Johnson Controls International plc (NYSE:JCI) Q4 2023 Earnings Call Transcript

Johnson Controls International plc (NYSE:JCI) Q4 2023 Earnings Call Transcript December 12, 2023

Johnson Controls International plc misses on earnings expectations. Reported EPS is $1.05 EPS, expectations were $1.09.

Operator: Good morning, and welcome to the Johnson Controls Fourth Quarter 2023 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] Please note today’s event is being recorded. I would now like to turn the conference over to Jim Lucas, Vice President, Investor Relations. Please go ahead.

Jim Lucas: Good morning and thank you for joining our conference call to discuss Johnson Controls’ fourth quarter fiscal 2023 results. The press release and all related tables that were issued earlier this morning as well as the conference call slide presentation can be found on the Investor Relations portion of our website at johnsoncontrols.com. Joining me on the call today are Johnson Controls’ Chairman and Chief Executive Officer, George Oliver; and Chief Financial Officer, Olivier Leonetti. Before we begin, let me remind you that during our presentation today, we will make forward-looking statements. Listeners are cautioned that these statements are subject to certain risks and uncertainties, many of which are difficult to predict and generally beyond the control of Johnson Controls.

These risks and uncertainties can cause actual results to differ materially from our current expectations. We advise listeners to carefully review the risk factors and cautionary statements in our most recent Form 10-Q, Form 10-K and today’s release. We will also reference certain non-GAAP measures. Reconciliations of these non-GAAP measures to the most directly comparable GAAP measures are contained in the schedules attached to our press release and in the appendix to this presentation, both of which can be found on the Investor Relations section of Johnson Controls’ website. I will now turn the call over to George.

George Oliver: Thanks, Jim, and good morning, everyone. Thank you for joining us on the call today. Before discussing our fourth quarter and fiscal 2023 results, I wanted to take a moment to thank all of our employees for their quick agile response to the cyber incident beginning in the last week of September. Our teams responded quickly and worked diligently to minimize the impact from the incident. We greatly appreciate everyone’s patience from customers to suppliers, to shareholders as we work through our remediation efforts. We now have the incident behind us and our operations are back to normal. Now let’s begin with Slide 3. We feel it is important to not lose sight of the strong year we had in fiscal 2023, regardless of the impact on our fourth quarter results from the cyber incident.

For the full year, we grew sales organically 8%, expanded segment margins 80 basis points to 15% and delivered adjusted EPS growth of 17%. We saw continued strength in our Service business as our efforts in maximizing our large installed base are coming to fruition. In fact, we grew service 10% for the year with solid order momentum ending the fiscal year. Our total backlog grew 9% to $12.1 billion as demand remains strong across our Commercial Building Solutions offerings. In fiscal 2023, we generated $1.8 billion in free cash flow, which represented 76% conversion. During the year, we returned $1.6 billion to shareholders via dividends and share repurchases. Our capital allocation strategy remains unchanged, targeting to return 100% of our free cash flow to shareholders through dividends and share repurchases.

We have the highest conviction ever in our strategy to lead in Building Solutions, and we’ll continue to prioritize allocating capital accordingly toward that objective. Overall, we are pleased with our continued execution despite macro-driven headwinds over the fiscal year and believe that we are well positioned heading into fiscal 2024 with our strong backlog and resilient service business. We’re initiating guidance for fiscal 2024 for approximately mid-single-digit sales and adjusted EPS growth, respectively, and for free cash flow conversion of approximately 85%. Olivier will provide additional color on the guidance later in the call, but fiscal 2024 will show improvement following a seasonally slower first quarter. Now turning to Slide 4.

Demand for our Building Solutions is accelerating with our customers around the globe, as we are developing Applied Solutions to deliver outcomes that save energy and reduce emissions, while improving the overall occupant experience. We are able to achieve these outcomes not only through our leading domain expertise and applied HVAC & Controls solutions, but also through world-class fire detection and protection and smart security solutions enabled by an industry-leading digital platform, OpenBlue. All of our systems build on each other in are complementary components of our total solutions offering. The journey starts with our customer as we design, digitize and deploy solutions that achieve efficiency, sustainability and decarbonization. This turnkey offering drives operations, service and maintenance, which underpin our as-a-service offerings that make buildings smarter through our digital solutions.

This helps our customers enable peak operating conditions, protect investments and achieve the lowest life cycle cost. Johnson Controls is unique with our value proposition to make buildings smarter through OpenBlue. Our comprehensive ecosystem of connected digital solutions for buildings can break down silos and connect building systems regardless of equipment OEM and make them interoperable to build resiliency and efficiency. We were honored recently to be ranked number two on the Guidehouse Insights leaderboard in an assessment of leading energy service companies. The recognition underscores our commitment to excellence and sustainability on a global scale. It is a testament to our hard work and continued commitment to helping clients meet their sustainability goals.

Moving on to Slide 5. Fiscal 2023 saw continued strength in install orders, which creates a strong service opportunity over the life of the equipment. As we advance our digital strategy, including more than doubling our connected assets during the fiscal year, we are gathering more intelligence through data. This data allows us to better segment customer needs and create more proactive offerings across all of our domains, effectively utilizing our industry-leading service organization of over 20,000 professionals that make over 5.5 million visits annually. With our large installed base, improved operations and strong pipeline, we see a long runway of continued growth for our service business. Turning to Slide 6. Our value creation framework remains unchanged.

We truly believe we are well positioned to drive continued growth, delivering solutions across sustainable and healthy buildings, while leveraging the increased adoption of OpenBlue to drive margin expansion. Our pipeline remains strong in our longer-cycle Building Solutions business, as we continue to realize top line growth. Our shorter-cycle businesses in Global Products, primarily global residential HVAC and parts of Fire & Security are stabilizing as the new fiscal year progresses. Converting our strong top line growth into improved margins and cash flow is our top priority. We are beginning to see our gross margins improve as supply chain disruptions continue to lessen. Within Building Solutions, we are also seeing stronger margins in our record backlog and as service continues to accelerate, we should see favorable mix as well.

Cash flow is a key area of focus for us. On the receivables front, we are making progress in improving the longer collection cycle historically associated with our installed business. Inventories in our short-cycle businesses continue to reduce as lead times normalize, and we are adding capacity to meet the strong demand in our applied HVAC business. As you can see, we are very excited about the opportunity ahead. I will now turn the call over to Olivier to go through the financial details of the quarter. Olivier?

Olivier Leonetti: Thanks, George, and good morning, everyone. Let me start with the summary on Slide 7. Total sales grew 3% to $6.9 billion, while organic sales increased 2% with another strong quarter from our service business, which grew 9% organically. The cyber incident was a 1% headwind in the quarter. Adjusted segment EBITA was flat year-over-year with margins declining 50 basis points to 16%. Price/cost was positive, and we delivered strong productivity savings achieving our $340 million target for the year. Turning to our EPS bridge on Slide 8. Adjusted EPS of $1.05 increased 6% year-over-year and include a $0.04 headwind from the cyber incident. Operations contributed $0.03 of the growth in the quarter, benefiting from positive price/cost and our ongoing SG&A and COGS actions.

Below the line, we saw favorability from non-controlling interest and a lower share count. Let’s now discuss our segment results in more detail on Slides 9 through 12. Beginning on Slide 9. Organic sales in our shorter-cycle Global Products business, excluding the 2% headwind from the cyber incident were flat year-over-year with price upsetting a decline in volume. Global Products saw continued strength in Commercial HVAC, which grew high single-digits after growing mid-teens in the comparable period one year ago. Demand remained strong and our leading position in Commercial HVAC was further extended in fiscal 2023. Fire & Security declined low single-digits as inventory further rebalanced as lead times improved materially year-over-year. Industrial Refrigeration had another strong quarter, growing over 45% driven by EMEALA.

Global residential decline high-teens, driven by a greater than 30% decline in North America and a high single-digit decline in Rest of World. North America faced challenging year-over-year comparisons as we were still working out of a backlog from last fiscal year. In Europe, the heat pump market overall experienced lower growth than anticipated. As our book-to-bill business begins to normalize with improved lead times, our global products, third-party backlog decreased 4% from the prior year to $2.5 billion and remained flat sequentially. Adjusted segment EBITA margins declined 85 basis points against a tough comparison to 21% as continued weakness in global residential offset positive price cost and productivity savings. One of the biggest factor impacting our Global Products margin performance is due to lower absorption costs in Global Residential business.

Moving to Slide 11 to discuss our Building Solutions performance. Order momentum remained strong with 9% growth. Service orders grew 7% in the quarter and 11% for the full year as our transformation into a service-led organization gains momentum. Install orders increased 10%, led by double-digit orders in North America and EMEALA. Organic sales grew 5%, driven by strong growth in service of 9%. And in-store grew 2% organically against a tough comparison. The cyber incident was a 1% headwind in the quarter. Adjusted segment EBITA increased 5%, while margins declined 10 basis points as a higher mix of equipment installations and weakness in China offset positive price/cost and savings from productivity initiatives. Strong equipment sales are an important contributor to future higher-margin recurring service revenue.

Building Solutions backlog remains at record levels, growing 9% to $12.1 billion. Service backlog increased 12% and installed backlog grew 8% year-over-year. Let’s discuss the Building Solutions performance by region on Slide 12. Orders in North America increased 8% with continued strength across our HVAC & Controls platform, up over 20% year-over-year. Overall, there was robust demand in our office, data center, health care, government and manufacturing sectors. Install orders increased 11% year-over-year with solid growth in new construction. Sales in North America were up 8% organically with broad-based growth across the portfolio. Our installed business grew 9% with continued momentum in new construction, up 25% year-over-year. Organic sales in service grew 7% in the quarter and 8% for the full year, driven by a strong performance across our shorter-term transactional business which is the direct result of having a large customer base.

Sales across our HVAC & Controls platform grew high teens year-over-year, while Fire & Security was flat. Segment margins expanded 70 basis points year-over-year to 15.4%, driven by ongoing productivity benefits, the continued execution of higher-margin backlog and strength in our higher-margin service business. Total backlog ended the quarter at $8.3 billion, up 10% year-over-year. In EMEA/LA, orders were up 6% with solid contributions of 16% growth from both served and in store. Demand in commercial remained strong, growing 50% year-over-year driven by HVAC and security as the decarbonization efforts in Europe continue to gain momentum, our offerings in Industrial Refrigeration and HVAC & Controls increased orders by over 20% across the industrial sector.

By region, other growth was broad-based. Sales in EMEA/LA grew 3% organically, led by mid-teen growth in service with double-digit growth from both our recurring contracts and our shorter cycle transactional business. Applied Commercial HVAC and Fire & Security grew low single-digits within the quarter. Segment EBITA margins declined 160 basis points to 7.8%, driven primarily by execution of lower margin jobs within the backlog. Backlog was up 10% year-over-year to $2.3 billion. In Asia Pacific, orders grew 3%, driven by double-digit growth in service with healthy growth across our HVAC & Controls platform. Overall, we saw strong demand in the institutional sector growing over 30%. Sales in Asia Pacific declined 6%, as the installation business was impacted primarily by weakness in China.

Our service business continued the momentum of double-digit growth, increasing 11% in the quarter and 14% for the full year. Overall, Fire & Security grew mid-single digits, while HVAC & Controls declined high single-digits. Segment EBITA margins declined 50 basis points to 13.5%, as weakness in China offset ongoing productivity savings and positive price/cost. Backlog of $1.5 billion is flat year-over-year. Turning to our balance sheet and cash flow on Slide 13. We ended the fourth quarter with approximately $800 million in available cash and net debt declined to 1.9 times, which is lower than our long-term target range of 2 to 2.5 times. As George mentioned, during 2023, we returned $1.6 billion to our shareholders via dividends and share repurchases.

Our free cash flow conversion of 76% was better than our updated guidance. On the working capital front, our receivable collection has extended as our installation business critical to generate our service business has grown. We are making structural changes, such as more upfront payments to improve our cash collection cycle in the installation business. While inventories remain elevated versus historical levels, primarily due to the challenges in our global residential businesses, we saw overall inventories improved five days sequentially in the fourth quarter. We anticipate further improvement entering fiscal 2024. We have the fundamentals in place to be a 100% cash conversion company over time. However, continued growth investments and some further restructuring in fiscal 2024 will be headwinds in the fiscal year.

Now let’s discuss our first quarter and fiscal 2024 guidance on Slide 14. We are entering fiscal year 2024 with a backlog at historical levels, strong momentum in our industry-leading service business and broad-based demand across end markets. When producing first quarter sales guidance of approximately flat year-over-year as we return to normalized seasonality. Our forecast includes a roughly 1% headwind from the cyber incident, as well as continued weakness anticipated in China. We expect Building Solutions momentum to continue, led by our resilient service business. Global Products faces a tough year-over-year comparison as we were working through elevated backlogs in the comparable quarter last year, especially in Residential HVAC and certain Fire & Security indirect channels.

For the first quarter, we expect segment EBITA margin to be approximately 13% and adjusted EPS to be in the range of $0.48 to $0.50. We’re expecting a slower start of the year as we return to more normalized seasonality, incurred a negative impact from the cyber incident and anticipate continued weakness in China. For the full year, we anticipate Global Products to stabilize in the second half of 2024, as backlog continues to normalize and Building Solutions converts its higher-margin backlog. We expect organic sales to grow approximately mid-single digits with Building Solutions leading the growth, particularly in service. Segment EBITA margins, I expect that to expand approximately 25 basis points or greater as price/cost remains positive and mix improved throughout the year.

Adjusted EPS should be in the range of approximately $3.65 to $3.80, representing growth of 4% to 9% year-over-year. For the first quarter, we anticipate our normal seasonal cash usage with incremental impact from the cyber incident. We expect free cash flow conversion to be 85% for the full year. Our results and guidance reflect great progress advancing our service strategy enabled by digital, momentum in our commercial products offering and we enter fiscal 2024 with strong order momentum and record backlog in our longer-cycle Building Solutions business. With that, Operator, open up the lines for questions.

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Q&A Session

Operator: [Operator Instructions] And today’s first question comes from Jeff Sprague with Vertical Research. Please go ahead.

Jeff Sprague: Hi. Thank you. Good morning, everyone. Maybe we could just touch on cash flow a bit more. A, how much kind of recovery from the cyber incident do you kind of expect embedded in this 85% in 2024? And then also just — it seems peculiar, Olivier, your net financial charges are going up to $420 million per your guide versus $280 million last year. Is there something going on in the factoring or something else in kind of the capital structure that would explain that sort of delta year-over-year?

Olivier Leonetti: Thank you for your question, Jeff. Regarding the free cash flow, we had an impact in the first quarter, which we believe will be about $200 million. If you look at the guide for 2024 at 85%, that includes two elements; one, some restructuring and also some investments in CapEx to support the strong demand in our applied business, George mentioned that in his opening remarks. If you look at the levers of improvement for free cash flow, we see, one, inventory reducing as we reduce our inventory in resi. Two, in receivables, we believe we’re going to be able to demand more upfront payments as our lead times have improved, and also we have implemented our supplier financing program across the network, and that will help further improve GPO.

To go back to your net financing charge is the byproduct of higher interest rate. We are going to refinance some debt. We have some commercial papers as well, which are going to be priced at the current higher interest rate. Factoring is a small proportion of the cost.

Jeff Sprague: And then separately, could you just address — I mean, orders obviously looked pretty solid in the quarter. Was there any impact from the cyber and the ability to kind of book orders, either as you ended the September quarter or as you’ve entered this particular quarter? Maybe just give us a little bit more color on what the challenges were in the business as you work your way through this?

George Oliver: Yes. So when we look at our orders, Jeff, obviously, they continue very strong. And I think we’re seeing strong growth in office data centers, health care, state and local government, education. We do see manufacturing, industrial bookings continue at an elevated level after a strong growth in construction starts. It is focused on the EV and semiconductor manufacturing. And then when we look at our pipeline, it’s very strong. And a lot of that pipeline is focused on these key verticals. I would say from a booking standpoint, we were tracking prior to the cyber incident, a little bit better. And then with the outage, I think we’re somewhat slowed a bit in that last week. But I think as we look at first quarter and for the year with the pipeline that we have, we’re going to see continued strong order growth.

And I think when you look at our – mainly around Commercial HVAC trends, it’s clear that we’re gaining share pretty much across all of the industries. That’s creating significant equipment sales into our Building Solutions business, which is creating a really nice installed base that we’re now capitalizing on the service opportunity. In Building Solutions, our applied orders were up about 20%. And then in the ducting space, when you take out resi, our commercial ducting was up over 50%. So our portfolio of Commercial HVAC is playing out strong. And that ultimately is what’s driving the installed base within our commercial — within the Commercial Building Solutions business.

Operator: Thank you. And our next question today comes from Joe Ritchie at Goldman Sachs. Please go ahead.

Joe Ritchie: Thanks. Good morning everyone.

George Oliver: Good morning.

Joe Ritchie: Hey guys, can we start on just the mix impact this quarter. I was a little surprised to see the Business Solutions business see $100 million impact from mix. And also because it seems like your service business has farly exceeded growth versus install this quarter. So what exactly is going on within Business Solutions that’s driving negative mix and is that expected to reverse in 2024?

Olivier Leonetti: So if you look at the equipment sales today, particularly in the high end of our market, we are gaining share. This is a strong part of the market. This business is very attractive for us because for $1 of hardware, we typically generate over the life cycle of the equipment another $9 of solutions, including $4 of services. And you saw also Joe in services today we clearly have momentum. Services is growing fast, enabled by digital. And as a reminder, services is twice the profit of the average of the company. So this mix is based upon equipment sales, which would generate attractive profit with the service and UTM solution annuity.

Joe Ritchie: Okay. Got it. Understood. And I guess maybe my one follow-on question then would be on 1Q. And so to look, it’s December 12, we’re clearly well into the quarter. You’ve given a fairly narrow range for the first quarter. I guess, I’m just trying to understand two things. Number one, confidence that, that will be the range when you report results? And then secondly, just any help that you can give on the bridge? Because even if you adjust for the insurance settlement from last year, it seems like a relatively large decline in the first quarter despite flat organic sales expected this year.

Olivier Leonetti: So if you look at Q1, we see a strong order momentum continuing. If you look at, of course, the confidence, we have now a few days to go before the end of the quarter. So that by itself answer to the question. If you look at what is happening in Q1, we have strong momentum in our Building Solutions business, service, solution powered by digital is growing fast. We see weaknesses in our Global Products division, particularly as it comes from resi. We have some impact also in China. Also, we have the impact of cyber, which is about 1% of the top line, and it’s difficult to dimensionalize exactly about $0.02 of EPS. And last but not least, GP now is going through a more normalized seasonality after a few years of supply chain impact.