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

All right. One more before lunch here. We've got Olivier Leonetti, CFO of Johnson Controls, as well as in the back of the room, freshly minted IR, VP of IR, whatever. Jim Lucas, everyone. Olivier, maybe a couple of minutes just on what you're seeing out there demand-wise? And then we'll hop right into questions.

How is the sound? Does this sound okay? Can you hear me? Good morning. Nice to see many familiar faces. Hope you're well. So demand, we're going to spend a lot of time on this, a lot of conversations about the state of the demand. We are serving as an organization, mainly the commercial market and so far, we haven't seen a slowdown in the demand. The demand is very strong and today, higher than what we can supply. So largely today, it's a supplier market. That's point one. Point number two, if you look at Johnson Controls, we are going through a transformation. George Oliver, our CEO and Chairman, had a vision for the merger of 2 conglomerates, the vision was to create a smart building company, and we are into this journey. And we're very excited by what we're going to be able to deliver for our customers. When it come to services, when it comes to sustainability when it comes to using the power of digital, we think that the best is in front of us. We are in execution mode now and more to come. And we look forward to your question, Steve, and the questions from the audience.

So we were talking earlier how we always like to sit on this side of the table. Like last year, we switched up, because I don't want the same outcome as last year -- this quarter as it was last year.

It's a good thing.

We're starting at a fresh place. On that front, order trends, you guys have talked about Field being in the mid-single digits. You said it may be accelerated a little bit in the beginning of this quarter. Where do you see that Field order rate kind of playing out here this quarter and then into the rest of the year?

So again, when we started the year, we had a lot of question marks about the market. What could happen in Europe? What could happen in Asia? What can happen even in the U.S.? And so far, the market -- the commercial markets we serve has been -- remained strong. The macro indicators are positive, and that is translating for our company, the demand rate you are mentioning, mid-single digits, high single-digit demand. So, so far, we are performing as we have communicated to you over the last few weeks.

And then China was, I think, a bit of a variable. You guys had some challenges in the fiscal first quarter. How is China playing out here in the fiscal second?

Strong rebound and China is performing as per our expectations. We had a strong business in China before, and this business is going to remain strong. We think that this is a business, which should clock low single-digit growth rate, no reason for that to be changed. Strong rebound.

And as far as the supply chain, you talked -- you guys have talked a lot about this. Maybe give us a kind of a comprehensive update on where you guys stand there relative to your expectations? And then what are the various moving parts from a supply chain perspective and liquidating some backlog?

So our guide did not assume any improvement in the supply chain. And today, the supply chain at our company, the supply chain across the industrial space is slightly improving. For us, you go back today, this is a supplier market. Our ability to keep addressing the supply chain will have tremendous impact on top line and margin. So, so far, so good on the supply chain, but still not what they used to be pre-pandemic. No question.

What are the areas that you're seeing -- still seeing pressure around?

The theme would be no surprise to the audience. Electronics is the main gating factor in most of the cases. Electronics in the control panel, electronics in an applied equipment. So electronics is the main gating factor.

And I think you mentioned some other types of products like variable speed drives or anything else or is that all electronic related as well?

All electronics.

Okay. Would you expect to liquidate backlog from here until year-end? Or do you think that -- how do you think about the backlog kind of exiting '23?

Difficult to answer to this question, because of the strength of the demand. So the supply chain is improving, that should allow backlog to reduce. The backlog is elevated relative to historical levels. So supply chain improving, that's the case, should decline the backlog, but the demand is very strong. So you have out and in the net of that is going to be difficult to predict. So it's difficult to conclude on where the backlog will be at the end of the year.

When it comes to pricing, you guys have embedded a pretty significant amount of price in revenue, but there's also, I think, a strong double-digit amount of pricing that's in the backlog. Your guidance is for $400 million plus of price cost. Maybe talk about visibility on that pricing coming through, how that price trends in orders in the next several quarters and then a bit about inflation as well?

So today, because of the supply chain constraints we have, and again, we're in a good company, we don't think we are alone facing this environment. We're largely pricing to capacity. If you look at today the pricing for our company is in a range of about 10%; 10% is the range. And we're assuming inflation is going to be very close to that level being prudent. So if inflation is starting to be better, of course, as a result the margin in our business is going to be better. I give you 1 number. We mentioned that statistic before. In orders today, our margin in the Field business is improving sequentially, it has been the case now for about 3 quarters, about a point sequentially continuous improvement, assuming a high level of inflation, which might not materialize. As a result of that, when we convert the backlog into revenue, we would expect the Field margin to increase. We have mentioned that before, the Field margin improvement in Q3 should be in the 3 points improvement. A large part of that being run by our North America business. So we feel today because of the backlog, its size and the margin embedded and the conservative inflation assumptions embedded in this backlog, we believe the margin is going to be strong, and we believe we're going to meet our expectations as a result.

Right. And you have pretty good visibility as long as the supply chain is not moving around a lot. You have pretty good visibility on this because it's embedded in the backlog, right? So you're confident in that second half, what looks like a step up. It's more of a nice sequential trend. Maybe talk about that in the first quarter because I know that there was -- the first quarter wasn't spotless from an execution perspective, but there were still some positive signs sequentially in the gross margin, right? You were talking about that last night a bit.

Correct. So if you look -- let me talk about the backlog first, and I would speak about the margin afterwards because the characteristics of our backlog are unique. Our backlog is about in the Field business about $11 billion, as have been growing in the December quarter by 11% year-on-year. On top of that, you have a global product backlog of about $3 billion, growing at about 30%. This backlog is bespoke. What the orders we have are specific to what we do. In the Field business, we deliver a solution. You cannot replace our solution with another solution. And in 50% of the cases, the backlog for the Field is for a new building. You want to get the delivery of those products ASAP because you want to finish your building and rent it. So strong backlog in the Field bespoke aligned to new buildings. In the Field, you have another part of the backlog. The other part is 50%, is about retrofit. A retrofit with a high return on investments. You want to get that done very quickly. The backlog at our company has been very sticky and really been stable. No push. If you look at the product backlog, again, Applied is a very specific piece of equipment, very sticky. We have in Applied today demand for more than a year of supply, more than a year supply. That's why our CEO and Chairman, George Oliver, said on the December quarter, we're going to increase supply capacity significantly because the demand is so strong. Now you could argue, why is demand so strong when you have the macro backlog, a few factors for this. Government incentives across the planet, all equipments, in the U.S., in our country, 80% of the building of equipments, which are 20 years old or plus. So incentive all equipment. New equipment being very attractive at pent-up demand as a result of COVID. So the demand is very strong. The backlog is resilient. So let me now cover your second point, Steve, about the margin. So the margin went up in Q1 by about 138 basis points in aggregate. Global Products was up close to 6 full points and the Field was down by about 1 point. But that was your question in the Field in Q1, the gross margin was up 50 basis points. The segment EBITDA margin was down in the Field. Why is this? Because we're investing in a new ERP, and we're investing also in our vector growth. So you started to see in Q1, to your point, Steve, already the velocity of the backlog and a rich margin playing out. And then we will turn the Field positive in Q2 and we'll turn even more the Field positive in Q3 and you would get 3 points of margin. And the global product margin has been strong for a part of time. We believe it's going to remain strong year-on-year in Q2 and maybe stabilized, but this is a very good margin business today. So that's your margin question, Steve.

Got it. You've also guided to $340 million plus of SG&A and COGS savings. How much visibility is there to those -- to the cost out? And maybe just talk about the various -- the initiatives and the drivers there?

So originally, for '23, our productivity program was $260 million. We have now $340 million. That's $80 million higher than expectations. The programs are largely around standardization of the operations. As you standardize, you can offshore, as you can offshore, you have better cost, you can start to automate that have been the levers across all the elements of the value chain. Our productivity programs do not include activities such as moving from 140 ERPs to 2. That's not included. From rationalization of our SKU base, that's not included. The better operation for our Field operations. We have created now a function driving Field operations for the planet. That will drive efficiency. Those efficiencies are not included in the productivity program I have announced. That is to come. That's why, again, over time, as we execute, we believe we have margin power in the operation, not only by running the operations better, but also by driving a richer mix for our top line, more services, more digital, more solution, including sustainability.

Right. And there's -- I guess, the -- just remind us of what the total number is for that program this year? I think the number we talked about last night was like 3...

$340 million.

$340 million.

Correct.

Yes. And that you're reaffirming that number.

Correct.

Okay. That should be pretty visible. Anything else that's going against the bridge this year? I mean, there's, I guess, some supply disruption costs that you're still absorbing. There's some pension maybe. What are a couple of the other items that people need to keep in mind?

Two elements to keep in mind, again, that's included in the guide and the culture you gave us is give the good news and -- but also the less good news is FX. That's going to be probably a bit less than $100 million impact on the profit. And then pension income as well about the same amount, $50 million, give or take. So those would be the major headwinds to manage FX and pension income.

Got it. So the $340 million is actually net of whatever other supply chain disruptions that you're talking about?

Correct.

Okay. When it comes to the look to next year on these items. I mean, to get to the long-term targets, we're talking about some pretty significant growth. Obviously, you kind of gotten a bit of a hole last year on those long-term targets. I mean how achievable are the long-term targets?

So again, you could...

Are they out of the question now or...

No. You can do the math, right? It would depend on what we do this year. If you look at the high end, if we're at the high end of -- this is a squeeze question. High end of the guide, if we achieve the high end of the guide in '23, you will need 7% revenue growth next year. Is it a tundish? No. If we're at the high end of the guide, we need 150 basis points margin expansion. Is it a tundish? No. If we are at the end of the guide in '23, we need EPS growth of 24%. That's a good number. But we are clocking in those ranges at the moment. So I mean, again, there is a lot of work to do, to your point, the level of work we have to do is higher than what it was when we announced the guide 3 years ago. Ukraine was not at war. We didn't -- COVID was the rearview mirror. Inflation was a forbidden word in the vocabulary. I mean, of course, it was a different environment. Still '24 is still not out of reach. It's going to be more difficult, but not today, Utopia.

Yes. And in The Street is not there to be clear. I mean -- The Street...

For sure. And we're not guiding today for '24 either. The macro would be the key deciding factor. No question.

That makes sense. Stepping a bit higher level to some of the business model changes. Maybe talk about OpenBlue and what this does for you. I think there's a little bit of confusion around this being some sort of a software subscription product, if you will. I think there's an element to it, it's that. But it's -- to me, it's more of an enabler of the business model transformation you're going through and driving the profitable services mix. Maybe just talk about what OpenBlue is and what it does for you guys? An update there.

So OpenBlue is doing 2 things, which are 2 different things. First, we OpenBlue connect the device. You connect a chiller, you connect a BMS, you connect a security device. As you connect this device, you maintain it better. Now I want to be clear, all of our device is connected through a BMS. BMS give you an on and off signal in the best case. When we talk about connection to OpenBlue, we're talking about connection on the device, the scientists would call that connection at the edge. As you do that, you do preventive monitoring of your device. You know before a chiller going to break down that it's likely to be in distress. That's scenario #1 for digital. And that's going to allow us to drive the service business, is going to allow us to increase the win rate on our service business, is going to allow us to increase margin on the service business, is going to allow us also to increase retention of our customers. So that's OpenBlue play #1, game #1. The game #2 is smart building. What is it? You orchestrate what is happening in the building. We have today the room is full. We have, I don't know, 100 of us in this room. We have the technology to know. We have 100 people in this room. We probably need to clean the air a bit more. We give a signal to the chiller to clean the air a bit more. That's scenario #2 in digital. You drive comfort, you drive safety, you drive energy savings, you drive decarbonization through orchestration. Nobody else is doing that in the industry today. And as we have a strong capillarity in the building, we can offer those solutions. And you cannot solve global warming. You cannot optimize a chiller if you do not do digital play #2, and we do both. Those 2 digital revolutions are at the very start. We created -- George created OpenBlue about 3 years ago. Midyear last year, we were able to connect devices through a box, which is easier to install. And now we are in the implementation zone. So at just at the start of this digital revolution in the industry just at the start of the digital revolution at our company. And we're very excited by what that can provide...

And maybe talk about the attachment rates and your services business. 30% of sales, 2x the margin rates, how you see that playing out over the next several years through a cycle?

So services on its own could be a revolution for the shape of the financial performance of the company. Why do I say this? The service business is an addressable market across the world of about $160 billion per year, 1-6-0. Our -- we are a leader in the world in services with $6 billion. We have a market share, you can do the math, 4%. As due to privilege of focus on services, which is, to your point, twice the EBIT rate of the company. I repeat, services is twice the EBIT rate of the company. Through the focus on services, we used to grow services about 3 years ago at about 3%. Last year was 7%. This year, we're starting to be at 10%. What is happening? It's due mainly to us being focused on services, better offering, a compensation plan, driving services, a better training of the engineers, a better set of KPIs to make sure we drive our service business better. What this 10% does not include yet is the power of digital. Why is the power of digital important in services? The service market is managed by local players. They do a break fix. They come to a building at a scheduled time. As you digitize services, you can do preventive maintenance. A local player cannot play that game. So we think that the 10% of today has the opportunity to be higher as we keep executing and layer on top of it digital services. So we are very excited by what services could do at Johnson Controls.

Yes. And I think there's another element to OpenBlue and the services profile. I mean we were discussing, when I was in Milwaukee a couple of months ago, the productivity opportunity that provides for the -- you guys have 15,000 service techs running around out there. Is that something that's embedded in these cost savings today? Or is that something that's still -- as this digital product gets proliferated, that's something that's more on the come as another leg to the financial profile?

So digital, to your point, drive the top line, drive success rate, drive pricing and then margin. Digital allows you to run your operation better. We do not have enough technicians in the industry. All of us have college graduates that we train to make sure we keep feeding the technician pool, but this is not going to be enough. So digital allows you also to be more efficient in the way you manage your technician team. By the way, they're excited by that too. Because of digital, you only deploy a technician when you have to. You don't need to go because you need to schedule a monthly schedule. You need to -- you go because you have to, because you have the sign of distress. As a result, we can today increase significantly the productivity of our technicians. So you run the operation better, but also you're going to manage better bottleneck, you are going to have in terms of labor availability. So digital has also an impact on running the operations.

Can we take a step back and just talk about the -- more of like the core equipment markets. So you mentioned the HVAC stuff on the commercial side, the chillers, you're expanding capacity. How fast do you think that market is growing from -- on a unit basis? I guess you can use orders. I guess, what -- because supply is going to constrain some of that. But how fast do you think the global chiller market is growing on a unit basis? And how are you guys performing against the market?

So if you look at in the total market share with the exception of North America resi, we have been maintaining our shares largely. That includes also Applied and that, of course, includes chiller. This is a market which in units is growing mid- to low single digits, low single digits is the growth. As I said at the outset, today, we have more demand that we can satisfy. By the way, that's true for us. That's true for the market because again, we're not losing share. So we're in the same position as everybody else. So we are ramping capacity. And then you could say, why do you do this? I'll go back to what I said at the outset when we talked about the market, old equipments, incentive programs, new equipment being much more efficient. Let me mention the incentive programs. If you look at the IRA in the U.S., $370 billion of incentives over 10 years. When you have $1 of incentive, you sell $5 to $10 products. It's a -- it's just for the U.S. The IRA has not hit the market. Our best modeling indicates that the IRA will start to impact the demand in the market in about 2 years. That's why George Oliver, our CEO and Chairman, said on the December call, we are going to double chiller capacity. We're going to double chiller capacity in the next 12 months. And we are ramping capacity as we speak. Sequentially, we have increased chiller capacity quite substantially this quarter. So again, we feel the demand is there, the commercial and the client in particular.

If you look at your entire portfolio, there's obviously increasing concern on the macro, I guess, mostly around U.S. commercial office. That's the one that kind of stands out right now with relatively high vacancy rates. And I don't think some of these retrenchments and technology markets are going to help very much on that front. But what is your exposure to office globally and then just in the U.S.?

Yes. So it's a great question. A question we don't cover enough. So the office building for us is about 10% of our demand, 10% globally, globally. So the vertical we serve are hospital, government building, manufacturing, data center and those markets are very strong. Let's speak about the office building. It's a good news what you said. Why is it a good news? One, the level of technology deployed per square footage is increasing. So maybe you use less square foot to run your operations, but you deploy more dollars. You deploy more dollars because you want clean air, because you want to have better equipment and so on. That's point number one, good news. The good news number two is nobody is going to leave an office building empty. People are going to live in this. We're agnostic. Employees living on it or families living on it is good for us. A large building in Manhattan, empty -- will not stay empty for too long. It's a good news for Johnson Controls, because it's not a residential space. So we're not -- so it's a low part of the revenue, more dollar per square footage and net-net, we are agnostic to who is in the building as long as it's used, and it will be used in one way or another. And buildings have long leads. So it's not something which is going to happen overnight. It's not an on and off demand signal.

Right. And there's also -- you guys have a significant percentage of services. So it's kind of a different profile than just a new building being put up. What are you guys seeing in Europe? Train makes a lot of noise about their European commercial business. What are you guys seeing there? And how are you performing relative to the market?

So again, I mean, you can guess very close to this part of the world for obvious reasons. We thought that the market would go in negative territories. It hasn't been the case. The market is behaving well. We have avoided an energy crisis and the demand today is performing as per our expectations and this is a growing market.

And are you guys keeping up with the market? What are some of the key products there, heat pumps on the commercial side?

Heat pump is today growing faster in Europe and also in the U.S. where we have a relatively low penetration rate, but heat pump is the big theme in Europe, either in resi or in commercial. That's why we're investing in the portfolio. That's why we believe we have one of the most competitive portfolio of heat pump in the market. That's why we do acquisitions of IP in this market. And that's why 90% of the new product introduction has some form of heat pump technology in them.

And then Silent-Aire and the update on data centers, that's another area of debate that we're having more and more sustainability of demand in data center.

So year 1 of the acquisition, the market did not perform as strongly as we had expected, did not. Not because we lost shares, because our key customers didn't buy as much as before. We had a 180 degrees change this year. The demand for data center from our customers, and we have won a few new, is very strong, more than we can, again, fulfill.

And then Fire & Security, kind of a part of the portfolio nobody talks about. What kind of trend are you seeing there?

So it's 40% of the revenue organization. We like Fire & Security for a few reasons. They are a bit intuitive. One, it's a very -- I mean it's a great part of the portfolio. I will explain why we believe that is. And two, it's very profitable. It's at the high end of our margin pyramid. Why do we like Fire & Security? First, they are very synergetic. If you offer Fire & Security in the building, you know who is in the building, it's security. You have a fire, you can then offer a solution to your customer that nobody else can offer. When you have both, deploying digital, you offer a solution that others cannot offer. So we like the synergy between the 2. What we like also about the security is that security is evolving. The technology is evolving. We talk more and more about computer vision in the security space. It's relatively easy to change a security device. You're not going to change a chiller. The costs to exit are too high, but you would change your security product if the technology is really different. So for all those reasons, synergy in the context of smart building, strong margin, new technology. It's a business which is very exciting for us and total part of a smart building offering.

And can that grow? Can that keep up with the commercial HVAC? Growth rates as a perception that it's much lower growth in the commercial HVAC stuff.

We think it should keep up with the commercial HVAC business.

Okay. Any questions?

[indiscernible] [ access to funding ]?

It hasn't been today. I mean, we looked at what happened in the U.S. last week, of course. The demand today for what we do is still strong. So funding has not been a key constraint despite high interest rates.

And I guess a follow-up on that. In COVID, you guys performed like everybody, a lot of guys did pretty well. Given all these -- given the cost structure you're going to come out with after rationalizing, given the growth in services and the margin there, what would be the playbook for a mild recession where your revenues went down 5%? How should we think about the deleveraging on that?

So I mean, like everybody else, in the business world, all of us have a playbook. We have our playbook as well. We have executed on this playbook well during the COVID year. We believe that in the situation, we would have a mild recession, we could maintain the profit rate of the organization.

Flat margins?

Flat margin.

And that's mix? Cost structure...

It's mix. Its cost structure. It's all of the above, correct.

Right. On free cash flow, everybody has had challenges with supply chain. You guys are, I think, guiding to 80% to 90% this year. When can we sniff 100% on that metric conversion?

So there are no questions. No question that we are 100% free cash flow conversion company. No question about this. If you look at today what is going on, CapEx are flat year-on-year. They have been flat for now the last 2 to 3 years. We can run the operation and execute on the road map, I've described today with flat dollar CapEx, point number one. DSO is improving. DPO is improving. It's all about inventory. And it's all about supply chain recovery. We're working hard on this, of course. The inventory will normalize. We believe we're going to be in the 80%, 90% free cash flow. This year will depend on inventory, but there was no question that this inventory will be solved and that we would be a 100% free cash flow company.

Is that something that you can target for '24? Or is that more aspirational for fiscal '24?

We should be able to target that for '24.

For '24?

Yes.

Okay? Any other questions out there. When it comes to this -- you talked about price and orders, orders up 5, with high-teens price. And for most cap goods analyst that implies that volumes are down pretty substantially. Maybe help explain how you guys account for price and volume in the Field business, because I think it's worth noting that there's some nuance there, some pretty significant nuance there.

Right. So I mean, clearly this is a confusing message. I think the way to think about this is, today, the ability we have to price -- to value and to price when you were in a supply market allows us to increase margin in orders regularly every quarter. As I said at the outset, in the December quarter, order margin in the Field were up by 1 point sequentially. So -- and we are assuming, again, high single digits inflation. If that's better, then the margin will be better. I think it's the way to think about this, because for the Field business units when you sell a solution with a lot of solution around it, some Blue products, which could go away, the unit measures start to be irrelevant. So the way to think about it is margin in the Field in orders is increasing every quarter. That's the way to think about this.

And your products, whether it's a new chiller or a new fire security system, that volume continues to grow to the extent that you're adding capacity. It's kind of the third-party content that you may not be dealing with in the particular project that you're pursuing.

So the answer is yes. Why is this? Third-party products have lower margin, and we want to improve the margin profile of our company, that's factor number one. Factor number two, we will increase volume this quarter. Volume will be up.

Right. And in revenue, in revenue.

Of course.

Yes. And orders? I mean, not orders, though, because orders obviously are how you guys define it. Volume of orders will still be mathematically down?

So just -- so what we said at the outset, orders in the quarter would be mid- to high single digits.

Yes, yes. Again, with a high level of price, that means the volume technically is down...

Correct. Now again, on the order, you speak about the Field, you speak about the solution you speak about third-party products that we might not be interested in having year-on-year.

Okay. Anybody else?

[indiscernible] right now. Can you just talk about [indiscernible]? And what those will look like 5 years from now? [indiscernible]?

So it's a -- so the question for the audience, what will happen to the lower margin part of the business over time? So let me -- I'm not going to give you a precise answer because this is not a precise answer. But if you look at the margin profile of our business, service mix, operations being run better, less ERPs, less number of SKUs, Field operations being run in 1 model across the planet. When you stack -- and us being very selective on installation and only doing installation when we drive a service event at the end, when you stack all those levers, you see margin expansion in the business. If I was to give you a precise answer, the install is a part of the business where the margin would be improved. Through operations, number one, and being very selective about the installed business we take.

Great. Thanks.

Thank you very much.