Johnson Controls Plans a Return to the Driver's Seat

 | Dec 21, 2012 | 9:30 AM EST  | Comments
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At its annual investor day meeting on Wednesday, Johnson Controls (JCI) management took clear ownership of the subpar performance of the company's Automotive Experience segment during the past 18 months and asserted that the issue is now aggressively being fixed.

Reflecting that confidence, the headline of the day was the raised fiscal 2013 guidance to earnings per share of $2.60 to $2.70 and enhanced revenue growth of 3% to 4%. More optimistic management guidance is becoming increasingly rare in general, but even more noteworthy is that Johnson Controls' statements come after management provided disappointing guidance in October.

What has changed in the last two months? Basically, better visibility into the troubled European auto market and higher confidence that Johnson's actions in that segment will be successful.

The company's Automotive Experience segment is composed of seating, interiors and electronics. Management has split the segment into its three component pieces and assigned its resident turnaround expert, Bill Jackson, to run both interiors and electronics.

The interiors unit has been suffering with some poorly structured or executed contracts, exacerbated by industry volume weakness. At the meeting, Jackson identified five specific programs that are responsible for the bulk of the issues, each of which is being addressed to first eliminate losses and then drive returns above the company's cost of capital. For the first time, the company acknowledged that a major restructuring is likely in Europe.

The outlook for the other components of the Automotive Experience unit is significantly brighter. Its seating unit is the clear global leader in its niche. Its strong current position in China through joint ventures is not well reflected in its financial statements, and this will be a value driver as the auto industry in China grows and slowly moves upscale. Additionally, the electronics unit is a shining star for Johnson, as original equipment manufacturers push more electronic content such as infotainment, safety systems and controls into cars in order to provide differentiation and to meet customer demand.

Power solutions, the auto battery business, will see future growth and innovation from tighter fuel-efficiency mandates, and the current lead-acid business will be extremely profitable if there is normal weather this winter.

Finally, building efficiency (HVAC for commercial and institutional properties) is stable, with growing profitability from better pricing and cost controls. Nevertheless, it likely will not garner much investor attention until business confidence improves, thereby increasing demand for the higher-margin discretionary projects that will really drive profits.

Through it all, Johnson's corporate model is conservative and shareholder-focused. Capital spending will come down $400 million this year. As there is no real interest in an acquisition during the next few years, free cash flow will rise substantially to about $1.2 billion. This cash will be used to reduce net debt to a more comfortable 27% of total capital and to increase the dividend, currently a 2.5% yield, with a target of a 35% payout of earnings, up from the current level of about 28% of 2013 earnings.

We like Johnson Controls in the context of a recovering global economy. Many of its businesses are directly or indirectly in the sweet spot of the energy-efficiency mega-trend. Valuation is reasonable at about 11.3x this year's earnings estimate, and the stock offers a more than decent dividend, with long-term growth potential well above GDP or market averages.

Industrials are starting to benefit from a growing conviction that China is starting to reaccelerate and that the US economic recovery will continue. JCI is a highly respected player in the sector, and it offers an attractive combination of upside potential and a high likelihood of achieving it.

We would be a buyer here.

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