By: Chuck Carnevale, F.A.S.T. Graphs, Inc.
This article is Part 6 of a 7-part series that is looking at the incredible opportunity that a cyclical company can represent as earnings recover coming out of a recession. A primary objective of this series of articles is to illustrate that price drops of well-established companies are usually temporary even after earnings are cyclically weak.
In Part 6 we look at Johnson Controls (JCI).
Johnson Controls (JCI) Their Businesses
Johnson Controls (JCI) operates three core businesses that generate approximately $40 billion a year in revenues. Their largest segment representing 48% of sales is their automotive interior segment. The second largest segment in representing 37% of sales is there building interior controls business, and their third segment representing 15% of sales is their power segment which is predominately automotive batteries. To put these businesses into perspective, approximate 63% of their business is related to and/or dependent on the automotive sector.
The following slide excerpt from a presentation made by management on 06/27/2011 at the Power Solutions Analyst Day summarizes the company’s core businesses. The fact that the slide was titled “Three world-class growth businesses” offers an interesting insight and perspective on this quality company. As we will soon illustrate, Johnson Controls has a legacy of generating an above average and very consistent level of earnings growth. However, the great recession of 2008 and 2009 brought an abrupt change as it interjected a high level of cyclicality into the company’s earnings record.
Johnson Controls Inc.: A Legacy of Consistent Growth
The following earnings and price correlated F.A.S.T. Graphs™ on Johnson Controls from 1992 to calendar year 2007, one year before the great recession of 2008, illustrates a remarkable pattern of earnings growth and price performance. Johnson Controls (JCI) grew earnings (the orange line with white triangles) at an average rate of 16.7% per annum with a remarkable degree of consistency. The black line on the graph represents monthly closing stock prices which clearly followed earnings consistently higher over this time frame. This is a picture which represents a quintessential example of a true growth stock. However, this series of articles was written about cyclical stocks, which up to this point Johnson Controls would not typify.
The associated performance results on the earnings and price correlated graph above shows that shareholders earned a 16.8% annual capital appreciation which almost perfectly mirrored earnings growth. Add in a dividend that was increased every year, and the total annual rate of return increases to 17.5% per annum. This is growth in its purest form.
Along Came the Great Recession
As previously pointed out, over 60% of Johnson Controls’ business is exposed to the extremely cyclical automotive industry. Therefore, it’s a testament to the quality of the management of this company that they were able to generate such an exemplary record of earnings growth up to calendar year 2007. However, when the recession of 2008 brought with it an extreme level of stress on the automotive sector, Johnson Controls was unable to avoid succumbing to the cyclicality of the major industry they served.
Therefore, fiscal year 2009 (fiscal year end September 30) experienced an earnings collapse of 80%, as earnings fell from $2.38 to $.48. This instigated the stock price to fall from an overvalued price of $43.72 on the way down to $8.35 by February of 2009. But when the recession ended, as they all do, earnings recovered to $2.04 in fiscal 2010 and are expected to reach $2.45 this fiscal year, which will be their highest level of earnings ever. Of course, as the graph depicts, the stock price recovery was just as swift as the earnings recovery.
One of the lessons learned here, is how quickly that the earnings and price of a well-entrenched quality business can recover when business conditions normalize. When stock prices fall like they did for Johnson Controls, traumatized investors almost always feel that they can never recover their losses. But as the following graphics illustrate, recovery can be swift and sure. Frankly, this was a big surprise to us, but the F.A.S.T. Graphs™ clearly illustrate how and why the recovery happened and in much more vivid detail than a mere stock price chart could have shown.
It’s also noteworthy to recognize that the earnings growth rate for Johnson Controls (JCI) has reasserted itself to an average growth of 12% per annum. So when we look at the company fundamentally today, we see a reasonable price earnings ratio of 15.1, a dividend yield of 1.8%, and a debt to equity ratio of only 20%. Consequently, we find it equally surprising how swiftly the company’s fundamentals deteriorated during the recession and how quickly they were able to recover fundamentally speaking.
When we review the associated performance results with the above graph, we once again find the uncanny correlation between earnings growth and shareholder returns. Now that the earnings growth rate has returned to an average of 12% per annum, shareholder capital appreciation of 12% per annum directly reflects the earnings achievement. But perhaps most interesting of all, when reviewing these performance results is the fact that Johnson Controls maintained their dividend throughout their earnings interruption. Consequently, shareholders relying on dividend income were not hurt by the enormous volatility of Johnson Controls’ stock price.
A Candid Confession
The primary reason we were compelled to write a series of articles was partially stimulated by Johnson Controls. In March of 2005 we invested in this terrific business at an approximate price of $19 per share. By June of 2006 we felt the stock had become overvalued and sold our position at approximately $29 a share. By September of 2006 the stock had fallen to $22 a share and our decision looked like a good one. However, by the end of October 2007 the stock price rallied to almost $44 per share, and our decision now looked shortsighted.
On the other hand, at $44 a share Johnson Controls was clearly overvalued and promptly fell back down to $32 per share by January of 2008. At $32 a share, the stock was once again trading at 15 times earnings which we considered a fair price so we re-purchased about a third of the number of shares that we originally sold. Our intent was to eventually rebuild our full position. By April 2008 the stock had rallied to over $35 a share, which we felt was modestly overvalued so we refrained from adding to our position.
What happened next was an experience that we would never care to relive. Of course, we are referring to the great recession which caused Johnson Controls’ stock to initially fall to approximately $28 per share then staged a minor rally back to approximately $31 a share and then all hell broke loose. Earnings per share began to collapse and along with falling earnings, Johnson Controls’ stock price plunged to approximately $8.35 a share. Then the real mistake was made. The stock price rallied back to $13 a share by April 2009 and we sold out.
The moral of this story is that our actions were consistent with our investment philosophy. If