Johnson Controls: Auto Batteries and HVAC Make Strange Bedfellows

Johnson Controls is an industrial company with diverse interests in automotive, heating and air conditioning. Johnson Controls is really three companies in one. Already one of the leading automotive seating and interiors suppliers, Johnson Controls continues to diversify. Growth in its building efficiency and power solutions group helps offset vicious cyclical declines in the automotive experience group.

The automotive segment contributed 51% of fiscal 2013 sales, down from 69% in fiscal 2005, which shows the company's increasing diversification.

Building efficiency in fiscal 2013 was a $14.6 billion business, contributing 34% of sales compared with 21% in fiscal 2005. The 2006 acquisition of York, manufacturers of heating and air conditioning equipment, made Johnson Controls a much larger player in HVAC equipment and service. This depth allows the company to market itself as a one-stop shop for service, controls, and equipment, which differentiates JCI from other large providers. Eighty-three percent of segment sales come from repeat business, but the company seeks to increase its exposure to more profitable HVAC product sales for a 50/50 product and service segment mix.

Power solutions is highly profitable, with 15% of fiscal 2013 sales and an operating margin over 15% in fiscal 2013. The segment has 36% share in the lead acid automotive battery market. This business is also a good diversifier because 80% of segment sales are to the replacement market, which makes battery demand more inelastic and gives the company strong pricing power. Johnson is the dominant player in start-stop vehicle technology thanks to its leading position in absorbent glass mat AGM batteries. Power solutions should benefit from automakers needing more fuel-efficient vehicles to meet environmental regulations.

There is tremendous growth and profit potential in AGMs because the batteries sell for twice the price of a normal lead acid battery. AGMs also generate 50% better profit margin. European auto production is forecast to increase the use of advanced lead acid batteries, such as AGMs, to 75% by 2015 from 40% in 2011. North American auto production is forecast to increase advanced lead acid use to 59% by 2015 from nearly zero in 2011. Globally, management expects start-stop to be 50%-60% of powertrains in new vehicles by 2020, up from 14% in 2012.

At the current price and a 15% anticipated EPS growth rate, JCI is trading below its earnings growth rate with a 2014 PE of 13.  JCI has been paying a dividend for decades and the current price offers a dividend yield of 2.0%.  JCI has a 5-yr dividend growth rate 7.9% and a 3-yr growth rate of 13.5%.  Management recently announced a dividend increase of 16.1%.  However, reported EPS over the same timeframe have been rather flat, mainly due to restructuring charges. 

JCI has a price target of $56, about 35% above its current price of $41.  While EPS have been stagnant over the past few years due to restructuring and charges, management should be about complete with its realignment of their businesses.  The underlying strength in the automotive and construction industries should help turn earnings around.   After being negative in 2010 and 2012, Free Cash Flow (operating cash flow minus capital expenditures) turned positive in 2013 to the tune of over $1.3 billion, and continues positive YTD.  Management believes free cash flow could top $2.0 billion by the end of 2016.

From Morningstar’s JCI report:

Johnson Controls has 15,000 HVAC service providers, making it 3 times the size of the second-largest player.
More governments wanting green buildings and the company's unique ability as a one-stop shop will keep the building segment growing and profitable, especially in emerging markets.
Increases in lead prices are mitigated by the fact that 100% of the lead price pass-through has been standard contracting with battery retailers for more than 70 years.
The company still gets about half of its sales from the very cyclical auto industry, and the market perceives it as an auto-parts supplier.
Commercial property servicing is very fragmented, and it could take time to capture significant share in the middle-market segment.
About 20% of battery sales are to automakers, which further exposes Johnson Controls to declines in auto production.

Investors looking for a high quality industrial company for the long term should review JCI.  Stock valuations have been consistently near the top of our universe.  More information can be found in JCI’s most recent investor’s presentation:

First appeared in the Oct 2014 issue of Guiding Mast Investments newsletter.  Thanks for reading,  George Fisher