Johnson Controls International Is A Great Company But Currently Overvalued
Summary
- Johnson Controls operates in an attractive industry helping buildings become more energy efficient and intelligent with HVAC, Security, Controls, and Fire offerings, as well as software to optimize their use.
- The company has decent growth and good financial characteristics such as high free cash flow conversion and improving operating margins.
- Unfortunately shares are currently overvalued and we would therefore lean towards either just holding or selling at least part of the position.
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Johnson Controls International (NYSE:JCI) is a company leading the evolution of smart, healthy, and connected buildings through their HVAC, Controls, Security, and Fire offerings. The company also offers software to optimize the functioning of these devices, with a platform called OpenBlue. OpenBlue uses the data that buildings generate to drive comfort, security and sustainability. Through OpenBlue customers can focus on creating the desired outcomes without worrying about the details of optimizing the individual devices.
Source: Johnson Controls International Investor Relations
We'll use some selected slides from the recent Investor Day presentation to detail why we think Johnson Controls is a good business, and also provide analysis on why the valuation is a little stretched at the moment.
Markets
The markets where the company operates are attractive, and the company is set to benefit from a push towards more optimized and energy efficient buildings. The company estimates its target addressable market to be $300 billion, with a decade of growth ahead. It also considers its direct channel presence a key competitive advantage.
Source: Johnson Controls International Investor Relations
The company has a very valuable patent portfolio and is considered among the most innovative companies in the world. It has the broadest building-technology portfolio and an increasingly relevant software platform to optimize device operations for outcomes with OpenBlue.
Source: Johnson Controls International Investor Relations
As previously mentioned, Johnson Controls can service a ~$300 billion market, with half of it being services, 41% being HVAC and Controls, and the rest Fire & Security. The company believes there is potential for it to expand by ~$250 billion over the next decade, thanks to several mega-trends such as decarbonization efforts, healthy buildings, and smart buildings. This report estimates that just the market for smart buildings is expected to grow at a CAGR of 21.6% between 2021 to 2028.
Source: Johnson Controls International Investor Relations
The company has a healthy diversification, in terms of geographies, business mix, and domain. The fiscal year 2021 forecasted revenue is $23.7 billion, with most of the revenue coming from Fire & Security, followed by Commercial HVAC & Controls, with Residential HVAC being meaningful as well.
Source: Johnson Controls International Investor Relations
Financials
The company is guiding to 100% free cash flow conversion thanks to improvements in working capital management and disciplined capex. It is also guiding to mid-single digit sales growth and 250-300 bps of margin expansion. This would result in double digit EPS growth for the next few years with some optionality coming from M&A.
Source: Johnson Controls International Investor Relations
The margin improvement is the result of Cost of Goods (COGS) and Selling, General & Administrative (SG&A) cost reductions. In the case of SG&A there are $300 million in identified potential savings, and for COGS the amount is $250 million. The cost to implement this cost reduction measures is estimated to be $385 million.
Source: Johnson Controls International Investor Relations
Hopefully these profitability improvements will result in a higher return on invested capital, which so far has been nothing to write home about.
At least the company does have a track record of improving margins, and we believe they are very likely to deliver on the 250-300 bps improvement target.
One bright spot is the company's balance sheet, which has a good amount of cash on hand and a $3 billion revolving credit facility. The company has a BBB+ credit rating and is targeting a ~2-2.5x net debt EBITDA ratio. We are not overly concerned by the amount of debt, even if it is significant at ~$7.8 billion, since the leverage is relatively low.
Source: Johnson Controls International Investor Relations
Leverage is currently at 2.3x, therefore comfortably within the target range the company has set itself.
Valuation
Where we have the biggest issue is with the valuation the company is trading at. That is despite guidance for 18% to 21% EPS growth from FY21 to FY24. Even with the potential M&A boost, the guided EPS increase does not compensate for the expensive valuation.
Source: Johnson Controls International Investor Relations
Thanks to profitability improvements the EV/EBITDA ratio does not look as expensive compared to its history, but it is high in absolute terms at ~17x. What looks more stretched is the price/sales ratio near a record at ~2.3x.
Shares look pricey as well when looking at the Price/Earnings ratio which stands at 27x when using FY21 estimates, and ~16x if using FY25 earnings estimates. Based on the level of growth the company is generating we think asking for a 27x multiple is too much.
Source: Seeking Alpha
ESG Credentials
Johnson Controls has a culture of "Zero Harm to People and the Environment". With corresponding safety, health, and environment policies to achieve this goal. This efforts have resulted in the company being considered an ESG Leader, even appearing in the prestigious Corporate Knights Global 100 list in position #38.
Source: Johnson Controls International Investor Relations
Conclusion
Johnson Controls is participating in several exciting mega-trends including decarbonization, energy efficiency, smart buildings and indoor air quality. The company is guiding for EPS growth in the 18-21% range and is expecting significant margin expansion. However shares are expensive relative to sales and earnings. Much of the expected profitability improvements are already baked into today's prices. It can be argued that it is worth continuing to hold the shares, but it is difficult arguing for a new investment at today's prices.
This article was written by
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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.
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