Investors in Johnson Controls Inc. (JCI +2.41%) have watched the company being restructured in the past couple of years, and the recent third-quarter results promised more of the same. Having announced an intent to explore strategic options for its Automotive Experience segment (dealing in car seating and interiors) in June, management subsequently released third-quarter results and announced plans for a tax-free spinoff of the segment -- one that could change the nature of the company. With this development in mind, let's look at the five key takeaways from the earnings report.
Spinoff
First, the spinoff of the Automotive Experience segment may have surprised the investment community, as "exploring strategic options" is often a euphemism for a divestiture. Indeed, CEO Alex Molinaroli stated on the earnings call that the plans didn't "preclude us being able to sell this business if it came up." In answering a question from CLSA analyst Emmanuel Rosner, Moilnaroli outlined the reasons management took the spinoff option rather than wait for a sale: "It's possible you could still sell, but we need to provide the same amount of work in order to make the spin decision. And I think our customers also needed to have some certainty about what it is that we were going to do, particularly our Chinese customers, because as you know we have many partnerships in China."
In other words, a quick sale didn't seem to be in the cards, and the company needed to act quickly to give its customers clarity -- at which point readers might be asking what the key difference is strategically between a spinoff and a sale.
One answer is that a sale would grant the company a lump sum of cash, with which it could pursue significant acquisition opportunities for its Building Efficiency and Power Solutions businesses. With a spinoff, Johnson Controls would have to raise debt to make a significant acquisition -- although this might prove easier to do, because the remaining businesses are seen as being less cyclical, arguably making it easier to raise debt .
Ongoing margin expansion
Second, the results show an impressive improvement in overall margin but some mixed performance on a segmental basis. In addition, foreign currency effects significantly affected overall and segmental sales:
| Metric |
Automotive Experience |
Building Efficiency |
Power Solutions |
Total |
|---|---|---|---|---|
|
Sales growth |
(6%) |
5% |
(2%) |
(2%) |
|
Sales growth ex- foreign currency |
3% |
10% |
6% |
5% |
|
Segment income (millions) |
$342 |
$272 |
$234 |
$848 |
|
Income growth |
19% |
3% |
22% |
14% |
|
Margin improvement |
130 |
-25 |
320 |
120% |
Source: Johnson Controls presentations.
Building Efficiency
Third, the Building Efficiency segment saw a small margin decline despite good revenue growth. When questioned on the earnings call, Moilinaroli reminded analysts that "one of the things and I did signal this last quarter is that we were going to be staffing up in advance of the growth of the market."
The segment is seeing an improvement in its core U.S. institutional market: Building Efficiency order growth in constant currency was up 6% in the quarter, with backlog also up 5%, and the hiring is intended to capture future growth. However, it's coming at the expense of immediate margin expansion.
Power Solutions
Fourth, the Power Solutions segment (i.e., automotive batteries) delivered strong results, with particularly good growth in the aftermarket. On a global basis, original equipment manufacturers sales were up 2%, but aftermarket sales were up 7%. Volumes were flat in North America but increased 22% in Europe and 8% in Asia.
With regard to the impressive margin expansion, management put it down to an improvement in operating performance, volume growth, and product mix.
Automotive Experience
Fifth, the focal point of interest in the Automotive Experience segment is obviously going to be the future spinoff, but that shouldn't detract from the strong increase in margin recorded in the quarter. On the other hand, markets are always forward-thinking, and there are concerns that the China automotive market is slowing.
Indeed, the company highlighted that China's industry production was up just 2% in the quarter. However, passenger-car production was up 7%, and Johnson Controls' sales (mostly nonconsolidated, as it has joint-venture partners) were up 10%. Moilnaroli argued that this was partly due to having "the right mix of customers and the right mix of programs."
Where next?
All told, it was a solid quarter, but the market will worry about China's future car production activity and its impact on Johnson Controls. I suspect a quick sale of the Automotive Experience segment would have pleased investors. In addition, hiring efforts in Building Efficiency could lead to disappointment if the U.S. institutional market starts to slow again.
On the other hand, Power Solutions looks in good shape, and the ongoing restructuring is obviously increasing margins and should allow management to make more acquisitions in future years.
