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Edited Transcript of JCI earnings conference call or presentation 1-May-19 12:30pm GMT

Q2 2019 Johnson Controls International PLC Earnings Call

Cork May 3, 2019 (Thomson StreetEvents) -- Edited Transcript of Johnson Controls International PLC earnings conference call or presentation Wednesday, May 1, 2019 at 12:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Antonella Franzen

Johnson Controls International plc - VP and Chief IR & Communications Officer

* Brian J. Stief

Johnson Controls International plc - Executive VP & CFO

* George R. Oliver

Johnson Controls International plc - Chairman & CEO

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Conference Call Participants

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* Andrew Alec Kaplowitz

Citigroup Inc, Research Division - MD and U.S. Industrial Sector Head

* Charles Stephen Tusa

JP Morgan Chase & Co, Research Division - MD

* David Lu

RBC Capital Markets, LLC, Research Division - Associate VP

* Jeffrey Joseph Molinari

Cowen and Company, LLC, Research Division - Research Associate

* Jeffrey Todd Sprague

Vertical Research Partners, LLC - Founder and Managing Partner

* Joshua Charles Pokrzywinski

Morgan Stanley, Research Division - Equity Analyst

* Nigel Edward Coe

Wolfe Research, LLC - MD & Senior Research Analyst

* Timothy Ronald Wojs

Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst

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Presentation

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Operator [1]

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Welcome to Johnson Controls Second Quarter 2019 Earnings Call. (Operator Instructions) This conference is being recorded. If you have any objections, please disconnect at this time.

I will now turn the call over to Antonella Franzen, Vice President and Chief Investor Relations and Communications Officer.

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Antonella Franzen, Johnson Controls International plc - VP and Chief IR & Communications Officer [2]

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Good morning, and thank you for joining our conference call to discuss Johnson Controls second quarter fiscal 2019 results. The press release and all related tables issued earlier this morning as well as the conference call slide presentation can be found on the Investor Relations portion of our website at johnsoncontrols.com.

With me today are Johnson Controls' Chairman and Chief Executive Officer, George Oliver; and our Executive Vice President and Chief Financial Officer, Brian Stief.

Before we begin, I would like to remind you that during the course of today's call, we will be providing certain forward-looking information. We ask that you review today's press release and read through the forward-looking cautionary informational statements that we've included there.

In addition, we will use certain non-GAAP measures in our discussion, and we ask that you read through the sections of our press release that address the use of these items. In discussing our results during the call, references to adjusted EBITA and adjusted EBIT margins exclude restructuring and integration costs as well as other special items. These metrics are non-GAAP measures and are reconciled in the schedules attached to our press release and in the appendix to the presentation posted on our website.

Given the sale of our Power Solutions business, the results of Power are reported as discontinued operations. The focus of this call will be on continuing operations.

GAAP earnings per share from continuing operations attributable to Johnson Controls ordinary shareholders was $0.26 for the quarter and included a net charge of $0.06 related to special items. These special items primarily relate to integration costs in the quarter. Adjusting for these special items, non-GAAP adjusted diluted earnings per share from continuing operations was $0.32 per share compared to $0.26 in the prior year quarter.

Now let me turn the call over to George.

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [3]

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Thanks, Antonella, and good morning, everyone. Thank you for joining us on today's call.

Let me start with some of the high-level strategic highlights from the quarter beginning on Slide 4.

We delivered another quarter of solid results with continued improvement across the majority of our underlying fundamental metrics. The investments we have made throughout the sales organization and into new product development combined with our ongoing efforts around commercial excellence continued to drive strong organic top line growth across the board. We continue to grow our service business, a key element of our overall strategy in enhancing value for our Buildings customers. And as I will share with you in just a second, these efforts are increasingly being acknowledged by our customers.

With the exception of Asia Pacific, margins were higher in each segment as we remain focused on driving productivity, optimizing our cost structure and improving our pricing discipline across our product categories as well as in our project businesses. Operational leverage is improving, which will become more evident over the next several quarters as the pricing we have built into the system over the last 12 months fully matures and raw materials and tariff impacts have stabilized.

Although we were impacted by some timing of orders being booked in the quarter, our order pipeline remains robust, still tracking in the mid- to high single-digit range for the year. And our backlog continues to build with an attractive mix of service and balanced profile of short- and long-cycle project activity. With this as our backdrop, we remain confident in our outlook for the second half of fiscal 2019.

Regarding Power Solutions, we announced the closing of the sale this morning, about 60 days ahead of schedule, which allows us to accelerate the return of capital to our shareholders. As Brian will discuss with you later in the call, we have updated our assumptions with respect to the timing of the use of proceeds, and those assumptions are now reflected in our updated 2019 guidance.

I'd like to thank Joe Walicki as well as the thousands of Power Solutions employees around the globe and wish them all the best as they start their new journey under the stewardship of Brookfield. I'd also like to thank our separation team who have put in countless hours over the past several months in order to bring this transaction to a close. Truly, a tremendous effort.

Looking forward, we will continue our journey as a pure-play building solutions provider with a commitment to enhancing value for our customers with the integrated solutions that create more intelligent, efficient and sustainable buildings and infrastructure.

We are committed to driving execution, and we are well positioned to continue investing for growth across the portfolio. As a case in point, I wanted to highlight a few examples of how our strategy is playing out in the recent months. Let me start with an example that represents the core of Johnson Controls legacy as a sustainability company.

We have had a long-standing relationship with the University of Hawaii and are in the process of executing the second phase in the university's multiyear energy efficiency and renewable energy project, which envisions the entire university system, spanning 10 campuses across the state, becoming a net-zero energy consumer by 2035.

We were awarded our first energy performance contract back in 2010 and are proud to continue our partnership with the expectation of producing a substantial amount of energy savings over the next 20 years and helping the university achieve their goal of being one of the first higher education campuses in the nation to be free of the need to rely on fossil fuels.

The middle picture on the bottom of the page is Bee'ah's iconic new headquarters building currently being constructed in the UAE. For those of you who are not familiar, Bee'ah is one of the Middle East's pioneering developers of sustainable solutions. Just last week, along with our partners at Microsoft and Bee'ah, we announced a joint agreement to collaborate on what will be one of the most sustainable and smartest buildings in the Middle East, fully powered by renewable energy sources with zero-net energy consumption and a LEED platinum rating. Importantly, this building will come to represent a global showcase for artificial intelligence capabilities and smart building solutions and is expected to be the first building in the region and one of the first in the world to have fully integrated AI capabilities.

Leveraging the Johnson Controls Digital Vault, which is our proprietary cloud-based data analytics solution, along with our data-enabled EDGE devices and software, Bee'ah will have a completely integrated system with capabilities to optimize energy efficiency, comfort, safety and sustainability as well as enable the building's occupants to increase productivity. We are extremely excited to have been selected to participate in this groundbreaking project, which allows us to demonstrate our preeminent position as a leading smart and sustainable building solution provider.

In mid-April, we officially opened our new 900,000-square-foot, state-of-the-art Rooftop Center of Excellence in Norman, Oklahoma, which has been the primary design, manufacturing and testing campus for our duct and HVAC business for nearly 50 years. This expansion project represents a multiyear investment effort aimed at upgrading our innovation and manufacturing capabilities specifically for our high-efficiency rooftop HVAC business.

We have added almost 400,000 square feet of additional laboratory and manufacturing space and renovated an existing 150,000 square feet of office and meeting spaces. This new capacity provides us with the full capability to conduct on-site complex system development and meet regulatory compliance, performance, safety and reliability standards for units up to 150 tons. This will allow us to increase our speed to market, provide unmatched quality assurance for our customers and supports the development of the industry-leading, energy-efficient technology.

Turning to orders on Slide 5. As you can see from the chart, we are lapping more difficult prior year comparisons. Orders in our field businesses increased 2% organically due to some timing in both the current and prior year periods that are skewing the results. Importantly, our project pipeline remains robust, still tracking in the high single-digit range.

Based on our historical conversion rates, I am confident in achieving a mid- to high single-digit order growth rate in the second half despite the increasingly difficult comps. Brian will provide you with some order details in his segment review, but we continue to see broad-based activity across all 3 regions and across most of our core product platforms.

Our backlog ended the quarter at a strong $8.8 billion, up 6% organically versus the prior year, which not only supports our second half revenue assumptions but also provides visibility into 2020. Generally speaking, our end markets remain healthy with no notable slowdown in any of our internal leading indicators as our short-cycle book-to-bill trends, service growth and both small and large project bookings remain robust.

Turning now to Slide 6. Let me recap the financial results for the quarter. Sales of $5.8 billion increased 6% on an organic basis led by 7% growth in products and 6% growth in the field businesses. We continue to see solid growth from our service businesses across the globe, which were up 5% in the quarter. Our project business is also performing well with installation revenue up 6% in the quarter.

Adjusted EBIT of $469 million grew 10% on a reported basis, which includes a headwind from FX of just over $20 million in the quarter. Excluding FX, adjusted EBIT grew 16% on an organic basis driven by solid growth in segment profit as well as lower corporate expense. Overall, underlying EBIT margins expanded 70 basis points year-over-year excluding the impact of FX and M&A.

Adjusted EPS of $0.32 increased 23% over the prior year driven by solid top line performance and a modest benefit from below-the-line items. Adjusted free cash flow of approximately $200 million in the quarter brought us back to slightly positive for the first half, which is consistent with our normal seasonal pattern and our expectation we laid out to you on the Q1 call. We have made significant progress in this area over the past year, and we are well on track to reach our targeted 95% conversion for the year.

With that, I will turn it over to Brian to discuss our performance in more detail.

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Brian J. Stief, Johnson Controls International plc - Executive VP & CFO [4]

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Thanks, George, and good morning, everyone.

So let's start on Slide 7 and look at our year-over-year EPS bridge. As you can see, operational performance including synergies and productivity contributed about $0.10, and this was partially offset by $0.02 of continued product investments and the carryover run rate of our fiscal '18 sales force additions. We also saw some other items create $0.02 worth of headwinds related primarily to FX and some below-the-line items. As George mentioned, overall EPS in the quarter was up 23%.

So moving to Slide 8, let's take a look at Buildings on a consolidated basis. Sales of $5.8 billion increased 6% organically led by continued strength in our shorter-cycle product segment, which was up 7%, and 6% growth in our field businesses where we saw continued strength in service and project installation, which were up 5% and 6%, respectively. The continued strength in our field business is a reflection of the strong backlog we've been building over the past several quarters.

Total segment EBITA of $671 million grew 11% organically driven by strong growth from our field and product businesses as well as ongoing productivity and cost synergy saves.

Total segment EBITA margin expanded 50 basis points on an organic basis to 11.6%. And as you can see in the waterfall, underlying operational improvement contributed about 100 basis points, and this was partially offset by the product investments and run rate sales force additions.

Now let's take a look at each segment within Buildings, starting with Slide 9 in North America. Sales of $2.2 billion grew 5% organically driven by continued strength in both install and service, which were up 5% and 4%, respectively. Both applied HVAC & Controls and Fire & Security continued to outperform, growing in the mid-single digits. Our solutions business declined low single digits this quarter, but as you know, this business can be a bit choppy quarter-to-quarter on both an order intake and revenue basis.

Adjusted EBITA of $259 million grew 7% on an organic basis, and EBIT margins expanded 20 basis points to 11.8%. We saw the benefits from synergy and productivity save as well as modest volume leverage, partially offset by the run rate sales force investments and some unfavorable mix on selected platforms.

Orders in North America increased 2% organically, and orders for applied HVAC were up low single digits overall, reflecting a year-over-year decline in equipment orders. This was due primarily to the timing impacts of some price increases in both years. I would point out that on a year-to-date basis, HVAC equipment orders are up low teens.

Fire & Security field orders were up low single digits in the quarter while our solutions business saw order growth in the high single digits. Backlog of $5.6 billion increased 5% year-over-year. I would just also point out that our current North America order pipeline supports a mid- to high single-digit order growth in Q3.

So let's move to Slide 10 in EMEA/LA. Sales of $878 million grew 4% organically with continued strength in service, which was up 5%, and a return to growth in project installation, which was up 4%. Growth was positive in most regions and across most lines of business.

In Europe, we saw mid-single-digit growth led by mid-single-digit growth in our Fire & Security business, which accounts for about 2/3 of our revenue in that region, and we saw low double-digit growth on our industrial refrigeration and HVAC businesses. Orders in Europe increased mid-single digits organically led by strong demand in IR, security and HVAC.

In the Middle East, revenues declined low single digits as continued growth in service activity was more than offset by softness in HVAC project installations. And in Latin America, revenues increased high single digits led by broad-based strength across most platforms.

Adjusted EBITA of $81 million increased 17% organically, and EBITA margin expanded 60 basis points to 9.2%. This included a 40 basis point headwind for FX. So similar to Q1, underlying margins increased 100 basis points as the favorable volume and productivity and synergy save more than offset the run rate impact of our fiscal '18 sales force additions.

Orders in EMEA/LA increased 3% led by solid growth in Europe and Latin America across both service and project install. In the Middle East, orders declined in the low teens rate driven by continued pressure we're seeing in applied chiller end markets. Backlog ended the quarter at $1.7 billion, up 9% organically.

So let's move to APAC on Slide 11. Sales of $628 million grew 12% organically led by accelerating project installation activity, which grew over 15% in the quarter. We also saw strong growth in our core HVAC and BMS platforms with overall low teens growth in China. Service growth expanded 7% overall, and I would note that it was over 20% in China.

Adjusted EBITA of $76 million increased 11% on an organic basis, and we saw adjusted EBITA margins flat at 12.1%, which was slightly better than we were anticipating due primarily to the higher volumes. Favorable volume leverage was offset by the higher install mix, run rate sales force investments and the ongoing margin pressures we continued to see in APAC.

Asia Pac orders increased 1% with low single-digit growth in project installation, partially offset by a modest decline in service. Backlog is up 8% year-over-year to $1.6 billion.

So global products on Slide 12 increased 7% organically top line despite a difficult 6% prior year comparison to $2.1 billion. BMS grew double digits with continued strength across all platforms. Sales across our HVAC and IR equipment businesses grew mid-single digits collectively, and we saw global residential HVAC grow low single digits in the quarter.

The North America residential HVAC revenue grew 11% despite a tough high-teens growth comp in the prior year, and this was benefiting from a higher -- from favorable weather trends, strong price realization and the continued expansion of our distribution footprint. Global light commercial HVAC grew mid-teens in the quarter with North America up low teens as we continued to see strong growth in our key national account business. IR equipment revenues declined high single digits in the quarter due primarily to very difficult high-teens growth rates in the prior year. And then finally, our applied HVAC equipment business grew mid-teens, reflecting strength in our indirect channels in both North America and Asia.

Lastly, Specialty Products grew low double digits on strong demand from our fire suppression products with broad-based growth across all regions, particularly in APAC.

Segment EBITA of $255 million was up 13% organically, and products EBITA margins expanded 60 basis points as the leverage on higher volumes, favorable mix, positive price/cost and synergy and productivity save were slightly offset by an ongoing product investment.

So let's move to corporate quickly on Slide 13. Corporate expense was down 8% year-over-year to $104 million. And for the full year, we continue to expect corporate expense to be in the range of $380 million to $395 million.

Free cash flow on Slide 14. Reported cash flow was roughly $100 million in the quarter, but if you exclude the integration and transaction costs, adjusted free cash flow was approximately $200 million. Year-to-date adjusted free cash flow was slightly above breakeven, which is in line with our expectations for the year and our normal seasonal patterns for the Buildings business. We remain on track to deliver 95% conversion for the year.

Moving to the balance sheet on Slide 15. You can see our net debt to cap increase sequentially to 37.7%, which primarily reflects the borrowings to support our share buyback program we talked with you about in the first quarter call. We remain aggressive on share repurchase through the first half, and we completed $533 million in the quarter to get to our $1 billion share buyback for the first half.

Before I turn the call back over to George, let me update you on the close of the Power Solutions transaction as outlined on Page 16. The net proceeds from the transaction are now $11.6 billion, which is $200 million better than our original projections as we were able to bring our cash taxes down by approximately $200 million. Our intended use of these net proceeds remains unchanged with a debt paydown of $3.4 billion and $8 billion-plus of share repurchases.

As you saw on our press release this morning, we did announce a debt tender offer in the amount of $1.5 billion, which we expect to complete in early -- by early June. The other $1.9 billion in debt reduction will occur via normal paydown of debt maturities and commercial paper paydown over the course of the next several weeks. This debt paydown will result in $40 million of interest save in fiscal '19 with a run rate annualized benefit of over $100 million.

Additionally, we noted in the press release this morning that we intend to launch a share tender for up to $4 billion with a price range of $36 to $40 a share. All pertinent details will be filed in a formal offer document later this week.

On a final point, I'd just like to indicate to you that given the size of the share tender in Q3, it will have a significant impact on our weighted average share count, particularly in the fourth quarter on a stand-alone basis. As a result, the sum of our quarterly EPS will not equal the full year guidance midpoint that we've provided in the $1.85 to $1.95. As you know, our full year guidance is based upon a weighted average share count for a full 12 months, which is now expected to be 880 million shares.

And just to frame this for you, in the first quarter, we had $0.26 EPS. In the second quarter, we had $0.32 EPS. For the third quarter, we expect to have in the low $0.60 EPS. And in the fourth quarter, we expect to be in the mid-70s. If you add those up, you end up at about $1.95. And again, that is going to be higher than the midpoint of the guidance we gave because of the impact of the fourth quarter share count as a result of the share tenders.

So finally, we are committed to reduce our corporate cost by about $50 million by the end of fiscal '20.

And with that, let me turn the call back over to George.

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [5]

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Thanks, Brian. Before we open up the lines for questions, just a quick update on our 2019 guidance, starting with our EPS walk on Slide 17. The only change to our bridge versus what we shared with you last quarter is the EPS benefit associated with the use of proceeds related to the Power sale.

With the earlier close, we have updated all of our assumptions with respect to net interest savings associated with our planned debt reductions as well as a reduction in share count we should be able to achieve with our planned share tender. There are no changes to any of our operating assumptions or other below-the-line items.

The additional $0.10 benefit from use of proceeds resulted an increase to our adjusted EPS from continuing operations range to $1.85 to $1.95. This represents year-over-year EPS growth of 16% to 23%.

Just to reaffirm some of the details of our underlying operating assumptions on Slide 18. Again, you will see there are no changes with the exception of the 2 items we have boxed for you.

And just a few final comments before we get to your questions. We are encouraged by our performance year-to-date and feel very confident in our outlook for the second half. Our end markets do remain healthy. Our competitive position is strong, and we are well positioned. As we close an important chapter in the history of Johnson Controls with the Power Solutions sale, we are extremely excited to capitalize on the opportunities we have in front of us as one of the industry's leading building solutions providers.

With that, let me turn it over to our operator to open the line for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) The first question in the queue is from Nigel Coe with Wolfe Research.

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Nigel Edward Coe, Wolfe Research, LLC - MD & Senior Research Analyst [2]

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Congratulations on closing the deal early. I'm not that familiar with the modified Dutch auction process. Maybe just why $4 billion? If you're going to purchase up to $8 billion, could it not have been up to -- closer to the $8 billion number?

And then does -- once it's closed, does it in any way restrict you on further repurchases in the open market, ASRs or deal flow?

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Brian J. Stief, Johnson Controls International plc - Executive VP & CFO [3]

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So as it relates to the modified Dutch auction, the way that process works, that will be launched this week. And as I mentioned, it's got a floor price of $36, and it's got a top end price of $40. And as the book gets built over the next 20 business days or so, we would expect that tender to be completed sometime in early June. As far as the amount of the tender itself, I mean, that was -- there's a lot of discussions with our -- among the management team here and our outside advisers regarding what the right limit is for going into the market and buying back shares at this time. And I think $4 billion was the number that we all landed on. I would just point out that there's an opportunity for us to upsize that by $500 million should we decide to do that. So right now, think in terms of $4 billion to $4.5 billion. But our initial play is going to be at the $4 billion level, and we'll see how demand plays out.

And your second part of the question, Nigel, I'm sorry, was what?

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Nigel Edward Coe, Wolfe Research, LLC - MD & Senior Research Analyst [4]

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Yes, Brian. Just does it in any way bind you for a time period on further repurchases or M&A, any restrictions following the close of the deal?

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Brian J. Stief, Johnson Controls International plc - Executive VP & CFO [5]

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No, not at all. Not at all. The implications of a tender really provide us more optionality after the tender is complete to decide if we move forward with share repurchases, what approach we may use.

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Nigel Edward Coe, Wolfe Research, LLC - MD & Senior Research Analyst [6]

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Great. And then just my follow-on is, George, here, obviously, you're expressing a high degree of confidence in your end markets and the order flow. Turning to your short-cycle businesses within products, I mean, in '15, '16, we did see some pressure from channel, from oil and gas pressures in some of those businesses. Have you seen any signs of pressure in some of the shorter-cycle businesses?

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [7]

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Not at all, Nigel. If anything, we've seen a very robust market within these businesses. If you look at our -- mainly in our Fire & Security product businesses, we're up low teens, and that's across both -- all 3 of the key platforms here: fire detection, security as well as in Specialty Products with our fire suppression business. In addition, that's supported with the field up about mid-single digits, and that's pretty much broad-based across the globe. So there's really no signs right now on the short-cycle metrics that would suggest that there's any significant slowdown here.

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Operator [8]

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The next question is from Gautam Khanna with Cowen and Company.

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Jeffrey Joseph Molinari, Cowen and Company, LLC, Research Division - Research Associate [9]

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This is Jeff on for Gautam. So a quick one on the Power proceeds. What's baked into your guide assumption as far as the debt reduction? Is it the $1.5 billion or the $3.4 billion? And also, what about -- which -- what repo assumption is baked into that guide, the -- like as a dollar amount for '19?

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Brian J. Stief, Johnson Controls International plc - Executive VP & CFO [10]

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Yes. So the debt paydown, so $11.6 billion is net proceeds. Debt paydown is $3.4 billion. The $1.5 billion is actually a tender that's part of the $3.4 billion to buy back that debt. The remaining $1.9 billion will be taken out over the next several weeks through either normal maturities of debt or commercial paper paydowns. So $3.4 billion of debt, which will generate $40 million save this year, an annual run rate of $100 million.

As far as the share repurchase, what's baked into the guidance we had given you is $4 billion in a tender that will be taken out by early June. And then the remaining $4.2 billion, we had to make some assumptions relative to what we were going to calculate our guidance based upon. So we've assumed the remaining $4.2 billion for now will be put on our balance sheet in some -- on some interest-earning investment. And then as we make final decisions on what approach in share repurchase we're going to use, we'll update the guidance accordingly.

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Jeffrey Joseph Molinari, Cowen and Company, LLC, Research Division - Research Associate [11]

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Okay. Brian, that's clear. So any -- that would be incremental.

And then maybe one on order pipeline, if I may. So you mentioned Q3 orders are tracking mid- to high single digits. Can you kind of dissect that a little bit by HVAC product, like unitary, applied, resi, kind of which is the strongest? Or just any color there would be helpful.

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [12]

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When you look at our -- if you just look at what played through in Q2, we've had strong product growth, and that's been pretty much across-the-board, double-digit growth in our Building Management Systems, mid- to upper single-digit growth in our HVAC platform. And as we talked about in our Specialty Products, we had nice double-digit growth, so that's continuing.

When you look at our field and our installation as well as service, it's broad-based across all of the domains with the project pipeline that's been building and what we've been able to convert here in the quarter and then what we see in the pipeline to convert here in the third and fourth quarters.

So obviously, we're performing very well in HVAC. When you look at our HVAC businesses across the globe, I'd say that we are beginning to really accelerate our performance. And then with that, we're seeing the volumes come through. That is putting a little bit of, from a mix standpoint at the gross margin level, a little bit of pressure on our business. But overall, we've been performing well. So just to sum up, I'd say it's broad-based. It's across all domains, across all regions and a nice split between both project on a project-based business as well as service business with service growing about 5%.

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Operator [13]

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The next question is from Jeff Sprague with Vertical Research Partners.

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Jeffrey Todd Sprague, Vertical Research Partners, LLC - Founder and Managing Partner [14]

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George, you made a comment in your opening remarks about, I think, operating leverage really picking up or kicking into higher gear or words to that effect in the back half. I'm just wondering if you could elaborate on that a little bit more, right? From our seat, kind of the observed incremental just at the segment level is 28%, which is solid. Underneath that, it's actually better, right, with the currency and other noise. But it's not clear to me from the guidance that we would observe much more than high 20s. Maybe it's 30-ish or so in the back half, but any other color on all those dynamics, the leverage, how price/cost is playing through and how to think about how that scales up into the back half would be helpful.

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [15]

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Let me start by saying that when you look at our incremental margins today, Jeff, they're actually in the low 20s, and that's before productivity and investments. So when you look at the mix of that, it's really driven by high teens within our field businesses and upper -- mid- to upper 20s in our product-based businesses. And so on a go-forward basis, when we look at what we're doing both from a pricing standpoint and productivity standpoint, we have a road map to get those businesses on the incremental margins to mid-20s, and that's driven by getting our field businesses up to 20-plus percent and our product based businesses up to 30-plus percent over the next couple of years.

Now recognize, when you look at our pricing activities this year, we've made significant progress. Last year, we got behind, and for the year, we were negative. I think it was roughly about $35 million. Now with all of the actions that we took in the second half of last year, and then we've continued that this year taking into account not only the inflationary pressures but also the tariffs, we feel very confident that through the course of the year, that's going to continue to accrete margins pretty much across the board and very confident of that.

So when you look at the year, we're going to continue to grow kind of mid-single digits across the board. That levers nicely. So it's -- when you look at the total year, it's about 30 basis points of leverage. It's about 60 basis points of productivity and synergies. That's somewhat offset with the reinvestments that we're making back in the business through sales force as well as technology. We do have a little bit of pension headwind, and that nets us to being able to achieve about 40 to 60 basis points for the year across all of the businesses.

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Jeffrey Todd Sprague, Vertical Research Partners, LLC - Founder and Managing Partner [16]

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Great. And then just back to redeployment. As I'm sure you know, HVAC consolidation speculation has been rampant for the better part of 6 months or so. Can you just update us on your view on that? It would seem going ahead with plan A on the tender and the debt reduction would be a fairly clear indication that in the near term you don't see an opportunity there, but I don't want to put words in your mouth. Just what do you see kind of the optionality moving forward for this pure-play building efficiency company that you've created?

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [17]

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Yes. So when I look at where we are, it's been -- as I've communicated multiple times, we're very much focused on execution. We have an incredible portfolio that has historically underperformed. We're beginning to accelerate our performance, beginning to get more consistent performance, delivering on our commitments. And as I said, there's tremendous runway here as we continue to improve. And that's been the focus.

And so when we announced that we were going to redeploy the proceeds not only in the debt paydown but also the buybacks, it's believing that we've got a lot of opportunity here in front of us. We did announce a $4 billion tender. And as Brian mentioned, we'll see how that plays out. And we have every intent here to continue with the plan that we have to buy back up to roughly $8.2 billion in buybacks.

Now relative to the industry, certainly, lots of speculation. I'm not going to speculate on it. Certainly, when I stepped up to take over, recognized that the building space is a very attractive end market, and we had tremendous opportunity to reinvest and be able to deliver on growth. And that's what we're focused on doing. And as you've seen others, they're doing similar, right? They're streamlining their portfolios and positioning to do the same. But at this stage, I think we have a tremendous opportunity with the investments we've made and the continued investments we're making to be able to deliver strong performance.

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Operator [18]

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Next question is from Steve Tusa with JPMorgan.

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Charles Stephen Tusa, JP Morgan Chase & Co, Research Division - MD [19]

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Could you maybe just talk about what you're seeing in China? You've put up some pretty good growth there. Obviously, the orders slowed a little bit, but maybe just delve into a bit of the dynamics there on HVAC.

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [20]

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Yes. Let me start, Steve, by saying it's roughly about 6% of our total revenues, and it's broken out into about 2/3 in the field and 1/3 in products. And so we were -- this is something we're watching closely because as things -- with all of the trade discussions and maybe seeing a little bit of a slowdown, we were concerned for the year. I think through the course of the second quarter, we're feeling a little bit better. I think as Brian went through the segment, we're seeing good order growth, good pipeline development. And then from a revenue standpoint, we actually did better than what we originally thought in how we converted revenue in the quarter.

And so we still want to make sure that we're watching this closely to make sure that with the investments we're making there that they're going to play out as planned. But at this stage -- and the other part I noticed from a service standpoint, not only is it important to get higher market share in the installed base, but we've been very much focused on getting the service revenues. And so right now, it is ramping up. It's about 1/3 of our revenues in China. We see this as a big opportunity going forward, especially as we -- if we were to get into a down cycle that this would be a very attractive segment for us.

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Charles Stephen Tusa, JP Morgan Chase & Co, Research Division - MD [21]

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Also, just following up on Jeff's question. How do you view the market share dynamics of commercial? I know there's really only 3 major applied guys -- applied suppliers in the U.S. But obviously, applied is kind of a loose term, if you will. It's customized work. I mean when you kind of look at the market structure, do you look at it as 3 major players in the U.S. and pretty consolidated? Or do you look at it as there is various verticals within in which there are kind of a range of solutions that compete in those markets? Does that question make any sense whatsoever?

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [22]

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Yes. Let me give it a shot. Let me start with the residential because I think it builds into the commercial. Residential is a space that we're obviously not in the top 2 or 3, and that's a space that we've been reinvesting in North America with new product and -- as well as expanding our distribution, and that's playing through pretty nicely. Our residential North America business was up 11%, and that's to a tough prior year comp. And a lot of that not only is the technology and the product, but also, of course, it would be the pricing increases that we've seen here over the last 12, 18 months.

Now if we talk about commercial, this is where we've been relatively strong, and then there are 3 key players here in this space. Certainly, that we had -- over the last decade had underinvested. Over the last 2 or 3 years, we've significantly ramped up that investment. And I believe with the products that you see coming to market now, we're going to be very well positioned to be able to gain more of that share. A big focus, our strength here is in national accounts. So there might be some segmentation of the market with how we serve customers. But I think when you look at our commercial HVAC equipment, it's up 13%.

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Charles Stephen Tusa, JP Morgan Chase & Co, Research Division - MD [23]

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Yes. I guess I'm just asking about market structure. I guess a very simple way to ask it a little bit -- to put it a little bit more of a finer point, is it consolidated? Or am I -- are we looking at it the wrong way? Should it be segmented in a, "Hey, there are various solutions for these buildings," and so it's not as saturated or consolidated as it would look when we just talk about a chiller, which is basically Carrier, York and Trane, right? That's kind of what I'm asking.

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [24]

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When you look at the commercial space, what I would say is it's similar. When you look at the landscape within the market, it's similar to the applied space where you have 5 or 6 key players. Now there's differing footprints and different product mixes within that, but there's mainly 5 or 6 key players within the commercial space.

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Charles Stephen Tusa, JP Morgan Chase & Co, Research Division - MD [25]

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Okay. Would you consider that saturated and consolidated or not?

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [26]

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I'm not going to -- I mean, at this stage, I think I'm not going to speculate, Steve, relative to each of the players' market positions. But what I would say is that we're focused on the investments we're making and making sure that we've got the right footprint in how we go to market to be able to gain market share and grow within the key end markets that we serve.

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Operator [27]

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Next question is from Andy Kaplowitz with Citigroup.

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Andrew Alec Kaplowitz, Citigroup Inc, Research Division - MD and U.S. Industrial Sector Head [28]

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George, despite the slowing in the field orders in the quarter, you obviously seemed quite positive about your pipeline. You made a comment in the presentation, I think for the first time, around your field backlog that you now have some visibility into fiscal '20? Could you elaborate on what that means? Do you have enough projects now in the backlog where you feel that field sales growth has a good chance to continue to grow in the mid-single-digit range in 2020?

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [29]

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Yes. Let me start by saying that when we book projects, on the short end, they turn within 3 to 6 months or some can be multiyear. Our average project turn is somewhere around, depending on the mix, it's typically about a year. So we're now building a pipeline. As I've said, we have a very strong pipeline. Pipelines are up high single digits. We continue to add sales force. Now we're maintaining our sales cost as a percent of revenue now because we're getting productivity with these sales force that we had added last year. So in line with that, we continue to expand our sales force. We're going after this pipeline, converting the pipeline. And what we're turning now, we have some projects that will support the second half, but there's a lot of the projects that we're executing today that will set us up with backlog for 2020. And so that's what gives me confidence that as we continue to execute through 2019 that we'll see that -- we'll see continued progress here as we're setting up 2020.

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Andrew Alec Kaplowitz, Citigroup Inc, Research Division - MD and U.S. Industrial Sector Head [30]

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Okay, George. At this point though in the year, would you say above average visibility into the next year versus what you've seen?

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [31]

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Absolutely. I mean, we're halfway through the year. Like I said, and with the pipelines that we have, all of our pipelines are tracked across the board now. We can see that by segmentation, by region, by install, by service. And through our regular reviews, monthly reviews, I'm very encouraged in our ability to be able to continue to support the execution through the second half of 2019 but even more important now setting up for that continuing in 2020.

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Andrew Alec Kaplowitz, Citigroup Inc, Research Division - MD and U.S. Industrial Sector Head [32]

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And Brian, I just wanted to ask you about cash flow. Obviously, you've kept the guide at 95% conversion. Seasonally, we would expect a bigger ramp up in the second half of the year. You've talked in the past about needing to go after pockets of inventory that you have in your business and maybe standardizing cash collections on your smaller markets and collecting more from your JVs. So can you give us the confidence level that you have to get more cash out of your business in these areas? And how important are they to reach the goal for the year?

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Brian J. Stief, Johnson Controls International plc - Executive VP & CFO [33]

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Yes. I think if you look at last year in the third quarter, our free cash flow, adjusted free cash flow was $0.5 billion. We're expecting about $600 million in Q3 of this year. And then last year, Q4 was about $900 million, and we're expecting -- I'm rounding numbers here, $1 billion, $1 billion-plus in Q4 this year. So with those numbers, we deliver the 95% free cash flow.

I would tell you from the standpoint of improvements that we're making, if you look at year-over-year, trade working capital as a percentage of sales, we have made a 40 basis point improvement March of last year to March of this year. And I also look at things sequentially. And sequentially, we've gone from 12.1% at the end of the first quarter to 12% at the end of the second quarter. So we are seeing improvements in trade working capital as a percentage of sales.

Now having said that, if I look at trade working capital globally and where we've made progress with our cash management office over the last 15 months or so, I would tell you that payables, we've standardized terms with our vendors. I think we've got things in really good working order in most major locations as it relates to payables.

When I look at inventory, I would say there's probably a couple of pockets, one in Japan, one in North America that we need to go to work on. But we are talking huge numbers. It's probably $50 million to $100 million of opportunity. And the area that I think we really can continue to improve on is accounts receivable, and we've kind of got all hands on deck on that as we speak. And we're going to see that gradually improve. And actually, that improvement is what's driving some of the year-over-year improvement that we're going to see in the back half of this year versus the back half of last year.

And then the last thing I'd say relative to joint venture dividends, we continue to have conversations with our joint venture partners regarding whether or not we take out current dividends or reinvest those in the business, and we'll update you as we move through the rest of the year. Most of those conversations take place in the back half of our fiscal year with decisions made at that time. So we're hopeful that over the next several months here that we can get some positive developments relative to our joint venture dividends as well. But that's all kind of baked into our 95% guidance we provided.

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Operator [34]

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Next question is from Deane Dray with RBC Capital Markets.

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David Lu, RBC Capital Markets, LLC, Research Division - Associate VP [35]

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This is David Lu on for Deane. I just have one question. I know you mentioned orders tracking around mid- to high single digits for the third quarter. But did you see any level of pull-in of customer spending from the second half of the year into the first half to get ahead of tariffs or price increases? Any material impact there?

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [36]

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No. I think we saw our normal flow in the quarter, and we track these year-on-year, but nothing unusual or significant as far as that.

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Antonella Franzen, Johnson Controls International plc - VP and Chief IR & Communications Officer [37]

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Yes, David. The only thing we talked about last quarter, remember, is in North America we did see some pull forward from Q2 to Q1 but nothing from second half into first half.

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David Lu, RBC Capital Markets, LLC, Research Division - Associate VP [38]

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Got it. And then if I could just sneak one more in, any update on tariff headwinds? I know the List 3 tariffs kind of stayed at this 10% range. But you were projecting for, I think, 130 to 140 of total headwinds between 2018 and 2019. Could we potentially see some upside from lower cost increases here?

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [39]

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That's about the range that on a 2-year basis the impact that we're seeing and, as I've said earlier, that we're well positioned from a pricing standpoint to offset those. Certainly, we've been planning our supply chains so that on a go-forward basis, we can mitigate some of that. But our plan right now is we're planning for these tariffs, and that's what ultimately is in our guidance.

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Operator [40]

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Next question is from Tim Wojs with Baird.

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Timothy Ronald Wojs, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [41]

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I just wanted to go back to pricing and just try to -- George, is there a way to kind of frame what pricing in backlog and your orders is right now versus what might be running through the P&L or what that looked like maybe a year ago?

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [42]

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Yes. So the easiest way to frame it up is the year ago pricing on our revenue was -- impacted our revenue by 1% to 2%., and then pricing this year is going to be 2% to 3%. And so think about it as an order of magnitude what's coming through on price. And so that is in our product businesses. It's shorter cycle, so you see the realization quicker. You'll see realization on service increases quicker, and then the one that's been more of a cycle time impact is the work we're doing around our installation project-based business.

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Timothy Ronald Wojs, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [43]

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Okay. Great. And then I think you had mentioned this, but I missed it. On the gross margins is I think they're down slightly year-on-year year-to-date. Is that really more a function of mix relative to price/cost or anything else that's kind of running through there?

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [44]

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Yes. The 2 areas that we've had the pressure, and let me start with APAC. It's been -- mainly, we've been foreshadowing that here this year because of what we had in backlog. That's going to play out this second half of the year. But with the work we're doing, that will begin to improve and we'll see that in 2020.

The other is the mix of -- when you look at North America, when you look at the domains together, we are performing in HVAC very well. And at the gross margin level, that's less in Fire & Security. But other than that, we're getting price and margin expansion across all domains and across all regions in the plan as we execute on the second half.

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Operator [45]

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Next question is from Josh Pokrzywinski with Morgan Stanley.

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Joshua Charles Pokrzywinski, Morgan Stanley, Research Division - Equity Analyst [46]

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We've covered a lot of ground on the quarter. Maybe shifting gears, thinking about where we're at in the cycle, I think one of your competitors yesterday -- I'll put words in their mouth a little bit, it seems we're in a bit of a golden age for HVAC and kind of building investment in general that between energy, efficiency and greenhouse gas emissions that folks are just spending a lot more and putting a lot more attention on that, which seems to favor the JCI portfolio. Within that, do you feel like you're winning your entitlement? Or have you seen new entrants or kind of new product lines pop up in the space? First question there.

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [47]

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So you're absolutely right. The opportunity that we have around sustainability and energy reduction does play to our strengths. I highlighted a couple of examples that we've recently won. We're executing with the University of Hawaii, and the other is a new project that is all focused on sustainability and being the smartest building in the Middle East.

So the reason why we're well positioned, not only do we have leadership HVAC, which as we know is a significant consumption of energy, but that combined with our Building Management Systems and our ability to optimize not only the equipment but beyond the equipment, the rest -- the use of the building is what ultimately delivers on the vision of our customers. And so what I would tell you is that in our Building Management Systems, we had double-digit growth. I mean, we're low teens in the quarter, and that's the way that we serve the market today.

What's happening is as we move forward, those capabilities are converging. It's enabling us now to use our Digital Vault, which is our proprietary cloud-based data solution, to be able to deliver on what I would say is entitlement of energy reduction. And so for us, I think in spite of the cycle, that's going to be an attractive space for us and one that we're well positioned.

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Joshua Charles Pokrzywinski, Morgan Stanley, Research Division - Equity Analyst [48]

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Got it. So you don't see anything competitively changing or new entrants or anything like that?

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [49]

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No. What I would say is that it's the combination of having leadership product, having technology platforms and then having a footprint in the key markets that you're serving that is close to customers and being able to take their vision with ours and convert it into what the next-generation solution is going to be, and that's what we're doing.

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Joshua Charles Pokrzywinski, Morgan Stanley, Research Division - Equity Analyst [50]

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Got it. And then just to pivot a little bit off of that, how pleased are you today with your mix, George? I think looking at some of the other folks in the HVAC landscape or in the buildings landscape, you do a bit more of your own installation and you have kind of a wider range of service from the super high-end stuff to, I think, things that would be maybe a bit more locally competitive. Within this kind of new regime for building investment, do you think JCI's organization does too much, too little, the right amount as it pertains to the kind of product mix and what that ultimately means for operating leverage?

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [51]

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So let me just simplify it. When you look at the portfolio, we're about 40% install, about 35% or 30% service and about 25% product. And what I would tell you is the investments we're making the product is to put ourselves in a leadership position across each of the platforms. I think we're making great progress. We're not where we'd like to be, but we're on track to the plan that we've got in place with the reinvestments. Then if you look at our -- and that is core not only for our direct channel but also making sure that we leverage all distribution to lead the industry.

The second is our field-based businesses. We've got an incredible footprint across the globe, and it's not only leveraging the product but also our technology platforms that enable us to bring compelling solutions that ultimately drive sustainability, energy reduction and ultimately efficiency for the customers that we serve. And what we've done well, especially during this cycle, is that we've had significant growth in our install business creating that installed base.

And what I've been doing here since I've taken over is put a big focus on service. At our field-based businesses, we have significant opportunity to expand our services and how we service that installed base. And so that is another area that we believe that we can -- there's a lot of room to grow. It's very attractive from a margin standpoint. And it's going to be a key contributor to our long-term success.

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Antonella Franzen, Johnson Controls International plc - VP and Chief IR & Communications Officer [52]

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Great. Operator, I'd like to turn the call over to George for some closing comments.

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [53]

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So thanks, again, all of you for joining our call this morning. As I said earlier, our end markets remain healthy. We're strengthening our competitive position. And I believe we're well positioned not only for the remainder of this year but setting up 2020. We are very excited now with the sale of Power Solutions to capitalize on the opportunities that we have in front of us and truly position Johnson Controls as the industry's leading building solutions provider. So on that, I look forward to seeing many of you soon. And operator, that concludes our call.

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Operator [54]

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This concludes today's call. Thank you for your participation. You may disconnect at this time.