Johnson Controls: Good Long Term Pick At Reasonable Valuation (NYSE:JCI)

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Investment Thesis

Johnson Controls’ (NYSE:JCI) backlog remained elevated at the end of Q3 FY22 due to strong demand for its products and supply chain issues. To mitigate its supply chain constraints, the company is working with its suppliers as well as improving its productivity and factory utilization. In Q4 FY22 and beyond, the improvement in supply chain constraints, higher price realization, and higher backlog levels should support revenue growth. The company is leveraging its OpenBlue platform to grow its service revenue and margins. Apart from this, the margins should improve going forward due to positive price/cost, conversion of higher margin projects in the backlog, and supply chain issues.

JCI Revenue Outlook

JCI reported solid topline growth in Q3 FY22, driven primarily by pricing. The volume growth in the quarter was flat as supply chain constraints affected the backlog conversion, primarily in longer cycle North America Solutions business. To manage the supply chain constraints, the company is working with its suppliers to secure critical materials and improve its production and factory utilization. JCI has been able to improve its supply of building management systems in North America significantly. The overall demand backdrop for the company remains robust, with field orders up 11% Y/Y organically last quarter and the backlog increasing to record levels of $11.1 bn by growing 13% Y/Y organically. In the North America Business Solutions segment, orders were up 15%, driven by continued demand in the data center and health care verticals. The segment’s backlog increased 17% Y/Y to $7.2 bn. In the EMEA/LA Business Solutions segment, orders were up 8% Y/Y, led by mid-teen growth in the fire and security business. The segment’s backlog was up 10% Y/Y to $2.2 bn. The orders in the APAC Business Solutions segment increased 2% Y/Y driven primarily by continued momentum within the industrial vertical in China. The pipeline of infrastructure investments across key verticals like data centers, semiconductors, petrochemicals, and healthcare drove the order rate. The backlog grew by 1% Y/Y to $1.7 bn. The Global Products backlog grew more than 50% Y/Y to $2.2 bn with orders being up in mid-single digit Y/Y driven by strong growth in service.

Looking forward, the company’s close coordination with its suppliers and improvements at its facilities should reduce the supply chain challenges, thus improving volumes in Q4 FY22 and beyond. The backlog conversion is expected to improve by two months and should get back to historical levels, supporting the volume growth in Q4 FY22 and 1H FY23.

In the healthy building business, the growth opportunity remains strong with the global government supporting indoor air quality investments. The U.K. parliament proposed the Clean Air Bill that would require mandatory monitoring of indoor air quality and improve air quality in England and Wales. The U.S. government is also investing in improving indoor air quality at schools, colleges, and universities. Healthy Buildings orders in Q3 FY22 increased 27% Y/Y and the order pipeline represents a 33% Y/Y increase to $1.3 bn. The company plans to leverage its OpenBlue technology to take advantage of the investments going around the world in healthy buildings.

In Europe, the decarbonizing trend and goal to get net-zero emissions by 2050 should be a tailwind for the company. This strategy is underpinned by EU-level legislation such as climate law, the energy efficiency directive, and the energy performance of buildings. The EU is currently focusing on reducing its dependency on Russian fossil fuels by 2027, and this is going to require new public buildings to have zero emissions. JCI’s work on low GWP (Global Warming Potential) products as well as energy-efficient products should benefit the company’s topline. In FY22, the company is expecting the topline to grow 8% to 9% Y/Y organically, with pricing contributing 7%.

Service Business Growth

JCI’s connectivity platform, OpenBlue, is a fully integrated digital platform, providing cybersecurity, AI enablement, and digital twin capabilities. In Q2 FY22, the company launched its OpenBlue Gateway, a step towards accelerating the connectivity of JCI’s equipment and a key enabler of its ability to deliver enhanced digital service offerings. The service orders in Q3 FY22 increased 7% Y/Y. JCI has connected over 8,400 chillers with its OpenBlue technology, representing an 86% Y/Y increase. The launch of its connected control platform, which represents the integration of OpenBlue with JCI’s medicine platform, should allow the company to intelligently automate buildings and optimize air quality, energy efficiency, and carbon reduction needs as well as transform its service value proposition.

The company is also engaged in M&As to improve its OpenBlue platform and technological capabilities. JCI acquired FogHorn in Q1 FY22 and Tempered Networks in June 2022 to enhance its OpenBlue technology stack by leveraging their best-in-class technologies. Tempered Network is a leading-edge security-focused and proprietary air wall technology that will be embedded in the OpenBlue platform to enhance the crust and connectivity of JCI’s growing network.

Margins

The adjusted EBITA margin in Q3 FY22 was down 110 bps Y/Y to 15.1% due to 104 bps headwinds from lower volume and supply chain-related challenges, partially offset by the ongoing SG&A and COGS improvement program. Supply chain disruption in the quarter was $65 mn. The company saw positive price/cost for the first time in the quarter by $20 mn.

Looking forward, as the supply chain constraints improve, their impact should decrease in Q4 compared to Q3 FY22. The price/cost is expected to be around $30 mn in Q4 FY22. Additionally, the mix should get better as the higher margin projects booked in the backlog get converted. This should be accretive to margins. The North America segment’s adjusted EBITA margin should increase 4.5 percentage points sequentially and remain flat Y/Y. JCI’s OpenBlue platform is receiving high demand from customers and putting high-quality projects into backlog, underpinning the margin improvement. Additional levers include functionalizing and simplification in its ERP rollout to further drive productivity efforts. The company’s target is to achieve $220 mn in productivity savings in FY22 and has realized $170 mn year-to-date.

Valuation & Conclusion

The stock is currently trading at 17.07x FY22 consensus EPS estimate of $3.00 and 14.20x FY23 consensus EPS estimate of $3.61, which is below its five-year average forward P/E of 18.34x. JCI’s revenue should benefit from volume growth due to the improvement in supply chain constraints and higher price realization. The company has elevated backlog levels and a strong order pipeline, which benefit revenue in 1H FY23 and beyond. The company’s margin should benefit from positive price/cost, the mix of the business, and SG&A and COGS improvement programs. Given reasonable valuations and good growth prospects, I have a buy rating on the stock.



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