The Long and Short
Johnson Controls upgrade potential
Meredith Contente | March 3, 2023
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.
Johnson Control International’s fiscal first quarter results and fiscal 2023 guidance highlight that margins and free cash flow are moving in the right direction to be considered for an upgrade by Moody’s. The agency put JCI’s Baa2 rating on positive outlook in November last year, noting that ratings could be considered for an upgrade should EBITA margins improve, and free cash flow generation returns to historical levels well above $1.0 billion annually. Free cash flow has resumed normalized seasonal patterns and working capital improvements set the stage for free cash flow to approach $2 billion this year, in line with historical free cash flow generation. Additionally, management maintains a conservative approach to leverage with net leverage comfortably within management’s target range.
While JCI trades through peers such as Parker-Hannafin Corp (PH – Baa1(n)/BBB+(n)/BBB+(n)) and Trane Technologies PLC (TT – Baa2/BBB), JCI’s 2% 2031 bonds trade at a dollar discount to the company’s on the run 10-year bond (4.9% 2032) and provides for an approximate 10 bp to 12 bp pickup to the company’s 1.75% 2030 issue. Specifically, the median average of spread differential between JCI’s 2031 and 2032 issues has been approximately 14 bp though the 2032 bonds. Currently that spread differential is only 7 bp through. JCI 2031 bonds have traded as tight as 29 bp through the 2032 bonds, as recent as January of this year.
Exhibit 1. Historical Spread Curve (JCI 2% 9/16/31 vs. JCI 4.9% 12/1/32)
EBITA margin witnessed solid growth
JCI witnessed strong adjusted EBITA growth of 15% in fiscal first quarter and posted an adjusted EBITA margin of 13.7%, a 140 bp improvement from the year-ago period. Management noted that the improvement was driven by better pricing as well as improved productivity measures, which offset the negative impact from product mix. On a LTM basis, JCI’s adjusted EBITA margin was 14.5%, up 30 bp sequentially and 10 bp year-over-year. Given the strong quarterly growth, JCI is now guiding to full year EBITA margin growth in the 90 bp to 140 bp range, up from previous guidance of 80 bp to 140 bp. That said, EBITA margins are expected to end the year in the 15.1% to 15.6% range. Additionally, management provided second quarter guidance of adjusted EBITA margin growth in the 100 bp to 110 bp range. Management remains confident in their guidance as they execute on their higher booked margin backlog as they move through the fiscal year.
Backlog remains at record levels
Management’s confidence in its guidance rests in the company’s backlog which was a record $11.3 billion at the end of the quarter, up 11% year-over-year. JCI’s service backlog was a record $2.3 billion, and management believes the service component is a key competitive differentiator to peers. JCI noted that while supply chain realization and China polices related to their Covid lockdowns negatively impacted in-field order flow during the quarter, order momentum improved as they headed into fiscal second quarter.
Exhibit 2. JCI backlog 1Q21-1Q23
Service backlog witnessed 13% growth in the quarter as JCI saw strong growth across all regions. JCI saw service orders and revenue growth of 10% in the quarter and remains confident in their ability to capture $2bn in additional service revenue by 2024. Install backlog saw 10% growth in the quarter, which was primarily driven by North American order activity. The North American business witnessed total order growth of 6%, with new construction orders (primarily in HVAC) growing over 50%. Energy efficiency and air quality post pandemic are expected to remain a tailwind, which bodes well for JCI as commercial HVAC accounts for just over 40% of JCI’s revenue base.
Free cash flow to improve as supply chain disruptions ease
Free cash flow returned to its normal seasonal pattern with a cash outflow in fiscal first quarter. Additionally, management noted that free cash flow was negatively impacted by a softer residential market coupled with continued supply chain disruptions. Full year free cash flow conversion is being guided to the 80%-90% range. While below its historical conversion rate of 100% or more, it is a solid improvement from the 67% conversion rate posted in fiscal 2022. The improvement is expected to be driven by better working capital management and the reduction in of inventory levels as the supply chain starts to normalize. With cash flow moving back to more seasonal patterns, JCI will return to positive free cash flow generation in fiscal second quarter, with the expectation for a breakeven level for the first half of fiscal 2023. Consensus estimates are calling for fiscal 2023 free cash flow to hover around $2.0 billion, in line with free cash flow generation in fiscal 2021.
Leverage within management’s target range
JCI ended the quarter with net leverage of 2.2x, within management’s target range of 2.0x-2.5x. Total leverage stood at 2.6x which is roughly in line with Moody’s target of the mid-2.0x area. JCI has long managed leverage conservatively and was below its target leverage range in fiscal fourth quarter of 2022 and fiscal first quarter of 2022. Leverage is likely to improve as we move through the year and EBITA margins expand. Additionally, JCI benefits from strong liquidity, having ended the quarter with roughly $1.5 billion of cash on hand and $3.0 billion in untapped revolvers. We anticipate that JCI is looking to extend the maturity of its current revolvers as $500 million is expected to mature on 11/30/23 and $2.5 billion to mature on 12/5/24. JCI has only one debt maturity this fiscal year, with EUR888 million maturing on 9/15/23.