Industrials

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

Quarters like this don't do much to convince Johnson Controls International Plc investors that it deserves a higher valuation.

The $40 billion maker of HVAC and fire-safety systems last year completed its merger with Tyco International and spun off its auto-parts business, all in the name of obtaining the kind of multi-industrial growth and margin profile that commands better billing in the stock market. The company reported results on Thursday for its second full quarter post-merger, and the numbers were anything but new and improved.

Keep Trying
Johnson Controls has struggled to convince investors its transformation is complete and on the right track
Source: Bloomberg

Johnson Controls said revenue grew 2 percent in the most recent period excluding the impact of M&A and currency swings. That was in line with guidance, but that forecast had been underwhelming to begin with and and made its annual outlook appear untenable. So it didn't come as a total surprise that Johnson Controls knocked down its organic growth forecast to about 3 percent for the year and now expects adjusted earnings per share of $2.60 to $2.68 -- matching analysts (heavily lowered) expectations.

Reining It In
Johnson Controls lowered its organic growth outlook and the midpoint of its EPS forecast. Overall sales will be better than originally anticipated due to less of a currency headwind.
Source: Bloomberg

I mean, give a balloon to Johnson Controls for not having a significantly worse performance than the disappointment that everyone was anticipating. But the guidance cut is still a little hard to swallow in an earnings season where we've seen a number of raises -- i.e., Ingersoll-Rand Plc, Honeywell International Inc. RBC analyst Deane Dray notes that Johnson Controls is the only company in his multi-industrial coverage universe besides W.W. Grainger Inc. to lower its forecast for 2017. You do not want to be in a club with W.W. Grainger right now.

Optically, it looks even worse that Johnson Controls cut its guidance even as it concurrently announced an upsized share buyback. Dray notes that the actual earnings boost from the repurchases may be minimal because it will happen in the second half of the year, but it still raises questions about what's going on with Johnson Controls' underlying operations.

Even with better-than-expected synergies from the Tyco deal and a little help from the taxman, Johnson Controls' adjusted EPS for the most recent quarter was only about a penny better than estimates. Underlying operating income was slightly weaker than what analysts were looking for. Relying on below-the-line assistance has been a no-no for industrial investors this earnings season and Johnson Controls was appropriately punished for it.

No Points for Participation
Johnson Control earnings didn't go over well
Source: Bloomberg
Intraday times are displayed in ET.

So now it's just a waiting game. Investors should take some heart from the progress Johnson Controls is making on the Tyco integration. The company also wrung out better-than-forecast cost savings in the first quarter, suggesting it could exceed targets for the full year. Importantly, Johnson Controls said it was still on track to hit its margin improvement goals for the year. That's not enough, though, to get EPS where it wants it.  Meanwhile,  it still doesn't have a lot of room to ramp up share repurchases further or make acquisitions, despite the pending $2 billion sale of its Scott Safety business .  

Losing Confidence
Analysts have become increasingly skeptical of Johnson Controls' earnings power this year
Source: Bloomberg

One way to change the narrative would be to get rid of the volatile battery business it's still holding onto despite its transformation. The unit helped buttress Johnson Controls' growth last quarter, but organic sales declined this period, falling well short of analysts' expectations. The business just fits better with a different company and getting rid of it -- and the investments it entails -- could help Johnson Controls get its free cash flow conversion more in line with peers.

Meantime, enjoy your balloon, Johnson Controls.  

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

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