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

All right. Good morning, everyone, and thank you for joining us again at the 9th Annual Credit Suisse Industrials Conference. My name is John Walsh, and I am the multi-industrial analyst. This is day 3, and we are very excited to be kicking it off with Johnson Controls. With us today, we have Olivier Leonetti, Johnson Controls' CFO. And before we head into the fire side, Olivier has a couple of remarks. And I would also just remind everyone, if you'd like me to ask a question on your behalf, you can e-mail me at [email protected]. And with that, I'd like to turn it over to Olivier.

Thank you, John. Good morning, everyone. And again, thank you for taking the time to spend half an hour with us. So a few opening remarks. We have said that, many times, we believe we are facing, as an industry, one of the most exciting decade we have had in the smart building business. Why? Because buildings are equipped to be key to solve the sustainability issues we have across the planet. We have also key challenges with indoor air quality. And we have now as an industry, we have now as a company, the tools to solve those important problems with a good return in investments. Few comments about the year we closed. We closed the year strong. We met during the year closely all of our commitments despite a difficult environment. Our COGS programs are in place. Our transformation is well on track. And we have launched exciting new vector of growth on Johnson Controls. And I would like to remind you that we have initiated a few weeks ago our FY '22 guidance, which is a high single digits top line, 70 to 80 basis points of margin expansion and a 22% to 25% EPS expansion. And we have, today, we believe, uniquely positioned to solve the demand from our customers. We have a great installed base. We have, today, a field presence. We have a worldwide presence. And the utilization of OpenBlue and digital in this context is good to create a key competitive advantage for Johnson Controls. And John, I'm looking forward to our exchange today.

Great. Appreciate the opening remarks. And I definitely want to touch on a lot of those more strategic questions. But maybe before we get there, the obligatory question as it relates to supply chains and what you're seeing there, would love to kind of just get an update.

So John, when we issued our guide, we indicated to you and to our investors that our planning assumption that -- would be that, for the December and January quarter, that the environment in labor, parts availability will remain the same as before. And it is. It's not deteriorating, but it's not fundamentally improving. That was we -- this is what we assumed in our financial guide. So it's as per our expectations, John. We observed on the key raw materials a decline. That's not really enough to really change the [ treasury ] at this stage.

Great. And maybe just segueing in there because one of the topics has been around steel and other commodity prices. Can you remind us your expectations around price/cost and how it might phase in through fiscal 2022 in your guidance?

So we have been able -- in terms of price/cost, over '21, over the second half of '21, in Q4 of '21, we've been able to be price/cost positive, including the impact of excess labor costs and excess freight costs. We're positive with those excess costs. In terms of price and price/cost for '22, we expect price to drive 3 to 4 points of revenue growth, and we expect to be positive from a price/cost standpoint for the year.

Great. And I guess, sticking with that theme, obviously, a very strong service and field business at JCI. Are you seeing any labor availability issues? And then can you remind us if you have inflation escalators built into your contracts? How that works?

So labor is a constraint. The beauty of the model we're implementing today is we want to move to a digital-orientated service. And that is a great offering for our customers, but it's also an opportunity for us to deploy our resources in a more efficient manner. So meaning, we're driving productivity. So we're able to navigate, and we're able to also to answer to the needs of our customers. Relative to contract features, we built about 2 or 3 years ago features in the contract, which will allow us to adjust pricing, when needed, in most of the cases. And so far, we have been able, in partnership with our customers, to find a balance between their interest and our interest to protect our P&L and -- but also to protect their P&L as well. So, so far, we have been able to manage this situation from a labor availability and inflation standpoint, John.

Great. And you touched on a little bit there, but obviously, at the Analyst Day, you laid out, and even before that, these self-help levers on your COGS, cost-out and your SG&A programs. Can you give us an update on how they're tracking? And then what are the tools you use to make sure they're staying on track?

So our program, which is -- which was launched at the middle of last year, is well on track. We met our objectives during the last fiscal year. We have a high level of commitment to those. They are net commitments. We -- the way we track them today is we have, like many other companies, a PMO, a Project Management Office. We go through an update every week. The meeting is chaired by the Executive Committee of the company, including our CEO and Chairman, George. And we track all the projects one by one. There was nothing sophisticated about this, but the discipline around the project is very strong. Our incentive program also is based upon us achieving those goals, and we are very pleased with the way we are executing those productivity programs.

Great. And one of the things that was very helpful last quarter is, as a company, you spiked out some more total addressable market and sales around healthy buildings, right, decarb and smart buildings. And I'd like to dive into those topics, but maybe from a high-level standpoint, do you think we'll continue to get that kind of detail going forward? Or is it we're now seeing these -- they kind of blend together from a customers' perspective? So we'd love to get your thought there.

We will be -- I mean, you have a blending, of course, going on, but we would be able actually to understand with a certain level of precision what is driving what. And we believe those trends around healthy buildings and sustainability, we're going to be able to inform you around those as they are fundamental to what is happening to our company but also to the industry. And we see those trends, John, I'm sure we'll talk a bit more about this, really accelerating. In the second half of last year, we saw really an ON button being pressed when it comes to those trends, much more than what we had anticipated. And we believe that these -- those trends, which actually drive this industry, will drive our ability to perform as a company for the decade to come.

Great. And if we just isolate the HVAC portion, this is traditionally a replacement market, are you seeing any change in customers' behavior on how they evaluate when they want to replace equipment?

We do. Today, too, we could improve sustainability by deploying our OpenBlue platform without doing any adjustments to the equipment. Just manage the equipment better, you could actually achieve with OpenBlue -- that you can deploy in a matter of now a week or so. You could achieve 10%, 15% improvement in the way you manage operation. But really, if you want to get to the full potential of decarbonization, and our customers are trying to be in a position where they need to achieve their full potential, now replacement start to be a key element of the discussion. And you have quoted the statistic, John, in the past, in the U.S., it's largely true also in Europe, 80% of the building, 8-0, have equipment, HVAC equipment, which have been in place for more than 20 years, right? So the technology has changed fundamentally. So now replacement is starting to be more and more part of the conversation. That's point #1. Point #2, ROI now is measured differently. More and more of our customers are saying, "I need to decarb. My investor is asking me to do that. My customer is asking me to do that. My Board of Director is asking me to do that. My employee is asking me to do that." So the ROI now includes other factors which are not only pure financial. And the same also when you talk about indoor air quality. The air, for my employees, are starting to be part of the equation. So we see 2 changes: replacement and ROI being broader in the way it's being measured.

Great. And so then, I guess, that brings up the question and probably something you deal with on a daily basis, do you have enough capacity to meet that demand? And how should we think about this over time? I mean, is this a couple of years and then it fades? Or is this a really long tail, where it's a secular trend?

We think it's a secular trend. The way -- so what we have indicated during our Investor Day is we believe that the indoor air quality, that decarbonization trend is a market, which, over the next 10 years, will deliver revenue of about $250 billion, and that will be ramping. Let me tell you how we model it. We triangulated the methodology to size the market in different ways. But one way to talk about this would be like this, John. If you take the Class A building in the world, which is 10% to 15% of the total building in the world, and if you say that 5-0, 50% of those buildings will achieve their decarb goal, then you get to the market I mentioned. Meaning, we are not really stretching the model to size this market. So we believe that the $250 billion over 10 years is realistic. It's possible that will be bigger, and we're seeing this market accelerating between now and the next 10 years. So it will be a secular trend. That's our belief. There is nothing indicating today that we are wrong. The size of the pipeline, the pool from our customers, but also the activities of players, competitors, consulting companies, digital company in this building indicate that all of us are seeing the same market and all of us want to participate. It's not only a Johnson Controls market, which has been identified.

Great. And then, I guess, just focusing on that CapEx piece. I think you're taking up your capacity in residential. You're also making investments in digital. Can you help kind of size that for us? And how you think about CapEx going forward?

So we think that CapEx will remain, in dollar, about the same amount as what we have had before. No change in the way we're going to run our CapEx on Johnson Controls. To answer -- to your question on resi, we're indeed, as we speak, expanding our North America resi capacity by 30%. And more to come in expanding our capacity in resi. The reason for this is it's an attractive market. We believe that the resi market -- I know we have a lot of conversations about what this market would do going forward. We think it's going to be an exciting market. We have been gaining share. We have been not able to deliver our full potential because of capacity constraints. So we're investing in this market today, John, but that would be in the envelope of the CapEx you have seen from Johnson Controls before. No deviation on this.

Great. And then as we think about Johnson Controls, right, you have your HVAC business and then your Fire & Security business. And I'd like to talk a little bit about some of the financial differences between those buckets, if we may. And you talked about resi HVAC right there, which is, I believe, mix positive to the HVAC business. But can you talk about what will grow margins on the HVAC side of the business? And then what are the margin levers on the Fire & Security side of the business that you've laid out?

So if you look at, today, digital is going to be central to everything we do. You cannot obtain the optimum sustainability goal of your customers if you just optimize an equipment. You need to optimize a building. Digital is central to everything we do, reaching the goals of our customers, improving our service outcome, improving the service reliability. And what we observed today is when we couple digital in our offering, our win rate is higher by about 20 points. And the margin today is about 3 points higher relative to a standard deal. And we're just at the start, John. I mean, we need to remind ourselves that we have been really into this OpenBlue rollout and strategy for now a bit more than a year. And we already see win rate higher, margin higher by about 3 points, as I've said. So we believe, today, that the digital is going to allow us to grow the top line, but also increase margin because the ASP higher, but also because we're going to be able to run our operation better for our customers, right? If you use digital to manage your service operation at Johnson Controls, you're going to do that in a more efficient way. And we believe that this margin gap we see is going to keep increasing as we are getting better at this.

Great. So it sounds like that story goes on both sides of the house.

No question.

Okay. Maybe we could start talking a little bit about free cash flow. Obviously, Johnson Controls has really elevated their conversion. What gives you confidence that you can sustain that 100%? And then maybe some insights into trade working capital as we think about this year and into next as you look to grow.

So as you mentioned, free cash flow has been good. Now KPI, Johnson Controls, last year, our conversion was 105%, including the absorption of restructuring costs. Without that, we would have been, if you normalize for this, 115%. So 115% was the true operational number. We're committing to 100% this year. We have a high level of confidence about achieving this number. Why? First, we are all aligned on this objective. So we have said that before, 1/3, 33% of the exited compensation of Johnson Controls, so the 120 levers is based on free cash flow, the same for a large proportion of the compensation plan of our sales maker. So we have alignment of objectives. We have, again, a project management practice that we view every week to make sure we're on track. So -- and we are today delivering as per our expectations. If you look at trade working capital, if you look at the way we are managing, we are performing that today, we are close to being very, very good if you do an analysis versus our peers. And we believe that in GPO and GSO that we have levers to do better. We believe we'll be able to still reduce our cash conversion cycle this year between anything 5 to 8 days with those 2 levers. Eventually, we believe that we will not be able to recoup it because we need to secure inventory in the current environment. But we have power to make trade working capital a good news in the free cash flow generation, John.

Great. And then before we get into some specifics, maybe just remind us your capital allocation priorities. And then from there, we have a follow-up.

So we are -- based upon the strength of the free cash flow of the enterprise, based upon our low level of leverage, we have committed to allocate capital this way. 100% of our free cash flow would be distributed in the form of dividend and buyback. We have committed to $1.4 billion buyback program, and we grow our dividends with earnings. So 100% of the free cash flow would be given back to our shareholders using those 2 forms. We will have ample capabilities to then, on top, deploy capital in the context of M&A. Taking M&A in the field of technology, in our Global Products, portfolio, digital, which will be no surprise, services and sustainability. And we believe we should, I would say, with a high level of confidence, drive to 1% or 2% of revenue growth through M&A.

And just to make sure we understand, that 1% to 2%, is that in your long-term forecast that you gave at the Analyst Day? Or is that incremental?

That's incremental. So during Investor Day, let me remind you of the numbers we have communicated. We have said 6% to 7% revenue growth. EPS CAGR, over 3 years, we have communicated to 18% to 21%. M&A will be on top of that, John.

Great. And then maybe we could talk a little bit about Silent-Aire, right, recent acquisition by JCI. We've seen one of your competitors acquire another asset in the data center space. Would love to get your thoughts on how the transaction is being integrated, and then kind of why the data center space is exciting and maybe why you weren't there before, or what Silent-Aire brings new to JCI.

So if you look at the verticals we cover, data center is a very exciting vertical, and we were underrepresented in this vertical. It was a growing vertical for all the reasons we know: card computing and the pool of data. Obviously, that data center is a byproduct of that trend. We were underrepresented. This asset allowed us to double our market share in this space. They are great technologies to address the specific needs of our data center customers. So it was a perfect fit within the JCI portfolio. The asset is performing well, and we're excited by what we're going to be able to do in that space going forward.

Great. And because it's a question we get, we wanted to get your perspective on the tax rate. Obviously, there's a lot of uncertainty out there around what tax policy will ultimately look like. But can you just speak to at least what's in your kind of longer-term guide and how you think about it philosophically?

So at this stage, we have assumed status quo in the guidance about the tax rate. We don't know what to model because the regulators around the world have not really clarified or enacted the various tax laws. What we know, based upon what has been communicated to date, is we have, today, a competitive advantage from a tax rate standpoint. It's highly likely that, that will remain the case. Based upon what we know, that's a second part of my answer, John, we have a high level of comfort, as much as you can have in business, about our tax rate of 13.5%, of course, in '22, but also in '23, based upon our understanding of what is happening in the market, but also based upon the various activities we have at Johnson Controls. So not a perfect answer and not that you expected -- not that you expected the preferred answer, but we believe we'll be able to remain competitive from a tax rate standpoint. No question in our mind.

Great. And then one of the things that I'd like to ask you around is heat pumps. A lot of excitement around this technology, change that's happening. Can you talk a little bit about how heat pumps play into JCI's portfolio?

So heat pump is very important to this industry, very important to decarbonize, very important to drive energy consumption. So all of us are strong in this business. We believe that we have a very competitive portfolio in the Q3 financial quarter. We presented the strength of the portfolio. If you look at it from Johnson Controls, it's following, if you talk -- can talk about this instance, about 65% of the portfolio of HVAC. So it's a big deal. We're continuing -- we are innovating in that space. And today, we believe that our ability to gain shares in the HVAC market, which has been a theme now for us for a number of quarters, is also part -- is also an outcome based upon the strength of our heat pump portfolio.

Great. And maybe pivoting over to Fire & Security. Obviously, one of your competitors has made a decision on their portfolio. Can you talk about how the field business interacts with your products business within JCI? Are there synergies having both of those channels within your portfolio?

So 2 questions. So Fire & Security, in the context of -- the world has changed. And if you go back to a smart building value proposition, the more you have connection points in the building, the better you need to be able to serve your customer. Many data points mean many data, many data means that you can optimize really the outcome for your customers. If you look at security, it's kind of been tricky, John. It's actually a data point in the building. If you know, within the building, you can optimize how you manage the building, and you have a lot of innovation happening today in security. So we are very excited by what is happening in the security portfolio today, and we're looking at that space very, very closely. And we look at smart security solutions. Today, it's about 40% of the portfolio, $9 billion. The margin is higher than the company average by actually a sizable margin. So that's the question to your first -- the answer to your first question. The synergy between the 2 businesses. To optimize a building, you need to understand the devices. You need to be a domain expert. The evolution of machine learning, artificial intelligence is not sufficient to deliver the best outcome just through data. You need data with domain expertise. And the Global Products give us this product expertise. We can design based upon what our customers want. As we understand the functioning of a piece of equipment, we can better serve the demand of our customers. So it's extremely synergetic in the world of today. Maybe 5 years ago, I would have debated. Not today. I go back to another industry, if you speak about medicine, Watson, right, which all of us have studied at some stage, you cannot do better outcome just through data. You need to combine domain expertise from a doctor with the data. It's the same in the building. And Global Products help us having this domain expertise.

Great. Well, I'm just looking at the time, and I think we'll have to leave it there. I could have kept on going. Really appreciate the insights there, Olivier. And thank you again for everyone joining us, and we hope that everyone stays safe and well.

You take care. Be safe. Have a great weekend, everybody. Talk to you later.

Take care.

Thank you, John, for your time.

Thank you.