Johnson Controls (JCI +0.44%) investors will be buoyed by the stock's recent strong run, but can it continue? Management has ample reason to believe it can improve revenue and margin growth across its segments in 2015. I've already examined the bullish case for the stock in a previous article; now it's time to look at the bearish case.
3 bearish factors for Johnson Controls
Before going into detail, I should note that I'm positive on management's restructuring efforts and internal execution. However, the company's valuation and the potential for deterioration in China's economy -- and ultimately car sales -- suggest there may be better ways to play the other positive end-market trends the company is seeing. (More on that in a future article.)
The company's segmental income in fiscal 2014 was a roughly three-way split among the building efficiency (heating, ventilation, and air conditioning), power solutions (car batteries), and automotive experience (car seating and interiors) businesses. Two of the three risks the company faces relate specifically to the auto experience segment.
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China's auto sales appear to be slowing, even as Johnson Controls is becoming increasingly reliant on the nation for growth -- particularly in the auto experience segment.
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Planned increases in cash flow conversion are fine, but the company has a patchy record in this regard.
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Outperformance of its customers in the auto experience segment might not continue in 2015.
China auto sales statistics
Johnson Controls' automotive experience segment has been outperforming its marketplace in China. As Vice Chairman Bruce McDonald said in discussing fourth-quarter automotive experience sales, "[M]ost of our business is through nonconsolidated joint ventures, and you can see in the fourth quarter here we are seeing our sales were up 17% to $1.8 billion, which substantially outpaced the 8% improvement in estimated production for the region."
The segment made $5.1 billion in sales in the fourth quarter. In addition, at a J.P. Morgan event in the summer, management disclosed that 80% of its three-year seating backlog was in China. Clearly, China matters to Johnson Controls' growth prospects. However, recent data indicates weakening passenger car sales in China.
Source: China Association of Automobile Manufacturers.
While 6.4% growth in sales for the last two months shown is satisfactory -- particularly against some strong comparables from last year -- the six-month trend remains downward. Given that Johnson Controls' growth has been double that of the market in China, any downturn in production would hit the company disproportionately.
Execution on free cash flow
The potential for an increase in free cash flow conversion is a reason to be bullish about Johnson Controls. However, investors would be right to be cautious on the issue. Indeed, the company's history of converting net income into free cash flow has not always been good.
Source: Morningstar Research.
As recently as August, management forecasts called for free cash flow of $1.6 billion for the full year to September; it came in at $1.5 billion. That calls into question whether the company will achieve the substantive increases in free cash flow conversion from sales that its guidance implies.
Source: Morningstar Research, Google Finance, author's analysis. 2014 figures exclude contribution from electronics divestiture.
Automotive customers outperformed in 2014; what about 2015?
Finally, the automotive experience segment might face some headwinds in Europe. The Continent's growth appears to be slowing (as do car production rates) alongside Johnson Controls' waning outperformance in Europe. Here is a look at the company's estimates for industry production through the last three quarters.
| Car Production Growth | Q2 | Q3 | Q4 |
|---|---|---|---|
| North America | 5% | 4% | 8% |
| Europe | 5% | 1% | (1%) |
| China | 9% | 11% | 8% |
Source: Johnson Controls Presentations.
In addition, management disclosures regarding European performance have suggested the company is no longer outperforming the market. For example, in discussing the company's second-quarter results, Vice Chairman Bruce McDonald talked of a "pretty favorable product mix, particularly in Europe." Moving on to the third quarter, in discussing the automotive experience segment, McDonald said "we are able to exceed the market production levels in all three of the main regions [North America, Europe, and China]." Fast-forward to the fourth quarter, and his narrative changed for the worse: "In Europe, our revenues were down 1%, generally speaking, in line with the industry reduction."
All told, management has done a good job of restructuring the company and putting it on the path to growth. However, Johnson Controls will always be exposed to the cyclical vagaries of automobile production in its automotive experience segment (and to a certain extent in the power solutions business). Conditions in North America look fine, but car sales appear to be slowing in China, and its outperformance in Europe appears to be ebbing. Will strength in the U.S. auto production market and in other parts of the company be enough for Johnson Controls to hit estimates in 2015?
