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

Good morning. Thanks for joining us again. We're continuing on the industrial track here at the Wolfe conference with JCI. Very pleased to welcome George Oliver back to the virtual stage. Thanks, George, for being here. My name is Nigel Coe. I cover the multi-industry sector. And for the benefit of those on the replay, today is May 27. So George, again, thanks for the time. I'm going to hand over to you for some remarks, and then we'll go into Q&A.

Sure. Thanks, Nigel. It's great to be with you again. And hopefully, this will be the last time we're together virtually, the last time, hopefully. Just a few comments here and then we can get right into the Q&A. I'd say we see strong momentum on our various growth initiatives, and I think we're seeing that pretty much across the portfolio. I'd say end markets continue to improve at a pace of reopening which is accelerating in many parts of the world. I would say that I'm very pleased with the sequential improvement we're seeing across most of our business units with that reopening. We're very well positioned for many of the secular trends, both in HVAC as well as fire and security, and increasingly important, I'd say, in smart buildings. And I would categorize those with 3 priorities: healthy buildings into air quality, sustainability, decarbonization of buildings and then connectivity and digital transformation of all of what we do and how we serve our customers. And so the rollout, in line with that, the rollout and customer adoption of OpenBlue continues to accelerate. We're seeing very good traction, not only in how we digitize our services, but then with the data that we extract and the analytics we provide really fundamentally changing the outputs that we perform for our customers. It is an incredible platform that I believe is going to transform the way that our customers view their building and infrastructure assets. We have announced aggressive new cost programs. We'll generate $550 million in savings over the next 2.5 years, and this will get us close to the margin gap -- we'll close the margin gap to our peers. We continue to execute extremely well on free cash flow, which has significantly improved over the last few years and positioned now to sustain 100% conversion. And then when you look at our capital allocation, I'd say we're very attractive and more balanced capital allocation plan coming together. We are very excited about the Silent-Aire transaction and then the overall M&A pipeline overall and our ability to be able to do similar-type transactions that take the strong fundamentals we've built with the transformation that we've gone through over the last 2 or 3 years and then being able to do strategic bolt-ons that become very attractive and become accretive. We'll continue to buy back shares. We're going to continue to support a strong dividend and growth in line with our earnings, and we're continuing to reinvest. We're supporting reinvestment through R&D as well as CapEx, and that has positioned us to be able to gain share in our products and then as you look at the differentiation with OpenBlue and our services really now fundamentally changing how we can change that growth trajectory of our services on a go-forward basis. And then specific to fiscal 2021, we've raised the guidance twice, and we feel very good about the outlook that we have now for the second half of the year. So with that, Nigel, I'll turn it back to you, and let's open it up for questions.

I thought for a second there, George, you're going to raise your guidance for the third time, but 2 is not bad. So I definitely want to pick on some of the topics you just raised there. You talked about reopening, and I'm curious the degree to which you are geared to that reopening. And I'm thinking here about preparations at commercial offices, lodging establishments, government buildings, et cetera, making -- to bring back employees to work because it does feel like September is going to be when the light is switched on.

Yes. I would say, Nigel, that, that has been -- especially here in North America, the U.S., especially, that demand to bring people back has accelerated rapidly. We've seen a lot of [ lift-outs ] with the stimulus. The stimulus that -- the bill that was -- we were very actively involved in constructing, focused on education. K-12 is a big vertical for us, and we've been able to now follow the flow of the stimulus and making sure that we're positioned to support our -- we support 6,000 of the school districts across the U.S., and we've been following that stimulus and making sure that we're very proactive in how we're supporting those customers and bringing -- elevating the indoor air quality, the overall HVAC systems and the like to be able to bring students back to schools. So that, we benefited from that. And then more recently now with the return to commercial buildings and the need to make sure that their -- the indoor air quality and the overall health and safety of the building has been elevated, in line with the expectations that I think we're all seeing from our employees, that they want to understand that the environment that they're coming back to is healthy and safe. So I think we're seeing that return. And initially, we see that in our services. And so our services are expanding nicely. We're positioned in the second half here to be strong double digits, kind of probably low to mid-teens, and we're building that backlog with the order pipeline that's converting with our performance contracts. And really, we've been focusing on not only new business getting a higher attach rate but also in the existing installed base, working very actively with our customers to get that installed base connected. And then through that connectivity, how do we ultimately enhance the services that we can perform for the customers that we serve? So I think the overall environment, when we look at our forecast here in Q3, although it is the easiest compare, we're going to be very well positioned here for mid-teens organic growth in the third quarter. That's going to be led by our products. So Global Products will be the clear leader. They will grow 20-plus percent, which we talked about during our Q2 call. And the Field businesses should be up low double digits in aggregate. It looks like [ mail ] is coming back pretty strong, and that's going to probably lead to regions. And then across North America, we see continued improvement. We'll see a positive 2-year stack in the Q4, and then we'll be set up nice with the backlog that we're building, especially as we look at shorter cycle orders. We've done a nice job in filling in the whole of the non-resi construction decline that we saw the latter part of last year. We've been able to do a lot more of the shorter-cycle upgrades, repairs, in line with the indoor air quality and healthy buildings. And so that has played out well, so that our backlog is actually up. And then as we're projecting orders to be double digit, low to mid-teens in the quarter, that's going to set us up well, not only for the remainder of the year, but also as we project into 2022. So overall, I think it's in line with what we laid out during the earnings call, and I think I'm encouraged by the amount of activity that I see pretty broad-based now.

And you mentioned services up back to double-digit growth in services, which is important because services was a bit lagging last quarter. So are we now moving beyond site access restrictions and services? We're now sort of on a more sort of single button here?

Yes. We've made sure that the service strategy is core to growth strategy, and we've been working to build services here over the last couple of years to get the fundamentals in place, to understand where we are with the installed base that we've created for decades in many cases. And then how do we make sure that our all new installations that we put into the field, that they're connected and that we can differentiate the services through that connectivity with the use of the data, using analytics and ultimately creating different outcomes. And so Nigel, as you know, we started this, we -- last year, when we assessed the installed base, we only had contracts attached to about 35% of our installed base. And so on a go-forward basis, we felt that we could pick that up by about 400 basis points this year, and that would only accelerate going forward. So what that does for us is we're going back like, for instance, within our chillers, connecting 5,000 chillers that were in our installed base that weren't connected before. That not only enables us to get visibility to those chillers and seeing -- getting a better understanding of how those chillers are being operated. We can then compare that to the fleet, and then we can come back to customers and provide new value propositions on those chillers and the like. That's one example. So on a go-forward basis, we're getting all of what we do connected. We're going back to install the -- or connect what was in the installed base, and that's going to give us a higher recurring revenue. So as we build our backlog, we'll have a higher recurring revenue. So on a go-forward basis, we're positioning to get a growth rate that's 200 or 300 basis points above the overall industry growth rate. And I think all the fundamentals that we've been building is playing out and now the ability to really digitize what we do and then with that digitization and the use of the data, differentiate and then get more revenue per customer with the services that we can perform is playing out as I expected.

Okay. That's great, George. Driving penetration rates on chillers seems like the most obvious and natural thing to do, and Carrier has got a very similar strategy as well. Is the -- are we now sort of in a point where we're offering more payer services and therefore getting away from price-based conversations versus ISPs and competitors. Is that what's driving your ability to drive the higher penetration? Or is this something else?

Well, I would start, Nigel, by saying when you look at historically what we've done, it's mainly break-fix, maintain-type services. And then now as we drive the digitization of that installed base and then on a go-forward basis how we differentiate with that with the use of data, you're creating significantly more value for the customers that you serve. So not only does it enhance how you actually perform the historical services that you would have performed for that customer, but it gives you a lens to be able to create new opportunities, to be able to create value, to optimize how that equipment is ultimately performing. And then I think from an OpenBlue standpoint, when you think about OpenBlue, it's really digitizing all of what we've done historically and then through that connectivity fundamentally changing the outcomes. When we think about, for instance, the new outcomes around decarbonization or healthy and safe buildings or just digitization and what does that do for the occupant experience, so when you think about these growth vectors, and they all pretty much come together, we have the opportunity -- like for the global carbon footprint is -- the buildings represent 40% of the global carbon footprint. And so -- and about 75% of that is tied to the operations of a building. And so the more that we can get buildings connected with the understanding of how buildings are being operated with the occupancy and tied to the overall indoor air quality is what gives us the ability to not only elevate the indoor air quality but then to do it most efficiently with the energy that ultimately is consumed to do that. And so I think as we begin to go down that path that you -- or more around performance contracting, committing to an output that's tied to a value that ultimately then you get compensated for.

Obviously, it's now been commercial for not quite a year, but close to a year. How would you sort of mark-to-market on the progress you've made with customers? You talked about $1 billion of pipeline opportunities with OpenBlue. Where are we right now? And then on the performance contracting side, that's primarily been a lumpy, government-driven business in the past. What's the scope for making that broader business going forward?

Yes. So 2 good questions here. When we think of the progress we've made, think about how buildings historically have been served. They're at the domain level. They're typically with a facility, either through the contracting phase, through the contracting firm or in the operations phase with a facilities operator or building manager. And what's happened in the last year, buildings have become much more strategic, Nigel, where indoor air quality is a big deal, right? So every CEO or a C-suite is focused on are their buildings safe? Are they at the right level? And then couple that with sustainability. Most CEOs have made commitments to get to net zero carbon emissions, while buildings are a big chunk of the overall carbon footprint. So now you're thinking of your building very differently as far as -- you're building much more efficient to be able to achieve the goals that you've committed to. And so I think for that reason, our engagement with customers are at a much higher level. So when we look at our top 100 enterprise customers, these are engagements with the C-suite in understanding not only what are their strategies within their model -- their business model and how they're going to grow their company, but then how do buildings and infrastructure contribute to that and how do you then ultimately achieve these other objectives around sustainability and health and safety. It all comes together. And so it's much more elevated. That has opened up a lot more partnerships where instead of you going in and you're bidding cost plus or you're doing a transactional agreement, it's much more strategic in ultimately the outcomes that you provide. Now as it relates to performance contracting, certainly, that has been historically focused in the government sector. I believe with what we're learning and we're doing a lot of work around decarbonization of buildings and infrastructure. And through those learnings, we've done thousands of interviews with key customers in all of the different verticals that we support. And so the insights that you gain are amazing because now as they think about this, as far as how historically we've contracted and now ultimately what can be done to put that together into a performance contract where you can bring financing, you can do upgrades, you can deploy digital and then you can ultimately commit to an outcome, like, for instance, in energy, reducing energy. We typically can go in and do a survey of a building, do an upgrade, deploy digital and get energy savings up 30%, 40%, 50%. And so as we have been working with the administration and educating the administration and as they think about decarbonization of buildings and of all infrastructure, this certainly has been put front and center. And so our -- not only through the education, but now through the demonstration of what can be achieved. You can actually get an economic return for the type of solutions that we can deploy. So it's a very attractive way to solve the problem to be able to contribute to solving the decarbonization challenge that we all have, and I think in a way that actually creates -- can create returns.

One more question on sort of secular drivers and demand before we switch to margins because I think that's a very important part of your story, decarbonizations, CO2 abatements, very, very key topics. C-suite is definitely more focused on ESG and I've seen reducing costs. But what do you think is going to be sort of the stick behind this rather than the carrot? Do you think there's going to be federal regulations and big taps around this? Do you think it's more sort of local and state regulations? Do you think it's ASHRAE code compliance? I mean what do you think is going to be the big driver of these upgrades?

Well, I think you've seen this just recently in the executive order from the President around creating a building standard of what ultimately would be acceptable to support the overall goals that are being targeted from a decarbonization standpoint. So I think it does start there. We've been very actively involved in this process, not only with the new administration, but also, as you know, I lead the Energy and Environment Committee on the BRT and working with all of my peers relative to commitments that they've made and ultimately what we're trying to achieve altogether in line with the overall goal. And so we've been very active in driving that because we believe that in the space we're in, it actually is a good deployment of infrastructure, of upgrades and capital and the like because you can actually generate a return, and it can be much more sustainable on a go-forward basis. So I think it's going to -- there'll be some of that. And I think then in line with the very active planning that's underway across all companies and relative to how do they ultimately get to their commitments to get to net zero carbon emissions here over the next summer, within a decade or 2, it's not a small feat, and you actually have to go after the carbon that's a result of buildings.

Yes. No question. No question. And then maybe just touching on education similar -- I mean is the question does your -- but there's obviously tens of billions of dollars going to the education sector in the U.S. It's a big vertical for you guys. I mean what are you seeing right now?

Yes. What I would say is we've been very active and that stimulus, right from day 1, working closely in how the bill was put together, focusing on the real demand of making sure that schools were healthy and safe and making sure that there was a lot of stimulus targeted for education. That's a big vertical for us. We support, like I said, over 6,000 school districts across the U.S. And then because of that, we've been working very proactively in deploying those resources. We're seeing acceleration. I mean I think we've talked about this whole stimulus could be tens of billions of dollars that impact our space. We talk about healthy buildings or indoor air quality, about $10 billion to $15 billion. And we said that we had a pipeline of multiple millions of dollars. That's been accelerating. Our ability, not only pipeline, but our conversion. We're, to date, up over -- well over $200 million of orders that we've been able to convert. And so we believe that this will continue, not only through '21, but into '22 and certainly plays to our strengths with our ability to not only bring the technology, the right solution depending on the application. And then with our footprint and our services, be very agile and how we actually deploy it to capitalize on the stimulus and ultimately get to the outcome that they're looking for.

But importantly, not just on the HVAC, but also product security. That's a key plan as well.

Well, the differentiation comes from the combined solution. So to optimize not only for indoor air quality but also for efficiency, it is the combination of the digital assets. Now that -- with the data that's extracted with OpenBlue allows us to be able to really get a better sense of how the facility is being operated and ultimately then focusing on how do you get to those heightened outcomes, whether it be a level of indoor air quality at the same time that you're reducing the energy required to actually achieve that higher level. Because as you know, Nigel, during the last -- before the pandemic, a lot of the sustainability was achieved by recycling or recirculating air. The pandemic immediately, it's to then bring in more of the makeup air from the outside. Well, that requires more energy, depending -- whether you're in a cooling cycle or a heating cycle. And so I think, for us, it's the ability to be able to use -- we talk about a clean air delivery rate. So it allows us to be able to know exactly what that indoor space is, what the occupancy is, and then through algorithms, what is required from the overall system, the building system, to be able to maintain that heightened indoor air quality. And it's through all of those inputs that enable us to be able to do that.

Great. So switching to margins, and you've committed to $550 million of net cost reduction. So I think it's $640 million of gross -- net of $9 million of reinvestment. So you're saying $550 million drops through to operating income, which is about 2 points plus of margin, net realized margin. So that gets you pretty close to sort of best in class, if you will. What could be the offsets to that? I mean you've committed to $9 million of investment. Number one, what does that get you? What does that investment spending get you? You announced this morning the transition to R-454B refrigerants. Does that create a big investment cycle over the next 3 years to get your products compliant with that? And then one of your competitors is very bullish on the opportunity in commercial business for heat pumps in Europe, in China and potentially in the U.S. as well. Where is JCI today in that market?

So Nigel, you had about 4 -- that's about 4 questions there. So let's start with margins. What I would say, although we have a different mix, I would say that there's no reason now, given the work we've done over the last few years, that the fundamentals we have in place with how we now have measured those fundamentals so that we're getting to our entitlement pretty much across the globe within every business that we can't be equivalent to best in class. And we announced the $550 million. So think of the $550 million is with all the work that we've done, not only SG&A, but COGS, and really doing a baseline and understanding what is that next level of reduction of variation that gets that project by project that amount of value, both SG&A as well as COGS. That's in addition to normally on just a run rate basis, focusing on every year with volume mix and then price/cost that we historically get about 30 basis points of improvement annually. That will continue. The focus on that will continue so that we're getting leverage. We're offsetting potential headwinds around inflation and whether it be labor materials that we're offsetting that with productivity on a run rate basis. So you can -- on a go-forward basis, we can continue to sustain that level of improvement on a margin basis. So we feel -- and then with the costs that are being incurred to ultimately get these savings, these are project by project, understanding what the return is. Whether it's going to a shared service, whether it's automating part of the process, there's a lot of different projects that contribute to that. And it's roughly -- I think it's roughly about -- in the field, it's roughly about $180 million. And it's tied to installation and service and how we optimize the utilization of labor, how we go to 100% shared services on the more of the back office. And then it's enabling them with digital tools to be much more efficient in how we better serve the customer and ultimately deliver on the growth. And then in manufacturing, there's still -- even though we've made a lot of progress with the consolidation of the footprint and the utilization of that footprint, there's still about $70 million of projects that we're working to make sure we're getting full utilization. We're automating some of the processes to get a higher level of quality, higher level of productivity and ultimately getting to higher margin. So that is on the cost side. It's all lined out, project by project. We're executing it as planned, and that will ultimately be done and fall to the bottom line here over the next -- this year and the next 2 years. Your second question on the reinvestment on refrigerants, that all has been factored in our reinvestment rate. So we've been investing in the refrigerant changes and doing tests and making sure that once we did come to a conclusion, that we're going to have the right refrigerant that, ultimately, we believe, is going to set us up to be best in class, not only from a system standpoint, but from an environment standpoint and the like. And you can go through all of the criteria that we've been through on that. So that all has been factored in our reinvestment rate. As you know, we've been -- we elevated our reinvestment rate 4 years ago. And we've been able to sustain that elevated rate as a percent -- you'd have to look at it as a percent of our product revenues. That has been at a 7% to 8% reinvestment rate, which does incorporate the changes that we're making around refrigerants. And then the third -- what was the third?

I think it's around inflation.

We did talk a lot about this during our last earnings call because you can imagine, as we have been deploying our decarbonization strategy pretty much across the globe and we -- like I said, we've engaged thousands of customers in understanding their goals and ultimately what is going to be required to achieve those goals. Heat pumps has become front and center, and we believe it's about $11 billion opportunity that's growing high single digits over the next few years. And I think the -- at least initially, the higher growth is coming from Europe and Asia Pac. But it doesn't mean that, that can't also happen in North America. A lot of it is coming from the environmental regulations and incentives, outright bans on oil or gas-based heating equipment across Northern Europe and the U.K. There's incentives and rebates in place for heat pump replacements. You might have seen, even last week, there was an article in Bloomberg with Prime Minister Johnson in the U.K., proposals favoring heat pumps over boilers. So there's a lot of focus on this. We laid out -- because we've had a lot of interest in this, we've laid out our full portfolio during our last earnings call. And I would say that we're historically best equipped. We're a leader in the complex industrial verticals. We have been reinvesting and strengthening our position in commercial and residential verticals. And this is the area that we believe that, given our footprint and our capabilities, is where we're going to continue to invest and then several new products that we have planned here to launch over the next few quarters. So we feel very bullish, and we think it's going to be a critical element of the overall sustainability solutions that we developed to address decarbonization.

And George, I apologize for the brain damage of the multiple questions there. But the bottom line is do you think you will be competitive in the commercial building opportunity?

Very much. I mean I think when we combine -- it isn't just the HVAC but how HVAC ties to the digital capabilities. The combination can create incredible outcomes, reduction of energy demand and the like, so absolutely.

Great. And then we're running a bit short on time here, but I did want to squeeze one in on capital allocation. You just announced and closed the Silent-Aire acquisition. It sounds like you're more focused here on bolt-on opportunities from here. But do you see the scope for larger-scale consolidation or acquisitions going forward? What are your competitors have gone on record are saying there needs to be more consolidation in the 5% to 15% sort of market share category? And you continue -- so I'll leave it there. No more multipart questions.

So what I would say, Nigel, and we've had this discussion, consolidation is always a topic of discussion when you look not only our industry but all industries, right, and potential synergies and leverage of scale and whether it be at the manufacturing level or ultimately the field level. And I think when you look at our space, when you look at the top players, they're all high-quality players, right, within our space and ultimately being able to drive strong fundamentals, each with -- what I would say, there is difference with competitive advantages within each one of our competitors. And I think what I would say about Johnson Controls, we have transformed our company, right, not only in how we're executing with the fundamentals, but strategically how we're now leveraging the full portfolio to be much more disruptive, to be positioned to capitalize on these trends. And so when you think about Johnson Controls and we want to be compared whether it be HVAC or other players in that space, we're a different company. And so the opportunity that we see to execute our growth strategy of not only digitizing all that we do, getting that connectivity and building out robust digital services, then moving upstream and how we actually create autonomous buildings, where, eventually, buildings will become much more autonomous, no different than any other industry, we think we're in a whole position to do that. And it's a combination of HVAC with the building technologies that give us the opportunity to do that. And so the way I would look at it is that we're positioned to outperform organically, right, with the work that we've done to reinvest in product and gaining market share in product and being able to differentiate service through digital and the use of data and analytics. And then even in the install space to fundamentally change the game with how we go to market much more strategically and how digital becomes a more critical part to new installations that ultimately are much more sustainable. And obviously, we're focused on creating healthy and safe workplaces. So what we believe is that with our position from an M&A standpoint that there's many more Silent-Aires that can take our above market organic growth, that can take -- our leverage is less than 2 as we sit here today, the opportunity that we have to be able to contribute 1%, 2%, 3% incremental growth above the organic growth with the deployment of capital towards strategic M&A that really addresses continued product leadership, product technology and leadership, continued service expansion and then the ability to truly lead the whole digital building that ultimately is more focused on these, what I would call, accelerated accelerators, which are decarbonization, health and safety and then digitization of the building, which ultimately creates different occupant experiences and ultimately different outcomes.

Great. Well, George, that's a great place to draw the line here. I appreciate the time, the thoughtful answers and, of course, being here with us. So thank you very much, George.

Thank you, Nigel. It's been great to be with you. Have a good day.

Thank you.