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

All right. I think this is the last one of the day, I think. It's like 4:00 or something. But we're very pleased to have JCI and Olivier Leonetti, the CFO of the company. Olivier, I think you wanted to give a bit of a preamble, and then we'll run -- jump right into Q&A. Thanks for joining us.

Thank you for the invite. So happy to be back in person. I was -- I took a selfie actually in front of the Chrysler building, first time in 2 years back in New York City. Nice to see some familiar faces that we saw on Zoom or Teams. Two things I wanted to say. One is we're going to spend time to get on this. Our company is going through a transformation. We are 2 years into this. And the transformation will mean a change in the operating model but also us capitalizing in new vectors of growth, which are going through an inflection point. We'll go through that with Steve in a minute, inflection point. In this way, we will deliver services in the way we decarbonize the building. A bit of update also is typical on a conference like this to give an update on the quarter. Our order velocity is still trending as we had expected in the quarter, high single digits. We are reaffirming our guide. I'll repeat what the guide-wise, high single digits in terms of revenue growth, an EPS guide of $0.62 to $0.64. And we're reaffirming this guide. Having said that, we are all watching TV. We're all watching what is happening in Europe, also watching what's happening in China with COVID cases happening. And the environment is very, very frit. And we are going to be agile, and we're going to be ready to compete. With that, Steve?

Great.

Your turn.

Okay. Russia exposure, what are you seeing over there? Any spillover into Europe, just as the first obligatory question here?

We have 1% of our revenue in Russia, so relatively immaterial. The spillover, we'll have to watch. We're not going to be different than any other company. What would happen with the war, impact on the economy, your view is as good as mine on this. But low exposure to Russia today on any front, supply chain, revenue or manufacturing.

And then what's happening over in China around COVID seems to me to be worse than it's been in the last several months. What are you guys -- anything on the ground that you're seeing over there that's in addition to what we're reading on Bloomberg.

So we're chatting over that before the session. Hong Kong was in lockdown because of COVID. And you heard in the news like me, Foxconn has closed because of lockdown. So we'll have to see. We're watching that very closely. China is 6% of our revenue, but it's also a large part of the supply chain for the world. So watching what is happening. And yes, so business as usual is pretty discordant.

It's not business as usual, right?

Correct.

Right, right, right. Can you talk about supply chain, maybe what you guys are seeing? And I guess, with China, you're saying it's probably a little bit worse. I mean, some companies are saying it's a little bit better. What are you guys seeing? And where are the great -- where is the kind of longest pole in the tent on that front?

It's a net similar. Some pieces are improving. Some pieces are slightly deteriorating. Net-net, the situation is largely similar to what it was in the prior quarter. Raw materials were declining. Labor, increasing, freight, increasing. The net all of this is similar as we are observing what is happening.

And are there any particular components that you're seeing moving around either getting better or getting worse?

Microchips is the big commodity. It's marginally better but not to the point where we can say we're out of the constraints in supply chain.

And when it comes to your labor, which is, I think, a little bit different than having a bunch of guys or gals working in factories, what is the rate of inflation you're seeing on that front broadly for your -- for that total cost?

So labor inflation is there. It has been low single digit for us. And we have been able as a company to protect the P&L through pricing. Another trend which is happening is this industry will have to digitize its service business to remain competitive. And we'll talk about that a bit more. Today, the service business, which is a very large business, it's $150 billion addressable market mainly a local mechanical business, labor-intensive. We believe that this market is ready to be now digitized. And we're going to talk about that, I presume, Steve, a bit later. We're ready also for the digitization of our service business.

And so that plays into the productivity around like labor inflation?

Correct. So the digitization of services will drive better outcome from our customers but also would be one of the elements to manage your labor inflation or scarcity of labor, absolutely.

On price cost, any update there? Commodities were coming down. Did you embed that into your guidance, so now they're going back up? There's risk. Talk about those dynamics.

We have indicated that in the second half of our fiscal year, where September quarter, end of the year, we would expect to be price/cost positive. We are not changing this view based upon what has been happening in the market. We have driven a strong price dynamic at our company. I don't believe we are the only one. We have been very disciplined, and we believe we're going to be able to achieve our price cost goals for the second half of the year.

Even with the recent move up in...

The recent move up is not significant enough to change this view. And we factored an inflation going forward of mid- to high single digits in the way we have been pricing. And today, unfortunately, the situation is unfolding as we had expected.

And so do you need more price increases from here? Or have you already kind of put those into the channel and booked what you need to get to that price cost target for the year?

So we have priced at what we need to deliver the price cost. If the situation is different from a price -- from a cost standpoint than expected, we will be adjusting our pricing. I mean, if you look at today on some of our product lines, we have increased pricing 6x if you look at controls HVAC, 6x. We had one of our #1 peer today announcing also an important price increase. We will react to protect the P&L as we have done.

Who is that?

Carrier updated their price today.

And is that on commercial stuff? Or is that like across the board?

I believe it was HVAC, commercial I believe. It came in this morning.

Okay. Got it. I'll take a look at that. And then I -- sometimes people ask me about the risk around fuel and your fleet. I don't know. It's like 1% of cost of goods sold.

1%. Like everybody else, we're driving analytics on fuel consumptions, communicate messages about how to drive a truck. And it's going to be an incentive to drive more EV in our fleet. So all those trends around electrification are being accelerated today, for sure.

Does...

Including in the building, and we talked about this.

Right. Does any of this stuff impact SG&A and COGS initiatives that you have? I mean, we could break it out and say, price offset cost. All that stuff is still intact. Any of it influencing that trajectory?

The net answer is no. So the productivity program, $550 million, about 3 years, $60 million last year to $30 million this year to $60 million next year, mainly addressing fixed costs. If you look at our enterprise, we have been running our company largely in a decentralized manner. And as we centralize, automate, standardize the organization, functionalize the organization, we are very convinced that we're going to realize those productivity programs.

So if raw materials stabilize or maybe even like go down a little bit over the next couple of quarters, why can FY '23 kind of set up as a -- an above-average incremental margin year, comfortably above-average incremental margin year?

It should be. It should be an above-margin rate going forward. I mean, if you look at the underlying margin today, they're increasing by more than a full point. And if you look at history, we have been able to really protect the P&L well.

And if we look out to that year after that, do you have more confidence today in the revenue outlook or less confidence in the long-term revenue outlook, given what we're seeing today in the world, putting Russia aside, I guess?

All of us are seeing different things. I don't know what to see, right? The 2 countries today in war maybe are going to find an agreement. Who knows? We are very today optimistic about how we are positioning our company. The operating change at our company, standardization, functionalization, across all the elements of the value chain across the world, we believe are going to drive our revenue and margin expansion on their own. And we believe that the vector growth we talked about, services, decarb, sustainability powered by digital are going to augment our ability to compete. We believe we are in an inflection point in this industry. And we talked about that earlier with some of you in the room. Some of you in the room said, "Well, we heard the story before." This story did not happen before. The ability to digitize a building is a new trend, which is unfolding as we speak. And we believe that what we're observing, shortage in labor, price of energy, government driving decarbonization, we believe that the trends we have been anticipating are accelerating. So we feel positive about the long-term view of this industry and our position in this industry.

So I think the long-term guide was like 6% to 8% organic. And then it was an underlying incremental of like 20% or something like that. If the market comes in a couple of points less than that, it would still seem to me to be achievable. Maybe a little bit lower growth, but higher incrementals. Or is that -- we just talked about '23 being a pretty good year from an incremental margin perspective. Can we look at it that way? I mean, I guess, are there countermeasures? I mean, how do we think about the outlook in the context of perhaps markets being slower?

I mean...

I mean, I think all the companies are going to -- everybody seemed to -- you guys guided to 6% to 8%. And then all of a sudden, the 3% sector became a 6% to 8% sector. Every single company guided there. And now I think every single company is going to be probably saying it's not 6% to 8% at least for the foreseeable future. So you guys would seem to be in the bucket that there is company-specific cushion to that. Is that wrong? Or do you really need to grow?

So what we communicated was 6% to 7% organic, M&A being on top of this 1% to 2% and incremental of about 30%, just to clarify. Today, we are in a flex environment. We have positive and unknown. No way -- no reason for us to change that view with the information we have. If you go look at those secular trends, and -- those secular trends are going to transform the building industry. We talk about the revolution in the building industry, similar to what is happening in the EV market or similar to what has been happening in the online retail market. We believe it's one of those trends. We believe that those trends are unfolding as we speak.

So where -- in the EV market, we can go look at Tesla deliveries, and we can go look at huge plants being built in wherever, in Arizona or Ohio to build batteries. It's -- I think it's a little bit harder for us to see where this growth is coming from. Is there a certain part of the market in a certain application, whether it's smaller buildings, bigger buildings across the street? Like where -- should we look at the nonres construction data that's out there? Like where do we -- where are we going to see this validation of the growth you guys are all talking about?

So let me speak about our company first. If you look at the service business today, all right, go back to the statistics, it's a $150 billion addressable market. We sell $6 billion of this market. We're #1 in the world, but we have 4% market share. This market today is local mechanical. Difficult for us to compete. If you believe that this market is going to be digitized and there was a case for this, this is going to be a different vector of growth for us. We are now -- we have been piloting a new connection device plugged to OpenBlue, which is delivered in about 6 hours, used to take weeks, 6 hours now at a cost point which is below $1,000. It used to be thousands of dollars. That's a game changer. We have run a pilot for now about more than 2 quarters. A/B testing where we have connection, higher price, higher margin significantly, win rate 30% higher, retention rate of our customers 75% better. It's a very different business model. So just on services, 150, 4% market share, you could see for Johnson Controls the ability to really grow this business. Let me give you a bit more details. Our supply -- our installed base of chillers is about 100,000 today. 7% of those chillers are connected today, 7%. We believe it's realistic by the end of the year to connect 20% of those. You can do the economics. So there was clearly just on services, a vector of growth for our company if we execute and we have the technology, we have the game plan, we have the supply chain to do that. Now let's speak about decarbonization and sustainability. You cannot do that without digital. You cannot do that without OpenBlue. You cannot do indoor air quality by connecting multiple devices in your building. You cannot do decarbonization without connecting multiple devices. We have the technology to do that today. Again, we believe it's going to be an acceleration of this vector of growth. When energy is at the price it is today, when you have government mandates across the world mandating decarbonization of buildings, when you have investors, citizens in various countries demanding for decarbonization, that's going to be another vector of growth we believe we're going to be exposed and immediately positioned to compete. So you have specifics to us as well.

What is your installed base when you think about the control systems and fire and security products? I mean, how many buildings are you guys touching out there? I mean, Honeywell used like a 10 million number.

Yes. So I don't have the statistics. We are 1 of the 3 leaders in building management systems, and the building management system is going through evolution. So again, today, if you want to make your building management system better, you need to change it. Tomorrow, with a digital platform open, you run it live. You update it live. It's easier to connect, safer from a cyber standpoint. You have cloud and edge compute capabilities. This is a very different model for building management system. And we believe we are going to be uniquely positioned to compete in this business.

When you're signing people up to these connected -- I mean, is this in LTSA? How are you kind of going about locking them in? I think in the elevator industry, obviously, that's like 4- to 5-year contracts, get renewed. They're typically with them for 15 years or whatever it is. HVAC is way more variable, right? So how do we think about the business model here? And how actually captive and locked in that is as this evolves?

So the value to our customers is at multiple levels. So we talked about services. Again, as you connect a device with this kind of technology, you increase your price, you increase the recurring revenue, you increase your margin, your win rate and the attrition by a margin. Then digital allow you to do indoor air quality, you cannot do indoor air quality without digital. You cannot do indoor air quality without connecting multiple devices. In this room, the technology exists to understand how many of us are in the room and then based upon the occupancy, change the air flow of the HVAC while managing your energy consumption. You cannot do that without digital. We are selling that today. We are selling indoor air quality as a service. We're the only one to do that today in the industry. You cannot decarb the building or do net zero without digital. And all of those business model today are being rolled out by our company. Let me give you statistics. So on decarbonization, we have created about more than 2 quarters ago a sustainability business at Johnson Controls worldwide, going across the planet. Our pipeline has been growing. It's now about $1.5 billion. And the enablement again is through digital and pulling all the equipment you have in the equipment in the building.

And that's differentiated for you guys versus what these other -- Carrier and Trane can do?

So the differentiator is if you have a single line of business player, you're handicapped because you don't have the other domains. We have the full set of portfolio. If you do only building management system, you don't have the domain expertise, which we have. So we have the breadth of the product portfolio. We have the digital know-how. We believe our platform is among the most competitive. We are in the top 3 depending on who you speak to. We are either #1 and #2. And we have the field presence to act on the inside. This is a formidable competitive advantage.

When you look at growth this year, how much of the growth this year can you identify as being basic market plus what you guys are doing? Because the growth rates seem pretty similar to -- across the 3 players.

So largely digital services is not embedded in this year. It's starting. Largely, sustainability, the pipeline of $1.5 billion has to convert into revenue. Largely those trends are not in the P&L of Johnson Controls.

How long does it take for the $1.5 billion to work its way into the revenue base?

It would be about 3 quarters.

3 quarters. Okay. On OpenBlue, lots of progress, lots of different modules coming out. How has that business model evolved? And when will we kind of start to see more traction there and some revenue growth coming from that source? And then how do you make sure that, that is open but captive? You know what I mean? Like...

I do.

You don't have to configure it a ton, but you also want to make it yours and something that you can attach to the equipment.

Yes.

How do you walk that fine line?

Yes. So a bit of history about OpenBlue. We launched the capability about 2 years ago. And we've been scaling it and accelerating what we do with OpenBlue, accelerating the learning about 3 quarters ago. We have a new Chief Technology Officer, which I believe you should meet, Vijay. And we have changed the way we manage now digital at our company. So all digital activities, product management, product development across the companies under one leader, which allows us to be much more targeted in the approach. And OpenBlue now is foundational in everything we do, services, indoor air quality, sustainability and so on. So it's starting to have an impact and will have a bigger impact as we start to open the new fiscal year. To open to your question, it's open, needs to remain open. Otherwise, nobody is going to implement it. Nobody wants kept it. And the game is to make it so good at run by you that people don't want to go away. What we do is we have a cloud capability with OpenBlue. We have edge compute capability with OpenBlue, and we keep improving it. And those 2 points are not trivial. Some don't want only cloud. Some wants cloud and edge. Edge because it's cheaper, edge because it's safer, edge because it's faster. We have now edge compute capability. We bought FogHorn, an asset which is in terms of edge compute for our industry, a leading asset. So the way to keep our customers with us is to keep advancing OpenBlue platform.

Where are you seeing customers adopt more? What types of customers? When you look at the commercial real estate environment, what types of customers are most interested here?

Larger customers today, which is intuitive, and we can talk a bit more about this. So the top 150 account of Johnson Controls are embracing digital and are also multi buyers of our product range. So they buy a solution, which has been to combine, from our products, HVAC, security, fire control in the vast majority of the cases. And they buy that with a solution which is enabled through digital. Those accounts thrive today. They grow today at 3x the company average. Why? Largely because we are focused on them. We believe that at some stage, the mid-market would be also an opportunity for us. We're prioritizing the larger accounts today.

What's the revenue base of those top 150 accounts ish?

About 20% of the revenue of the company.

Right. What else on digitization? And you wanted to talk a lot about this. Is there anything else we're missing that we're not asking as this evolves?.

No. I think the question -- we think that the question is legitimate, it has not happened today. We believe today that is going to transform our company, is going to transform the industry, and that is happening now. That's what I would say. And we are only in terms of investment. And we have been creating at our company a very competitive platform by a margin.

What are you seeing on HVAC specifically? What are you seeing on the commercial side in the U.S. so far? Is there any pause in construction projects because of inflation or pretty steady state and solid growth in this -- from a cyclical sense?

Largely all of us have been maxed out in terms of demand. We are not able to satisfy demand for us, particularly in resi and Lat commercial. We have been totally maxed out for probably about 2 -- 3 quarters. We have maintained our manufacturing capacity for the North America market as a result. We will increase capacity by 30%. We are building a new plant in Mexico. This plant is at 50%, 5-0 potential, full speed by the end of September. The market is still very strong.

And vertical-wise, where are you seeing -- is it the same data center, education?

And health care.

And health care.

Correct.

Got it. Office, pretty stable?

Pretty stable. I mean, we're all watching how that would go. For the office, which is a small part of what we serve, office is about 10% of the vertical we cover. On the office, you have 2 trends going on. Less occupancy but more dollar per square footage being deployed. Again, indoor air quality, decarbonization, the net of these 2 is largely balancing each other for the office business.

How have you seen customers balance that? A higher level of IAQ filtration, but having to run your machines, obviously, much harder, the trade-off between IAQ and efficiency.

And that's where you need digital because you don't want to trade off. You want to do both, and you can only do both if you are very smart, meaning if you digitize. So again, this room, we might pump more air quality, but the room where we were is now empty. You have the technology that -- to know that the other room is empty, you can decrease the HVAC in the other one. You can do both if you are connected. You have to do more if you have the insight.

Have an update on Silent-Aire in the context of some relatively high profile challenges at a competitor?

So Silent-Aire in the accounts it used to serve has increased its market share and signed up last week a new large account. So it's a lumpy business, but this business today is performing as per our expectations.

Got it. And you expect that data center market to grow high singles this year, volume-wise? What's the outlook for data center?

This market is growing in that zip code indeed.

Okay. Any questions, audience questions? When you think about -- sorry, go ahead. You have a question? Oh, good. The IAQ opportunities. I think you had said $400 million or something in...

$450 million of orders.

$450 million of orders. What types of solution does that break into? How do you measure that? Is that just filters sold through you guys? Is it various types of -- you manufacture these solutions? Or is it taking somebody else's and putting it through your channel? How do you measure that?

So the solution today at Johnson Controls, so we sell indoor quality as a service. We certify indoor air quality for our customers. We use our technology, digital, but also the key partners, SafeTraces and the like. So the way we market it is the way I've described. We certify an indoor air quality level for a customer and sell it as a service. That's the way we sell it.

And that's -- so it's not necessarily like a product. You're...

You sell an outcome. Yes. Yes.

Okay. Got it. What are you -- and are you seeing people just upgrade -- basically upgrade filters? Like it's as simple as that? You put a higher MERV filter and then...

Filter, digital, you want to probably batch people, you want to connect what you do with energy pricing, which you can, the weather, trend of occupancy, that's what you have in the algorithm. So it's software, hardware partnership. I mean, it's becoming a science. We are -- I mean, we'll have to see how it goes. But we are invested in a start-up, which grab particles from a room, analyze it at the level of the HVAC to understand the pathogen in the room. This is starting to be a different ballgame.

How do they pay you? How do you price that? Like basically they're paying you for essentially like a dashboard that -- and a system that makes sure that, that dashboard validates that the air is...

That's exactly right. And as a result, you would be able to say, Steve, to your team members, come at the office. I have this great deal. Johnson Controls has certified the air quality in my building. By the way, if you look at schools, again, it's a big deal. 70% of the schools in the U.S. or in Western Europe, you have big data.

Do they pay you by the square foot or something like that?

They pay you by the square foot. 70% of those schools have poor air quality. So you can imagine the addressable market due to the opportunity.

And what is the -- what's kind of a rough rate per square foot for air quality?

I wouldn't -- I'd give measurements. The turn per hour of the air and so on.

It just seems like it would be hard to measure and -- somebody to pay for something like that. fire and security, anything going on there by the different types of products, whether it's intrusion, fire? That's not a business that gets talked about very much. What are the trends like there?

So it's about 40% of the revenue of the company. Those products are the very end of our margin stack, and those product lines are today growing faster than the average of the company. So you talk low double digits, high single digits depending on the product line. So this is an important part of the portfolio on multiple dimensions, growth, profitability but also the ability to sell a solution.

And what part of that -- is fire more differentiated than the security stuff? What are you seeing on the differentiation of the various parts of the portfolio?

Security is starting to be more differentiated. You start to have more and more smart security devices now. Security connected with fire, security connected with HVAC for obvious reasons. You have a fire and know who is in the building. You want indoor air quality maximized, your decarbonization, you need to know who is in the building. So all of that is being very synergetic and play in tandem more and more. But security much smarter as a device, much more IP content.

Free cash flow on track for kind of normal seasonality here for the year, 100% conversion?

Correct. Action packed. We are -- we have been now -- I mean, we were more than 100% free cash flow company. We believe we are 100% free cash flow company this -- include this year.

And what will you do with the cash? I mean, you're buying back a little bit. There's probably a bit of an M&A pipeline. How do we see that capital being deployed over the next couple of years?

100% of the free cash flow deployed between dividend and buyback 60-40. You can do the math.

Yes.

And we believe we have enough firing power due to our leverage and the growth in profit to generate 1 to 2 points of growth through M&A. So we believe we're going to be able to redeploy through dividend and buyback and acquire the assets we need to keep being competitive.

Is there anything you could do? I mean, Otis bought out Zardoya. Carrier bought out Toshiba. I mean, are there any JVs out there that you'd want to pull in to simplify the structure at all? I mean, you have the Hitachi JV. It's a big company. How would you -- any opportunities there?

We are happy with the way the setup is. I think there was mutual set of incentives. And if you look at where we deploy our M&A dollars, going to be intuitive, services, digital, sustainability and IP in products. So a smart security device, a smart refrigerant technology. That's what -- where we want to deploy our M&A dollars.

And are -- what are you doing with the resi business? I know historically, JCI has talked about wanting to build that out. Obviously, you're -- I would say you're subscale there in the U.S. at least. Is that a keeper? Do you build on that at all? Most of the discussion has been around commercial, rightfully so. But how does resi kind of fit into the future? And what's your appetite for doing something on the acquisition front there?

So resi, an important part of the portfolio. We are a worldwide player. And the 2 markets are very different from a technology standpoint. VRF technology, much more present outside the U.S., growing faster in the U.S. As a technology, we are #2 in the world in VRF. It's much more efficient as a technology. We want to play in resi is the net in both markets, rest of the world and North America. That's why we're building a new factory. That's why we're expanding our new footprint, and we are pleased with the economics of this vertical. So it's clearly a keep. We don't think that bigger is better necessarily. So we'll go to an organic path.

How does your resi business, including whatever JVs you have, play into the heat pump opportunity in Europe? I know that it's definitely not a U.S. resi play, if you will. But do you guys have a kind of a backdoor way into that opportunity with the EU putting out all these incentives for resi pumps?

Yes. So the decarbonization of a house of resi is mainly through heat pump technology. We are today one of the leader in heat pump technology. I mean, if you look at the portfolio today from commercial to resi, it's a key part of our value proposition. And we are competing well in those markets.

In Europe, though, in resi? What are you selling in Europe in resi?

We are selling today mainly in Asia and North America. We have a small footprint, very tiny footprint in Europe.

Okay. Got it. And is that through the JCI brand? Or is that through the -- okay.

Correct, through the JCI brand. Tiny today.

Okay. Got it. A question over here.

[indiscernible]

You say it should be higher than 100%?

Yes, on the amount -- you have a large amount of amortization rate. CapEx, I don't think it's [indiscernible].

Well, based upon the level of profit of the enterprise, the level of CapEx and trade working capital, I mean, if you do the math, based upon everything we have communicated today and during Investor Day, 100% is actually -- would make sense, and we can, yes.

I think that's it. Olivier, thank you very much.

It was a pleasure.

Yes. Thank you.

Thank you, everybody. Appreciate it.