Johnson Controls (JCI) Spin-Off: Is Adient A Buy Or Sell? by Ben Reynolds

Johnson Controls (JCI) will spin off its automotive seatings and interiors businesses on October 31st.  The newly formed company will be called Adient and trade under the ticker (ADNT).

Johnson Controls shareholders will receive 1 share of Adient for every 10 shares of Johnson Controls.  The date of record to receive these shares is October 19th.  No action is required for shareholders – new shares will be distributed automatically.

Note:  Remainders of less than 10 shares will be sold, with cash distributed to Johnson Controls shareholders based on the amount of shares they hold.

Johnson Controls currently ranks as a buy using The 8 Rules of Dividend Investing.  The question of what to do with shares of the new spin-off is pertinent.

[drizzle]Should current Johnson Controls shareholders hold shares of Adient – or sell them?

This article answers this question by examining Adient’s competitive advantage and earnings power.  Fair value for the new company is also estimated.

Adient – Business Overview

Adient will be the global leader in automotive seating and interiors based on volume.  The company will have:

  • 230 Locations
  • In 33 Countries
  • With ~74,000 Employees

Operations will be split into 2 segments:  Seatings and Interiors.  The Seatings segment is about four times the size of the Interiors segment based on sales data over the last 9 months.

The company’s revenue and earnings will be cyclical and dependent upon new car production.  As a supplier of automotive interiors and seating, Johnson Controls does not have control over new car production.  Therefore, growth is tied to factors outside the company’s control.  The image below shows global vehicle production over the last several years:

Johnson Controls, Adient

Source:  Adient Spin-Off Information Report
The automotive industry is not growing equally in all markets.  Growth in China is far outpacing growth in Europe and the United States.

Importantly, Adient will be the largest supplier of automotive seats in China thanks to its 17 joint ventures and 60 manufacturing facilities.  The company currently has 45% market share in China.

The image below gives a breakdown of the company’s sales by geography.

Johnson Controls, Adient

Source:  Adient Spin-Off Information Report
Note:  Unconsolidated sales are a result of joint-venture sales, primarily in China.

Bruce McDonald will be the company’s CEO.  McDonald was Johnson Control’s CFO from 2005 to 2014.  In 2014, he became the company’s executive vice president and vice chairman.

Adient’s earnings power and competitive advantage is examined in the next section of this article.

Earnings Power & Competitive Advantage

Adient generated $20.1 billion in sales before joint ventures in fiscal 2015.  The company realized a gross margin of 9.2% on these sales.

The company generated $721 million in profit before financing charges, taxes, divestitures, and restructuring charges for a pretax adjusted profit margin of 3.6%.

There’s no question that Adient is in a low margin business.  Size and scale in a low-margin, cost-driven industry creates a strong competitive advantage.

The spin-off will allow Adient’s management to focus on making efficiency improvements within the company, further strengthening its competitive advantage.

Leveraging the company’s excellent global manufacturing footprint factors heavily into Adient’s growth plans.  In addition, the company already works with many of the world’s largest automobile manufacturers.  These valuable relationships further strengthen the company’s competitive position.

As mentioned earlier, Adient generated $721 million in adjusted profit before taxes and equity income from its joint ventures.  Adding in joint venture income, the company generated $1,016 in pretax profit, before financing expenses.  Let’s call this number an even $1 billion for simplicity.

Adient will have significant interest expenses going forward.  The company is taking on around $3.5 billion in debt during the spin-off.  This debt has an average interest rate of 3.4%.  This equates to an interest expense of around $125 million a year.

Backing out interest expense from adjusted earnings, we get ~$875 million in earnings before taxes.  The company’s tax rate was 17% in its most recent quarter, and 30% for the most recent 9 months.  We will use a 30% effective tax rate to be conservative.

The company has after tax adjusted earnings of $612 million.  Adient will have 93.6 million outstanding shares.  This gives the company adjusted earnings-per-share of $6.54 for the fiscal year ended September 2015.

I believe earnings-per-share of around $6.50 is a reasonable estimate of future earnings power, after restructuring and various tax and legal matters from the spin-off settle.  The company will show a GAAP earnings loss in its first fiscal year due to restructuring, tax, and legal expenses.

Dividend Policy

Adient’s management has stated they intend to pay a dividend, but have given no specifics.

The company has to jump through some legal hoops to begin paying its dividend.  This is because Adient is headquartered in Ireland.  Adient has a plan to quickly acquire legal ability to pay dividends.  I don’t anticipate this to be an issue in paying dividends in the long run.  It could delay the first dividend payment for several months, however.

The company plans on deleveraging and paying a dividend.  It will offer a dividend reinvestment plan.  If you’re enrolled in Johnson Controls DRIP plan, you will be automatically enrolled in Adient’s DRIP plan.

At this point, there has been no definitive guidance as to Adient’s payout ratio.  My best guess is that it will be fairly conservative as the company uses cash to pay down debt and possibly repurchase shares.

The New Business Will Likely Be Undervalued

Spin-offs tend to trade for lower than average valuation multiples.  This is because investors often sell the newly formed company’s stock for no reason in particular other than it is new and they didn’t actively purchase it.

This behavior drives down valuations.  In addition, the automotive industry has lower than average price-to-earnings ratios in general.

Adient will likely trade at an adjusted price-to-earnings ratio below 10 using its adjusted earnings calculated earlier in this article.  Even with a 30% payout ratio, this would equate to a dividend yield of 3%.  While specific dividend policy has not yet been announced.  Adient is likely to be an example of a high yield low payout ratio stock with a strong competitive advantage.

With that said, the stock will likely be volatile.  It will likely decline shortly after the spin-off due to selling pressure (though this doesn’t have to happen, obviously).  Downturns in the automotive industry will also likely cause greater-than-average volatility in the stock price.

Adient may not be a good holding for risk-averse investors.  I will be holding onto my shares after the spin-off, as they will likely be a value play and offer favorable total return potential.  The one caveat to this is management’s dividend policy.  Once that is disclosed in greater detail, dividend investors will have a better understanding of what to do with shares.

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