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Johnson Controls International (JCI): Paying Dividends Since 1887

Founded in 1885, Johnson Controls International (JCI) is a diversified global industrial conglomerate that provides: heating, ventilating, and air conditioning (HVAC) systems, industrial refrigeration products, energy management services, security products and systems, fire detection systems, and batteries for a variety of vehicles.

The company sells to more than 4 million commercial, industrial, retail, residential, small business, institutional, and governmental customers in over 150 countries. 

Johnson Controls International operates through two business segments: 

  • Building Technologies & Solutions (76% of 2017 sales): the core heating, cooling, and security business.

  • Power Solutions (24% of 2017 sales): focused on the automotive industry, with 76% of sales to the automotive replacement market (the remaining 24% to automotive manufacturers).

While it operates around the globe, Johnson Controls remains heavily geographically focused on the U.S. which derives 48% of its revenue. Other important markets are China (7%), Japan (6%), Germany (6%), the U.K. (3%), Mexico (3%), the rest of the EU (9%), and the rest of the world (18%).

Johnson Controls International was formed by the 2016 inversion merger of Johnson Controls and Tyco, a deal that moved the company's headquarters to Cork, Ireland. This meant that the company would face much lower taxes, though U.S. investors would face a 20% dividend withholding tax.

Business Analysis

Industrial conglomerates can be solid income growth stocks for several reasons.

First, industrial companies often make mission-critical components for their industrial and commercial clients. These products provide significant value but typically represent a relatively small portion of a good's total cost. Combined with long-standing relationships (sometimes spanning decades), this creates high switching costs that can grant an industrial company stronger pricing power. 

Switching suppliers would be a risky move for a customer, representing risk of business disruption which can cost them market share and profits. For example, automotive OEMs that use Johnson Controls' products in their vehicles have multi-year production schedules, making it more challenging to switch suppliers.

In other words, Johnson Controls has managed to build strong relationships with automotive manufacturers, as well as third-party replacement part sellers such as Advance Auto Parts, AutoZone, Bosch, Costco, NAPA, O’Reilly, and Walmart. 

In addition, its consumer-facing products (such as car batteries) have a high reputation for low prices, quality, and reliability that makes them the preferred choice for many retail customers. Meanwhile, Johnson Controls also partners with its aftermarket resellers to optimize their inventory management and maximize turnover (boosting sales and profitability). 

Large industrial companies like Johnson Controls also enjoy meaningful economies of scale. After all, the firm has spent over 100 years building global supply, distribution, and manufacturing chains. This requires massive capital investment and long lead times that make it much harder for upstart rivals to challenge the company. 

For example, the Power Solutions business has 68 factories located in 17 countries, able to source low cost raw materials and sell products tailored to local customer tastes. In total, Johnson Controls has manufacturing, distribution, and R&D facilities in over 60 countries. 

R&D is another strong suit for Johnson Controls, allowing it to generate over 8,500 active patents and create more advanced products over time. In 2017 the company spent $360 million (1.3% of revenue) on R&D on initiatives such as specialized batteries used in hybrid cars and trucks. 

Part of its R&D efforts include making its batteries highly recyclable. Today 99% of its automotive batteries can be recycled, and the company's own recycling facilities are capable of providing sufficient automotive batteries to service the entire U.S. aftermarket on its own. Not only are recyclable batteries better for the environment, but management believes that by reusing the raw materials in them it can achieve a cost advantage of more than 10% over its rivals. 

These competitive advantages are why Johnson Control's Power Solutions business has over 30% global market share. In addition, with 76% of sales to the aftermarket (replacement parts and fast consumable components), this segment enjoys relatively stable recurring sources of cash flow. 

The building segment, which accounts for over 70% of sales and is primarily focused on HVAC equipment, similarly enjoys a competitive moat. However, while Johnson Control has few main rivals in its automotive batteries business, in heating and cooling systems it must compete with giant firms such as United Technologies (UTX) and Honeywell International (HON). 

Fortunately, the building segment does benefit from recurring revenue in the form of maintenance contracts as well as subscription revenue of its building automation system Metasys. 

The security business (part of the building segment) also enjoys recurring cash flow due to monitoring fees clients pay the company to not only monitor their premises, but also provide continuous security software updates (such as against cyber threats). 

Overall, the buildings solution business generates 25% of its cash flow from recurring revenue. In total, about 40% of Johnson Controls' revenues are from recurring sources. 

Despite some of the firm's competitive advantages and nice mix of recurring revenue for an industrial business, Johnson Controls still operates in fairly challenging industries that have held its operating margin below 10% most years.

Management has made a number of major capital allocation decisions in recent years in an attempt to strengthen the companies profile. The most notable deal was its $16.5 billion acquisition of Tyco in 2016. 

Prior to the Tyco merger, about two thirds of Johnson Controls' business was from the cyclical automotive industry. Tyco helped to transform the company into a global powerhouse in cooling, heating, and security systems which offer larger opportunities for profitable growth. 

In addition, management believes it can achieve $1.2 billion in merger synergies (mostly cost cutting) that should further boost the firm's profitability over time. Currently the company says it's on track to achieve its cost reduction targets, with the first $1.1 billion in cost savings achieved by the end of 2018. 

Due to the Tyco merger, Johnson Controls took on $4 billion in debt. This increased its debt burden by 50% and left it with a relatively weak balance sheet. 

To help pay down its debt, Johnson Controls has been divesting assets, including $2.2 billion in deals last year. The largest sale was its Scott Safety business to 3M (MMM) for approximately $2.0 billion. Those asset sales helped to calm credit rating agencies and helped the company retain a strong investment grade credit rating (BBB+). 

However, with transaction-related tax payments and restructuring and integration charges weighing on Johnson Controls' ability to generate significant free cash flow, management decided to take more significant action.  

In March 2018, Johnson Controls announced it was considering selling its entire Power Solutions business. That would certainly help bring down the company's debt load since that segment generated $7.3 billion in 2017 sales and $1.6 billion in adjusted EBITDA, indicating it could likely fetch a large price ($10 billion to $15 billion). 

The trouble is that selling or spinning off this division would represent a big blow to the company's sales and cash flow. That's because about 32% of the company's cash flow currently originates in the Power segment. While becoming a pure-play heating, cooling, and security company would help solve its debt problem, it could also lead to a lower dividend, depending on the nature of any transaction. For now, it is too soon to say.

The Power Solutions segment is also a faster growing business with higher margins compared to Building Solutions. Therefore, if this division is entirely divested or spun off, the remaining Johnson Controls will have a somewhat less impressive profile, as well as a smaller base of recurring revenue. 

Key Risks

First, because Johnson Controls is an Irish company there is a 20% dividend tax withholding on payments made to U.S. shareholders. Fortunately, U.S. investors qualify for a dollar-for-dollar tax credit that offsets their U.S. dividend tax burden. However, there is a limit of $300 per individual and $600 per couple for the entire year. If your foreign dividend withholdings are above this limit, then you need to use the more complicated Form 1116 rather than the simpler 1040.

Back to the fundamentals, Johnson Controls derives 60% of its sales from cyclical industries including: oil and gas, chemicals, mining, and construction. This can lead to high volatility in the company's sales, earnings, and cash flow. In 2009, for example, the company's sales and earnings fell 25% and 91%, respectively. Simply put, Johnson Controls' business is very sensitive to the global economy.

Over the short term, Johnson Controls' results can also be impacted by volatility in commodity prices for key raw materials such as lead, steel, aluminum, and various chemicals. The potential for tariffs could put upward pressure on certain input costs, too. There's currency risk to consider as well, since 55% of sales are from outside the U.S. If the U.S. dollar appreciates against local currencies, the firm's foreign sales translate into slower sales and cash flow growth in U.S. dollars.

Fortunately, none of these issues are likely to impair Johnson Controls' long-term earnings power. 

However, the biggest reason to consider avoiding Johnson Controls as a dividend growth stock is the company's relatively poor track record when it comes to its payout, especially compared to other industrial rivals such as Honeywell, United Technologies, and 3M.

For example, between 1985 and 2016 Johnson Controls had raised its dividend every single year, putting it on the road to becoming a dividend aristocrat (S&P 500 companies with 25+ consecutive years of dividend growth). 

However, after spinning off Adient (ADNT) in 2016, Johnson Controls reduced its regular quarterly dividend from 29 cents to 25 cents. Shareholders received one share of Adient for every 10 JCI shares they held, a value that more than offset the drop in the regular dividend. 

In 2017, Johnson Controls raised its quarterly dividend by a penny to 26 cents per share (4% growth). That pace is well below the dividend growth rates recorded by most of its industrial rivals. 

Simply put, the company's spin-off of Adient and merger with Tyco complicated the Johnson Controls' dividend growth story while also adding substantial debt and weighing on the firm's ability to generate substantial free cash flow over the short term. 

With management now reviewing strategic options for the company's Power business, which will likely be structured in a manner that reduces Johnson Controls' ongoing cash flow further, the firm's dividend growth story remains murky and complicated.

With so many high quality dividend aristocrats and kings in the industrial sector, there don't seem to be many reasons for income growth investors to own Johnson Controls over the alternatives out there.

Closing Thoughts on Johnson Controls International

Johnson Controls has managed to pay dividends each year since 1887 thanks to its strong brands, innovative products with dominant market share, and large base of high-margin aftermarket revenue. 

However, in recent years the company's spin-off of Adient, merger with Tyco, and divestiture of several business lines have complicated the story. With Johnson Controls now evaluating strategic alternatives for its attractive automotive battery business, the company will likely become completely reliant on its lower margin, more cyclical, and slower growing Building Technologies & Solution segment. 

In the process, the firm will see its ongoing cash flow reduce. When combined with its payout ratio near 40%, that could lead Johnson Controls to moderately lower its regular dividend again. Depending on the Power segment's ultimate fate, shareholders could receive value that more than makes up for that reduction (e.g. getting shares in the new spin-off, which could be sold for income).

However, that's not a preferable way for dividend growth investors to generate dependable income. With the industrial sector awash in more profitable and faster growing dividend aristocrats and kings (who also don't have foreign dividend tax withholdings), most dividend investors are likely better off looking elsewhere. 

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