This Company Needs A Jump Start
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Johnson Controls (NYSE: JCI) first came to my attention right after I got out of high school and became interested in the stock market. The company offers a dividend reinvestment plan that anyone can begin with just $50. As a young person, this seemed like the perfect way to get started. A lot has changed about the company since I first looked at it back in the 1990s. With the company's most recent earnings report, there are some truly troubling signs that this old-school company has a long road ahead.
Johnson Controls is really three different businesses under one name. Each of their businesses faces significant competitors, but maybe none more than their automotive interiors business. In my eyes, this is the most promising part of Johnson Controls, as I've written before about the seemingly obvious signs of a recovery in the new car industry. With the company's overall revenues up 7%, if you exclude foreign exchange issues, and EPS up over 17%, on the surface the headline numbers look decent. However, beyond these headline numbers are some troubling statistics that investors should pay close attention to.
The first issue that I noticed was with the companies earnings per share growth. This is truly a case where growth came from cost cuts instead of higher sales. Specifically, the company's gross profit was down $13 million, and this was offset by equity income, which increased $14 million. The only reason the company reported 17% higher EPS was that the company cut selling general and administrative expenses by over $100 million. When a company has to cut expenses, and use equity income to offset a decline in gross profit that's a big red flag for investors. The company's individual divisions show problems that lead to this gross profit decline.
In the Building Efficiency division, the company reported overall sales down 2% but, excluding foreign exchange sales, actually increased 7%. This was primarily on the back of a 24% sales increase in residential HVAC from an unusually warm spring and summer. Segment income increased 28%, driven by cost-cutting efforts. In the company's Power Solutions division, sales decreased by 3% while segment income dropped by 9%. The primary issue in this division was the higher cost of battery cores for recycling. While both of these divisions give the company some diversification away from the auto industry, the automotive division is, I believe, where much of the company's growth in the next few years could come from.
Automotive Experience sales increased by 7%, but challenges in Europe blunted the effect of double-digit increases in most other markets. This division's segment income increased by 42%. On the surface these look like excellent results, but the number of competitors in this market makes continued strength a challenge. In the auto interiors and systems market, Johnson Controls faces multiple competitors. Companies such as Magna Int. (NYSE: MGA) and Lear Corp. (NYSE: LEA) provide both interior and seating systems which are major businesses for Johnson Controls. Another competitor is Dana Holding (NYSE: DAN) which produces seating and electrical systems, but focuses on drivetrains also. As proof the consistency in the automotive market is difficult, consider that among these three competitors one has missed estimates two of the last four quarters (Magna), one beat estimates three of the last four quarters (Lear), and only one beat estimates every quarter last year (Dana). Unfortunately for Johnson Controls shareholders, the company has actually performed the worst, by missing estimates in three of the last four quarters. For the company to have a chance at delivering decent returns to shareholders, one thing that will have to change is the company's financials.
Even if you accept that cost-cutting is a legitimate way to increase earnings per share, what can't be acceptable over the long term is more debt with no increase in cash flow. On a year-over-year basis, Johnson Controls saw net income plus depreciation increase 13.26%, but a jump in capital expenditures caused free cash flow to come in basically flat. Though the company's free cash flow payout ratio is just about 60%, Johnson Controls has increased its long-term debt by over $1 billion in the last year. This is a continuing concern of mine; the company does not generate significant enough free cash flow to continually take on more long-term debt. Almost as confirmation that this additional debt will be a drag on performance, the company updated their fourth-quarter guidance. Management said that earnings per share will be flat to up 5%, which is down significantly from earlier expectations of double-digit earnings improvement. Looking at the competition: There are two potential choices for investors, Johnson Controls or Magna International.
One of the positives of Johnson Controls stock is the company's dividend yield of just over 3%. Competitors Lear Corp. and Dana Holding have yields that are roughly half of what Johnson Controls currently offers. In addition, both of these companies have future growth rates of 8% and 9.4% respectively, versus Johnson Controls, expected to grow earnings at over 16%. Magna Int. might be the best alternative, as the company's yield of 2.85% is very similar to what investors would get from Johnson Controls. In addition, Magna has the advantage of having beat earnings estimates in the most recent two quarters. While I would like to believe that Johnson Controls management can meet analysts' long-term expectations for the company, I have my doubts. A turnaround in the new car industry might be the jump start that this company needs. Investors should use this information as a starting point for their own research and decide if Johnson Controls or Magna Int. could be additions to drive their portfolio's returns.
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