Johnson Controls Ready to Play Catch-Up

 | Mar 12, 2013 | 8:00 AM EDT
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In the current market rally, industrial stocks have been a strong contributor. We've been bullish on industrials, and we expect this sector to be among the leaders as the year unfolds. One stock in this group that we have liked and have written about is Johnson Controls (JCI). While the stock is up nicely so far this year, it has been lagging the group over the past 12 months.

On the basis of what's going on at the company and in its end markets, we expect Johnson Controls to play catch-up and be an outperformer in upcoming periods.

In late January, the company reported its December quarter (the first of fiscal 2013), which beat expectations, and reiterated guidance for the full year. But management still created a modest disappointment by guiding the March quarter below consensus, essentially saying that the Street got the business cadence wrong, specifically concerning the near-term prospects for the European auto business. After the call, the stock became directionless, as some investors believed that in light of the first-quarter guidance, there were better places to make money in 2013.

Our take is that many people were not listening closely enough to management's outline of how the European auto industry would develop throughout the year, and that the trajectory of the first two quarters is not different from what was communicated during the December investor day presentations. In fact, consensus EPS estimates for the September 2013 quarter are barely changed from prior to the report, belying the supposed change in mind-set. The company's commentary on the first-quarter call about the environment for each of the five segments was within expectations and was unchanged from what it had said at its investor day.

The other new news about Johnson Controls is more interesting and may have more far-reaching consequences. The company announced just last week that it has hired an investment banker to explore the concept of separating the automotive electronics business. At the investor day presentation, the company had highlighted this unit as having good growth and profitability prospects. On its face, this would be a modest increment to value, probably less than $1 a share, making some assumptions around valuation and taxes.

Interestingly though, Johnson Controls' stock rose more than the incremental value would indicate. Why? Recall that the company has five segments in three completely different industries. After the stock's underperformance over the last one and two years compared with both the S&P 500 and the industrials sector, management is under the gun to do better for shareholders.

For years, there has been a persistent buzz about breaking up the company, in order to focus greater operating attention on each component business, thereby improving results and driving the value of the individual parts above the combined total. It may be that the interest in separating electronics is a sign that the company is looking at its component parts more strategically and from the perspective of shareholder value.

While we don't believe that the last two difficult years should overwhelm management's successful long-term track record, we do believe that actively assessing the rationale for retaining each business under the Johnson Controls corporate umbrella could be a good thing for shareholders. Furthermore, if management's expectation of a "back-end loaded" year indeed plays out, that trajectory, coupled with some global economic improvement, could drive considerable market interest in Johnson Controls. The result could very well be that Johnson Controls will become an outperforming catch-up play in 2013.

The stock has already moved up some, but it is not expensive, trading at 13.1x estimated 2013 earnings per share, which is still at a meaningful discount to its industrial peers. It pays a dividend in line with the yield on the S&P 500, and it will likely increase faster than earnings. In Johnson Controls' specific businesses, it is the leading global player.

There's still enough headroom within our intrinsic value estimate above $40 to warrant buying the stock at current price levels.

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volatility is quite low here, and we could see some downsides here in the short term. ...



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