The market liked Johnson Controls' (JCI 2.88%) fourth-quarter results and marked the stock up more than 3% when earnings were released on Oct. 30. The stock certainly needed the boost, because up to that point it was down nearly 13% on the year. Johnson Controls investors will be looking for the earnings to spark a recovery in the stock price. Here are the five things that management hopes will take the stock higher.
Building efficiency segment set to improve
Johnson Controls is trying to expand its building efficiency segment sales in an attempt to reduce its reliance on the automobile sector -- an industry known for its cyclicality. The building efficiency segment sells heating, ventilation, and air conditioning, or HVAC, solutions. Unfortunately, this year has proven to be tougher than management expected, but the good news is that the segment's fortunes look set to improve.
On the recent conference call, CEO Alex Molinaroli first highlighted the improvement in the institutional component (the company's core HVAC market) of the Architecture Billings Index -- a key industry measure of construction growth. A reading above 50 indicates expansion.
Source: American Institute of Architects.
Second, Molinaroli confirmed that he was seeing a strengthening pipeline: "[I]f you look at our pipelines, which are usually looking out six months, we're seeing some significant projects on the board." Moreover, the integration of ADT, a company acquired earlier this year that focuses on the light-commercial sector, is, according to Molinaroli, going "very well." Indeed, Vice-Chairman Bruce McDonald talked up the potential for ADT to complement its existing activities "even though it's early days; we are already starting to see some of the benefits of cross-selling" -- good news all around.
Auto experience segment experiencing margin growth
Johnson Control's auto experience segment has been subject to a substantive amount of restructuring this year. The result has been a startling increase in profitability. For example, after adjusting for nonrecurring items and integration costs, the segment's income increased 68% to $994 million for the full year.
However, according to McDonald, there is more to come. On an adjusted basis, the segment's margin came in at 4.5% for the full year, but in answering an analyst's question on where margins in the segment could go, McDonald outlined that the goal "over the next few years" was '"to take that to 7% or maybe even a little bit above 7%."
Power solutions
The segment's adjusted income only increased 7.8% in 2014. However, management disclosed two things that could lead to improvements in the future. First, customer destocking in Europe has slowed demand for car batteries in the region. However, customers can't destock forever, and aftermarket sales were only down 5% in the fourth quarter. If a cold winter ensues in Europe this year, then its European sales could turn around sooner rather than later.
Moreover, according to McDonald, margin growth in the segment has been negatively affected by "changing from LIFO to FIFO inventory accounting." (LIFO stands for "last-in/first-out" and FIFO is "first-in/first-out.") In an environment of falling input prices (in this case for lead), this switch will, initially, at least, negatively impact profits, because the "first-in" lead will be at a higher price than the "last-in" lead. However, this will correct itself in future quarters as the less expensive "last-in" lead starts to get accounted for.
Commitment to improving free cash flow
One area that Johnson Controls needs to improve upon is its free cash flow generation. The following chart indicates the key metrics it needs to work on. As the data indicates, free cash flow conversion from sales and net income actually got worse in 2014.
Source: Morningstar Research, author's analysis.
The good news is that CFO Brian Stief explicitly recognized that the company needs to focus on improving working capital requirements (so cash isn't tied up in servicing these requirements) in 2015. Stief said on the earnings call, "I would point out this area of working capital is something that we need to focus on as we move into 2015."
Reorganization continues
Finally, the company's reorganization is going to continue in 2015. The building efficiency segment is in the process of restructuring, with the intent being to separate its North American operations from its global operations. Furthermore, Stief confirmed the timetable for the creation of joint ventures within building efficiency (Hitachi) and automobile interiors and Global Workplace Solutions, or GWS, a facilities management business within the building efficiency segment: "We continue to make progress with the previously announced portfolio activities which would be the GWS divestiture, the Hitachi JV and interiors JV. As we sit here today, our targeted completion for those is the second half of fiscal 2015."
The takeaway
All told, investors have reason to believe that all three segments will improve performance going forward, and management is candid about the need to improve free cash flow generation. Moreover, the restructuring activities are ongoing and investors can look forward to the analyst day on Dec. 2 for more color on management's expectations for 2015. There is a lot to look forward to with Johnson Controls.
