2023-06-07 07:15:38 ET
Summary
- Johnson Controls continues to perform well, with a steady increase in orders and solid 1H23 performance.
- The key catalyst for future success is margin improvement, driven by product mix optimization, and increased productivity.
- I expect to outperform its historical EBITDA margin range, which will support its valuation to at least 12x forward EBITDA.
Thesis
Johnson Controls ( JCI ) keeps doing what I expected them to do in my thesis , and I reiterate my buy rating on the stock. My expectations were met by 1H23 performance, and the upward trajectory continues with solid performance on orders. I expect JCI performance to eventually attract new fund flow into the stock as it outperforms in this uncertain macro. The important metric and catalyst, in my opinion, is margin improvements. So long as JCI can continue to grow the business while improving margin due to product mix and increased productivity, I expect JCI to do a beat and raise in guidance. Consensus would then follow by revising their estimates upwards, which is likely to drive the stock price upwards as well.
Order book
JCI's orders have been steadily increasing, indicating that business is gaining momentum. The government and manufacturing sectors both contributed significantly to the 8% increase in NA orders. There was a 14% increase in service orders, with both recurring and one-time contracts seeing double-digit growth. High single-digit increases were seen in HVAC and controls orders, with an overall increase in field and service orders of mid-single-digits. The key metric is that backlog, which increased sequentially to $11.7 billion, comprised of $9.3 billion in install and $2.3 billion in service backlog. For readers that are new, this mix dynamic of having more install backlog is a good thing for the mid-term but bad for the near-term. On the former, the high mix of backlog provides high level of revenue visibility and a stream of long-term service profits. As for the latter (negative), install comes with lower margin, as such would damper the near-term performance. It's also important to realize that the installation process is a pivotal point in the customer acquisition lifecycle because it fosters intimacy with the customer, which in turn motivates the provision of services. If we look at JCI recent history, it is evident that they are successful in driving service growth, as the growth of service is now in the range of 10% vs the 3% range in recent history. Since the process of digitization is just getting started, I believe this growth will last for some time to come. As millennials and Gen Z adopt more Internet of Things devices into their daily routines, the number of chillers connected with edge computing is only expected to rise. I'd also like to highlight a quote from the CEO that encapsulates the value proposition of IoT and was given at the Baird Global Industrial Conference in 2022 : "When you have edge compute capabilities, you can anticipate a problem. You know because a chiller or piece of equipment is behaving in a certain way, let's say the chiller vibrate too much, you know that is likely to be in distress and break in two hours." Hence, I am optimistic and see a lot of room for growth for the service business.
Margin
Margins were also up nicely in 2Q23 despite the weak incremental margin from new volume, which I attribute to the product mix shift towards more heavy equipment that have lower margins. To me, this is more of a matter of delivery schedules than anything else (especially since margins are still well within historical norms). There were also some one-time expenses, which will work to the benefit of future margin comparisons. What I would be focusing on is the structural improvement in margins over time as the backlog of orders today translate to service revenue that carries higher margin profile. I also anticipate that efforts to boost productivity will have a positive effect on margins in the long run. For example, JCI recently established a global field operations business, which I believe will lead to more targeted and margin-enhancing install business as a result of improved operational efficiency. Management has stated that they expect to meet their FY23 cost savings target of $340 million and that they have sufficient levers at their disposal to generate 30% incremental margins. Put all of these together and one will realize that JCI has a lot of potential to exceed its historical EBITDA margin range.
Valuation
As JCI continues to execute and demonstrate more structural margin improvement potential in the coming years, I see a path for JCI to outperform its historical EBITDA margin range, which is also my variant perception vs consensus estimates. I believe the consensus is being conservative in terms of how much margin can be improved, as they are embedding a 16% EBITDA margin in FY25/26, which is only a 100bps increase from FY22. This appears to be too low to me, given the higher mix of service margin and productivity enhancement. With the improved margin profile, I anticipate that valuation will be well supported at 12x forward EBITDA, which is the 10-year average.
Valuation model
Conclusion
My thesis on JCI remains intact, and I reiterate my buy rating on the stock. The company's performance in 1H23 aligns with my expectations, and I believe it will continue to attract new fund flow as it outperforms in the current uncertain macro environment. The key catalyst for JCI's future success is margin improvement, driven by product mix optimization and increased productivity. The steady increase in orders, particularly in the service sector, indicates business momentum and revenue visibility. Although the near-term performance may be impacted by lower-margin installation backlog, the long-term growth potential of the service business is promising, fueled by the digitization trend and IoT adoption. Margins in 2Q23 were strong despite some one-time expenses, and I anticipate structural margin improvement over time.
For further details see:
Johnson Controls: Margin Profile Should Improve Over Time