Description

Recommendation

• Short JCI common stock with a target of less than $32
• Long IR stock as it is the RemainCo piece’s key comp in HVAC and Building Solutions
• OR; Long XLI, however in current tape, suggest hedge option 1 in order to avoid wearing unnecessary macro risk

Summary Thesis

At the current ~$37.50, shorting JCI here has a risk/reward profile of risk ~$2 to make ~$8-10. JCI is a below-average cost-out story that has floated the ever magical “strategic alternatives” process as a way to dress up what is a necessary, dilutive, and increasingly glib, sale process of its Power Solutions business. Since the March 22nd announcement, the only positives have been a dealreporter article that speculated Apollo and CD&R have made it through first round bids with a potential 8-9x multiple. Post this July 12th publication, the Power Solutions business printed a sharp 200bp margin contraction and management expects this to linger through FY2018. Additionally, the management has pushed their end-date of the review out from what was a few months post March to November. With the sale process likely leading to a multiple at 8x or below, JCI is overvalued.

Key Catalysts

• Conclusion of Strategic Review by November illuminating (1) Underwhelming SaleCo Multiple and (2) RemainCo Multiple vs. IR Multiple Mispriced
• Tariffs Exposure
• Consensus Too High & Valuation Highly Sensitive

Risks to Short

• JCI management ability to structure a tax-free spin
• Less tax leakage than modeled leading to greater cash available for buybacks
• RemainCo FCF power improves and thus market willing to ascribe an in-line IR multiple

----

Table of Contents:

A. Situational Backdrop

B. JCI WholeCo Overview

C. JCI Segment Level Overview

D. Presented Strategic Options

E. What’s Priced in Today

F.   Why JCI is Going Lower

----

A. Situational Backdrop

• Prior CEO Alex Molinaroli was at the helm from 2013-2017 when JCI transitioned away from the Automotive industry towards more of a multi-industry portfolio, via the spins / divestments of Global Workplace Solutions, Auto Electronics, Auto Interiors, and Adient / Automotive Experience, as well as transformative deals like Tyco.
• Unlike a precedent / comparable situation in Dover (“DOV”), the change in management side of the equation has already played out such that there is not embedded optionality to monetize an announced turnover. There was shareholder ire around board structure, corporate governance and compensation incentives. In August of 2017, Independent Director and Chair of the Compensation Committee Jeff Joerres stepped down after 16 years, being replaced by Jurgen Tinggren from Tyco, with Michael Daniels joining the board and its compensation committee from Tyco as well.
• Not only was there a refresh at the board level, JCI announced that effective September 1, 2017, George Oliver (President and COO) would assume both Chairman and CEO roles, making for an early departure of Molinaroli as investors had expected a March 2018 expiration date. At the time of this announcement, discussions around the Power Solutions business were already beginning, with CS noting “Mr Oliver may be viewed as providing a firmer hand on the tiller in terms of operating  performance (regarding FCF performance and synergy extraction regarding the TYC integration), …[and] Mr. Oliver may be more amenable to the notion of spinning off the Power Solutions business, in an effort to improve operating performance (and the valuation multiple) at both the Buildings and Battery sides of the company.”
• On March 22nd, 2018, JCI announced that it is evaluating strategic alternatives for its Power Solutions business, indicating that the transaction determination will be based on both the fundamentals of the Power business and maximizing tax-efficiencies. Street reactions were actually somewhat mixed, with UBS claiming a bullish victory (“JCI should be worth >35% more, no matter how you ‘spin-it’”) and JPM taking a much more conservative posture, noting that while the divestiture of this asset has been long in the making, its presence “in a slow secular decline with little presence in the EV play, with weak FCF due to heavy capex requirements to maintain the installed base barriers and exposure to lead price volatility…is almost the exact opposite of what a typical EE/MI investor values”.
• On July 12th, dealreporter published that JCI’s Power Solutions has garnered interest from Apollo and Clayton, Dubilier & Rice for a sale that “could yield more than USD 10bn in debt financing…The business…collected first-round bids at the end of June.” It goes on to explain that management meetings are being held in late July, and they are marketing SaleCo with 1.86B in EBITDA and EV multiples of 8-9x which underwrites a surprisingly high 6.5x leverage. Even at this 6.5x debt financing structure, the equity check would be a large ~2B.
• JCI has broadly underperformed over the last year as its moved through the Tyco merger and investors see two negative narratives fundamentally: (1) LT secular concerns given no solution product for EVs and (2) Incongruous assets with its lead-acid battery business injecting price volatility to the WholeCo model while syphoning off FCF. A dive into both of the Power Solutions and BTS units are below.

B. JCI WholeCo Overview

Business Overview: JCI is trading at ~$38 with a ~35B market cap and ~48B TEV and is an Irish domiciled corporation. Its current net leverage profile is just shy of 3x when factoring in its underfunded pension of ~775M, but ~2.6x if excluding. It is a LSD top-line compounder with a consensus 18-20 revenue CAGR of ~3.5%. The company has a long history that has led to its core competencies being in the controls business. However, over the last +40 years, the company has been involved in a diversification strategy when the broader industrial logic mandated “bigger is better”. In the last couple of years we have seen the market reward peers willing to get skinnier and smarter, and since 2014, JCI has attempted to simplify the business, selling off stakes and offloading its auto interiors, electronics, and seating businesses. The culmination of its business model evolution culminated with the Tyco merger in 2016. A byproduct of the deal making had led to a disadvantageous product mix – auto (i.e. its lead-acid battery exposure) ended up becoming ~80% of sales and profits. The auto market began to turn for a multitude of reasons, but predominantly as North America experienced overcapacity, the pricing environment deteriorated and JCI sought to acquire their way to safety. The York HVAC deal became the basis for the Building Technologies and Solutions ("BTS") business unit today, and is the core business that investors would like to see JCI streamline into.

Financial Overview: Gross margins are stable at ~31% while the street expects operating leverage to drive EBITDA to CAGR over the same period at MSD 6%. With estimated Adj. EBITDA margins of ~15.5% for 2018E and an eventual +100bp cumulative expansion by 2020E, analysts are implicitly giving credit for a turnaround in the FCF power of the business. Within the large-cap space, JCI is only second to GE and UTX in having the worst FCF algorithm. The comp group (absent JCI, UTX and GE) is expecting 2019 FCF conversion of 104% while JCI is expected to convert ~85% of its EBITDA into cash flow. In respect to growth however, there is nothing glaringly different about JCI that should see its top-line in the NT contract or expand at a deviated rate from the avg. organic expectation of ~4% for the group. The capital intensity of the business is a structural business mix issue which drives the FCF delta mentioned above. Unsurprisingly, this has led the market to ascribe JCI a discounted multiple to the broader group. With the group trading on 18/19 EBITDA of ~13.5x/~12.5x, each of the sub-100% FCF converters is prescribed an average 2.5 turn lower capitalization rate on EBITDA.

C. JCI Segment Level Overview

Building Technology & Solutions (“BTS”) Segment Overview (~75% of sales, ~66% of EBIT): This segment has been the bright-spot for JCI. Buildings is viewed as a solid LSD performer over the immediate term, with street modeling a ~3% CAGR for the segment out to 2020. This segment however is effectively combining the fire/security side of construction and the commercial/resi HVAC opportunities. The former is modeled to be a LSD grower while the latter could be slightly accelerated at MSD as technological enhancements become more entrenched in new construction mandates as well as a more general trend for stricter energy efficiency standards. On the margin front, the key moving parts are synergy rationalizing / productivity from the Tyco deal partially offset by ongoing investments. Absent the residual M&A dynamics, consensus sees solid high-teens to low-20s conversion on organic growth, leading to cumulative margin expansion of ~130bps from ‘18-‘20.

Building Technology & Solutions (“BTS”) Drivers:

• Non-residential Construction: Seen as the primary driver for both the security/automation and HVAC businesses. We are in what is considered to be the 8th year of “recovery”, and leading indicators such as the ABI remain strong (above 50 for a while now) while we have begun to see some global decelerations on the PMI side of the equation. JPM notes that they don’t buy into concerns over the cycle as real growth is within the state of the economy. That being said, JCI has benefited largely from the institutional vertical, specifically public education square foot expansion, and within the context of a rising rate environment muni bond issuances have cooled down, making the go-to market pipeline funding incrementally difficult.

• Building Automation + Controls: Perhaps a derivative of non-resi construction, there is additionally an upgrade cycle that multis have taken advantage of as the commercial stock has continued to age. Analysts cite Navigant research as forecasting end-market growth of MSD 5% and HSD for the sub-vertical lighting space. Anecdotally, a case study for this individual driver is Acuity Brands (AYI), which was a company that was considered to be the LED-lighting player benefitting from the same industrial story that a component of JCI’s stock theoretically should too. Investors grossly underestimated both what the natural penetration level in these automation upgrades should be and how commoditized these business lines truly are. On the former, the pace of upgrades decelerated at a surprising speed, and on the latter, Chinese products flooded the market as customers preferred an individual component strategy during construction vs. bundling. On this value proposition point, we have seen some analysts cite this as why they expect JCI to under grow the broader market, with JPM commenting “Mid-single-digit growth in any market feels a bit aggressive in the context of a generally soft macro environment and a non-res cycle in early innings…we see potential for JCI to slightly underperform the market near term as it is focusing on selling an integrated solution in a space that is mostly a la carte”.

• HVAC: Consensus is underwriting MSD growth based again on a LSD compounding construction cycle and a replacement that clips 3% per annum. There was a strong catch-up period in 2013-2016 where the replacement rate for more advanced heat/cooling solutions moved from ~5% to a cycle-high ~7% (2005 saw the peak at ~8.5%) but analysts believe that there is a new “steady-state” due to a strong consumer and a positive home improvement market.

Power Solutions Segment Overview (~25% of sales, ~34% of EBIT):

Bears would argue that this business is a supplier to the broader internal combustion engine market which has an expiration date on it, while bulls would tell you the grouping isn’t indicative of near-term or even medium-term performance due to the after-market exposure. In terms of its profile, the Power Solutions unit maintains ~60% exposure to the Americas region, with ~30% coming from EMEA and ~10% from Asia. It is estimated to have ~50% market share in the global lead-acid original equipment market (OE) and ~35% share in the global lead-acid after-market market (AM), with the former expected to compound from ’18-’22 at ~2% and the latter at a slightly elevated ~2.5%.

Despite the relatively minor China exposure, it is actually the key driving force behind underwriting any longer-term growth in this business. The North American and even EMEA exposed sale lines are predominantly after-market at ~80%, but China still is skewed towards the OE markets. JCI is investing heavily in the region (maintains a $200M JV for Chinese focused projects) as it looks to advance its existing #3 share position. It is currently the largest OE market and the expectation is that it will be the largest overall market (OE + AM) by 2020. The relevancy to this market is that JCI thinks China represents half of the entire world’s battery growth in the next decade with a market-CAGR of ~9%. Furthermore, the maturation of the Chinese fleet should boost that after-market flywheel that maintains similar characteristics to a recurring stream. JCI’s existing OEM relationships with Ford, GM and others domestically has provided a higher margin profile than its existing Asian footprint, but it sees opportunities to build out its scale and flesh out costs across its plant base once built to drive economies of scale. While this sounds great, it reads as further evidence that assuming any type of improving FCF conversion contradicts the mechanical necessities of its global aspirations.

As the battery itself evolves, its importance within the powertrain complex has increased as OEMs are craving new technology to meet what has been an onslaught of environmental regulations (e.g., CAFE). JCI argues that its absorbent glass mat (AGM) technology is a differentiator over the medium term despite its view that lead-acid will likely remain dominant for the time being. AGM batteries have penetration in ~25% of vehicles today with the expectation that it will shift to the majority by 2025. The needle moving point is that the AGM technology is competitive, it is relevant and it is a viable option for OEMs in the medium term. Perhaps a misconception with this business is the belief that you need to see a world where EVs are the dominant share in the global car fleet to be bearish. The inherent competitor is not really the EV, rather it is the Li-ion battery which has seen its cost fall precipitously over the last few years, in turn driving the EV penetration rate revisions upwards. Total cost of ownership still favors traditional lead-acid batteries in the US, but only narrowly so, and it is nearly at parody in the EU. JCIs pushback would be that they actually do not deny the cliff in which this business will eventually be pushed over, but that the bridge they are building to get there via AGM is much longer and sturdier than you may think.

Investors can’t refute the fact that Power Solutions is a margin-accretive business, and thus it is the multiple that the market argues over. Sell-side teams have comprehensive models detailing EV penetration and how that impacts this unit, but the ranges given are comically wide (UBS calls for either an $8 Power Solutions scenario or a $20 scenario contextualized with detailed, long-dated DCF EV modeling). In respect to unit economics, while JCI suggests they have pass-through contracts in place such that the moat on margins is strong, the volatility associated with these movements does significantly impact top-line. This was actually one of the key points around why analysts / investors were questioning the marriage of these two units under one home, as the earnings vol was an incremental distraction from what was happening on the BTS side. For example, when JCI provided a LT guidance outlook they cited $18-$24M in profit headwind due to prices jumping up from $1,800/MT to $2,400/MT, with the company needing some time to adjust for this price swing, putting the pass-through notion on weaker standing.  

D. Presented Strategic Options

Strategic Sale: In a potential sale process, it is hard to identify a realistic strategic buyer of the business due to size, antitrust risk, and a Chinese domiciled corp being the most strategically sound. With JCI at ~36% of the total lead-acid market per analysts, the next largest is Camel Group (601311 CH) at 15% share, also a name that thus far analysts have floated as a theoretical interested party. The only other names in this bucket of synergistic candidates is Enersys ($3B EV company) and GS Yuasa (6674 JP) which are estimated at sub-5% and ~10% share respectively.  The biggest bull on the street, UBS, has said there is a very little chance that any strategic could buy this. The key comps for the PS business are Enersys (ENS US) and Exide (EXID IN) which are trading on 2019 EBITDA at ~8x and ~10x respectively. While there is a temptation to apply some type of premium on the ~9x average due to strategic synergies, there are a few reasons that make underwriting a “typical 20% multiple premium to the current peer group multiple”, as Barclays writes, difficult: (1) Consensus P&L for the PS asset assumes FCF conversion of ~75% when peers on average operate at ~95% (2) Lack of EV exposure places a de facto expiration date on the terminal multiple for the lead-acid business and (3) Unclear buyer universe makes betting on a competitive process extracting max value unlikely, further depressing the multiple in a strategic decision to sell.

LBO: Similar to the above scenario, a natural financial buyer of this asset is not intuitive. At a take-out multiple a turn below the 9x strategic figure, an LBO would be sizable at +13B. Levering up to the level at which dealreporter suggests is palatable in a late-cycle environment and clear terminal multiple issues due to EV penetration appears aggressive. In our model, we are a bit more conservative, while still giving some bullish assumptions around financeable EBITDA. In a scenario where the financeable 2018 EBITDA can be elevated to ~1.9B from the ~1.7B due to synergy extraction from a theoretical PortCo (despite consensus numbers already screening too high), than the Debt/Equity mix at ~5x leverage is 69%/31%. It is difficult to underwrite entry/exit parody at ~9x, which is what some street analysts originally had done, with all of the aforementioned factors – it is debatable if the PS business is worth 8x today, let-alone in a 5 year time horizon when the reality of lead-acid batteries place in the auto supply chain is likely even more obsolete. At 5x leverage, and an Entry/Exit multiple of 8x/7x, the implied IRR is ~15%.

Spin: Precedent industrial spins show that associated costs can vary wildly – JCI saw ~$380M of separation costs for ADNT and HON is expecting $800M - $1.2B for both their Transportation and Home Distribution businesses. In this case, we are modeling ~2% of SpinCo revenues which is in line with precedents. While this option would avoid the tax leakage associated with an outright sale, the specifics around the PS business and its competitive positioning point to a bottom tier multiple ascription. While it would be marketed as one of the world’s leading automotive battery suppliers, it has been for good reason the natural asset singled out amidst EV headwind fears. The JCI business mix is heavily skewed towards lead-acid, mimicking the market exposure itself. Selling more into the after-market has been a plus for the asset’s narrative, but unlike peers, its R&D investment has been around conventional start-stop lead-acid batteries. In the very near-term this makes some logical sense as the CO2 emission costs aren’t set to provide issue for a bit, but LT the focus is a head-scratcher, rendering the ability to underwrite steady state market-share in an industrial shift weaker. The multiple here would likely be somewhat similar to the sale at 9x but has clear risk to trade in the low-end of peer range at ~8x. ENS has much less auto lead-acid exposure with a majority of business coming from its Stationary / Industrial Power end markets as an example, and EXID IN maintains international exposure to India where it acts in a duopolistic market, thus likely commanding a higher multiple. At 8x – 9x and separation costs from 2-3%, the proceeds from a theoretical spin would be less than from a sale process, implying less ability to mitigate the dilution from the gap in profitability loss from Power Solutions.

E. What’s Priced in Today

Assuming the Power Solutions business garners a multiple in the 7-9x range, at today’s price, the implied multiple on the RemainCo (Building/HVAC solutions) is ~11.5 – 10.5x. Note that this contemplates the entire tax leakage from a sale. While JCI recently has called out the potential for a spin in their last earnings call, that option appears highly unlikely. As a result of the As a condition of the Tyco-JCI inversion merger back in September 2016, the Company is precluded from engaging in any tax-free spin of assets with a 5-year look back period, bringing the termination date into September 2021. The structure would be complicated, and if anything, would be a clear marker that a sale at a desired multiple was likely not reached since that would be the preferable outcome.

F. Why JCI is Going Lower

Price Target: We estimate JCI is worth ~$30 in a base-case. This assumes a more sensible ~8x on the Power Solutions business with a 2.5x target net leverage for RemainCo. At this leverage assumption, JCI would have ~7.8B left for stock buybacks. Assuming a modest ~15% discount to the IR’s 2019 EBITDA multiple of 11x would mean RemainCo trades at 9.5x. With the current cap structure PF for debt pay down and share buybacks, at a 9.5x multiple the stock is worth ~30.

Short Thesis Support:

• Underwhelming SaleCo Multiple: The Power Solutions auction does not have a lot of optionality. To command a premium multiple, you’d tend to want to see a large theoretical buyer universe with perhaps a different strategic path available, such as a simplistic spin whereby the public markets have the appetite for the asset. This process has neither – the Power Solutions business is in the financial sponsor world, and the chance of a strategic being able to extract any value out of this past squeezing FCF out of it is highly unlikely. Neither CD&R, nor Apollo have Portfolio Companies that offer synergistic upside that in turn make them a de facto strategic. The last quarter also damaged the feasibility of an LBO as a decent top-line print was offset by clear margin degradation. The buyer thesis of this asset is going to be predicated on financial engineering vs. some type of real asset appreciation in the form of growth and margin expansion. The fact that we have seen margin pressure downward along with management now pushing out the end-date of strategic alternatives to November and an apparent new found realization that they can potentially construct a tax-free spin despite being within the 5-year look back period makes me think the process is going poorly.

• RemainCo Multiple vs. IR Multiple: IR maintains an industrial arm (~20% of sales), but is one of the best comps we have for the pure HVAC/Building Solutions RemainCo piece of JCI due this portion driving ~80% of sales. It is expected to grow it’s top-line from 2018-2020 at a ~4% CAGR vs. JCI’s ~3.5% absent power solutions. Most importantly for the EBITDA multiple assignment is the FCF conversion power of these respective businesses. With IR running at an estimated ~100% FCF conversion vs. JCI’s targeted 80% figure, the delta is material. The FCF guidance per management sees ~50% of the 200M YoY increase as a result of cash management initiatives, ~25% from inventory management at the Power Solutions business which will not be a lever post theoretical sale, and ~25% from earnings growth. With only ¼ of the FCF coming from a sustainable base of growing earnings, the quality of this 80% convert may be questioned, with analysts viewing JCI as a generally underwhelming cost-out name. Lastly, running a sensitivity on the JCI EBITDA estimate shows that should it come in even slightly below consensus, than the remaining piece is likely in-line, or at a premium to, IR’s 2019 EBITDA multiple at various SpinCo sale multiples.

• Tariff Exposure: On the last quarter conference call, JCI had the following to say in regards to tariff impact: “…the direct impact related to steel and aluminum tariffs are nominal and will be fully offset…Giving the evolving changes, we continue to monitor developments and update our analysis. Included in the tariffs are compressors, electronics, motors and valves, which impact our Buildings businesses…As part of our ongoing assessment, we are simultaneously identifying mitigating actions to minimize any direct impact…Based on the analysis we have done so far related to our exposure and mitigating actions, we have already worked this down to a very manageable level. We will continue to monitor developments.” If the first phase was worked down to a “manageable level”, it is unclear at the moment what an incremental 200B in may lead to and how much of this can be offset. Further, management says power solutions isn’t the main business to be impacted, but a key pillar of growth for them has been China volumes, and ~7% of sales are China exposed per their latest 10K.

• Consensus Too High & Sensitivity to Such: Current 2019 consensus EBITDA estimate is ~5.1B vs. Cowen estimating something closer to ~4.9B as does JPM. Note that every 100M move in EBITDA impacts the Px by ~$1, such that the downside case is $2 overstated if you believe numbers are high. Last Q saw the Power Solutions business post a sharp 200bp margin contraction despite revenues increasing 10% primarily due to Fuel/Transport costs, input pricing and FX moves. These are not one-time, and management expects this to linger through FY2018. WholeCo JCI had a narrow beat due to the remaining buildings business showing positive growth in tandem with a lower tax rate. The FCF profile has arguably gotten riskier and of lower quality such that the RemainCo multiple discount to IR should be more pronounced. Currently, numbers screen high as FY19 faces tax rate and FX translation YoY vomps that are difficult to lap such that incremental cost synergies are likely off-set. Should the recent bout of freight cost inflation in the space continue which would likely be occurring in tandem with continued upward rate movement, than numbers are aggressive (note ~33% of JCI’s debt are variable rate instruments). In the case that this is too high, the below shows the implied premium the market is placing on the RemainCo piece to IR, a far superior comp.

Catalyst

- Conclusion of Strategic Review by November illuminating (1) Underwhelming SaleCo Multiple and (2) RemainCo Multiple vs. IR Multiple Mispriced

- Tariffs Exposure

- Consensus Too High & Valuation Highly Sensitive