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Johnson Controls' Coverage Gets Jump-Start With Narrow Moat

Battery manufacturer has intangible assets, consumer switching costs powering its moat.

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Upon the transfer of coverage to a new analyst, we have taken a fresh look at  Johnson Controls' (JCI) valuation following the Tyco merger and Adient seating spin-off. We are increasing our fair value estimate to $52 from $50 per share due to enhanced cost synergy assumptions included in our five-year explicit forecast.

The Adient spin-off and Tyco merger result in a more profitable and less cyclical business, with much less exposure to automakers' volatility and more exposure to higher-margin, recurring service revenue. We think Tyco's suite of security and fire-protection products and services complements Johnson Controls' building efficiency business, and the combination should drive synergies and enhanced market penetration. We expect building efficiency and fire and security sales to benefit from Chinese urbanization, increased demand for smart building solutions, and improving U.S. commercial construction.

Johnson Control’s power solutions segment is the largest producer of lead-acid automotive batteries in the world, with 36% global market share. The company is the leading supplier in the Americas and Europe and the third-largest supplier in China, with aspirations to become the second-largest supplier by 2020. Power solutions’ significant exposure to the inelastic aftermarket yields stability, while the segment’s participation in emerging markets and start-stop technology provide substantial growth opportunities.

The market has long viewed Johnson Controls as an automotive parts company, and rightly so, given that the company has, on average, generated 66% of sales from automakers and aftermarket partners over the past 10 years. However, with the spin-off of Johnson Controls’ automotive seating business, Adient, on Oct. 31, 2016, along with the merger with Tyco International on Sept. 2, 2016, we think of Johnson Controls as a true multi-industrial player, free from the stigma associated with automotive companies. The Adient spin-off and Tyco merger result in a more profitable and less cyclical business, one with much less exposure to the volatility of the automotive original equipment manufacturer market, or OEM, and more exposure to higher-margin, recurring service revenue. We think Tyco's suite of security and fire-protection products and services complements Johnson Controls' building efficiency business, and the combination should drive synergies and enhanced market penetration. We expect building efficiency and fire and security products and services to benefit from secular trends in global urbanization and increased demand for smart building solutions.

Johnson Control’s power solutions segment is the largest producer of lead-acid automotive batteries in the world, manufacturing approximately 146 million lead-acid batteries annually. The company has 36% global market share and is the leading supplier in the Americas and Europe, and the firm is the third-largest supplier in China, with aspirations to become the second-largest supplier by 2020. Power solutions’ significant exposure to the inelastic aftermarket business (74% of segment sales) yields stability, while the segment’s participation in emerging markets and start-stop vehicle technology provide substantial growth opportunities. 

Over the next few years, Johnson Controls expects to reduce operating costs by $900 million and realize tax savings of approximately $150 million. Achieving this target will support improved profitability and earnings growth for the combined company.

Intangible Assets, Customer Switching Costs Produce Wide Moat
We think Johnson Controls’ intangible assets, cost advantages, and customer switching costs create sustainable competitive advantages that should support economic profits over at least the next 10 years. Although we think the company’s power solutions segment has a wide economic moat, at 22% of consolidated pro forma sales, the segment is not a large enough contributor to warrant a wide moat rating for the consolidated entity. We believe the building efficiency and fire and security businesses (78% of pro forma sales) benefit from competitive advantages; however, we think these two businesses face stronger competitive pressures than the power solutions segment and generate lower ROICs more indicative of a narrow economic moat. As such, we assign Johnson Controls a narrow economic moat.

We believe Johnson Controls’ power solutions segment boasts the strongest competitive advantages among the firm’s business lines. The power solutions segment has forged strong relationships with automakers and some of the most recognized aftermarket retail companies and has a robust product portfolio. We think it would be nearly impossible for a competitor to build a stronger customer base and brand portfolio. Johnson Controls’ power solutions segment sells automotive batteries to automakers (26% of segment sales) and aftermarket retailers (74% of segment sales). Aftermarket demand is far more inelastic than automaker demand, which helps aftermarket pricing. The company has established relationships with automakers such as  Ford (F),  GM (GM),  Daimler (DDAIY),  BMW (BMW), and  Volkswagen (VLKAY). These automaker relationships allow Johnson Controls to be on the forefront of design and technological changes affecting the industry. Automaker partnerships also lend credibility to the company’s product quality and supply capabilities, which have helped Johnson Controls expand its aftermarket battery business. The company sells its aftermarket batteries to retailers and suppliers such as  Advance Auto Parts (AAP) , AC Delco,  AutoZone (AZO), Bosch,  Costco (COST), NAPA,  O'Reilly (ORLY), Interstate Batteries, Sears, and  Wal-Mart (WMT), to name a few. 

Johnson Controls has made significant power solutions R&D investments, which has led to the introduction of advanced batteries, such as absorbent glass mat, or AGM, batteries that are used in start-stop vehicles. The company believes start-stop vehicles will become ubiquitous as automakers adopt affordable technology to meet emissions and fuel efficiency regulations. Johnson Controls projects that by 2020, 45% of new U.S. vehicles and 60% of new Chinese vehicles will use start-stop technology, up from 10% in the U.S. and below 10% in China today. Johnson Controls has invested heavily in AGM capacity to meet perceived future demand, and the company is currently the AGM market leader, with 70% worldwide market share. The power solutions group has R&D facilities in Shanghai, China; Hanover, Germany; Holland, Michigan; and Milwaukee, Wisconsin. Johnson Controls’ Milwaukee R&D facility is the largest battery R&D center in North America. The company also partners with external research laboratories and universities, such as MIT, Berkeley, University of Michigan, Joint Center for Energy Storage Research, and the Argonne National Laboratory, to maintain technology leadership and develop a pipeline of talent. As mentioned above, the company leverages its relationship with automakers to develop new solutions and stay ahead of the technological curve. New technologies developed for automakers are eventually integrated into aftermarket solutions, which strengthens Johnson Controls’ competitiveness in the aftermarket channel. We think Johnson Controls’ strong research and automaker partnerships, paired with a robust R&D spending budget, make it difficult for competitors to match the company’s innovation capabilities. 

Company Utilizes Recycling as a Cost Advantage
We think that power solutions’ global footprint, vertical integration capabilities, and technology drive a marked cost advantage over competing products. Furthermore, we believe that customer switching costs support durable customer relationships. Batteries have a low value/weight ratio, so Johnson Control’s large geographic footprint near key power solutions customers is a key cost advantage. Given the capital requirements and regulatory approvals required to build battery manufacturing facilities and distribution centers, we think replicating the company’s footprint would be an expensive and lengthy endeavor. Johnson Controls’ battery recycling capacity is another source of the firm’s cost advantage. The company’s batteries are designed for 99% recyclability. Johnson Controls utilizes its logistics network to collect spent batteries from its partners, which are then sent to the company’s recycling facilities that extract metals, plastics, and liquids from used batteries and either reuses them to manufacture new batteries or sells materials to manufacturers of detergents and consumer products. Johnson Controls is the world’s largest lead recycler, and the company’s recycling facilities are able to recycle 8,000 batteries per hour, which is enough to supply the annual demand of the U.S. aftermarket. The company estimates that its recycling capabilities results in a 5%-20% cost advantage over close competitors. We think Johnson Control’s cost advantage vis-a-vis its recycling infrastructure benefits from a network effect: As the company captures increased market share and strengthens its logistics network, it increases its access to raw materials. Johnson Controls utilizes its patented PowerFrame grid stamping process to build more durable batteries at a lower cost. Company studies have shown that PowerFrame technology is 66% more durable and provides 70% better electrical flow than traditional technologies, but requires less input metal and 20% less energy to manufacture. Although similar technology is replicable, significant capital expenditures are needed to build the requisite infrastructure needed to manufacture stamped grid technology. Johnson Controls has developed strong partnerships with automakers and aftermarket retailers and has proven its ability to continually meet customer needs. Given the company’s high-quality products, innovation, and cost leadership position, we believe its key customers would be unwilling to replace Johnson Controls with competing suppliers. This is especially true for automakers that are using Johnson Controls batteries in multiyear production runs.

Brian Bernard does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.