After the S&P 500's recent falls, many investors will be looking at picking up some stocks at bargain-basement prices, and Johnson Controls (NYSE:JCI) could fit the bill. Since trading around the $50 mark in June, the stock is off around 20% as I write. The move has attracted Goldman Sachs analysts, who recently upgraded the stock from "neutral" to "buy," saying the market has already priced in the heightened risk in the automotive sector in China. It's not a view that I share, and it should be noted that Goldman Sachs was recently hired to give financial advice for the spinoff of the company's automotive experience segment. With that said, let's look at five takeaways from the third-quarter earnings call that might be support the bullish case for the stock.
1. Strength in building efficiency
One of Johnson Controls' key positives is the return to growth of its core institutional construction market. Indeed, CEO Alex Molinaroli indicated his confidence on the call: "As we look at the institutional markets, where we mostly participate, they seem to be healthy."
He went on to say that the company will have around 100 new salespeople in place to capture "the opportunities," noting that "it's a great opportunity and it's a great problem to have the fact that we need to staff up."
2. Automotive experience customers
It's no secret that China's economic growth is slowing, and consequently, expectations for the automotive sector have been scaled back this year. As such, the automotive experience segment -- which manufactures automotive seating and interiors -- is at risk of disappointing investors. However, Molinaroli argued: "We have the right mix of customers and the right mix of programs. And in fact, one of the things that you need to make sure that you understand when you look at our business is we are in the passenger-car business."
Indeed, in the third-quarter presentation, management stated that industry production in China in Johnson Controls' third quarter was up 2% overall, but passenger-car production was up 7%.
3. Power solutions' AGM batteries and Europe
The power solutions segment manufactures automotive batteries, and management feels it has good future growth prospects. For example, Molinaroli highlighted the 47% growth in absorbent glass mat, or AGM, battery units. AGM batteries are more stable than conventional flooded batteries and offer a longer life. Said Molinaroli on the earnings call: "I think the most noteworthy thing that we are seeing is we have talked about this last couple of quarters, but really rapid acceleration in AGM demand from the customers. We were awarded just in this quarter a $1.4 million unit order."
Moreover, he reiterated that production capacity was being expanded for AGM batteries. Another area where Power Solutions is making greater strides is with its Europe sales, where volumes are up 22%.
4. Power solutions aftermarket
The company's batteries are sold to original equipment manufacturers, or OEMs, and the aftermarket. If you buy the thesis that automotive production growth will slow in the near future -- not least in China -- then the OEM market is likely to slow, too. However, Molinaroli said aftermarket growth will more than compensate for any OEM slowdown: "The market is not only an OE business, but we are going to be able to participate in the growing aftermarket business. We see a CAGR of 8% to 9% through 2020 even with the slowdown in the OE business, because the aftermarket was growing so rapidly."
VP of Global Investor Relations Glen Ponczak disclosed that management sees its aftermarket shares growing from 40% of its business to around 60% by the end of the decade.
5. Free cash flow guidance
Free cash flow generation has been an ongoing concern for investors in Johnson Controls, but Molinaroli confirmed that he still believes the $1.5 billion target will be hit this year, despite the company having to generate $1.4 billion in free cash flow in the fourth quarter alone.
What does it all mean?
The strength in the institutional market is excellent news, and expanding the sales force is obviously the right move. However, it doesn't come without risk. The economic recovery since the last recession has been very uneven and inconsistent, so don't be surprised if the institutional market slows in the future.
Turning to the automotive experience segment, fears about China's growth prospects obviously overhang the segment, and it's hard to see the passenger-car market continuing to significantly outperform in any slowdown.
Power solutions looks to have some strong noncyclical growth prospects from AGM and aftermarket demand, and if oil prices stay low, then automobile miles driven could increase -- something that usually increases demand for replacement parts.
In addition, the company's valuation gives little room for comfort given the increased risk from China. For example, the forecast free cash flow generation of $1.5 billion represents 4.3% of the company's enterprise value (market cap plus net debt), or EV. It's not a cheap stock, and even if you pencil in free cash flow generation equivalent to forecast earnings growth of 14% in 2016, the forward FCF/EV figure is almost 5%. On a risk/reward basis, it's not a stock I would chase right now.