued success down the road.

Operator

Thank you your next question is from Brett Hoselton, your lines open.

Brett Hoselton - Keybanc Capital Mkts

Hi, guys, is Denise there too?

Denise Zutz

Yes, sir.

Brett Hoselton - Keybanc Capital Mkts

Hi, Denise, how are you?

Denise Zutz

Fine, thanks, Brett.

Brett Hoselton - Keybanc Capital Mkts

First of all, what related product areas might you be referring with regard to expanding your middle market presence?

Keith Wandell

[OVERLAY] if we said something that might create more concern, The reason I say that is because there are three or four players in the area that we’re targeting, so that would be a little too specific for us, okay? I wish I could give you that guidance.

Brett Hoselton - Keybanc Capital Mkts

That’s, okay, I figured I’d ask and if you told me that would be great. Anyway, residential softer than expected, can you give me a from-to, what you were thinking before, what you’re thinking now?

Bruce McDonald

I think we were hoping that we would see maybe a flat-ish market for the year, that was kind of our assumption when we started off the year. We also expected to outperform the market because of the US, their commissioning transaction that we completed late in our fourth quarter. If you look at our used processes in the quarter, despite the fact that we have the incremental volume for the US Air transaction, our sales were down about 20%, so quite a bit softer than we expected.

Keith Wandell

I think for the full year, Brad, the estimates are now honed in on down to 8% down 10% from an industry standpoint.

Brett Hoselton - Keybanc Capital Mkts

A theoretical question, what are the major changes versus your prior guidance. You talked about the exchange rate being better, lower North American production is obviously a negative, are there any other significant changes?

Steve Roell

The ones we talked about were really the [inaudible – 00:06:45] in North America and the residential begin softer than we expected. Those are the two major ones, exchange rates a little bit different than what we thought [inaudible – 00:06:50] but it’s normalized again from what we assumed at the time.

Brett Hoselton - Keybanc Capital Mkts

The $78 million pre-tax charge, what was that in again? I apologize, I didn't quite catch that.

Bruce McDonald

That was the total of the unusual items flowed through our equity income line in the quarter, Brett.

Brett Hoselton - Keybanc Capital Mkts

Finally, this is just a theoretical question, I’m not sure I understand. You’re spending a lot of money on the lithium battery business right now. You’re a really smart company, good return on capital, wise use of capital and so forth. Somehow you obviously believe you’re going to get a return on capital for lithium batteries, I think, unless of course, you’re just going to do it because you’re nice guys and you’re going to look green and so on and so forth. Somehow you think there’s a business scope for lithium batteries that I just don’t see at this point in time. Can you very, very briefly, Steve, give me an idea where I might find the business case for lithium batteries.

Steve Roell

I’m actually anxious to answer this question.

Bruce McDonald

I’m not so anxious, but we are nice guys.

Steve Roell

The way we look at it is, clearly there is a move towards hybridization of vehicles for all the reasons that we know about. Our view is that even if 7% or 8% say of the total vehicle build is hybrid, that’s not a huge number. But the market for lithium batteries will be bigger than the total lead acid battery market today that we participate in, that’s really our business case.

Beyond that, there’s going to be winners and losers in this thing, and our intention is to have the best technology and partner with our customers and help them be successful.

Brett Hoselton - Keybanc Capital Mkts

Is that in a dollar revenue basis?

Steve Roell

Yes.

Brett Hoselton - Keybanc Capital Mkts

And is that considering the idea or thought that lithium batteries are hopefully going to come down in cost?

Steve Roell

Yes, absolutely. That’s assuming that it’s scaled appropriately, Brad. I also think, just a commentary, this offers us an opportunity to really strengthen our relationships with the OEs. It’s much bigger than supplying a battery. It’s a much closer relationship. There’s a lot more sharing, a lot more discussion. So this is not a typical supplier/customer relationship and everybody understands that.

Brett Hoselton - Keybanc Capital Mkts

Then, Steve, you rattled off a lot of pertinent data related to the Dodge construction index and the American Institute of Architecture and so forth, my question is can you get Denise or may Glen to maybe send us some of that data?

Steve Roell

Sure we can get you some of that data. It’s all public information from web sites, we’ll try to get some of that to you.

Brett Hoselton - Keybanc Capital Mkts

That would be really helpful, thank you. And Denise, you’re a nice person, too, I didn't mean to leave you out.

Denise Zutz

Appreciate that, Brett. And operator, I think we’re close to the top of the hour, so I think that’s the end of our question and answer session and we just want to say that we appreciate everyone’s interest in the company and we’re more than happy to take any more question you may have, later today. Thank you.

Operator

And thank you, this does conclude the Johnson Control Conference, you may disconnect your lines.

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