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

Good morning, everyone. This is Joe Ritchie, Head of Goldman's U.S. multi-industry team. I'm super excited today to have Johnson Controls with us for the next fireside chat. We have both George Oliver, the Chairman and CEO; as well as Brian Stief, Vice Chairman and Chief Financial Officer. Thank you both for being here with us today.

Thanks, Joe.

Yes. Thanks, Joe, for having us participate in the conference. We're certainly thrilled that we can be here with you today. I thought I'd maybe start off with making a few high-level comments. Well, we just did our earnings call 2 weeks ago, before we jump into the fireside chat. Joe, is that okay?

Certainly, George. Go right ahead.

First off, I'd like to start just by saying how proud I am of all of our JCI employees around the globe and how they have come together in this time of crisis to support our customers, the communities that we work with in and each other. It could be -- it has been extremely rewarding to see. A few things I would emphasize from our earnings call. I'd start by saying we're navigating through this crisis in a position of strength. We have a solid balance sheet, and we have significantly improved our business fundamentals over the last couple of years. We have a very large, stable and resilient service base of revenue, which is over $6 billion. And although not immune to a financial downturn, it is much more defensive. And we have leading market positions across HVAC, fire and security. And given our cost structure as 2/3 variable and 1/3 fixed, we are able to quickly flex our cost structure and put significant mitigating actions in place to lessen the financial impact of a revenue decline. Despite a mid-single-digit organic revenue decline in our fiscal Q2, we were able to hold very impressive decrementals. And as we move into the second half, although the revenue decline will be significantly more pronounced, our printed decrementals, when you take into account the synergies and productivity in the second half of the year, we'll be in the mid to high-teens, which, from what I've heard thus far, should be viewed as best-in-class. And more importantly, given the cost structure changes being made from a run rate basis, we'll have a better margin structure in 2021. And as I mentioned on our earnings call, from a cost perspective, we are planning for an L-shaped recovery, but from a competitive perspective, we are planning for a V-shaped recovery. So with that, Joe, let's get into the fireside chat.

Thanks, George. That was a helpful intro commentary. Before I get into the actual questions, just a reminder to everybody that's listening in. If you have any questions for the management team, feel free to shoot me an e-mail at [email protected]. Or if you're in the webcast, there's an opportunity for you to send me questions as well.

So George, maybe just kind of kicking off. Look, you've been on this journey for the last several years just creating this one-stop shop for building owners, developers across the different suite of products that you offer. What have you learned about the receptivity to the bundle by your customers and prospects? And where are you along that journey?

So I'd start, Joe, by saying it's really not about bundling or being a one-stop shop. It's really about having the ability to solve customer problems and using connectivity and data, which is at the heart of that. When we looked at the merger, we came together, and from a relationship standpoint, an opportunity to leverage each of our domains, the way that we always went to market. But our strategy now revolves around providing our customers with the most comprehensive integrated solutions who are looking to create more efficient, more intelligent spaces. And then we have been enhancing those solutions with digital transformation, being able to leverage our breadth of portfolio with connected equipment, products, controls, our analytics platform. We're collecting and analyzing data to implement things like AI, machine learning, creating digital twins to improve building life cycle management. And what's happening is that the buying decisions are being elevated to the C-suite, making sure that we're aligned with achieving our customers' digital strategies and how they operate their infrastructure. And you build much more strategic relationships. And so our view is that we can get a much better picture of what our customers are looking for to be more efficient, and we can ultimately design solutions around that, which ultimately leads to a much more collaborative solution versus bringing any one of our domains, whether it be HVAC, Fire & Security, to them. And now with the -- what I'd say is with the global pandemic, there is being -- there's a new norm that's being defined. And when you look at what we do, HVAC, fire, security, no matter what happens in the end markets, it is still going to be required and demanded. We're working very closely with our customers in defining what this new norm looks like and how do they bring their people back to commercial buildings, to schools, to universities and the like and what new technology can be deployed to be able to assure safety and efficiency as well as mitigate any potential risk of the spread of the virus. And I think it's going to change. When I look at what's happening, it's going to change the way space is used. I mean we learned that with the way that we set up temporary hospitals around the globe, setting up isolation rooms to be able to treat the folks infected with this disease, but it's also going to require higher purification of air and ventilation. It's going to require frictionless so that everything, no matter what happens within a building, can be operated in a frictionless manner. We're going to require temperature screening and the like. And all of this, a lot of this is available today, but there's a lot of innovation that's taking place that's going to position us to be able to really be positioned to support -- work with customers and support this new norm. And lastly, I'd say is when you look at health care and education, just given what's happening, I believe that with the new demand and what's going to happen as this plays out, that they're going to perform very well.

Yes. That's super helpful. And appreciate that clarification on the data aspect of your offering. George, you touched on a bunch of different things there. And I've already gotten a few questions from the audience, specifically as it relates to indoor air quality and that potential opportunity resulting from the pandemic. Can you maybe just touch on that aspect a little bit further, how you're positioned with your capabilities today? And then what that means necessarily from like from an investment perspective for you guys on the go forward and what new products could potentially come from this?

Yes. I'd start, Joe, by saying this has been a core to what we do in HVAC. It's always been core. What I can say is we've seen a significant uptick in customer requests for our air purification systems. We've been working endlessly here over the last couple of months closely with our customers to help educate them on what's available. And what are the potential changes that can be made to protect against airborne transmission. We've offered various technologies as optional features in combination with our core HVAC and air handling, our air distribution for years, as I said. And whether through it's our Koch filtration business or deploying some of the more active cleaning methodologies, including the use of UV lighting or bipolar ionization, all of these technologies are critical to preventing the spread of airborne pathogens inside buildings. So I think when you look at what we've been doing, our high-end commercial and HEPA filters can trap and contain over 99% of all bacteria, viruses and other particulates across a wide array of molecule sizes. So we had -- during our Q2 earnings discussion, we highlighted the Koch IsoClean system, which is a self-contained, high-efficiency HEPA filtration system, which we've been installing as part of our negative pressure isolation rooms in hospitals and -- as well as other health care facilities throughout the crisis. And then we can also clean and treat the air as well as the surfaces that the air comes in contact with. So think of the -- all of the air ducts and fans and heating and cooling coils utilizing our ultraviolet germicidal irradiation lighting solution, which essentially kills viruses touched by the light or by using our bipolar ionization technology. What that does, it works by flooding the air with positive and negative ions, attaching themselves to dangerous microbes in the air, making the particles larger and then easier to trap in our filters. So these are -- these have been available. We continue to invest, as you said, in new technologies, incorporating other technologies to make sure that in the installed systems that we've deployed that we're bringing the best, the most effective, most economical solutions that we can to our customers.

That's helpful color, George, and obviously something we'll be paying kind of close attention to over the coming quarters and probably years. Maybe switching gears a little bit. And just wanted to touch on your service business. So when I think of your field business and service specifically, I think of it as being kind of roughly a $6 billion business. During the downturn, this is the part of the business that typically, I would expect to see like a strengthening in demand because customers are going to run their assets harder as opposed to buying equipment. Now fully recognize, look, this time is unique because you have limited access to buildings. But I just would love to understand a little bit better -- what portion of your business do you kind of consider locked in on the service side?

So I'd start, Joe, by agreeing that services is definitely more resilient and defensive in a downturn. I think as we discussed during our earnings, the dynamic we face this time is a little bit different where we've had a lot of lockdowns around the world, which, short term, has impacted us. But I believe, as we have seen April and now May play out, that's going to continue to get better. When you look at our service business, there are certain parts of the business which do not require access to the customer's facility. And what I would tell you is of our service, it's north of 20% of the overall service revenue. And then in addition, I'd say there's probably an incremental 20% that continues without being disrupted, which, although it requires to be on site, the work is done at mutually agreed upon times during the course of the year. And so what I'd say is there's a very little risk to that segment also. The remaining -- when you look at the remaining portion of the service, it's predominantly fire inspections and time and material type of service. The fire inspections do require a tech to be on site. And to your point, customers may run their assets harder versus a full replacement during downturn. And so this will also require additional service from a T&M standpoint. So again, I'd say it's far -- when you look at service, it is resilient and defensive in nature. It will hold up much better in this type of environment versus the install and products. But as we said earlier, it's not totally immune to a financial crisis, especially that's been driven by shutdowns all across the globe. And so like I said, the difference has been that. I would say, in China, as that has played out, we did see a significant impact in the second quarter, but that has come back nicely here in -- during the month of March and then in April and now May. So we are starting to see that work pick up. And what I would expect is that continues across the globe on a go-forward basis.

Got it. That's helpful, George. And it was helpful to get that breakdown, too. I'm sure we'll talk about China in a minute. But maybe just the follow-up question there, on the 60% of the business that is, I guess, reliant on you basically having like on-premise access, you mentioned fire inspections, do you think that there's going to be some pent-up demand then for that business once you actually get full access to these sites?

Yes, absolutely. I mean we saw that. As I just mentioned, we saw that in China. Once things began to open up, the service work increased. I would expect that, that's going to continue across the globe, a similar dynamic. And what I would tell you is we saw April to be -- going to be the most difficult because of shutdowns. And by the end of April, we saw things getting a little bit better where things started to open up, and that is continuing in May. I think at this stage, there's no doubt that everyone wants to get their people back into buildings, whether it be commercial buildings or schools and universities and lots of focus on this. And I think in every aspect, HVAC, Fire & Security is going to be an important aspect across the board and how that ultimately is executed upon.

Yes, that makes sense. And look, great to hear that China is continuing to open up and that things are occurring in May as well. I just -- I guess I'm curious, as you kind of think about North America and your other regions, anything discernible about the trends you've seen so far in May? Obviously, we know April is going to be a very tough month. And are there any differences between the regions that you would highlight?

At this stage, I think Europe was shut down. The shutdown in Europe was much broader initially in April. That's starting to come back, so we're watching that closely. I would say in North America that we were deemed essential everywhere we do business, but depending on the shutdowns is what limited our ability to be able to perform the service. I'd say North America is a little bit better than what we saw in the month of April than we saw in Europe. And so I think as the lockdowns get lifted, as we get back to work and the access to these facilities become more accessible, then we're going to see a similar trend, I believe, in Europe and North America.

Got it. Okay. That's helpful. Maybe kind of switching a little bit. Just -- you guys provided a framework. And I agree that with your opening remarks on the framework, it is kind of best in class what we're kind of seeing across the space in terms of what you're seeing from both a growth perspective and the decrementals as well. I guess on the decrementals maybe more specifically, you guys gave us just a lot of good detail around the $400 million to $450 million in cost actions. I know 20% of it is expected to be structural. Maybe talk about some of the new structural actions that you're taking and whether we should expect the phasing of these pieces to be like predominantly 3Q weighted?

Yes. Let me start, Joe, by giving you the framework because I think it's important to understand how we've planned and how we're executing. We have planned conservatively. So at this stage, given how this is going to play out, there's limited visibility. But as I mentioned during the earnings call, April was down roughly high teens, limited access to customers. And knowing that April was going to be the toughest, we started to see improvement. And now we're starting to see also our facilities in Mexico and other areas now steadily improving our output. And we planned for -- as I said, we planned for an L recovery and competitively for a V. And so what happened was we quickly got ahead of this. And so what we did was we -- not only on the temporary -- the short-term temporary actions, but the structural actions that we planned. So we're -- as it relates to those actions, we're finalizing and beginning to execute those. We're centered around our manufacturing footprint and how we can continue to simplify and restructure that footprint as well as our field ops structure, and that you'll see not only productivity in how we operate, but also productivity in the G&A structural costs that we have within those businesses. And on a run rate basis, with the work that we're doing, that we're going to be positioned for an even better margin structure in 2021 with better incrementals when growth returns, like 30%. And so given the timing of these actions on the structural side, we're really only getting a benefit in the fourth quarter this year. And so as you play this out for 2021, there will be a very nice tailwind for us going into 2021, which will -- if you look at the temporary costs that we discussed during our earnings call, it will offset those with -- that we took so that on a run rate basis, we actually have a better margin structure in 2021.

Got it. That's super helpful. I guess maybe just a follow-on there, given that you guys outlined the $400 million to $450 million. I think 80% of it was supposed to be temporary. So that portion of it, how much of that do you think returns in 2021? I would imagine a lot of it does, but I'd be curious how you're thinking about it just given that you're focused on an L-shaped recovery?

Well, in terms of the 80% temporary, what we talked about, there was compensation, there was facility costs and there were indirect costs. And so when you look at those buckets, when you look at compensation, I'd say maybe 2/3, 3/4 of those compensation costs return, maybe 60% of the facility costs. And then I would tell you that we've all learned through this period of time that we've changed the way we work. And so a lot of the indirect costs that were associated with how we worked in the past is going to be very different to how we work in the future. And so although some of that will come back, on a run rate basis, our indirect costs will be less as a percent of revenue with all of the discretionary spend and the reductions that we've made. And so I would say some of that returns. But overall, we're going to see some benefits from the changes that have been made with what we've learned during the last few months and how we're now going to deploy that as a new norm for how we operate the company and that some of those will actually translate into permanent cost reductions also. But again, I would say that, that, combined with the structural changes that we're making, we're going to be able to more than offset these temporary costs that we're taking out in 2020. And then as a result of that, on a run rate basis, we'll actually have a better margin structure, as I said, in 2021.

Yes. No, that all makes sense and sounds good for -- in terms of the setup for next year. I guess maybe switching gears and moving back into the regions for a second. So interesting commentary around North America, and that it sounds like things are starting to open up and starting to get better. I'd be curious if you can maybe just kind of parse out what you're seeing across your different offerings, so between HVAC and Fire & Security and maybe the performance contracting business, what you're seeing across those different pieces would be great.

Yes. What I would say, overall, I mean, if you look at the high level, I think service is going to hold up much better here than install in both in North America as well as EMEALA. And we think that, that's going to not only play through Q3 but Q4. When you look at the segments in North America, for HVAC and Fire & Security, we're starting to see, as I said, customer sites are beginning to open up. That's clearly a positive. We have -- again, I'll reinforce that we've sustained our essential status everywhere we work. We've worked very closely with governments and state governments and the like to make sure that we are in full operation, certainly limited based on customer sites being shut down and the like. And so as these open up, I think it's clearly a positive, and we're going to see, I think, continued improvement from what we saw in April. And I think you'll see a quicker improvement in service versus install. And what I would say, HVAC, when you look at the mix in North America, I'll give you rough numbers, HVAC represents a bit north of 40% of the revenue. North America Fire & Security is roughly 50%, and that would include our retail business, and Performance Solutions is around 5%. And so the one segment there that's someone lumpy is Performance Solutions, and that will move around a bit depending on the large projects that we book and ultimately execute by large projects.

Got it. No, that's super helpful color. I guess maybe just the one follow-up there, with service holding in better than install, I'm just curious, you guys have been talking about pretty good backlog on the installed business as well. I'm just wondering what risk of cancellation do you see there.

Yes. I don't -- when I look at the business, we have been -- we have a pretty robust commercial system now where we track pipelines, we track conversions, we track pushouts, we track cancellations. And what I would tell you, and we do that -- we've been doing that on a weekly basis given the situation. And what we are seeing, we are seeing some activity pushing to the right for a quarter. And that's purely based on being able to access sites and facilities, but we're not seeing any material cancellations. Typically, these funded jobs. They're funded. We'll see some delay. They get pushed to the right, but you typically don't see them canceled. What I would say tends to happen in a financial downturn is that the current backlog will ultimately convert. Then you have retrofit, which tends to lead stimulus, you get some stimulus funding, and we're seeing that, right? We're seeing some new business coming because of what we do and the criticality of what we do to support customers. And then you also have small projects that tend to pop up. What we're watching closely now is our pipeline of new construction projects, which are in our pipeline but haven't converted to an order. What happens now to those new projects that we've been working on upstream and then see how -- if they're delayed or postponed until such time there's a recovery. So at this stage, we've seen some of that push maybe a quarter in the pipeline, but nothing significantly at this stage, but something we're going to watch closely. So I think we will see, based on the orders we saw at the end of March and then again, in April, we'll see a pocket. You tend to see an air pocket of -- I mean when you have a gap in install orders, you'll see some of that impact over the next -- it's typically early as 6 months, 9, 12 months on the revenue side. But we're watching that closely. And we're also -- to fill the gap, if there are any gaps, we have a lot of new opportunities because of what the new norm will be that we can capitalize on to support our customers.

Yes. That makes a lot of sense. And know that it's obviously a pretty fluid backdrop from a nonres construction perspective. I guess I don't know if this is something that you guys have at your fingertips, but to the extent like -- the way you think about the verticals that you're exposed to in North America nonres and what's been happening with this backdrop and whether it's like the hotel industry or restaurant industry, you mentioned retail. Is there a certain portion that your -- of your business that you are concerned about over the next, call it, 12 to 24 months?

Well, I mean, you highlighted, although it's a small -- much smaller percentage of the company, retail has been hard hit here short term. Now in the new company, it's only -- it's low single digits, low to mid-single digits of our overall revenue. So although it's been hard hit, it's a small portion of our revenue. That would be one. Sports and entertainment. That's -- again, it's an attractive end market for us. But again, it's very low single digits when you look at the total revenue. Oil and gas in the past has been a concern for us in the old Tyco. And then with the combined company, that's low single digits. So there's definitely some end markets that have been hit here from an economy standpoint that obviously would be concerning. When you look at where our strength is, certainly, in institutional, and institutional is our -- we're roughly -- it's about 1/4, maybe a little bit better of our revenue, and that's made up of health care and education, which we see a lot of new demand because of what the mitigation solutions will be in the new environment. And so -- and then the commercial is the second biggest one for us. And although there's a lot of discussion around what's going to happen with commercial -- in the commercial space, we see opportunity with everything that we've done, whether it be -- it might be a slowdown in, obviously, in construction, but there's going to be a demand, a new demand for the existing infrastructure to be able to address that, to be able to mitigate the risk with the virus on a go-forward basis, how this ultimately plays out longer term. And so that would be my view on the verticals.

Yes. That's great, George. I appreciate that color. And maybe just kind of going away from North America for a second and just touching on EMEALA. Can you just maybe just tell us what you're seeing just regionally, right, in Europe, Middle East, Latin America and just provide a little bit of color on how those regions are performing in this backdrop?

Yes. I'd start by saying, Joe, it's -- we do have a lot of -- within the EMEALA structure, there are a lot of various different regions and obviously, a lot of varying dimensions here. But -- so there's a little bit more complexity. I do expect, I'd say, in total, EMEALA to be hit harder shorter term, and I think we saw that in March when all the shutdowns took place and then that played out here in April. But things are getting back to business, beginning to reopen and start up. What I would say, if you want to get into more of the specifics there, I would say, Europe shutdowns have been extensive. We are seeing -- starting to see pockets, expecting this region to be under pressure here short term, as I said. Middle East, I would say, we expect that to get hit the hardest. It was already -- we were already a little bit pressured there because of the market economy and mainly being linked to oil and gas. And then I would say LatAm, I'm not quite sure it's as much market, but our mix there will be the most resilient for us because we do have a large subscriber base in the region, so that -- which ultimately has a lot of recurring revenue. And so that would be kind of my perspectives across that segment.

Great. And maybe, I guess, just moving over to Asia, can you just kind of just touch on the Hitachi JV and how that's been performing on the way out? I know that there's some good exposure there to not just China but also Japan, and there's diverging things happening in both of those regions today.

So I'd tell you, when you look at global products, as we've been saying, about 30 -- mid-30s, 30%, 40% of our revenues are Asia Pac, and a lot of that is driven by our Hitachi JV that we consolidate. That's about $3 billion in sales. It's mostly Japan, Taiwan, India. Approximately 2/3 of those sales are RAC, PAC systems, which ultimately serve the residential vertical. What I would say in that business, in Japan, because that's a big market for us, from a residential standpoint, it's been impacted by COVID pretty seriously, impacting the market demand. I'd estimate that to be down kind of mid-teens, mid to upper teens. What I would say on the B2B, that's -- there's also been a slowdown there mainly because of the decline or the -- with the shutdowns and the postponement of some of the construction. And where we've been short term hit hard, and it's been tied to the shutdowns, and we've worked very closely within the government there in maintaining our operations, but with all of the significant outbreak of the virus, we had a -- really got hit hard in March, in April, but most of our operations there are coming back. So our organic revenue, when you look at the Hitachi JV, was down about 8% organically in the quarter. Residential led that, being down kind of mid-teens. And then like commercial was actually up a bit, and applied was down about 10% with VRF flat. So when we look at the second half, based on what we learned in the first half, we are going to see a continued challenged environment, particularly in Q3 as things have been shut down, and we're trying to get back to more normal. We do believe that, that's going to come back gradually through Q3 and then ultimately Q4. But there's certainly going to be some pressure there.

Okay, great. That was great color, George. Maybe switching gears, we've got a couple of minutes left. Brian, want to give you some airtime and talk on cash flow and maybe some capital deployment. But just on the cash flow piece, you guys are still expecting 100% conversion this year. Just talk a little bit about the work that you guys are doing on the working capital front? And then is there -- what do you think is the kind of biggest risk in your view to hitting that number?

Right. Yes. As you know, our original guidance was 95%, and we moved that up on our second quarter call to greater than 100%. I mean a lot of that is due to the fact that we're going to see some pressure on net income that's driving that. But we're also making good progress on some of our trade working capital initiatives. Our second quarter, I think trade working capital as a percentage of sales moved up about 10 basis points, which wasn't as strong as the first quarter, but we continue to make improvements in that regard, and we feel very good about the fact that we're going to deliver greater than that 100%. The risks, as I think about the second half, I mean, I think going into an environment where our customers in certain sectors are going to be under cash pressure themselves, we're going to have to keep the pedal to the metal relative to making sure we get paid on time for all the products and services we're performing. So we've got teams, crisis teams working on all of that on an ongoing basis as we move into the back half just to make sure that all of the cash flow projections we have are met. And we're very confident with what we see in April and so far in May that we're going to be able to deliver on that. I think as you look forward, a more normalized cash flow for us is going to be around that 100% level. And we've been pretty consistent in that over the last year or so.

That's helpful, Brian. And maybe one last question to kind of wrap this up. On the cash flow piece, you guys had referenced on the call, I think you're going to come back to us at some point with the cash restructuring charges associated with the actions that you just laid out on the most recent call. I guess any thoughts on how large those charges could be and -- or still kind of TBD based on you guys rolling out the actions?

All right. Joe, I can frame it for you. I think right now, I mean, most of the work has been done. And the reason it is, is because we want to get these actions taken as quickly as we could in Q3 so that we can get a little bit of benefit potentially in the back half of Q3 and then as George mentioned, get the full run rate benefit in Q4 and then into next year. I mean in terms of range, I would say, the cash restructuring piece is going to be probably around $150 million or so. The all-in charge could be $150 million to $200 million. And then the one thing I'd just comment on, that would not include anything that would potentially relate to, let's say, an impairment charge related to some intangible assets or goodwill for certain of our reporting units. I mean just given the impact of COVID on our financials, as you know, every quarter, we need to go through a review of recoverability of our intangible assets. And so sitting here today, we haven't done any of those tests. We'll wait until the end of the quarter, look at what our forecasts are. But I think as far as the cash restructuring fees, you can think in terms of around $150 million.

That's helpful, Brian. Maybe one last clarification on the impairment testing. Is that typically done on a regional basis? Or is it done on like a product-by-product basis?

It's done intangible asset-by-intangible asset across the company. I mean all of those intangible assets have been allocated to individual businesses, Joe. So it's actually done based upon a business unit forecast and cash flow recoverability test.

Okay. Great. George and Brian, thank you so much for being with us today. Good luck the rest of the day on the one-on-ones, and have a great weekend.

Terrific, Joe. Thank you.

Thanks, Joe.