Johnson Controls Inc. Has Upside Potential Even After Mixed Results

It's rare that someone can point to a company that has just delivered an increase in quarterly earnings of more than 50% and say that its results were "mixed," but that's exactly the case with Johnson Controls Inc. (NYSE: JCI  ) . Its automotive-based segments gave mixed results, while its construction-based segment's results were disappointing. Moreover, its guidance for the construction industry was somewhat at odds with what rivals like Lennox International (NYSE: LII  ) and Ingersoll-Rand (NYSE: IR  ) reported. But there is a lot to like about the company, and investors should follow the current share price decline with a lot of interest.

What investors were expecting from Johnson Controls
The company reports results within three separate segments, and a look at its segmental income for the first half reveals how it makes money. For ease of reference, its power solutions business is a leading supplier of automotive batteries, automotive experience sells automotive finishing (seating, interiors, etc.), and building efficiency sells heating, ventilation, and air conditioning, or HVAC, solutions.


Source: Johnson Controls presentations

It's fair to say that at the start of 2014, Fools may have expected the following from each segment:

  • Ongoing recovery in the global automotive market (particularly in China and North America) to aid the automotive experience segment
  • Poor weather in North America to boost battery sales for power solution
  • The long-anticipated upturn in commercial construction to drive an improvement in building efficiency sales

What investors got from Johnson Controls
As every Fool knows, sometimes investing doesn't work out as expected. A look at segmental sales and income growth in the quarter demonstrates how these expectations have been confounded in all three segments. There is one big positive, one disappointment, and one frustration.


Source: Johnson Controls presentations

The positive result comes from the automotive experience segment. At the start of the year, management were expecting 1%-2% revenue growth for the year, but with 11% growth in the second quarter, first half, growth has been much better than expected. The big surprise has been how strong its European performance has been with sales up by a double-digit amount. Essentially, European car sales have done better than expected, and Johnson Controls' automotive customers have been doing particularly well. 

The disappointment comes from power solutions. Essentially, strong North American sales have been offset by weak European sales. Its key profit driver is the replacement market (usually around 75% of segment sales, with 25% going to the original equipment manufacturers, or OEM, market), but an unseasonably warm winter has hurt European aftermarket sales, particularly in northern Europe. In fact, OEM battery shipments were up 9%, yet with aftermarket shipments up just 1%.

Johnson Controls on commercial construction
The frustration -- at least from an end-market perspective -- comes from its building efficiency segment. Johnson Controls CEO Alex Molinaroli said on the conference call: "Building Efficiency, probably the most frustrating part about this business is the commercial HVAC markets, particularly the high-end particularly the institutional segments continue not to grow." 

It's especially annoying for Johnson Controls, because the company has positioned itself to benefit from a pickup in the industry. But there are two reasons to look a bit more positively on matters.

First, HVAC sellers like Ingersoll-Rand and Lennox International are seeing slightly better conditions. For example, Fools already know that Lennox International's commercial revenue was up 6% in its recent quarter, and management forecast its North American commercial shipments to be up in low-single digits. Meanwhile, although Ingersoll-Rand kept its forecast for yearly growth in its climate segment (largely HVAC products) at 4%-5%, its climate orders were actually up 7% in the quarter.

Second, despite a fall in its building efficiency sales, income actually went up by 9.4% (see chart above). This margin expansion suggests that Johnson Controls can generate some operational leverage in the future, provided that its end markets improve.

Where next for Johnson Controls?
The next two quarters are the most important for the HVAC industry. For example, Lennox International generated 68% of its rolling year EPS in these quarters over the last year, and the same figure for Ingersoll-Rand was 72%. Therefore, don't be surprised if the disappointing first quarter gives way to an improvement, particularly with some of the new construction activity that may have been affected by bad weather in North America.

Furthermore, prospects at the power solutions segment seem to be affected more by the weather than any underlying weakness in market positioning. Meanwhile, automotive experience looks set for a strong year. Given this combination of upside possibilities, and its P/E valuation of around 14 times forecast earnings, the stock is starting to look very interesting. Johnson Controls has upside potential. 

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