Up 60% in 2021, This Red-Hot Stock Has Room to Run

Building controls and heating, ventilation, and air conditioning (HVAC) company Johnson Controls (JCI -1.36%) will hold its investor day on Sept. 8. But investors don't have to wait for this event to understand how exciting the stock is to invest in. The company's recent third-quarter 2021 earnings highlighted its long-term potential to benefit from corporate commitments to reduce carbon emissions. It all adds up to a highly attractive stock for long-term investors. Here's the lowdown.

Earnings momentum

Two overarching factors characterized the recent earnings season. First, many industrial companies reported strengthening sales trends (in line with an improving economy), but they also reported rising raw material costs and supply chain difficulties that added to costs. Thus, the critical question is whether the company saw enough sales growth to offset cost pressures on its earnings growth. 

Image source: Getty Images.

The answer from Johnson Controls is yes so far. As you can see below, management raised its earnings margin and earnings per share guidance. Moreover, during the earnings call, CEO George Oliver said, "We are successfully leveraging our pricing capabilities to offset inflation, and we still expect to remain price cost positive for the year."

In other words, despite cost pressures, Oliver still expects price increases to offset cost increases in 2021.

Data source: Johnson Controls presentations. EBITA = earnings before interest, taxation, and amortization. bps is basis points, where 100 bps = 1%. 

In addition, the company's growth trend is on a good path. Organic orders rose 18% in the third quarter, and the backlog increased 7% to $10 billion. While that growth rate might not seem anything to write home about, especially given that it comes up against a weak comparison in 2020, it's worth noting that the compound annual growth rate in backlog from the third quarter of 2019 to the same quarter in 2021 is still 5.4%.

Data source: Johnson Controls presentations. Chart by author.

The underlying growth rate in the company's backlog is synonymous with a company aiming to grow revenue at a mid-single-digit rate in the future.

Long-term growth

The key to the company's long-term growth prospects comes down to a combination of factors:

• Management believes it has a $240 billion market opportunity over the next decade, coming from the need of building owners to reduce carbon emissions.
• Oliver believes the company has a $10 billion to $15 billion market opportunity due to an increased need for well-ventilated, "healthy buildings" (an awareness heightened by the pandemic).
• Johnson Controls' connected digital solutions, known as OpenBlue, will drive its underlying growth in services and improve its ability to take advantage of the two growth opportunities noted above.

With buildings responsible for 40% of greenhouse gas emissions, corporates have a real incentive to invest in retrofitting buildings and using smart building controls to improve energy efficiency and reduce emissions.

Image source: Getty Images.

In addition, the pandemic has heightened the need for the air to be continually changed in buildings (ventilation), and most of the leading HVAC and smart infrastructure companies are looking to take advantage of it. 

Using Johnson Controls' OpenBlue will enable building owners to use artificial intelligence and data analytics to manage building efficiency better and predict maintenance work. In addition, the benefits of OpenBlue should help Johnson Controls increase services revenue on the equipment it installs in buildings. As such, the company should see profit margins rising in the future.

A stock to buy?

Wall Street analysts have the industrial company growing revenue at a mid-single-digit rate over the medium term. Moreover, with earnings margins rising, earnings and free cash flow are expected to grow at a double-digit rate. In this context, the company's valuation -- trading on 28 times expected earnings in 2021 and 23 times expected earnings in 2022 -- looks reasonable.

Cautious investors may well want to wait until the investor day presentations on Sept. 8 to get more color on management's medium-term expectations -- not a bad strategy in light of the stock's current valuation. Given the company's earnings momentum in 2021 and its positive long-term earnings drivers, management may well have some very positive updates for the market. Still, it may make more sense to listen in on the event before buying in.