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

Hello, everybody, and welcome to our next session. We're super excited today to have Johnson Controls with us. We have fairly newly minted CFO, Olivier Leonetti. Thank you, Olivier, for spending time with us today. We're excited to talk to you.

Likewise. Thank you for having us on your great platform, Joe. We are delighted to have this airtime. Thank you very much.

Yes. Great. Look, Olivier, before we get into the nitty-gritty on the business, I want to maybe just take a step back, right? You've been on the job now for 6-plus months coming from Zebra. I also know that you sit on Eaton's Board. I'm sure that there are multiple opportunities that you had for your services. I'm just curious like why did you choose JCI? Let's just start there. And maybe perhaps you can start with some of your impressions in your first 6-plus months on the job.

Yes. So it's a great question. I mean, I need to make a living like most of us, but I can't decide where to do that. I have aged parents, and then I have 3 kids to look after. Five reasons. One, strength of the end market. I believe that the building industry is going through a revolution and that this decade we're entering is going to be an exciting decade for the building industry, point number one. Point number two, I believe we have a unique competitive position, which is not well understood today by the community at large, including investors. We're changing that. That's point number two. Point number three, culture. I spend -- all of us spend a lot of time at the office. It has to be fun. It has to be engaging. Diversity is important to me, inclusion is important to me, everybody having a chance. So the culture was important. Four is, do we want the function that represents to be at the table shaping operational discipline and strategy? And five is obviously the relationship with the CEO and Chairman that was George. I joined for those 5 reasons. And after now 7 months, it's just better. And the end markets are better. Our ability to compete is better, our culture is better. We are more the table than I thought we would be. That's true for our function but also for the other functions. We have a very inclusive style. And the relationship with George, our CEO and Chairman, is even better than before. And I'm very excited. We're going fast. It's fun. We're delivering value. And yes, I'm excited to go through all of that with you, Joe, today.

Olivier, that's really great to hear. And I should let everybody else know, when we were in the green room, you described it to me as the X Games, right?

That's true.

So it sounds like it has been fun. I'm curious...

Yes, we do 2 things. I mean, we are materializing the benefits of the merger, right? A lot of work has been done. Amazing work has been done, but still work to be done. That's one. But on top of that, we reset -- we are augmenting our strategy -- strategic ambition. So it's double work.

Yes. We're going to get into the whole transformation that's occurring within the company. I do want to touch on one of those 5 points, which is point number two, the unique competitive positioning and the underappreciation in the market. So maybe talk about that a little bit and why you believe you are underappreciated.

And we are closing the gap. It's a formidable industry. We have a lot of respect for all our peers, our competitors, and the bar is raised all the time. There are, I guess, 3 things, which were underappreciated. One is the delta in margin profile. Was it closable? Yes or no? We think it is closable, and we have indicated to you how we need to close the gap. So that was one of the gap. And that includes also profit and then cash flow. Cash flow now starts to be a bit behind us. As a [ cushion ], we have had now a few quarters, 3, where we have had an amazing performance. But profitability, we're closing the gap. The other one is we can compete in the as-is offering at another level. Services, we can operate at another level, global products, our ability to gain shares, the importance of our go-to-market today as a force where you have install, where you have services. And then another final point is in the world of digital, I'm sure we'll spend a lot of time on that today, you need to sense a lot of data, analyze them and propose an action. Sense, analyze, act. We can sense more than anybody in the industry because we have the largest installed base in a building than anybody else. We can analyze today in OpenBlue, and then we can propose an action, very targeted through the largest fleet of field engineers in the industry, 16,000. So we believe today, when we start to speak about decarbonization of building, digital, when we speak about indoor air quality, having a service business which is moving from mechanical to digital, that the model we have is also a competitive advantage. So if I summarize: one, the profit discount, we will close this, we are starting; two, the core, operate our game at another level; and three, to play on the key secular trends affecting our industry, decarbonization being the main one.

No, that's very clear, and I'm sure we're going to get into each one of those. The biggest one with the cost transformation that you're undergoing and what you've announced over the last couple of months, it would be helpful -- before we dig into the opportunity at JCI, it probably would be helpful also for the audience for you to discuss perhaps some similar transformations that you went through in your prior life, like whether it was at Zebra or Dell or Western Digital, to help us understand and level set your process and your ability to get after the cost structure.

So this -- the transformation at Johnson Controls is the fifth one I've been part of. And I've learned from the past 4 about what to do and what not to do and you learn equally in life. That's true in business, too. There are a few things here where we have an alignment. And I haven't been, Joe, in an organization going as fast as Johnson Controls. And there are a few reasons today. One is we have a [ burning ] platform. It's very clear where we were [ out of cost ] position. We know where it is. It's solvable. We communicate that to our team, everybody is on board, burning platform. Two, the [ turn ] at the top. We made very clear, George made very clear, our CEO and Chairman, our Board, we need to address this to another top. Three, extreme, and I use the word extreme on purpose, extreme alignment from the executive team to get it done. Four, it's a concept I like to use. It's very difficult to run the business and change the business at the same time. We have -- we like the concept of lane's owner. And productivity at Johnson Control is a lane, and we have a team across the enterprise, centrally in the businesses across the globe. We have a team dedicated to the transformation effort, so lane owners. Then we have a central team doing a PMO, project management of what -- of the transformation. We have a set of KPIs. We're advised by an adviser, who have been with us now for more than 2 years. And every week -- and let me give you the time, 7:00 to 8:00 Central Time, 40 executives from the planet are on the call every single week. The meeting is chaired by George, where we go through the transformation effort, project by project, everything which is red. So you have a machinery going on. And this machinery has been put in place because of what was there before I came, but we have also augmented it based upon the learnings before. And we -- I mean, it's hard to do, right? You need to meet the quarter, you need to do M&A, you need to incubate the new strategy and then you do the cost takeout. It's a lot of work, but we are doing that very well. From where I stand, a best practice, based upon my modest experience, Joe, the best practice.

That's wonderful to hear. And it sounds like you're tackling this in a variety of different ways, very structured, very process-oriented. You've laid out this plan that basically shows, call it, 300 basis points of expansion over the next few years. Some folks call that ambitious, right, just based on where your gross margins are today and based on where your -- what your starting point is. I guess what's your take on that feedback from the investor base on whether it's ambitious and your confidence level in achieving it?

We have done -- again, it's obvious. Of course, we did very detailed work to understand the levers of productivity. So we have many projects impacting all the elements of the value chain. We have benchmarking supporting this, value mapping supporting this and the alignment from all the business owners behind every single levers. So it didn't come up from consultant magic model. There was a deep alignment to make it happen. And what we have communicated and nobody does this, right? I mean, nobody gives to you our best game. This is our risk-adjusted game. Our internal plans are always to do better. And so far, and this is a 2-year transformation, we're running faster than the time we have been communicating to you. So I give you a bit of replay. When we announce any cost initiative, we increase the guide by the benefit. During the March quarter, we further increased the guide, right, so more than the productivity initiative, and the increase was higher than the beat we had in the March quarter. So you see today, you have clearly velocity happening.

Yes. No. That's fantastic to hear. I guess your comment on risk adjusted, which is also nice to hear, when I think about that, like how much of this -- how much of volume is going to have to play in order for you to get after these costs versus being volume-dependent and really volumes could potentially take you to a much higher level?

Volume could take -- so today, we took a relatively conservative view of the future as we should. Volume, obviously, would create scaling. I mean volume would have some side effects because of the environment we have around raw materials, inflation, labor inflation. But all things being equal, volume is obviously a good trend for us. But over time, volume will allow us to do a better job on profitability. No question about this.

Makes sense. Olivier, maybe can we step into some of these initiatives? And the most recent one that you broke up was the cost of sales, the cost of goods sold initiative, the $250 million savings by 2023. I know that you've kind of talked about field labor versus manufacturing. But maybe just give us a little bit more color and detail on where you see the opportunities across those functional areas.

The theme we have is lack of standardization and lack of implementation of best practices across the network. That's the theme. So I'll give you a tangible example. In the U.S., we have said that many times, we have about 140 branches in the U.S., and you can imagine when you extrapolate that across the world. Every branch, to a large extent, has bespoke processes. The way we procure, the way we deploy our field engineers, the technology, and I can go on. And what the productivity initiative is doing is basically standardizing those practices. When do you deploy? Which technology do you use? How could you -- center of excellence and so on. So that's what the productivity initiative is about, particularly on the field operation, and that will impact our installation business and our service business both through the standardization, automation and offshoring of some activities. I mean I can give you example. Today, Joe, I mean, to make it alive for a business, we deployed equipment in a building, we might buy 25 different cameras across the globe, 25 brands. Actually, this number is actually lower than it is actually. We should have 3 across the globe, good, better, best. Imagine the scaling you have not only in procurement savings but also simplicity of activities, right? You have a catalog, you click a button, and so that's what we are talking about. Nothing complicated, but we have to do it at scale, we have to do it well and we have to do it fast.

Your comment around standardization, and maybe I'm thinking about this wrong, but it would be helpful to get your perspective on this. If you think about standardization of sales, planning, scoping, all of that stuff, it should also probably help one of your other goals, which is improving your service attachment rates. Tell us at all, is that going to be interconnected? Just any thoughts around that would be helpful.

So when we did the end-to-end evaluation of where productivity would be, we said on some parts of the value chain, we would reduce cost. That's the 3 points of margin improvement that you mentioned, more than $0.5 billion of costs net flowing to the bottom line. But some -- on some activities, we believe that the best way to generate the potential is through increased productivity. So we don't reduce cost. We keep the same cost but improve the output. That's true for 2 functions: sales and R&D. We know today that our sales team spend half the time selling relative to benchmark, relative to our competition, half the time. And what we're going to do then is remove what is preventing our sales force to sell and then increase their output. We do the same in R&D by simplification of the R&D road map, platforming and the like. So on those 2 functions, the lever is not reducing cost but increasing the output for the same cost. So sales and marketing -- sales cost as a proportion of revenue should decline. R&D -- or be stable. R&D as a proportion of revenue should decline or be stable. That's how you will see it in the P&L.

That makes a lot of sense. And then maybe shifting gears just to the SG&A initiatives. You called out $60 million in potential savings in 2021. How is that going so far?

So when we communicate this number, we increased the guide at the same time. During our March quarter, as I indicated, we increased the guide by more than the March quarter performance. So in other words, today, I mean, the core business is doing well, but we are today well on track on our productivity initiative. No question.

Okay. Wonderful. And the lift that you expected to get in 2022 is going to be -- is expected to be more substantial, right?

Correct.

I guess when you think about the SG&A component of it, one of the things that we talked about a little bit before we got on this public webcast was really just like some constraints around labor, right? And I'm just wondering like are you seeing a lot of labor constraints in your business today? How much of a toggle do you have because you're in the process of really improving your productivity? So do you maybe have more bandwidth than maybe some others do at this point just given where you are in your initiatives?

You're absolutely right. So inflation, everything is obviously a concern for all of us. Now we are uniquely positioned -- is today, we need to improve productivity, meaning we need to do more with less. So we're not exposed to the same extent to this issue. I mean we're building digital capabilities. We're impacted on some parts of the business, of course. But overall, at the level of enterprise, we are much less impacted than many other companies.

That's really great to hear, Olivier. We're getting a couple of questions in from the audience. And so there's -- one of the questions that I've gotten actually dovetails well with this whole discussion around the framework that you've put together from a cost standpoint. So this person would like to know whether you can run on incremental margins, whether incremental margins can be above 30% for 2022 and 2023, just given all the cost-outs that you see and the inflection that you're seeing from a growth perspective.

So the incremental in '22 and '23, I mean, would be at 40% before Silent-Aire. So we are there already. After that, we believe we can -- that 30% incremental would be a good number. By then, there are 2 things which would take over the restructuring program. One is we'd be standardized across the enterprise. It's actually an effort, by the way. After that, we should be able to have -- be able to scale the enterprise much better than before. That's point number one. And point number two, by then, we should be operating under 2 ERPs. We have 140 today.

That's incredible.

So you can imagine the productivity gained by then, the productivity gained through standardization and then through a very unified IT platform.

That's incredible. It's part of a question -- I know that we're going to get to this later, but I may as well ask it now. Part of what you're doing, you're increasing your investments, right, over the next few years in order to drive some of these productivity improvements, some of these cost outs. When -- and kudos to you guys. I thought it was great that you gave us an all-in number on the free cash flow. So very much appreciated on that front. This free -- did you get a tailwind in the next couple of years? Like how do we think about these investments, cash investments into your business? And if you are able to do 100% free cash flow conversion this year, is there a potential tailwind in 2022 and 2023 from the investments actually stepping down from a cash standpoint?

Well, just to make sure I understand your question, easier question, can the free cash flow -- so we have committed -- we are on track to 100% cash flow conversion, including the impact of restructuring.

Correct.

Now your question is -- is your question, after that, could we do better? Is it your question on free cash flow?

Yes, because it would seem that some of your investments are front-end loaded, so...

You're right. And the answer, we are there already. I mean, we're absorbing an exceptional cost today and still deliver 100%. So de facto, it's happening today. And we believe that once those one-off penalty, if you can call it this way, go away, we have the ability to be over that. That's -- no question about this.

Okay. Wonderful.

And by the way, there are some things going on, Joe, and I'm sorry to interrupt here. We are working today on levers to improve free cash flow in a year and more. So again, we're trying to be ahead of the game here to keep improving. So even as the one-off costs go away, we are delivering also on structural improvement in the free cash flow generation of the enterprise.

No, that's great to hear. Okay. So I've got a couple of other questions coming in from the audience. So we're going to transition anyway into the growth opportunities. But before we get there, somebody wants to know explicitly whether the margin targets are volume-dependent or not. I know I asked, but explicitly.

No, no, they are not. They are not. Sorry if I was unclear. They can go up with more volume, but they are not dependent. No question about this.

Okay. Perfect. Clear. Second question, education stimulus, K-12, IAQ, healthy buildings, a lot of stuff going on. When do you think you'll start to see it show up in orders? And how do you think that this -- the trajectory is going to look like for these opportunities?

So we believe that the building industry is going to go through a very different decade, and you mentioned some of the trends. Decarbonization, the push for the decarbonization, healthy building, smart building with a different experience for our employees. The technology is there to make it up, and the push from the market is there to make it happen, either the regulator, you as investors that orders, our citizens and so on. So there was a conference [indiscernible] also set of assets out there, 80% of the building today have equipment, 80%, which we've put in place 20 years ago. I mean, technology has changed so much since then. So really, we believe this is going to be a golden decade for the building industry, and we believe we are uniquely positioned to do that. As you have an amazing footprint in the building with digital, you can leverage those trends.

That makes a lot of sense. I guess, specifically, maybe just peeling some of that back. On the educational side of things, there's a lot of folks that are excited, right? And it seems like the government is going to be putting a lot of work, K-12, $200 billion worth of work. I know you've got about 7% to 8% type total exposure, right, to North America education. Just any sense there? Just like how are those conversations progressing? And what's your sense on the uptick there?

So let me give you first -- and you asked it before, and I didn't answer to the question. Where do we see it in the P&L? So -- and we said that we are lagging business, right? So meaning today, what you see in the P&L in the March quarter reflects what happened in the middle of the pandemic, right? So really, the true indicator of performance is orders. And if you look at today in the March quarter, and I'm going to answer your question specifically about education, our install orders in the March quarter, the growth was 9%, 9%, all coming from retrofit. Usually, it's 50-50 between newbuilding and retrofit. All the 9% is from retrofit. All the 9% is based upon what you have said, the stimulus program. So we're capturing a fair amount of the stimulus. Why? We -- you mentioned it, education, government, they represent about 10% of the revenue of the company. And we have a large coverage of those today 2 verticals. We are present in every state. We understand the stimulus well. And today, we have shovel-ready offering to take into account the benefit of the stimulus and to package that with financing, KPI-based contracting and the like. So we see today really a big push in our business. And you see that in the performance of our company due to those trends.

Perfect. And we mentioned digital earlier, right? We talked about that as being one of the growth platforms as well. OpenBlue, you guys are making a big push there. Just talk to us a little bit about how you believe OpenBlue differentiates versus some of your peers? And can you highlight maybe some recent wins with OpenBlue?

So we're all trying to do this, right? In every industry, everybody is digitizing their offering. We are no exception. We're all trying to gain this pattern. So let me describe OpenBlue first, and then I will talk about the benefits we start to see. So what is OpenBlue? I mean OpenBlue, so one is open. So it's agnostic to device, brands and so on. You can plug anything to OpenBlue. That's point number one. Point number two, it's in the cloud. And meaning it's at scale. And three, it's modular, meaning you can launch in this platform one new module, and the module would be then replicated across the planet to all our customers, right? And the benefit of the cloud is you connect -- if you have a business -- a building management system, you connect the equipment in one building. You cannot connect multiple buildings across the world through a business management system. It's not designed to do this. Only the cloud can do this. So OpenBlue allows us to connect all the chillers we have in the planet in one platform. Now you start to mine a lot of data because of this. So that's unique. Now you speak about OpenBlue, what it's doing? 2 things. One is it's allowing a device to be smarter. So how do you optimize the management of a chiller? Why is it important? Today, the management of chiller, which is a service event, is done locally, local players using a mechanical kind of road to market, right, or mechanical offering. We believe that we, in turn, transform the service business to be a digital business and then global. You -- if you're a local player, you cannot have the benefit of digital. OpenBlue will be a revolution, we believe, in the service market. That's point number one. Point number two, OpenBlue allows you to do smart building. What does that mean? So let's speak about indoor air quality. We know how to do clean air in a building. It's easy to do, you ramp your HVAC. As you do that, you increase your consumption of energy, you increase carbon emission. To do clean and efficient from an energy standpoint, you need smart, you need OpenBlue. And OpenBlue -- and you do smart if you have many connection points in the building. Today, we have HVAC. Today, we have security. We know who is in the building. We know building occupancy. We know who is where. We can optimize then the building more than other players. Let me finish by another competitive advantage. Digital, I go back to what I said earlier. You need to sense a lot of data, analyze and act. And we have the largest installed base of equipment in the industry and the largest fleet of engineers. So you see that OpenBlue then is the capability, and you can get the full power of the capability because of our field presence. And we see today, in the performance of the organization, we have about 20% of the revenue, 20% of the revenue, which is connected today. And this revenue, we are tracking it, win rate higher, margin rate higher. And then the conversation are different. We used to transact today at the level of the facility manager. There was nothing wrong with that, by the way, just to make it clear. But now the conversation are C-suite to C-suite. A CEO today has to commit a decarbonization goal. A building is 40% of the carbon emission of a CEO, 40%. We can improve the carbon emission of a building, it's a coincidence, by the way, by 40%. We -- so today, OpenBlue, the capability, all that is elevating our game. And we think we are uniquely positioned as a company to materialize this trend.

It sounds like there's a tremendous amount of opportunity just within your own installed base, right? And so being able to increase that 20% win rate or attachment rate, it seems like it'd be pretty substantial for your business. I guess just in terms of adoption, how quickly are you seeing some of your customers adopt this at this point?

So you have 2 trends going on. So one, if you connect a device, that's immediate. So the benefit of connecting a chiller and having insight on the chiller and monitoring the chiller better, doing preventive maintenance, optimizing the management of this equipment, that's happening now. And there was a lot of adoption for this because the ROI is very high. Then you have another business, which is smart building, which is an emerging business in the industry. And today, more and more CEOs are interested by smart buildings for decarbonization, clean air, but also employees' experience. And today, we see C-suite to C-suite conversations going on there. We talked about this. And in the vast majority of the cases, we are competing against smart building players, not against HVAC players, point number one. Point number two, in the vast majority of the cases, we seem to be coming in front of the competitive race because of the quality of the offering. So it's in a good territory today.

That's great to hear. I have to ask you about -- since we're talking about OpenBlue, this should all help with your service business as well and attachment rates. You guys have been a lot more front footed with disclosures recently, telling us that it's 2x the margin of the company average. The service orders this past quarter were down modestly, low single digits for the quarter. The backlog was up. Just anything you can tell us about what you're seeing in terms of a pickup in the service business because clearly, such an important driver of profitability and important to your business overall?

So service is about $6 billion of revenue for the company. I mean it's an important part of what we do. And to your point, it's double the bottom line relative to the company average [ only ]. I just wanted to repeat what you said. We believe that service orders will grow double-digit in the second half of the year, point number one. Point number two, a key indicator because you could have volatility in one quarter not because of access to sites. But today, attach rate, which is an important leading indicator, we said we should increase attach rate so a contract attached to a piece of equipment by 4 points in the year. After 2 quarters, we have increased it by 3 points, so running faster than we thought we would. Why is this? There are 2 activities going on. One, I would call that focus. We have a new go-to-market dedicated to service. We have new offering in service. We have a new training program for service. We have a comp program for our reps and our engineers, which is very focused on services. We have a central organization now looking at services across the enterprise. And we look at -- you remember the meeting I mentioned, 7:00 to 8:00, looking at productivity. We have one, which is 6:00 to 7:00 Central Time, to look after services every week. So high focus. So that's driving what is happening in services. And you have also the connection I talked about. So you have the classic service management, but then you have the new one, which is digital, the use of digital, which we believe will be a revolution in the service business. You move from local to global, from mechanical to digital. So that's the other force, which is going to impact and impacting today our service business.

No, that's helpful, Olivier. And I want to close, I know that -- with a question around M&A. I know that's another one of the top 10 priorities where you have your weekly meetings. By the way, when am I going to get an invite to one of these meetings? It would be nice to kind of sit in on those.

Sure. It's action packed. It's action packed. And we say, Joe, there is some friction, and friction is movement. So you can get a taste for what is going on here.

Yes. Great. I'll be awaiting an invite. The -- so M&A is -- so Silent-Aire, congrats on closing the deal, just happened. Just talk a little bit about that acquisition, whether there's any additional information to tell us for this year. We know what the accretion is for next year. And then secondly, broader M&A ambitions across your universe.

Yes. So let me talk about M&A first, and then I would drill into Silent-Aire after that. So we believe today, we're ready to do M&A. We couldn't do that earlier. Earlier, we had to finalize some elements of the integration. We needed to have a stable cash flow. We were not able to integrate a team. Now we are. We have the cash flow to do this. We have also the clarity of the operational discipline. So we are ready. We have said, George has said, our CEO and Chairman has said, we believe we should be able to add 1% to 2% revenue growth, profitable revenue growth to the top line to M&A. And we're going to do 3 phases in M&A. One, we do not believe on large M&A. It's very -- it's a distraction. We believe we have the scale we need today. And you see from the conversation, the battle of tomorrow is not having 2 plants of managing HVAC into one. The game is services. The game is digital. The game is smart, right? So M&A is going to be around 3 avenues: one, tuck-in in global products like Silent-Aire; two, services, contract, you [ fold ] them and the JCI got the machine; and three, digital to augment smart as we discussed. Now let's speak about Silent-Aire. Wonderful company, augmenting -- it's really showcasing what we want to do. We are weak in a vertical today or we were because the acquisition closed yesterday. We were weak in data centers. Data center is growing more than other verticals. So we decided to buy this asset. The beauty of this asset is it's doubling our market share. It's a leading company. They have been growing at 40% over the last 5 years, and we love the culture of Silent-Aire. We are going to have a reverse integration. George, our CEO and Chairman, said we want -- this is a family business, by the way. If you're fascinated by business, it's a fascinating place to study, was created by the mom and the dad. Both of them created this business, and then the 2 brothers took over and created a worldwide business. And we want to learn from them. George said, "Tell us what we need to do to do what you have done. We want to do that faster, better across the globe." And we believe we can deploy this asset now faster, more in Europe. 90% of the revenue is U.S. based. We want to deploy the technology. We want to enable the Silent-Aire to penetrate the European market and also the Asian market. Silent-Aire has also new technologies that we want to deploy faster. And also, from a services point of view, this is today a business which is not to develop, we want to develop it and we talk about our service know-how. So you see, it's an exciting acquisition. And we want to do more of this. You mentioned it, Joe. You know us well, 10 key activities, M&A is one of the 10. So again, we have a whole team to grow our pipeline. We have augmented our M&A teams across the globe, and we look at this on a weekly basis, where is the pipeline, where are we and more to come.

Olivier, lots of great things happening within the organization. As always, a pleasure to speak with you today. Thanks for spending the time with us, and have a wonderful rest of your week.

Thank you for having us. It was fun, Joe. You take care. Talk to you soon.

Thank you, Olivier. Bye-bye.