Johnson Controls' Growing Service and Digital-Related Revenue Should Support Margin Expansion

Sector Director

Brian Bernard

Revenue segments as reported by the company.

Building Solutions North America

Building Solutions EMEA/LA

Building Solutions Asia Pacific

Global Products

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Before 2016, the market had long viewed Johnson Controls as an automotive-parts company because about two thirds of its sales came from automakers. However, after merging with Tyco and spinning off its automotive seating business, now known as Adient, in late 2016, Johnson Controls is now a more profitable and less cyclical pure-play building technology firm that manufacturers heating, ventilation, and air-conditioning systems; fire and security products; and building automation and control products.

In early 2019, Johnson Controls sold its power solutions business to a consortium of investors for $11.6 billion of net proceeds that the firm used to pay down debt and repurchase shares. We believe Johnson Controls' prudent capital allocation strategy in tandem with its simplified business model that is clearly showing improving fundamentals have been catalysts for the stock.

As a pure play building technologies and solutions business, Johnson Controls stands to benefit from secular trends in global urbanization and increased demand for energy-efficient and smart building products and solutions. We also expect the COVID-19 pandemic will increase the market opportunity for healthy building solutions, such as air filtration and touchless access controls. These secular tailwinds should allow Johnson Controls to grow faster than the economies it serves. Indeed, over the next couple of years (through fiscal 2024), the firm is targeting revenue growth at a 6%-7% compound annual rate, compared with expectations of 4%-5% market growth. Key levers behind Johnson Controls' targeted outperformance include continued product innovation (supporting market share gains and pricing); increased service penetration (a higher margin opportunity); and the firm's participation in meaningful growth themes (for example, energy efficiency, smart buildings, and indoor air quality solutions).

Business Strategy & Outlook

We think Johnson Controls benefits from maintainable competitive advantages that should support economic profits for at least the next 10 years. As such, we assign Johnson Controls a narrow economic moat rating. 

Johnson Controls’ building technologies and solutions business holds a strong position in commercial HVAC equipment, building automation and controls, and fire and security. 

Our Economic Moat Source Series: Intangible Assets white paper states that, "While many companies claim their reputation and customer relationships are a competitive advantage, we consider this the exception rather than the rule. In complex industries, a good record in offering customers durable, well-engineered, and reliable equipment cannot be achieved without technological know-how." We believe that Johnson Controls' technological know-how is a key differentiator, especially for large, complex commercial building system projects. Indeed, there are only a handful of competitors than compete in that specific piece of the market.

Johnson Controls' installed base of HVAC, building automation, and fire and security systems are important assets that generate a lucrative stream of recurring revenue over the lifetime of the installed system. Given the mission-critical nature of commercial HVAC systems, maintenance, service, and aftermarket parts are needed to avoid disruptive and costly system breakdowns. Johnson Controls' installed base of Metasys, the firm's building automation system, generates recurring software upgrade and subscription-based revenue. Metasys software updates improve system functionality and guard against new cybersecurity threats. With the Tyco merger in 2016, Johnson Controls added a large installed base of fire and security systems that generate a significant amount of recurring maintenance and monitoring revenue. During Tyco's final analyst day before the merger (November 2014), the company noted that approximately 25% of its top line was recurring service revenue.

New commercial HVAC, building automation, and fire and security systems are a large investment that can require lengthy installation time. As such, we believe building operators would be reluctant to completely replace entire HVAC, building automation, and fire and security systems and instead prefer to upgrade, retrofit, or reconfigure existing systems to adapt to changing technology, regulatory standards, and user requirements. This is a favorable dynamic for Johnson Controls, which is well-positioned to capture upgrade, retrofit, and reconfiguration spending from its installed base.

In terms of service revenue, Johnson Controls' ability to capture future HVAC maintenance and service revenue from its installed base is not always guaranteed. Third-party service companies and competing manufacturers are generally able to service many of Johnson Controls' products, and some customers have internal engineers that can service systems to a certain extent. A competing manufacturer that wins a service contract on a Johnson Controls system can slowly replace components of that system with its own equipment over time. However, there are only a handful of companies that can challenge Johnson Controls' commercial HVAC position, including Carrier, Trane Technologies, Daikin, and to a lesser extent Lennox (which only competes in light commercial applications). Of course, Johnson Controls has the same opportunity to win service contracts on competing HVAC systems as well.

We don't believe that Johnson Controls' switching cost advantage extends to the residential HVAC market because residential replacement costs are comparatively low, and the service market is far more fragmented and competitive. However, residential HVAC sales account for less than 10% of Johnson Controls' consolidated revenue.

In regards to Johnson Controls' fire and security monitoring services, we believe in many cases it's more cost-effective for a customer to outsource these monitoring services to Johnson Controls rather than use an in-house monitoring staff.

Few of Johnson Controls' competitors offer such a comprehensive suite of commercial building systems and related services. As such, there are few alternatives for building operators that value Johnson Controls' one-stop-shop approach and prefer to use one firm's equipment and services for its key building systems.

Service is an important source of revenue and profitability for Johnson Controls' buildings business. The company uses an extensive branch network to provide installation and services for its customers around the globe. While myriad HVAC and fire and security service providers exist, few have the revenue base to support a similar-size branch network. As such, Johnson Controls is much better positioned to directly service customers that have multiple locations across the U.S. and the world compared with local and regional competitors that don't have the scale to profitably service customers with national or multinational footprints. Furthermore, we believe Johnson Controls' branch density results in better service quality.

Narrow

Economic Moat

Johnson Controls

Johnson Controls International Plc engages in the provision of building products, energy solutions, integrated infrastructure and next generation transportation systems. Its technology and service capabilities include fire, security, HVAC, power solutions and energy storage to serve various end markets including large institutions, commercial buildings, retail, industrial, small business and residential. The company was established in 1885 and is headquartered in Cork, Ireland.

Earnings data Q2 2023

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