Johnson Controls Earnings - Behind the Headlines

By Chad Henage - May 2, 2012 | Tickers: JCI, SI | 0 Comments

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Johnson Controls (NYSE: JCI) is one of the first companies I ever invested in. The reason was simple, I was in college, didn't have a lot of money, and you could invest directly with the company for just $50. While my initial investment with Johnson Controls is long gone, I always keep up with what's going on with the company. Recently Johnson Controls reported earnings, and while the company met EPS estimates, there are some trends behind the headline numbers that tell an ominous tale.

The headline numbers were, revenues up 4%, net income was basically flat, and EPS fell from $0.56 last year to $0.53 this year. Since this past quarter might not be reflective of future results, let's look at what the company said about the rest of the year in each division.

Power Solutions:

In the Power Solutions segment, the company believes that its pricing actions, and the benefits of being more vertically integrated will benefit sales and margins. A third positive is, the company is on track to build its third battery plant in China which will reduce the cost of the batteries in the country because they won't have to import as many for sale.

Automotive Experience:

The company cites the absence of events like the 2011 tsunami as having a positive impact on earnings comparisons. The bigger drivers to this division's profits are likely to be increased automotive production, and higher seasonal profits coming in the spring, summer, and fall. Automotive Experience is Johnson Controls' largest division representing about 53% of sales.

Building Efficiency:

The building efficiency division of Johnson Controls is expected to benefit from pricing actions, improved performance in the services business, and seasonal factors. Building efficiency is a potential growth driver for Johnson Controls, that isn't tied to the performance of the auto industry. A challenge in this industry is larger, more well capitalized competitors. As an example Siemens AG (NYSE: SI) has much larger operating cash flow ($10 billion vs $1 billion for JCI), and a better balance sheet ($3 bil. Net cash versus JCI's $4 billion net debt).

Johnson Controls said they feel comfortable with analyst estimates for the rest of 2012. However, there are several factors about Johnson Controls's financial performance that make me uncomfortable. Specifically the trends in margins, cash flow, SG&A, and long-term debt.

Gross Margin:

Johnson Controls's gross margin worries me. Coming out of the Great Recession, you would expect an industrial company's margins to improve, which they did. However, the company's gross margin, which topped out at 15.41% in 2010, has fallen each year since. This includes the most recent earnings report which shows teh gross margin dropping to 14.66%. This might not sound like a big deal, but when a company's gross margin drops by 1% in two years, I get concerned.

Cash Flow:

Johnson Controls has potentially an even bigger problem with the company's free cash flow payout ratio of the dividend. The same trend happened as with gross margin, coming out of the recession this payout percentage went down. However, in the last two years, this payout percentage has jumped from 23.57% to 50.62% as of the most recent quarter. While this isn't a problem today, this is something for shareholders to watch.

SG&A:

Johnson Controls has a problem when it comes to selling, general and administrative costs (SG&A). Look at the last three years, and the projection of this year with March 2012 as our guide:

You can see that each of the last 3 years SG&A has increased. If the company maintains its current pace, SG&A will increase again for 2012. This is fine if the company is growing, but not for Johnson Controls with basically flat earnings.

Long term debt:

A final concern for shareholders, should be the steadily increasing amount of long-term debt that sits on Johnson Controls's balance sheet. Look at the last 3 years plus this current quarter:

This is a growing issue as the company takes on more debt, it must create more cash flow to service this debt. Johnson Controls is turning about 2.3% of its sales into operating cash flow as of the first quarter. Assuming the company meets revenue projections, and this rate of cash conversion stays the same, look at the projected numbers versus last year. 

These are not numbers I would be comfortable with if I'm buying the stock.

Conclusion:

I do think that Johnson Controls will benefit from the automotive industry's strength going forward. However, if I were a shareholder, I would want to see much better control over SG&A, less capital expenditures with respect to cash flow, and the long-term debt situation being addressed. As you can see, reading just the headlines doesn't begin to tell the true story of what's going on with a company. In Johnson Controls case, the headline numbers weren't all that bad, behind the headlines the numbers get a little scary.

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