One of the investment and corporate finance topics that has been getting more airtime recently is the notion of “peak margins” - the idea that many (if not most) companies have squeezed all they can from mass firings, IT investments, and other sorts of cost “rationalizations”. If this theory proves accurate, stocks could well be meaningfully overpriced on the basis of margin expansion expectations that just won't materialize.
That could be a relevant topic in the case of Johnson Controls (NYSE:JCI), as sell-side analysts continue to project margin improvements well ahead of historical experience. Certainly there are reasons to think that this company could be near a point of margin inflection – the building efficiency business should be close to turning and the company may be ready to start reaping better returns from batteries as well. That said, betting on a significant transformation at a company with a record of underwhelming performance could be a risky bet.

Discount Brokers Comparison: Your one-stop shop for finding the perfect broker for your investments.

Summarizing Fiscal Second Quarter Results – At Least They Didn't Disappoint
Johnson Controls' fiscal second quarter was hardly strong, but at least the company has stopped disappointing. Revenue fell a little more than 1%, but beat the average estimate by about 2%. In an environment where so many industrial conglomerates have disappointed (including Illinois Tool Works (NYSE:ITW), Ingersoll-Rand (NYSE:IR), and Siemens (NYSE:SI)), this is a welcome outperformance.

Although several auto suppliers have been reporting better than expected quarters (including seating rival Lear (NYSE:LEA)), Johnson Controls was just barely ahead of consensus here, as revenue fell about 3%. Building Efficiency was also down about 3%, coming in about as far below expectation as autos were above. Last and not least, Power Solutions revenue was slightly better than expected, up about 7% on an organic basis.

Margins were okay, but still aren't showing the sort of outperformance that the bulls seem to continue to expect. Gross margin fell slightly from the year-ago period (about 40bp) and came in very slightly ahead of the average estimate. On the other hand, segment profits were down almost 20% and missed the average sell-side target by about 2%.

SEE: Understanding The Income Statement 

It's Always Tomorrow Today
One of my biggest complaints about Johnson Controls is that the big turn is always just around the corner. To be fair, this is not entirely (or even mostly) the fault of management – while company executives have an obligation to communicate honestly about the state of business and their expectations for the future, they can't be held accountable for reining in overly ambitious analysts.

So the question now is how much better business will get for Johnson Controls, and how quickly that will happen. I'm a little concerned about the auto business, as the company couldn't keep pace with Illinois Tool Works or Lear (a much more relevant direct competitor) and the U.S. auto industry seems to be softening a bit, while European automakers may still be building inventory.

On the building side, business was softer than expected due in large part to the non-US business and orders declined about 10%. While companies like Siemens, United Technologies (NYSE:UTX) and Johnson Controls may all still have solid long-term opportunities in this market once construction activity recovers, it looks like Johnson Controls really needs a recovery in Europe and/or China to help drive that near-term turnaround. Just to be clear, I believe the issue is not so much if demand will recover, as when.

Last and not least is the battery business. Johnson Controls should be in position to benefit from better margins and capacity utilization, as well as a more typical second half recovery in the business. With a meaningful part of this business tied to autos, though, don't ignore the ramifications if auto activity slows even further (and/or fails to pick up as many analysts expect in the second half). Thinking longer term, I am optimistic about the potential of this business – particularly if the company moves with prudent aggression to position itself as a leader in solar power storage.

SEE: 5 Must-Have Metrics For Value Investors

The Bottom Line
In many respects, Johnson Controls doesn't make all that much sense as currently constituted. While the auto business has significant share, it's not nearly so significant of a profit driver and this entire industry could use consolidation and rationalization. On the other hand, the building efficiency business is good (if in a cyclical downswing) and the battery business has potential above and beyond the auto/EV opportunity.

My problem with Johnson Controls stock comes down to the expectations that sell-side analysts have for margin improvement. Starting in 2014, many of these analysts are expecting a big turnaround in margins and cash generation, driven by improvements in the auto and building markets, coupled with internal improvements in the auto business. I think these expectations may be too generous, as many analysts are looking for free cash flow margins well ahead of anything the company has achieved in the last decade.

I believe that Johnson Controls can, and will, improve, but at a slower pace. I'm looking for revenue growth in the neighborhood of 4% and long-term free cash flow margins in the mid single-digits, which points to a fair value in the $20's. If the bulls are right, though, and Johnson Controls can produce free cash flow margins in the high single-digits, the fair value jumps to $40 and the stock suddenly looks considerably more attractive. I'm not so comfortable with that scenario (particularly as it seems to assume big macro improvements in construction), so I won't be joining in but other investors can decide for themselves.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

Related Articles
  1. Active Trading

    5 Must-Have Metrics For Value Investors

    These quick-and-dirty ratios will help you find the most undervalued stocks on the market.
  2. Active Trading

    Is Warren Buffett Really A Value Investor?

    Warren Buffett has long been hailed as a value investor. But is that statement still accurate?
  3. Active Trading

    The Value Investor's Handbook

    Learn the technique that Buffett, Lynch and other pros used to make their fortunes.
  4. Mutual Funds & ETFs

    What Exactly Are Arbitrage Mutual Funds?

    Learn about arbitrage funds and how this type of investment generates profits by taking advantage of price differentials between the cash and futures markets.
  5. Investing News

    Ferrari’s IPO: Ready to Roll or Poor Timing?

    Will Ferrari's shares move fast off the line only to sputter later?
  6. Stock Analysis

    5 Cheap Dividend Stocks for a Bear Market

    Here are five stocks that pay safe dividends and should be at least somewhat resilient to a bear market.
  7. Investing

    How to Win More by Losing Less in Today’s Markets

    The further you fall, the harder it is to climb back up. It’s a universal truth that is painfully apparent in the investing world.
  8. Fundamental Analysis

    Use Options Data To Predict Stock Market Direction

    Options market trading data can provide important insights about the direction of stocks and the overall market. Here’s how to track it.
  9. Stock Analysis

    2 Oil Stocks to Buy Right Now (PSX,TSO)

    Can these two oil stocks buck the trend?
  10. Investing News

    What Alcoa’s (AA) Breakup Means for Investors

    Alcoa plans to split into two companies. Is this a bullish catalyst for investors?
  1. Can working capital be too high?

    A company's working capital ratio can be too high in the sense that an excessively high ratio is generally considered an ... Read Full Answer >>
  2. How do I use discounted cash flow (DCF) to value stock?

    Discounted cash flow (DCF) analysis can be a very helpful tool for analysts and investors in equity valuation. It provides ... Read Full Answer >>
  3. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  4. What is the formula for calculating compound annual growth rate (CAGR) in Excel?

    The compound annual growth rate, or CAGR for short, measures the return on an investment over a certain period of time. Below ... Read Full Answer >>
  5. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  6. When does the fixed charge coverage ratio suggest that a company should stop borrowing ...

    Since the fixed charge coverage ratio indicates the number of times a company is capable of making its fixed charge payments ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!