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A Look at the New Johnson Controls

Exiting autos is a dramatic transformation, but the moat looks safe.

Uncertainties include execution risk and market perception of the company after the spin-off, but we like management's plan to reinvent the building unit with more balance between HVAC products and HVAC service while also pursuing new technology for the company such as variable refrigerant flow.

A New Path Forward When Alex Molinaroli took over as CEO in late 2013, he made it clear that Johnson Controls would narrow its focus to businesses in which it is a leading player while becoming a multi-industrial company with a healthy automotive business. Acquiring HVAC product businesses are a key part of this transformation, but management changed course in June this year by announcing that it was exploring the separation of its automotive experience segment. This $20.1 billion segment (fiscal 2015) consists of the number-one seating business, including seating joint ventures in China, and Johnson Controls' 30% ownership in an interiors joint venture with Yanfeng Automotive Trim Systems. This joint venture is the world's largest automotive interiors supplier, and management expects it to have annual revenue of $8.5 billion. In July, Johnson Controls announced that the automotive experience segment will be spun off as a publicly traded company to shareholders in a tax-free transaction, which we expect to occur Oct. 1, 2016. The yet-to-be-named company will pay Johnson Controls a dividend at separation at an amount to be determined later.

We thought the seating business was still part of the company's core competencies. However, the desire to exit a cyclical business that was also taking too much capital (seating and interiors combined constituted 50% of $1.2 billion in fiscal 2014 capital expenditures and 49% in fiscal 2015) led management to decide that it wants to be more like Honeywell HON, United Technologies UTX, or Ingersoll Rand IR than Lear LEA or Magna MGA. We cannot argue with the logic of a diversified industrial company being more favorably perceived by the market than an auto-parts supplier. Furthermore, management said demands for future growth in areas outside autos meant that the automotive experience group was in danger of receiving inadequate investment, which would eventually cause it to lose its leading position.

We have heard nothing to make us think that after the spin-off Johnson Controls wants to move beyond batteries and HVAC products and service. We think it just wants to expand these businesses (especially HVAC products) without the distraction and capital drain of autos. We also think both Johnson Controls and the spin-off have a good chance of retaining their economic moats because, strategically speaking, nothing about any of the businesses is changing.

Seating Spin-Off Number One Globally Through a series of acquisitions in recent years, Johnson Controls has solidified its leading position in automotive seating, a sector it controls along with Lear, Magna, Faurecia EO, and keiretsu-type entities in Japan such as Toyota Boshoku. Johnson Controls made these acquisitions, such as Keiper for recliner technology, Recaro for seating in performance vehicles, Michel Thierry for fabrics, and Hammerstein for components and mechanisms, because of original-equipment manufacturers changing convention and sourcing more often by component rather than by complete seat systems. Johnson Controls' seating business today holds the top spot in every major area of seating (cut and sew, fabrics, foam, mechanisms, and structures) as well as complete seats. Fiscal 2015 seating revenue of $16.5 billion was likely about 50% from Europe. The company's more than 40 seating joint ventures in China dominate the single-largest vehicle market in the world, with 45% share. In fiscal 2015, seating's revenue declined 5.7% year over year, but management expected this decline as it walked away from some vehicle programs three years ago that had lower profitability than desired. This move seems to be a good one, as seating's return on sales in fiscal 2015 rose 70 basis points year over year to 5.6% while segment income grew 8.8%, all despite a much stronger dollar against the euro than the $1.30 rate management budgeted for.

The automotive experience segment's moat sources in our moat framework come from cost advantages and switching costs. The spin-off will have excellent cost advantages over a new entrant because of scale from being the market leader in every facet of seating. This integration in seating also allows Johnson Controls to adapt to the recent change in automakers now buying seating by components rather than complete systems. The company reached this point thanks to outstanding manufacturing processes that are hard to replicate. Advantages in supplying automakers do not come just from cost; quality is important to ensure that a supplier is not responsible for a customer having to slow or stop production. Size also creates switching costs for a customer, since moving to a new supplier requires extensive testing and costly removal of tooling equipment as well as taking a leap of faith in a new supplier's reliability. Changing suppliers in the middle of a multiyear vehicle program is not ideal for an automaker, and only the largest suppliers can serve an automaker on the same vehicle program throughout the world--a critical point as OEMs expand in emerging markets. Global OEMs need global suppliers, and this is an advantage the spin-off has against a local supplier in markets such as China or India. Large research and development programs that drive patents and innovation lead to multiyear supply contracts and create highly integrated long-term customer relationships. As a result, the Johnson Controls spin-off, as well as the other seating companies, enjoys significant barriers to new entrants.

Details of the spin-off have not been disclosed, although we expect more information over time. Management has said that the tax-free spin-off will pay Johnson Controls a dividend when the deal closes and that the spin-off's financial leverage will be similar to peers'. Because stand-alone financials and capital structure are not yet available, we value the spin-off using the average of two valuation methods--a price/sales multiple and enterprise value/EBITDA--at $10.3 billion. This balance constitutes about $13, or about 27%, of our current Johnson Controls fair value estimate of $49 per share.

Building Segment Stays and Also Has a Moat The building efficiency segment is a late-cycle business that focuses on HVAC equipment and service, with only about 20% of its $14.2 billion of fiscal 2014 revenue coming from new construction. Johnson Controls is the only large provider that operates in equipment, controls, and service. Its most formidable competitor is United Technologies' Carrier brand, but Johnson Controls has about 2.5 times the number of service providers that Carrier has. In controls, Johnson Controls competes with Honeywell and Siemens SIEGY; in products, competitors include Carrier, Lennox LII, and Ingersoll Rand.

Building efficiency operating margin was 8.8% in fiscal 2015 and should be much higher going forward following the sale of the global workplace solutions unit in September 2015. Segment operating margin increased 70 basis points year over year. Building efficiency derives its moat from cost advantages from scale of its manufacturing but also an intangible advantage from its technical knowledge of large, complex Class A real estate such as the Empire State Building and the Shanghai World Financial Center, where the company designed, installed, and implemented a single network to support all building systems. Systems work carries over to large events such as the World Cup soccer tournament. Switching costs also matter since the company is the only provider that can operate in equipment, controls, and service, which gives Johnson Controls the deep technical knowledge for Class A buildings but also brings service revenue. The company has primarily been more of a service provider than a product firm, but management wants to bring that balance closer to a 50/50 revenue mix from about 70% service when Molinaroli took over as CEO. The service element means that once Johnson Controls gets its equipment in the building, it is more likely to keep winning the service contracts for its own parts. Therefore, if management succeeds in moving more toward products, the building efficiency moat would become stronger because of enhanced switching costs. Higher returns would also occur, since product margins can be as much as 300 basis points higher than service margins. In fiscal 2013, the last time Johnson Controls disclosed North American systems and service separately, systems return on sales was 11.8% versus 10.7% for service.

HVAC Growth Coming From Acquisitions and Partnerships Molinaroli's vision for more product work still centers on HVAC-related products that the company is handling as part of its chiller business such as variable refrigerant flow, or VRF, cooling towers and heat exchangers. In June 2014, the company acquired Air Distribution Technologies for $1.6 billion. At the time, ADT had nearly $1 billion in annual sales and EBIT margin of about 9%. We said then that we liked the deal, and we still do. ADT's revenue was about 76% nonresidential, with 92% of sales from North America, which fits well with Johnson Controls' existing building segment that is mostly nonresidential. The two firms' distribution channels have hardly any overlap, so Johnson Controls' chiller expertise combined with ADT's products such as fans, dampers, grilles, registers, and diffusers gives Johnson Controls access to almost any nonresidential construction job in the United States. Johnson Controls can then use its scale to get purchasing savings, consolidate manufacturing, and reduce corporate overlap to generate $75 million-$100 million of cost synergies by the third quarter of fiscal 2016, according to management's estimate. We think these cost savings would raise ADT's EBIT margin from about 9% to around 16%. Management expects no earnings per share accretion until fiscal 2016 (then $0.10-$0.15). We think these targets are achievable.

VRF is a major priority for management because of its common usage in Asia, especially in smaller middle-market buildings, offering an attractive new growth runway for Johnson Controls. VRF allows for more energy-efficient and precise use of HVAC systems by delivering heating or cooling at different rates across a building. Johnson Controls' three-pipe system means the VRF system can deliver heating and cooling to different parts of a building at the same time, as opposed to a two-pipe system that must deliver all cooling or all heating. Energy savings matter because buildings consume 40% of the world's energy, according to Johnson Controls management.

Hitachi is a key partner in the VRF expansion plan. Johnson Controls just formed a joint venture with Hitachi with 60% ownership and a $550 million up-front investment. Johnson Controls expects the joint venture to have fiscal 2016 revenue of $3 billion and margin of 4%-5%, adding $0.05-$0.07 of EPS excluding integration costs. VRF is the top reason Johnson Controls pursued this deal because Hitachi is a top-three player in VRF globally and the joint venture will be the number-two VRF player in China, a nation with 35,000 high-rise buildings, according to Johnson Controls. Management expects 50,000 new high-rise buildings in China by 2025, and 50% of all buildings 10 stories or higher built through 2020 will be in China. In fiscal 2014, China constituted about $1.1 billion in revenue (7.8% of building efficiency's revenue) and about $210 million, or nearly 23%, of the segment's income. The Hitachi joint venture makes a lot of sense to us because it unites Hitachi's VRF business with Johnson Controls' strong position in air handlers, building management systems, and highly profitable chillers. We see buildings as a key margin expansion driver for the company over our five-year forecast period. Management's guidance given in December 2014 for the building efficiency group was for annual revenue growth of 6%-7% and annual margin expansion of 40-50 basis points through fiscal 2019 to 11%-12%, excluding global workplace solutions.

Batteries Bring a Solid Moat and Growth Opportunity We have long thought of the battery group--power solutions--as the crown jewel of Johnson Controls because it has high profit margins and about 80% of its business comes from the aftermarket and thus misses most of the pressure of annual price reductions demanded by automakers. In fiscal 2015, power solutions sales of $6.6 billion made up 17.7% of revenue but contributed about 35% of adjusted pretax profit, thanks to the division posting adjusted return on sales of 17.5%, up 160 basis points from fiscal 2014.

Power solutions' moat is due to a cost advantage from tremendous scale and Johnson Controls' expertise creating switching costs in the OEM part of the business. Johnson Controls is the dominant firm in traditional lead-acid batteries, with about 35%-40% of the global market. Global car battery sales in calendar 2015 should total slightly less than 390 million units. The next-largest firms have high-single-digit to low-double-digit share. About 80% of the global industry is aftermarket sales. In the U.S., that means a supplier needs relationships with big-box retailers such as Wal-Mart, which is Johnson Controls' second-largest battery customer behind Interstate. The brand of battery matters for shelf space, and Johnson Controls owns several labels such as Optima and Interstate (49% ownership of the latter) in North America, Varta in Europe, and LTH in Latin America.

The reach of a large firm is also important. For example, in Europe there is no large battery retailer with the volume of a Wal-Mart. Johnson Controls' scale should be furthered along with its lead recycling. As the largest global lead recycler, the firm's about 500 metric tons recycled per year enables vertical integration to strengthen its cost advantage. In the past few years, the company opened new recycling plants in Mexico and South Carolina to further the recycling effort. Johnson Controls says it recycles 8,000 batteries every hour and its own batteries are made with over 80% recycled content.

There's also technical expertise that gives an intangible advantage to the business. On the OEM side of the battery business, a supplier must have a consistent manufacturing process and superior quality; Johnson Controls has both. This is important because it keeps competitors at bay and reinforces a key point about suppliers in the auto industry. It takes decades to build up reliable, consistent quality to please an automaker. Customer standards are very strict and purchasing is not purely based on price or a hot new technology. Relationships can be stickier than in other industries because of the switching costs of getting a new supplier, so a global supplier such as Johnson Controls has the means to keep investing in new technology and to apply its existing lead-acid manufacturing knowledge to absorbent glass mat batteries for start-stop vehicles and lithium-ion battery manufacturing. This advantage seems to be working well, since Johnson Controls has about 80% of the global start-stop market. The U.S. adoption of start-stop along with expanded adoption in Europe should strengthen the moat because Johnson Controls is already the dominant start-stop provider to the automakers. AGM batteries sell for about twice the price and three times the EBIT profit dollars of SLI batteries sold to OEMs at wholesale, which equates to a 50% higher margin than a traditional lead-acid battery. As AGM becomes common in North America, we expect Johnson Controls' OEM leadership to carry over into the aftermarket channel and for it to keep growing in the rest of the world.

Growing Adoption of Start-Stop Will Help Johnson Controls Europe has used start-stop for many years but the U.S. started adopting it only a few years ago and it is now used on a variety of vehicles, even pickup trucks. The technology allows a vehicle to shut off its engine when idling in traffic or a red light. The advanced lead-acid battery in the vehicle (typically AGM) enables the vehicle to keep electrical systems and heating on (as well as air conditioning, in some cases) while idling. The engine restarts in a fraction of a second as soon as the driver's foot is removed from the brake. We have seen reported fuel economy savings of 5%-10% from using start-stop, though Johnson Controls says its numbers are over 5% for conventional start-stop and up to 8% for advanced start-stop. Start-stop technology came to the U.S. because the federal CAFE rules became ever stricter in recent years, with the standard calling for fleetwide average fuel economy of as much as 54.5 miles per gallon for the 2025 model year, up from 34.1 mpg for the 2016 model year.

Navigant Consulting suggests a long growth runway for AGM batteries thanks to more start-stop adoption over the long run, with annual global start-stop sales increasing to 59 million by 2024 from about 19 million in 2015. Johnson Controls' own projections given in August are for 40% of North American light-vehicle production to have start-stop by 2020, up from about 10% in 2015. The company expects penetration in Western Europe of 90% by 2020, up from 60% currently, which is more optimistic than Navigant's prediction of 82% by 2024.

As start-stop penetration deepens, automakers will seek to add a second battery to make an advanced start-stop system, according to Johnson Controls' technology strategist. Based on an agreement that Johnson Controls announced with Toshiba in January 2015, we expect this dual system to debut in Europe in 2018 and in the U.S. after that. This second battery will be a 12-volt lithium-ion battery using Toshiba's lithium titanate expertise to store electricity from regenerative braking, enabling greater power and load management. The current start-stop format is one advanced lead-acid battery for the start-stop as well as all electrical components and systems. The dual-battery format will enable the 12-volt lithium-ion battery to recover energy from braking faster than AGM batteries can today, while the 12-volt AGM battery remains in the vehicle and keeps running the start-stop system and other functions such as lights, navigation systems, and radio. Johnson Controls estimates fuel economy improvement of as much as 8% over a conventional internal combustion vehicle.

Longer term, a single 48-volt lithium-ion battery will be combined with a 12-volt lead-acid battery and a 48-volt motor--in what Johnson Controls calls a microhybrid vehicle--to supply electricity for vehicle systems such as electric power steering. However, this 48-volt battery plus redesign of electrical components in the vehicle is reported to cost as much as $1,200 per vehicle, so this type of change is a long way off. Johnson Controls estimates fuel economy improvement over conventional vehicles of 12%-15% with this 48-volt system. Advanced lead-acid batteries sell for about twice the price and 50% more profit margin than SLI batteries. Therefore, it is not surprising to see management's guidance through fiscal 2019 call for average margin expansion of 50 basis points to 18%-19% thanks to cost-cutting and a richer product mix.

Management clearly--and in our opinion correctly--sees that for at least the midterm the industry will generate mass volume sales in internal combustion, advanced start-stop (12-volt batteries), microhybrid start-stop vehicles (48-volt), and full hybrids as opposed to battery electric vehicles such as those from Tesla, the Nissan Leaf, or Chevrolet Bolt. For cost, range, and infrastructure issues, we also do not expect electric vehicles to gain meaningful share of industry sales through 2020. However, we would like Johnson Controls to win an electric vehicle battery program at some point to get more experience in this emerging segment, which has been dominated by Asian battery makers. Perhaps once the spin-off is complete, Johnson Controls will use some of the dividend as well as future cash flow for battery R&D to increase range. Another application is energy storage for industrial or commercial purposes, but this business is still in its very early stages.

Johnson Controls Offers a Moat Our fair value estimate of $49 per share for Johnson Controls includes $13 per share of value from the spin-off, which we model at the start of fiscal 2017. We think the company after the spin-off has double-digit operating margin potential even before equity income, up from total company levels of 6%-7% presently. We model a midcycle EBIT margin before equity income of 10% and 11.6% including equity income. Our revenue mix forecast for fiscal 2019 is about 65% buildings and 35% batteries. Assuming a 2019 earnings mix of about 55% buildings and 45% batteries, along with management's fiscal 2019 return on sales guidance including equity income of 11%-12% for buildings and 18%-19% for batteries, a weighted average calculation suggests that management targets a margin including equity income of at least 14.2%. In our opinion, that may be more of a peak than a midcycle level, plus the company will still have some cyclical elements to its business after the spin-off, albeit more in buildings than batteries, since the latter is about 80% aftermarket. However, we do not expect the company to be anywhere near as cyclical as it is today with autos.

There is execution risk--although low, in our opinion--in the company transforming its building business into a more product-focused unit with the ADT deal, the Hitachi joint venture, and more building acquisitions over time. We think there is also uncertainty in the market about what will the new company look like, its ability to execute, and how to value the company after the spin-off. Management may call Johnson Controls a multi-industrial company, but it is not a diversified industrial firm in the same massive form of a General Electric, Honeywell, or United Technologies; so we consider the new company's multiple highly uncertain, especially if it keeps being covered by automotive analysts after the auto segment is spun off. Still, we see attractive returns at the right price thanks to the spin-off, the move to more HVAC products, and a mix shift in batteries to more advanced lead-acid units. We expect return on invested capital to increase to the midteens from the low double digits of the past few years once the automotive group is divested at the start of fiscal 2017.

We have no objection to management's capital-allocation plans. The company has paid a dividend every year since 1887 and increased it in 35 of the past 37 years. Our own talks with management lead us to believe that it realizes the dividend remains a priority to the shareholder base even in light of the upcoming dramatic transformation. The board has almost always voted for increasing the dividend, with the only exception over the past several decades being during the financial crisis after Lehman Brothers collapsed. The most recent increase was 11.5% to $0.29 a share quarterly in fiscal 2016, following 18% and 16% increases in the prior two fiscal years.

Molinaroli moved to change the capital-allocation policy in November 2013 with the announcement of a share-repurchase program. Previously, management preferred to reinvest all proceeds other than the dividend back into the business. We think the company has the cash flow to do buybacks, a dividend, and reinvest in the business. The 2013 buyback announcement raised the authorization by $3 billion to total $3.65 billion. The plan does not expire, but management committed to using all of the authorization through fiscal 2016 and has kept its word by making $1.2 billion of buybacks in fiscal 2014 and an additional $1.4 billion in fiscal 2015. We expect the final $1 billion of buybacks in fiscal 2016.

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