Summary
- JCI raised its EPS forecast for FY23 from $3.20 to $3.60 to $3.30 to $3.60, and segment EBITA margin from 80 to 120 bps to 90 to 120 bps.
- Adoption of digital methods of operation is expected to result in long-term, higher growth in service and related metrics.
- I believe JCI has 18% upside potential, driven by backlog margins and the return of more typical 2H levels of improvement.
Thesis
Johnson Controls ( JCI ) has 18% upside. JCI backlog margins are the primary source of support for this thesis, as they will facilitate a return to more typical 2H levels of improvement, while faster-turning, lower-margin segment continues to slightly dilute the near-term outlook. Quarterly orders increased by 5%, and I expect a pickup in the following quarters as businesses in China resume normal operations and make up for lost time in converting outstanding quotes. Furthermore, this quarter's applied HVAC growth was above 20%, which I expect the same momentum over the near-term, fueled by existing backlog + stimulus orders that aren't likely to ship until the following year. Despite the disappointment of FY22's missed margin targets, the business's long cycles meant for the less profitable work to be shipped first, so the situation is not as dire as it might seem. The margin in converted backlog should also normalize in the third quarter, which should boost margins in the Americas Field and the overall margin. As I see JCI and its competitors increasingly adopt digital methods of operation, I expect to see longer-term, higher growth in service and related metrics. While investors mull over early cycle rotation, I believe that the stock's valuation will remain fairly stable because the company is still under-earning despite having end markets that are further along in the business cycle.
Earnings takeaway
For the 1Q23, JCI reported an adj. EPS of $0.67, with profits falling short by 3%. Despite a miss in Global Products, organic sales grew by 9%. Volume growth, however, was down. For Global Products, in particular, management mentioned there was a fire in a warehouse that impacted their business targeting the fire suppression industry. Which, in turn, affected finished goods they had in storage, reducing their product-level growth rate by about 2-3%. The next set of numbers should look slightly better as management expects to recoup most of that volume. Global Products' volume growth was additionally impacted by the sluggishness in demand for residential HVAC systems.
Due in large part to better-than-anticipated price and cost benefit and cost-savings programs, segment margin performance was robust in 1Q, coming in at 12.4%.
Order book
While orders for most manufacturers of capital goods have leveled off, JCI's field business increased by 5% during the quarter. Despite a slowdown from the 9% growth seen in 4Q22, management is anticipating a return to high-single-digit growth in 2Q23; I have faith in this prediction given this guide is based on an assessment of January '23 data. On the other hands, management has stated that order timing and Covid-related impacts in China are to blame for the recent slowdown in field orders, with the latter factor also having a significant effect on the company's installation business. A one to two percent decrease in install orders and a one to two percent delay in project orders were both caused by the lockdowns and disruptions at China Covid. As China resumes normal operations, I anticipate a pickup in the upcoming quarters, with orders increasing to the HSD range.
As for backlog, it increased sequentially to $11.3 billion, with install contributing $9 billion and service backlog totaling $2.3 billion. As it stands, 90% of LTM install revenues are still accounted for by the install backlog, giving me a great deal of confidence in the FY23 outlook.
Pricing
The 1Q23 order pricing of 18% was 1% higher than the 4Q22 order pricing, and I anticipate this will be a boon to margins as JCI works through backlogs priced to account for inflation. It's important to remember that the impact of a price hike on profits won't be seen for at least 9 to 12 months. The fact that order prices have been rising steadily since 1Q22 is indicative of this trend. This bodes well for future quarters, as I expect pricing to increase thanks to this trend.
Margin
Profit margins improved significantly this quarter and I expect to continue expanding through FY23. If we take into account pricing, backlog, supply chain impacts, and foreign exchange tailwinds, I think margin expansion is possible. Due to the higher margin services business model and improved project execution, I expect the higher base in 2H23 to be sustainable, laying the groundwork for further expansion in FY24.
Earnings update
JCI reported the following results:
- 1FQ23 adj. EPS of $0.67
- Organic growth was 9%, based on 10% price growth and 1% volume decline.
- By segment, there was a 10% increase in North America, a 12% increase in Europe and Latin America, a 7% increase in Asia Pacific, and a 7% increase in Global Products. Organic orders in the field totaled 5%.
Guidance
JCI raised its EPS forecast for FY23 from $3.20 to $3.60 to $3.30 to $3.60, assuming the same rate of organic growth (high single digits to low double digits) as before. The new range for expected growth in segment EBITA margin is 90 to 120 bps, which is higher than the previous range of 80 to 120 bps. In addition, JCI reported an EPS forecast for 2FQ23 of $0.72 to $0.74.
Management's guidance strikes me as on the cautious side. The supply chain and foreign exchange are expected to become less of a drag on JCI's results in FY23, and the company's pricing has been picking up, which should be aided to some extent by disinflation. Meanwhile, the company's cost savings initiatives should continue to boost margins.
Valuation
Based on this quarter earnings update, my expectations on growth and margin, and consensus figures. I see an 18% upside to JCI over next 2 years. I would point out additional upside is possible if JCI were to trade at the same EV/EBITDA with Trane Technologies ( TT ) (another peer in the HVAC space). JCI current trades at similar to its HVAC peers, but well below TT which trades trading at 16x forward EBITDA.
Conclusion
JCI's segment EBITA for 1FQ23 was slightly below expectations, with the company's strength in Global Products being offset by lower EBITA in NA, EMEA/LA. For NA Buildings in particular, an unfavorable combination of bigger projects and continuous investments had an adverse effect. To be honest, I anticipated a more rapid continuation of the 4Q22 margin ramp into 1Q23 within this division. Despite the fact that this did not occur because the supply chain appears to be improving at a slower pace, I am relieved by management's assurance that margins will rise in the second half of FY23, and I expect that the increased conversion of higher-margin projects from the backlog will help support NA margins then.
As for guidance, I think JCI can hit the high end of the guidance for the full year, thanks to the more favorable price and cost mix and higher productivity. Moreover, FX should have strengthened since the previous quarter.
Overall, I believe JCI is a compelling long due to its high exposure to a growing end market and potential to deliver above-average EPS growth.
For further details see:
Johnson Controls: Potential For Margins To Outperform In Coming Quarters