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

Good morning. I'm Tim Wojs. I cover building products here at Baird, and we're very delighted to have Johnson Controls, join us again this year at our Global Industrial Conference. Johnson Controls is one of the largest global manufacturers of HVAC, building management and security systems. And from the company, we have CFO, Olivier Leonetti. And so maybe we'll start with a couple of prepared remarks from Olivier, and then we'll go into Q&A. So be interactive. So if anybody has any questions, feel free to e-mail me at [email protected]. So with that, I will turn it over to you.

Yes. Good morning. Is the sound okay? Yes, the sound is okay as well. Very nice to see you. Thank you for taking the time. I'm not going to do a long introduction. I will go through the session with team, but you would see we have a very differentiated business model, we can play in the product space, but we also play in the solution space. And we believe that the future is to be in the solution offering. So we'll cover that during the Q&A.

Great. So maybe just to start, maybe on that exact topic. I mean, your model is different. You have a field business. You also have HVAC, you have fire and security, you have building management systems. So if you just -- could you walk through why that's the right business model and what that allows you to kind of do as the systems within buildings continue to evolve?

So you have 2 business models today in the industry, one which is your product manufacturer and you sell to the channel. We have a division like this, it's called the product division. It's about $10 billion out of the $26 billion we have as a revenue in the company. And this product division is doing very well, gaining share, we mainly present in the HVAC market. We gained about in commercial HVAC, 1.5 points of share, and we gained, for example, in China, 4 points of share. So this division doing HVAC, doing also fire and security is doing very well. Margin last year has improved by about 2 points. And then you have another division, $16 billion, which is in the solution space. And to answer to the question from Tim, why do we believe it's a superior model. We believe it's a superior model because you cannot solve the problems that our customers have without offering a solution. You cannot solve sustainability, indoor air quality, you cannot solve for cost if you don't orchestrate a 360 solution. And we can do that for a few reasons. Number one, we have the product portfolio to do that. We're in HVAC, we're in fire, we're in security, and we're in control. So it's a broad portfolio of assets, for number one. But number two, we install those products, connect those devices, create customer intimacy. Number three, we collect this data and analyze the data in what we consider the best digital platform in the industry, OpenBlue. And then we have the ability to act on this data directly ourselves because we have the largest fleet of engineers in the industry. So we have to summarize 2 business models, a product division doing well, gaining share, improving margin year after year, and the solution business, which is a one-stop shop, which we believe is a key differentiator.

And historically, you've -- to a customer, you've installed it, you've serviced it, but you haven't really run the product. And so as you think about the development of the service business, do you see a shift where Johnson Controls would start to take ownership of operating equipment and converting more from a -- converting more from a widget sale or an install sale to something that you can get more of a recurring revenue or some sort of monthly type fee?

Yes. No, absolutely. If you look at today, the market recover, it's an addressable market across the world, which is $450 billion, which is a 1/3 product, a 1/3 installation and 1/3 services. So service is about $160 billion. This service market is very disaggregated, mainly local players doing mechanical services. We have -- we are #1 in the service market with a 4% market share. And we want to disrupt this market. Why? Because the level of competition is relatively low; two, it's a very profitable market. We realized a profit all in. So operating profit, which is twice the company average in the range of 24%. And we believe that with our go-to-market where we install, we mine the data and we can action on the data, we believe that we can disrupt the service market fundamentally and make it digital, local. So if you look at today, the service market, we used to grow in services at about 3%, the revenue. This year, we have been growing at about 8%. We believe we can grow this business by about low single digits. That's what is implied in our guide for '23. The 8% has been achieved through traditional operational focus. But we believe we're going to break through as the digitization of our services is taking more and more speed, and we are in the middle of this. So we feel very good about really capturing an unfair share of this market, and we believe that this business model will be a big enabler.

Could you maybe talk about OpenBlue a little bit? I mean it's still, I guess, relatively new, a couple of years old since you've really introduced it. But what's the vision for the platform?

So OpenBlue is critical to our solution business. OpenBlue allows us to drive sustainability. And by the way, you cannot drive sustainability with a very good chiller, with a great heat pump in a basement. You drive sustainability Net Zero, if you connect. If you understand who's going to be in the building, if you understand the weather, energy pricing and digital and OpenBlue platform allows you to do that, for example. In this room, for example, we would know because we're in the security business, then we have many of us, about 70 people will then increase the filtration of the HVAC. Nobody else can do that. So that's what OpenBlue allows. Let me speak about OpenBlue now in a bit more detail. OpenBlue is a data aggregation platform. We aggregate data, then mine the data through machine learning, artificial intelligence. We have launched OpenBlue about 2 years ago. And today in the industry, this platform is perceived as being the leading platform. About 2 quarters ago, we have then deployed a gateway, which allows us to connect the device very quickly at a low cost and grab data, which is then analyzed in OpenBlue. So that was Phase 2 open Blue. And Phase 3 now is to enable our go-to-market and speed that up. But everything we do in the solution business is enabled, amplified, recognized because of OpenBlue. When we deploy OpenBlue, we talk to the C-suite, our win rate is higher, our margin rate is higher and the proportion of recurring revenue is higher. And as you indicated, Tim, in some cases, we will secure Net Zero, we'll secure an outcome for a customer and manage the building to achieve that goal over a long period of time. And this business is actually very attractive from a margin standpoint.

And I guess when you think about building systems, I mean, historically, they've been siloed. And so where does OpenBlue kind of sit in? And is there any sort of kind of in-fighting within a building in terms of operating an elevator or getting data off of a fire sensor or something like that? I mean where does OpenBlue kind of sit as a software platform?

So OpenBlue today would be on top of a building. We can connect OpenBlue with a building management system. OpenBlue is open, so brand-agnostic. OpenBlue also allows us to launch new solutions, which are then also close to the device. So we have very high-performing edge compute capabilities where you bypass your building management system. You connect a piece of equipment directly with OpenBlue. Why is that important? A building management system tells you what is happening now. You have a piece of equipment, which is broken, you need to intervene. When you have edge compute capabilities, you can anticipate a problem. You know because a chiller or a piece of equipment is behaving in a certain way, let's say, the chiller vibrate too much. You know that it's likely to be in distress and break in 2 hours. So you can intervene before it's too late. So OpenBlue allows you to do that. Mine data, brand-agnostic and allows you to do preventive actions and deliver solutions. And when we deploy OpenBlue as we said, access to C-suite, win rate better, recurring rate better and then margin rate better.

A question here from the audience. Just can you talk about the revenue model of OpenBlue? And is it a long-term contract? Is it a some sort of Software-as-a-Service? How does it kind of flow through your P&L?

It could be all of those. And more and more today, we're signing recurring contract where we certify Net Zero as a service and air quality as a service. So more and more, they are long-term revenue associated with OpenBlue deployment. And as I said, this is just the start of our digital evolution. So far, we have set up, the capability is starting to ramp. And I would say we're in Phase 1 of this ramping, which has probably 30, 40 phases to come. So really at the start.

And how critical is Accenture in all of this? Because I think you do partner with them in OpenBlue and just given their expertise around building -- just systems integration in general? How critical are they to the system?

So we partner today with many companies in the digital world, Microsoft, Accenture, we have partnership as well to develop indoor air quality solutions. So we have a series of partnerships. Those companies will help us to develop a solution, so writing code. And also, we will also use them to go to market. So Accenture, Microsoft and many others, they are part of our go-to-market strategy.

Okay. Maybe just switching gears a little bit to some of the growth vectors. I think you're particularly excited about decarbonization. I think it's a -- I think you've outlined it as a $240 billion type end market over the next 15 years. Given some of your assets, I mean, do you uniquely benefit from decarbonization relative to some of your peers?

We think that we are uniquely positioned. Again, you cannot achieve Net Zero by having a piece of equipment, a chiller in a basement with a heat pump, you don't optimize the outcome. If you connect the device, understand the weather, the cost of energy, the occupancy, you can really deliver a sustainability outcome. And we offer to our customers a turnkey solution. This business today in terms of orders was about 1 billion, actually a bit more than 1 billion during last fiscal year. In terms of revenue, $800 million in the fiscal year, growing at about 15% mid-single digits on top of last year, which was growing on 45%. So really a difficult compare. And nobody can offer [indiscernible] as we do in 1:1 contract. We certify the outcome. We have a joint venture with Apollo also which will allow us to finance the deployment. And we have been gaining share as a result of this offering in the sustainability case. And no need to remind that to you, but 40% of the carbon emission in the planet is generated by a building. So we cannot solve global warming without the building, and we believe we're uniquely positioned to do that. And the P&L, the order flow is a representation of us winning in the marketplace.

How is the customer -- how has the customer's philosophy changed over the last 3 to 5 years? Because historically, I'd say the commercial buildings kind of market grew at 3% to 4%, but you've got indoor air quality and decarbonization and IAQ and digital and services and all these things that are kind of layered on top. So how is the end customer thinking about HVAC just structurally within their building, structurally within their budgets? Is this just a big opportunity to just expand the wallet share that you have in building systems?

That's very true. We think the building is going through a revolution. Why it must go through a revolution, it's an expensive part of a P&L for a company. Sustainability can only be achieved by -- through the building. And now we have the technology. So the incentives are there. And the technology is there. So we think today that the building space is going to be very exciting. We gave a guide for next fiscal year, which is low double digits in terms of growth rate with an improvement in margin of about a full point. Again, why? It is because we can offer solutions, which are highly differentiated, which solve our customer problems. Digital is part of the solution set. Our direct presence is part of the solution set and the understanding of the domain is part of the solution set. And all of that together give us a formidable competitive advantage.

And I guess, how have the paybacks changed? Has the paybacks stayed relatively the same and you're able to deliver more efficiency and so it makes more sense for the building owners to go ahead? Or are you actually seeing building owners say, what was a 4-year payback before we're willing to kind of stretch that to 5 or 6 because there's a lot of qualitative benefits that come with it?

If you deploy digital and if you know how to do this, the payback of the solution is below 1 year. We're looking at now 3 quarters. So it's making really the transformation and attaining those goals, sustainability, indoor air quality, reduction of the cost of a building now very appealing and achievable because of the payback. If you're not familiar with the industry, paybacks before in this industry used to be about 3 years. So you move from 3 years to about 3/4 now. So very attractive value proposition.

Any questions from the audience? I can keep going. So you're probably one of the only companies that's actually given guidance for next year. So maybe just talk a little bit about your mentality to '23, it's a pretty dynamic environment. And then just some of the big swing factors we should think about as you're trying to manage the business over the next year?

So it's always difficult to give an annual guidance, particularly at this time. Obviously, everybody is talking about a recession. What we said is we haven't seen so far, it could change, but so far, signs of recession at least at Johnson Controls. Why are we saying this? First of all, if you look at the indicators in the commercial space where we are highly exposed, indicators are indicating still a growth, less than before, but still a growth. So positive indicators. If you look in the last quarter we had, we had 9% of the growth. If you look at this quarter orders, and we have communicated that last week during our earnings, the level of orders accelerating, is faster than it was in Q2. If you look at our backlog, we have a backlog of $13 billion, growing the growth last quarter was 13%. And then you could say, well, is this backlog going to stay, remain. If we go through a recession, if you look at our backlog, we sell solutions. We have in our backlog, bespoke solutions. This backlog cannot be replaced by somebody else offering because very turnkey bespoke for a particular offering. And this backlog is mainly 50% to finish a building, you want to get that done ASAP. You have CapEx, which is either you want to finish your building, you need to have this order being delivered and the other 50% of the backlog is on retrofit, bespoke again, high return on investments. So macro indicators still green, orders accelerating, strong backlog. And when you go through the secular trends we are facing, services, sustainability, indoor quality and when you look at those trends and our competitive advantage, we feel as good as you can be in business about the year to come.

And maybe just on the backlog, it's -- I don't think it's a metric that you normally report, but how would you frame backlog margin relative to maybe what you're kind of putting through the P&L? Or what shipments look like today? Because I guess if you would look at your margin guide for next year, I mean, you probably have some visibility to that in your backlog. So if you can just give us a little bit of flavor of how the margins look within the backlog versus what's through the shipment data today?

So the margin profile of the company every quarter is improving. We're guiding for full points plus of margin improvement next year. Why? Again, you go back to the 2 businesses we have, business number one, a product division selling to the channel. This business has done very well, gaining shares and improving margin last year by 180 basis points. The field business last year had been impacted because of supply chain. You price at the cost point, inflation was transitory. When you price a particular deal, it becomes less transitory, you impacted but that is changing. And now we have repriced the backlog, the price log -- the backlog has a very strong margin, and you're going to start to see the backlog now improving the margin in the P&L. Let me give you one statistic. In Q4, our orders in the field business were priced with a level of inflation -- not level of inflation, level of price increase of 17.4%, 1-7.4. Then you say, how is it possible? So many investors have asked, how could you do this? We could do this because, again, if you go back to what we said earlier, what I said earlier, the value proposition of what we offer is unique. The payback is unique. As a result, the return for our customers is attractive even if you have a price of 17%. And costs are not increasing by 17%, of course, well below 10%. As a result, as the backlog will flow through, we will expect to see a margin expansion that's implied in the guide for Q1. That's implied in the guide for the full year. And that's what we saw also in the December quarter and expansion of the guide -- on the margin.

Great. There's a question here from the audience. Just how do you think about price cost? Is it a margin headwind next year? And how long does that price cost kind of dynamic take to play out?

So in Q4, we were price cost positive, $55 million. In the full year, we were price positive. So it -- I mean, clearly, we are price positive. It's still going to be a margin rate headwind, but really price cost as an issue is well, well behind us.

Okay. Okay, good. Could you maybe talk a little bit about some of the product investments that you're making, kind of, I don't know if annually or quarterly. I'm thinking areas like refrigerants, new products and just kind of the distribution to get those to markets?

We have a relatively high level of R&D investment for a business like ours. If you look at today, where we invest 90%, 9-0, is investments in new refrigerant or heat pump. If you look at our heat pump business, particularly about 25% of our R&D investment is dedicated to heat pump. Heat pump is no secret. It's a vector of growth for the industry. We sell in terms of heat pump associated revenue every quarter about $800 million and about 48%, close to 50% our HVAC portfolio has a heat pump technology. So we're investing today in heat pump, new refrigerant, and we are growing because it's important for sustainability and a heat pump revenue is growing and gaining share. And we believe we're going to be able to accelerate that ability to gain share. Let me mention maybe a statistic on this. If you look at today, where we use the model, the full model of digital and solutions. It's in the U.S. In chiller, and I'm adding here my notes, we gained in the quarter 4 points of share in the world. If you look at in the U.S. where we deploy heat pump, OpenBlue, a full solution, we gained 6 points of share in chiller, and it's a very competitive market. So you start to see here the power of the investment in R&D, the power of investment in heat pump, but that being multiplied because of the solution we provide through OpenBlue.

Great. A question here from the audience. How are you kind of thinking about Europe and Asia next year?

So we are looking at those 2 regions very closely. We are a very international company, Europe, particularly. So far, Europe, when you look at our order velocity this quarter now as we speak, the order velocity is actually accelerating. But if you look at the portfolio of assets we have, Tim, there are enough place, enough games we have for us to be as comfortable you can be in business regarding next year because we are international. We have a very diversified channel. We sell through multiple product lines. We have a solution play. So we think we are highly diversified, and that as a result, if something was to happen to Europe, we will have enough alternatives for us to be deliver on our commitments.

Great. Maybe just on free cash flow on the portfolio while we wrap up here. But this last year, a little tougher on the free cash flow side. I think a lot of that was just due to working capital and inventory build. But how would you expect the free cash flow profile of JCI to look over time? And maybe that's a relative to earnings comment or just in totality?

So if you look at this year, our free cash flow has been about 70%. The only reason why it's 70% is because of inventory. Many companies have mentioned this. We prefer to have inventory to satisfy the orders we have rather than maximize free cash flow. But also you have disruption still in the supply chain. So as a result, it is impacting inventory and free cash flow. But if you look at free cash flow, the preceding 3 years in each of those years were over 100%. Next year, this year now, we are guiding to 80%, 90%, why is this? The 2 reasons. Reason number one, if you grow and we are guiding to low double-digit growth, if you grow at this level of rate, you use working capital. So relative to a 7%, 8% growth, 12%, 13% is 10 points of free cash flow usage, all things being equal. So next year, the growth of the company and inventory still lingering, explain why we have a guide at 80% to 90%, but we have no doubt a 100% free cash flow company. And we have been, if you look at the 3 preceding years well over that number.

And just given the demand drivers that you're seeing today and maybe over the next 3 to 5 years, how do you feel about your internal capabilities from a capacity perspective to be able to absorb that level of demand?

When you say capacity, you mean manufacturing capacity? We have today -- the main constraint is not capacity. The main constraint is execution. We have a very exciting game plan. It's now can we move the company from a hardware company to a solution company, from a mechanical company to a solution company, can we do that fast at scale. That's where the challenge is rather than capacity. And so far, as I like to say, we're running faster, getting better at that game.

Great. I think we're out of time. So please join me in thanking...