Johnson Controls (JCI 4.37%) investors were disappointed recently as its fiscal third-quarter earnings report and, more importantly, its fiscal fourth-quarter guidance fell short of expectations. The sharp decline in the share price took the stock into negative territory for the year. Such situations often create buying opportunities but can also be a precursor to further declines. Which is it with Johnson Controls?
Why the market hated the company's recent earnings report
It wasn't so much the earnings as the implied fourth-quarter guidance that concerned investors. The company's fiscal year finishes at the end of September, so its full-year guidance incorporates its fourth-quarter guidance. Unfortunately, management downgraded its full-year sales guidance from 10% growth to "high single-digit" growth, and updated its full-year earnings per share guidance to $3.55 from a previous range of $3.50-$3.60.
NYSE: JCI
Key Data Points
The sales downgrade comes from pressure on sales in its residential heating, ventilation, and air conditioning (HVAC) and fire and security products (global products segment). On the earnings call, CEO George Oliver said, "Inventories in the channel are resetting as we've been able to improve lead times, and so, therefore, there are some short-term adjustments in the book-to-bill revenues."
In plain English, it means its dealers previously rushed to build up inventory when the company's lead times (the time it takes to deliver product) were elevated due to the supply chain crisis. Now that lead times are normalizing, dealers are running down inventory rather than buying from Johnson Controls, which puts pressure on sales.
Short-term issue or the start of something worse?
Management sees this as a temporary impact, with destocking expected to continue in the fourth quarter. It expects conditions to be "pretty normalized" in the first and second quarters of fiscal 2024, which end in December and March.
It's something for investors to look out for, and nervousness on the issue is understandable given that fire and security products tend to be "short cycle" products. In other words, they have a short period between order and delivery, making them early barometers of a potential industry slowdown.
Another reason investors didn't like the earnings report comes down to a sense of deja vu as management lowered guidance (this time full-year 2022 earnings guidance) on the second-quarter earnings call in May 2022. Back then, it was an issue of the company being able to convert on its backlog due to a shortage of materials such as semiconductor chips and components.
Image source: Getty Images.
Management did achieve what it said it would do back in May 2022 -- notably on delivering on its backlog and raising margin -- and it proved an opportune time to buy the stock too. For example, despite the recent fall, the stock is still outperforming the S&P 500 index by generating a 7.2% return compared to 3.9% for the index.
Orders keep growing
In support of management's view that the sales slowdown in residential HVAC and fire and security products will prove temporary, it's worth noting that its third-party backlog of global products grew 8% in the quarter to $2.5 billion, compared to $2.3 billion at the end of the second quarter.
Moreover, orders in the other segment, building solutions, also grew strongly in the quarter. As a reminder, global products represent sales of applied and light commercial HVAC, residential HVAC, controls, fire and security, and refrigeration products. While building solutions is the installation, service, and equipment side of the business.
The good news is building solutions field orders rose 8% year over year organically for the second consecutive month, with particular strength in services orders -- up 12% in the third quarter, following 14% growth in the second quarter.
This led to a record backlog at the company (see chart below) and demonstrated that management is making real progress in growing its services business due to expanding its digitally connected offerings and its OpenBlue software platform.
Data source: Johnson Controls presentations. Chart by author.
Is Johnson Controls stock a buy?
On balance, I think it's once again a good buying opportunity for the stock. It's never good when a company lowers sales guidance, and management needs to avoid turning this into a habit to retain investors' confidence.
That said, the long-cycle order growth indicates Johnson Controls' end markets remain healthy, and it's not the only company seeing some sales correct as customers destock. As such, the company deserves the benefit of the doubt and remains a good investing option.
