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

Good morning and welcome to the Wolfe Research Global Transportation and Industrials Conference. This is the fireside chat with Johnson Controls International hosted by Wolfe's Managing Director covering electrical equipment and multi-industry, Nigel Coe. [Operator Instructions] And now I hand the call over to Nigel.

Hello. Good morning and thanks for joining us. Very pleased to welcome Johnson Controls to the Wolfe conference. With me on the virtual stage is George Oliver, Chairman and CEO. George has been the CEO since 2017. And of course, George was CEO of Tyco prior to this merger with Johnson Controls. With George is Brian Stief, Vice Chair and CFO. Brian is set to retire at the end of this year. We're all very jealous about that. So Brian, congratulations on that. Brian has been with the company for 10 years after a long and distinguished career at PricewaterhouseCoopers. That's the firm where I cut my teeth out of college. So gents, thanks for your time. George, let me hand over to you for some opening remarks.

Sure. And thanks, Nigel, for having us participate in the conference. We are glad to be here. What I thought I'd do is just make a couple of high-level comments before we jump into the fireside chat. First off, I'd start off by saying how proud I am of all of the JCI employees around the globe, how they've come together in this time of crisis to support our customers, our communities, and each other, and it has been extremely rewarding for me to see. A few things I'd emphasize from our earnings call about 3 weeks ago. We are navigating through this crisis in a position of strength. We have a strong balance sheet. We have significantly improved the 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, much more defensive. We have leading market positions across HVAC, fire and security. And our core strategy to enhance the intelligence, comfort, safety and efficiency of our customers' buildings and infrastructure couldn't be better aligned in the current environment. 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. Given our cost structure is 2/3 variable and 1/3 fixed, we were able to quickly flex our cost structure and put significant mitigating actions in place to lessen the financial impact of a revenue decline. And 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 of the year, although that 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, will be in the mid to high teens, in which from what I've heard so far, should be viewed as best-in-class. More importantly, given the cost structure changes being made, from a run rate basis, we'll have a better margin structure in 2021. So with that, Nigel, let's get into the fireside chat.

Thanks, George. That's a great summary. Maybe keep it a little bit near term to start off with. Obviously, we heard from you a few years ago, you're planning for [ 50% down ] in the second half of the year. As you spun on of a few weeks into May, how does that look compared to expected?

Yes. I'd start by saying that we plan conservatively. Clearly, visibility is somewhat limited, although getting better every day. As I mentioned in our earnings call, our orders in April were down roughly high teens, 20%. And then given limited access to some of our customers as far as the revenue turn, which we did expect to see in April, will be the toughest month within our field businesses. So what I'd say is we started to see improvement as the month went on at the end of April, getting access to our customers' facilities as they started to open up. And we've seen that trend continue here in May. I would go back to China where this all started. And what I would share with you there, although we began the recovery in March, as we look at April and May, we're getting back to almost 90-plus percent within our -- not only the customer activity, but also our ability to be able to operate our facilities. We have 2 of our major facilities there in China. And then our supply chain is operating now 90-plus percent. So I would expect that as you go around the world and as this spread around the world, we're going to start to see similar type activity. If you look at EMEALA, we are starting to see sites opening up as the lockdowns are lifted. As you look at the U.S., what I would say is that is -- as we're opening up and customers are coming back to work and sites are being opened, we are seeing improvement on a day-to-day basis. What I would say, the hardest-hit area is in the Northeast, and that's where we've seen the -- it's been the slowest recovery here as things are beginning to open up. But overall, I think that April will be the toughest month. Third quarter will be the toughest quarter. And then I think sequentially, we are going to start to see improvement as the months go on here through the second half.

Okay. I know you mentioned, obviously, the $6 billion recurring revenue base, which is obviously impacted by the nature of the shutdowns and just urbans closed. We heard yesterday from one of your competitors in Europe, Stanley Black & Decker, that talked about, they've seen a sharp improvement in Europe during May. Would you echo those comments as those companies get back online?

Yes. I don't know if I'd categorize it as sharp, but I would say that as we're -- we're pulsing this on a daily, weekly, daily basis. And as we're reviewing activity and we're flexing our labor and making sure that we understand what our customers are doing and what we need to do to support them as they get back into their facilities, and so that is absolutely improving. And as the shutdowns are opening up or you're being lifted and sites are being opening up, we're absolutely seeing an improvement day to day in -- pretty much broad based across Europe.

To be fair, the word sharp is mine, not theirs. So I got a little bit excited there. So that's -- I think they said improving, not sharp improvements. That's great. And a few more on the near term, George. If you can kind of -- before we get onto the longer-term strategic stuff, it feels like everyone's quite bearish shown on commercial construction in particular. Maybe talk about how you view the landscape for the next 12, 18 months in commercial? Where do you think the opportunity is? Where do you think is the challenge is for JCI?

Yes. So what I would say, when we're -- as we're planning for kind of a post-COVID world and what -- how that's going to play out, I think it starts with really getting an understanding from our customers, what their world will be and how do we make sure that we align ourselves in all aspects of what we do, whether it be HVAC and air purification and what's going to happen from a new construction standpoint. And then when you look at our building management systems, we have an incredible opportunity to be able to address the new norm with our customer base. And so we've got tremendous pipeline that's being built. I would categorize it around 4 key themes where space will be utilized differently and how do we help facilitate flexible space, how we take existing infrastructure and really focus on air purification, upgrading our installations in air purification. I would focus on safety, what we can do as we expand our safety capabilities, and that can include this idea of temperature checking that's embedded and connected to our systems. That can be being able to monitor social distancing and density of space with people movement. And then the last, I would say, from a service standpoint, we have an incredible opportunity here with the base that we have and with connectivity and with the use of data, how do we do more of that remotely and do it in a way that we can actually contribute a lot more value with some of the capabilities that they might do today themselves that we can ultimately do through our connectivity. So that being said, what I would say from a macro basis, we've been planning -- the macro environment certainly is uncertain, low visibility to ultimately forecast. So what we've done, as I said in my prepared remarks, is that we're planning for an L-shaped recovery. So we saw opportunities to able, not only short term, be able to address some of the cost challenges, but on a longer-term basis, really taking the structural cost actions that not only is going to contribute to our second half, but it's really going to position us well as we now look at what the might -- the new norm might be in 2021. So I think this is going to be the most challenging quarter. I think Q4 will be better. And I think we'll see some headwinds in the first half of 2021. What I would tell you is we're tracking not only all of the economic forecast and what's being forecasted. We're tying that to, obviously, nonresidential forecast and construction. And then based on our backlog and how our backlog is going to turn, what ultimately that might mean from a revenue turn standpoint as we look at the next 12 or 18 months. And so I think we'll see some headwinds in the early part of 2021 based on volume. But I'm certain that given the cost actions we're taking, the margin structure we're putting into place during this cycle is going to position us extremely well to be able to be positioned no matter what happens from a volume standpoint. And then I would say on the service side, I am bullish on service. I think with our ability now, as every day goes by and we're working with customers, the opportunity to be able to really leverage our presence, our existing installed base, combined with new technology and innovation that ultimately enables them to be able to address what their new norm will be in the facilities that they operate.

So if that mean -- if I could just paraphrase and then take how you view the post-COVID landscape and some of the opportunities that's going to throw at us, hate to use the word opportunities because -- given what's happening. But it seems like there might be more on the building management side and perhaps the security side as opposed to the HVAC side. Is that fair? Do you think there's more opportunities in those 2 areas?

I'd say it varies. So I would say that, although historically, we've gone to market with separate domains, you can imagine, in today's world, we've been doing much more integrations with the combined capabilities and that the HVAC is an important element relative to air purification. And then when you look at all of our building systems, the ability to be able to use the data from all of our building systems and then being able to add new capabilities that then you can use our systems to be able to extract and provide new solutions. So I would say it's broad based. It's broad based, but I would say from a -- historically, when you look at our Fire & Security, a lot of that is driven by compliance, right, as far as what we do, especially with the inspections that we do and the deficiencies that we uncover and how we upgrade. And then now combined with the new norm and how do we position our capabilities to help our customers with the new norm, I would say that, that right now is getting a lot of attention because everyone now is trying to figure out with all of these lockdowns lifted, going back to work, what does that mean? And no employer -- including ourselves, every step of the way, we have focused on our employees' safety. And although we've maintained our operations pretty well across the globe, that has been paramount. So we've led in our ability to be able to reconfigure our manufacturing sites and put up barriers between work stations so that we don't have any issues with any spread of any infection and all of those protocols, we've deployed. And now what's happening is, and as we've done that, we've learned a lot, and then we're now putting that now into the solutions that we can work with our customers on. And so I think it's mixed, Nigel. I think -- but I think all of what we do within infrastructure, building as an infrastructure, it is going to be different. And as we fight this virus, whether we get a vaccine short term or not, to be able to contain the virus and isolate it and minimize spread, all of what we do in a building is absolutely paramount.

Yes. In terms of indoor air quality, and we're seeing a lot of interest from investors in terms of whose best positioned in this area. Maybe just talk about how JCI today, what you do in indoor air quality. I understand today, it's primarily a China business, but correct me if I'm wrong there. And how do you see the potential to globalize this business and maybe getting to a much more meaningful part of your value proposition.

Yes. I mean you can imagine, right, I mean, the unknown. And let's face it, over the last 10 weeks, there's been a lot of learning about this, and customers are engaging us and trying to learn more about what we do around purification. And so we're working closely not only to educate them, but then making sure that they understand what's available, what ultimately the changes that can be made to prevent against airborne transmission. And so we've offered -- in our portfolio, we have various technologies as optional features to our HVAC systems that in combination with our core HVAC and air handling distribution, it's Koch filtration business. We have a filtration business. We're deploying more active cleaning methodologies, including the use of UV lighting or bipolar ionization and then all of these technologies, depending on the application done together or apart, ultimately work to prevent the spread of the airborne pathogens inside buildings. One of the most attractive solutions that we've had based on the work we've done on the frontline supporting health care has been our high-end commercial and HEPA filters, which can trap and contain about 99% of all bacteria, viruses and particulates across a wide array of molecule sizes. And the product that we brought to market, that we had in the market that ultimately has had high demand is our Koch IsoClean system. And we talked a little bit about that on the Q2 call a few weeks ago. And we've been installing that in these negative pressure isolation rooms that we've set up to be able to support our health care customers being able to respond to the crisis. And so there's a lot of different solutions. So it depends on the application, the environment, the vertical. But we're now obviously working with all of our customers in understanding their current situation, what needs to be done so that they can feel they have confidence that their environment is going to be clean. It's going to have the right air purification.

One of your competitors called out, only 1% of their residential customers have an air purification system as part of the HVAC units. So it sounds to me like this could be a pretty significant opportunity for yourself and the industry. Speaking of residential, obviously, we spend a lot of time talking about commercial end markets. But what are you seeing right now in residential? And as part of the question is, we're spending a lot more time at home right now. It seems we're spending a lot more money on DIY. It seems like there could be some tailwinds to HVAC. It seems like there's obviously a lot of headwinds with unemployment and consumer confidence. How -- what are you seeing right now in residential and how do you see this market in the next few months?

Yes. As we've talked about residential and coming into the year, obviously, last year was a challenging year. And then we did some restructuring with our Canadian business and the U.S. and the like. And then obviously, the crisis hit. So we were still projecting that it was going to be down for the year. And then with the crisis down a little bit further, the -- I think at the end of the day, when we're pulsing this, there seems to be -- and this is short-term demand, so it's hard to say it's a trend. It seems like that activity is picking up relative to the residential space, which, for us, it would be good. And so we're working to understand that. And based on our forecast and is that in line with what we expect? Is it more or less? So I think the activity is there. I'd say where we also got hit in residential pretty hard was our JCH business in Japan. The market there was down pretty significantly even before COVID-19. And then with COVID-19, certainly with the shutdown there in Japan and some of the challenges there, that has been, short term, been a lot of pressure for us. We believe that as things start to get back to normal, that, that demand will start picking up on a go-forward basis. But I'd say at this stage, Nigel, it's not much different than what we talked about during our Q2 earnings. I would be a little bit optimistic with the activity that we see happening. But at this stage, it's hard to call.

Okay. No, I understand that. And just to clarify, the optimism, would that be in the U.S. or outside of the U.S.?

Yes. That would be mainly in our unitary business in the U.S. and that's just on looking at a daily -- when we're looking at daily activity.

Okay. Maybe talk about -- obviously, you've got a lot of cost reductions underway right now, and it sounds like you're confident in capturing the cost reductions that you laid out. And then, of course, then on top of that, you got some structural costs coming through with the remaining type of synergies and the productivity that you're driving there. Maybe just talk about -- take a step back and just review the type of integration, kind of what -- how did the -- give us a recap or a maybe a report card on kind of what went really well, what maybe didn't quite tick the boxes. I mean where will we be and where are we on this integration?

Yes. This is -- if you go back to what we committed with the Tyco integration, at the time, it was -- and that included all of JCI prior to the selling the Power Solutions business. But I think, Brian, it's mainly about $900 million in total now with the Power Solutions separate in total. And the $150 million this year is the last of the synergies in productivity. And when you think about that integration, it's where we took the 2 structures, we integrated the structures across all of what we do. A lot of that is still coming through in this last year is the manufacturing footprint, is the G&A in the last -- the structural cost, and a lot of this was because it took a little bit longer around our shared service centers in being able to get into shared services in every region across the globe. And so that is absolutely on track and hasn't been dependent on the revenue. So $150 million that we committed with -- $80 million of that is coming through the second half of this year, is still going to be achieved. And so what I think went well from that standpoint is that, all of the structural costs and all the work we did to be able to achieve the synergies, and what we've been accelerating over the last 2 years, which I'm very confident that there's still a lot of room that we can continue to improve are the -- in the operations. And so a lot of what we've done here with the structural cost actions that we communicated during our earnings call, those actions are being taken as we speak, going through Q3, we'll get the benefit. We'll get a run rate benefit in the Q4. And then when you look at the run rate in 2021, a full year benefit, that more than offsets the temporary cost actions that we took short-term with this fast volume decline that we saw in Q3. So I'm confident that as far as the operations, there's still plenty of room for improvement. We still have a strong pipeline for productivity, operational improvements, whether it be in our manufacturing facilities and our product businesses or within the field. And that's what we're executing on. And we believe that with that, that we're going to have a better cost structure, not only what we're doing on the variable cost, but the structural cost with these actions that we're taking, we'll have a better margin structure in 2021. And we have a pipeline that's going to continue to improve to be able to get to very strong margins.

One thing I struggle to understand, and now we've got a bunch of stand-alone HVAC sort of building technology companies with Carrier and JCI ex building -- ex Power Solutions and obviously, Trane. And you're all in the sort of low teens type levels on operating margin. So given the service nature of your business, given the strong pricing, it's kind of surprising that margins are where they are compared to the mid-upper teens that we see for most of the companies that we cover. So is there any reason why the business model can't be a mid to upper-teens margin over time?

No. Not at all. I mean there's no reason that our segment margins, as I shared with you, with the improvements that we're making around our fundamentals right from front to back across the businesses that we shouldn't be in the mid-teens. And we have been and continue to address our cost structure. We're going to continue to see improvements as we move forward. I think there are some differences, right, there are differences when you look at the portfolio, the mix of the portfolios. We have a very large field footprint versus others that have a higher mix of product, product distribution. That being said, what I would tell you is that in the new world, with now the integration of technology and data and new capabilities, we have incredible insights into our customers through this direct channel. And the opportunity that we have now to be able to take not only our core domain technologies, but integrating those technologies such that -- with the data that we extract, we can really get at problems now that historically we haven't been positioned to solve. And so I think the go-to market, as we think about becoming more of a technology company, is going to be very important in how we deploy some of the new capabilities through our service franchise.

Great. Well, I think we've got maybe time for 2 or 3 more questions. As a reminder to the audience, if you got any questions, please type it into the text box, type into -- to fill those questions that any of you have. ESG, I mean going back to this year, it seemed like there was a flood of interest in commercial building efficiencies and how to drive lower CO2 emissions. There's obviously some regulations around that as well. With COVID now dominating the headlines, has that now just died away? I mean, how do we think about this going forward?

Yes. I mean not at all, Nigel. ESG has been core to our culture, mission, the values of the company. I'd say that we've been at the forefront of ESG for -- especially as it relates to sustainability for decades. If you look at our performance over the years, since 2002, we've reduced our greenhouse gas intensity by almost 2/3 and we've doubled our energy productivity. And when you look at reporting, we've been extremely transparent with how we report. We're committed to transparency and reporting, our 2020 sustainability report conforming to all the major reporting standards. And then when you look at our customers, whether COVID-19 or not, lowering greenhouse gas emissions is definitely a topic our customers are engaging with and more and more focused on. And in our view, we believe that it's going to become even more so in spite of the crisis on a go-forward basis. If you look at the -- we did a survey. So when you look at the latest energy efficiency indicator survey, it's about 1,300 organizations globally. Investments in technology that reduces greenhouse gas emissions was second only to energy cost savings in terms of investment priorities. Now when you look at what we do within infrastructure, that is what we do, right? We not only drive sustainability, but also, from an energy savings, is a big part of that savings. We did it ourself, when you look at our portfolio, almost 50% of our annual revenue today comes from products that reduce greenhouse gas emissions and improve energy efficiency. So it is -- it really is core to what we do, and I don't see where this is going to take a backseat on a go-forward basis. I believe with technology today, with what can be achieved, that we're going to be positioned to really capitalize on that. Just in North America alone with our -- when you look at our performance contracting projects, in North America, we've saved over 1.5 million metric tons of carbon emissions just last year. And so this isn't just because of the crisis, it's going to be put aside. This is going to be -- I believe it could be actually accelerated with the opportunities that we see from a technology deployment.

Right. It's 10:30, but I do want to sneak in one more question for Brian because I don't want to Brian to get away [ scratch-free ] here. So on the free cash flow, you've raised the conversion target this year to over 100%. Maybe just recap, Brian, what's driving the better free cash conversion than you expected? And maybe just touch on the buyback program. Obviously, your liquidity is now paramount. But do you see it's going to restart, that buyback program, anytime soon?

Yes. I think as far as the buyback program, Nigel, I think we've decided that for the remainder of this fiscal year, we are going to keep that on hold. There's $700 million left on the $2.2 billion that we planned for this year. I think until we get our way through some of the core of the pandemic here, we're going to wait until the end of the year to kind of revisit what we do with share repo as we move into '21. So I wouldn't expect anything more there versus what we've done today. As far as free cash flow, we did move it from 95% to greater than 100% as far as our guide. Some of that, to be honest, is attributable to the -- simply the denominator net income is lower because of the impact of COVID. But there's also improvements that we continue to make as a result of the cash management office initiatives, trade working capital as a percentage of sales was down really nice in the first quarter, another 10 basis points year-over-year in the second quarter. So we feel really good about, as we go forward, a normalized free cash flow for Johnson Controls, ought to be in that 100% range.

Great. George, I think we're out of time. So any closing remarks from you?

No. Like I started, I think, that we've been very proactive with the crisis and very quickly flex what we do to make sure we're more aligned to what is flowing through. We've made incredible -- like I said from the start, we're extremely proud of the team and the work that we've done and how we've pivoted the company and now even more clarity that all of the strategy that we're deploying is accelerating and being able to now capitalize as we get through the crisis and position for the new norm. I think we're going to be set up extremely well.

All right, gents, that's all, and thank you very much for your time. Really appreciate it and...

Thanks, Nigel.

Thank you.

Thanks, Nigel.