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

All right, everybody. I think we're finally ready to get on with the next presentation. Sorry for the delay. Excited to have in person with us today, Olivier Leonetti from JCI, JCI's CFO. Olivier, great to see you.

Great to see you in person for the first time.

I know. It's amazing. I can't believe it. All the Zooms. But it feels like we've met before, but this is -- it's great to have you here. So let's kick it off.

Look, nice quarter. Why don't we start there? But before we get into the quarter, look, there's been -- you've been at JCI now for -- what -- 3 years, a little over 3 years. Maybe just talk to us about like the evolution of the company over the last 3 years, the cost transformation journey, where you are today versus where you were and where you're going?

So it's unusual to have this kind of question. And I was pleased that you asked it. The transformation of the company has been remarkable. I mean if you look at this company, we have been in business for 140 years. We are very proud of our heritage created in Milwaukee, Wisconsin. We have a strong culture, but we went through before a set of holding companies. We have been an operating company for about 3 years plus, not much more. And over the last 3 years, the transformation of the company around all the elements of the value chain has been remarkable. From the way we deploy capital in R&D to the way we build products, the way we go to market, the way we service on all the elements of transformation has been remarkable. That was behind the productivity program, this transformation and much more to come. I believe we have -- just at the start of a multi-years journey when it comes to the transformation of Johnson Controls. And we talk about why I believe that during this conversation.

Great. So why don't we get right into it, right? You talked about this $550 million in cost-outs that you promised with $250 million coming in cost of sales, another $300 million in SG&A. Maybe just talk to us about the progress that you made, how confident you feel in the synergies for this year. And then we'll talk about the longer-term perspective as well.

So we feel very confident about our ability to deliver on this productivity program. We have announced the number you mentioned at the start of the year. We are on track. But we believe we're not going to get done. When it comes to the transformation of the P&L shape of the company, you're going to have a few transformations going on. One, as we drive a richer mix of products, more solutions, more services, better deployment of installation, you will see an increase of the mix. As we run the operations better, as the supply chain is less being disrupted, you would expect the cost of manufacturing to improve. And we have a fair amount of work still to be done in scaling our SG&A. So we think today that we are, again, in a journey when it comes to the transformation of the P&L, in the evolution of the productivity. That's why we have said we should have enough levers to have a level of incremental, which is in the 30% range.

So is that the right way then to think about all of the synergies coming through this year, beyond this year? 30% incremental margins, assuming supply chain, which has started to ease, normalizes, you should be able to deliver on that going forward?

Correct.

Okay. Great. So let's talk about the supply chain, right? And you were able to over-deliver on the margin expansion that we saw in the North America buildings business this quarter. I think everybody is expecting 100 basis points, you put up 190. How much of the improvement was really dependent on supply chains finally starting to ease? And then what confidence level do you have throughout the rest of the year on being able to deliver on the targets that you've set forth?

So if you look at the Building Solutions business, we used to call that the field business. It's a long-cycle business.

I still call it the field business.

Yes, but -- you book an order today, you deliver with the supply chain disruptions 12 months after that. So when you lock a contract at a certain price, when inflation is transitory, you can understand where we have ended up. Even if you can renegotiate, you could have a margin impact. So we have been reacting quickly in changing the margin on the orders. And the margin on the orders have been improving regularly all through the last 4 quarters. In the current quarter, the margin installed is still increasing sequentially in orders. So that's orders. Now let me answer to your question about in the P&L. We are now realizing the rich margin backlog in the P&L. You started to see that actually in the December quarter. The gross margin of the Building Solutions business in Q1 was higher year-on-year, not the segment operating margin. Why? Because of the scaling of SG&A. Why? Because we have been investing in rationalizing our ERP footprint. We have invested in services. We have invested in digital. In Q2, the gross margin has been increasing year-on-year even more, and that has covered the SG&A. And the SG&A in dollar is going to be now -- the investments are going to be more muted in the second half. That's what is happening. And we believe that the Building Solution margin in the second half is going to keep increasing. So now in the P&L, the Building Solution is going to take over in terms of margin performance. So you should see strong improvement in the second half. Then you ask level of confidence. Level of confidence, for a few reasons. One, the backlog is strong. The backlog is resilient. The backlog has a strong margin. Resilient mean we haven't seen any cancellation or pushout. So the backlog is $12 billion, growing 8% year-on-year. That gives us confidence. We have also a strong performance in the service business, starting now to perform at double-digits low teens rate. And we think we are just at the start. We have leverage on the SG&A line. And when you look at the macro, at the commercial level, the commercial market is growing. And some actually institutions see the growing -- the commercial market growing even faster than before because of all those indicators. And the last one is the strength of the pipeline. We feel confident with the guide we gave you, including from a margin standpoint.

There's a lot of goodness to unpack there, but let's just -- let's take each piece. So SG&A, it seems to me that on a sequential basis then, you're not expecting much of a change in the SG&A line so that you can scale. As revenues increase, you can scale and leverage that SG&A. Is that fair?

We could start to scale in the second half. I mean, you speak about the sequential decline -- trend. The revenue is going to be more elevated in the second half. But scaling is something you will start to see even more in the Building Solutions business.

Okay. Great. And then talking about the margin, the gross margin, specifically in the margin that's in your backlog, you just started the see it over the last 2 quarters. We know that there's been a lag from what you've seen from a pricing perspective in your order book versus what you're actually seeing in your P&L. So it seems like we're probably at the start...

We are.

Of what could be very good gross margin expansion in that business going forward?

Correct.

Okay. Great. I think one of the things that really stood out to me this quarter was that your install business -- really just across geographies. So let's just talk about North America. The install business was growing at a much faster pace than your service business was. So your order rates are a lot faster right now in your service business than install. Service tends to have, what, 2x the margin of install?

Correct.

Okay. So talk to us about what you're seeing specifically on the service side of the business and why it's growing at a double digit CAGR at this point.

So let me -- I will answer to that in a second. Let me speak about the install for a second. We want to do install only if we drive a service event. And we have demonstrated, we believe we have the insight to demonstrate when you do install, you have customer intimacy. When you have customer intimacy, you drive services. So we want to drive install for service. And we want also to optimize the install margin. There are a few activities, maybe we talk about that later. So that's one on install. On services, it's a large market. $140 billion, $160 billion addressable depending on who you talk to. And we have a market share of about 5%, 6%. We're the leader in the world. The margin is very rich. We have a Building Solutions business, which allow us to address this market. And the growth of services used to be about 3% about 3 years ago. It's now 10%. The difference in growth rate, Joe, has been due to only more focus on the traditional service model. Better comp design, better training of the engineer, better service events, the management team looking at services day in, day out. That's what drove the 3% to the 10%. The impact of digital, which is going to be the ultimate transformation of this business, where you could really disrupt the local players doing mechanical, that's starting as we speak. So we gave you a statistic. We have doubled the number of chillers being connected last quarter. We believe that all chillers are connected, but they're not connected with edge compute. That's what we're talking about, connection to an edge compute. We have doubled the connection. But by the end of the year, we will have connected only 10% of our chiller installed base. So you see all the headroom we have in chillers to connect. We will connect controls at the end of the year. And we keep connecting through smart connection the rest of the portfolio. That would allow the service business to grow even faster. As you connect, you drive insights, you deploy AI, you deploy ML. You start to be really driving an amazing value proposition for your customers. So that's why we believe that the service business should grow potentially at an accelerated rate going forward.

That's great to hear. It's interesting. You mentioned in that answer, you mentioned deploying AI, right? I mean, it's still early stages. And we haven't had a ton of discussions heretofore about AI. But I'm curious, like how do you see that potentially impacting your service capabilities?

So as we -- so the impact is going to be immense. How immense it's going to be will have to be debated. All of us are looking at this in the industry. We are not unique. Digital is a big part of our strategy. Digital is a big part of developing the full potential of the Building Solution and digital and AI go together. So of course, we are talking with the large technology company to deploy AI. And we see today quite amazing impact as you manage data. And that's going to be a strong differentiator for our company, Joe, strong differentiator.

So you talk about really 10% of your installed base is -- has been penetrated...

Chillers.

Yes, chillers. Chiller installed base has been penetrated at this point. I mean, how do we put it into numbers just in terms of like what the expectations should be then for your service business going forward? I know 3% to 10% is a pretty big leap. But by no means do you expect your service business to grow double digits over the coming years, right?

We believe that this business should grow above 10%, for sure. No question about this.

Okay. All right. That's punchy. Yes. That could be really good for your margins going forward. I guess maybe taking a step back and we'll kind of discuss the longer-term earnings framework, right? Like you guys -- and I know the environment is a lot different than when you gave your original framework. It's really calling -- let's call it like high teens to low 20s type EPS growth. And clearly, there's been an uneven path in the last 12 months right, specifically as it relates to all the supply chain issues and inflationary pressures that everybody has experienced. How do you feel about the long-term framework today from where we are today going forward the next few years?

So you go back to some of the themes we have discussed, better mix of products, more solutions, more services, more targeted installation business to drive services, very competitive set of commercial products with heat pump and new refrigerant. So you see a positive impact due to product mix and solution mix, that's going to expand margin. A better manufacturing tool. Again, the manufacturing operation is still being disrupted. We have inefficiencies in manufacturing that is being worked out. More leverage on the SG&A, usage of digital to wrap all that around. The margin potential of this company as we execute is going to be very strong. And I go back to the 30% incremental I discussed earlier.

Yes. That should basically be our North Star going forward.

Correct.

Okay. The one thing I did want to ask about the North America business that I failed to ask earlier was you talked about improved velocity this quarter. So maybe just touch on that. Specifically, what's really changed? Was that just some supply chain easing? What's enabled the better velocity in turning around the backlog in that business?