The Long and Short
Paving a green path forward with Johnson Controls
Meredith Contente | October 15, 2021
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
JCI (Baa2/BBB+) is market leader in the evolution of smart, healthy and connected buildings, a need that grew exponentially due to the pandemic. A broad synergistic portfolio which encompasses HVAC, controls, fire and security has enabled JCI to address building needs globally. JCI has demonstrated their leadership in ESG sustainable solutions as companies look to reduce their carbon footprints while operating healthy buildings post-pandemic. Company management believes these two factors present a $250 billion market opportunity over the next decade, which is expected to provide for meaningful top line growth. JCI’s curve remains one of the steepest versus peers such as Otis Worldwide Corporation (OTIS – Baa2/BBB) and Trane Technologies (TT – Baa2/BBB), despite being rated one notch higher at S&P and having the best long-term growth prospects. Relative value investors should move into JCI’s long dated bonds as its curve is likely to compress closer to peers.
Aiding the medium term outlook, roughly 54% of JCI’s revenues are recurring in nature due to its services business, which helps to provide for stability to cash flows. Management is forecasting revenue growth of 6%-7% on a CAGR basis over the next three years and EBITDA margin expansion of 250 to 300 bp over the same time period.
Exhibit 1. BBB Diversified Manufacturing Curve
Buildings Play a Crucial Role in Decarbonization Efforts
The building sector represents approximately 40% of the global carbon footprint. With most companies and governments laying out ESG framework for net zero carbon emissions, JCI believes the global decarbonization segment is a $240 billion market over the next decade. HVAC technology solutions will likely be the largest component, representing about 39% of the addressable market, a clear opportunity for JCI given its expertise in HVAC & Controls. This will come from a combination of improving the installed base to achieve the reductions necessary as well as new innovation on how the infrastructure is designed moving forward.
JCI is employing a two-pronged approach by electrifying and digitalizing buildings, which is where JCI’s OpenBlue digital platform comes into play. OpenBlue includes a full spectrum of sustainability offerings tailored to schools, campuses, data centers, healthcare facilities as well as commercial and industrial buildings. The digital platform analyzes energy, water, materials and GHG emissions while helping to optimize siloed pieces of equipment, bringing them together as a whole system. Digitizing existing systems enables them to communicate effectively with power grids, once the systems have been electrified. The communication is necessary in order to not overburden power grids. OpenBlue helps to deliver an additional 50% of efficiency on top of what any single piece of equipment can achieve. JCI is uniquely positioned to offer OpenBlue as an “as a service” model that can help customers with risk management tools while delivering a net zero outcome, for a recurring monthly fee. The demand is likely to be strong for this service, thus increasing the company’s recurring revenue base.
Backlog Hits Record – Growth Exceeding Pre-Pandemic Levels
End markets have continued to improve since 2020 and order growth has accelerated largely driven by retrofit demand. New construction is beginning to recover, but those projects tend to be longer in nature and demand is really in short cycle projects. JCI reported in the most recent quarter that field orders were up 18% year-over-year, while service orders were up 13% and install orders were accelerating at 23%. This has led to a record backlog of $10 billion, which is up 7% year-over-year on an organic basis, with roughly 75% of the backlog related to install base orders. JCI noted that retrofit or smaller turn projects in North America were up 30% year-over-year which has been a big driver of their install business. Looking to 4Q, management does not expect to witness any slowdown in order growth.
Exhibit 2. JCI Field Order Growth and Backlog
For the quarter, JCI posted strong organic sales growth of 15%, which we note was above the overall growth rate witnessed in 2019. JCI witnessed solid growth across all segments with its Global Products unit posting the strongest growth rate of 21%. Solid operational execution in the quarter led to a 30bps increase in the EBITA margin, to 16.2%. JCI is forecasting similar margin growth in fiscal 4Q. For the full year, EBITA margin growth is expected to be in the 80 to 90 bp range on mid-single digit sales growth. JCI raised EPS guidance once again to the $2.64-$2.66 range (up from $2.58-$2.65), which translates to 18%-19% growth from 2020.
Strong Balance Sheet and Disciplined Capital Allocation Policies
JCI targets a credit rating of high BBB and maintains a strong balance sheet with a net leverage target in the 2.0x-2.5x range. We note that currently JCI is under their net leverage target as they ended the most recent quarter with net leverage of 1.8x. Liquidity also remains strong as JCI ended the quarter with $1.5 billion of cash on hand and $3 billion of availability under its revolvers. JCI has no debt maturing for the remainder of the calendar year or in 2022. The company’s next real debt maturity is not until 9/15/23, when EUR 888 million comes due. Liquidity has also been boosted by strong free cash flow generation, which totaled $1.7 billion year-to-date. This compares very favorably to the $1.1 billion posted in the year-ago period.
Management has explicitly stated that preserving a strong capital structure and green financing instruments remains critical to their financial policies. As such, JCI’s most recent debt issuance was a $500 million sustainability linked bond (SLB) where the coupon steps 12.5 bp annually on 3/16/26 if the company has not met its Scope 1 and Scope 2 key performance indicators (determined by an external verifier) and an additional 12.5 bp if Scope 3 performance targets are not met. We have seen a rise in SLB issuance which essentially holds management teams accountable for achieving ESG goals or compensate bondholders with increased interest payments.
Exhibit 3. JCI Capital Structure & Liquidity