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

Hi. Good morning and thanks for joining us for Morgan Stanley's 9th Annual Laguna Conference, virtual, this year, of course. With me today is the EVP and Chief Financial Officer of Johnson Controls, Olivier Leonetti. Olivier, thanks for joining us. Before I pass it over to you, I just need to read a quick disclosure on my end and just to remind folks for more information about disclosures to visit morganstanley.com/researchdisclosures and then for all other questions to please reach out to their Morgan Stanley salesperson. So again, Olivier, thanks for joining us. I know you're fresh off your Analyst Day last week, so plenty to chat about this morning. I'm looking forward to it. Anything to lead us off here on what you're seeing, what you're focused on, what you want investors to focus on? And we'll take it from there.

All right. So -- and again, good morning, Josh, and good morning, everybody. Thank you for your time. I hope we do this conference, we're joking about this, in California next year. So we have been through our Investor Day last week, and we cannot be more excited by the building industry. We believe that the building industry is going to face one of its most exciting decade in a period of time. Why? We need to decarbonize the planet. We need to have clean air in our buildings, in our schools. Those problems today are being amplified in the industry and Johnson Controls have the solutions to solve those problems at a very attractive return on investment. We would argue at Johnson Controls that having the portfolio we have, being able to install, build products, have the digital capability we have and be able to then act on the digital insights that this model is going to be and is today a key competitive advantage to solve the important problems of our customers. So we couldn't be more excited, Josh, and I'm sure we'll cover most of those points today.

Excellent. And I certainly agree on our end. I think maybe just to start off -- what has been kind of a unique past 18 months, and you touched on indoor air quality as being a driver there. Obviously, something that we've talked a lot about since the early days of the pandemic, are you seeing that show up with customers today where this has gone from something that we've more theory crafted around or you have done specification work to dollars being spent? And how have those dollars sort of trended versus your own expectation of the TAM or the extra growth that you would have expected to be able to generate?

So we see today a very important focus on indoor air quality moving to indoor environmental quality, so more than the clean air. Why is this? And it broadened then [ C-19 ]. We think that, if you look at in schools, for example, it's a well-measured industry, 70% of the schools in our country, in the U.S. have poor to bad indoor air quality. Same statistics for Europe, same statistics for -- or close to office buildings. And that's not going to go away with global warming. If you look at what happened on the West Coast of the U.S., air quality was bad in buildings. So it has to be addressed. And the challenge to address that need is how do you have clean air in a building while reducing your carbon footprint? It's easy to have clean air, you pump up the HVAC and then you put more, then you have an increased level of energy consumption. The only way to solve the indoor air quality and reduce your energy bill and reduce the carbon emission is to use smart solutions, which we have. We know who's in the building. We measure the air quality at the HVAC level. We now start to have technologies increasing where you measure pathogen levels to the HVAC. So we are very excited by this trend. And what we see today is that the dollar of equipments we deploy per square foot is improving, increasing by 20% to 30% when our customers want to provide good air for their employees or their kids at school. So we're very excited. That's the trend which is going through the planet today.

Got it. So technology, I think, is something that you mentioned there and you mentioned a lot during last week's Analyst Day. OpenBlue, I think, has been out for roughly the past year. How critical is technology, whether it's software, controls, some sort of digital service in achieving some of these goals? Because I think the way a lot of folks have perspective for this industry is that there's a box in a basement pumping out cold air. When the box breaks, you fix it or buy a new one. But now there seems to be more of a tech element. Is that something that plays a big role? And how do you think about that incremental growth that you're seeing on traditional business versus things like OpenBlue or other tech vectors?

So digital is critical to achieve the goals of our customers, and we deploy digital at 2 levels. First, at the level of the device. Having an HVAC -- a chiller -- an HVAC equipment, a chiller with digital, make it much more productive, much more efficient. But also digital allows you to have a smart building solution. And actually, you only optimize a building when you use digital to manage all the elements of a building, and OpenBlue is used for this. OpenBlue orchestrates what is happening in the building and allows you to achieve a great level of productivity at a good ROI. The ROI for our technology is to be 3 to 5 years. With OpenBlue now and with digital capabilities, it's within a year. And OpenBlue is a revolution to manage a building. We had before, Josh, building management systems, 20 years technology. Fits an objective, but it's not a agile piece of technology. OpenBlue digital solution is agile, always learning, always learning from algorithm, and then giving instructions to a piece of equipment, a chiller or another piece of equipment in a building. It's a game-changing technology. We would argue that, over time, this technology will actually supercede business management technology. Let me give you another statistic. When -- we have launched now OpenBlue for a bit more than a year. To deploy it -- about a year ago, it used to take us 2 months. Now we can do it in a day and start to drive insights. We can improve the energy consumption of a building by 15% just through digital, without changing, without retrofitting the equipment. So it's really game changing for our industry, and we believe we have a leading capability with OpenBlue.

That's a pretty compelling savings there. And I -- probably a good segue into the broader portfolio and the role it plays. So I think a lot of investors sort of view Fire & Security as kind of being the overall part of the portfolio. You've seen other competitors divest those businesses entirely. I think you were very clear last week that Fire & Security actually plays an integral role in what you're trying to accomplish. What sort of examples do you have on those OpenBlue deployments with the role of Fire & Security? And are these basically just another set of eyes and ears acting with sensing? Or is there another benefit they provide where you would need to sell both to really take advantage of the savings, the productivity, kind of the other outputs?

No, it's exactly what you said, Josh. If you look at Fire & Security, which is about 40% of our portfolio, that's -- and also is the category with the highest margin [ of our ] portfolio. It is very synergistic with HVAC and it's extremely strategic to a smart building solution. Why? You alluded to that, Josh, because there is -- with security, you know who is in the building. If you know who is in the building, you can optimize the management of the building from indoor air quality and also from an HVAC standpoint. So it's really critical to be a smart building player, and that allows us then to have a bigger footprint in the building and then be perceived as a smart building player. I'll give you another statistic. If you look at all the technology in the building, HVAC, Fire & Security, it's about 50%. So with the 50%, you have to see it has a domain expert and then being advised -- being able to advise all the elements of a building management as well, so there is a strategic dimension to Fire & Security.

Got it. And then you talked about the objective around service attachment. I know it's been on everyone's radar here for a couple of years, and you spell out that sensitivity for the 15 points of higher attachment here over the medium term. And I still think that we have some headway to some of what others would consider best-in-class, so an achievable target. How does this convergent building increase that attachment rate? I mean when you deploy OpenBlue, is that customer already signing up for a service contract? Or is the service component the way you see it, sort of a different silo of base mechanical services and digital is extra? Did those 2 come together? Or are those really separate agendas [ here ]?

No, they come together. So let me talk about services for a second and attach rates. So it's a 6 billion -- Services is a $6 billion business for us. It's the level of profit all in, so bottom line, including SG&A, is double the company average. And we have said that our attach rate is now at about 40%. It used to be 4 points lower about a year ago. And we have said we'll increase the attach rate by 5 points every year. Now you go back to your point, it's -- well, that's like -- that's not a great statistic relative to competition. Now it depends how you measure it, Josh. At point of sales, our attachment of services contract is very high. The 40% soon to be 55% at the end of the 3-year period is service contracts over all the installed base of Johnson Control products in use today. It's a very high bar. So let me repeat it. At point of sales, first 2 years, very high attach rate. But that's not the goal we want to give ourselves. We want to attach a contract to all Johnson Controls machines available today. Some are available for 20 years, a chiller, for example, right? So that's how we want to target ourselves and we're very excited about what we can do. And this industry, the services industry is changing. You can -- again, it's intuitive. It is today local, done by local company or done by a user. And we believe that this business is going to be regional and digital, predictive. And we believe that as a result, we're going to disrupt the service industry tremendously and then gain more shares and increase the profile of our company, the financial profile of the company and drive better outcome for our customers. So it's a game-changing trend happening in the service industry, and we believe we are at the forefront of this transformation.

Just pivoting over to the cost side. The $550 million in savings over 3 years is one of the bigger cost take-out programs, I think, in the space right now. It only comes a few years after the Tyco synergies. So I guess maybe the question is, what drove the realization that this was such a big opportunity coming off of what was a big basket of savings? Was it leakage on the old program? Was it some other industry change that enabled this? Or a good old-fashioned kind of rolling up your sleeves and saying, there was always more to do there and we just stopped too early?

So in the first few years post merger, we were very busy doing other things, right? You need to organize a team, you need to [ disinvest ] each part of the portfolio, get a more precise view of your strategy. So now about a year ago, the conditions to go to another level in terms of synergy was created. That's how the program came. And the $550 million includes standardization, centralization and then automation at the back of it, of our operations. We are well on track today. And we believe that this amount will flow to the bottom line on top of incrementals over the next 3 years. So we have a high level of discipline. We have created, over the years, a strong project management structure at Johnson Controls to make sure the transformation agenda is on track. And this particular agenda is well on track. We're actually slightly ahead of our timing. We can commit to more, but we are very positive about our ability to pull this amount of savings today.

Got it. And then I guess you mentioned that briefly on incremental margins. Over the '24 horizon, I think ex savings and that 20%-ish incremental margin range, you talked about a couple of things that would be particularly accretive, incremental margin like service growth, like digital. I guess what are the gating factors that would prevent that from being higher? I mean, obviously, everyone is aware of the price/cost environment and logistics right now being tight. Is it just as simple as we think we can do better, but hey, look at a price chart for any input and it's up into the right, and we want to take that into consideration? Or are there real other investments that you need to make back in the business that sort of hold back the leverage?

So 2 elements. One, if you look at the margin profile for Johnson Controls, the productivity program we mentioned, the business mix, more services, more recurring revenue, decarb as a service, cooling as a service for data center, more consultancy approach with a higher margin. So we feel positive about the vector of margin expansion we have facing us. No question. And we don't think we are playing our best game or that we have declared our best game to date. You're right, pricing is -- inflation is playing also a role. We have, in the P&L today, over the next 3 years, about 1 point of growth, extra growth due to more inflation. On this additional inflation, we're not pulling the same margin rate we do on the normal business. We pass the cost but not at the same margin rate, that's also a factor. When you [ deface ] -- when you remove all of that, you have a higher level of incremental. And by the way, despite the [ strengths ], we're going to be able to pull a quite attractive EPS growth for the company, still in the 20% range, EPS CAGR growth over the next 3 years, which is going to be stacking well versus what is done in the market.

Got it. I think that's helpful context, especially on building in the inflation environment. I guess maybe pivoting over to that, it seems like every supply chain has gotten tougher over the last 60 days. I think you've had a handful of companies out there, not necessarily competitors saying, at any price, there are some components we can't get. How do you feel about the last couple of months of how that had progressed? Where have been the big pain points? And is there anything you're considering on a more structural basis in light of that, whether it's around manufacturing positions or supply chains, et cetera, that you would look to rework?

So if you look at -- if I first start at a high level, we are very pleased with the way our business is behaving. Order growth, very strong; backlog, one of the highest we have had; margin expansion is also trending very nicely; EPS as a result as well and free cash flow as well. Now because of those supply chain changes, we're not able, in a short term, to deliver the full potential of the enterprise. Our team is doing an amazing job. We're not the only one. Every supply chain today is underlying those issues. So far, it's preventing us to realize our full potential, but we have been able to -- nevertheless to navigate. I'm not going to go to details of what is being done by the company, but some of those solutions are quite innovative actually, quite outside the box, and it's a day-to-day activity. We believe nobody knows for sure. All of us believe that, that will start to normalize. Is it in a quarter? Is it in 2 quarters, we don't know, but we'll normalize. But so far, Johnson Controls is behaving very well, and our team is doing an amazing job there.

And just understanding that spot prices only tell part of the story, a company the size of Johnson Controls has contracts and hedges and purchase agreements and all sorts of things that sort of operate as a lag. When should we see basically the spot rate of activity, whether it's material or freight or some of the other big inputs? Do those really just peak out more like early next year given the timing? Or do you feel like you're reasonably close to where the current market is today in your P&L? I know there's a lot of inputs, so it's a little unfair question. But when do you start to really kind of lap the real inflation in the system and realize that versus where you are today?

So you said that we don't really know, right? So we're tracking commodity pricing like everybody else. Some went down, some went up again, aluminum being one of them because of coup d'état in a country far away in Africa, so we are surprised all the time. But we believe today that we have achieved probably a top. And what is important is this industry traditionally has been very disciplined in terms of pricing. So at Johnson Controls, we have been leading price increases in the industry. And usually, our peers have followed through 2, 3 weeks afterwards. And if you look at the past, it's very unusual for this industry to decline pricing when competitive pricing is still getting better, which might happen. So potentially, we could have a good news for the industry and certainly for Johnson Controls going forward as and when commodity pricing start to decline.

And just on the backlog that you guys have accumulated thus far, last quarter was a great order intake quarter. It sounds like this quarter is probably more of the same. Is this really backlog for calendar '22 at this point? I mean lead times seem like they're sort of stretched out. I think everyone has held to the standard of what can you deliver today because the cyclical recovery is so strong. But you guys have always been kind of a longer and later cycle business. I mean is what you're booking today more '22 focused than what you would otherwise see in a normal year or normal recovery?

It is. The backlog is -- I would qualify it as exceptionally high. And of course, it's going to be helping us for next year and what is happening? I mean, of course, you have a pent-up demand, but the trend we have been mentioning, decarbonization, indoor air quality are being accelerated. They are being accelerated by schools, they're being accelerated by large organizations, the government is putting more and more legislation out there to augment the focus on decarb and clean air in buildings. So you have a series of trends today creating this strong demand. Some is one-off, some is going to be recurring and augmenting. And you and I, we're talking about this before our call here, we are very excited by the trends this industry is facing. Now I go back, 40% of the carbon emission is done -- generated in the world are generated by a building. 80% of the buildings in our country in the U.S. have equipment which is 20 years or older. You can reduce, with technology, the carbon emission of a building by 50%. I repeat that, with technology existing, 50%. Just by deploying digital, you can improve energy efficiency without deploying new equipment by 15%. So all those trends are playing out. So despite the demand you see today, which some of it could be backlog being materialized, we see all those trends impacting also the demand for the industry and Johnson Controls as well.

So within that, obviously, more kind of governmental support or attention at least, both the U.S. and Europe. It seems like it's taken a couple of forms. K-12, obviously, very topical in the U.S. We'll get more reconciliations to see what else happens here later in the year. But when you guys lobby, when you speak to lawmakers, what is it that you think of as kind of the biggest opportunity or where they should focus, whether it's -- what would have the largest benefit or cheapest to deploy or biggest kind of societal improvement? Like where do you guys focus your time when it comes to the governmental affairs side?

So it's interesting because the communication lines have changed. We are highly asked, we are asked by government. We are asked by our government here in the U.S., we are asked by governments in Europe or in China to provide advice. So we are consulted, our phone is ringing. Josh, phone is ringing. And what we see today is more -- because, of course, governments across the globe, Europe, China and the U.S., want to fix indoor air quality, wants to fix global warming and we are asked to advise. And as a result of this, you saw, in our country, massive legislations being enacted, COVID legislation, bipartisan infrastructure bill, [ December ] bipartisan energy bill, these building performance -- I mean, I can go on and on, and those bills are $100 million -- $100 billion each or plus targeted at buildings. So we see the trend, the pull from the market to advise, tremendous. And again, good trend for us as citizens because we need to try to solve this important problem, good trend for our industry and very good trend for Johnson Controls because we believe we are uniquely positioned to solve those issues because of the portfolio, products, service, install, digital and because of our know-how.

Excellent. So I guess maybe a derivative of that line of thinking is this whole concept of performance contracting. It's been around forever. It seems like in this environment, with the types of paybacks you mentioned, especially on digital, that this should be a much more active conversation. I know it's a pretty small percentage of the business today. I think you talked about some outsized growth there last week. But why isn't -- why hasn't performance contracting been larger? And why can't it be even bigger still just based on all these things that we've been talking about for the past 25 minutes?

It's a great question, and it's a relatively easy answer. This trend is starting now. So let me, a bit, going back to provide the audience a few data points. If you look at the performance infrastructure business in the U.S., in our country, it's a $5 billion to $6 billion market. It's growing mid-teens now. It's growing mid-teens. We have been in this market for about 20 years. We totally manage a building, a campus for our customers. Those contracts are long-term contracts, very attractive, high proportion of recurring revenue. And in this market, we have been growing at a premium to the market, so we are growing more than mid-teens as we speak. And we have a market share which is close to 20% in this market in the U.S., twice the #1 competitor share, twice. And this know-how today, we are now pushing it to the private sector where we have now a full 360 set of offerings, including financing. That's why we have created a joint venture with our partner, Apollo. So to answer now to your question, the performance market now in the U.S., because all of -- because of all the laws which have been enacted, which have been enacted too long ago, this market, we believe, is going to grow significantly in the U.S., significantly in Europe as well. And we believe that this market for the public sector also is going to be replicated through different incentives in the private sector as well. Again, what does that mean? High-margin business, recurring revenue, stickier revenue, pool of the full portfolio of our products, we are very excited by its trend.

Excellent. And I think that captures a lot of what we've talked about here. I see we're out of time. Olivier, thanks so much for your time. Always a pleasure to talk about the story. And again, congrats on the Analyst Day last week. I thought it gave a lot of detail for what we're talking about here today. Hopefully, like you said, we can all do this again in person with some palm trees next year in Laguna.

You take care. Have a good one, Josh.

You too.

Thank you for everybody. Take care.