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

Well, thanks, everyone, for being here. It's my pleasure to have up next Johnson Controls, Marc Vandiepenbeeck, CFO. Thanks so much, Marc, for being here. I think we'll get straight into questions, if that's okay.

Perfect. Yes.

And so first one, nice to have you here, of course, without sort of bringing someone else in as well. But you have a new CEO joining in, well, a month, a bit less than a month, I think. Sort of what are you most excited about to work on with him when he joins? JCI has already done a lot the last couple of years since you become CFO, even there's been a lot of change in a small period of time. What type of things should we expect? What type of things are you looking forward to getting stuck into?

So we've worked a lot over the last past years on our portfolio, our market focus, kind of what's the mission statement for the company and how we organize ourselves. And I think the next level of opportunity for the company from a growth and profit standpoint is really reorganizing our operating model. And what I'm the most excited about is Joakim brings an enormous amount of experience around developing, deploying and living through transformative operating model change at Danaher and in his prior experiences. And it's really coming at a great time for JCI as we have now really focused ourselves on that commercial Building Solutions market, driving the maximum opportunity from a cross-domain standpoint and continue to feed and accelerate our service growth across the life cycle opportunity within our products. We have a lot of great key vertical megatrends that support our growth. And so it's really about organizing our operating model a little bit better, more targeted and more growth-oriented and driving that leverage across the organization over the next few years. And he is the right man for the job.

Great. And if we start with that top line perspective, I think you've got sort of mid-single-digit type organic growth penciled in for the current fiscal year. Is that kind of the right way to think about the medium-term framework with that new operating model and portfolio?

I'd say our current algorithm of mid-single-digit growth stands as it sits right now. But as you know, with the new CEO coming in, Joakim, who is going to have kind of an outside perspective, fresh set of eyes into how our operating model drive growth, how we address customer and market opportunities in the most effective way, I think there's an opportunity there potentially to accelerate that growth, probably higher than mid-single digit over time. We do right now target in certain parts of the market, bigger growth than that but there's some fundamental in our portfolio that is kind of restraining that growth. Some of our more traditional construction index businesses see growth in the low single digit, if you'd like and that's dampening a little bit our ability to go past that mid-single digit. There's obviously verticals and I'm sure we're going to talk about it like data center or health care growing in the high double digit and higher that actually drive a lot of the potential growth. But there's a big part of the core business that's not seeing as much growth as you would want at this stage. And some of it can -- some of that growth can be unlocked by improving our go-to-market strategies and reorganizing a little bit the way we approach the markets. Some of that growth will come with new product innovation and kind of better portfolio management of our capabilities.

And if we think about, I guess, that sort of access of -- you've got the different product offerings of the company and solution, there's HVAC, Fire & Security, Building Management Systems, let's say, those kind of 3 or 4. And then to your point, vertical-wise, data center, health care doing very well, maybe at the other end, office, multifamily. So when we look at that kind of matrix, how does it stack up? Like do we finally say that HVAC is outgrowing Fire & Security in most verticals, most of the time or it's very kind of vertical dependent rather than JCI's offering within each one?

It's much more vertical dependent. So I'll tell you, our BMS business on the data center segment is growing as fast as our HVAC business in that particular. Same thing for Fire & Security to a certain extent. In parts of the vertical market where we don't see growth in Fire & Security, it's the same thing for HVAC & Controls. So it's not like you're going to see HVAC growing 20% in office or commercial real estate and fire staying low single digit. The dynamic of that markets are the same. Now each domain, each product line has a different mix of market exposure versus one versus the other. And our Fire & Security control is more tilted towards commercial real estate and your more traditional construction markets than maybe the pure HVAC industries. The pure HVAC industry has certain kind of megatrends that support it. I'm thinking particularly about Europe and what you see from a commercial heat pump standpoint and large-scale heat pump projects around district heating or district cooling in the Middle East that really drive massive growth where there is a Fire & Security play there but proportionately much smaller than the than the HVAC one.

That's helpful. And I know it's always been tough to sort of cross-sell a lot of this stuff into the building. There's different purchasing managers within the buildings. But maybe how has that progressed in terms of that cross-selling ability? Has it developed at all in recent years? Or it's just the customer kind of moves so slowly, you don't really see it yet.

It's improved but we probably only cross-sell across all of our domain about 10% of the time, if you think about a customer account standpoint. And that opportunity within our space is generally between 15% and 25% depending on which kind of industrial capability or buildings capacity compare yourself. So we're far from entitlements. That's for sure. It's much better than a couple of percentage points we were just 5 or 6 years ago. There's 2 things that have been a little bit hindering that ability. The first one is, the way we are organized, where we were organized by channel instead of being organized by markets where, it's something we're thinking about very seriously, getting organized by market, having real market back -- account back management instead of channel forward, actually will drive better cross-selling opportunity. Generally, when we approach an account, we always win with one particular domain. It's not always HVAC. It's not always fire, we approach with one domain and then we expand. And so you really need to create an account planning and account mapping around that to be able to win across multiple domains. It's going to work with a lot of customers but it's not going to work with every -- in each customer. But our larger accounts and our larger vertical are generally highly concentrated type of accounts where their expectation is JCI should be able to help me across those lines. So we often talk about data center, where we're able to cross-sell quite a bit. But I often refer to the health care vertical is for us, one that's growing extremely well. What you see in that health care vertical is we're able to cross-sell in the vast majority of those accounts. They generally want controls with HVAC. Once we have control, fire detection comes in very quickly. And for the most part, security and access control becomes part of an embedded offering. It's also a vertical where the customer are generally very excited for an OEM to stand behind their product. And so the service attachment rate is very high in that verticals 70s, 80s.

And on that point on service, I think it's around 1/3 of revenue today. How much of that business is kind of contractual in nature versus just kind of parts? How would you assess the strength of that business versus some of your fire or HVAC competitors?

Yes. So the vast majority of that business is based on contractual agreement. The contractual revenue part of that is a little over half of it. And the other half is all of the parts and chargeable hours that our technicians spend with those customers, what that service business does not include. And I'd like to reinforce that because that's not the definition everybody uses for service. It does not include our retrofit business. So any upgrade, any kind of anything that's system like, installation like, we keep that in install completely separate. We want kind of the purity of that service business being very much recurring revenue, mostly multiyear experience with the customer that drives really that predictability and also better margin overall.

Yes. And you mentioned it is a sort of recurring activity. Any clarity you could give us around sort of attrition or retention rates in service? How have they evolved recent years?

We've improved a lot on our attrition. Our growth attrition is probably in the low teens to the high single digit depending on the domain you're looking at. We've done a lot of work in improving our operating model and simply our customer engagement to make sure that we actually get ahead of that attrition. There's a lot of early indicating sign of a customer thinking about switching to a different provider or thinking about just not continuing with the service contract. And [Audio Gap] that customer experience and that value [Audio Gap]. What I will tell you is one of the big driver that has really changed the momentum on that attrition is our connected services. As soon as that service is not just a service contract break fix but we have a connection, it's a connected chiller, it's a connected control system, it's a connected fire panel, that preventative ability, that detection of fault has really allowed us to demonstrate the value of an OEM servicing that product much better than we have with our nonconnected contracts. And you've seen the attrition in those contracts really collapsing versus a contract that would traditionally be, I would say, unconnected.

Got it. And when you look at the other side of Building Solutions and you mentioned it a little bit the sort of install or systems activity. Again, investors often ask, well, it's sort of half the company. Could you shrink large chunks of it to get margins up at JCI, like what's the cost of doing that for products and services? Now I realize it's sort of a very complicated question but how do we think about that? And I guess people are asking because they're wondering if you and the new CEO will maybe spend time on sort of pruning that systems part of the company.

So you could absolutely shrink it. The question is you should and is that really the problem you are trying to solve. What you want to do is that systems part of the field solution, is you want to maximize its opportunity to drive life cycle. And that's where historically we've had challenges where we were chasing systems opportunity or install or whatever you want to call it, where we were addressing markets where it was hard to sell value or we were addressing markets where we knew from the beginning that the customer was likely not going to sit with us through the life cycle, either not take the service or not be a parts customer over time because they either would self-serve or find a different way to use the assets ultimately. And our operating model by channel is supposed to maximize the opportunity of what the Building Solutions team and where we failed historically maybe to do that, where we deployed resource against parts of the markets that wasn't suitable for the life cycle. We should have probably pivoted those markets to our distribution model where we let a channel partner still do the installation and services but still have our market share from a pure product standpoint. And where you've seen an evolution in our operating model over the last few years kind of maturing a little bit, is where you've seen our ability to deploy those resource in those parts of the market that work more, increasing the attachment rate and increasing the profitability overall. That -- what you've seen in the evolution of the profitability of our EMEALA segment over the last 2 or 3 years, it's just that. It's about the same amount of growth you get on systems but in more focus parts of the market, so you have a better margin when you get in. And then because you have a high attachment rate, you have massive service growth on the back end. And that mix really lifts that profit rate very, very quickly. We're still only at a 40% to 45% attachment rate. I think our entitlement is much greater than that. There are certain things we got to do to continue to refine our go-to-market strategy and our operating model, which is what I mentioned on your opening question with Joakim's kind of first priorities, if you'd like, to get closer to maybe 50%, 60%, 70% attachment rate and an ability to actually pivot a mix of revenue even more towards the service side, which would be massively accretive for the enterprise.

Got it. So one way to think about the install or systems business, if there are parts of it that cannot get the attachment rate up, you would just say, why are we doing this?

You pivot. Yes. And that's where I am -- that's why I've said you don't -- you got to think about systems as an engineered solution and you got to decide as you go market back, whether you want to put the resources of our field business, your branches, your engineer against the parts of the market that will pay for that or the parts of the market that ultimately will not pay for that. Now it's not as simple as a customer will immediately tell you, I will or will not take service and I will or will not pay for your margin. But that's where bringing that intelligence back at the center and controlling how we deploy resource and where the resource, based on experience, based on what we see in the market allows us to have a higher win rate in markets that makes the most sense and drive more consistency in those outcomes.

Got it. And switching to profitability, maybe, I mean, it's somewhat tied to that service penetration because it is very high margin. But I think this year, the sort of segment operating margin of the company is 17-odd percent, a bit under maybe but around there. Where can that get to now with this new operating model? Like what do you see as your entitlement once you get service attachment up and that kind of thing?

So you need to think about the progression of our operating margin in 3 buckets. The first one is, we are addressing the fact that we've delivered a little bit the company by selling our residential and light commercial business, you reduce about 25% of the revenue. So you got to deal with that stranded cost. That restructuring program that is in place right now is first and foremost addressing that stranded cost but also drive better leverage moving forward as we drive further volume. The second aspect is exactly what I was talking about on the go-to-market strategy. If you're more maniacal about how and where you deploy resources, from a building solutions versus a global product kind of approach and you use your distributor in markets where you get the most leverage there and you use your branches in the most attractive parts of the market, you will actually lower overall your cost to serve and get better leverage overall from a profit rate standpoint. And then the last component of the improvement on that profit rate is really around that service mix. And so you do those 3 things, there's no reason for us to not to have our segment margin in the high teens and very transparently over the next 3 years, potentially well beyond that.

Yes. Got it. And I think if we look at one of the segments, say, on margins, the Global Products business has had the most portfolio change and certainly I think surprised investors around how high the margins have been in the last kind of 6 months or so. Like how do we think about where an Global Products margins go, kind of where should they be this year starting out?

Well, first, I'll start with where we thought they were going to be in the first half versus where we see them landing and then I'll tell you a little bit where they're heading. We've done a lot of work over the last 2 years kind of fixing the fundamentals of that business, aligning the base cut, simplifying the operating model, having better sales and operation processes in the front end. All of that means that every time that business sees a little bit of volume growth, a lot of it will fall to the bottom line. You also got to remember that the Global Products business is both the factory for the indirect channel but also the factory for all of our direct business. So that volume growth when it goes well on both sides of the equation, there's a lot that drop at the bottom line. When we guided for the first quarter and we were talking about the segment margin, I was talking about the first half will be on one side of the 20s and the second half, probably higher 20s and 30s. That anticipation was the first half was going to be a unit growth of, call it, 5% or 6%. And if you look at the first quarter, Global Products grew at 15%, 4% price, 11% unit. So that's almost double the unit growth we originally anticipated. Some of it had to do with the timing of what's happening from the administration, acceleration of orders but that volume growth, we saw it both in the indirect third-party volume and the direct demand. And that created great absorption opportunity within that segment and drove the margin to 30%. And I think once that business gets to that volume, which it is now, it's going to be able to maintain plus/minus 1% or 2%, a margin rate of about 30%. Where it goes from there is that the volume continues to grow both internally and externally, that margin continues to improve in the mid-30s and beyond as you roll the clock.

Got it. And if we think about sort of this year's guidance, you had a very, very strong start. So in some ways, the guide looks very conservative for the balance of the year. Also though you had a strange base kind of sequentially with the divestment year-on-year with the cyber. So I guess sort of trying to -- I guess, how do you characterize that guidance? Like is it conservative? Or you'd say well, the start was a bit odd because of onetimers?

I'd say our original guide was what you would qualify as a little bit conservative. We -- our existing guide has 2 kind of headwinds that we've included in them. The first one is currency. As you know, the strengthening of the dollar has impacted us quite a bit. And it's between $0.05 and $0.10 of headwind there. And then the effect of tariffs and I'm not just talking about the cost of tariff and how much we are going to absorb. But we are concerned that some of those trade wars could potentially dampen a little bit the growth we see, not only in North America but in Asia and potentially in Europe as well. And so we want to be a little bit cautious about what is the upside opportunity now. If things settle down and if China starts to recover, if Europe doesn't get into too much of a slowdown because of export challenges, I think there's upside to where we are today. And then from a tariff standpoint, I think we're very comfortable that for the most part, we're going to be able to cover the cost itself. The question remains whether we're going to be able to continue to maintain margin. Am I going to be able to recover margin when I charge a customer for that tariff cost? It's more challenge for the larger customer, obviously. The bigger the customer, the bigger the check, the more commercially involved we are, the less transactional the deal is and the more transparent impact is on their bottom line.

That's fair. And when we think about sort of capital allocation from here, you've got this nice check coming in soon from Bosch. How are we thinking about sort of usage of that? And what's happened with sort of the M&A? Is the M&A pipeline very quiet now because you just got to execute on the buyback? Any thoughts on that?

I wouldn't call it quiet. First, on the proceeds, assuming nothing from an acquisition standpoint comes to fruition in the next 6 months. And again, we're talking about closing the transaction with Bosch in the fourth quarter, probably on the earlier part of the fourth quarter. And the plan right now is to redeploy 100% of those proceeds, about $5 billion back to shareholders. But if you think about capital deployment beyond that, our pipeline of acquisition, it's still pretty healthy. Transparently, the valuations are rich in the parts of the market that are the most attractive to us. And you see some of those deals getting printed outside, where we have a hard time reconciling the value that those assets could bring to the enterprise versus our ability to actually develop a lot of those capabilities internally. And so we continue to be very active. We have a lot of partnerships that -- and engagement that we are watching. I would say that the M&A pipeline continued to grow. The relationship we have and the companies we watch over continue to mature and get more and more ready. I'd be surprised if we don't do anything in the next 12 months but timing M&A transaction is an art, not a science. So it's going to be hard for me to tell you exactly when that's going to fall.

And -- I see. And is the point that, that would sort of potentially use some share of the net proceeds, the $5 billion or...

Ideally, yes. But it's going to -- for me to tell you, I'm going to perfectly time a divestiture with an acquisition, that would be pretty arrogant of me to do. But the other thing is, there's no reason to hold the cash for any time. Our leverage will be probably right around 2 turn at the time of the closing of the transaction. If a property becomes very attractive, we can always lever up for a short period of time and figure it out later. I'd rather return the cash to shareholder and give clear visibility and transparency about our capital allocation rather than holding a couple of billions of dollars for 6, 9, 12 months. You never know how long a deal will take until we redeploy those proceeds.

Got it. And when you think about the sort of that pipeline that you mentioned, it's what it's sort of core products JCI is involved with today, core markets, nothing too adjacent.

No, no. We're not going to add another domain. We're not going to add another leg. I mean, I'll tell you 2 things. The first one is a lot of the pipeline that we have today is all on the fundamental of the core domains we have. It's new capabilities, new geographical capabilities or further capabilities in terms of either cooling or building management, building electronics type of play. And then obviously, Joakim coming in, he's going to have a very strong opinion on where the next bet should be placed based on where the market is and may put his view on the direction and the allocation of portfolio. But there's not a lack of opportunity, to be honest with you. It's about having the operating model settled a little bit at JCI before we do something too substantial.

Got it. So that pipeline is a mix of sort of bolt-ons and then a few larger ones, a typical mix?

Yes. I mean, always funny to see what a bolt-on number really is in your head but depending on your definition, yes, they all bolt-on. Some of them are pretty large bolts. But they're not a third leg. They're not something that would massively disrupt the organization. They are companies that are in the $500 million to a couple of billion dollars of revenue.

Got it. Okay. That's very helpful. And then as you said, there's proceeds, you also -- cash generation is getting better to deploy as you see fit. Conversion this year seems like it's on a good path. I think that moves up to the 90s kind of consistently...

Yes, [ 602 ]. I would tell you the structural headwinds we've talked about on our cash conversion, restructuring this year of about $250 million, that's not a going rate. We're not going to spend $200-plus million on restructuring for the foreseeable future, a little bit more in '26. But after that, '27 completely falls off. And then we talked a lot about our effective tax rate versus our cash tax rate and global minimum tax putting 500 basis points of pressure on our effective tax rate. But really, in essence, not putting a lot of pressure on our cash tax rate. So those 2 numbers coming closer together will help conversion rate overall. But fundamentally, the basics of working capital management continue to improve. And that gives us a tailwind to really comfortably be in the 90s and working ourselves up over the next couple of years to a more consistent par cash converter.

Great. Well, with that, we have to switch to the audience response questions. So maybe the first one is around sort of current ownership of JCI. So about half on those. Secondly is around sort of broad perception of the company today. So generally sort of positive. Third question is around earnings growth or EPS growth of JCI versus the multi-industry average. So generally above peers. Next question is around uses of excess cash, which we were just discussing. So generally, buybacks is what people want. Next question is on what PE should JCI trade at? So generally around a market multiple. And then the last question is, kind of why only a market multiple, if you like, why not a premium. It's sort of a core growth. Fantastic. Thanks so much, Marc.

Good to be back here. Thank you.

Thank you.