Welcome to Johnson Controls first quarter 2023 earnings call. Your lines have been placed on listen only until the question and answer session. To ask a question, please press star one on your telephone keypad. This conference is being recorded. If you have any objections, please disconnect at this time. I will turn the call over to Jim Lucas, Vice President, Investor Relations.
Good morning, and thank you for joining our conference call to discuss Johnson Controls first quarter fiscal 2023 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. Joining me on the call today are Johnson Controls Chairman and Chief Executive Officer, George Oliver, and Chief Financial Officer, Olivier Leonetti. Before we begin, let me remind you that during our presentation today, we will make forward-looking statements. Listeners are cautioned that these statements are subject to certain risks and uncertainties, many of which are difficult to predict and generally beyond the control of Johnson Controls. These risks and uncertainties can cause actual results to differ materially from our current expectations.
We advise listeners to carefully review the risk factors and cautionary statements in our most recent Form 10-Q, Form 10-K and today's release. We will also reference certain non-GAAP measures. Reconciliations of these non-GAAP measures to the most directly comparable GAAP measures are contained in the schedule attached to our press release and in the appendix to this presentation, both of which can be found on the investor relations section of Johnson Controls website. I will now turn the call over to George.
Thanks, Jim. Good morning, everyone. Thank you for joining us on the call today. Let's begin with slide 3. Fiscal 2023 is off to a strong start with solid Q1 results. Our teams across the globe have executed well, delivering strong financial performance for our shareholders while pushing the pace of innovation to provide our customers with the next phase of digital solutions across our vectors of growth. During the quarter, we accelerated growth across our service-based businesses, drove higher margins, and delivered profitability at the high end of our adjusted EPS guidance range. Overall, organic revenue grew at a healthy pace. Our $11.3 billion backlog remains resilient, growing 11% year-over-year. Our service strength was resilient and remains a key competitive differentiator.
While order timing, supply chain realization, and China policies have impacted our global products in field install order flow during the quarter, we are seeing incremental improvements in order momentum heading into Q2. As we mentioned over the last few quarters, we remain focused on the fundamentals of our business in improving our operational execution. Our teams have done a great job advancing our initiatives to accelerate growth and optimize the efficiency of our cost structure. During the quarter, we delivered $90 million in productivity cost savings and are on track to reach our $340 million savings target over the course of this fiscal year. We are also committed to our prudent approach to capital allocation, reinvesting in new products and technology to drive long-term shareholder value while continuing to return capital to our shareholders.
We recently announced our plans to enhance our growing industrial heat pump portfolio with the acquisition of Hybrid Energy. Acquisitions are an integral part of our growth strategy, and by investing in Hybrid's patented high temperature heat pump technology, we are continuing to strengthen our leading global product portfolio and provide our customers with the most efficient, sustainable building solutions. We are well-positioned to capitalize on large growth opportunities across our dynamic product portfolio and field business. Through our integrated domain expertise, global coverage, and scale, we are leading the way towards smart, healthy, and sustainable buildings for our customers. While the global macroeconomic environment remains uncertain, based on our strong start to Q1 and our expectations for the remainder of the year, we are raising the lower book end of our adjusted EPS guidance range for the year. Now turning to slide 4.
During the quarter, our OpenBlue platform continued to expand as we enhanced our capabilities, leveraging the power of AI and providing customers with unique insights. A good example is the deployment of OpenBlue Enterprise Manager at a leading tech manufacturer to help them meet their energy and sustainability goals. In addition, we have recently installed OpenBlue Companion at their facility to enhance employee productivity and space utilization. From advancing predictive analytics to integrations at the edge, our full suite of solutions empowers our customers to meet their carbon emission goals and create a healthier, more productive workspace for their people. To date, we have enhanced the existing connectivity of over 11,000 chillers through OpenBlue, representing a 79% increase year-over-year. Moving on to slide 5. Our digital service journey has accelerated since we launched our innovative OpenBlue platform in fiscal 2021.
At that time, we entered the first phase of our digital transformation with a focus on enhancing data mining capabilities. Over fiscal 2022, we launched the OpenBlue Gateway, enabling data access at scale and increased connectivity across our growing installed base. We are now positioned for the next phase of our journey as we standardize our field operations globally. Linking the benefits of real-time monitoring of connected devices to our extensive service network, we can provide our customers with faster response times while optimizing the deployment of our global field service presence. We are beginning to see the results of our digital offerings enabling service growth. During the first quarter, service orders and revenue grew 10% year-over-year.
With continued growth, we are in a great position to reach the goal we set out at our Investor Day in fiscal 2021 to capture $2 billion in additional service revenue by 2024. On to slide 6. With nearly 40% of the world's carbon emissions coming from commercial and industrial buildings, the goal of achieving net zero starts at the building level. Through our vast sustainable infrastructure partnership ecosystem, we play an integral role in helping our customers achieve these targets no matter where they are in their decarbonization journey. Starting with our established advisory services and goal-setting partnerships with KPMG and Accenture, we help customers take the first step to accelerate and solve their decarbonization and efficiency goals. We are also able to help fast-track our customers' net zero targets through carbon reduction services, collaborating with leading renewable energy supply and distributed energy providers.
With our comprehensive customer solutions and strategic partnerships, we are positioned to take full advantage of favorable regulatory tailwinds and continued momentum. During Q1, we realized over $200 million in organic revenue, growing over 20% year-over-year, with orders over the last 12 months growing at 6%. Turning to slide 7. The Healthy Buildings opportunity remains attractive as our customers invest in indoor environmental quality improvements post-COVID. Solving for the indoor air quality and energy consumption challenges of hybrid work models is driving a compelling intersection of our Healthy Buildings and sustainability strategic growth vectors. We are in a leadership position, thanks to OpenBlue Indoor Air Quality as a Service, which continued to gain momentum in Q1, as well as our leading IAQ and space management capabilities in OpenBlue Enterprise Manager.
In our Healthy Buildings business, trailing 12-month orders increased 11% year-over-year. Our pipeline of $1.2 billion remains strong. Looking forward, we expect continued growth momentum as the value of indoor environmental quality improvements delivers benefits for our customers. On to slide 8. We are honored to be continually recognized for our dedicated sustainability efforts. Among other honorable recognitions, two of Johnson Controls leaders were awarded for their efforts. Chief Sustainability Officer Katie McGinty was named one of 2022's Most Influential Women Executives for Sustainability Leadership by WOMEN Inc. Magazine. Anu Rathinde, President of Asia Pacific, received the ESG Exploration Character of the Year from the 2022 ESG Pioneer 60 Awards by Jiemian. I am proud of our team for leading by example and executing on our values.
I will now turn the call over to Olivier to go through the financial details of the quarter. Olivier?
Thanks, George. Good morning, everyone. Let me start with the summary on slide 9. Total sales grew 4% with organic sales increasing 9%, comprised of 10% price and a modest volume decline. FX was a 6% headwind during the quarter. We saw strong performance across our longer cycle field businesses, which grew 10% in a quarter. Our shorter cycle global products business grew sales 7% impacted by a slowdown in residential demand. Adjusted Segment EBITA increased 15% with margins expanding 140 basis points to 13.7%. Positive price cost and improved productivity more than offset unfavorable business mix. Adjusted EPS of $0.67 was at the high end of our guidance and increased 24% year-over-year. During the quarter, we absorbed an additional $0.01 of FX headwinds versus the prior guide.
Free cash flow returned to the normal seasonal pattern with the usage to start the year. Inventory levels were impacted by softness in residential as well as continued supply chain disruptions, which, while improving, impacted our ability to satisfy growing demand in commercial. Turning to our EPS bridge on slide 10. Overall, operations contributed $0.19 versus the prior year, including an $0.11 benefit from our productivity programs, for which we are on track to meet our targeted savings for the year. In the quarter, FX was a $0.04 headwind. Below the line, higher net financing charges and corporate expense were offset by a lower share count and favorable non-controlling interest. Please turn to slide 11. Total orders for our field businesses increased 5%. As George stated earlier, orders in the quarter were affected by timing and COVID-related impacts in China.
Order timing had the largest impact within our in-store business, which grew 1% in the quarter. We were encouraged by 10% order growth in our service business, driven by double-digit growth in both EMEA and APAC. Feedback log remains at record levels, growing 11% to $11.3 billion, an $800 million increase versus the prior year, while growing $250 million sequentially. Our global products third-party backlog grew more than 30% over the prior year to $2.8 billion. Let's now discuss our segment results in more details on slides 12 and 13. Sales in North America were up 10% organically with broad-based growth across the portfolio. Our in-store business grew 12% with low double-digit growth in both retrofit and new construction.
Overall, HVAC and controls continues to gain momentum, growing mid-teens year-over-year, while fire and security increased high single digits. Order timing mainly impacted North America as orders increased 6% with solid growth of 7% in our service business. New construction orders grew over 50%, primarily in HVAC. In aggregate, fire and security orders grew low single digits. Total backlog ended the quarter at $7.5 billion, up 16% year-over-year. Segment margins decreased 30 basis points year-over-year to 11.3% as positive price cost and ongoing productivity benefits were offset by unfavorable project mix. Sales in MILA grew 12% organically with strong performance in applied commercial HVAC and fire and security. Our service-based business was strong in the quarter, growing mid-teens year-over-year with recurring revenue contributing low double-digit growth.
Orders were up 5%, led by over 20% growth across our fire and security platforms, which was partially offset by declines in HVAC and industrial refrigeration. Backlog was up 5% year-over-year to $2.2 billion. Segment EBITA margins declined 310 basis points to 7.7% as a result of unfavorable mix and dilutive price cost, which offset favorable volume leverage and the benefits of cost savings during the quarter. Sales in Asia Pacific increased 7%, driven by mid-single-digit growth in our commercial HVAC and controls platform. Service performed well in the quarter, growing low double digits, benefiting from our shorter cycle transactional business, primarily in HVAC and controls. China grew 1% in the quarter, impacted by COVID-induced lockdowns. As China continues to reopen, we are encouraged with the momentum building within the region.
Orders declined 1% as low double-digit growth in service was offset by a decline in HVAC and controls installation. Overall, in-store orders declined 5% organically. Backlog of $1.6 billion declined 1% year-over-year. Segment EBITA margins increased 40 basis points to 10.5%, driven by positive price cost and productivity savings, which offset lower volumes and FX headwinds over the quarter. Sales in our shorter cycle products business increased 7% in the quarter, benefiting from strong price realization of 11%. Commercial HVAC product sales were up low double digits with strength in light commercial, driven by over 20% growth in North America and MILA respectively. Applied HVAC sales were up low double digits with continued demand in Chile within our data center end market. Outside of North America, our global residential HVAC sales were up low single digits.
North America resi HVAC declined 20% as the overall market softened, and we were challenged by unfavorable product mix in the channel. Our HVAC business grew mid-single digits, led by more than 25% growth in applied within EMEALA, as well as strong demand from our Hitachi commercial heat pump in EMEA. Fire and security products grew high single digits in aggregate, led by continued demand in North America and in the Middle East for our fire detection products. EBITA margins expanded 580 basis points to 20.3%, driven by positive price cost and the benefit of productivity savings. Turning to our balance sheet and cash flow on slide 14.
We ended Q1 with $1.5 billion in available cash and net debt at 2.2x, which is within our target range of 2x-2.5x. Let's discuss our fiscal 2023 guidance on slide 15. We were pleased with our start of the year and are encouraged by the continued strength and resilience in our order and backlog. Our backlog grew double digits and remains at record level. We are providing Q2 organic sales guidance of approximately 10% growth, with price being the principal contributor. Segment EBITA margin is expected to expand 100-110 basis points, and adjusted EPS is an expected range of $0.72-$0.74, which represents year-over-year growth of 15%-18%.
On a full year basis, we're raising the lower end of the wide range we introduced to beginning the year. While we are encouraged with our strong start to the year and our current second quarter outlook, we continue to take a cautious outlook for the full year given the ongoing macroeconomic uncertainty. Our full year adjusted EPS guidance range of $3.30-$3.60 represent growth of 10%-20%. The top third of our EPS range signifies our base case scenario. This account for normalized GDP growth, continued growth vectors acceleration, and conversion of our existing backlog. The low end of this range provides a bookend reflecting a potential macro downside scenario, which accounts for a potential degradation of global GDP that we believe will be offset by our resilient services and commercial market presence, along with additional cost mitigation actions.
On the top line, we anticipate high single digit to low double digit organic growth, with price representing about 10%. We anticipate Segment EBITA margin expansion of 90-120 basis points as we continue to execute our higher booked margin backlog throughout the fiscal year. Full year free cash flow conversion is expected to be between 80%-90%. Operationally, we continue to improve our working capital management and expect further improvements from the gradual reduction of inventories as the supply chain normalizes. As George mentioned, we are pleased with the strong start to the fiscal year. Whilst supply chain disruptions continue to impact our global products business, we see positive momentum in our field-based services.
Across our vectors of growth, our pipeline remains robust and we are well positioned to capture secular tailwinds while continuing to improve our operational execution as we navigate through the first half of the fiscal year. With that, operator, please open up the lines for questions.
If you would like to ask a question, please press star one, unmute your phone and record your name clearly. If you would like to withdraw a question, please press star two. Again, to ask a question, please press star one. In respect of time, we ask that you limit yourself to one question and one follow-up question. Our first question is gonna come from Nigel Coe from Wolfe Research. Nigel, your line is open.
Thanks, good morning, everyone.
Good morning, Nigel.
Hi, guys. Yeah, you mentioned, you know, field timing for field orders, coming in at +1%. Maybe just can you just like double click on what's causing some of the delays that perhaps you didn't expect. China, I think I understand, but, you know, outside of China.
When you look at our field orders, you know what is encouraging, although the install was up 1%, services was up over 10%, and we're very encouraged with the progress we're making there, Nigel. On the install side, it's mainly a couple of factors here that impacted us here in the quarter. It was the China COVID lockdowns. We have a incredible pipeline, but because of the disruption and ultimately the delay in getting those closed, impacted us in the quarter, and that's 1%-2%. Then in our project-based business, as we now drive our vectors of growth, you know, around sustainability and healthy buildings, there's larger projects and a lot of these, it's hard to predict the timing of conversion.
That amounted to another roughly 1%-2%. Those are the key drivers as far as the orders, field orders. Nigel, the backlog is up over 11%. The pipeline continues to be strong double digits in our conversion. As we're now executing on the strategy, we are encouraged that our conversion is gonna continue very strong here in Q2 and beyond for the year. Now the way that we've been set up here with the backlog, being up for the year, really does give us a lot of confidence in our ability to be able to deliver on the guide that we provided for the full year.
Great. Thanks, George. My follow-up question is on, you know, the margin expansion for the full year. You've raised the bottom end by 10 basis points. I'm curious, you know, has the mix between the segments changed? I'm referring here to the obviously the strength we saw in global products, the weakness we saw in EMEA, LA. Just wondering if the mix of that margin expansion has changed at all.
We're making tremendous progress on our margins, it's not only, you know, this has been over the last couple of years, instilling a discipline around price cost and more important about the value propositions that we're bringing to the market with our vectors of growth. You see that not only in our shorter cycle business with our global products and the strength that we're having in margins that's combined not only the value proposition, but now also the additional productivity that's playing through and the leverage that we're getting on that. As we project the current year, we're gonna continue, you're gonna see momentum in margins, you know, because the longer cycle business, we've got strong margins in backlog.
As we increase the velocity on the turn of these projects, you're gonna start to see much stronger margins come through on the rest of the year. Olivier, maybe you can comment on the segments.
Absolutely. One clarifying point on the orders. We expect as a an impact on orders due to the move of the orders from Q1 to Q2, orders in the field to be high single digits in Q2.
Regarding the margin, we expect global product margin to remain strong for the rest of the year, and we expect the field margin to turn positive in Q2, probably about 51-100 basis points at the Segment EBITA level and increase thereafter, significantly with a strong increase as we end the year, Nigel, in the field business.
Great. That's very helpful. Thank you.
Our next question comes from Joe Ritchie from Goldman Sachs. Joe, your line is open.
Thanks. Good morning, everyone.
Morning, Joe.
Olivier, I wanna pick up off that last point on field margins improving. You guys called out unfavorable mix both in North America and EMELA. I wanna understand that a little bit better. Specifically on North America, yeah, I know that you guys saw the sequential improvement last quarter, but the margins now have been down year-over-year for the last 7 quarters. Just help us understand what's driving the confidence in those margins getting better from here. What was the issue with unfavorable mix that was coming through the field business this quarter?
It would be from a project to projects mix or larger projects flowing through in the quarter. If you look at the high level and we have discussed that, Joe, before, we have booked orders at a higher level of margin all through last year, those orders are now starting to flow through to the field business. As indicated to Nigel earlier, we expect the field margin to improve at a Segment EBITA level in Q2 by 50 to 100 basis points and keep increasing thereafter. That would include also our North America business. The expectations for the margin increase in Segment EBITA level for North America in Q2 is expected the increase to be over a full point.
As we keep converting the backlog, which is at a higher margin, as we keep delivering our productivity initiatives, as we keep increasing the mix of our service business in our company, which was very strong in Q1, we expect this momentum to continue in Q2. You will see the field margin business to increase, I would say materially between Q1 and Q4, Joe.
Okay. That's good, it's good to hear. I don't usually ask questions on North America resi business 'cause it's a small portion of the overall portfolio. It was pretty interesting to see that business down 20%. I think you guys called out product mix in the channel. Maybe provide a little bit more color what's happening there 'cause that seems to be a little bit lower than what we've seen reported so far from some of your peers.
When you look at our North America resi ducted business, when you look at the overall market, it's down in units, you know, in the teens. We're down more than that, and it's really two big factors here. This is where we've had, coming into the year, we still had continued supply chain disruptions. We also had the launch of our new product, the 2023 product. We worked through that. We worked through the supply chain. Although we were down further in units, we had strong pricing coming through. You know, we worked with our distributors. There's another key point to make. On our field direct channel, which is a small portion of our distribution, we were actually up 13%.
That's similar to what others have seen. On the distribution side, we've worked with our distributors in making sure that now, as we have continued to improve our supply chain through the quarter, that we're gonna be positioned to be able to deliver on their expectations from a demand standpoint as we now go through the rest of the year. When you look at the rest of the year, we are projecting that the market will be down, you know, high single digits in units. There'll be continued strong pricing coming through, and we'll be in line with the industry. We believe that now with our recovery of the supply chain, we actually start to pick up some of the share that we had lost over the last year due to the supply chain.
Got it. Very helpful. Thank you.
Thank you, Joe.
Our next question comes from Steve Tusa, J.P. Morgan. Steve, your line is open.
Hey, guys. Good morning.
Morning, Steve.
Morning.
If I look at, roughly kind of the 350 or so, where consensus is, it implies we're using the midpoint of your guidance about, you know, $2.00, $2.10 or so of earnings in the second half. That's about $1.00 per quarter by my math. Do you is that kind of the right type of seasonality? Would you expect fourth quarter to be above third quarter, and how materially above? Maybe just give us a little bit of a, little more color on how the third and the fourth quarters break out EPS-wise.
Yeah, at the high level, Steve, when we look at our build for the year, we're in a very different place this year than we were last, as we're now continuing to accelerate our capacity expansion across our, you know, our product-based businesses. We've seen a nice ramp, for instance, in our applied businesses. In some cases, we're expanding capacity 2 or 3x , and we're starting to see that volume come through. We have worked with our supply chain, so we're very much aligned now going into our seasonal ramp, as well as the recovery of our backlog to be able to begin to accelerate here in Q2, and that'll continue through the seasonality that we see in Q3 and Q4.
We're in a very different place than we were a year ago, in being able to execute on that ramp. I'm very encouraged with the work that we've done, especially across our applied business where, you know, from a core strength, that is our strength, and we're beginning to see that pick up across the board. Olivier, I don't know if you've got any.
No, not much more to add. The backlog conversion now is going to have its full impact. It will be very strong from Q2 onwards. The productivity initiatives are still well on track. We are identifying new productivity initiatives all through the year. The backlog is very resilient. Our service mix is very strong, accelerating significantly across the portfolio. We see margin expansion clearly in the second half, Steve.
Like $1 around the right number for 3Q, and then it kind of, you know, steps up a bit from there? Is it, you know, more fourth quarter weighted? Maybe just a little more precision to get people in line.
Roughly, you're in the ballpark, Steve, indeed.
Okay. One, just one last one on non-res, activity. You said that things are, you know, you expect things to pick up here. What are you seeing in January on that front? I assume you're seeing some positive things. What's, you know, the latest outlook on how things trend, in the back half of the calendar year?
When we look at our, you know, our pipeline, and we track our pipeline very closely, especially as it relates to all of the, our growth vectors and then the overall general market. When you look at the Dodge number, and, you know, when you look at that growth, you know, we are lagging that. We're seeing significant opportunity there as that plays through. We are watching the ABI, which is longer term, you know, from projects that are coming to market. It did soften in November. It did come back and stabilize in December.
For us, and then when you look at our mix of our businesses, with the demand for our core applied business, when we look at our chillers, when you look at industrial refrigeration, you look at our data center offerings. Across our supply, across that portfolio, we're seeing incredible demand. We're working to make sure that we're executing on the capacity expansions that we made, that we started over 1 year ago to be positioned to be able to support that demand, and we're making good progress, Steve. From a non-res, as far as our mix and where we see our strength to be, we see continued very strong activity, building on the pipeline.
Great. Thanks a lot.
Thank you.
Our next question comes from Julian Mitchell from Barclays. Julian, your line is open.
Hi, good morning. maybe I just.
Julian.
Good morning. I just wanted to start off perhaps with the inventory and the cash flow, 'cause I think the inventory was up, you know, about $400 million sequentially. It seems like it's a mix of kind of too much supply and too little demand in things like resi and then, too much demand and too little supply in some other areas like commercial HVAC. Maybe just help us understand kind of what's going on in that inventory balance. What does that mean for the pace at which free cash flow improves over the balance of the year? You know, do you think free cash flow can be up year-on-year in the current second quarter, or it's more of a sort of second half recovery on cash?
If you look at, first of all, the full guide, it's unchanged 80%-90% free cash flow for the full year. If you look at the seasonality of your question, we believe we're going to go back to historical free cash flow generation seasonality. That means that we should be, year to date at the end of Q2, close to break even from a free cash flow standpoint. You can infer from that we should be positive in Q4, in Q2, I'm sorry. Break even year to date at the end of Q2, positive in Q2. You're right, inventory was the key variable explaining what happened in free cash flow in Q1. Largely, George covered that, resi and some mismatch of inventory is what is explaining this trend.
We believe that this is going to keep improving all through the year. We have detailed action in place. We believe that breaking even after the first half is an achievable goal from a free cash flow standpoint.
Julian, just to add to that, as you look at our commercial applied business, in many product lines, we're doubling and in some cases tripling. We're in the process of building up and being able to achieve that output through the course of the year. We're in a build, and we're making good progress on the applied business. When you look at our total applied business, with what we do externally as well as internally, it's up very strong here in the first quarter. The second is what Olivier said as we work through the residential disruption that really comes down to one plant supporting our residential business with the disruption that we had really coming into the quarter.
We've worked through that. We're positioned to adjust given the mismatch we had. We've lined out with our distributors relative to what they expect. We have confidence that that's gonna normalize here over the next quarter or two.
Thanks very much. I just wanted to circle back to the North America field business again. You know, 'cause you've had, I think 7 quarters now of down margins year-over-year. The Q1 margin was 200 points lower than it was 2 years ago. I think you'd mentioned mix as a headwind specifically in the 1st quarter, but clearly there have been issues, you know, predating that, pulling down the margin. It seems like it's taken longer than you'd expected to get that North America field margin to turn the corner. You know, I think clearly the guide embeds an improvement there, you know, getting to that $1 of EPS, for example, in Q3.
maybe give us a bit more color on what you're doing kind of inside that organization to get the margins to turn around, and how much of the improvement in margin is that internal self-help versus, getting some sort of macro or supplier, benefits?
Let me touch on that, then I'll turn it over to Olivier. When you look at the turn, what we've booked over the last, it's really been the last year, 15 months, what's been turning some of the longer cycle projects that are turning now, and you look at what's gonna turn second, third and fourth quarter, a much higher mix, Julian, relative to what, you know, the margin that we booked into the backlog. That margin is tied to much greater value propositions and then ultimately an installed base that's gonna spin off service. We're going through the last of the tail that was prior to this inflationary period of projects that are still coming through.
I have confidence that when we look at how we've been building these projects, costing and then ultimately executing, you're gonna start to see a nice pickup in margins. Then the other factor is that the velocity of our turn, because of the improvement in the supply chain, you'll start to see much higher productivity because the velocity of being able to turn these projects more consistently as we work through the year. Those are the two big factors. Olivier, maybe you comment on the margin rate.
Absolutely. As a byproduct of this, the speed of the backlog conversion, we will see, as I indicated earlier, Julian, margin expansion. I can go a bit more into the details of the numbers here. Probably in Q2, we will expect Segment EBITDA margin to increase close to a full point. Today, for Q3, we are planning actually close to a 4 points margin improvement in this business, not assuming a significant change in turn rates of the backlog.
Great. Thank you.
Our next question comes from Scott Davis from Melius Research. Scott, your line is open.
Hi. Good morning, George and Olivier, and welcome Jim-
Thanks, Scott.
to the call, and our world again here. Guys, I think that the story really this cycle has been about pricing power. You know, I'm kinda curious to see as demand kind of flattens out here and maybe some of the big COVID drivers kind of anniversary. What's your confidence that price is something that you can continue to capture? I don't really mean in your backlog. What's in the backlog is in the backlog, I suppose. In forward contracts, you start to think about, you know, back half of 2023 and into 2024.
Yeah, Scott, I, you know, as we look at what we've done as we've been executing on the strategy that we outlined a couple of years back, and where we are in that journey, it's really now capitalizing on a much bigger value proposition as we focus on our vectors of growth. That's not only in how we pull together our combined capabilities within our products, but now with OpenBlue and ultimately are creating solutions that deliver on an outcome for our customers. The outcome is typically focused on energy reduction, obviously heightened indoor environmental quality, and then ultimately leading to an autonomous building. As we focused on our core, then when you look at the contribution that our HVAC business has to being able to achieve those outcomes, it is significant.
The value proposition comes with being able to create a solution that's very different than what historically has been provided, leveraging our technology, and then being able to really leverage the core in how we ultimately deliver on that with the technology that we have in our products. We're confident that when you look at how we're pricing today with the value proposition we bring and the new products that we're bringing to market, our new product investment is up about 20, 25, 28% year-on-year. We've got the leading portfolio in heat pumps. You know, heat pumps now today are gonna be a big part of the solution in being able to reduce energy while we're, you know, continuing to enhance the indoor air quality.
We have new heat pumps pretty much across the board where that technology is being applied, you know, across our entire portfolio from the most complex industrial applications with our chillers and industrial refrigeration across all of our commercial products, rooftops, as well as our applied air-cooled chillers going into data centers and then across our residential portfolio. I'm confident that with the technology, the value proposition, and then our ability to fundamentally change how we serve our customers with solutions that focus on outputs, on delivering for them, we're seeing significant momentum on that.
That's helpful, George. When you break... I mean, it certainly makes a ton of sense in HVAC. When you think about fire and security, how has that sales pitch kinda changed over the last few years? I mean, I certainly understand the connected building, how specifically has that value proposition, I guess, which is so tangible in HVAC, but perhaps less so in fire and security, if you can update us there. Thanks.
Yeah. The way that we've leveraged our fire and security portfolio, you know, today it's still very attractive. It's still 40% of our revenues. It's core to building systems. On the digital side, they are critical systems that do integrate with an overall smart building. Because of the sensors that these systems bring into the building, very important for the data that we collect within OpenBlue in how we ultimately create a smart building. It starts there. Now, you would argue that it's more around the security systems.
Whether it be access control, intrusion, or video, those are very important sensors and systems that historically have been separate and apart, but then ultimately converge with our building controls and the other digital systems within the building that with now with OpenBlue, we can bridge all of those systems into one solution, into one data set. It starts there. From a fire standpoint, that when we install a fire system, that the value proposition that we bring through service is significant in our ability to be able to connect and monitor and ultimately be very proactive in how we support our customers through service.
those are the two, when you think about fire and security, the value proposition that it has into the solution set that we're building and ultimately differentiating the outputs that we can create for the customers that we serve, Scott.
Okay. Makes sense. Best of luck, guys, for 2023. I'll pass it on.
Thank you, Scott.
Our next question comes from Noah Kaye, from Oppenheimer. Noah, your line is open.
Good morning. Thanks. Maybe circling back to supply chain health. Can you give us a little bit of a better sense of what you saw across the business lines during the quarter, particularly in global products? Maybe quantify any impact on how much revenue was pushed, and then just your line of sight on the supply chain helping that, improving pace of backlog conversion.
Yeah. Looking at our global products, when you look at the impact that we had, and I think the other point to make here on our global products volume, we had a fire in a warehouse within our fire suppression business. It impacted the finished goods that we had stored. Although we worked to try to recover that in the quarter, that impacted our growth rate, you know, at the product level, about 2% or 3%. That is a big factor. We're gonna recover that volume here in the second quarter and most of it in the second quarter, but maybe into the third quarter. It's worthy to mention that. The resi demand hit us for another roughly 1%-2%.
When we look at China. We're significantly ramping up our applied businesses. When you look at our applied mix, we're up double digits across the board. We're confident that with the capacity expansion, with the work that we've done with our supply base and making sure we have visibility to the volumes as we ramp, like I said earlier, you know, in some cases we're doubling or tripling our volumes in our applied space. You know, I'm confident that, you know, although. When you look at our total product units, we're relatively flat because some of the units do go into our direct channel solutions. We're gonna be ramping here. We're gonna deliver, you know, unit growth here as we, as we position for Q2.
That'll continue to expand as we go through Q3 and Q4. Those are the key factors that, Noah, that have been impacting our ability to be able to turn.
Okay. Very helpful. Then just wanted to circle back to orders timing. Maybe we can focus particularly on sustainability. You know, we look at the pipeline growing, was it 26%, versus the orders growth in the quarter. You know, we've obviously had a lot of significant relevant, you know, legislation and policy. How much of this is, you know, that playing into the actual timing as, you know, clients figure out the implications? Are we waiting for things like treasury guidance before more folks sign? You know, is there any kind of unexpected air pocket here, or, you know, do you expect that conversion to significantly increase in the next quarter or two?
We're expecting that this is gonna continue to significantly increase. When you look at the IRA, there's $369 billion in incentives over the next 10 years. We believe it's all focused on electrification, which we deliver through heat pumps. It's focused on impact on grid capacity and generation, which we do incorporate renewable supply into our solutions, just the overall energy efficiency. This is right in our sweet spot. We think that the $369 actually multiplies by 5 to 10x , given the amount of resource that'll be put to work in being able to deliver on our customers' sustainability goals. When you look at the pipeline that we're working to convert, it's well over $7 billion.
We had, you know, last year that had ramped up to about $1 billion. Last year, we see that accelerating over the course of the year. These are larger projects, so it's hard to predict the timing of conversion. Our teams, we've got the team on the field that with the depth and expertise. I think that fundamentally changes how we can go about serving our customers with the type of solutions that we're developing. All of that is delivered. When you think about the optimal solution, it's not just the equipment, because we have leadership equipment, we're developing, you know, a leadership portfolio of heat pumps, but it's how the equipment comes together with our digital platform that ultimately delivers on our customers' expectations.
That's what's gonna, I think, differentiate us, Noah, as we build, not only build the pipeline, but begin to convert, and capitalize on the opportunity ahead. Just one last note in Europe. It's similar in Europe. I mean, we talk about the IRA, but we've been working very closely with the EU, with a number of their strategies, you know, the Green Deal, net zero by 2050. They've got the EU-level legislation around. They got Climate Law. They got, you know, an Energy Performance of Buildings initiative, and then more recently, it was the REPowerEU, you know, focusing on the independence from Russian fossil fuels. All of these activities, we've been aligned, working and making sure we're aligned so that we're gonna be positioned to ultimately achieve the goals that they're setting out to achieve.
That's very helpful, color. I'll correct myself, that healthy buildings pipeline was up 26% and sustainability up 20%. Thank you for the color.
Thank you, Noah.
Our next question comes from Jeff Sprague from Vertical Research. Jeff, your line is open.
Hey, thank you. Good morning, everyone.
Hey, Jeff.
Hey.
I just wanted to actually come back to, I guess, a couple topics that have already been addressed, but just to really kinda clarify. First, just on the notion of margins improving on kind of acceleration of execution out of the backlog. It doesn't seem like that's what you're guiding. I don't know if you updated the volume forecast for the year, but I guess your guide sort of assumes kinda little or no volume growth. I guess the first question is it that you expect acceleration to happen, but you're not quite willing to guide that way yet? Or is there, you know, some governing factor, supply chain, labor on the job sites, that sort of thing, you know, that you're looking to get past first?
If you look at the margin acceleration, which is a by-product of the backlog conversion, as you said, Jeff, that has it's not really a variable associated with unit volumes. If you look at the field business, which is about $16 billion of revenue for the enterprise, this is more and more a business which is solution-based, where units are less and less a relevant measure. Solution because we sell services, we sell sustainability, we sell Indoor Air Quality. The margin acceleration is a by-product of just the conversion, and we are planning, to your point, for volume to be growing, low single digits, about 2% for the back half of the year.
Right. Then.
Just a comment on that. A comment on that, Jeff. As we have instituted, you know, over the last two years, the significant improvement in our ability to strategically price and then make sure that we're, within that pricing, we're incorporating, you know, future inflation. As we're costing in these longer cycle projects, making sure we have the right costs and the right terms and conditions and the like, that has significantly improved. When we look at what's gonna turn the next three quarters, a high percentage of the projects that are gonna turn are in backlog. The margin is as we have been working through the older backlog that was priced prior to the inflationary period, that is becoming less and less.
We're confident that what's in the margin and backlog is a significant step up. Now it's just our ability to be able to, you know, minimize disruption, get more precise relative to the material flows that support these projects. By doing so, we accelerate the velocity of the turn. What that does, it gives us higher productivity, and then also, you know, from an inventory standpoint, our ability to be able to recognize revenue with the execution on a shorter cycle. That's a big element. I think, you know, we're cautious relative to the continued improvement that we're seeing in those factors, but we're confident that the margins that have been booked are gonna turn in turn and be significantly improved over the course of the year.
You know, thanks for that, and that partially addresses my second question. I did wanna come back to kind of projects and mix. You know, you pointed to kind of large projects being mixed negative in the quarter, and I think a lot of the kind of OpenBlue healthy buildings, you know, indoor air would inherently often be larger projects. Is it an issue that the stuff that's coming through the backlog is also, as you say, maybe wasn't priced appropriately for the inflation that was coming, but also just inherently had, you know, less of the newer stuff embedded in it? Really wanna kind of understand if we're waiting on big projects to come through that. In fact, when we convert them, their margin accreted to the equation.
No, I mean, it's actually the opposite, Jeff. When you look at our cores, we have focused our field-based business on our strategy to really differentiate and capitalize on the growth vectors, which is ultimately, you know, the energy reduction, the healthy environment and then overall automation of building. Making sure that everything we do is deploying our core capability, core technology, getting it connected, and then ultimately converting it to a service. By doing so, it has, you know, refocused the business so that the value proposition's greater with what we do. Taking out a lot of the historical contracting that we might have done that ultimately was low margin and didn't convert to services, is a much higher focus on leveraging our core.
Obviously leveraging digital, then ultimately delivering on outcomes that historically hadn't been achieved. I think from that standpoint, when you look at our applied product business, we're up, you know, it's up double-digit with the applied products flowing into our channel. Ultimately is helping us create a bigger installed base. It's also getting the connectivity to that base, which then drives us to be able to create new value propositions with the data that ultimately we use from that installed base.
Great. Thanks for the color. Appreciate it.
Sure. Jeff.
Our next question comes from Nicole DeBlase from Deutsche Bank. Nicole, your line is open.
Yeah, thanks for taking my question. Good morning, guys.
Good morning.
I just kind of wanted to pick off where Jeff just left off because I'm not sure I'm totally getting it. I mean, if we think about, it seems like unfavorable mix was the big cause of the weaker margins in the field business this quarter, but it seems like you do have confidence that then unfavorable mix will not be a factor throughout the rest of the year. I guess what is the risk that larger projects come through again greater than you expected in the second quarter to the fourth quarter, driving then unfavorable mix again? That's the piece that I'm just not getting. Thank you.
Yeah. A simple, a simple fundamental is we track, you know, how we book and what was booked, you know, from a cost standpoint and how does that tie to the value proposition then how it turns. Nicole, when we talk about mix on a forward-looking basis, every quarter, you have less of the older projects that maybe didn't incorporate the higher inflationary rates that we now have experienced over the last 18 months or so. When we talk about mix, is part of that as well as our ability to be able to. Everything we've been booking from a strategy standpoint is more aligned to how we create an installed base and ultimately get a recurring revenue from that installed base with service.
That is when we talk about on a go-forward basis. That continues to improve, recognizing that we still have projects that will be turning that, you know, that didn't necessarily have that factored in.
Okay. Thanks, George. That's really helpful clarification. The second thing I just wanted to hit on is the global products margins have been really impressive and I think a big driver of, you know, upside or offset to field weakness for several quarters now. I guess, like, what's the confidence that you can continue to improve global products margins from here? At some point, do you kind of see, somewhat of a margin ceiling? Thanks.
Yeah, if you look at today, we believe we're going to be able to maintain the margin in global product and keep improving the margin in the field. I know, Nicole DeBlase, just to go back to your prior question on mix, the backlog conversion is the big variable for mix improvement more than anything else. We have a high confidence in that now happening with no improvement in lead time. Going back to your global margin question, you go back to what George Oliver has indicated. We are mainly exposed to the commercial market today in global products. Resi is a small proportion of our portfolio. In global products, we are investing heavily in heat pump. If you look at the new product introductions today, 90% of them are very strong heat pump capabilities.
We bought a small asset also in the quarter with Hybrid Energy AS. We believe that the channel, the strength of the portfolio, is going to keep allowing us to maintain a strong margin in global products. If you look at the macro, Nicole, today from a commercial standpoint, is still strong for commercial.
Thanks a lot, guys.
Our next question comes from Josh Pokrzywinski from Morgan Stanley. Josh, your line is open.
Hi. Good morning, guys.
Morning, Josh.
Just a follow-up. Yeah, good morning. Just to follow up on the IRA, wondering if that is something that you guys expect to start booking this year, and if we really don't expect to see any sort of shipments until 2024. Is that sort of the way you guys are thinking about the timing, booking start this year and maybe start to see the revenue benefit next year?
Yeah. I mean, we're, you know, obviously we're already working with customers and working through what this, what this means and how they go about it. You know, recognizing that we're obviously part of that, as this bill was formed. We're definitely gonna start to see some momentum here on the, on the order side. Depending on the timing, how that flows, through the, the year and into next, you know, we'll continue to keep you updated. This is ultimately helping to build the pipeline that we have and the confidence that we have in being able to, turn, not only book, but then turn sustainable, solutions here. It's across all of our portfolio, right from residential incentives right up through, you know, some of the more complex, offerings that we have.
Josh, this is where the field presence is very important. We have today a field presence allowing us to advise our customers.
About how to best leverage the benefits of the IRA.
Got it. Then just on maybe a little deeper trip into the weeds on the IRA. I think there's $5 a sq ft in commercial energy retrofit incentives. My understanding is some of the stuff like OpenBlue is significantly below that per sq ft. I guess, it seems sort of like a layup for customers. What would hold them back, if anything? Or is it just the industry, yourselves included, can only install products so fast?
Yeah, I mean, it's just purely, you know, there's an educational element that we're working through and understanding what it is, and then what we can do and how we can go about solving the problem and being able to capitalize on the incentives. Like, to your point, you know, the value proposition that we bring with the output that we can create, again, it becomes very attractive for the customer. It isn't a matter of that I think that they're gonna ultimately proceed. It's more just the timing of going through that initial upfront process in getting, you know, getting it defined and then ultimately being able to execute.
We're confident, Josh, with the solution set that we've built, that we're gonna be well positioned to be able to capitalize on the dollars that come into the market as a result of that.
Some of it is when you look at customers, it's also changing how they're thinking about whether it be capital or OpEx and how these business models are configured, and then, you know, how they match that to the benefits that they see. You know, we're working through that. We've got a team that's working directly with our customer base and sorting that out, but we're gonna start to see momentum that on that, both in the orders and then our ability to be able to convert.
All right. Thanks, I'll leave it there.
Thank you, Josh.
For our last question, we have Gautam Khanna from Cowen. Gautam, your line is open.
Hey, good morning, guys.
Morning.
Good morning.
Was wondering if you could talk about any differences you're seeing in the forward pipeline of, you know, order pipeline between fire and security and the applied HVAC market. I remember back when you had your investor day, you thought those markets would grow at a similar rate. Is that consistent with what you're seeing today?
On the fire and security, you know, we are seeing strength with the Dodge Construction Network and the activity coming through, and we're positioned well on that. On the more of the retrofit side, you know, we thrive from a service standpoint and how we upgrade and ultimately reconfigure indoor space and the like. We're seeing a lot of that given the hybrid work and how people are coming back to work. Those are the factors that drive fire and security. You know, we were up, both orders and revenue up, close to double-digit in both. Typically, a little bit lower growth rate than what we see in HVAC.
HVAC is really being driven by, you know, what we've discussed here or frequently here during today's call around, you know, the value proposition, not only with the efficiency that we bring within the new equipment, but, you know, the deployment of heat pumps, for instance. You know, we're in a situation where we've improved our technology with the temperatures that we can generate when you take a chiller and convert to a heat pump and then be able to replace a boiler, significantly reduces the carbon footprint for our customers. At the same time, you're getting 3 to 5 x the efficiency out of the unit. You get a tremendous payback.
It's through these models, Gautam, that as we begin to unleash, you know, what we believe to be a very attractive market and does play to our strengths, that it's gonna be a different demand, cycle than what historically we've seen in HVAC.
One statistic, Gautam, to complement what George has indicated. Our adjusted pipeline growth today is in the mid-teens, just reflecting what George has indicated.
Could you comment on your updated expectations for commodity inflation or deflation, I should say, this year, and if you could just also comment on lead times that you guys are quoting in the applied commercial HVAC space? Thank you.
Yeah. On the, on the inflation as it relates to commodities, we're watching that closely. Certainly, some of that has moderated. As they've moderated, other costs have continued to increase. That's something we're watching closely, and certainly wanna make sure that we stay disciplined with the impact that that might have. I think what's important to us now is that the business proposition here is that we're creating value not necessarily tied to purely price cost, as what, you know, historically we would have done. I think that's one factor. Then the second was on the applied. What was it?
The lead time commitment.
Oh, the lead times. As a result of the strong demand, you got to realize, Gautam, that as we've gone through the last year, we've had significant pickup in our backlog around applied. On a go forward basis, it's important that we get... You know, we've been building our capacity. We're expanding a number of our plants, and whether it be water-cooled chillers or air-cooled chillers or dust or refrigeration, our data centers, data center solutions. We're significantly increasing our capacity as we've been ramping up, and we've been doing this in line with the supply chain recovery that we've been executing on. With this backlog, we're trying to address the backlog so that we can open up capacity with shorter lead times to now be able to capitalize on what we see to be very strong demand going forward.
The lead times are being reduced. They're not to where we'd like them to be, but with the additional capacity we're putting online as we go through the year, we're gonna be positioned very competitively from a lead time to be able to respond ultimately and support the customer demand that we see.
Can you give us what the lead times are today? Is it like nine to 12 months? What are you thinking?
They vary, so it's hard to state any one, you know, depending on the right from the residential to the large commercial, you know. We've been reducing them significantly here over the last six months. We are now with the additional capacity coming on board, I would tell you our volumes in our applied business, you know, on a run rate basis with our chillers, and then our water-cooled chillers and our air-cooled chillers, we're looking at volumes on a run rate basis that are going to be 2 or 3x . As we're putting those, you know, that capacity in place, it does give us an opportunity on a forward-looking basis to reduce the lead times that we're quoting to our customers.
Thanks, guys.
Thanks, Gautam.
That was our final question for today. I will now turn the call back over to for final comment.
Yeah, I'd like to thank everyone once again for joining us on today's call. As we have discussed, we have a very strong start to the fiscal year. I'm very confident in our ability to execute and continue the momentum in the coming quarters, as we step, you know, really step up into the next phase of our digital transformation journey. With that, look forward to seeing many of you over the conferences over the next month or so. With that operator, that concludes our call.
That concludes the call. Thank you for participating. You may disconnect at this time.