Johnson Controls and Tyco Unite: Leaving Autos in Rearview Mirror

Johnson Controls' Transformation Continues: Merges With Tyco and Divests the Auto Business Tyco is the leading worldwide provider of security, fire-protection, and life safety products and services, with 9% global market share. Approximately 60% of the company's revenue is generated from product sales, with the remaining 40% of sales from higher-margin services. After the Adient spin-off, legacy Johnson Controls will consist of the Building Efficiency segment and the Power Solutions segment. The Building Efficiency segment sells HVAC and building automation products and services. The segment is the market leader in commercial HVAC and industrial refrigeration. The Power Solutions segment is the largest producer of lead-acid batteries in the world, selling 146 million lead-acid batteries in 2015, and is the lead-acid battery market leader with 36% market share.

The Spin-Off of Johnson Controls' Automotive Business Likely Improves Market Perception The market has long viewed Johnson Controls as an automotive parts company, and rightly so, given that the company has, on average, generated 66% of sales from automakers and aftermarket partners over the past 10 years and the Automotive Experience segment made up 54% of fiscal 2015 revenue. Despite contributing a significant share of sales, the company's Automotive Experience segment has historically been the company's least profitable segment.

Since Tyco's restructuring in 2012, the company's profitability has generally been slightly better than that of Johnson Controls' Building Efficiency segment. The combination of Tyco and Johnson Controls without the automotive business will result in a more profitable company, even before any synergies are realized. Pro forma results show that the new structure would have increased Johnson Controls' fiscal 2015 GAAP operating margins (excluding equity income) by 60 basis points when including purchase accounting and other merger adjustments, and by 230 basis points when excluding these items.

The market has generally placed low multiples on automotive parts companies, and we think replacing the lower-margin, lower-multiple automotive business with Tyco's higher-margin, higher-multiple business should increase Johnson Controls' perceived enterprise value.

We think Tyco enjoys a narrow economic moat, mainly from customer switching costs and intangible assets, which strengthens the combined company's competitive advantage in the $250 billion buildings infrastructure market.

Both the Building Efficiency segment and Tyco win new contracts through competitive bidding and generate revenue from product sales and installation and subsequent maintenance and services. The Tyco merger more than doubles the amount of higher-margin service revenue generated and improves the service revenue gross margin. We believe a great deal of the combined company's service revenue is recurring in nature.

Tyco is typically able to capture ongoing monitoring and maintenance services on its installed security and fire-detection and -suppression systems. In 2015, 40% of Tyco’s sales were generated from services, approximately 60% of which comprised recurring revenue. Security system customers generally enter one- to three-year contracts for system monitoring and maintenance; these contracts are subject to early-termination penalties. We think that Tyco’s security monitoring services are particularly sticky, as in-house monitoring by customers is likely not cost-effective, and switching vendors could cause system compatibility challenges. Building Efficiency service revenue accounted for 10% of Johnson Controls’ 2015 sales; however, this number increases to 27% of total sales when automotive sales are excluded. The Building Efficiency segment's large base of customers often leads to repeat business (around 70% of segment sales), and customer relationships often span entire building lifecycles. We think Johnson Controls’ propensity to generate repeat business is a testament to the segment’s product quality, system integration expertise, and localized branch and distribution structure.

Tyco also brings a portfolio of well-recognized brands, such as Tyco and SimplexGrinnell in fire protection, Sensormatic in retail security, and Scott in life safety products. Tyco's brands add to Johnson Controls' already robust portfolio of brands, such as York in cooling and heating equipment, Metasys in building automation, Frick in refrigeration, and Ruskin and Titus in air distribution. Both companies have historically made healthy research and development investments to drive continued product improvement and innovation. We think combining R&D capabilities and new product pipelines will serve to strengthen brand reputation.

Our opinion on Johnson Controls' Power Solutions segment has not changed; we still believe the automotive battery division is a great business that benefits from strong competitive advantages. Power Solutions has forged strong relationships with major automakers and some of the most recognized aftermarket retailers, such as Advance Auto Parts, AutoZone, O'Reilly, and Wal-Mart. The company also has a robust product portfolio, with brands such as Optima, Interstate (49% owned), and Varta, to name a few.

Johnson Controls has made significant R&D investments in the Power Solutions segment, which has led to the introduction of advanced lead-acid batteries, such as absorbent glass mat batteries that are used in start-stop systems, and the company's patented PowerFrame grid stamping process, which builds more durable batteries at a lower cost. Company studies have shown that PowerFrame technology is 66% more durable and provides 70% better electrical flow than traditional technologies, but requires less input metal and 20% less energy to manufacture. The Power Solutions group has numerous R&D facilities across the globe, including the largest battery R&D center in North America. The company also partners with external research laboratories and universities, such as MIT, Berkeley, University of Michigan, Joint Center for Energy Storage Research, and the Argonne National Laboratory, to maintain technology leadership and develop a pipeline of talent. Power Solutions leverages its relationships with automakers to develop new solutions and stay ahead of the technological curve. New technologies developed for automakers are eventually integrated into aftermarket solutions, which strengthen Johnson Controls’ competitiveness in the aftermarket channel.

We think the segment's global footprint, vertical integration capabilities, and technology drive a marked cost advantage over competing products. Batteries have a low value/weight ratio, so Power Solutions' large geographic footprint near key customers is a key cost advantage. The segment's battery-recycling capacity is another source of the firm’s cost advantage. The company’s batteries are designed for 99% recyclability, and the company is the world's largest lead recycler. Johnson Controls utilizes its logistics network to collect spent batteries from its partners, which are then sent to the company’s recycling facilities that extract metals, plastics, and liquids from used batteries and either reuses them to manufacture new batteries or sells materials to manufacturers of detergents and consumer products. Johnson Controls’ recycling facilities are able to recycle 8,000 batteries per hour, which is enough to supply the annual demand of the U.S. aftermarket. The company estimates that its recycling capabilities result in a 5%-20% cost advantage over close competitors. We think Johnson Control’s cost advantage vis-a-vis its recycling infrastructure benefits from a network effect: As the company captures increased market share and strengthens its logistics network, it increases its access to raw materials.

We estimate a $51 per share fair value for Johnson Controls post-spin-off, with an upside valuation of $67 per share if end markets strengthen, cross-selling initiatives are successful, and cost synergy realization is better than expected. We see a downside valuation of $30 per share if end markets weaken, cross-selling initiatives largely fail, and cost synergy realization is more challenging than expected.

Johnson Controls and Tyco have each capitalized on their competitive advantages to drive industry-leading market share. Johnson Controls' Building Efficiency segment is the market leader in commercial HVAC and industrial refrigeration. Johnson Controls' Power Solutions segment has 36% market share and is the largest producer of lead-acid batteries in the world, selling 146 million lead-acid batteries in 2015. Tyco is the market leader in a very fragmented fire-protection and security market, with 9% market share. A handful of other large competitors account for 10% of the market share, and the remaining market is served by smaller regional and local players.

Are the Planned Synergies Achievable? The combined company expects to achieve approximately $1.05 billion of cost synergies over the next three years. The largest savings comes from eliminating redundant public company costs, restructuring functional support, and utilizing shared service centers. Management believes these initiatives can reduce the combined company's general and administration expense by approximately 20%. The combined company is expected to spend $12 billion annually on procurement, and expects to save approximately $275 million, or 2% of the annual spend, by leveraging the new company's larger combined scale and continuing to improve upon and expand Johnson Controls' vendor sourcing initiatives. The combined company's manufacturing, engineering, commercial operations, and branch overhead costs total $8 billion. It plans on saving $225 million, or 3% of the annual spend, by improving and expanding lean manufacturing initiatives, consolidating the combined branch footprint, and eliminating duplicative costs. Finally, it expects to achieve an additional $150 million in tax savings from reincorporating in Ireland, with a combined corporate tax rate of approximately 17%, compared to Johnson Controls' 2014 and 2015 underlying effective tax rate of 19%. The company has highlighted that many of these initiatives have been in place prior to the merger announcement. In fact, of the $1.05 billion in management's expected cost savings, approximately 38% of the savings are related to Johnson Controls- and Tyco-specific initiatives, many of which are already in progress.

After digging into the details, we think the synergy target is achievable. For one, we think Tyco's selling, general, and administrative expenses are quite high to begin with, so there is certainly room to lower those costs. Also, eliminating duplicative public company costs and building out a shared service model to support the combined company are common integration tasks that should be attainable over the three-year timeline. We think the planned procurement and business unit level savings, at just 2.5% of the annualized spend, are achievable: if anything, they could be conservative, given the overlap in R&D efforts, salesforce, and branch footprint.