Johnson Controls International plc

Moat: 3/5

Understandability: 2/5

Balance Sheet Health: 4/5

Johnson Controls is a global leader in engineering, manufacturing, commissioning and retrofitting building products and systems, including commercial and residential heating, ventilation, and air conditioning (HVAC), building management systems, and related services. The company operates in over 150 countries, serving a wide range of customers across diverse industries.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Business Overview

Johnson Controls operates through two segments: Building Solutions and Global Products.

  • Building Solutions: This segment provides integrated building management systems, HVAC equipment, and related services. These include designing, installing, maintaining, and upgrading systems for large buildings, industrial facilities, and institutions. Key services include the installation of controls, such as HVAC, lighting, and fire safety.
  • Global Products: This segment manufactures and sells equipment and components used in heating, cooling, ventilation, and refrigeration systems. These include HVAC equipment, refrigeration and chillers. Notably, Global Products sales generate a more stable revenue stream and higher EBIT margin than the Building Solutions segment.

Industry Overview

The building solutions and HVAC industries, which are closely related to the performance of the real estate sector are seeing a shift towards efficiency and sustainability. The sector is seeing a push for buildings to be more energy-efficient and to integrate technology. Digitization is a key factor, with increasing use of connected buildings and smart controls. The industry also responds to changes in commodity prices, particularly energy.

Competitive Landscape

Johnson Controls faces competition from other large-scale players and from niche players who specialize in specific areas.

  • Large-Scale Competitors: Major players include Carrier and Trane, which also offer a wide range of building systems and equipment. These competitors have an edge on their brand recognition.
  • Niche Players: Niche players focus on specific building needs and often have differentiated technology, although without as wide of a distribution network.
  • There is no real moat on pure commoditized products, which has lead to an industry where pricing is the most important driver of sales.

What Makes Johnson Controls Different

  • Integrated Solutions: JCI’s strength lies in its ability to offer integrated building solutions that can combine their wide-range of products with different services. This sets them apart from competitors that only offer discrete building components.
  • Global Reach and Scale: JCI operates a large global network, giving them an advantage when dealing with large, international clients.
  • Strong Track Record: JCI has established partnerships and relationships that are hard to emulate (150+ years in business).

Moat Rating: 3/5

Johnson Controls has a narrow moat based on three competitive advantages:

  • Switching Costs: The integrated solutions they offer generate substantial switching costs to their clients. This is more significant when you factor in the costs of implementation and change.
  • Scale Economics in Distribution: JCI maintains an extensive global network, making them a low-cost supplier of specialized building solutions. They are much larger than their nearest competitors in distribution, which leads to greater profitability and control.
  • Regulatory Licenses: JCI maintains a strong relationship with regulatory bodies across the globe, as a lot of the equipment they sell is regulated heavily.
  • Though the business has several moats, it is not impenetrable. There is still a substantial amount of commoditization that can lead to erosion of pricing and profitability in the long term.

Risks to the Moat and Business Resilience

  • Economic Conditions: As a lot of JCI’s income comes from new construction, the business is heavily influenced by macroeconomic conditions. This is why JCI sees volatility based on recessions and expansion of the economy.
  • Commodity Prices: JCI is exposed to fluctuations in commodity prices, notably copper, steel, and aluminum. Increases in raw materials can compress profit margins.
  • Technological Disruption: The constant advance in technology brings a risk of obsolescence or innovation by competitors that might put JCI behind in technology.
  • Customer concentration: JCI is vulnerable to losing out on revenue from large clients, and may not be able to withstand losses in that case. They also might be vulnerable to clients’ pricing power if they become too concentrated.
    • Labor costs: Rising labor costs and wage pressures in developed economies may pose a threat to JCI’s bottom line, although they also may be able to offset with lower costs elsewhere.
    • Cybersecurity: As their operations become more and more interconnected, they are vulnerable to hacks which can impact production, and also their intellectual property.

Financial Analysis

  • Revenue Trends: JCI’s revenue growth has been somewhat inconsistent in the past, but it is showing signs of improvement. Their total revenue for fiscal year 2022 was roughly $25.9 billion, showing strong growth. They are also seeing an increase in revenues generated by their software offerings.
  • Profitability: JCI’s operating margins vary over different periods due to a host of factors, including operational disruptions and a challenging economic environment. While they are targeting to improve margins in the long term, the recent past has seen fluctuations, particularly in the Building Solutions segment. In FY22, their net income from continuing operations was $1.7B, with an adjusted diluted EPS of $2.90.
  • Debt and Capital Structure: Johnson Controls relies heavily on debt financing, with a substantial amount of long-term debt. They aim to maintain a certain debt-to-equity ratio, which may influence how much and when debt should be added.
  • Cash Flow: While their cash flow from operations has been consistent over the past few years, it has sometimes been offset by investments in long-term investments. In FY22, cash flow from operations was $1.4B.
    • JCI has a solid ability to convert earnings into cash, which provides flexibility.
  • Share repurchases: Company is heavily engaged in stock buybacks. JCI purchased $2.1 billion in stock for FY22 and authorized a $1.5 Billion share repurchase program for Q1 2023.

Recent Concerns & Management Commentary * Supply chain disruptions have been a big challenge for JCI over the past few years. They had problems in availability of materials and components, which led to higher costs and slower production. Although these problems have receded over the past year, JCI’s management indicated they will continue to monitor them. They mention in recent reports that supply-chain disruptions will continue to be a pain point for their business. * JCI, along with many other firms, are still struggling with inflation and rising costs. Management have put in place strategic pricing measures.

  • There is a growing concern regarding building systems and their impact on the environment. This means there will be constant pressure on JCI to innovate and develop better, more green products.
    • Management is emphasizing new green technology for both current and new projects to meet those requirements. They are also emphasizing sustainable design.
  • There has been some impact from the Russia-Ukraine war. However, JCI was able to mitigate the impact and continue business with minimal operational issues.
    • JCI has a lot of revenues generated from different areas of the world and they are exposed to fluctuations in exchange rates. This also increases their expenses, including the cost of imports. JCI has put in place a hedging policy to mitigate risks from currency fluctuations.
  • Management is highlighting the benefits from their transition to connected and digital buildings.
  • Management has also made comments about improving financial performance and cost control, and has recently implemented actions to trim down bureaucracy.
  • They are emphasizing growing their backlog as a sign of future growth.

Understandability: 2/5

JCI’s business model is not terribly complicated, and it has a well-understood and simple business of producing and installing HVAC and building automation systems. However, understanding the nuances of valuation becomes more complex due to the global nature of its operations, frequent changes in technology and economic forces, and the nature of contracts with governments. It is also not a pure play on one specific type of business. Further, JCI has a very large portfolio of different products, which makes assessing the long term implications difficult. The need to understand their financial statements and also their projections for the future adds further to the complexity. Therefore, a 2 seems to be most appropriate.

Balance Sheet Health: 4/5

JCI has an acceptable balance sheet. There are some issues, such as their high level of debt, that lead to some risks. They also had a substantial amount of goodwill in their balance sheets, which are also a cause of concern. However, JCI consistently manages to generate cash flows and maintains consistent earnings, which reduces those risks considerably. Hence, a 4 seems to be appropriate.

The Bottom Line

JCI is a company that has a narrow but relatively reliable moat supported by switching costs, scale, and licensing. The business is not particularly simple to understand, and there are considerable risks such as changing technology and macroeconomic factors. While the company is highly levered and has a sizeable amount of intangibles, their consistency in generating cash flows is impressive and offers a good offset to those risks. In general, it is a business with some level of competitive advantage in a mostly commoditized world that deserves attention from the thoughtful investor.