Johnson Controls Has Good Growth Prospects

Jun. 08, 2022 2:36 PM ETJohnson Controls International plc (JCI)6 Likes
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Summary

  • The near-term headwinds from the supply chain are waning and should further improve in the second half of 2022.
  • The higher-priced backlog is expected to flow through the revenues in the second half of 2022 and beyond, improving the company’s revenue and margin growth.
  • Valuations are attractive.

Air conditioners on the roof of an industrial building. HVAC

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Investment Thesis

Johnson Controls (NYSE:JCI) Q2 2022 revenues benefited from higher pricing, but the company is still experiencing issues due to supply chain constraints affecting the backlog conversion rate. The headwind from the backlog's pace and mix resulted in a slight decrease in margins, which was partially offset by the company's cost-saving initiatives. Looking forward, the company anticipates supply chain constraints to ease, which should benefit both revenue and margins. Furthermore, the backlog that was booked at higher prices is expected to flow through the sales in the second half of 2022. This should boost revenue and margin growth in 2H 2022 and fiscal 2023. Over the next three years, the company is targeting to improve its margin by cutting costs, as well as growing revenue at a CAGR of 6% to 7%. We rate the stock “buy” based on its good near to medium-term growth prospects

Recent Quarter Earnings

The company recently reported better-than-expected earnings for the second quarter of 2022. The company's revenue for the quarter was $6.1 billion (up 9% year over year), exceeding the consensus estimate of $5.87 billion. The adjusted EPS for the quarter increased by 21% year over year, from $0.52 in Q2 2021 to $0.63 (vs. the $0.60 consensus estimate). The increase in revenue was due to a 6% contribution from price realization and a 3% contribution from volume growth during the quarter. The EBITA margin fell 10 basis points Y/Y to 12.6% due to higher inflation and supply chain challenges, which were partially offset by benefits from the ongoing SG&A and COGS program. During the quarter, adjusted EPS benefited from higher profitability and a lower share count. In the second quarter of fiscal 2022, the company repurchased over $500 million worth of stock.

Short term and Long term growth drivers

In Q2 2022, the company saw strong growth in both its shorter-cycle Global Products portfolio (up 14% year over year) and its longer-cycle Field business (up 7% year over year). There was good growth in both services and installations. Sales in the Field businesses grew 6% organically in North America, primarily due to strength in the Applied business, which grew in the low double digits, while the Fire & Security business grew in the low single digits. The company saw growth in the Fire & Security business in the EMEA/LA region, which grew in the high single digits in Q2 2022. Industrial Refrigeration grew by double digits as a result of the conversion of several large industrial heat pump projects. Low double-digit growth in applied HVAC drove sales growth in the APAC region, with China continuing to outperform with revenue up nearly 20% year over year. The strength across the portfolio, led by mid-teens growth across HVAC equipment platforms, drove growth in the Global Products segment.

Total orders in the Field businesses increased by 11%. Service orders were led by high teen growth in short-term transactional business, and installation orders continue to rebound primarily due to demand for applied HVAC and controls systems. The backlog in the Field business increased by 12% year over year to ~$10.9 billion, a ~$1.2 billion increase over the prior year, and a ~$500 million increase sequentially due to the strong demand in the end market. Organically, Global Products orders increased by the mid-teens, and the third-party backlog increased to ~$2 billion in the quarter.

As inflation began to accelerate last year, the company started factoring higher anticipated inflation into its long-cycle Field business backlog over the last few quarters. However, the company is still converting backlogs from early last year or prior to the last year (i.e. before price hikes). As the more recently booked higher-priced backlog begins to flow through revenues in the second half of fiscal 2022 and beyond we should see an acceleration in growth in 2H 22, FY23, and beyond.

Along with inflation, the company is facing supply chain headwinds, which are affecting the company's backlog conversion rate. For the past year, the company has been working with its semiconductor material suppliers and chip manufacturers to speed up the backlog conversion rate. The company witnessed some improvement in the supply chain in Q2 2022 and expects it to get better in the second half of fiscal 2022 and beyond. The company expects organic top-line growth of 8% to 10% in 2022, with higher prices contributing 6 to 7 percentage points, fully offsetting additional inflation. Higher pricing along with the improved supply chain should drive the company’s revenue growth year over year in FY22.

Despite near-term headwinds, JCI is positioning itself for long-term growth. Culture and leadership, accelerating growth strategies, driving margin expansion, and a disciplined capital allocation plan are the four key pillars of the strategy that the company is implementing to deliver long-term outperformance in its topline and profitability. The company is focusing on big secular trends within buildings, such as decarbonization, healthy buildings, and smart buildings, in order to accelerate growth strategies, and plans to deliver growth by leveraging its OpenBlue technology. OpenBlue technology should aid the company's transition from a break/fix service delivery model to an outcome-based service solution model. JCI can remotely monitor its installed base and generate recurring service revenue by combining existing product technology with OpenBlue technology. The company is targeting a 6% to 7% organic revenue CAGR over the next three years with an additional 1 to 2 percentage points of growth from M&A per year.

The company is also focusing on improving its productivity and taking $300 million in cost out from improved SG&A, and $250 million in COGS effort to improve gross margin. This should be accomplished by standardizing and simplifying operations throughout the value chain, from product development to manufacturing to go-to-market and support functions. JCI should be able to significantly increase its margins over the next three years as a result of this. The company also plans to focus on a disciplined capital allocation strategy that includes consistent share repurchases and opportunistic M&A.

Margin improvement prospects

The EBITA margin in Q2 2022 was down 10 bps Y/Y to 12.6% due to higher inflation and supply chain-related challenges which covered the solid underlying volume leverage and the benefits from ongoing SG&A and COGS programs. Despite achieving over $200 million in price on the top line, price/cost was slightly negative in the quarter, and along with the supply chain disruptions resulted in a 160 basis points margin headwind. The segment margin in North America fell 210 basis points to 10.6% in Q2 2021 from 12.7% in Q2 2021, as volume leverage and cost savings were more than offset by a 250 basis point headwind from the pace and mix of backlog conversion, resulting in lower cost absorption. Although the supply chain improved slightly from Q1 to Q2 2022, the recovery took longer to materialize, which coincided with the seasonal ramp into the peak season in March. These two issues cost the company $40 million in profits in North America.

Due to positive price/cost and the benefit of cost savings, the EMEA/LA segment's margin was in line with Q2 2021, despite supply chain disruptions and lower equity income. Due to price/cost and geographic mix headwinds, the APAC segment's margins fell 40 basis points Y/Y to 11.9%. The improvement in the Global Products segment offset the decline in margins in the Field business. Due to volume leverage, higher equity income, and the benefit of productivity actions, the Global Products EBITA margin increased by 170 basis points Y/Y to 16.1%, more than offsetting the price/cost headwinds.

Business Solution North America segment EBITA margin

Business Solution North America segment EBITA margin (Company data, GS Analytics Research)

North America has the highest margins of the four segments, but it has been declining year over year for the past four quarters due to inflation and supply chain issues. However, management is optimistic for the future, as these issues are only temporary and should be resolved. The disruption in Europe due to the Ukraine war, and in China due to the Covid lockdowns, is expected to have an impact on margins in the second half of 2022, so the company has factored in $100 million for the disruptions. The company's higher-priced backlog is expected to be converted in the second half of 2022 and beyond, boosting margins and keeping JCI on track to meet its fiscal 2024 goals. By the end of FY24, the company expects 250 to 300 basis points margin improvement compared to FY21, thanks to SG&A and COGS savings initiatives under its strategy

For the full year 2022, the company is expecting a slightly positive price/cost. The segment margin is expected to come in flat to down 30 basis points, reflecting pressure related to additional price on the top line with minimal margin contribution and the mix impact associated with the supply chain disruptions in North America. The combination of these two factors should result in an 80 basis point margin headwind, compared to management's prior guidance of a positive 50 to 60 basis point margin improvement. The ongoing conflict in Ukraine, Chinese lockdowns, and supply chain uncertainty have all been factored into the company's updated margin guidance for 2022. The management has also reduced its EPS guidance range from $3.22 to $3.32 to $2.95 to $3.05. This lowered guidance still implies ~13% Y/Y growth at the midpoint. I believe the cost headwinds are getting completely priced into management’s guidance and with any improvement in supply chain/ input costs, there is a possibility of a positive surprise.

Valuation & Conclusion

JCI is currently trading at a forward P/E of 18.52x FY22 consensus EPS estimate of $2.99 and 14.89x FY23 consensus EPS estimate of $3.72 which looks reasonable. I believe the stock is a good buy at the current levels due to the strong long term growth prospects which are temporarily overshadowed by supply chain constraints and inflation. I believe longer-term investors can overlook these negatives as they should be resolved in the coming quarters. Hence, I have a buy rating on the stock.

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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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