Deals

Brooke Sutherland is a Bloomberg Gadfly columnist covering deals. She previously wrote an M&A column for Bloomberg News.

Johnson Controls' auto business is getting the short end of the stick in the company's breakup. 

Once the largest U.S. supplier of car parts, Johnson Controls is spinning off what's left of its auto business and refocusing on air conditioning and fire systems with the acquisition of Tyco International. The merger -- an inversion that will move Johnson Controls' legal address to Ireland -- took a big step forward last week as the company locked up shareholder approvals. 

For Johnson Controls, ditching its car-parts past makes a load of sense. Building controls is a higher-margin business that won't get rocked as much by market swings. The more than $1 billion of cost savings expected from operational improvements, Tyco deal synergies and a lower tax rate will help too. As for the auto-parts spinoff? It's not the prettiest of pictures. 

Industrial Revolution
It may take a while for Johnson Controls' valuation to catch up to its metamorphosis, but its split still makes sense.
Source: Bloomberg
Johnson Controls multiple is calculated using the company's current enterprise value relative to its projections of $4.5 billion in combined Ebitda (before synergies) after the Tyco merger.

On the plus side, because Johnson Controls is spinning off the unit -- to be named Adient  -- after its merger with Tyco closes on Sep. 2, it will be able to give the car-seating business a foreign domicile and low tax rate as well. (The spinoff is set to be completed Oct. 31.) 

But Adient is taking on about $3.5 billion of debt in order to help fund a $3 billion cash payout to Johnson Controls. The company is expecting to wind up with a debt load about twice its Ebitda -- above what a Bloomberg Intelligence study conducted by Joel Levington found was the optimal range for the industry in terms of share outperformance. Adient itself acknowledged this risk in regulatory filings, saying that the significant amount of debt may place the company at a competitive disadvantage and may limit its ability to take advantage of business opportunities. 

The auto industry's cloudy outlook makes Adient's high leverage look even more worrisome. In the U.S., underwhelming July car sales data are fueling concerns that the market may have plateaued after years of growth. Carmakers are already starting to roll out hefty discounts to try to drum up sales amid weaker consumer demand. Meanwhile, Ford and General Motors have said Britain's decision to exit the EU will cost them hundreds of millions. Adient got 39 percent of its consolidated revenue from Europe and Africa in 2015.  

Reaching a Plateau?
There are signs auto sales growth may be running out of steam.
Source: Autodata Corp. Chart assistance from Jamie Butters in Detroit

There's also the issue of how Adient is going to be able to compete without the support of its larger parent. If you ask rival Lear, it's not going all that well so far. CEO Matthew Simoncini said last month that Johnson Controls' car-parts business had been doling out "irrational, unsustainable price quotes" in an effort to build its backlog. Given that Adient is already playing catch-up to Lear's trailing 12-month operating margin, that kind of tactic wouldn't help.

The bottom line -- it's hard to see Adient roaring out of the starting gate.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

  1. If you include the revenue Johnson Controls gets from its stakes in joint ventures, the company gets about 28 percent of its revenue from Europe and Africa. 

  2. Adient is targeting 200 basis points of margin expansion "over the mid-term." 

To contact the author of this story:
Brooke Sutherland in New York at bsutherland7@bloomberg.net

To contact the editor responsible for this story:
Beth Williams at bewilliams@bloomberg.net