Earnings Call Transcript - JCI Q2 2021

Operator, Operator

Welcome to the Johnson Controls’ Second Quarter 2021 Earnings Call. Your lines have been placed on a listen-only, until the question-and-answer session. This conference is being recorded. And if you have any objections, you may disconnect at this time. I will now turn the call over to Antonella Franzen, Vice President, Chief Investor Relations and Communications Officer.

Antonella Franzen, Vice President, Chief Investor Relations and Communications Officer

Good morning and thank you for joining our conference call to discuss Johnson Controls’ second quarter of fiscal 2021 results. The press release and all related tables issued earlier this morning as well as the conference call slide presentations can be found on the Investor Relations portion of our website at johnsoncontrols.com.

George Oliver, CEO

Thanks, Antonella, and good morning, everyone. Thank you for joining us on today’s call. I will start with a brief strategic update while adding a few specific areas related to our growth initiatives. Olivier will provide a detailed review of Q2 results and update you on our forward outlook. We will leave as much time as possible to take your questions. Let's get started on Slide 3. We delivered another quarter of solid financial performance. Organic sales and order growth reflected positive as anticipated, which when combined with our ongoing commitment to operational excellence enabled us to grow EBIT by more than 20% year-over-year. Despite some challenges in the macro environment, inflationary pressures, supply chain disruptions, and the lingering impacts of COVID-19, trends across most of our end markets continue to improve, and we continue to gain share. We have maintained an incredible level of engagement with our teams globally, as well as with our customers and partners. And we continue to execute on all of our strategic initiatives; expanding our service attachment rate and driving higher recurring revenue, enhancing and connecting our installed base with our digital OpenBlue platform and advancing our role in addressing the environmental needs of our customers. Lastly, as promised, we are announcing our cost of goods reduction program on today's call, which targets $250 million in run rate savings by fiscal 2023. In combination with the SG&A actions we announced earlier this quarter, we expect to deliver $550 million in net savings, which provides significant margin expansion over the next several years. These actions are a testament to our commitment to continuous improvement and will enable us to close our margin gap versus peers.

Olivier Leonetti, CFO

Thank you, George, and good morning, everyone. Continuing on Slide 10, organic sales inflected positive as anticipated in Q2 at 1% overall with strong growth in global products and underlying trends improving across our field businesses. The strength in global products was driven by continued high levels of demand in residential end markets, not only in our HVAC equipment business but also in security products.

Operator, Operator

Thank you. Our first question is from Nigel Coe, Wolfe Research. Your line is open.

Nigel Coe, Analyst

Thanks. Good morning, everyone. This has been a strange quarter for. So yes, first of all, just want to touch on the COGS and SG&A actions. I'd be curious, what prompted the sort of the second round of efficiency programs and what prompted the review? And is it a case of having lived through COVID and remote working that you've found more efficient ways of doing things in the case of Olivier coming in and having a fresh look? I mean what prompted these actions?

Olivier Leonetti, CFO

So, Nigel, good morning. Thank you for your question. After the merger, we established the conditions to achieve another level of profitability improvement. When I started, George asked us to identify ways to close the productivity gap compared to our competition. That was our main objective, which we communicated about seven months ago. We have been updating you as our plans develop. First, we focused on SG&A, and today we are discussing our COGS plan. As you can see from the numbers, Nigel, we believe we will significantly contribute to the bottom line and are on track to close the gap with our competitors.

George Oliver, CEO

And, Nigel, it's really a continuation of the work that we did with the integration. We've got strong fundamentals now across the board. We've got the right leadership team. And then the work that we've been doing, we recognize that there's a significant opportunity to continue to improve. And what we've done as a team is be able to detail that, and then we're very confident that we're going to be positioned to be able to deliver on those benefits.

Nigel Coe, Analyst

Great. Thanks, George. Thanks, Olivier. And then service orders down 3%. So I recognize the backlog is up. So maybe just talk about what caused that decline? Just given the initiatives you have in train to drive growth in services. And I heard transactional was within a bit of pressure in North America. But what is your confidence that orders start to impact positive from here?

George Oliver, CEO

Nigel, as you know, we have an incredible base of service, over $6 billion. And what I would say here, with the service strategies that we've been executing, I'm incredibly proud of the progress we've made. It's one of our biggest growth sectors. It's being able to increase market coverage, enhance technology with OpenBlue, create new service capabilities, really now being able to leverage the underserved install base, and then ultimately deliver a very attractive margin profile. When you look at the quarter, service orders were down slightly. And it's mainly just timing of conversion. We had an extremely strong March, which is continuing in April. Our service pipeline is up double digits. And then with the site access improving, that's also helping us to accelerate our L&M and our L&M contracts, which is labor and materials. And for our attach rate, when you look at our attach rate for service with our install projects, it is up significantly, up 300 basis points year-to-date. And so when you look at our backlog up 5%, the strong pipeline, and then the work that we've done executing on our strategy, we're very well positioned for a strong double digit second half in both orders and revenue.

Nigel Coe, Analyst

Thanks, George. I’ll leave it there.

Operator, Operator

Thank you. Our next question is from Gautam Khanna with Cowen. Your line is open.

Gautam Khanna, Analyst

Yes. George, I wanted to ask in your opening remarks, I think you talked about supply chain constraints and wanted you to expand on that. And just did it actually prevent you guys from delivering equipment in the quarter, maybe if you have any sort of quantification of how that manifested in first quarter results. And then I have a follow up.

George Oliver, CEO

Yes, Gautam, our team is doing incredible work across our supply chain as we're working to be able to support what we see to be an accelerating pipeline of opportunities across our businesses. We’re gaining share in every platform. And so as we're working to make sure that we've got secured components and materials to be able to support that new demand, certainly we're working it hard. I believe that our team has done a good job to mitigate most of the impact. I think where we’re seeing significant demand in residential, unitary as well as commercial unitary product, we're continuing to work that and not only expand our supply chain, but also our manufacturing footprint. And so we're working through that. Our backlogs are up in those businesses are record highs. And so we are working to continue to accelerate our supply chain to be able to address and support the increasing demand. But overall, I'm very proud of the team and the work we've done to be able to support our customers and ultimately deliver on the product that's being demanded.

Gautam Khanna, Analyst

And just as a follow up, George, any quantification of specific IAQ orders that you guys have in the quarter and perhaps any color on the front log of opportunities that are in IAQ specific? Thank you.

George Oliver, CEO

Yes. When we assess the progress with OpenBlue, we are not only digitizing our core business but also leveraging the data we've extracted to offer new solutions to the market. This positions us well to take advantage of significant accelerating trends. Our OpenBlue Healthy Buildings, launched in mid-January, features over 25 unique products and services aimed at promoting healthy people, places, and the planet. The market opportunity is expanding; we initially estimated it at $10 billion to $15 billion, and this figure is on the rise. Our pipeline is approaching $1 billion, and we have already secured over $150 million year-to-date. We anticipate continued growth, expecting several hundred million in 2021. We have established partnerships with schools and have a strong presence in over 6,000 K-12 districts, as well as collaborations with sports venues to facilitate the return of attendees to events. Our approach involves a thorough assessment followed by monitoring, remote maintenance, and optimization to deliver the best solutions. We are very excited about this trajectory. Additionally, OpenBlue is translating into various benefits, including improved service attach rates and profitability with favorable margins. Our competitiveness in the smart buildings sector is enhanced by our leadership in sustainability and decarbonization. The ongoing digitization of our existing service base, through connectivity, allows us to build closer relationships with our customers and introduce new capabilities that can significantly transform how we serve them.

Gautam Khanna, Analyst

Thank you.

Operator, Operator

Thank you. Our next question is from Jeff Sprague with Vertical Research. Your line is open.

Jeff Sprague, Analyst

Thank you. Good morning, everyone.

George Oliver, CEO

Good morning, Jeff.

Jeff Sprague, Analyst

Good morning. Two questions for me. First one, it looks like you're telling us you're going to absorb these cash restructuring costs and still convert at 100% free cash flow conversion. I just want to confirm that's the case. And if so, what's really allowing you to do that? I guess it has to be working capital. And if it is, maybe you could elaborate a little bit more on the working capital opportunity that's bridging you across that.

Olivier Leonetti, CFO

Good morning, Jeff. So you're right. The 100% free cash flow will include both the restructuring cash impact of our SG&A and COGS programs announced today. You're right. More profit will be part of how we get there and also enhanced working capital. If you look at today, for the second quarter, we have improved cash conversion cycle by about 24 days; eight in DSO, about 11 days in DIO inventory and about five days in DPO. And we have built over the quarters even before I took the position, a great machine to have a high focus on working capital. And you see that keep delivering. And we are actually very confident in our ability to deliver a 100% free cash flow this year, but also the following years. If you do some math, Jeff, just in the first half, we are converting at 140%. So we have quite fair headroom to now achieve 100% for the year.

Jeff Sprague, Analyst

Great. And then maybe secondarily, just on the COGS program, the mix of savings are interesting. I guess if I was going to feel the guess of where the costs would come out, I would have surmised maybe more in manufacturing and distribution and less so in field labor. I wonder if you could just kind of address the manufacturing and distribution piece. It looks like you've got a $3.2 billion cost base there if I'm interpreting the chart right, and you're targeting $70 million of savings there. I guess these plans might not be fully mature after a kind of a seven-month exercise, but would there be kind of more room in some of these numbers as you look forward?

Olivier Leonetti, CFO

So a few things. We said it. I'm going to repeat it. Those savings are net. Meaning they would flow to the bottom line. If you look at the mix, our team has done a great job in managing direct materials over the few quarters and we think now the biggest opportunity, that's why we have announced the numbers we have announced are in the standardization of our field operation across all the elements of field operation; install, services and procurement. Now the other question was, is there more possible? That's, of course, the case. We want to be prudent. And we keep informing you as we go through the quarters, but we have a high level of confidence in our ability to execute this COGS program.

George Oliver, CEO

And, Jeff, I think it's important to note that as we went through the integration, we developed a robust operating system for the field, which enables us to be able to take all of what we do to put into that one operating system. And then would that globally be able to focus on the variation at each one of the cost levels, and be able to drive improvement. So the work that we've done is we actually have that detail to that level across the board and how we're driving improvement within that operating system for our field-based businesses.

Jeff Sprague, Analyst

Great, thanks. Very encouraging. Good luck.

George Oliver, CEO

Thank you.

Operator, Operator

Thank you. Our next question is from Scott Davis with Melius Research. Your line is open.

Scott Davis, Analyst

Hi. Good morning, everybody.

George Oliver, CEO

Good morning, Scott.

Scott Davis, Analyst

I’m curious kind of logistically and otherwise what an outcome-based contract really looks like? Are you defying getting cash in the door? How long does it take to kind of prove the outcome that you're promising? Can you walk us through at a high level without giving away your trade secrets here or contract secrets, but can you walk us through at least at a high level what a contract like that looks like? I'll just leave it at that, George.

George Oliver, CEO

Yes. So, Scott, it's similar to our performance contracting that we have today where we ultimately do a survey of a customer site. We identify opportunities to be able to reduce energy, improve operations and the like. And when we do that, there's significant improvement to be made. Buildings historically have been very inefficient. They've been very energy intensive. And so our opportunity here is to be able to create an outcome, energy savings, higher operations, and then do that. In some cases, we bring in financing for the project, and ultimately then get a recurring revenue that goes over. It can be over 10, 15, 20 plus years depending on the type of projects. These are great returns, great recurring revenue that's tied to that initial install project, and ultimately delivering on the outcome. And our track record in being able to deliver on the commitments that we make with these types of contracts is extremely high. So we do manage a bit of risk, but it's relatively low and we ultimately make sure that with the technologies and capabilities that we provide, that we deliver on the outcome that we commit.

Olivier Leonetti, CFO

One statistic, Scott, and we haven't disclosed this before. If you look at the energy saving performance market in the U.S., which is a $4 billion market, the company has a market share which is 50% higher than our number two competitor. So we have a strong position in the energy saving outcome-based market, and we believe that we're going to leverage this capability going forward as buildings decarbonize across the planet.

George Oliver, CEO

Scott, it's crucial to recognize that buildings account for approximately 40% of the global carbon footprint, with about 75% of that relating to operational emissions. Therefore, as commitments to achieve net zero carbon emissions are made, buildings become essential in reaching that goal. We have a significant opportunity with our current capabilities—not only from our historical performance contracting but also through OpenBlue—which allows us to integrate complete systems. By utilizing data effectively, we can enhance optimization in what we deliver to our customers, helping them achieve their objectives.

Scott Davis, Analyst

It totally makes sense. Is it harder to collect in those contracts? Is there kind of disagreements of what the data shows and the sustainability of that? And with the savings, it seems like there would be some gray area items in there, but perhaps I'm wrong.

George Oliver, CEO

Scott, it's the opposite. It's very predictable. And I think our track record relative to the projects that we've executed, that has been very strong. So we make sure that as we look at these type of projects with the customers that we're doing these projects for, that we're obviously mitigating any risk and ultimately focus on executing on the commitments that we make.

Scott Davis, Analyst

Perfect. Thank you for the clarification. Good luck and congrats, guys. I’ll pass it on.

George Oliver, CEO

Thanks, Scott.

Operator, Operator

Thank you. Our next question is from Steve Tusa with JPMorgan.

Steve Tusa, Analyst

Hi. Good morning, guys.

George Oliver, CEO

Good morning, Steve.

Steve Tusa, Analyst

Can you just talk about a little bit more about price cost? What was the spread in the quarter and how you're seeing kind of pricing and costs evolve over the next couple of quarters? And is there any – given your kind of fiscal year-end timing, any leakage into next year?

George Oliver, CEO

Yes, Steve, I'll begin and then hand it over to Olivier for additional details. Over the past three years, we have developed strategic pricing capabilities throughout the company. In the last couple of years, this has allowed us to achieve a net increase of 100 basis points on the top line. This has been particularly beneficial as we face accelerating inflation. We have improved discipline in our operations, executing projects more effectively and at better margin rates. Within our product lines, where material costs have a quicker impact, we have implemented a dynamic pricing model across all our platforms. This model enables us to respond to immediate situations while also considering longer-term pricing strategies. In the second quarter, we saw approximately a 30 basis point benefit. We are confident that our focus on productivity, value analysis, direct material cost reduction, and overall supply chain efficiency will keep us in a positive position for the second half of the year.

Olivier Leonetti, CFO

No, nothing more to add, Steve. And when you look at Slide 19, when we say 30 basis point base margin improvement, we are factoring also our best view on next year price cost, but we have a great process across the organization to maintain that going forward in this very fluid environment.

Steve Tusa, Analyst

Okay. Any other mechanical items for next year that we should be aware of as you've moved through this year that flip either positive or negative outside of the kind of obvious restructuring and the activities you've already kind of talked about?

Olivier Leonetti, CFO

Nothing more than what we all read in the news. It's still a freed environment. We feel very bullish about how the economies across the world are rebounding. George mentioned that earlier in this call. Our order flow is increasing significantly. And something important, if you look at our install business, which is about 35% of the revenue of the organization, we see this business now growing, and that is done at the back of the retrofit market. Usually, 50% of install is associated with new buildings. The new buildings today are depressed. So as this new building is starting to rebound, and it is in the U.S. and across the world, we see our business really taking momentum, and that will translate into, of course, more global products, products being sold, higher service mix. So we feel very positive about what we see in front of us.

Steve Tusa, Analyst

Great. Thanks a lot. I appreciate it.

Operator, Operator

Thank you. Our next question is from Julian Mitchell with Barclays. Your line is open.

Julian Mitchell, Analyst

Hi. Good morning.

George Oliver, CEO

Good morning.

Julian Mitchell, Analyst

Morning. Maybe a first question around fire and security. You've got good sort of recovery trends, very evident on the HVAC side of the house. Fire and security sales still down mid-single digit. So maybe help us understand how you see the slope of that recovery from here? And perhaps how big of an impact is the sort of retail piece in there as a headwind?

George Oliver, CEO

Yes, Julian, let me start by discussing fire and security, what we observed in the quarter, and its implications for the future. This segment accounts for about 40% of our total revenues and is essential to our building systems. It has an attractive margin profile due to our mix of products and services. We also have a substantial installed base that drives recurring revenue. With the integration of OpenBlue, we can effectively differentiate our offerings in the long term to capture a larger share of that recurring revenue. In today's digital landscape, security is becoming a crucial asset for smart buildings, enabling data collection and analytics. When examining sequential trends, our short cycle business in fire and security has seen a positive increase. Overall product sales are up, reflecting low to mid-single-digit growth. Additionally, our service segment has shown a positive turnaround in field operations, which had faced challenges due to previous shutdowns. Looking ahead, the trends in short-cycle business appear promising, and for installation, we are gaining a significant portion of new projects, in both retrofit and installation segments. As these projects emerge and get deployed, we are well-positioned to enhance our installation revenues. Although installation revenues have declined, this is primarily due to timing of conversions, and we anticipate a strong pickup in orders in the second half of the year.

Julian Mitchell, Analyst

Great. Thank you. And then maybe switching to a topic that's relevant across the company. There's a lot of interest, obviously, in the U.S. education stimulus money that could flow over the next three years. Maybe help us understand what the scale of JCI's exposure is to that education vertical as you're looking across the field and global products business?

George Oliver, CEO

Yes, Julian, let me summarize quickly. The three large COVID relief packages totaled about $5 trillion in aid over the last 12 months, providing much-needed relief for our customers. We actively participated in shaping these bills to focus on healthy buildings, ensuring that whether it's bringing students back into classrooms or upgrading facilities, we were involved in detailing the requirements needed to address new challenges. The funding directed toward upgrading facilities in our key markets, such as K-12 education, higher education, and state and local government, aligns with our strengths. In K-12 education alone, we have relationships with approximately 6,000 school districts across North America, and around 1,900 at the higher education level. K-12 has been allocated about $195 billion. We are focused on both the initial phases of building and executing state-by-state through our program management office, tracking the flow of stimulus funds and preparing to meet the challenges they will address. We see the total addressable market in the U.S. as being in the billions, and the healthy buildings market, originally estimated at 10 to 15 billion, continues to grow with the stimulus influx. We believe we are in the early stages with a pipeline worth hundreds of millions of dollars that we are well positioned to capitalize on.

Antonella Franzen, Vice President, Chief Investor Relations and Communications Officer

And Julian, I would just add that when you look at education, it is a big vertical for JCI overall. And particularly when you look at North America, it's about 20% of the revenue.

Julian Mitchell, Analyst

That’s great. Thank you.

Operator, Operator

Thank you. Our next question is from Josh Pokrzywinski, Morgan Stanley. Your line is open.

Joshua Pokrzywinski, Analyst

Hi. Good morning, guys.

George Oliver, CEO

Good morning, Josh.

Joshua Pokrzywinski, Analyst

George, if you wouldn't mind just kind of taking a step back, I know with the nature of the field business and kind of the mix of fire and security and HVAC in there sort of makes benchmarking tough. But if I look at what we've kind of seen so far through the first quarter, it seems like maybe from an orders perspective, commercial HVAC is running up kind of mid-teens at the market level. I think you mentioned low double digits in applied North America, but what's your sense on kind of the product side of commercial HVAC and where we should sort of see order rates here, whether it's this quarter or kind of here in the medium term?

George Oliver, CEO

Josh, when we examine our product mix, it’s clear that we have a longer cycle with the installation service aspect of our portfolio. However, if we analyze the specific products across all categories, we are gaining market share. For example, in the commercial unitary business, new orders for rooftop equipment in North America have increased in the mid-teens, with March showing an increase of over 30%. Our backlog has doubled. These orders fall within our product-based business, so they won’t be visible directly in our reporting, but they are reflected in the book and bill. In terms of our unitary market share, we’ve seen an increase of approximately 40 basis points year-over-year. With a 100% rise in backlog and anticipated growth for the third quarter, we expect our North American unitary segment to grow by more than 30% this quarter. On the residential side, our order levels have also risen, increasing by about 88%, accompanied by a record backlog. Sales are up roughly 35%, and unit sales exceed 40%. We’re experiencing strong sell-through in that channel, and we anticipate continued strength into Q3 and Q4. The same positive trend is evident in our Hitachi business in Asia Pacific, where we’ve achieved strong double-digit revenue growth, primarily driven by success in Japan due to our new product launches. In North America, while our overall install orders increased by about 5%, we noticed mid-teens growth in applied equipment orders, which should benefit us significantly in the second half of the year, enhancing service attachment and revenue moving forward. It's important to dive into the details to recognize that we're setting up our distribution and install business for long-term attractiveness. Additionally, as Olivier mentioned, our install business has significantly outperformed during this cycle. While non-residential construction has declined, we have largely filled that gap with short-term retrofit upgrade orders, which increased by 20% in North America this quarter. This short-term demand trend is expected to persist, particularly in relation to healthy buildings and sustainability projects. We are also seeing new demand in the non-residential sector, which is a combination I’ve not previously observed. This alignment should lead to strong order growth and revenue generation in the latter half of the year.

Olivier Leonetti, CFO

And Josh, and one statistic again, which gives – allows you to put all that together, global products in aggregate for next quarter we believe we're going to be able to grow revenue in the 20% plus range. So that gives you an idea about what is going on around all the elements of the portfolio, 20% plus revenue year-on-year growth expected.

Joshua Pokrzywinski, Analyst

That's super color. Maybe just one follow up on Scott's question on performance contracting. George, I think to your point, this is a business that you guys have been around in for decades now. I'm surprised that given how compelling that is for a customer that the industry isn't bigger or JCI's exposure to that isn't bigger. It almost seems kind of like a free upgrade providing you a bond support to get that work done. What's been kind of the bottleneck to that historically?

George Oliver, CEO

It's a great question. So we're working with all of our customers. And historically, a big customer has been the government, both at the federal level, at the state level and at the local level with our 3P type contracts and performance contracts. And so we've been working with them and some of it is how they account for the projects and ultimately, how they look at it as an upfront cost and how they account versus an ongoing operational cost. And so we've been very active working with our customers to make sure that they're addressing some of their internal challenges that get in the way of doing a contract like this, which is very attractive in being able to get returns that pay for the cost of capital. And so we're working to really start to create that market above and beyond what it is today. And we believe that we're very well positioned to be able to then capitalize on that opportunity, Josh.

Joshua Pokrzywinski, Analyst

Perfect. Thanks, George. Good luck, guys.

Operator, Operator

Thank you. And our final question comes from Andy Kaplowitz with Citigroup. Your line is open.

Andrew Kaplowitz, Analyst

Hi. Good morning, guys.

George Oliver, CEO

Good morning, Andy.

Andrew Kaplowitz, Analyst

Olivier, can you give us a little more color on how to think about the 550 basis points of total cost out and what it actually means for incrementals over the next few years? It looks like inclusive of the core margin improvement of 30 basis points that you're dialing in on average, do you think you can get something like 300 basis points of margin improvement over the three-year period with an average 100 basis points and core incrementals in the 40% plus range? But I just want to sort of confirm those numbers.

Olivier Leonetti, CFO

Good morning, Andy. Your numbers are absolutely correct. If you exclude Silent-Aire in the next fiscal year and the following one, we anticipate an incremental improvement of about 40%. Beyond that, we expect to have established the conditions necessary to achieve a 30% incremental improvement. We've already provided you with a lot of data, and we'll share even more on Investor Day in September.

Andrew Kaplowitz, Analyst

Very helpful. Olivier, as a follow-up, we know that JCI operates as an inverted company, so we wouldn't expect a significant impact from Biden's corporate tax win. How are you considering the stability of your tax rate if a global minimum tax agreement occurs? What strategies can you implement to maintain your relatively low tax rate advantage?

Olivier Leonetti, CFO

So the situation is fluid. All of us are reading the papers. All of us have insights on what could happen. So one, we are, of course, committed to the 13.5% tax rate for this fiscal. And going forward, we have ran various scenarios. We are highly confident that our tax rate will remain competitive relative to the industry. And we have various levers to achieve that. Some of it is, of course, where we are registered as a company and the complexity of our legal entity structure. We believe it's going to be and remain a competitive advantage.

Andrew Kaplowitz, Analyst

Very helpful, Olivier. Thank you.

Olivier Leonetti, CFO

Thank you, Andy.

Antonella Franzen, Vice President, Chief Investor Relations and Communications Officer

George, would you like to do some final comments?

George Oliver, CEO

Yes. Let's wrap up the call this morning. As I mentioned earlier, we've had a very strong first half of the year and the momentum we are seeing across our portfolio coupled with our strategic focus and improved execution gives me high confidence in our ability to be able to outperform as we go forward. I hope you and your families continue to remain safe, and I look forward to speaking with many of you soon. So with that, operator, that concludes our call.

Operator, Operator

Thank you. This does conclude the call. You may disconnect your lines, and thank you for your participation.