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

Good afternoon, everybody. Welcome back to the Citigroup Global Industrial Conference. We're very happy to have you. This is Andy Kaplowitz again, U.S. sector head of industrials. I'm really happy to have Johnson Controls with us. I think George Oliver has done a tremendous job over the last few years in really improving the company in all facets, whether it's growth, margin, you name it. I'm going to turn it over to George in a second, but we're also very happy to have Olivier Leonetti on with us, who recently joined the company as the CFO. And I know Olivier has a great background, and I know you're going to do great things as well. So let me turn it over to George for some brief preparatory remarks. George?

Sure. Thanks, Andy. And thanks to everyone for joining, and thanks for having us. It's great to be with all of you. I thought I would start off with a few opening comments, and then we'll quickly get into the questions, Andy, that you might have. What -- I would start by saying we're off to a strong start in fiscal '21 after wrapping up a year of very strong execution in a very challenging environment. Our portfolio is very well-aligned with the strong secular trends, including sustainability and energy efficiency, elevated health and safety requirements for buildings and connectivity driving occupant experience. Johnson Controls is uniquely positioned to serve these trends with a holistic approach that leverages the, what I would say, the most comprehensive product portfolio in the industry, combined with one of the largest installed bases, with the broadest direct channel footprint that enables our extensive go-to-market advantage. And with our digital transformation platform, OpenBlue, we are uniquely positioned to serve smart buildings of the future with a comprehensive suite of solutions that connect the -- both the IT as well as the OT in and out of the building, leveraging data analytics, artificial intelligence and machine learning and ultimately, delivering outcome-based solutions for our customers. Moving on to sustainability in ESG. Both are core to our vision, mission, and values of the company. We are very well-positioned from a product portfolio standpoint to address our customers' goals to lower greenhouse gas emissions, with nearly half of our revenue coming from products designed to exceed minimum efficiency requirements and significantly reduce greenhouse gas emissions. We did recently issue our new ESG commitments when we did our earnings call. And finally, I would like to, in addition to the depth and breadth of our product portfolio, also talk a little bit about our largest direct channel footprint with an unmatched history and expertise in the buildings environment and a best-in-class team of sales and service engineers. This, we believe, especially with these new trends and the ability to be able to bring solutions to our customers, is another clear competitive advantage for us. And from a strategic standpoint, as we look to 2021 and beyond, we're focused on, number one, accelerating top line growth. We have a number of strategic initiatives aimed at driving above-market growth over the next few years, including higher new product launches, increasing service attachment rates and revenue per user and scaling the launch of our OpenBlue platform and then optimizing our G&A structure. We will continue our focus on expanding margins and increasing profitability, with a renewed focus on managing operating expenses lower over time. And I'm sure, as you would have seen this morning, we have detailed our multiyear SG&A cost reduction actions to further optimize our SG&A cost structure by $300 million on a run-rate basis by 2023. And as we have previously discussed, we're also finalizing our plan to reduce COGS, and we'll share those details on or before the Q2 earnings call. These actions, coupled with ongoing productivity, will drive significant margin expansion and ultimately close the gap to our peers. And as we expect to begin recognizing some of the benefits from these actions in the second half, we are raising our full year segment EBITDA margin and adjusted EPS guidance. We're now expecting segment margin expansion of 60 to 90 basis points and adjusted EPS of $2.50 to $2.60, which is a 12% to 16% increase year-on-year. And then lastly, capital allocation, very disciplined. By the end of 2021, we will have successfully redeployed 100% of the Power Solutions proceeds. Our balance sheet is in excellent shape, with leverage still below our target range and ample sources of liquidity. Cash generation has improved tremendously over the last few years, and we are expecting 100% plus free cash conversion this year in 2021. And given the relative ROI profiles, we continue to buy back our stock while, at the same time, maintaining an active M&A pipeline. So with that, Andy, I'll turn it back to you, and I'm looking forward to your questions.

George, that's great stuff. Obviously, very interesting news today. So let's just start with that first. You actually mentioned in your prepared remarks that this is part of the way to close the gap versus peers. So the first thing I just wanted to ask you is, structurally, is there any reason why you couldn't close all of that gap?

No,I mean given what we've done over the last 3 years -- the last 3 years when you think about the work that we've done is we've been building fundamentals across all of our business processes, with the idea that we can leverage our scale in how we support our customers and then be able to continue the reinvestment required to be able to deliver on our growth initiatives and be able to outperform the market with our market share gains while we're getting better leverage on our cost structure. And that's exactly what we've laid out. We took all of the work we've done in the last 3 years. And as we learned during the pandemic, as we went into the pandemic, we were very well-positioned to be able to mitigate the impact that we saw with the decline in revenue last year. And more important, we seized the opportunity to make some structural changes then, and then with the work that we did, saw plenty of opportunities to do more, which is ultimately what we laid out here this morning. So we're very confident that with the actions that we've laid out, we're going to be able to close the gap and be similar, from a margin standpoint, be similar to our peers.

Great. So George, the $300 million is a pretty big number, more than 1% of sales. So maybe talk about sort of what this is. Give us a little more color on what the G&A takeout is. Is it focused more on one particular region, for example? And how does it ladder in over time?

Well, I'll frame it up, and then I'll ask Olivier to go through more of the details. But as I said, really, the way that we've been running the company, we're making this productivity cost-out core to the DNA in how we've been running the company, and I think you've seen that progress over the last few years. And then making sure that every aspect of what we do, not only from selling and being disciplined and having fundamentals to make sure we're getting productivity from the sales force, but right through the back office. And so as I said, as we've put all of these fundamentals in place, we've also identified significant opportunity to improve. And so when Olivier came in, in August, right out of the gate, I asked him to say, now that we've got the fundamentals in place, we're now delivering market or above-market growth, how do we now truly get the leverage from the cost structure that we have in place. And so Olivier has been working, taking everything that's been done, understanding how do we now take this forward, what are the big opportunities. And that's what we've laid out here today. So Olivier, maybe you can walk through the details.

No, absolutely. So we have -- we're going to have 5 levers to improve the profitability of the enterprise. G&A is one of them. But let me repeat what's the other 4. We'll spend more details in G&A in a second. One, mix would drive an improvement in gross margin. So we talked a lot about services. We believe we see services as a vector of growth and as a vector of profitable growth. We have indicated to you for the first time during the last quarter earnings that services has a profit rate all in, which is twice the company average. Mix would be an element of the profit story. Another one, and that's important, if you are looking at the current performance of the enterprise, we have been able to increase gross margin despite many headwinds in terms of the level of mix: lack of absorption; lower mix of security and fire, which is high-margin for us; North America resi, which is not at the top of our margin pyramid; and also commodity cost going up. So despite that, we have been able to increase the margin rate, the gross margin rate, of the enterprise. So we feel positive about where mix could drive the gross margin. That's one. 2 would be COGS. We've been working in COGS now for a number of months, and we'll come back to you with the details of our productivity initiatives on cost between anytime before or on earnings. Then we have 2 other levers. George mentioned those. One is sales productivity. We have identified today opportunities to improve the level of sales productivity. We're not going to reduce sales costs because we're excited by our end markets. But as a result, we're going to be able to sell more, with the same level of resource and scale sales as a proportion of revenue and the same on R&D for the same reason as this. Now let me talk about G&A. G&A includes a series of categories we put out on our release, this is on Slide 5, that will include Center of Excellence consolidation, some of them to best cost location; centralization of activities, product management being some of them; rationalization of some satellite offices; and also a broader effort around standardization and simplification. And in terms of external spend, which is a large proportion of the productivity savings, centralization, optimization of functions, indirect spend rationalization and also reduced level of trouble. Andy, we feel we have a good G&A in the company and a good engine in the company to transform the enterprise from a cost standpoint. And we feel, I would say, despite the size of the productivity initiative and -- on G&A, confident about those numbers.

So Olivier or George, maybe just following up on that, I mean, you mentioned sort of this ongoing review of cost of goods. So does that result in sort of a new bucket of savings when you get through it?

Yes. So when you look at cost as we look at not only the material costs and how we're managing our supply chain, but all of our manufacturing costs and overhead within manufacturing and the like, and we've done incredible work over the integration to get to where we are today, but there's still plenty of opportunity. And so as we manage through the pandemic, it also has highlighted opportunity to continue to consolidate the supply chain, and getting better leverage off of our buy and obviously, stronger negotiations and at the same time, continuing to consolidate the way that we work within our manufacturing facilities and be able to reduce the footprint and the like. So it's looking at all aspects of cost of goods, Andy, right from the raw materials, to the conversion, to ultimately the entire supply chain, supporting all of that. And I would tell you that the team that we have in place, the leadership that we put into place over the last couple of years and the strength of it really is -- this is core to what they do, and they're really good at what they do. And so what's happening is we're getting the normal productivity that we've always historically gotten. Now it's the ability to be able to get at some of these elements and make it a step function change here over the next year or so, given what we've learned and what we're doing.

And an additional important lever, Andy, will be the ability to improve the level of profit out of our field operation. Today, the field operation is a fairly decentralized model. And we believe that a large proportion of the opportunity will also come from field operations, services and installed base.

Yes. No, it's very interesting, Olivier, because I know that George knows this well. The field, I remember back in the Tyco days and all that kind of stuff. So it's like -- it seems like there's a lot of opportunity there, right, but it develops over time. So that's why I'm asking about timing. This is something that you're working on now for the next few quarters and then you sort of tell us, end of the year or next year, or like is it something more imminent around what the savings could be on the field, for instance, that kind of thing?

This is -- no. This is being worked real time. We saw during the pandemic and the opportunity that as we not only address short-term the temporary cost we could take out, but then the next layer of structural costs and within the supply chain, how do we optimize what we do and as much, how do we create the standards so that no matter where we do the work, we do it the same, Andy, across the globe. And there's been tremendous work in bringing the team together as an enterprise, standardizing our operations, standardizing around our best practices and then ultimately driving the improvement. We've got an operating system now across our field, which has been developed over the last couple of years, that I would say is getting to top of class, where we can -- really now all of the fundamentals that drive our performance right from selling to pricing, to managing the overall cost of an installation or cost of service, to execution and being on time to the customer -- our operating systems now are pretty standard and they're deployed universally. And that allows us to be able to get leverage off of the work that we do to be able to help expand the margins.

From a timing standpoint, Andy, I'm sorry to interrupt, we will announce the COGS details, timing, cash elements and so on, on or before our next earnings call just to...

Easy enough. And one of the reasons, George, why I asked you about sort of regional differences is, as you know, you probably get asked this question, there's one segment, EMEA/LA, that sticks out a little bit versus the other 2, in terms of margins being a little lower. I mean again, structurally, is there any reason why the margins are lower there, or that margin can get up to closer to where the other segments are?

And I'm assuming you're referencing installation, Andy?

Well, I'm talking about -- so I mean, again, if I just look at segment margins, right, I see segment margins a little lower in EMEA/LA versus the other 2 segments. That's what I'm talking about.

Yes. What I'll -- there's no reason. There's no structural reason why we can't get similar-type margins and returns. And of course, every -- when we started the transformation, when I took over, in the work that's been done, it's been across the board. But the starting point from where we were within each one of these businesses were different. I would tell you that with the leadership team that we have in place and the way that they're executing, and we're executing as an enterprise, as one team, and ultimately continuing to accelerate the progress that we're making across each one of these fundamentals, there's no reason why we can't take the best-in-class that we have within the current structure and get that universal across each one of our regions in how we ultimately deliver returns.

Great stuff. So listen, let me shift to growth then because, obviously, it's also extremely important. And we'll start with services, right, because it's a huge initiative for you, George, and as Olivier has come in here. Obviously, we've seen pretty good service performance. Maybe revenue is still down a little, but orders have turned positive here. So as you think about services going forward, what does it take to get back to that sort of mid-single-digit-plus annual services? Do you need a better market? Is it just going to be easy comparisons that are going to get us there? And then I know we're going to talk about OpenBlue, so let's just do that now. So like, again, I think you gave a really good update in earnings. But as you've continued to sort of roll it out, does it feel like it adds significantly to that mid-single-digit-plus background as you continue to roll it out?

So Andy, I think it's helpful to understand the strategy of the company before and what has changed in making service one of our key growth vectors and making the strategy around service central to all of what we do. So before, the strategy was, within the installation service business, create an installed base and then ultimately believe you have an entitlement to service. And a lot of that service was mechanical service, break, fix, repair, maintain. And so when we started our service strategy, when I took over 3 years ago, it was all about making sure that we're embedding technology in the installed base to connect everything we do in that installed base and then being able to leverage the data to be able to differentiate the type of services that we can perform. And the output of that strategy would be a higher attach rate, higher revenue per customer, higher backlog of recurring revenue and ultimately, higher growth. So we've been executing on that strategy, and with that, we've upgraded our leadership. We've actually created an enterprise structure. So we're doing this consistently across all of the regions with that leadership. And so as a result -- now with the strategy, before the pandemic, we actually got to 4% or 5%. And that was blocking and tackling, making sure that we had the right footprint of capabilities in the field. And at the same time, we were restructuring our sales force to segment service sales to be able to make it much more strategic in how we ultimately grew the company. We did all of that. We got our growth to 4% to 5%. And then with the pandemic, we've been accelerating our capabilities with digital, making sure that everything that we put into the field we connect and then now ultimately getting an attached contract with everything that we connect, so that we can manage that installation well through warranty. And then with that connectivity, we then extend that contract with additional value that we can create with that connectivity. So with that, we laid out this year that we can take our attach rate -- so when you look at our domains historically because there wasn't a lot of connectivity, it was more of a break, fix, repair, maintain after the fact, now with our connectivity, we're getting a much higher attach rate. So we start off in the mid-30s, when you average our domains. Now everything we put out is connected. Now we manage it through warranty. And then ultimately, we extend that with longer-term contracts post warranty. So we believe with that, we'll improve our attach rate 300 or 400 basis points this year. Through the year, it will actually accelerate and continue to get better, much better next year. And that, for us, is an incredible opportunity to be able to then add on additional services, utilize data, differentiate what we can do, reducing energy, whether it be HVAC or with connectivity, creating a healthier and safer solution in a lot of what we do combined. So that's a big element of the strategy. When you look at, historically, because it wasn't really core to the strategy, most of our equipment wasn't connected. And so in the last year, we've been working back to get everything connected and then being able to bring that installed base forward with a lot of the new technologies by upgrading and then extending with that connectivity with the use of data. So OpenBlue, as I said during the earnings, I think OpenBlue is our -- is really the data layer that no matter whether it be a new installation that we can embed OpenBlue in an integrated solution to be able to create an output that our customers are looking for within their building, and that could be energy efficiency, that could be upgrading indoor air quality or health and safety or many other business models there. So it not only enhances our ability to get that installed, but more important is the connectivity with the use of data that allows us to be able to create value over the life cycle with that installation. So we're extremely excited about where we are and the progress we've made. And like I said, our installed base has been undermined, underserved. And the opportunity that we have now to be able to upgrade, bring the technology forward and then utilize data to differentiate the outcomes that we can produce on that installed base is pretty significant.

One detail, Andy, if I may, if you look at the service market today, it's very important. The service market is covered by local players doing a mechanical kind of service. So you can imagine now those players will not have the fore of digital. So they are going to be -- clearly, we're going to be at a competitive advantage significantly going forward.

Yes. Olivier, that's a very important point because I was going to ask you like who are you taking share from, right? And the reality is, is that if you're taking it from these local players with your big digital platform, it shouldn't be that difficult, right? But like when I listen to some of your bigger peers, they talk about 50%-plus attachment rates, I mean, one does at 100%. Like so what's the theoretical point where you're saying that this is pretty good, George or Olivier? Like I assume you don't want to stop at 40...

Yes. Yes. What I would say is that there's a number of customers that we serve that are self-maintainers and so a lot of times, that we do support them in what they do to maintain their buildings and equipment. So think of it now with our capabilities with digital, we can actually enhance the services that we provide to customers that actually do their own maintenance and support. And then all of the other customer base, we believe our entitlement, if you measure it to all of that other customer base, our entitlement is more towards 70-plus percent to be able to attach, if you really want to measure it across each of the domains and then, in total, what our overall attach rate would be. So we have a lot of room for improvement there. One of the best examples is like, this year alone, we'll connect thousands of chillers that historically weren't connected. And you can imagine, if they go back to some of the older technology. So now once we know what the condition of that chiller is, we can propose upgrades. And then with the data that we're collecting, we can then propose how do you get better operations of that chiller, how do you reduce energy consumed to be able to operate that chiller. So there's a tremendous value proposition to bring the installed base forward and then be able to -- with that, be able to attach a contract and then actually, from a longer-term standpoint, continue to build on that. The other good example is Metasys. So Metasys, we've got an incredible installed base, and it was an installed base that never was mined to say how do you take -- no different than any other software model -- how do you take that installed base and constantly upgrade the software to bring it to the current with a value proposition with a recurring revenue with that upgrade. And so some of -- we're seeing tremendous success in how we're now upgrading that -- the building controls with Metasys. We go back as far as Metasys 5 or 6. Today, we're at Metasys 11. So you can imagine how much has changed in the value proposition that we have with the functionality and the features of the current version of Metasys to be able to really create a value proposition and then get a recurring revenue on a forward-looking basis. So those are a couple of examples that we're working on.

Great. So clearly, visibility on the service, a big factor is your own self-help, I mean, when it comes down to it. It's way more in almost self-help than what the market does as long as the market isn't somehow imploding that we don't know about.