2023-04-09 04:10:28 ET
Summary
- Digitization of buildings to reduce operational costs and improve sustainability holds promise for Johnson Controls.
- Investors should watch the progress of its recurring revenues from its software services.
- Poor return on invested capital keeps me from investing in Johnson Controls.
Johnson Controls International ( JCI ) is navigating a changing residential and commercial real estate market. The company faces short-term challenges due to troubles in the commercial real estate market caused by rising interest rates. It has long-term opportunities surrounding the digitization of buildings and their management. It is essential to monitor the progress of this company concerning its revenue growth and profitability to see changes in the trend. But, the company's poor financial returns and overvaluation prevent me from investing.
Slowing revenue growth
Johnson Controls saw good high-single-digit revenue growth in 2021 but slowed in 2022 (Exhibit 1) . The company saw revenue growth of 5% in its FY 2022 Q4, which ended in September 2022. In Q1 2023, its revenue growth was 3.5%. The company's gross margins have recovered from 32.2% in December 2021 to 34.4% in December 2022, a gain of 220 basis points. Its gross margins have averaged 33.6% since June 2020, with a low standard deviation of 1%.
Exhibit 1:
Johnson Controls Quarterly Revenue, Gross, Operating Profit, and Margins (Seeking Alpha, Author Compilation)
The company's operating margins have fluctuated more than the gross margins may be due to its investment in digital solutions (Exhibit 1) . In Q1 2023, the quarter ending December 2021, the company mentioned a fire at a leased warehouse facility, certain investments to support growth, and one-time transaction and separation costs negatively impacted its selling, general, and administration costs. This increase in SG&A would have reduced operating margins in that quarter to 8.5%, compared to its average of 10%, with a standard deviation of 1.99% since June 2020.
One-time events drive these impacts on operating margins, and the company can recover from them. It can boost its cash flows if it consistently delivers a 10% operating margin with low variability.
Watch unearned revenue
The company's Open Blue software platform provides data-driven solutions to create smarter, safer, and more sustainable buildings. This platform is sold on a subscription basis, and, similar to software companies like Salesforce or Microsoft, some portion of the revenue is recognized over the contract's duration. The unearned part of the contract is a liability and is recorded as such in the balance sheet. The company had unearned revenue of $2 billion at the end of December 2022 (Exhibit 2) .
Exhibit 2:
Johnson Controls Unearned Revenue (June 2020 - December 2022) (Seeking Alpha, Author Compilation)
This $2 billion is money the company has received for which it will deliver products and services in the future. The company grew its y/y unearned revenue at a double-digit pace in 2021 and the first half of 2022. This revenue may continue decelerating in 2023, given the broad economic slowdown. The financial troubles in the commercial real estate market may exacerbate the troubles for building product companies.
Sustainability and smart building management are long-term trends that should drive its Open Blue business and increase Johnson Controls' revenue. The unearned revenue may be a minuscule 6.8% of its 2022 revenue, but the company has made its digitization efforts a central aspect of its growth strategy.
As the company calls it, these digitization efforts, or buildings-as-a-service , must lower the cost of owning and operating a building. If Johnson Controls can show a clear return on investment, this software platform should have long-term implications for its growth and profitability. This software platform can generate recurring revenues, which could increase the unearned revenue line, thus smoothing revenue fluctuations due to one-time product sales.
Johnson Controls is overvalued
The company is trading at a forward PE of 18.2x . Its industrial peers, Carrier Global ( CARR ) and Trane Technologies ( TT ), are trading at 16.4x and 20.5x, respectively. A discounted cash flow model estimates a per-share equity value of $40.91, well below its current overvalued price of $55.98 (Exhibit 3) . This model assumes a growth rate of 4%, a free cash flow margin of 7%, and a discount rate of 9%. The 7% free cash flow margin is close to its average since June 2020.
Exhibit 3:
Johnson Controls Discounted Cash Flow Model (Seeking Alpha, Author Calculations)
Johnson Controls offers a low return on invested capital with a return of 4.7% (Exhibit 4) . The cost of capital has increased for all companies, especially those with high debt loads, such as Johnson Controls. A 4.7% return on capital does not even come close to covering its cost of capital, let alone earning a favorable return for shareholders. The company has much potential with its digitization, cost savings, and sustainability push in the initial innings. Its software offering may carry higher margins and can boost overall profitability and even smooth fluctuations in revenue. The company may have to grow its software revenues consistently to gain a higher valuation.
The company is fully valued based on the valuation metrics. It is overvalued based on a discounted cash flow model, and its return on the invested capital shows it has much work to do to improve its performance.
Exhibit 4:
Johnson Controls, Trane Technologies, Carrier Global Return on Invested Capital (Seeking Alpha)
The stock is lacking any interest from the bulls
The company has lost 14.3% over the past three months and 15% over the past year. The stock has underperformed the Vanguard Industrials Index ETF ( VIS ), which lost 2.56%, and the Vanguard S&P 500 Index ETF ( VOO ), which lost 8.4% over the past year. The stock has underperformed the S&P 500 Index over the past decade with a total return of 142.9% compared to the S&P 500 Index's return of 220.3%.
The company's poor free cash flow generation, high debt, and troubles in the commercial real estate market may also be responsible for its significant underperformance over the past three months. The company generated a free cash flow yield of 1.8% based on its trailing twelve months of cash flow generation and the current stock price of $55.98 (Exhibit 5) . Trane Technologies and Carrier Global performed better on this metric, generating 3.02% and 3.8% in free cash flow yield, respectively.
Exhibit 5:
Johnson Controls Free Cash Flow and Free Cash Flow Yield (Seeking Alpha, Author Calculations)
Exhibit 6:
Johnson Controls, Trane Technologies, and Carrier Global Free Cash Flow Yield (Seeking Alpha)
The company carries a high debt load with a debt-to-EBITDA ratio of 3.7x compared to 1.7x for Carrier Global and Trane Technologies (Exhibit 8) . It had total debt of $9.7 billion and net debt, after cash, of $8.3 billion and held a "stable" and "positive" outlook from S&P and Moody's rating agency (Exhibit 7) . At the end of December 2022, the company had $1.96 billion (sum of short-term debt and current portion of long-term debt) in debt due in 2023.
Exhibit 7:
Johnson Controls Net Debt (June 2020 - December 2022) (Seeking Alpha, Author Compilation)
Exhibit 8:
Johnson Controls, Trane Technologies, Carrier Global Debt-to-EBITDA Ratio (Seeking Alpha)
Capital return to shareholders
The company has spent $3.5 billion on effective share repurchases (difference between shares repurchased and issued) since June 2020, reducing the share count from 744 million to 690.3 million in December 2022 (Exhibit 9) . The effective repurchase price was $65.77 per share , about 17.4% above its current price.
Exhibit 9:
Johnson Controls Share Repurchases (June 2020 - December 2022) (Seeking Alpha, Author Compilation)
The company offers an attractive dividend yield of 2.5% with a payout ratio of 44.5%, although it is much lower than the yield of 3.99% the risk-free 2-year U.S. Treasury ( US2Y ) offers. Over the past five years, the company has grown its dividend at a CAGR of 6.6%. Its total dividend payment was $966 million over the trailing twelve months (Exhibit 10) .
Exhibit 10:
Johnson Controls Annual Dividend Payment (2013 - 2022) (Seeking Alpha, Author Compilation)
Johnson Controls has much potential but has much work to do to fulfill it. Its focus on digitization can lead to a more considerable portion of its revenue from recurring sources and increase its margins. The company needs to generate better free cash flow yield and returns on invested capital. Investors may have to wait for a lower valuation to justify buying Johnson Controls International.
For further details see:
Johnson Controls: Poor Financial Returns, Watch Recurring Revenue From Software Services