Johnson Controls International plc (JCI) Earnings Call Transcript & Summary

Good morning. Thank you for your attention here. We're very pleased to have with us Johnson Controls, JCI, represented by Chairman and CEO, George Oliver; and Vice Chairman and CFO; Brian Stief. We also have Antonella Franzen and then Ryan Edelman as well here. My name is Gautam Khanna. I'm the research analyst at Cowen, who has covered JCI and before that, Tyco, for a number of years. And it's going to be a fireside chat format. First, I wanted to turn it over to George and Brian for some opening remarks, then we'll get to the Q&A.

First, I'd like to thank you, Gautam, for having us at the conference. It's always good to be here with you and the team. And what I'd say is we're coming off of 2 very good years of performance. And when we had our earnings call a couple of weeks ago, we're off to a good start in 2020. So I think it's probably appropriate we get into the fireside chat.

Sure. I appreciate that. Well, George, maybe at a high level, could you take us around the world and give us a sense for the demand environment, what you're seeing, what's changing?

Yes. So let me start with North America. North America continues to expand, maybe at a little bit of a slower rate, but we're still seeing good activity across the verticals that we support. We do have -- when you look at our backlogs, it's still up mid-single digits on a go-forward basis. When you go to -- if you go to EMEA, we've had really good performance there over the last couple of years in how we've positioned the business and how we're gaining share and outperforming in spite of the economic conditions. We've delivered very nice growth. In the first quarter, we're 6%, 7%. And then as we project the year, we're still going to be kind of low to mid-single digits for the rest of the year, and that's continuing as planned. And I had the opportunity to spend a week in Latin America last week. And in spite of the economic conditions there, we've also seen very strong performance. And a lot of that is, I think, capitalizing on the capabilities that we bring to that market, the value propositions that we make to our customers. And we've seen nice double-digit growth there, and that performance will continue. And when you go to Asia, we've had solid performance there. It's a little bit mixed. But overall, good performance in the first quarter. Certainly, the situation with the coronavirus we're watching is very fluid. We're watching that daily and making sure that we're positioned to continue to minimize any impact that we see from that. But overall, we're -- like I said, we started the year with continuing to maintain our backlog of about 6%. We're projecting that we're going to continue to convert orders kind of low to mid-single digits, and that has positioned us to be able to deliver again a very, very strong performance in 2020.

Can you expand a little bit about what's going on in EMEA? Your company-specific initiatives, you started a couple of years ago. And what specifically has changed and why it's actually gaining commercial traction?

In EMEA/LA?

In -- yes, EMEA/LA, yes.

So EMEA/LA is -- when we started the -- when you go back to the integration of those businesses, those businesses didn't have -- a lot of the businesses didn't have scale. The fundamentals were strained. And so what the team has done there extremely well is to put the businesses together during the integration, streamline the businesses so that from a go-to-market standpoint, in every market, we have a good understanding of the market that we serve, how do we segment our sales team to be successful and how we grow in each of the markets; and then from an efficiency standpoint, get tremendous leverage off of the footprint that we have. And they've done an extremely good job in doing that. And then not only expanding our installed base would the -- kind of the over market performance with how we're executing on our installation business, but from a service standpoint, making sure that with that installed base, we're getting our fair share or more of the service growth and the recurring revenue. And they've done a nice job there. So I mean I'm very pleased with the work that's been done over the last 2 or 3 years. And I believe the fundamentals are in place so that we can continue to improve the fundamentals while we're continuing to reinvest and ultimately outperforming the market.

Can you guys -- I would just say, I think if you look at Europe, dial back a couple of years ago as part of the integration and some of the restructuring that was done in Europe, Jeff Williams did a really nice job when he was the leader of the European business to take a real hard look at the cost structure post JCI-Tyco integration there. And I think the benefits of that, we've seen really come through the last 12 months. I mean we're -- 200 basis points improvement, I think, is pretty solid.

And speaking of the -- increasing the service tail, if you will, can you talk a little bit about attach rates now versus 2, 3 years ago before the integration really began?

Yes. I would say, from a strategy -- this has been a key element of the strategy over the last 2 years that as we put resources into how we develop the installed base and differentiate that installed base, that we're making sure that from a go-to-market standpoint, we're capitalizing on that to be able to get the recurring revenue, whether it be through an attach contract or through L&M, depending on how our customer works. And so I'd say it varies, but across the globe, we're seeing improved performance. When you look at our service growth from where we were really 3 years ago, it was relatively flat, low single digits. And on average, we've achieved over 2 consecutive years 4% or 5%. And the idea here is not only do we continue that with the expansion of our footprint with the traditional service, but the opportunity that we have going forward is how we're now taking our digital technologies not only to enhance the service that historically we have performed and being able to make it much more predictive, do some of it remotely, but then to be able to build on that base because with our installed systems today, we can extract a lot of data from multiple systems. And then with that data, we can create incredible outcomes above and beyond historically what we've done. And the big focus right now is around energy. HVAC is one of the most significant users of energy within a building or infrastructure. And when we not only bring our leadership product, but then from a connectivity standpoint, within the building, we utilize all of the data across the building not just relative to the equipment. You can optimize that such that we can reduce energy, 20%, 30%, 40%. And so there's a lot of value to be created now with not only the equipment that we deploy but also the systems that we can leverage, and that ultimately then creates service in how we ultimately better support the customer base that we serve.

Speaking of that, we often hear Trane technology -- Ingersoll Rand talk about this type of performance contracting, incentive contracting, where they will guarantee some level of energy savings, anything above that. Maybe they'll get -- they'll share in the upside that the customer saves. Are you guys -- is that part of the business model? And where is that?

Yes. So just to size that for you, Gautam, it's about a $600 million business at Johnson Controls. And essentially, what that performance contract business does is we'll go into a large building or set of commercial buildings, and we'll do engineering studies to determine what type of savings we think we could generate in that set of commercial buildings on a go-forward basis. So these contract terms can be as long as 20 or 30 years. What we do is we go in and commit to a level of guaranteed savings, such that the cash flows of the savings from a customer perspective essentially provide really the cover to their financing cost plus some incremental savings on a stand-alone basis for the customer. And so from a risk standpoint at JCI, you'd say, "Okay. Well, you're guaranteeing these savings contracts for a multiyear period." Our experience with those has been extremely favorable. I mean our guaranteed savings shortfall in any contract has been really de minimis for the period of time that we've been in this. So because of the size of some of these contracts, it can be a bit choppy as far as orders secured in a particular quarter and the flow rates of some of those contracts. But all in all, it's about a $600 million business, and I wouldn't expect huge growth one way or the other on a go-forward basis in that.

Because it's fairly mature as it stands right now.

Yes.

Going back to EMEA/LA just for a second. You did call out, I think, the Middle East being a little bit softer. And that was about 10% of the segment, if I recall. What specifically is going on there? And when do you see that starting to abate?

Yes, that market has been -- obviously, it was an incredible growth market for us up until a couple of years ago. And then with the compares we had, we had tough from a compares standpoint last year in 2018, and then that continued. On a run rate basis, we're actually back, I think, slightly positive year-on-year now. And so the team has done -- I was over there latter part of last year. We've done a tremendous job making sure that we're not only positioned with the right technology and product but also from a footprint standpoint, that we're best positioned to be able to support the infrastructure there. So I believe that with some of the recovery and the like that we're well positioned. We're building services as a percent of our revenue. Service continues to expand with the installed base that we have there. So I think it's just making sure that from an economic standpoint, we understand what the impact is and that we're always focused on how do we create more value for our customers that through the economic cycle positions us to be able to have a better service footprint.

And at a high level, talking about service growing in the mid-single-digit range, is that sort of the long-term average that you would expect up and through the cycles? Or how should we think about how service is relative to the product business and the install business?

Yes. When you look at our core businesses and each of the domains, whether it be HVAC, Fire, Security and then when you build an installed base what is that revenue stream over the life cycle? It's been relatively low growth, the traditional. It's been kind of in line with the overall GDP-type growth. As we now have put services front and center to what we're going to -- how we're going to take the company forward, there's tremendous opportunity to expand what we currently do. And a lot of that is not only expanding our footprint and making sure that from a customer standpoint, we're best positioned to serve existing customers. But as I said earlier with our digital capabilities, there's tremendous value propositions that we can add to our current services that we believe opens up a whole new market. And that is in line with what's happening just more broadly with digitalization of buildings and infrastructure. And with our position in buildings, with all of our multiple digital assets as they're defined today, we're -- what we're doing is we're bringing all of those assets together into a simpler architecture that when we build our data layer, that utilizing multiple streams of data, applying artificial intelligence or machine learning, that we can create incredible outcomes beyond what historically we've done to serve our customers. So with that new market growth on top of our traditional growth, we believe that we can sustain kind of a mid-single-digit-plus growth on a go-forward basis. But there is -- with this disruption that's happening, we believe that the combination of our technology and products and our installed base, combined with the technology that we deploy that enhances our services, we have a tremendous opportunity to capitalize on the trends that are happening within buildings.

So is it fair to assume then that -- also that service as it matures is going to be much higher contribution margin than traditional service has been because it is digitally enabled? What -- and you can charge for the value and...

Yes. I mean what I would say is that a company that is -- with the reinvestments we're making, we want to make sure that with the value propositions that we create to serve our customers, that we're getting the appropriate returns on those value propositions. So with the digital capabilities, there's much higher value. And so you would expect that with that that you'd be able to maintain and grow margins as a result of that new business, I don't know, within the digital space.

That makes sense. One thing that I -- it's been nearly 4 years since the merger. And I'm just curious, where are you in the integration? You talked about the initiatives in EMEA/LA. We know about what's happened in North America. But is the branch consolidation all done? I mean where are we in that journey? What's still left to be done?

So what I would say is when you take 2 large, very complex companies across multiple domains and we put them together because we believe that longer term, the combined capabilities was what was truly going to differentiate Johnson Controls to lead Buildings, all of that has been true. Now when you do that, it is very complex. We have a very complex footprint. And bringing it all together, we've made tremendous progress in the first 3-plus years here. And so the idea going forward is with that foundation, with the strategy to ultimately be positioned to grow and get leverage with the growth, that there's still tremendous opportunity to continue to drive productivity through the system that enables us that as we continue to grow, we can continue to deliver productivity, continue to reinvest and still be able to see nice improvement in margins on a go-forward basis.

Sure. But in terms of like the branch -- you guys actually had laid out several buckets of cost savings. Are we mostly -- is that basically behind us? Or where are we? I know it's a continuous...

Yes. It is. I would just say, to frame it from a financial standpoint, as I think you know, we had committed to ex Power Solutions about $900 million of productivity and synergy save. And the remainder of that save will be delivered in 2020. So it was a 4-year program, '17 through '20. We've got $150 million that we'll deliver this year, and that will really be, I would say, the end of the original view as to what type of effort was required to integrate the businesses. We were -- you'd kind of say, why $150 million in the fourth year? Why did it take so long? You might remember that as part of the JCI-Tyco merger, we were restricted for a period of time in merging all of the operations because we had some debt outstanding. And we talked to -- about it as the TSarl debt, which required us to operate the 2 businesses as almost stand-alone companies to some extent for a period of time, and a lot of that had to do with our ability to integrate branches and certain of the operations. That was alleviated in third quarter of last year when we paid off the TSarl debt. And so we now are finishing up all the branch integration and move to shared service centers. And a lot of that activity is what's happening in fiscal '20. So I think as you move forward into 2021, we're no longer going to have the integration costs. We'll leverage, as George said, the base that we've established through the combined companies.

Interesting. That's actually very helpful context. So -- but we will have achieved $900 million of savings by the end of this fiscal year?

Sure.

Okay. One of the things we talked about at the onset of the merger was the potential for revenue synergies, which I know at the time was just hypothetical. But can you speak to whether any of that actually manifested? And if so where?

And so when you looked at -- when we did the merger, we're relatively low -- very low growth. And very quickly as we got through that first year and I ultimately succeeded Alex, we took a step back and said, "Are we really positioned now from a sales capacity productivity, market-backed structure that enables us to be able to now leverage all of our combined capabilities to be able to deliver on outperformance of the markets we serve?" And so we did a tremendous amount of work. And if you look at the last 2 years with what -- how we built out our capacity, now how we're getting leverage with that capacity to be able to accelerate the growth. Recognizing that, when you look at our domains, HVAC or Fire & Security, we're still positioned to be able to serve customers the way that they were served. So it isn't just -- it isn't bundling per se. But it's leveraging our regional presence with the customer base that we serve, whether it be in HVAC, Fire & Security. And then as they evolve going forward, that we're much better positioned now to take the expanded capability and really help them transform their business and ultimately deliver a lot of value. So when you look at our growth rates that we've achieved over the last 2 years, we've delivered on that and then some, I believe, based on how we've put the structure together, how we've segmented the market, how we've established our sales force and then now how we've executed on not only building pipelines but converting pipelines to orders and ultimately to revenue. We are definitely getting the leverage out of that expanded capability.

Meaning, you're introducing HVAC products to your legacy Fire & Security customers and vice versa?

So today, we still -- it's -- you're obviously influenced by how the customer buys, whether it be HVAC, Fire & Security. But you can imagine, especially with when you look at our portfolio of BMS, Building Management Systems, we have a strong position in building controls, which tends to be the foundation of the digital assets within a building. And then we have electronic fire, electronic security, and that breaks out into 3 or 4 domains. And so the idea is not only do we continue to operate as we do within the domains. But more important now, from a customer standpoint, we have this incredible opportunity to bring all of that together and create a whole new value proposition going forward. So not only are we getting the leverage across the domains with the regional footprint, but now being able to really transform customers with the combined capability.

Which brings me to a remark you made on the earnings call, which was at the front log of the pipeline of opportunities is still continuing to grow. I think you said at one point mid- to high single digits on the call, and maybe correct me if I'm wrong. But is that kind of what we're seeing? And maybe if you could break that out or give us some color on that regionally, how that pipeline is tracking and where it's juicier then?

Yes. I mean when you look at this, I mean we now have an operating system across our sales structure that we're tracking pipeline, cycles of conversion, conversion, probability and then ultimately to revenue. And so over the last 2 years, as we've expanded our footprint and repositioned a lot of our resources in line where we strategically want to grow, our pipelines have continuously been expanding kind of mid-single digit, mid- to upper single digits depending on the region and the activity. For the most part, that's true across the board. Because it's not only the market that's driving that, but it's also how we're repositioning our resources to capitalize on the key markets. So as I said on the call, our backlog is up 6%. So that's still -- that positions us to be able to deliver on the low to mid-single-digit revenue growth that we've committed for the year. And that we believe, from a pipeline standpoint, being up kind of mid- to upper single digits, and again that varies across the regions, that we are positioned to be able to deliver a similar-type order growth through the course of the year.

Can you speak -- we haven't talked about North America, let's get to that. So what specifically are you seeing in the North American markets? Maybe start with applied and talk about the resi and the unitary business as well.

Yes. So when you look at pretty much across the board, we continue to expand. And when you look at HVAC, we've had very strong performance here over the last couple of years with applied in how we've converted not only orders but to revenue. That expansion continues obviously at a lower rate, I mean because we've -- obviously, the market is still expanding but I think slightly reduced. That's continuing. Fire & Security globally, if you look at the global number, last quarter or the first quarter, we had mid-single-digit growth both globally across products as well as across all of the regions, and it was broad-based. I mean there's no one region that was driving that. So I think overall, on North America, we're positioned with an incredible position. We've got good pipelines. We're focused on converting the pipeline. Positioned extremely well.

What about on the resi side?

On the resi, when you look at...

Or unitary products group.

Yes. So if you go into global products, and that's where we've had some softness, it really breaks out into North America with our UPG business. And then our unducted business, our Hitachi JV in Asia, and it's mainly driven by the Japanese market, and it's really been the market. And we've got a very high position, high market position there, and we're maintaining our position. North America for us was that I think last year's cycle was very unusual, the whole -- the way that the season played out and the temperature and the like, and that created some anomalies during the course of the year. And so then at the same time that as we're looking to position the business more efficiently so that we're positioned to accelerate growth and gain share, we've done some restructuring of our distribution. Some of that was in Canada, which, I think, created some disruption on the quarter. And then based on that, I think when you normalize all that, we're still probably down low to mid-single digits. But it's a business that we've invested extremely well into new products. We've got a lot of new products in the market. We're making sure that we're tracking each one of the investments and making sure not only with the product but also with the distribution, we're positioned to perform. So that's where we are in North America. And then in -- with the residential, which is the other big piece in Asia, we've performed extremely well with our Hitachi JV over the last 3 or 4 years. Certainly, the market condition there, that's been challenging in Japan. But we're continuing to launch products as planned and on time. And I think we'll -- over the cycle, we'll be well positioned to be able to continue to perform.