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

Thanks so much. Our next session is with Johnson Controls. And we're going to be hosting a fireside chat with Marc Vandiepenbeeck, Executive Vice President of the company. Thanks so much for being here. We're very, very excited. Let's start. Let's kick it off.

Yes. Thanks for having us.

Can you talk about resegmenting? What drove the decision? And how does it reflect changes in operating philosophy and org charts?

Yes. So the resegmentation is really coming from a change in our operating model and JCI used to be organized with two independent operating model. We had our Building Solutions operating model that was really our field-based business, where we did our systems and services. And then we had our Global Products operating model, which was really the team that makes the products and finds channel partner distributors to actually sell those products. And we had those two operating models kind of working at the same time and often competing on the same turf. And what we saw is a lot of inefficiency when we were operating that way. And the goal was to bring those two operating models together and being really market focus. How do we win more customers on a particular turf? And some of our customers want an OEM that stand behind the system and service the assets over its life, and hopefully, is there for the replacement down the line. Some of our customers don't see that value and just want to buy the equipment and install, or maintain or manage, it themselves. They have a different kind of CPQ associated with how they buy. And so instead of having two teams trying to figure out the market and figure out how they play best, we decided they need to be combined together, look at the market opportunity and just win more customer in the market. That change in organization model is really a first step in simplifying how we run the company, being much more oriented against what the customer needs and the customer success looks like, and also starting to work on more verticalized approach to how we approach those markets. So what does a health care customer for, regardless of the channel we take? What does a higher end customer look for regardless of how we address that customer from a channel standpoint? And really get after the higher entitlement of growth but also profitability.

Excellent. So another question is cash conversion will be approaching 100% this year. What are -- what are the key drivers? And [ right ] now that you are not committing to 100%. But what would need to happen operationally to achieve 100% on a sustained basis going forward?

So first, how we got where we are. As soon as I took over focusing on cash conversion, quality of earnings overall was critical. We unwound our factoring program. We simplified our supply chain and procurement process. That drove really two clear benefits. A much better management of our cash inflow, account receivable, the way we build customer, the way we collect on that build, the way we manage that process across our businesses, and then how we manage our procurement, getting better entitlement on how we manage our supply base, how we manage terms with that supply base and how we buy overall. That has driven over the last 18 months, a massive improvement in the cash flow conversion. And that has allowed us to get past some of the structural headwind we have from a cash tax standpoint. We've talked about it in the past and slightly elevated level of CapEx as we were making certain investments in the business. I would say, for us to continuously improve on that cash conversion and being like -- me being comfortable telling you it's 100% all the way, we still got to work a lot on our inventory. And that has to do with the work that's been done on lean management and really simplifying and taking a lot of waste in how our manufacturing process works and how on-time delivery improves over time. And there's a lot that can be unlocked from an inventory management from a cash standpoint in the future. And this is not a 1- or 2-quarter adventure because it means transformation of supply chain, transformational process within the factory, elimination of waste and scrappage a lot of process need to come in to actually drive that. There's, by the way, margin improvement also associated with that. But the inventory benefit that comes with that will be a big tailwind over the next couple of years. And hopefully, when we get on the other side of that, we'll provide better visibility on a 100% cash...

And does the re-org in terms of that you no longer have this manufacturing organization and distribution organization sort of doing this intercompany transfer. Does that help structurally, sort of to simplify the system with inventory down the line?

It's a good first step to bring the sales and operations team more aligned into whats needed in the system and providing buying signal, or selling signal, earlier in the cycle because those teams are now under one roof.

So we've seen some of the benefit, but more to come?

And more to come. I think we transformed the organization on April 1. Give us a couple of quarters to actually optimize...

So more to come. Okay, fine. That's a bit -- okay. Another question is most multi-industrial companies now exclude M&A amortization from earnings. How do you think about this particularly as your cash flow approach is 100%?

Yes. Ultimately, the goal is to move to cash EPS. I'd say, when we've done a lot of interviews with our key shareholders, they wanted us to move ultimately to a cash EPS kind of view of our financials as soon as we had clear visibility on that 100% conversion. And so it's a little bit connected with my earlier comment. As soon as we've cleared that threshold, and I can confidently tell you that, I think it's going to be easier for us to give you a cash EPS number. But it is clear that the need and request for a pure transparent cash EPS is the solution long term.

So the next one is a direct quote from your CEO. And the quote is, "I'm taking an objective fresh look at our strategy and how to best further optimize our portfolio. I will share more at a later point in time about what I think is good for Johnson Controls as I deepen my understanding of our business, end markets and customer needs." So I guess the question is clearly, we're still very early, and the statement says that we're early. But looking from the outside, how comprehensive will the review process be?

There's going to be no stones unturned. I think Joakim is taking a clear unencumbered look at every part of the portfolio, understanding customer and how we serve customers, understanding our operating principles, how we are actually delivering the services and product to those customers. And that leads to both a strategic view of what those business need to take, but also a view on what the entitlement of profit and growth rate is. And as we go through that review of the portfolio, he's going to have an emotional view on what we do with those businesses. And there's going to be multiple possible outcomes. It's -- again, the man has been 8 weeks in the seat. So give them a little bit of room to actually do the hard work of understanding deeply those businesses. But it could lead to us deciding some of those assets are not part of the portfolio. It could lead to us deciding some of those assets could be run a whole lot better, and we could drive those businesses to better cash performance and help us support that long-term 100% free cash flow conversion. Not every part of the organization is going to grow double digit. And so for those parts of the portfolio that are growing a little slower than the rest of the portfolio, what do you do about it? And what are the operating changes you need to make whether you decide to keep that asset or not.

No, that's terrific. And meanwhile, I think you sort of brought up some sort of thoughts about M&A. But as we are undergoing this review, what is happening with M&A? How should we think about M&A JCI going forward? As I said, cash is clearly improving. Cleaned up a lot of the portfolio. But any regions or product technology verticals that really stand out? And as I model M&A or capital allocation, what's a good placeholder for M&A spend?

So first, I'll address the short-term part of that question. We are going to close the transaction on our divestiture in the fourth quarter. We have a healthy pipeline of M&A targets that we are looking at. And I'll describe in a little bit more detail where we're spending our time there. But nothing in the short term that will require action. And so we are going to redeploy the vast majority of the net proceeds, about $5 billion, against a quick share repurchase strategy in the fourth quarter. After that, between the health of our balance sheet and the continued performance on free cash flow, we have a lot of ability to acquire larger companies. But the goal here is not to do something massively transformative. It's very much trying to acquire new technologies that are complementary to our kind of terminal HVAC business, whether it's for particular verticals that we see growing faster than others, or whether it's for a particular region where we see the opportunity growing. And so yes, of course, there's assets we are looking at that would bring great capability from a data center vertical. We're also looking at assets that would give us capability continue leveraging on the growth we are seeing. For example, in Europe, in HVAC, where we're seeing the heat pump market, commercial heat pump continue to grow very rapidly and where we want to keep up pace with demand. And then our Controls business is really a world-class one, and we continue to try and create differentiated solution and continue to invest into new technologies that allows us to continuously differentiate our product and provide solution to particular vertical markets that are beneficial to us.

It was great. Speaking about data centers, can we talk about Silent-Aire? Clearly, it seems like a competitive advantage as it gets you into the data hall. I don't think people appreciate that you are bigger, just generally bigger in data centers than two of your large public competitors combined.

Yes. Yes. Oh, yes, combined for sure. It's -- So Silent-Aire is improving. As you know, we acquired that business 5 years ago, and it took us a little bit to really understand the backlog of what that business had actually signed up to prior to the acquisition, and be able to pivot and help the customers ultimately drive the value of the product they're looking for. That business continues to do extremely well, growing in the high double digit. As you know, data center is...

High double digits.

High double digit. Yes. That business, data center overall, not just Silent-Aire, it's about 10% -- just under 10% of our revenue. Silent-Aire is about 1/3 of that, and they continue to see increased demand regardless of the momentum that's happening at the chip level, because the solution they have in the data, [ whole ] works for liquid to air or liquid to liquid solutions, and provide kind of thermal efficiency that I think are very hard get from other competitors. They really have a very differentiated solution on a product that historically was very commoditized and very standard. They've really created a differentiated solution that our customers enjoy.

Okay. So can you just help us, who is the typical data center customer for JCI? Are you over-indexed to hyperscalers, colos, enterprise? Any comment on geographies?

So when you have that large of a presence in a market and you have 5 or 6 companies that are that large in that particular market, you are naturally a little bit more indexed towards those particular players than you would otherwise like. So yes, we have a very strong, very good relationship with all our hyperscalers. They define where the market is heading. So they really create earlier on the templates that some of the co-locator and some of the smaller software company will ultimately design against. So yes, it's tilt more towards hyperscaler, but it provides benefit for us to play across the board. And so while we have a lot of relationship with the hyperscaler, we deal with pretty much all of the larger global colocator. From a geographic standpoint, we have seen more success in North America than we have in other regions. I would say APAC comes second, and then we need to look at Europe and our opportunity there. There is not so much a capability standpoint. It's an ability to regionalize some of the solution. And then the pace of growth in Europe for data center is not as good as what you see in other regions because of the complexity around the regulatory environment that is creating some hard burns for actually most of the hyperscaler as when they decide to locate themselves. And then the availability of power is a problem globally, but particularly difficult to see a path to that power in Europe in the midterm. And so there's a lot of geopolitical moving pieces that are happening there. Some of that demand may shift a little bit east, or south, depending on what Europe decided to do from an energy and a regulatory standpoint on data center.

On APAC, is that outside of China or would APAC include China?

It's mostly outside of China, but we have deep relationship with some of the larger colocator in China. It's a very competitive market onshore China. We're playing our part, and we're seeing some good growth there. But it's a much tougher market with really, very creative I would say, local competitors that have provided very differentiated solutions for that market.

Got you. What are the missing pieces in your data center portfolio? For example, some of your competitors have entered the CDU market fairly recently. Any thoughts there?

Yes. It's a market we look at in deep details. I would say it all comes down to how far down the chip you want to go, and whether the economics of that thermal value chain will work out over time. Right now, there's a lot of CDU solutions. Right now, we are seeing not a lot of differentiation from a value or capabilities, it is just availability. And that availability game will die down very quickly. We will only enter, I would say, the data room, if we can find a way to create differentiated, integrated solution with what's happening outside of the data room and drive value for our customer. Chasing a highly commoditized, very temporary part of the segment of the market like CDU may not be our first bet.

No. We heard it's very interesting, and I'm really curious to see how the industry will develop. That, for example, folks who really have deep technological expertise in chillers, well positioned as we go to 2-phase cooling for sort of more complex architecture that, that creates an opening for more sophisticated players. Is that the right way of thinking about it?

That's absolutely the right way of thinking about it. And ultimately, it may eliminate the need for a CDU midterm. And so that creates a completely different paradigm on how you manage the whole thermal loop within the data room. And we are designing some solution right now that we'll address some of those needs, but there are some capabilities. We will ultimately, potentially, look outside of the company to acquire to be able to double down on the technology differentiation there.

And how much visibility do you have in your data center order book beyond '25?

We have great visibility. That order book continues to grow. I mean, our backlog overall has grown 12% year-on-year. So we have across data center, and all of other verticals, we have a very strong visibility on what's coming. The health of our pipeline in data center continues to improve. So it's not like you've seen a dampening. There's been a little bit of a shift of of where the demand comes in. You know what I mean, like a little bit less from hyperscaler that we still see a high demand and you see a more fragmented demand coming from different colo and mid-market software players. But ultimately, we are able to address all of those needs, particularly because the standards have come a lot from the hyperscaler and the market knows we have a differentiated solution there that can help those software players being extremely competitive from a cost to call their infrastructure standpoint.

And just so I have my notes correct and [ Devon ] is in the audience. But this high double-digit is that Silent-Aire order numbers? Is it total data center?

It's total data center.

So it's orders or revenue, sorry?

Both.

Okay. Okay. That looks good. Maybe just we'll finish with data centers. Do you see the timetable for rollout of GB300, introduction of Rubin, because the time line is changing?

Shifting a little bit, yes.

Are you seeing this impact what your customers are doing?

It changes a little bit the type of technology in the timing and the type of technology they intended or implementing originally. It shifts some things to the right. So it doesn't -- it doesn't change the demand overall for the thermal needs. It changed the type of architecture that end up being deployed. We have those solutions across the board. I think the more advanced less tested technology are being pushed a little bit more to the right, which is good. It gives everybody more time to validate the capability there. I think what you're seeing is the more complex data center customers are starting to understand that the blades, the racks, the CDUs, the air inside the data room and infrastructure are not 4 or 5 different parts of the thermal envelope. They're all one single unit, and they need to be able to find modularized -- sorry, approach to each component be able to play actively and be able to react to the need of what the thermal load is going to be at the chip level across that need. And so that containerized, that modularized approach, we see it across the board, because the timing of the deployment of particular chips constantly evolve. It's slowing down a little bit now. In 2 years from now, we're going to talk about a re-acceleration and then it's going to lead to different changes.

But I'm just sort of thinking, if you're a large hyperscaler customer and maybe GB200 is slipping to the right, but the gap between GB200 and Rubin is getting narrower. So on the margin, can you see some change in architecture to say, hey, maybe I'm going to -- it's less Blackwell more Rubin down the line as the mix. Is that, or is that too simplistic for you?

It's a little too simplistic because the application themselves are changing at the same time and the ability to get -- those higher chips are there for the larger language model. For the smaller language model, because of the productivity gains that have happened over the last year, you now have a pickup in productivity there that wasn't anticipated at first. And so the type of chip in the type of data center is shifting a little bit quicker. But there's a whole lot more that comes into play when it comes to data centers is memory, and now you have the power delivery that changes the thermal envelopes. There's like very complex ecosystem to be dealt with here.

So maybe just -- can you remind us about your recent capacity additions in North America, sort of brownfield versus greenfield?

Yes. the largest expansion we've done over the last 12 months was really to be able to keep up pace with the air cooled chiller demand we were seeing. Mostly investment we've made in our Mexico facility in [indiscernible], where we almost doubled the capacity of that plant simply because the backlog was more than double than it was in the prior year. We said the orders in the first half were double what they were in the whole prior year. And so as you see that momentum, we build capacity. Now with Joakim coming on board, there is a clear focus on lean and lean management, particularly lean manufacturing. Lean is not just manufacturing, but it is where it shines the most. And so we are now very comfortable with the footprint we have. The goal is how are we going to be able to -- what 30%, 40%, 50% capacity with the existing footprint by optimizing the flow, the structure and eliminated waste in how we run those facilities to create more output from existing infrastructure and also improving quality at the end of the day.

Got you. We sort of -- one of the themes, I think, is reshoring as, I think, the biggest applied player. What do you see in terms of reshoring opportunity in the U.S.? And do you participate in semi and biopharma reshoring? And what are you seeing? What are the good leading indicators to track? Is it start spending? What's a relevant metric for Johnson Controls?

So what we track is our quoting activity for that -- those particular vertical. And we see a big pick up. There's no question about it on an increasing quoting. Quotes don't always convert to orders, and they have not converted yet to order. So there's huge activity. A lot of people are clearly...

That's both on semis and biopharma? Or one specific?

Yes both. And generally, reshowing there's -- there are certain vertical, think about warehouses. 3, 4 years ago, I would have told you big boom in warehouses, great opportunity for us, growing double digit, and we see no end, and then it plateaued because the need for those logistical warehouses kind of leveled off in '23, '24. We see a pickup in those right now. That means manufacturing, or supply chain, is pivoting and people need that space to hold their goods as they transit through the system. That is the best early indicator of knowing that somebody needs to build new capability for factoring warehousing. It's your early indicator. Because you first buy to distribute and then you're tired of holding your wells and prebuying from your factory wherever they may be, and you build a factory to replace that capacity. And we see that momentum. Honestly, with how dynamic the geopolitical environment is, I don't want to tell you with clear confidence this is where it's heading. We want to give it a little bit of time. You can see -- you see the same indices. I see ABI is still pretty soft. Dodge Construction Momentum is kind of flattening out, to clicking up a little bit. So the big key indicator are a little bit softening, but they could quickly pick back up. We don't see that yet in our own internal KPI. But at some point, something is going to give.

So have you seen just -- let me drill down on biopharma because as the headlines have been quite exciting, and it's hard to tell how real it is. But you've talked to some...

Yes. We see the demand. Again, it's at the quoting stage. You got to convert that to orders. But similarly to what you saw probably 2 years ago, 3 years ago in the battery manufacturing craze, where we had 3 years ago, a massive demand in quotes, and we weren't seeing those orders coming through. And then everything gave out and we had tons of order coming in very quickly. I think it's going to be the same momentum. People are going to build their business craze. They're right now trying to figure out what would it cost to build that infrastructure in the U.S., what would it cost to run it, because it's not just chillers, unfortunately. It's a whole bunch of other aspects to that and I think we see that very positively right now.

Can we talk about other verticals in the U.S. Because looking at the construction spending data. It seems sort of data centers and manufacturing dominate the current construction spending. What are you seeing in other verticals? What's good, what's lagging?

So on the ones that are lagging, let's start with the tough one first. Government, retail, it's not a surprise. It's softening and it continues to soften. Retail has been soft for the better part of the last decade, but it's not in quite the opposite and government naturally, with what's happening with Dodge, you see some softness there. You look at higher ed, the state-owned type of higher ed, it's very soft. The privately owned, it's actually picking up. So we see good investments there. And then if you go to commercial real estate, which is a big part of the market, about 25% or so for us. It's kind of a tale of two cities. The Class A market, people continue to invest. They want great offices and we see a pickup in demand there. And then you go lower in the grade of offices and the demand like softened really rapidly. I think New York City is a great example. You would see building like this one, fully utilized, thousands of people coming in. You look at the floor plates. The floor plates are maximized with cubical, and meeting room, and space fully utilizing tons of people. And then you're going to see a class B or C office right next door. Half of it dark, completely unutilized. Something is going to give at some point, right, because we can't just double down on that, but that market remains very, very soft. The replacement cycle there has been lengthened quite a bit, and there's a lot of people sitting on the sideline waiting for something to happen in that market.

And hospitals, just to round that out?

So health care overall, the hospital, particularly, yes. If you look at health care overall, very healthy, life science has some softening that's been happening for a couple of years. And so we don't have that tailwind that much anymore. But if you look at hospital, there has been a shift in size. So mega hospital construction craze is a little bit behind us in -- I'm talking about North America. There's opportunities outside of North America. If you think about Southeast Asia and India and some parts of Europe where we see great opportunity there. In North America, it's really around smaller health care facilities, more self-contained, but more of them, and that's where our service capabilities come into play because now are dealing with those hospital groups that instead of having one large campus, have 7 or 8 satellites, and they want an OEM to be able to serve those satellites across the region and guarantee their service the same way they guarantee in the big infrastructure. We're seeing great growth there, actually as investments are continuously made.

Can we talk about Fire & Security fundamentals by region? Because Europe seemingly -- well, A, you guys you have done a lot of heavy lifting in Europe. Just maybe just talk about Fire & Security fundamentals by region because a big part of the company.

It's very small for APAC. So I don't think it's worth talking too much about it. APAC is mostly a HVAC controls market with a little bit of Fire & Security, but it's fundamentally not large. If you look at Europe, great franchise. We have the very, very strong margin. It's growing well. We've got to continue focusing on that success story. Yes, we've done a lot of work on improving the profitability of that business from like mid-single digit 2, 3 years ago, to mid-teens right now. But I think the entitlement of that business is much higher. Fire & Security continues to be a very healthy market for us in Europe. And we don't see any macro trend that would change that. In North America, the Fire & Security market, end market we serve, are very much tilted towards new construction and mid-market, that class B, C I was talking about. They're a little bit more exposed than it is in Europe. And that's why you've seen the growth of that business in the very low single digit, I would say, 0% to 5% depending on the quarter you look at. I don't think fundamentally, we are going to see a change in that market anytime soon. What we need to work on and where Joakim and I are really focused on right now is can we the profitability of that business? Can we do something different with that business? Or is it part of a bigger portfolio review and something somebody else could manage better than us?

So a question. What was your -- just talking about Fire & Security, EMEA/LA just pivoting. What were your big personal, big takeaways from the operational turnaround at EMEA/LA under your leadership? And what can be applied to the broader JCI playbook?

It's customer needs-based segmentation. What the team in Europe was trying to do is they had the right products. They had the right footprint. They were just not deploying the resource against the best parts of the market from a product capability standpoint. The goal of running a system or, an in-store for JCI, is ultimately to serve that customer. And if you start trying to sell using the branches, selling system in parts of the market where we are never going to win service, you're going to utilize resource wrong, and you're not going to get your return on your system investment through the service. But you saw in Europe in the last 2 or 3 years, you had a flat growth in systems, 0% to 1% to 2%. And then you had a double-digit growth, 10%, 15%, 20% some quarter service. That happened simply because the same level of install we were doing the year before, we did it with double the level of attachment rate in the year. That drove massive mix in both the quality and the type of margin we could comment on system, but also help the mix on service overall. And that's how you quickly drove margin improvement. We got to continue to improve that operating system. I think the work that we are doing on lean management over the next 2, 3 years will drive a massive improvement on gross margin and continue to bring better leverage on the SG&A that, that organization has.

We're almost out of time. We're right on time. Thanks so much.

Thank you. Thanks for having us. Thank you.