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

Good day, everyone. It's Deane Dray, RBC, senior analyst covering multi-industry electrical equipment. We are delighted to be hosting Johnson Controls today at the Industrials Conference. Olivier Leonetti, CFO, is with us today, right on the heels of a very successful comprehensive Analyst Day. So kudos to you and the team for putting together a very well -- I don't want to say slick, but it's just a very professional, multimedia event, including with some very impressive CEO testimonials. But First of all, Olivier, welcome.

Yes. Thank you for having us, and good Friday to everybody being on the call and all the credit for the quality of the Investor Day presentation goes to Antonella and Ryan. It was a fun event well-orchestrated by those amazing leaders. So they should take all the credit.

Yes. My concern is you guys have advanced the expectations of professionalism and multimedia that I'm hoping we still can go back to in-person events when that opportunity comes back.

No question. We cannot wait.

Okay. All right. So let's just start this off with -- there were so many dimensions to your Analyst Day. And from our perspective, a number of priorities that were emphasized, I think, OpenBlue had such a debut in terms of how pivotal it is to the company on a go-forward basis. But in your mind, in your words, what were the key messages that came out of the Analyst Day?

So what we want to say is that we believe that the building industry is facing one of its most exciting decade. And we believe that at Johnson Controls, we have the asset to materialize this opportunity. Why do we say those 2 things? One, if you look at today the world, global warming is a key issue. 40% is not getting better, by the way, despite everything we're trying, 40% of the carbon emission is generated by a building. So building is an issue. And why is this? Why is building an issue and approximately 80% of the buildings in the U.S. have technology, which was deployed 20 years or more. So you have antiquated technology. And we have now, as an industry, we have now adjoined some controls, the technology to solve this decarb issue, the technology to solve the indoor air quality issues at a very attractive cost point. And we can deploy our technology now and provide a return on investments, which used to be 3 to 5 years, now within the year. And we think that digital is going to be central to materialize the opportunities in front of us and central to solve the key problems of our customers.

So that's really helpful in terms of emphasizing digital, but then there's technology using to solve the problems indoor air quality and decarbonization. It really does sound that sometimes companies give this a presentation like that, and it's all in the future. It's all -- it's going to take time. It sounds you're already signing up companies, you're already providing these solutions. This is not something in the future. This tell us about how current this is moving the needle at JCI in terms of P&L.

So it's happening now because the problems are now more and more acute. The conversations are happening C-suite to C-suite, CEO, C-suite of large organizations are considering Johnson Control, the leader in smart building, a leader in decarbonization to solve the problems. Not only companies, but also governments across the globe are asking us to advise -- for advice on solving this important problem. And why do they do this? What do they ask us? We have been in this business for a period of time. Solution smart building, today, we are a leader in this segment. Let me give you one step, maybe a few statistics. If you look at the performance infrastructure business in the U.S., which is a business which is well measured. We understand the market. We understand the growth. It's a market of about $5 billion to $6 billion growing mid-teens. We have been in this business for 20 years, securing solutions for our customers with recurring revenue securing outcome, and we have today a leading market share. Our #2 competitor, #1 competitor has a market share, which is [Indiscernible]. So you see today, you have a problem and opportunity, and we see that we have the capabilities at Johnson Controls being augmented by OpenBlue. And we think today that this now is going to accelerate. And the trend we are starting to face are really surprising us by the speed of takeoff. Those conversations with CEOs, with companies, with government where we engage are accelerating.

You know what really resonated for me and it was early in the presentation when you talked about OpenBlue and how it's changing the business model. So as analysts, we always look at you install equipment and then there is a recurring nature to it and aftermarket. And the attractiveness has always been on these legacy businesses that you get 5x the revenue, servicing the equipment over the life -- of the economic life of the equipment. What was a revelation for us was when you said with OpenBlue and digital and the connected services that multiplier goes to 10x. Just want to make sure we understood that correctly, and what are the economics behind that?

So you're right. And we see today the power of the Johnson Controls model. To capture all the economics, so the $1 to the $10, there are 4 things you need to do. And we believe that only us can do those 4 things, what are those? You need to have great products. We believe we have a great set of products in the global -- our global product divisions. That's one. Two, you need to be able to install to solve a problem. So installation is important. Three, as we have installed, you can now connect through a leading digital platform, OpenBlue, I'm sure to spend more time around this. And four, you get the insight from OpenBlue that you could act upon, because you have your direct field presence, 16,000 field engineers using [indiscernible] from OpenBlue in the building of our customers. And only us have the domain expertise. Only us have this digital platform, the connection with the building in the industry to solve those problems. You cannot solve this problem if you only do smart without having the domain expertise. You cannot solve this problem if only you have products. You need all the elements, and we do. And we believe this is a formidable competitive advantage today.

Yes. So you've got the equipment. You could do the installation, you've got the field expertise so the domain expertise. And what was -- I'm not saying it was the missing piece, but what the evolution of the technology is now OpenBlue becomes the game changer on this. I know it gets overused, but they always talk about disruptive, and this was and continues to be -- and it's open architecture. So this -- it's not just JCI equipment. Is that not true?

So OpenBlue -- open is open architecture. It's today -- and it's evolving fast at Johnson Controls. Deployment of OpenBlue used to take about a year ago about 2 months. It can be done now in a day. It cannot be done in a day in a very inexpensive matter -- manner, and you can make a building smart very quickly. So it's indeed a revolution, it's open, it's modular. And we believe over time, actually an OpenBlue platform or something like this could actually revolutionize the building management system you have today, which I will argue is probably a 20-year-old technology. A BMS today would be a limited device with limited capabilities. You cannot control a device through the business management system, we have limited number of rules, OpenBlue is dynamic. You always perfect the way you manage your building. You always perfect the way you manage a piece of equipment. You learn all the time, you can give command to your equipment. It's a formidable tool to solve the important problems of our customers. The benefit for Johnson Controls is higher win rate, pull-through of all the elements of our business, higher margin, and higher proportion of service of recurring revenue. It's a set of exciting trends facing our company.

Olivier, help us understand going back to that multiplier of 10x the revenue, thanks to the connected digital side of this. What does that mean in terms of margin trajectory, a mix shift higher for the company and then eventually to cash flow?

So we think that the margin would increase. We think that the revenue will be stickier. Again, we are observing that we are winning more bids in the smart building business. Our win rate is 60%. We communicated that to you. So margin will be up. Recurring revenue will be up. Software content of what we do will be up and as a result as you alluded to our free cash flow will follow through and keep improving, knowing that already we are 100-plus percent free cash flow conversion company. We believe that this ratio, over time, has the ability to increase as well.

So let's -- I want to talk about that last point on free cash flow. And it really struck me in your Analyst Day and then just now how very matter of factly you say, and Johnson Controls is a 100% free cash flow conversion company. That wasn't the case a couple of years ago. You all were underachieving chronically on free cash flow. And we know we got -- it was a high priority by George Oliver, and there was traction and didn't happen overnight. But now very matter of factly you all commit to 100%, which puts you in exactly the kind of place that people would expect the business model to be able to generate. So what has changed? How is it permanent? And where and what's the upside from here on a free cash flow conversion basis?

So a lot of great work has been done by Brian my predecessor, and we kept the momentum. Let me give you a few numbers first. So this year, we have committed to one -- so this year is going to finish in now 3 weeks. So we said would commit to a 105% free cash flow conversion. Now that includes the absorption of restructuring. So really, we are 110%, this year. We are committing to 100% for the next 3 years. We will have also some restructuring. So we are already over 100% in the next 3 years. There are three things going on with free cash flow: one is, it's a high level of discipline across the organization. One of the model that George, our CEO and Chairman, want to implement Johnson Controls, we want to be a smart building company, -- solution company, and that includes a high level of functionalization of the enterprise. So we believe in lane ownership. For cash, we have a lane ownership, it belongs to the CFO office. So we have a team only dedicated to cash flow management. We have weekly calls that includes all the element of the business and the executive teams is also -- of the company is part of those calls. And we have a high proportion of our compensation associated with free cash flow, because we believe, is a driver of long-term shareholder value creation. So when you put all of that together, you have the performance, I've described.

Good. All right. Now you said something else that is -- I want to say remarkable based upon my history with the company is you're including restructuring charges in your commitment on free cash flow. From a quality of earnings standpoint, that's fabulous. That's -- it's a watershed moment for the company because you pay as you go restructuring is, from our standpoint, one of the litmus tests for quality of earnings. So when and how did that commitment get made?

So again, part of it -- and we try our best to do that, it's a high bar. So when we commit to restructuring program, it's a net commitment, net of reinvestment. We believe the only way to manage cash flow properly is all in. We're not a fan of excluding. It's creating a lot of discipline inside the company and it's also creating credibility. So it's part of the mindset we have when we commit to you, our shareholders and also to you, Deane. It's a mindset.

Great. Let's pivot over to price/cost. This has been a big theme for the past 2 days at our industrials conference. Every company is basically in the same boat. If you're manufacturing, you're facing higher material costs, component shortages, labor issues, where does that stand for you? and what does that say about going into '20 -- fiscal 2022?

So I go back to my question about functionalization of the enterprise. Very early after the merger, George Oliver, our CEO, created a pricing practice across the enterprise. So pricing is a global function centralized. And that follows quality of execution, best practice. So we have been leading in terms of margin and margin expansion for a period of time because of this discipline. Let me give you a few statistics, and we have been public about those. In terms of price cost this year, which is a year during which inflation has been incredible. Q1 fiscal price/cost equation at Johnson Controls 80 basis points margin contribution positive. Q2, 30 basis points positive. Q3, slightly negative. Q4, we have committed to a positive second half, we are committed to a positive. In the worst environment, we have had in many decades, we are delivering on the positive cash cost price. And we believe, we're going to be able to maintain this rigor going forward. Another data point. In terms of price increases, we have been leading the industry, in the majority and the cases. And you have seen today that in the majority of the cases, the industry has followed. So we feel confident about our ability to still deliver on the positive price/cost equation going forward.

That's good to hear. Do you -- will you ever have to give back price? Once we're through this bubble period, hyperinflation period, things are normal on steel, copper, semiconductor, will you have to roll back prices at all or you going to keep them?

So it's difficult to talk about the future. If you look at the past and some -- most of the time, the past is a good reflection of what might happen, this industry has been very disciplined, and it has been very unusual for this industry to go down in price, very unusual. So you can infer that indeed, price cost could start to be very positive as the cost of raw materials start to decrease, and it has in some commodities.

Good. That's exactly our expectation. One of the surprises in your 3-year guidance targets -- positive surprises was a -- what I thought was pretty impressive top line, 6% to 7%. And then during the course of the presentation, we saw that that did not include M&A. So M&A is upside to that. So talk about the levers that you can hold on M&A, how much capacity you have? And what -- should it be things like silent air? Where are the priorities?

Yes. So 6% to 7%, and you're right, on top of that top line growth, 1 to 2 points of M&A. That's additive to the top line would be additive to EPS as well. And we have said also in terms of capital allocation, we will distribute 100% of our free cash flow in the form of dividend and buyback and we'll have ample power to do M&A because of the leverage and the improvement in the EBITDA of the enterprise. And the tuck-in acquisitions we will do -- tuck-in is important. So the tuck-in acquisitions, we will do in priority are going to be one in Digital. Again, no surprise, Digital is going to be transformative for this industry. It's going to be key to reach the goals of our customers. So M&A deployment will be digital first. Second would be tuck-in in global products in parts of the portfolio where we have gaps. Nothing of size, we don't think that bigger is better in M&A. So tuck-in Silent-Aire that we did in data center is a good proxy for what we will do. And third, capabilities in services, including in decarbonization as a service. So digital, tuck-in products, services, decarbonization as a service, 4 areas of focus for M&A.

So I always find as an analyst, it's important to listen for what's not said. And that's always the harder part. We can dissect every nuance of what's on a slide and what managers say. But you know what, I did not hear at all was that there needs to be more consolidation in the HVAC industry that you have gaps in your portfolio that longer term, there needs to be some structural changes. Is that fair? Is that -- you feel -- does there need to be consolidation in the HVAC industry?

Let's start for our company and George has been very clear around that as well. We believe that bigger is not better. A large acquisition is very disruptive -- distracting is a better word. We believe that smart is better, smart mean digital. We think the market -- we are very happy with the portfolio we have built over the last years. We are very confident in the portfolio of hardware we have, HVAC, fire and security. It's a very synergistic portfolio. Next is to be smart through digital. Bigger is not smarter in any way. you're right.

Right, that's really very helpful. And then if we could -- we've only got 5 minutes because it is so topical, the indoor air quality because a number of the people that are listening today are kind of positioning and thinking they're going to be back in an office at some point. And this is where JCI is so well positioned to talk about filtration, disinfection, ventilation, mixing of outdoor air. Talk about the monitoring of this? Because I know you have the technology, but the monitoring, are people going to know in their office what the air exchange rates are, the CO2 levels, the filtration? How does this come actually down to the people in the office? It's a little bit of trust to verify. How will they be able to verify?

It's a great question. So I'm going to try to go fast. It's so exciting. So let me give you a statistic. The same studies are present for the office building. Schools, 70% of the schools in our country in the U.S., 70% of the school in Europe are bad to poor air quality. That's a big deal. Same in offices. I mean look at everything happening in the planet today in our country included, air quality is starting to be an issue. You cannot do air quality without digital and you cannot do good quality without increasing your carbon footprint. Usually, the solution is you want clean air, if you increase the power of your HVAC, then you consume too much energy. You need to use your HVAC equipment in a smart way to do clean air and to reduce carbon emission. We can do this. Another point you mentioned, and by the way, we are very excited by what can happen in terms of innovation to manage indoor air quality. You could think about solutions where the HVAC is a control point for everything happening in terms of pathogen in the building and give you the indicators. Actually, if you look at the demo we presented on Investor Day, Deane, we had an air quality indicator being part of what we have as on one pane of glass. Another important topic, because people will ask, will people go back to the office. We believe they will in a hybrid manner, but we have observed that today. When you do clean air, the dollar per square foot of technology deployed is improving, increasing by 20% to 30%. That's remarkable. Again, part of the excitement about the office business for our industry and for us. Sorry, it was a long answer.

Could you -- but could you say that again about the 20% to 30%?

The key metric for us is not the number of employees is going to a building, of course, it's important. But mainly we measure the level of investment per square foot. And we observed today that to have clean air, the investment per square foot is increasing by 20% to 30%.

Yes. Okay. Good.

Now you can imagine how exciting the office environment is still, even if it's not the main part of the industry, it's still a very exciting place. And technology would be amazing in this space. We will talk more about that, I'm sure, in a not-too-distant future.

You've said put a dollar amount on the healthy building, indoor air quality, $10 billion to $15 billion. Is that still a framework? And remind us the time frame.

So we think that this is this business over the next 10 years. We think it's an appropriate number. We could be surprised. The question we have internally is, will the smart building industry will be clean air in the building follow the trend of not -- of the EV market. Look at how that has evolved over the last 1.5 years, it's remarkable. Look at the penetration of e-commerce remarkable. What kind of curve will the smart building follow? Is it going to be one of those? We think it could be. And we have nothing indicating from the conversations we have at the C-suite level. There was nothing indicating based upon all that we have from governments around the world. There was nothing indicating that those curves are not going to follow a steep curve up. That's our view.

I couldn't imagine a better point to end here is -- looking at that curve, I think up and to the right, based upon what we heard at the Analyst Day, which was pivotal in so many ways, having covered the company for as long as we have. So congratulations to you and the team and being able to frame for us what that road map is. The topic is pivotal to everyone who cares about the climate and cares about getting back to work. And from that standpoint, we fully appreciate everything that you're doing. This -- again, we ran out of time here. This concludes the presentation by Johnson Controls. Olivier, thank you for sharing all your insights today.

Have a great time. Thank you for having us. You take care.

All the best. Sign off now. Appreciate it. Have a good day, everyone.

Take care.