Can a Power-Less Johnson Controls Unlock Shareholder Value?

Simplified Business Model but Slower Growth, Lower Operating Margins
With exception of power solutions’ distributed power storage products, which mainly serve building customers but are a nascent business, we don’t think there are many synergies between power solutions and Johnson Controls’ buildings segment. As such, the divestiture of power solutions would result in a simplified business model and allow Johnson Controls to redirect its resources to its core building technologies operations. A simplified business model and a narrowed focus come at the expense of slower growth and lower operating margins, at least over the near term. However, we see opportunities for buildings to post stronger organic revenue growth and margins over the coming years.

Since Johnson Controls began consistently reporting segment year-over-year organic revenue growth on a quarterly basis (the second quarter of 2012), we calculate that buildings’ quarterly year-over-year growth rate averaged about 1% while power solutions averaged about 5%. Over the past three years, the buildings segment’s average organic revenue growth has improved to about 3% while power solutions’ average organic revenue growth has moderated to 4%.

Power solutions has historically generated better margins than buildings, although the addition of Tyco’s more service-rich business and synergy realization helped buildings close the gap between the segments a bit in fiscal 2017.

Improved Free Cash Flow Conversion but Increased Cyclicality
The buildings segment currently converts more of its earnings into free cash flow than power solutions does. While it’s true that recent investments in absorbent glass mat battery capacity are weighing on power solutions’ free cash flow, our historical analysis indicates that a greater percentage of power solutions EBITDA has been reinvested in capital expenditures relative to the buildings segment.

Cash outflows related to the Tyco merger and Adient spin-off have been a drag on Johnson Controls’ free cash flow, but we expect this noise to dissipate as the Tyco integration progresses and the company executes on its cash flow management initiatives. While power solutions’ divestitures could result in some near-term cash outflows, we don’t expect such outflows will be of the same magnitude as the cumulative outflows related to the Tyco merger and Adient spin-off. Based on our analysis, after the power solutions divestiture is completed and any related cash outflows are incurred, we believe Johnson Controls’ remaining building technologies business can sustainably convert at least 90% of its earnings into free cash flow.

At least over the near term, we believe the divestiture of power solutions will result in increased cyclicality because Johnson Controls will lose approximately $5.6 billion in aftermarket battery sales, which we view as recurring revenue, given that battery replacement is a nondiscretionary purchase, in our view. Still, even without battery aftermarket revenue, Johnson Controls’ pro forma mix of service revenue as percentage of total revenue is better than it was before the Tyco merger and Adient spin-off.

A common misconception is that Johnson Controls’ buildings segment is dependent on new commercial construction. However, approximately 70% of buildings’ revenue is generated from retrofit and replacement spending, which is much less volatile than new construction spending. Furthermore, we believe Johnson Controls has ample opportunity to capture more service revenue over the coming years.

Net Proceeds Could Go to Deleveraging, Shareholders, and M&A
No matter what transaction structure through which Johnson Controls ultimately chooses to divest power solutions, the company will receive some amount of cash proceeds. A sale or joint venture partnership will generate cash from the acquiring party, and Johnson Controls would almost certainly leverage up a spun-off power solutions in order to pay a one-time dividend. However, the company disclosed that power solutions has a $3 billion tax basis, so Johnson Controls will probably incur some amount of tax liability that will net against any deal proceeds.

Johnson Controls ran a balanced capital-allocation strategy under Alex Molinaroli, and we don’t expect that to change under George Oliver’s leadership. We expect the company will utilize net deal proceeds to return cash to shareholders, deleverage the balance sheet, and possibly acquire businesses that can strengthen its position in buildings technology.

EV Bear-Case Stigma and Automaker Exposure Removed
We don’t believe that the growing adoption of electric vehicles is an existential threat to power solutions. However, there are certainly those who disagree with our outlook. While the spin-off of Adient greatly reduced Johnson Controls’ exposure to automakers, we calculate that about 6% of the company’s consolidated revenue came from automakers in fiscal 2017 (down from 59% in 2015). Automakers have tremendous buying power and are prone to cyclical downturns and overcapacity, conditions that can erode the profitability of suppliers such as Johnson Controls.

Selling power solutions will eliminate any concern related to the businesses’ limited EV position as well as the company’s remaining exposure to automakers. From a shareholder’s point of view, a joint venture will reduce downside risk related to power solutions’ future operations because the partner(s) will share some of the risk. In addition, the right partnership could better position power solutions in the automotive battery market or introduce ancillary automotive aftermarket opportunities that could lead to better performance than power solutions would have otherwise achieved. In the event of a spin-off, shareholders can decide whether they want to continue to own power solutions. As a stand-alone, independent company, power solutions could spend more time educating the investment community about its business model and addressing common misconceptions about the businesses’ competitive positioning, which could drive increased interest in the newly formed company.

Johnson Controls’ $1.2 billion synergy target is associated with Tyco-related cross-selling and cost structure optimization opportunities. Power solutions plays no role in achieving this synergy target, so its divestiture will not affect the company’s synergy goal. The sale of all or a portion of power solutions will result in transaction-related costs, such as consulting and legal fees and taxes on any recognized gain, and a spin-off would also probably result in additional separation and restructuring costs. We assume that proceeds from the divestiture will more than offset any divestiture-related costs, leaving the $1.2 billion synergy target unaffected.

Of course, the whole point of management’s decision to explore strategic alternatives for the power solutions business is to unlock shareholder value. We don’t believe Johnson Controls is currently receiving a fair valuation as a combined entity, and we think a divestiture could help the company and shareholders realize a better valuation.

Buildings’ Comprehensive Product Portfolio Stands Out Among Peers
We think Johnson Controls has a comprehensive portfolio of complementary products, which uniquely positions it in the buildings market. Furthermore, based on our analysis and company disclosures, we believe Johnson Controls holds a strong position in commercial HVAC, building automation and controls, and fire and security. Johnson Controls derives most of its revenue from the commercial market, and it is especially adept at large-scale, complex commercial projects (for example, Denver International Airport and the Pro Football Hall of Fame Village).

We know some investors remain skeptical about the revenue synergy opportunities between Johnson Controls’ legacy building efficiency business and Tyco because some building owners use a siloed approach to procuring and managing building technology. That is, a single individual is not responsible for all key building systems, and this could render a combined sales approach ineffective or at least inefficient. While this might be the case for smaller operations, our conversations with building engineers employed at large organizations lead us to believe that larger, more complex customers prefer a more holistic approach to procuring and managing building systems. For example, a building engineer who works for an industry-leading real estate services company told us he manages key building systems at his properties, including HVAC, building controls and automation, and fire and security systems. He said he viewed Johnson Controls’ one-stop shop approach as an attractive component of the company’s value proposition along with its strong service capabilities.

While we think the one-stop shop approach will help Johnson Controls continue to win large, sophisticated projects, the company will adapt its sales approach to meet customer preferences. That is, Johnson Controls can still handle that siloed approach to procuring and managing building systems. We don’t think the siloed approach precludes cross-selling opportunities either, because existing relationships with one gatekeeper in an organization can lead to relationships with other gatekeepers in the same organization.

Energy storage is a nascent business for Johnson Controls, but both the company and industry experts expect distributed energy storage to be a significant market opportunity in the coming years. Since none of Johnson Controls’ HVAC peers have energy storage capabilities, we’re hopeful that the company will continue to partner with power solutions after its fate is decided.

In our view, Johnson Controls offers a compelling value proposition for the commercial market. However, we acknowledge that its residential HVAC business, which is subscale and struggles with brand perception, is relatively weak compared with United Technologies (Carrier) (UTX), Ingersoll Rand (Trane) (IR), and Lennox (LII). That said, Johnson Controls’ relative competitive weakness in residential HVAC products doesn’t concern us because it’s a small part of the company’s overall business (less than 10% of consolidated revenue), and we believe commercial HVAC is a moatier business than residential HVAC because there are fewer companies that design, manufacture, and service large, complex commercial HVAC systems. Furthermore, related services associated with commercial HVAC systems are much sticker than residential HVAC services. As such, we’d prefer Johnson Controls to divest its residential HVAC business rather than allocate too much capital to a less competitive product offering.

Power Solutions Divestiture Doesn’t Affect Our Moat Rating
Johnson Controls’ building technologies and solutions segment holds a strong position in commercial HVAC equipment, building automation and controls, and fire and security. While this segment does enjoy competitive advantages stemming from intangible assets, customer switching costs, and economies of scale, we believe it faces tougher competition relative to the company’s power solutions business. Indeed, buildings competes against blue-chip companies such as United Technologies, Ingersoll Rand, Honeywell (HON), and Siemens (SIEGY), whereas Johnson Controls’ power solutions segment is the crown jewel in the lead-acid automotive battery market and competes against only a handful of inferior competitors, in our view. Power solutions has historically generated a higher operating income/assets ratio compared with the buildings segment, which we believe is indicative of power solutions’ stronger competitive positioning.

Intangible Assets: Technology and Customer Relationships
We believe technological know-how is a key differentiator for Johnson Controls, especially for large, complex commercial building system projects. Indeed, there are only a handful of competitors in that specific piece of the market.

Johnson Controls’ installed base of HVAC, building automation, and fire and security systems is an important asset that generates a lucrative stream of recurring revenue over the lifetime of the installed system, which can be over 20 years. Given the mission-critical nature of commercial HVAC systems, maintenance, service, and aftermarket parts are needed to avoid disruptive and costly system breakdowns. Johnson Controls’ installed base of Metasys, the company’s building automation system, generates recurring software upgrade and subscription-based revenue. Metasys software updates improve system functionality and guard against new cybersecurity threats. With the Tyco merger in 2016, Johnson Controls added a large installed base of fire and security systems that generate a significant amount of recurring maintenance and monitoring revenue. During Tyco’s final analyst day before the merger (November 2014), the company noted that approximately 25% of its top line was recurring service revenue.

Customer Switching Costs
New commercial HVAC, building automation, and fire and security systems are a large investment that can require lengthy installation time. As such, we believe building operators would be reluctant to completely replace entire systems and instead prefer to upgrade, retrofit, or reconfigure existing systems to adapt to changing technology, regulatory standards, and user requirements. This is a favorable dynamic for Johnson Controls, which is well positioned to capture upgrade, retrofit, and reconfiguration spending from its installed base.

In terms of service revenue, Johnson Controls’ ability to capture future HVAC maintenance and service revenue from its installed base is not always guaranteed. Third-party service companies and competing manufacturers are generally able to service many of Johnson Controls’ products, and some customers have internal engineers who can service systems to a certain extent. A competing manufacturer that wins a service contract on a Johnson Controls system can slowly replace components of that system with its own equipment over time. However, only a handful of companies can challenge Johnson Controls’ commercial HVAC position, including United Technologies (Carrier), Ingersoll Rand (Trane), Daikin, and to a lesser extent Lennox (which only competes in light commercial applications). Of course, Johnson Controls has the opportunity to win service contracts on competing HVAC systems as well.

We don’t believe Johnson Controls’ switching cost advantage extends to the residential HVAC market because residential replacement costs are comparatively low, and the service market is far more fragmented and competitive. However, residential HVAC sales account for less than 10% of Johnson Controls’ consolidated revenue.

In regard to Johnson Controls’ fire and security monitoring services, we believe that in many cases it’s more cost-effective for a customer to outsource these monitoring services to Johnson Controls rather than use an in-house monitoring staff.

Few of Johnson Controls’ competitors offer such a comprehensive suite of commercial building systems and related services. As such, there are few alternatives for building operators that value Johnson Controls’ one-stop-shop approach and prefer to use one company’s equipment and services for its key building systems.

Cost Advantage: Economies of Scale
Service is an important source of revenue and profitability for Johnson Controls’ buildings business. The company uses an extensive branch network to provide installation and services for its customers around the globe. While myriad HVAC and fire and security service providers exist, few have the revenue base to support a similar-size branch network. As such, Johnson Controls is much better positioned to directly service customers that have multiple locations across the U.S. and the world than local and regional competitors that don’t have the scale to profitably service customers with national or multinational footprints. Furthermore, we believe Johnson Controls’ branch density results in better service quality.

We believe Johnson Controls’ scale-driven cost advantage within its branch network could strengthen relative to competitors as the company integrates legacy building efficiency and Tyco branch networks. Before the Tyco merger, Johnson Controls disclosed that it operated approximately 650 global branches while Tyco disclosed that it operated over 700 branches. We believe there is opportunity for Johnson Controls to eliminate redundant branches and in turn offer more comprehensive service offerings across a more consolidated branch footprint.

We don’t think Johnson Controls’ buildings business has a wide economic moat because while few competitors are capable of replicating the company’s expertise in large complex commercial building systems, competition among those that do compete in the space (United Technologies, Ingersoll Rand, and Daikin) can be fierce. Furthermore, lucrative service revenue is not guaranteed, and competing companies could chip away at Johnson Controls’ installed base over time.

While we believe the power solutions business has a wide economic moat, it only accounts for about one fourth of Johnson Controls’ consolidated revenue. As such, we believe Johnson Controls has a narrow economic moat, and we don’t expect power solutions’ divestiture to affect our overall rating.

Better Growth and Profitability Lie Ahead for Buildings
Projecting that building technologies companies will benefit from urbanization, energy efficiency, and digitalization trends could sound like a cliche. Nevertheless, these secular trends are real and should represent growth opportunities for Johnson Controls and other building technologies companies.

Growing urbanization is the trend that will be most beneficial to Johnson Controls’ foreign operations. According to Ingersoll Rand’s estimates, by 2050 there will be 6 billion-6.5 billion people living in cities, up from 3.5 billion today. This massive migration to cities will require huge investments in infrastructure, including buildings. In India alone, Ingersoll Rand estimates that 85% of the buildings that will in exist in 2050 have not yet been built.

According to the U.S. Energy Information Administration, HVAC and refrigeration equipment account for over 60% of energy used in commercial buildings. We believe a perpetual desire to reduce building operating costs and meet regulatory standards will support demand for future retrofitting spending. Growing demand for smart building technology that interconnects building systems and collects data that can be used to optimize building operations is a favorable trend for Johnson Controls’ building automation products and services.

To benefit from increased demand for energy-efficient and smart building system products, Johnson Controls must stay at the forefront of product technology and continue to introduce ever more energy-efficient and user-friendly products. Since Johnson Controls does not break out research and development spending by segment, we looked at capital expenditures as a proxy for its reinvestment in its buildings business. By this metric, Johnson Controls (and legacy Tyco) appear to be ahead of the competition. We believe Johnson Controls’ reinvestment in its buildings business will drive strong product vitality, which is generally measured as the percentage of total revenue generated from new products, and support future revenue growth.

Johnson Controls recently expanded and reorganized its salesforce to help win a more diverse mix of business and improve its service penetration. Based on our conversations with the company, our understanding is that in the past, the sales team was responsible for project opportunities of all sizes, but they were encouraged to focus on large, longer-cycle projects that tend to result in lumpier revenue streams and can have lower margins compared with smaller projects. Now that the expanded sales team is segmented and properly motivated to focus on all types of projects, we believe Johnson Controls has an opportunity to win a more diverse mix of business that can lead to better sales visibility if its sales mix includes a greater proportion of shorter-cycle projects and recurring service revenue. We believe the changes made to the sales team’s organizational structure and incentive compensation can also drive better margins. Indeed, the margin of backlog projects has already begun to improve, and service revenue is growing.

Opportunities for Cross-Selling and Margin Gains
Johnson Controls’ merger with Tyco has already resulted in cross-selling wins, and we think these opportunities will continue. During the company’s December 2016 analyst day, management told investors that it expects to achieve $500 million of revenue synergies by 2020, which will result in $85 million-$100 million of incremental EBIT. On the basis of the company’s pace of announced cross-selling wins already, we don’t think this estimate is unreasonable.

In October 2017, Honeywell, which competes with Johnson Controls in building automation and fire and security, announced that it is spinning off its homes and global distribution businesses after facing pressure from activist investor Third Point. These businesses will be carved out from Honeywell’s home and building technologies segment. Now, Third Point is putting pressure on United Technologies to break itself into three separate companies: Otis; climate, control, and security; and aerospace. We believe Johnson Controls could take advantage of disruption at key competitors and take market share.

On the basis of our analysis, we believe Johnson Controls’ buildings segment can generate operating margins that are in line with or above those of peers such as Ingersoll Rand and Lennox. Over the next couple of years, we think Johnson Controls can continue to improve its buildings margins as it realizes incremental cost synergies and operating leverage while peers struggle to maintain what we view as peak margins.

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