Johnson Controls (JCI 0.29%) management didn't tell investors what they wanted to hear on the recent second-quarter 2022 earnings call (for the quarter ending March 31). Of course, no investor wants to hear about a full-year guidance cut and talk of a falling profit margin.
Consequently, the market aggressively sold off stock in the building products and systems company. It's now down almost 15% since the report's release on May 4, taking its year-to-date performance to more than a 35% drawdown.
However, the earnings and guidance weren't that bad if you look beyond the headlines, and the stock now looks a great value. Here's why.
What happened to Johnson Controls in Q2
Recapping what happened, the company suffered margin pressure due to what CEO George Oliver described on the earnings call as "supply chain disruptions and material availability, more specifically, inadequate supply of semiconductor chips and components or controls products." These pressures will lead to lower profit margins than previously expected, so management cut margin and earnings guidance, even though revenue growth guidance was maintained. Johnson Controls reported:
- Full-year organic revenue growth guidance was maintained at 8%-10%.
- Full-year segment adjusted earnings before interest, taxation, and amortization (EBITA) margin guidance was for 14.1%-14.4%, compared to prior guidance for 14.9%-15%.
- Full-year earnings per share (EPS) guidance was $2.95-$3.05, compared to prior guidance of $3.22-$3.32.
It's a significant earnings-guidance cut, but there's reason to believe the sell-off is massively overdone by digging into the details behind it.
Why the stock sell-off is exaggerated
First of all, this isn't a problem of end demand, orders, or backlog -- it's a problem of the company being able to convert its backlog into sales and at a profit margin in line with prior guidance. Furthermore, the issue with profit margin is exacerbated because the company couldn't fulfill higher-margin controls products backlog.
"[A] lot of this is our high margin mix as it relates to controls. And the good news is when we look at our digital or orders, the orders in our controls-based businesses were up over 30%," CEO Oliver explained on the earnings call.
As such, investors can look forward to significant margin expansion in the future as these higher-margin products get converted from the growing backlog. Moreover, the company's orders performance was outstanding in the quarter:
- Trailing three-month field orders were up 11%.
- Backlog increased by 12% on an organic year-over-year basis and now stands at a record $10.9 billion.
- Management maintained full-year sales guidance (as noted above), and pricing is expected to be stronger than previously anticipated.
In addition, management continues to progress with its OpenBlue software platform and digitally connected services. With OpenBlue, customers can generate and analyze a mass of data that can be used to optimize building performance and reduce carbon emissions.
The extra value-add from OpenBlue means Johnson Controls can increase the attachment rate (service contracts attached to equipment) and add more higher-margin services revenue in the future. Indeed, management noted that it's on track to hit its attachment-rate expansion in 2022.
The strategy is working -- orders are strong, pricing is improving, and the backlog is at a record high. The only problem is the (not inconsiderable) issue of supply chain difficulties and component availability impacting near-term margins.
Analysts were keen to ask whether margin performance would be more robust in fiscal 2023 as the company converts more of its higher-margin controls products. CFO Olivier Leonetti was unequivocal "regarding the health of our business, it's actually very strong, and the margin rate should increase significantly next year above average."
All told, while the guidance cut is disappointing and there is no cast-iron guarantee the supply chain issues around semiconductors will be resolved soon, everything points to Johnson Controls being on an excellent underlying track. Moreover, the midpoint of the revised guidance puts the company on a full-year 2022 price-to-earnings ratio of just 17 times earnings. That's too cheap for a company set to significantly increase earnings in 2023, especially since it has strong long-term growth prospects from the benefit of creating smart buildings and reducing carbon emissions.