Johnson Controls Inc (JCI) was doing well before 2009 when a crash in the economy also led to a sudden drop in revenues, and the firm could not adjust fixed costs accordingly, leading to the only year in the company's 21-year history when earnings fell. However, the firm pounced back with a totally restructured firm, canceling several joint ventures, like the partnership with Saft (to make lithium ion batteries), and building new strategic partnerships like a joint venture agreement with Pricol Limited in India to manufacture components for cars and motorcycle suppliers. The firm's current policy is to penetrate and dominate in emerging markets.
Even though margins are lower, still the firm is likely to experience increased earnings in the future due to its diverse operations. Its power solution segment is likely to bring a fortune, given that the Automotive Industry shifts to alternative sources of fuel. With a forward P/E of just 8x, JCI's shares present an opportunity to buy a high growth and innovative company at cheap valuations.
Following is a deeper look into the three divisions of the firm:
The company operates in more than 125 countries. With over 650 branch offices and 3,600 distribution partners around the world, the firm makes almost 30% of its total revenues from this division. The company forecasts a growth in this segment due to the following factors:
- Growth in emerging markets, especially the Asia-Pacific region, is expected as the Chinese economy is booming. According to the Mckinsey Study 2010, around 350 million Chinese will move to urban areas over a span of 15 years. It is predicted that 50,000 new skyscrapers will be built in this time period. Growth in oil-driven Middle East states is another positive sign. Growing Brazil will give JCI business in Latin America. According to the company s forecast, around 110 billion additional square feet will be built in the world in the next 10 years, and 80% will come from emerging markets.
The pie chart shows the situation graphically.
- Friendly government regulations; The Energy Act of 2005, implemented in 2010, promotes ways of efficiently using energy. The American Jobs Act suggests modernization of 35,000 schools. "Better Buildings Challenge" and Executive Order 15314, all promote energy efficient ways of construction, as does Europe's 20-20-20 goal i.e. 20% renewable portfolio, 20% better efficiency and 20% less green house gas emissions.
- Some rehabilitation work needs to be done in New Zealand and Japan after their deadly earthquakes.
- Rising oil and natural gas prices make the option of energy conservation very attractive to the public.
It is worthwhile to say that JCI is in a position to benefit from this situation only because of its presence in these areas.
In this segment, the firm has developed an integrated system software by the name of Panoptix. This global ERP system helps the firm understand the building dynamics in which their customers live. Using that knowledge, accompanied with their expertise, the firm suggests energy conservation methods. This software has helped the firm reduce operating costs by 9%. This software has given the firm a competitive advantage in this field, and has made the process of interacting with the customer a lot easier.
The segment is expected to grow 9-11% in this year and 10-15% annually till 2016.
Automotive Experience (AE)
AE is the biggest segment of the firm, and accounts for more than 50% of the firm's revenue. The firm has used the concept of vertical integration to increase its technological expertise and presence in emerging markets, which is considered to offer a promising future.
The chart shows that the major chunk of AE's sales come from Europe. The sales for this year have improved by 7% from $5.2 billion to $5.6 billion quarter-to-quarter. The reasons for this rise are:
- Strategic acquisitions that have led to 4% increase in sales - vertical integration has always enabled JCI to produce car components, cost efficiently, due to their collaboration with Original Equipment Manufacturers (OEM).
- Increased sales from China and the rest of Asia.
However, the following factors also negatively affected revenues:
- Consumers in developed nations are gradually shifting to smaller sized cars. This is primarily because of environmental awareness and fuel efficiency laws. Smaller cars mean lesser interiors, and hence lesser sales for JCI's AE segment. This trend is expected to continue.
- Local dealers in AE are often preferred over JCI by local governments in emerging markets, which naturally puts JCI at a disadvantage.
- The production of cars in Europe declined by 4%. Also, a decline in the Euro led to a massive foreign exchange currency loss.
In forecasting future earnings from this segment, the following factors need to be considered:
- The shift to smaller cars will continue, leading to lesser demand for interiors.
- Sales are expected to improve as Europe comes out of the prevalent crisis, and the Euro recovers.
- Car production in China is expected to rise to 36 million cars a year, from the current 18 million production mark in 2017. Production levels in other countries, excluding China, the U.S. and Europe, are expected to rise from 22 million a year to 33 million in 2017.
We can safely say that as long as the vehicles are being produced in the world, AE will keep making business.
The firm is very enthusiastic about its future in automotive interiors. The company claims that it enjoys the competitive advantage in this segment, since it focuses on the latest technology in interiors, and is working to implement them with the help of joint ventures with automobile OEMs. It has projected a global market of over $300 billion in 2017-18. It is also hopeful of cashing in from a big emerging market in China. The following graph was taken from its presentation in 2011.
CHINA'S SALES FORECAST
This division of the firm, even though it generates the least amount of revenues as compared to the other two, has the greatest potential to boost the firm's sales and profitability in the future, given the gradual change in the Automotive Industry and the increasing penetration of hybrid and electric cars in the global automotive market, especially in the U.S.
With 30 manufacturing facilities and 13,000 employees, JCI calls itself to be the largest provider of battery solutions to vehicle original equipment and the aftermarket. By aftermarket, we mean warranty supports and after-sales services.
JCI has predicted the evolution of energy usage in the following manner:
With the production of lead-acid batteries, the firm has also focused on production of energy efficient solutions. The recent introduction of the Absorbed Glass Mat (AGM) battery type is a fine example of this practice. This battery, that gives 15% gain in fuel efficiency, uses a start-stop technology, in which the engine automatically turns off when the car is idling.
- China is at the top of the list again, as JCI plans to invest over $1 billion by 2016 in China to open up new plants for battery production, focusing especially on AGM batteries.
- Next in line are the roaring forecasted demands in Europe and North America, where the trends have been changing. 95% of the revenue for this segment comes from these two continents (75% NA, 20% Europe). The firm intends to curtail lead-acid batteries production and introduce the AGM batteries on a large scale, in which its brand VARTA is the current market leader. This option is lucrative for the firm as the lead acid batteries' business is becoming increasingly competitive, and the cost of lead has risen from $0.45/lb in 2009 to $1.1/lb in 2011, and this cost cannot be easily passed on to consumers.
- The recent acquisition of the Johnson-Saft joint venture for $145 million by JCI shows how determined it is to become the market leader in the power solutions business. This deal is expected to bring in $500 million by the end of 2016.
It is imperative to say that because of a global presence in all of its three divisions, and its diversified operations in the field of automotive and energy conservation, the firm does not seem to be in trouble in the future, despite the current economic downturn.
With a forward multiple of 8x and earnings growth rate of 18%, the expected EPS and market price are given in the table below. These estimates seem plausible given the steady growth of the firm. However, the firm is actively trying to penetrate emerging markets. This can lead to increased revenues in the future. Also, the firm's power solutions business needs to be closely watched as the economy slowly moves towards alternative sources of fuel in light of the hike in oil and gas prices.
The earnings announcement a week later will clarify further the firm's future intentions regarding its power solution business.
The table given below compares JCI with one of its competitors, Magna International Inc (MGA). MGA is a global automotive supplier. The firm designs, manufactures and assembles automotive components into complete vehicles in order to sell them to OEMs of vehicles. Major divisions of MGA are automotive interiors and lithium-ion batteries against which JCI competes.
Even though the operations of JCI are much diversified than that of MGA, yet the financials show us that JCI is doing better. Also, the firm has no debt-related issues and the operating cash flow is positive. The stock also offers a dividend yield of 2.7%. We recommend buying the shares of JCI.