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

I would say in most markets, they're almost doubled than the systems margin. So you really think about that multiple. Now there's part of our systems market where the margins are very high where we really have differentiated product either because of great technology we've deployed or really thanks to the engineering we have. So particularly on data center, we've created a highly engineered solution that really lend itself really well with the need of that particular vertical. And we've been able to drive both volume and improvement on margin on a market that historically wasn't a great market from a net operating margin standpoint.

Okay. And then as part of the -- maybe just talk about that. The service attach rates, I think, were -- math, I think that maybe 20% or so back in FY '20. Now I think they're 48%. So maybe talk about selectivity on projects, i.e., walking away from projects where there's no service attach on the back end versus actually going back to your installed base and converting that back to a JCI contract. Maybe just talk about those two.

Yes. So the project selectivity is not so much walking away from projects, but it starts much earlier in the commercial effort. So as you build a pipeline on that $400 billion market opportunity, deploying your resource, whether it's marketing, frontline sales or any sort of lead-generation effort you have to try and get after that opportunity, very early on understanding your market, understanding the vertical that play well, understanding where the customers looking for solutions are the best position, that's where you actually get to that better margin in systems. Once you do that and once you get into that part of the market, you don't really have to walk away from anything. The rest comes naturally. Once you have that revenue -- and that backlog, I'm sorry, of project opportunity, you have better visibility on the margin expansion in our building solutions business. But you also therefore allow the manufacturing side that lends in the global product to have better visibility into what type of products they're going to need. And you now create a better absorption, a better lift. Our inventory levels come down because we have better predictability, and the overall cash performance of the overall company improved. I'm sorry, you had a second part of your question that I'm missing now.

I think it's gone back to the installed base and converting...

Oh, yes, the service side of that. So once you have refocused the front end of that pipeline, you have a good idea of how to attach that service rate and focus them. You also have a good idea on resisting installed base, which are the market players or the market vertical, which are the most attractive from an attached service rate. And by the way, we prefer to service our own product, but we have multiple time attacked the service space of our competitors. If you walk into a large facility like this one and you go to the chiller room, you're probably going to see 6 or 8 chillers. Not all of them are always going to be your chiller, even though they all should be your chiller, it's the best product on the market. But some of them may be inferior product from other competitors. We will go and try and address the entirety of that install build within that building. And then the flywheel comes in where we can actually start servicing the controls system or the fire detection or security business. And so that's where really attacking that installed base is critical. We have a good idea of where the opportunities are. But I can tell you, historically, there are subsegments of the market where we've played in where we have installed where the service opportunity is not always ideal. And so to tell you that we'll go after 100% of our installed base is not a reasonable expectation. But I think we should be in the 66% to 75% range for sure.

I'll take one more question, and then we'll throw it into the audience. Can you maybe talk about the kind of the challenges that JCI has experienced on free cash conversion and how that changes? And what is your confidence levels that we can be closer to 100% in 2025 as opposed to 80%?

So first, you got to understand the fundamentals of our cash flow conversion. And the way of effective tax rate and our cash tax rate have a bit of a disconnect. For good reasons, by the way, you want my effective tax rate to be lower than my cash tax rate to get after the opportunity from really net opportunity from a tax standpoint. But that delta is 5% to 6% right now, and that creates a drag versus 100%. We still have a large pension income. As you know, pension income is not really a cash return to the shareholder. That drags that performance a couple of points. And we are still making large investment in our ERP, trying to streamline and simplify our business. And then finally, there's great market opportunities, particularly in data center but other vertical where we need to build capacity. And we've spent a little bit more than traditionally in deploying that capacity against those growth markets. You put all of that together, I'm really comfortable telling you that we are going to be able to an 85, 90-plus converter in the future. And it will improve from there. So what needs to happen to improve from there? First of all, that cash tax rate. Global minimum tax will actually put pressure on our effective tax rate. Maybe not in the short term, but in the medium to long term, it will. It will not dramatically change our cash tax rate. So that delta will come together. We've taken action to bring -- to reduce a little bit of pension income to align better assets with our liabilities, and that will also give us some lift. And then as we get towards the back end of the deployment of the capital expenditure on our ERP program, in the next 18 to 24 months, that will also provide lift to ultimately much longer term getting higher than the 85% to 90%. As far as our historical performance, there's a lot of things that explain where we've been and why we've been there. I think the challenges from the supply chain, the manufacturing standpoint, where we ended up building more inventory than we have traditionally done to try and improve our processes, as well as the lack of deployment of our operating model in some of the markets, that created more variability in our operating performance. That variability reduced a little bit the quality of our earnings and ultimately impacted our ability to have a high conversion rate and a high quality of earnings. It's a prime focus, I can tell you, of mine for the next few quarters.

Good answer. Any questions? One in the back here, please. Do you have a mic? Thank you.

Could you elaborate on what has been the big driver of your improved service attachment rate. As you will need to go from 50% to 75% or greater, what investments need to be made?

Great question. So not a lot of investments per se in terms of dollar. It's really back to that redeployment in our sales force. The big change that have happened are really from a commercial resource standpoint, the way we deploy those commercial team and the way we compensate them. We've forced or realigned a lot of that sales force against part of the market where the service attach rate is better. We've also redeployed resource-specific teams that are solely focused on getting after that service opportunity and that service growth. And so it's more of a reallocation of resource than an additional investment. But as we continue to grow, there is always more investment in sales resources that we need to do. But those, I would say, grow in alignment with our orders and our revenue. The long-term game of the service business is really around labor and labor productivity. And that's where our digital offering and our connected asset structure come into play in a big role. What we've really been able to validate by connecting more than 20,000 assets over the last few years is we've now collected more information on how those assets perform, operate. We're being able to be more predictive in our maintenance. And when you're more predictive, you're more productive. But we've also been able to actually start yielding a lot of information on your normal wear and tear that you can expect by type of product, by type of assets. And that allows our frontline labor team to actually be much more productive and show up on the job site with actually the parts and component they need. Having that labor more productive is really a big part of unlocking that growth. The market opportunity from a service standpoint is almost unlimited, but it's about being able to build that labor and workforce as productive as possible. And that comes with investment into digital infrastructure. We've made that investment, now we are leveraging to a greater extent.

Good question. Anyone else? I think that's it. Can we talk about the portfolio disposals? Maybe just give us a bit a little bit of color on the process, any timelines we're working towards here, any news we can look forward to?

We are on the really final stages of a multiyear portfolio assessment. In terms of timeline, I wouldn't want to peg ourselves because it never leads to the right outcome. Our critical priority is speed, but first and foremost, maximizing shareholder value, and those two priorities sometimes conflict with each other. As you know, some of those assets have more complex ownership than an outright sale because of partners that we may have in those assets. But I can tell you that we are doing everything to get after the execution of those transactions and return back to shareholders of the proceeds as quickly and as efficiently as possible.

So am I to interpret that as saying that perhaps some of the 25% might get done this year, but some might push a little bit longer than that?

I am not going to commit on any timeline. We're trying to do as much as possible as quickly as possible.

That's fair enough. Okay. I appreciate that. Maybe talk about kind of what you're seeing out there in the market. I mean, I think we saw very strong growth in orders in systems and service during the quarter, backlog expanding very nicely. Is that continuing? You've still seen some really good healthy trends out there?

Yes. The health of our backlog at $12.6 billion has never been that good. The quality of the jobs and the margin we've put in the backlog is also unprecedented. We are going to continue to see an improvement there for two reasons. The first one is the growth we are seeing in the data center vertical with those big, lumpy orders, we are seeing that pipeline continue to grow. And so we think it's going to continue to come. The exact timeline of those orders are very lumpy, that's why we never really provide guidance on order. But what comes with that is we've built such tight relationship with those colos and hyperscaler, we're starting to plan with them for data center that are not going to break ground for another 12, 18 months. So that means our backlog is going to keep on building up with revenue that go further into the future. So our ability to turn the backlog within the current year, it's going to shift a little bit. But it's coming from really great verticals and also very healthy margin. If you look at the field, the business solutions systems across the different region, Asia Pacific, we've gone through a reset. We see Q4 as really the return to growth. I think you're going to see that backlog growing again there and that volume to go back up. In EMEA/LA, the past 6 months, we've gone through that repivoting that I was explaining on the commercial side. As you know, I wear two hats, and I've been taking that team through that repositioning. We are seeing a return to growth in that business in the second half. And now that we have really focused that commercial team against the parts of the market that are the most attractive but also growing the best, we are going to see some lift there. And then North America is more mature in the operating model, and we are going to continue to see a good progression there, both on the systems and the service side. So I think that all of the fundamental tailwind from a decarbonization, electrification of the building as well as sustainability, I think are supporting that backlog and that growth in the building solution across the board and across the regions.

Okay. And the EMEA/LA margin returned to double digits in the back half of the year. Given your background in that region, what's your degree of confidence there?

Yes. So I'm very confident that we are going to get there in Q4. I think Q3 is probably a little early to get there. The goal here is to create a sustainable operating model where we get back to double-digit -- we'll get back -- we get to actually double-digit operating margin in that business. That business hasn't seen that level of return, I think it's 7 or 8 years, so it's almost history there. There is really no market or label or technology reason as to why EMEA/LA shouldn't have similar operating margin as the other region except for the deployment of that operating system consistently across the market that, that region cover. And so we had to reposition a little bit some of the market, walk away from parts of the market where the life cycle solution wasn't going to play well or we were never going to get to a critical mass to be able to drive that profitable operating margin. We need a critical mass to operate at a high level of margin. And if we don't have that high level of margin, we don't have that critical mass, we then instead of deploying the business solution and go-to-market strategy, that's why we have a global product distribution model that can then come into that market and still capture some of that market in a more efficient way and a better net operating margin for the company.

Right. We're getting close on time here, but I do want to have two more questions on maybe the current trends. APAC, you mentioned reset. So how do we -- so we start to see the turn in the fourth quarter. Kind of 2025, should we expect there to be a strong bounce in that region? Or do we just grow normally off a reset base?

It's a bit early for me to talk about '25. What I can tell you is the quality of the pipeline that the team has been able to rebuild on the back end of having a leading position and being probably more exposed than most towards the large construction aspect of that market. And that's a market that really, with what happened in the real estate market, really pulled back very, very quickly. We had to repivot the resources away from that traditional market where we have a leading position and double down on other parts of the market. We've been able to do that. I think we are seeing an improvement in that pipeline. We're seeing the order growth continuing. I think that momentum will continue into '25 for sure. Now will it go to double digit or high single digit? It's difficult for me that early on to already commit to.

That's fair enough. And then in the Global Products portfolio, we've seen pretty significant headwinds in residential HVAC, the Fire & Security Products business as well on inventory adjustments. Are we seeing that turn in the back half of the year, that you expect?

The destocking on resi has really started to slow down and turn very quickly. The early sign we're seeing from an order standpoint in Q3 are very positive. May and June are going to be critical for the success, particularly in North America, for the success of that business. I think the early sign of what we're seeing are pretty healthy and actually align with where we've made commitments. But it's a market that's going through a couple of shifts at the same time with the refrigerant change we're seeing in some subsegments of the market as well as kind of a little bit of conservatism from the distribution channel in their inventory level. I think that inventory management has now normalized itself and I think you're going to see a more traditional seasonality in the business. And we're seeing very much a positive lift. We've dealt a lot with the base cost of that Global Product business, meaning a little bit of volume improvement goes a long way in the bottom line. There's a lot of leverage there. So we are very much focused on that commercial effort, adding more dealer, adding more lines of distribution, to be able to get after that volume increase on the back end and into '25.

That's great news. All right, Marc. We draw a line there. Thank you very much. That was a great discussion.

Thank you.