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

Fantastic. Well, next up, it's my pleasure to introduce Johnson Controls, Marc Vandiepenbeeck the CFO. So thanks very much for being here, Marc.

Thanks for having us. Yes.

Of course. And I think JCI had some news on an acquisition. So maybe just start off with the background on that and kind of what it brings to JCI's portfolio?

Yes. So this is really a capability acquisition. Alloy is quite an incredible firm with a team of engineering folks in Boston that really have created a differentiated technology to really combine manufacturing process and material technology to create differentiated solution for data center, but also for other mission-critical environment. The way that technology is going to apply to JCI product line is specifically and to start with our CDU. We have a great product we launched about 4, 5 months ago. The reception has been incredible. Our pipeline has now grown to almost $1 billion. We've booked order almost immediately after announcing the product. But today, if you look at the environment of CDU, there is some differentiation, but it's not as high as you would anticipate with 100 different players providing solutions. We think the Alloy technology with their stack forging capabilities will create a completely differentiated CDU offering and allow us to gain potentially a leadership position similar to what we have in the rest of the thermal chain. There's some application of what Alloy does that goes also into our chiller and the rest of our technology. And then, of course, being able to create those micro geometries has some clear interest within the cold plate. And so we are looking at that opportunity as well. Their own pipeline of opportunity. It's a very small revenue company, but they have an enormous pipeline that we intend to capitalize on.

Fantastic. And you mentioned the ability to drive a differentiated CDU offering. So maybe if we think about the commercial HVAC business there overall at JCI, very, very high order growth second half of the calendar year, particularly fourth quarter that you saw. Any kind of onetime factors driving that? How do you see the sustainability of high orders growth into this year? And what are the main sort of verticals, data center and beyond driving that?

Yes. The momentum is really coming from multiple factors, the increased demand coming from hyperscaler and colos that you see the CapEx commitment continues to increase.

Yes.

And then also the technology differentiation we've been able to achieve, particularly on chillers, has allowed us to take kind of a leadership position, and we think we gained more than our fair share last quarter and gain a higher share of wallet with most of the customers we have. The timing is very hard to predict. We could have seen that a quarter earlier. We could see a quarter later. In terms of momentum, we entered the quarter with a pipeline of opportunities that was growing double digit. And on any normal quarter, if you see a double-digit print in orders, your pipeline gets so depleted that it's very hard to maintain momentum in the order growth beyond because your pipeline gets depressed. What's incredible about last quarter is we entered with strong double-digit pipeline growth. We printed 40% and our exit pipeline still grew double digit on the back end, which honestly, in my 21-year at JCI, we've never seen. But that is really a testament to that continuous demand and kind of the customer intimacy and the effort the teams have done to really build the understanding and the road map for our customers to understand where they're investing, what product needs they have and how can we make an impact in their whole buildup of that incredible data center construction that's happening here.

Great. And when you think about the backlog is there. When we think about conversion of that into revenue, I suppose, help us understand kind of timing of that first off and just the mechanics on the lead and the lag and so forth into sales? And then also the capacity of JCI to manage that conversion efficiently. I think some other companies with high data center growth has been uneven, let's say, the incrementals on that revenue.

So multiple parts of your question, right? There's capacity, there is our ability to keep up with revenue growth, and then there's really the timing on when our customers are able or willing to take that revenue based on the orders they pushed. First on capacity, about 2 years ago, we almost tripled the hard capacity roof line manufacturing lines within our North American footprint to keep up with the demand we were seeing and the size of the pipeline. Through the transformation of our enterprise and the adoption of a business system, we are now working on increasing to a certain extent, the same level of capacity through soft capacity. What I mean by that is when you have a production line that can maybe output a chiller or 2 a week, can we dial that up to 3 or 4 chiller a week? And what does it take from a supply chain, from an automation, from a process management to just increase that output with the existing hard capacity we have. The way the demand has been shaping up is accelerating transparently faster than what our capacity planning was originally. We are working on trying to keep up with that demand. But if it continues to accelerate, it -- there will be a point where it outpace our ability to create that capacity. And from a revenue translation, a lot of those orders you saw in the first quarter, some of them are going to start renewing in the fourth quarter in August or September for us. But the vast majority are 2027 deliveries. Then the last part is the customer has to also be able to receive material. For the most part, because those orders have entered directly or backlog, that means most of those customers are willing to take delivery of the vast majority of those orders within 12 months.

Yes.

Are they able is a question. The biggest gating item that we are seeing in the short term, we don't know if that's going to continue, but in the short term, is the electrical infrastructure generally comes up 4 to 6 months ahead of us on a build-out of a data center. And it looks like the delivery either because of installation challenges or delivery challenges from the electrical infrastructure is being pushed out 3, 4 months at times. And so while we worked really hard on improving our on-time delivery, it looks like there are some challenges within that infrastructure that is pushing some of that ability to receive order early. Some of our customers are willing to actually take orders to stock. So they are happy to warehouse some of that equipment, but not all of them. And so we need to map out with greater clarity in '27, what that's going to mean. But from a pure HVAC equipment order, it means -- right double-digit growth for that particular part of the business.

And on that point, when you're looking at the overall, say, Americas business and assuming that a lot of that data center activity is domestic in the U.S. in terms of order intake.

It is.

Is it sort of fair to assume that, that segment should see for some period, we'll see but should see kind of double-digit organic sales growth few quarters out when this backlog starts to get the P&L.

So the dynamic of that segment is it's not all HVAC data center yet. But over time, it will. That business is about 50% HVAC and 50% fire security and some other businesses that are not directly seeing the support growth of the data center. These businesses are performing okay. We think we can operate better there, and we can help them accelerate growth. It will take time, but these businesses grow low single digit. And so it's a question of relative performance. But you're right, the HVAC will probably drive at least a high single-digit net-net growth and potentially moving that segment to the double digit depending on the timing of that revenue and that ramp I was talking about and the ability of those customers to take revenue. Everything perfect, absolutely. This growth is in the double digit, but I don't live in a perfect world, I live in the real world.

And I think one of your industry peers mentioned that they have not as large as yours, but they have a presence in building management systems, and that's helping them win share in Applied HVAC in data centers as well. So maybe you obviously have a very strong position in both commercial HVAC plus BMS. You've always been good there. Help us understand kind of that linkage. And is there more of that systems purchasing effort now by the larger data center customers?

The market is evolving from a pure play-by-play component kind of buying behavior to a more ecosystem approach. Some players within the market have taken a system integration kind of approach, encompassing not just thermal, but sometimes electrical as well. But we're seeing the buying behavior of a lot of our customers shifting towards a more integrated system. So they want to understand not just the chiller performance, but how does that correlate to the CDU performance? How does that correlate to the air handler and how those 3 assets are being controlled and managed by the BMS -- the BMS infrastructure? And is there a way to eke out more performance or reducing the overall energy usage. It's an evolving market. I would tell you, it's probably -- it's a smaller fraction of our orders that are really all encompassing the absolutely end-to-end value chain. But over time, you can see more and more as we start engineering the next generation of data center, it's starting to become the standard. They will want to understand how does the chiller and the CDU are going to interact, how does that capacity play out? How can you optimize the performance of the 2 by having optimized BAS. At some point, certain data center player had moved towards more PLC solution because they wanted that immediate reaction. Think of a PLC of able to react in tens of seconds or microseconds. The BMS reacts in a few seconds. So there was a sense that you needed that extremely quick speed to reaction because the demand management was so complex to plan for. Now that they've sold a lot of that demand management, they're really thinking more as a traditional BAS, how do you get all of those assets to actually talk to each other, interact more rapidly and more efficiently with each other. It's a journey, but we are extremely well positioned, especially with our Metasys solution that has a dedicated kind of platform to support the data center vertical.

And there's been a lot of debate in the last 2 months around data center cooling architectures and how that -- it will evolve. I guess help us understand kind of when you think about liquid cooling and the whole sort of CDU and cold plates and so forth, that growth rate the next few years in data center cooling versus, say, more traditional chillers and air handlers. How wide is that growth gap? And how confident are you that JCI will have also very high share in the liquid cooling side?

So it's a complex equation, but let me try and simplify it overall. The entire tide is rising very rapidly, right? So the total gigawatts or the size of those data center continues to increase. The -- over time, not this year, not next year, probably not the year after, but over time, in probably the next 3 to 7 years, the performance that you can get out of the chiller to manage the entire value chain -- cold chain, I'm sorry, of the data center, that performance will continue to improve, meaning over time, reduce the amount of dollar per megawatt that the chiller plays in the overall stack. The total addressable market for a company like ours is actually going to not decrease because of that, but increase because the CDU, the air handler, the control to generate that energy efficiency will continue to rise. Ultimately, the goal of the data center is really achieve that PUE, that energy performance level to reduce the amount of power that the data center is using to run those chiller and get to thermal load and bring that energy back to compute, which is what is generating revenue for them. So over time, yes, the chiller -- they're likely going to be chiller needs for a very, very long time. That chiller need with efficiency will come down per megawatt, the number of megawatts is moving so much quicker that the growth is there. It's just the mix within that growth that's going to evolve over time. That's why we made investment into developing our own CDU. That's why we made the Alloy investment to be -- to continue to be able to improve our total addressable market per megawatt of data center that's being built out.

And in terms of kind of market share, the liquid cooling world, you can get different types of players there, Asian tech hardware companies, that type of thing. So a very different type of competitor to what JCI or York has been used to dealing with. So help us understand kind of how you'll compete against them and the confidence in the market share in that liquid cooling portion?

So not everything is about competing. There are ways to partner. If you look, for example, at the cold plate market, the top 3 to 5 players are mostly Asian component manufacturer with incredible output. There's one U.S. player that is now owned by an electrical player. But the scale player in that market for the vast majority, very large output component manufacturer in Asia that operate at fairly limited margin because it's just about a volume game. If you look at it from the outside, it's a difficult market to find attractive because of the lack of differentiated between those different cold plate and just the mechanics of what a component manufacturer model brings. Where the market is evolving is towards more differentiated solution at the cold plate, at the CDU, at the chiller and throughout the ecosystem. That differentiation will take time because the level of engineering complexity as the thermal load of each CPU and GPU continues to increase, becomes rather complex. That's where an Alloy transaction comes into play in that technology. But that evolution is very important. So we do not perceive the need to be a player in every single part of that market and finding the right partner to play and support an end-to-end solution for our customer is where we think that approach. But you have seen when the demand is so high and the supply is constrained, you naturally see unnatural player coming into the market. And that's our fault as an industry to have not kept up sufficiently those players at bay. But naturally, they bring differentiation, different approach and different concept, but we think that the 140 years of experience in thermal management and the 3,000 engineers that back up that history will far outpace innovation and capabilities that some newer entrants may bring. But we are very cognizant of the dynamic of the market is playing. You can see that we're keeping a very tight pulse on where the technologies are moving and Alloy is a great example of that of -- I can pretty much guarantee that 90% of the people in the room have never heard about that technology and what they have to propose and offer. And it's a testament to how our engineering and R&D team and our corporate development team like are really thinking 3, 5, 10 years ahead and where the puck is moving and not looking at where it is right now.

Great. And then maybe switching to some of the sort of self-help around the productivity and the margins and so forth, huge focus there. One thing that is in the very short term, some questions since the very strong set of results for the last quarter around kind of the Americas margins not outsized expansion today, but is expected to step up later in the year. So kind of help us understand what the drivers are of that step-up, please?

Yes. So starting at the enterprise and then maybe going down the Americas comment you made. So from an enterprise level, the self-help come from the large restructuring program we announced about 18 months ago. And you've seen the return on that benefit. There's like 3 different aspects to that program. It's addressing the base cost in some of our functions; that's just brutal cost elimination and restructuring. Second is kind of the adoption of the business model and simplifying how the different team works with each other and reducing the cost to serve, whether it's the IT function, the procurement function, the finance function. You simplify your operating model. You need less people to actually support that operating model. You actually end up saving money, making decisions faster and stronger. And then thirdly is we have an incredible level of complexity from a product and manufacturing footprint standpoint. We have a little over 40 factories and distribution centers around the world. On paper, it looks like a great network of factories. But ultimately, if you design the ideal endpoint, given the demand we have today and in the future, it's probably a couple of handful to many factories. What that drives is if you consolidate those factories, you find a way to reduce your fixed overhead, you increase your speed, you reduce the whole functional support around supporting those 10 or so factories that you're going to consolidate, and you make the supply chain that much easier to manage for the enterprise. So we continuously see an opportunity to improve that self-help has driven a lot of value. Now when it comes to the dynamic of what's happening in North America, it's twofold. The first one is North America is benefiting from that extremely fast growth of the equipment business because of data center, life science and other complex manufacturing have also helped them quite substantially over the last couple of quarters. And our equipment sales margin, while really healthy, call it, 35%, 36%, they're about 10% lower than our service margin. And when you have a business at 35% margin that grows twice as fast as a business that has 45% margin, you have a mix headwind. So we have driven a lot of cost optimization within that team. We still have more to do within that segment. But in the short term, a lot of that improvement has been eaten up by that mix. In parallel, parts of the portfolio is struggling a little bit. Our security business is performing; it is not performing to expectation. It's not improving as fast as the rest of the portfolio. So there are things we need to do to really turn around that team and help them focus on better operation. And finally, when you build a franchise the size of our service franchise, one of the biggest challenge you have is you have an enormous base of contracts. And that base of contract has a natural attrition to it. Customers decide from time to time to shut down or find another provider to help them or decide to bid the project and somebody else ends up winning it. The more contracts you have, the bigger your attrition, the more challenging it is to grow in double digit, your revenue base. There's a solution for that, and we are working on those. But in North America, that size of the service growth means that there's a bit of a ceiling in the short term for that business to grow much more than a high single digit on service. We're working on breaking that ceiling. It means service productization. We can talk maybe about it a little later. But that means our ability to accelerate the growth of service to keep up the margin rate of service at the same pace as the rest is a little challenging in the short term. I'm not saying there's margin rate headwind, but it's all of the work we're doing from a self-help is not fully translating in Americas into a full bottom line translation yet, but it will come.

Got it. That's very comprehensive. And maybe, Marc, sort of corporate line, not the most interesting subject, but JCI is a fairly big lever coming down sort of relentlessly since the RLC (sic) [ R&LC ] divestment. How much more room is there for that corporate line to get you shrinking?

I mean we've come from $450 million to, call it, $350 million or so. It's not going to go down to 0. Otherwise, I won't have a chance to spend time with you guys because I'm in that line, unfortunately. But at some point, there is obviously a limit of the infrastructure, but we think there's still a whole lot more work to do. We've talked a little bit about it over time. What we have done is we've moved costs from the segment into the corporate structure to kind of eliminate and simplify a lot of that work. And then we move back a much lower base back into the segment from a service standpoint, and we're going to continue to do that way. So it means the corporate cost moves up and down, like it's moving towards a downward trend, but there's -- it's not a linear curve downwards. There's plateauing and then acceleration, plateauing and acceleration. And that's where it comes from. It's -- and it's part of really that business system transformation where you really create better clarity on your ways of working, who's responsible for one. What it means to be a function that supports the P&L, that supports the business, that supports the people, that help our customer every day. It's a change in approach mentality, but it drives real value from a corporate cost standpoint.

Fantastic. And then lastly, I guess, let's touch on the portfolio for a second. In terms of -- you mentioned parts of security are struggling. Like when do you take a decision to say, okay, it's better in parts of it or parts of any segment at JCI that's not performing well when is it time to maybe find a different owner for that and the scale of it? And separately on the acquisition front, you mentioned the acquisition announced in the last 24 hours. But what's the appetite to do something larger, say, in liquid cooling to really cement your position there?

So first on the overall portfolio, our job is to operate those assets the best we can. And so selling an asset because we're not managing it well is not a good enough reason to separate from it. Our decision on portfolio really come from our strategy. It's a focus on AI data center, mission-critical vertical where we can actually create differentiation and then energy efficiency or decarbonization. We think about those 3 pillars, there's assets that we own that that fit squarely there, like the HVAC Applied, the Controls business very clearly. And there's assets that are a little bit more challenged, either because they don't serve the right vertical. We've seen a couple of announcements. We've divested 2 of our residential security business over the last 2 quarters, and we're going to continue to divest more. We have businesses that serve end markets where there's no real mission-critical approach. There's no real AI view. There is no the decarbonization play. I'm thinking some of our retail end markets, some of our more residential end market. We are on a path to continuously improve those businesses and how they perform, but also looking at, is there a better owner? And even if there is a better owner, can we get sufficient value so we can create a shareholder-friendly transaction. Some of those transactions because the tax basis is so low, will remain dilutive because we'll pay a lot of tax. But there is a value to simplifying or finding a better owner for that asset than spending all of our time and energy fixing a business that really doesn't fit the overall strategy. Now when it comes to a greater acquisition, a big change, we do not believe it is required at this stage for us to be winning. I'm not saying it's not in the card. I'm saying it's not required for JCI to maintain the leadership position we've established in data center within our markets. We're opening up a little bit of aperture on what that market really means. And we'll keep you updated as we assess potential targets and what ultimately that strategy around data center really leads from what belongs to the portfolio and doesn't.

Fantastic. Well, with that, let's switch quickly to audience response questions, please. So the first question is around current ownership of JCI?

If you're not burning, you're missing out.

Right. So I don't know, 50%, no...

50-50.

Slightly below the average. I think most of them are in the 60s, no. Second question is sort of general attitude to the stock today?

[indiscernible]

So overwhelmingly positive. Third is around EPS growth through cycle kind of versus the multi-industry average.

The truth 3 have really done a terrible job today. I'll take the feedback. But...

There you go. 0%. So yes, very clearly above peers. Fourth is around cash usage. We just touched on that at the end of the discussion. So generally sort of smallish acquisitions. Next question is valuation related. What's the PE JCI should trade at on year 1?

Can I vote?

Next time. So in the 20s comfortably. And last question, what's the biggest kind of gating factor or valuation anchor?

All right.

So mishmash, but -- yes. Well, that's it. Thank you so much, everyone, for contributing. Thanks so much, Marc, for being here again. Lovely to see you.

Thank you.

Thank you.