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

Great. So why don't we get started? Good morning, everybody. Thanks for joining us at Baird's Global Industrial Conference. I'm Tim Wojs, and I cover residential and commercial building products here at Baird. And we're absolutely delighted to have Johnson Controls with us at the conference this morning. And JCI has really undergone a tremendous transformation over the past 5 years. They've shedded several businesses. They've acquired Tyco, and they've really positioned the company to take advantage of a lot of global mega trends around building decarbonization, digitization and health. So joining us from the company are Olivier Leonetti, who is EVP and CFO. We have Antonella Franzen, who's VP and Chief IR and Communications Officer; and then we have Ryan Edelman, who's Executive Director of IR. And in terms of format, we'll have Olivier give us a few prepared comments, almost a state of the union, if you will, and then we'll run through some Q&A. And feel free to use the browser box to e-mail me any questions, and I'll try to get to those as time allows. So with that, Olivier, I'll give the floor to you.

So thank you for the introduction, Tim. Thank you for having us, and thank you to everybody being on the call. We are very excited to spend a bit of time with you. As an intro, I'm not going to spend a lot of time. We just got our earnings about a few days ago. We are very excited about what is happening at Johnson Controls. So our team is executing very well in a very difficult environment. We finished the year strong. We had a strong year. We have exceeded our commitments in a very challenging environment. And we have issued also, for '22, what we believe is an exciting guide because we see a continued recovery in our end markets. We have committed to you to a 22% to 25% EPS growth, strong free cash flow and also high single-digit level of growth. And what you see today, Tim, and all of you in the audience is 2 companies at Johnson Controls, one, managing what we have been building over the years in a difficult environment and then a new company leveraging the vector of growth, the new company being built on the legacy of Johnson Control, managing vector of growth such as indoor air quality, digital services and sustainable smart buildings. And we believe that this decade is going to be one of the most exciting decade for the building industry for a while, and we believe we are uniquely positioned to leverage those secular trends. So Tim, I'm ready for you.

Great. Great. Well, if anybody has any questions, again, feel free to e-mail me. I'll start off maybe just kind of thinking about '22. You're probably one of the only companies here that actually has guidance out for next year. And just maybe if you could talk a little bit about some of the swing factors that you're thinking about next year. And obviously, I think your end markets are starting to gain some traction and improve. You've got the cost savings that you've talked about before, and then you've got some moving parts with price/cost. Just how do you kind of think about marrying those together? And how do you think the year should progress?

So we have said in our prepared remarks last Friday during our earnings calls that we expected the first half of the year to be still a difficult first half with everything going on around the planet about shortages and also inflation. But despite this, we start to see now our end market recovering. We see -- and we publish that strong order backlog at the end of at the end of Q4, a backlog growing at more than 9%. We see also a strong level of retrofit activity in our in-store business at the back of healthy buildings. And we see as a result of those various trends. Our installed revenue growing at about 6% to 8% for next year, services about 6% to 7% and then Global Products growing high single digits to low double digits. You mentioned a point about price/cost. We have been very good at executing from a price/cost standpoint. We have been positive in Q4 from a price/cost standpoint, positive in the second half of last year, inclusive, and it's important, Tim, higher labor cost and higher freight cost as well. So it's an all-in number. In the guide we have committed to you for next year, we're including 3 to 4 points of inflation in the top line. And to give you a few colors on your point on our productivity program, we have embarked into a 3 years productivity program. This year is year 2. We delivered on our year 1 commitment. This year, we're committing to deliver $230 million of net savings flowing to the bottom line, and we are highly confident in our ability to deliver on this productivity program. So overall, we're excited by the execution of our teams, and we are excited by the new vector of growth we're starting to materialize. I'm sure we spent time on this, but we gave to you during our call on Friday some exciting KPIs regarding how the new vectors of growth are behaving. We might spend time on this later, Tim.

Absolutely. We'll definitely get to that. The last -- the other question I just had on kind of the near term and maybe it's a little bit of a longer-term question. But you tend to carry a little bit more backlog just given your kind of longer cycle businesses and the installation and kind of service parts of the business. What's kind of happened beneath the covers or behind the scenes in terms of putting projects into backlog and then having them come out at the appropriate profitability? Because like you said, you're managing price/cost well. And if you look at gross margins, I think, cumulatively, they're up about 100 basis points over the last couple of years. So it does seem to suggest that there is a difference in terms of how the sales organization is going about pricing. So any kind of color there would be helpful.

The first piece of work our Chairman and CEO put in place after the merger was a strong pricing discipline at Johnson Control. And that translated into the P&L benefit you have mentioned and also then translated into the strong price/cost performance. When it comes to the backlog, we are -- we have a good understanding of when the backlog is going to flow into revenue, but also the margin on it. Why? A few reasons for this. One, we anticipated about 2 quarters ago some level of inflation for our products. We got it mainly right. Number two, 2 years ago, we changed our contracts to allow for price flexibility. Number three, we understand, because of the value we propose to our end market in indoor air quality, digital, sustainability, that we could demand a good value for our services and our offerings. We are also hedging our raw materials. We have a 6-month protection program for the key raw materials. And last but not least, our sales force management as well is incentivized on gross margin for a large proportion of their and our incentive. So we have a strong process, strong control, but also alignment of objectives, Tim, to believe -- deliver a good margin for the enterprise despite the environment.

Okay. Okay. That's great. When you think about -- maybe just kind of shifting over to some of the growth vectors. You had an Analyst Day a couple of months ago and really kind of gave us a comprehensive look at where you think the business can go over the next -- or really the intermediate term. Decarbonization is really kind of a secular mega trend. And I think you outlined that there's maybe a $240 billion market opportunity over the next 15 years. How would you say JCI is uniquely positioned to benefit from this? Because, I mean, you have, I'd say, unique assets relative to some of your peers in terms of building management and fire and security and some of the technology you've been developing with OpenBlue.

So we see the market, as you said, for sustainability to be a market of about $240 billion over the next decade. Why is this? The carbon emission of a building is 40% of the carbon emission in the world, 40% for 0. 80% of the building in U.S. -- it's largely true in Europe as well. 80% of the building in the U.S. have equipment, which are 20 years old or more. And we have now the technology to improve the carbon emission of a building. We have the technology to improve this carbon emission by half -- reducing it by half. And you cannot do that well. You can do that at a device level. You optimize an HVAC. We can do that as well. We connect an HVAC, piece of equipment. We connect a chiller. We can do this, and we could can do that well. And we combine that with heat pump technologies where we believe we have a strong portfolio. But you get only the full potential of technology if you manage the building. Let me give you an example, Tim. On OpenBlue, we have launched a series of applications, a series of apps. One of them is called central utility plant. So central utility is 35% of the power consumption of a building, 35%. Just with digital, no retrofit, just with digital, we have the ability to improve the energy saving by up to 15%. We can do that because we have a large understanding of what is happening in the building. So we believe that we are uniquely positioned today to deliver on the sustainability market. Understanding only a product is not enough. Understanding only smart is not enough. You need to have smart and a large understanding of the domain you serve, and we do. We have a large installed base. We have an open digital platform. We have a large fleet of engineers in the market, optimizing the insights. We think we have a formidable competitive advantage to serve our customers in sustainability, and more to come in that space.

Right, right. Okay. Good. When you think about just OpenBlue, I mean, I know it's still relatively new, but it does seem to be gaining real traction in the marketplace. Could you talk a little bit about the vision you have for that platform and if it changes kind of the economics of the business for JCI?

So it's central to everything we do. Digital is central to our product strategy, services strategy, smart building strategy, of course. So OpenBlue is brand-agnostic. You can connect our devices but also other devices we have in a building. It's using cloud compute technology but also edge compute close to the device, which you need to have, and it's foundational. If you want to deliver indoor air quality, you need to be smart because you want -- it's easy to improve the air quality in the building because you increase the usage of your equipment. But as you do that, you don't achieve your sustainability goals. You need to be smart to do indoor air quality well. Sustainability, we mentioned that OpenBlue is key to it. And I mentioned the competitive advantage we have. Again, if you want to do preventive maintenance in services -- services business today is local mechanical. With digital and OpenBlue, we can revolutionalize the service business and make it digital, make it better for our customers, cheaper as well. And OpenBlue is at the central of this economics now. With OpenBlue, our win rate is significantly different than the other offerings we have. When we compete with OpenBlue, our win rate is close to 50% higher. The margin is higher. The conversation we have with our customers is at C-suite, and the competitive landscape is very different than the traditional HVAC competitive market. So it's a game changer for our company, Tim.

Okay. Okay. No, that's helpful. I guess a question here from the audience just kind of on this topic. Could you discuss the expected improvement on the attachment rate? What's driving that? And kind of what's your long-term target or I guess, you might call it, what are you -- what's your fair share?

So if you look, we have achieved the 40% attach rate on a full installed base at the end of last year. We believe we can improve our attach rate by 3% to 4% this year. We have indicated that over time, we could, on the installed base, have an attach rate of about 70%. Why? Again, we discussed about that, Tim, digital. You transform how you manage your equipment through digital, and we have the competitive advantage to do this. We will have new machines today being delivered. We are already at the attach rate of 70-plus percent. And over time, we will have to turn the installed base to JCI services. How? Before -- at the start of the year -- just to give you an indication of how fast the technology goes. At the start of the year, Tim, it would take us about 2 months to deploy OpenBlue in a building, about 2 months. Now it's a matter of a few days. So again, it allows us to then digitize our services faster than ever before and drive a very differentiated service to our customers, hence, the belief that we can increase the attach rate as well.

Okay. Okay. Helpful. When you think about just kind of the overall model, I mean, do you see kind of the HVAC and buildings model changing over time? I mean, historically, you've sold equipment. You've installed it, and then you serviced it, but you didn't really operate it. And a lot of what seems -- you seem to be talking about is maybe shifting a lot to more of an operations model. And I know you have -- performance contracting is a part of your business, but what are kind of the puts and takes to -- I guess, a, would you agree that the model could be shifting? And b, what will be the puts and takes financially to that model shift?

Yes. So we don't know for sure, but it's clear that -- and we have been in this business now for 3 decades in the performance infrastructure business. It's difficult to manage a building well. And our customers do not -- that's not their business. So we see more and more demand where we manage a building, not all the elements, but a large part of it, for our customers. And the best proxy for this would be how we are doing in our performance infrastructure business in the U.S., where we are a leading share by margin. This business is about $700 million just in U.S. and has been growing in '21 -- last year by mid-teens. Orders for the full year were 38%. So the transformation is happening. The transformation is accelerating. And our ability to be at the table is very strong. To answer to your question, the economics today for this business is better than the total company average by already a few points. And we believe as we are deploying more capabilities, more digital capabilities in this business, the margin of this business will further improve. So we're excited by this vector of growth. We're excited by the demand we have in the market, our ability to compete, but also by the economics of this business, very much.

Okay. Okay. That's good to hear. That's very good to hear. And then I think when you think about just kind of healthy buildings and indoor air quality, I mean, how -- a lot of emphasis on it 12 months ago. Has that emphasis changed today as things kind of reopen and you kind of -- vaccinations and things? And do you just -- over time, should investors just think that this is a -- just a higher level of spend that building owners are going to devote towards HVAC to improve the indoor air quality, almost like a wallet share improvement?

We see this trend as a trend to be maintained. A large part of our installed business is due to the indoor air quality trend. So retrofit. I give you a few numbers. In Q4, the installed business at Johnson Control largely driven by retrofit and indoor air quality. The growth was 9%. In Q3, the growth was 18%. So we see it happening. Why? People go back to work. Our kids go back to school. I give you 2 statistics. In the U.S. and in Europe, 70% of the schools have bad to poor air quality. So let's forget COVID. Just the air in the space where we learn and congregate is of bad quality, we can address this. We also now -- we measure this. We see that when you have a good environment for work, including good air, productivity will start to measure it, increase by about 10%. And so we have a good footprint. Again, you go back. Digital is key to do indoor air quality. Heat pump will be part of this. And we have a good footprint in the vertical of the market, which value indoor air quality more than others. For example, schools, higher education, we have a large footprint in every part of the world in the U.S. as well. So this part of the business is growing. We had 400 million of orders secured in '21, $350 million of revenue, and the pipeline net is about $1 billion. So we're very excited by this trend. We're also innovating -- not alone. We mentioned on the call some strategic partnership regarding indoor air quality. So we are now trying to develop pathogen identification at the level of the HVAC. So based upon the air going to the HVAC, can we measure the pathogen? Can we detect C19? We are working on this solution with one of the start-up where we invested. UL, we have also announced some partnership with other indoor air quality leaders in this industry. So we combine our knowledge with also the best-of-breed in the market to differentiate our offering, hence, the result I've mentioned for the P&L of Johnson Controls.

Okay. Okay. Good. And I got an audience question here. And the question is, do you see any signs of heat pumps picking up in certain markets? And maybe just broaden that out a little bit, Olivier, if you can just talk about the position -- your position in the heat pump market and some of -- where you are today and the new product development that's going on behind that.

So we disclosed in Q3 -- it's part of our earnings deck -- the 4 heat pump portfolio we have. It's actually quite impressive. We believe we have a very strong competitive position. It's a technology, which is foundational to deliver efficiencies. We're investing in this technology, a statistic we haven't communicated before. But let me do that on this call, Tim. 65% of our HVAC portfolio use heat pump technology today. So it's central to what we do. It's central to the new products we're going to launch, and we are very pleased with where we are today.

And are you seeing signs of a meaningful pickup in adoption there in any of your markets?

Absolutely. Heat pump is foundational to the demand from our customers. The economics are so powerful for our customers that this is a technology, which is foundational when you bid an HVAC equipment.

Okay. Okay. Great. Maybe just a margin question here. When you think about kind of product investment, could you talk about kind of what you're spending annually in new product development and really where the focus is? So I generally think of investments around refrigerants products, distribution, any of those types of things. And how would you kind of frame that for investors in terms of what you're spending? And I don't know if you have a vitality index or anything like that, that you look at.

So if you look at today, the investments we have in our Global Products division in R&D, our product development, we used to spend 5 years ago, as a proportion of revenue, low single digits in product development. Now it's high single digits. And we get much more for every dollar being deployed. Let me indicate why. We are doing design to value. We didn't before. We're doing platforming. We were not doing that before. We are offshoring also some product development capabilities. We did not do that before. And all the trends you have mentioned, decarbonization, sustainabilities, are the various center services of our R&D deployment. The large majority of our R&D deployment is associated with the vector of growth I've mentioned. I'm going to give you another statistic. We indicated that on the call, we are launching this year about 175 products. Last year was about 150. So we're gaining share, and we believe we are maintaining our competitive advantage to the investments we have in technology.

Okay. Okay. Great. And when you think about incrementals, I think on an underlying basis, you're kind of in the high teens, 20% range on volumes. At least I think that's what's kind of implied in your kind of intermediate-term guidance. Are there any pluses or minuses to that over time? I mean is there an opportunity for that to mix higher as some of your growth vectors start to really gain some scale?

So you're right, the incrementals -- if you look at the guide and do a bit of math, the incremental of that in the range of mid-20s. If you normalize for price/cost, and we gave you all the details to do that normalization, the incrementals in the mid-30s. Can we do better? We believe we can. Why? We are not done with productivity at Johnson Controls. There are more we'll be able to do. And we believe that our offering, which will include more recurring revenue, more as-a-service revenue, more digital revenue that this business is rich in margin. So we have the ability -- if we execute well, we will have the ability, indeed, to keep improving the margin profile of our business.

Okay. Okay. That's great. And then...

I mean, all the vectors of growth, if you look at the decarbonization business, it's higher margin. Services, we mentioned that twice the average of the company. So a lot of indicators today in the way we perform allowing me to support what I told you about the overall enterprise.

Okay. Okay. Fantastic. And then, I guess, a couple of things just on the balance sheet and cash flow. It seems like from a cash flow perspective, we're at, at least kind of 100% conversion on a go-forward basis and -- which is an improvement from where we were a couple of years ago. Your balance sheet has been -- is in pretty good shape now. What are the types of kind of supplemental acquisitions that kind of excite you? I mean Silent-Aire is something you did 6 months ago. What else is out there from an opportunity standpoint? Or where are you kind of spending your time on the M&A side?

So let me go through the 3 points you mentioned very quickly, if you allow me. Last year, we delivered the 105% free cash flow conversion, including 10 points of conversion on the restructuring program. So the underlying free cash flow conversion last year was 115%. By the way, we are committing to a solid 100% inclusive of restructuring this year as a result. We have committed to a 14 -- to a very attractive buyback program and -- $1.4 billion, and we will grow dividends with earnings. We will have because of the growth in EBITDA and the low leverage the ability to do M&A. Tuck-in M&A, we believe that bigger is not better. We believe the opposite. Bolt-on acquisitions, so well. You're not going to be surprised by my answer, digital, decarbonization, first. Second, tuck-in to add technology to our product portfolio. And then very specific regional plays, Asia, is going to be on top of the list. So digital, decarb, first; technology and products and regional play, particularly in Asia. The pipeline is growing nicely. We have a new head of M&A at Johnson Controls coming from a company which was very acquisitive, which drove a lot of value at the back of acquisitions. And the pipeline is growing nicely. And you will see a rhythm where we are regularly announcing tuck-in acquisitions at Johnson Controls, Tim.

Okay. Great. Well, I think we're out of time. So please join me in thanking Olivier and the team for being here. And always good to see you and really appreciate the conversation. So thank you and hope you're well.

It was a pleasure. Thank you for your time and your questions.

Thank you.

Take care.