niphon
Investment thesis
Johnson Controls’ (NYSE: JCI) backlog remained high at the end of the third quarter of FY22 due to strong demand for its products and supply chain issues. To alleviate constraints in its supply chain, the company is also working with its suppliers such as improving its productivity and plant utilization. In the fourth quarter of FY22 and beyond, improving supply chain constraints, higher price realization and higher backlog levels are expected to support revenue growth. The company is leveraging its OpenBlue platform to increase revenue and service margins. Other than that, margins are expected to improve going forward due to a positive price/cost ratio, conversion of higher margin projects in the backlog, and supply chain issues.
JCI Income Prospects
JCI recorded solid revenue growth in the third quarter of FY22, driven primarily by pricing. Volume growth in the quarter remained flat as supply chain constraints affected backlog conversion, primarily in the longer cycle solutions business for North America. To manage supply chain constraints, the company is working with its suppliers to secure critical materials and improve its production and plant utilization. JCI has been able to significantly improve its building management systems offering in North America. The overall demand backdrop for the business remains robust, with field orders up 11% organically year-over-year in the last quarter and backlog reaching record highs of $11.1 billion, growing by 13% year-on-year on an organic basis. In the North America Business Solutions segment, orders increased 15%, driven by continued demand in data centers and healthcare verticals. The segment’s backlog grew 17% year-on-year to $7.2 billion. In the EMEA/LA Business Solutions segment, orders were up 8% year-over-year, driven by mid-teens growth in the fire and security business. The segment’s backlog increased 10% year-on-year to $2.2 billion. APAC Business Solutions segment orders were up 2% year-over-year, primarily due to continued momentum within the industrial vertical in China. The pipeline of infrastructure investments in key verticals such as data centers, semiconductors, petrochemicals and healthcare drove the order rate. Backlog increased 1% year-on-year to $1.7 billion. The Global Products backlog grew more than 50% year-on-year to $2.2 billion, as orders grew mid-single digit year-on-year, driven by strong growth in services.
Going forward, the company’s close coordination with its suppliers and improvements to its facilities should reduce supply chain challenges, improving volumes in the fourth quarter of FY22 and beyond. Backlog conversion is expected to improve by two months and is expected to return to historic levels, supporting volume growth in Q4 FY22 and 1H FY23.
In the healthy buildings sector, growth opportunities remain strong, with the global government supporting investment in indoor air quality. The British Parliament has proposed the Air Quality Bill this would require mandatory indoor air quality monitoring and improve air quality in England and Wales. The US government is also investing in improving indoor air quality in schools, colleges and universities. Healthy Buildings orders in Q3 FY22 increased 27% YoY and the order pipeline is up 33% YoY to $1.3B. The company plans to leverage its OpenBlue technology to capitalize on investments made worldwide in healthy buildings.
In Europe, the decarbonization trend and the goal of achieving net zero emissions by 2050 should be a tailwind for the company. This strategy is underpinned by European legislation such as the Climate Law, the Energy Efficiency Directive and the Energy Performance of Buildings. The EU is currently focused on reducing its dependence on Russian fossil fuels by 2027, which will require new public buildings to be zero emissions. JCI’s work on low GWP (Global Warming Potential) products as well as energy efficient products should benefit the company’s turnover. In FY22, the company expects revenue to grow 8% to 9% year-over-year, with pricing contributing 7%.
Growth in service activities
JCI’s connectivity platform, OpenBlue, is a fully integrated digital platform, providing cybersecurity, AI-enablement and digital twin capabilities. In the second quarter of FY22, the company launched its OpenBlue Gateway, a step towards accelerating JCI’s equipment connectivity and a key enabler of its ability to deliver enhanced digital service offerings. Service orders in Q3 FY22 were up 7% year-over-year. JCI connected more than 8,400 chillers with its OpenBlue technology, representing an 86% year-on-year increase. The launch of its connected control platform, which represents OpenBlue’s integration with JCI’s medical platform, is expected to enable the company to intelligently automate buildings and optimize air quality, efficiency energy and carbon reduction needs, as well as transforming its service value proposition.
The company is also engaged in mergers and acquisitions to enhance its OpenBlue platform and technology capabilities. JCI acquired FogHorn in the first quarter of FY22 and Tempered Networks in June 2022 to enhance its OpenBlue technology stack by leveraging their best technologies. Tempered Network is a proprietary, security-focused, state-of-the-art airwall technology that will be integrated into the OpenBlue platform to enhance the crust and connectivity of JCI’s growing network.
Margins
Q3 FY22 Adjusted EBITA margin declined 110bps YoY to 15.1% due to 104bps headwinds from lower volumes and supply chain challenges , partially offset by the ongoing improvement program of SG&A and COGS. Supply chain disruption in the quarter amounted to $65 million. The company recorded a positive price/cost ratio for the first time in the quarter of $20 million.
Going forward, as supply chain constraints improve, their impact is expected to decrease in the fourth quarter compared to the third quarter of FY22. Price/cost is expected to be approximately $30 million dollars in the fourth quarter of FY22. Additionally, the mix is expected to improve as higher margin projects in the backlog are converted. This should be accretive to margins. North America segment adjusted EBITA margin is expected to increase 4.5 percentage points sequentially and remain flat Y/Y. JCI’s OpenBlue platform receives strong demand from customers and places high-quality projects in the backlog, which underpins the improved margin. Additional levers include functionalizing and simplifying its ERP deployment to further boost productivity efforts. The company’s goal is to achieve $220 million in productivity savings in FY22 and has achieved $170 million year-to-date.
Evaluation and conclusion
The stock is currently trading at 17.07x FY22 consensus EPS estimate of $3.00 and 14.20x FY2023 consensus EPS estimate of $3.61, which is below its five-year average PER of 18.34x. JCI’s revenue is expected to benefit from volume growth due to improved supply chain constraints and higher price realization. The company has strong backlog levels and a strong order pipeline, which is benefiting revenue in the first half of FY23 and beyond. The company’s margin should benefit from a positive price/cost ratio, the business mix and the SG&A and COGS improvement programs. Given the reasonable valuations and good growth prospects, I have a buy rating on the stock.