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

And we'll continue with JCI. I'm very pleased to have Chief Financial Officer, Olivier Leonetti, with us. We're going to do Q&A. I don't think you've got specific opening remarks, if I...

We do not. I'm sure we'd cover everything I would have mentioned in my opening remarks later.

Right.

We are very excited to be here and looking forward to this discussion. Thank you for having us.

Thanks, Olivier. Great to have you here. Look, I'm going to do probably 99% of the Q&A, if not 100%, but if you've got any questions, I will pause halfway through, and please put your hand up if you've got a question. I'm sure there's lots of questions. But Olivier, you've been CFO now for almost -- well, 1.5 years.

1.5 years.

You've been at JCI for almost 2 years now, which is proof, if any is needed, that time flies. So maybe -- you've had a lot of experience as a CFO. You've spent a lot of time. I know it's -- I think, Dell, if I'm not mistaken.

Dell, yes, yes.

Back in the day. Maybe talk about JCI, the company you joined. What were some of the strengths and weaknesses you saw? And how is JCI evolving as an organization during your time here?

Yes, that's a great question. It's an unusual question to ask. I come from a technical background, from a digital background. And why would you join an industrial company, which is 138 years old? The reason why is because we're going through a digital transformation. And if you look at what we are trying to do, sustainability, services, healthy building, digital is going to be at the center to develop an amazing value proposition for our customers. What I've been excited about is the speed of change at our company, the desire to adopt these trends, the desire to adopt the digital revolution we are putting to our company. And for a 140 years old company, we are moving faster than any company I work with before, by a margin. I love our culture. I love how we work with each other. And I'm very excited by the value proposition we are developing for our customers. So it has been -- I mean, I don't know, it's a recorded event. I had high expectations, and the reality is better than I thought. I think our end markets are better. Our ability to compete is better. Our culture is better. The speed of transformation is better, and I'm having a great time. You have to, by the way, to navigate through this environment.

Definitely helps if you can have a good time as well. There's obviously been a lot of leadership changes as well at JCI. So you're one of many leadership changes. How has that been absorbed within your organization? Because when you take a company as old as JCI and you try and change too quickly, sometimes that can cause friction. Is there any evidence of that at all?

All of us -- so pretty much everybody in the management team is new. And -- but if you look at who came, everybody has a fair amount of experience. All of us have done some form of transformation or multiple transformations elsewhere. And we take a lot of time before to hire a new executive in the team, a lot of time. And we're looking for the appetite to transform, the appetite to drive change. But we're looking also for leader who have a high respect for what this company has been building over the years. To be in business, I'm a student of business, all of us are in this room. We've been in business for 140 years. You have to respect a company having been able to last for that long. So all of us are respecting what made us strong, and when transforming what has to be changed, we're respecting the past. It has been working well to date.

Okay. That's great. Okay. So let's spin over to 2Q, what happened during 2Q. And quite frankly, the question we get a lot from investors, and I know you do as well, is how did JCI perform this way in North America when some of the key competitors didn't? And was this a JCI-specific issue? Or are there some [ shares ], et cetera? So maybe just address that point because I think it's a really important point.

And we discussed about that last night over dinner. We have today at Johnson Controls 2 different companies in the building space. We have a product company, $11 billion out of $26 billion, shipping products to the channel. It's our short-cycle business. This business, for a number of quarters, Q2 was no exception, has been overperforming the market. In top line, 14% revenue growth; margin expansion, 160 basis points year-on-year, an absolute level of profit rate. This business is navigating remarkably well the environment. Then you have another business which is the solution business, $15 billion in revenue, give or take. This solution business is the future. Sustainability is going to be in this business, healthy building, services, we're going to talk about that. All of that enabled by digital. This business, you need to manage 3 supply chains when you put in place at a customer site a solution. You need to manage your own supply chain, the one of your customers and the one of your partner. And if you have one issue of you, then you are impacted in your ability to roll out. That has been happening in North America, which is the most sophisticated business we have. But if you look at, nevertheless, the business trends, let's take North America for an example. Order growth in Q2, 12%; revenue growth, 6%; massive building backlog. For the solution business, we have built year-on-year $1.2 billion worth of backlog year-on-year; quarter-on-quarter, $0.5 billion, with a very exciting margin because we have been anticipating now pricing with an elevated level of inflation with a very exciting business. So we have been impacted in Q2 because of the supply chain, but the silver lining is we're talking today a lot about supply chain constraints and impacting a short-cycle business. We are not going to be impacted by this business as much because this order book, which is one of the highest we have had in our history, is going to convert because of the unique value proposition of what we offer to our customers.

Right. I think it's worth reemphasizing the point so that the product segment because it's a point that's lost on a lot of investors. The $11 billion product segment maps more closely to Trane and Carrier and the solutions businesses, and that outperformed the markets. And I think that's a very, very important point to emphasize. The backlog. So there's lots of question marks from investors around backlog stability not for JCI, but just generally. And are we seeing double orders? And how real is this backlog build? But for you, these are very project-oriented. It's building-orientated. It feels like this backlog should convert. Maybe just address that point.

We -- I mean, we believe strongly that this backlog will convert. We are doing essential work. I mean if you're building a building, you need to install the equipment in it. What we do is essential. And what we do is very sticky. If you want to build, and you do, a sustainable business, if you want to build a healthy environment, we have today a strong value proposition, and we're going to talk about this. So this backlog is sticky. This backlog is strong and the margin profile of this backlog is very encouraging as well.

Yes. We will get on to that. But just staying with the supply chain, and what were the pressure points that you saw during 2Q and measures you put in place to solve that problem?

Again, we talk about this. There was nothing preparatory about managing supply chains. We all do the same. Our CEO is involved daily. I'm involved daily. We simplified our SKU. We redesigned microchip. We have contract with our suppliers for 18 months. We have spot buy. We have a high-level inventory. The to-do list is the same for all of us, as you would expect. We believe we have called the supply chain constraints well. We have been at it now as an industry for about 3 quarters, 2 years. Johnson Controls is no exception. We are built more resilient supply chain, for sure.

Okay. Okay. And you put a probably amount of contingency in your guidance in the second half of the year.

Reflecting the environment we are in. And again, we are a September year-end company, so we have less time or so to recover, for example, in China. China is still, in key parts of the country, in lockdown. You still have macro events looming out there, Europe being one of them and the Fed also, policies in our country. So we believe we have been prudent as we should be indeed in our guide.

We'll come back to China in a second, but I do want to talk about some of the more structural secular aspects of your business because that's becoming obviously a lot more important. Maybe given that your solutions businesses are very long cycle, you're talking to customers far in advance. You have RFPs, I assume. What is the nature of the conversations you're having today about 2023 and beyond in terms of air quality, in terms of energy efficiency, in terms of upgrades to existing systems, CO2 abatement, smart buildings? What are you seeing right now today?

So we believe we are unique today for 2 reasons. One, we have -- you cannot solve all those questions you mentioned without having a digital footprint. We have a strong digital footprint. We have strong digital capabilities, we believe among the most competitive in the market, but we have domain expertise. To answer to your question, you cannot solve energy crisis, you cannot solve climate change without addressing the building. The building is 40%, 4-0, of the carbon emission in the planet. You need to solve it through the building. You needed to solve it through the digitization of a building and the orchestration of all the elements you have in a building. You cannot solve climate energy conservation by only managing in a smart wear device. You need to orchestrate all the device in a building. We do that. You have actually not many players doing this. You have some players doing equipment, some player doing the smart element of a building management. Nobody today does both. We believe you need to have domain expertise and digital know-how to address it. And we are. That's why we are in -- if you look at the energy market in the U.S., in the performance infrastructure business, we are a leader in this market by a fair margin. We have a 50%, give or take, higher share than our #1 competitor. This business is growing significantly double digits on a very tough compare, and we are now exporting this know-how to the rest of the planet. We created in Q2 a new division at Johnson Controls, it's called Sustainability Infrastructure, to replicate the know-how we have developed in U.S. across the planet. The know-how includes solutions, products, digital, financing. We launched a financing agreement with Apollo in the U.S. which is working very well. And this model is being replicated and is resonating well with our customers or institutions, governments.

And you're right. I mean, Performance Infrastructure, in the -- back in the day, it was called ESPC, largely a government business, federal government, state governments. Is that starting to evolve into across the commercial building sector? We're starting to see universities and commercial -- even commercial offices adopting these solutions.

You do -- the key reasons is the payback. You have now the technology to reduce carbon emission, energy consumption by close to 40%, 50% with the technology with a payback, which is now well below 1 year. Again, we're not talking about this now, but in Q2, we're probably going to have a few questions, Nigel, on this, we launched what we call OpenBlue 2.0. 2.0, what does that mean? We have a gateway. It's connection box that you can deploy at the customer site in a few hours at a very attractive cost point and then connect the full set of equipments in your building. We launched that in Q2. That's new. We are launching in Q3 the ability -- we believe, it's a revolution, Nigel -- the ability to connect a Building Management System with OpenBlue, a Building Management System from Johnson Controls or for any other player. Why is it important? Today, to manage a Building Management System, you need to do that through a human. You need to book a visit. You look at the system from time to time. If you are connected 24/7, you have now another level of management of your building. Those capabilities have been launched in Q2 and now. That's another set of revolution in the building really resonating in the commercial space.

Right. Yes. I think the BMS -- your position as a big BMS player really gives you a natural seat at the table to be a smart building player as well. And that's why OpenBlue is so important here.

Correct.

And that connection with the BMS at OpenBlue is a very natural connection. So I think that most investors understand the logic, if you will, of being a very large commercial HVAC player, BMS player and OpenBlue around that. Where does Fire & Security come into the equation? And why is that important?

So if you look at today, the [ portfolio ] of our company, again, unique and I believe, unique today is a key part of our value proposition. Product, HVAC, Building Management System where we're leader, Fire & Security, the ability to install a solution, the ability then to digitize the solution, that's unique in the market and in high demand. Let me answer to your question specifically. Fire & Security is about 40% of our revenue mix. It's an important part of the portfolio and exciting on its own because it's growing and it's the highest margin profile in our company, so at the very end of our margin pyramid. The additional interest for us is that security is intuitive. It's actually a way to deploy a smart building capability. With security, you know within the building. You know who is where in the building. And then you can start to optimize the air quality in the building, you can optimize a set of solutions. So Fire & Security, very important in terms of revenue size, revenue growth, margin profile and being part of a smart solution.

Yes. Look, I think the disclosure that Fire & Security margins are at the very high end of the pyramid would surprise a lot of folks because I think the perception is that these are -- when we see -- like some of the competitors, Stanley would be there and obviously, you, Carrier, the margins are not comparable to where you are. So that's an important point. Maybe talk about China. And then after this I'll open up for Q&A. What have you seen in China right now? What did you actually assume for the third quarter fiscal? How is that playing out as planned? And how do you see the evolution in China?

Yes, so top of mind for a lot of reasons. Let me give you a bit of numbers about China for our company. It's about 6% of our revenue. We have a partner, Hisense, doing mid-commercial. This is not part of our revenue. We have a minority controllership. China for Johnson Controls has been doing extremely well, better than we thought. Revenue, double digits in the mid-teens out of very tough compare. Order velocity, to our surprise, is still very strong. Why is this? Our themes, you mentioned Nigel earlier, sustainability. We didn't discuss vertical, but data center, health care, infrastructure, all those projects are really aligned with what our value proposition is and with the offering we are giving to the market. Now what we're observing and we have included that in our guide to our investors, we're not assuming that China will fundamentally get better in this quarter. That was implied in our guide. Today, largely the reality is playing our expectations. You still have some cities opening, but we're not back to normal yet.

Okay. Most of these at this conference assume mid-May would be when we start to see that improvement. You've taken a more conservative approach.

We took July as being when things will be a bit more back to normal, knowing that we're not going to be back to normal, we believe, in the September quarter either. That's not what we're assuming. But for sure, we assumed a high level of disruption in June.

Okay. That's fine. Okay, guys, any questions from in the room? Please put your hand up, and if there is, we can get you a microphone. Yes, right here, please. Sorry, the microphone, please?

I was just curious if you can elaborate on the -- you highlighted some of the product savings, 1-year paybacks, 40%. Obviously, power prices have accelerated dramatically. I'm wondering is that at current power prices or more normalized? Then maybe you can talk about what we've seen with power prices, if this is even creating a further -- talk about what this impact is having on your order backlog in.

That's a great question. The statistics I've quoted are not based upon the current energy pricing. It is not. So if you keep this -- the cost of energy as it is now, the payback will be much, much higher. And we gave the statistic, the level of pipeline in sustainability has been accelerating for obvious reasons across the planet, Europe being a big part of it. That's also why we wanted to accelerate the deployment of our Sustainability Infrastructure division across our company. And more to come. I mean I'm going a bit on the side here. But for us, sustainability means offering to a customer a net zero as a service. That's the end game. It's not optimizing a building. It's making your building net zero. I mean you can guess what that means. Product's a big part of this. Digital, big part of this. Renewable would have to be part of this. Local energy storage will have to be part of it. Energy exchange with the grid will have to be part of it. We want to be present. I'm sure we'll talk about that in other conference. We want to be present in this market in this way because of your question, energy pricing increasing.

Any other questions? Yes.

Within your solutions business, can you give a little color of how much is like new construction versus retrofit? Is that about the same breakdown within revenues as in your backlog?

It's a great question. A large part of the backlog is driven by retrofit. Why is this? It's intuitive. We can, today, with technology, deploy solution, which will make -- the statistics is about if you can improve the energy consumption of a building by about 15%, give or take, just by deploying technology. You do not change anything, right? So again, the payback is very strong. So that's why it's called a retrofit event. We have seen new construction starting to increase for now 2, 3 quarters, but the acceleration is really on retrofit. Why? Because of the value proposition of a retrofit event. You get a high payback very fast.

Yes. Good questions. So we've got 5 minutes left, Olivier. I want to touch on sort of the backlog conversion into FY '23. But more importantly, where are the margins on the backlog here? So you've been putting through price pretty aggressive price. If I'm not mistaken, high single digits, so in that range, pricing, certainly, that's what's been on products. I'd be curious, number one, just address the backlog margin question. And then more broadly, the -- in the past, Tyco and JCI, the insulation portion of your solutions business has always been lower margin. But given the value that you're adding here with CO2 reduction, net zero, et cetera, why can't this be a high-margin business still?

So 2-part questions. The backlog today, we are pricing with a high single-digit inflation in mind. I mean, I hope it's not going to be the case. We have been very prudent. What we're observing today is the backlog conversion from a margin standpoint is very attractive. And again, if you look at next year, I mean, who knows what is going to happen? But clearly, some neutral sentiments. Our long-cycle business will be a strength from a P&L standpoint because we have the backlog. We discussed this. Now if you look at the installation, it's actually a very important question. If you look at the $26 billion of our company, $11 billion is the product division overperforming on every metric. $15 billion is our solution business. $6 billion of the $15 billion is services. The addressable market for services, where we are a worldwide leader is $150 billion. We have $6 billion in this market. We're a leader with 4% market share. We want to revolutionize this business through digital, and we are starting to do that now. Now you go to the install. The install is an important part of the business because it allows you to create customer intimacy and allows you to generate a service event at the end and service annuity. But the way we have run install, which is $9 billion in revenue, you can do the math. Services is double the profit rate of the company. You can do the math of what the margin is on install. It's much lower, and it's a large part of the revenue. We believe that this important install business from a strategic standpoint can be run in a very different manner, standardized by archetypes across the planet, deciding where we're going to install, when we're going to partner. We believe that the install business has a short-term -- is a short-term opportunity from a margin expansion standpoint, and more to come on that as well. That's a great question.

Great. Great. And then obviously, finishing off the circle here on services, and you've got many initiatives underway, OpenBlue-driven, but also increasing the attachment rate of services on chillers and other devices. So maybe just talk about is it really adding more value to the service proposition as opposed to just a break-fix type of relationship where it's very competitive that you're now doing things that your smaller competitors can't do? Is that really why you're able to accelerate services?

So I'll go back to the few numbers I mentioned. $150 billion addressable market. We are the leader in the world. We have a market share, only 6%. This market is local mechanical. If you have the ability to connect the equipment of a building, you are building a formidable competitive advantage. I mean if you connect, this is intuitive, you do preventive maintenance, you optimize the management of the device. I mean, you create significant energy savings. You create significant services savings. And this business today, digital services is not yet at Johnson Control. Our service business today is growing high single digits, 2-year stack growing at about mid-teens. It's not powered by digital. It's powered by a new go-to-market, privilege of focus, new offering on the traditional services. Digital services is starting as we speak, and we ramp over a number of quarters. So we haven't seen the full power of digital in services yet. And despite that, as I said, this is a business doing quite well in our business. So we're very, very optimistic about what will deliver for us and our customers. No question about this.

Okay. That's great. I think we're out of time, but I can't let you go without talking about a little bit of capital allocation and balance sheet management. We leave FY '23 for another day, I think, maybe close at FY '23. But in terms of -- you generated a lot of free cash flow. You've got a pretty healthy buyback in place. How do you see the capital allocation evolving over the next couple of years?

So we believe we are 100% free cash flow conversion company. Last year, we converted 110%. We had a 110% free cash flow conversion despite having the cost of restructuring. This year, because of inventory, we believe we'll be at about 90%. But we believe that structurally, we are 100% free cash flow conversion company. Now let me answer to your question. We want to deploy 100% of our free cash flow through 40% of the free cash flow dividend, 60% buyback. And because of our low level of debt and the increase in EBITDA rate and dollar, we'll have ample capacity to do M&A and generate 1% to 2% additional revenue through M&A. So that's the capital allocation strategy. From an M&A standpoint, we believe we have the balance sheet. We are now ready to absorb new assets. We have a clear strategic vision. We have a new head of strategy and business development, and I think we'd see very exciting things coming at Johnson Controls from an M&A standpoint in the non-too-distant future.

Great. Great. Perfect. Well, Olivier, thank you very much. That was great. Thank you very much.

Thank you, Nigel. Thank you, everybody. Have a good one. Thank you.