Welcome to Johnson Controls Power Solutions Strategic Review conference call. Your lines have been placed on listen only until the question and answer session. To ask a question, you may press star one on your touch-tone phone, and in respect of time, we ask you to limit yourself to one question and one follow-up question. This conference is being recorded. If you have any objections, please disconnect at this time. I will turn the call over to Antonella Franzen, Vice President and Chief Investor Relations and Communications Officer. You may begin.
Good morning. Thank you for joining our conference call to discuss the outcome of our Power Solutions strategic review. The press release 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 discussions, and we ask that you read through the sections of our press release that address the use of these items.
Let me turn the call over to George.
Thanks, Antonella. Good morning, everyone. Thank you for joining us on the call today. As we mentioned last week, we were in the final stages of the Power Solutions strategic review. I am excited to announce that we have entered into an agreement to sell our Power Solutions business to Brookfield Business Partners for $13.2 billion. Starting with slide three, we began this process in March with the top priority of creating long-term shareholder value. When we looked at our portfolio, we saw two market-leading platforms within their respective industries that were navigating very different industry landscapes and challenges. Both have a unique set of strategic, financial, and operational opportunities and requirements and serve different end markets. Our Power Solutions business has built tremendous scale over the years, with leading market positions across the globe with a high-margin aftermarket model.
That said, the business is more capital intensive when compared to our buildings platform. Over the past several months, we assessed a number of potential options, including a sale, a spin, a structured transaction, or retaining the business, all with the purpose of creating shareholder value and the best long-term results for both of our businesses. Turning to slide four, let me get into the details of the transaction. The purchase price of $13.2 billion reflects an attractive valuation of Power Solutions that exceeds its value embedded within the broader JCI portfolio and market expectations. This valuation reflects Power Solutions' market-leading position and the bright future ahead for the business under new ownership. Net after-tax proceeds of $11.4 billion will provide us with additional financial flexibility to execute a shareholder-centric capital allocation strategy by paying down debt, returning capital to shareholders, and supporting optionality in our buildings business.
We anticipate allocating $3 billion-$3.5 billion of proceeds to debt paydown, enabling us to meet our target net debt levels of 2 to 2.5 times net debt to EBITDA and to retain our investment-grade credit ratings. The remaining proceeds will be available to return to shareholders. Following the close of the transaction, Johnson Controls will become a pure-play building technologies and solutions provider, ready to lead the integration and evolution of the connected building. With a more focused portfolio, we will be better positioned to capitalize on growth trends in the HVAC, fire and security, and integrated building management systems markets. We will drive improvements in free cash flow conversion, lower capital intensity, and continue margin improvement. In addition, this transaction increases our optionality to benefit from potential strategic opportunities in the HVAC industry. Turning to slide five.
As I said, this was a very attractive valuation of the business at 7.9x trailing 12-month EBITDA, a testament to the conviction of the potential for this business by Brookfield. As a reminder, in 2018, Power Solutions delivered $8 billion in sales and $1.68 billion in EBITDA. We estimate tax leakage of $1.1 billion, and we expect to reduce corporate costs by approximately $50 million. Given that we are divesting a material portion of our portfolio, the results of Power Solutions will be reported as discontinued operations beginning with the first quarter of fiscal 2019. We have provided recasted results this morning in an 8-K filing, and these are included in the appendix of the slides. We expect the transaction to close by June 30, 2019. We will provide more details regarding our plans for use of proceeds around that time.
Moving to slide six, let me walk you through an illustrative pro forma of our 2019 EPS. As we discussed with you last week, our EPS guidance range for 2019 was $2.90-$3.05. At the midpoint, this included an expected $1.28 of EPS from Power Solutions, which will now be reported as a discontinued operation. Excluding the $1.28 related to Power Solutions, our 2019 continuing operations earnings per share, before any use of the proceeds from the Power transaction, would be $1.65-$1.75. We will provide an update to our guidance on a continuing operations basis on our Q1 earnings call. Again, for illustrative purposes, in order to give you a sense of the impact of the potential use of proceeds, we are estimating accretion of approximately $0.75, which assumes full deployment of proceeds as if the transaction occurred at the beginning of the fiscal year.
As you can see, that would result in a pro forma EPS range of $2.40-$2.50, equating to net EPS dilution of 16%-20%. The stronger fundamentals of our Buildings business better positions us with our industrial peers. This decision is an important milestone in the transformation of Johnson Controls. As I mentioned on last week's call, we balance the potential for dilution with the right portfolio long term. This positions us with optionality in Buildings and allows us to continue strengthening our Buildings platform. On slide seven, you'll find an overview of our portfolio. The result is a pure-play Buildings technology company with a focused management team that is ready to drive significant long-term shareholder value. In fiscal 2018, Buildings delivered $23.4 billion in sales with a 13.2% adjusted segment EBITA margin.
As we discussed last week, we are targeting roughly $24 billion in sales in fiscal 2019, with 40 to 60 basis points of EBITA margin expansion. Our product mix is 36% products and 64% install and service combined. We have leadership positions in HVAC, in fire and security end markets, with a strong product portfolio and an unmatched direct channel footprint. As I've said, with a streamlined portfolio and renewed focus, we will drive improvements in free cash flow conversion, lower capital intensity, and continue margin expansion. We will also have greater financial flexibility. Before we open up the line for questions, I want to thank all of our employees at Power Solutions for their hard work and dedication throughout the strategic review process.
The interest we saw throughout the process is a testament to the strong prospects of the business going forward. We believe Brookfield will be the perfect partner for the future. With that, let me turn it over to our operator to open the line for questions.
Thank you. We will now begin the question and answer session. If you would like to ask a question, you may press star followed by the number 1. Please unmute your phone and record your name slowly and clearly when prompted. Your name is needed to introduce your question. To cancel your request, press star 2. Our first question comes from Gautam Khanna of Cowen and Company. You may now proceed.
Thank you. Good morning and congratulations.
Good morning, Gautam. Good morning, Gautam.
Just wanted to ask, George, you mentioned the debt paydown, but then left open, at least in the press release, the $7.9 billion-$8.4 billion for buybacks or other alternatives. I'm just curious, what type of role do you think acquisitions might play in the deployment of the roughly $8 billion of proceeds? You mentioned North American strategic transactions. I'm curious if you could just expand on what you mean by that.
Yeah. The way that we've modeled it here, Gautam, is when you look at the dilution, if we were to be able to buy back with the proceeds to offset the dilution, obviously that leaves us here with about 16%-18% dilution. That being said, we are focused on our Buildings platform. We remain focused on execution, making sure we're building off the momentum that we had in 2018. We think that there is a lot of speculation on the industry consolidation. As I said, we're staying focused on executing. We believe that we are uniquely positioned to participate given the strength and breadth of our product portfolio, as well as the incredible strength that we have with our direct channel.
Our approach here is that we want to do both, that we want to ultimately make sure that we're returning cash to our shareholders, and at the same time making sure that we're positioning the business for optionality within our Buildings business going forward.
Thanks, guys. Good luck.
Thanks.
Thank you. Our next question comes from Steve Tusa of J.P. Morgan. You may now proceed.
Hey, good morning. Congratulations.
Good morning, Steve. Good morning, Steve.
Hey, George. You just talked about kind of being able to participate in consolidation. Does that mean that you would be willing to go beyond just using the leftover proceeds after debt reduction, that's kind of as big as you would be willing to go? Would you be willing to re-lever the balance sheet for the right opportunity?
As I said, Steve, I think what this does for us is that we stay focused on executing, right? That's most important here as we continue to execute on our strategy in buildings. At the same time, making sure we're returning cash to our shareholders. We also want to make sure that if the right opportunity would present itself, that we would go through the appropriate due diligence process and make sure that we consider all options available. I would tell you that we'll stay very disciplined through this approach, and that as we have laid out, we're going to be positioned to not only return cash to our shareholders, but also make sure that we're positioned to participate in whatever consolidation that might happen, that I think this positions us well to be able to do just that.
Just to follow up on kind of the leftover financials. Any changes to kind of tax rate or anything below the line that kind of moves around here, and then also, with the divestiture of battery, and then also just on free cash flow. What kind of, on a continuing ops basis, using the kind of $1.65-$1.75, which I assume that's what you're talking about guiding to, you're going to adjust to that number. I would assume, when you change the guide, what kind of conversion would you expect on that number?
Yeah. The tax rate on a continuing ops basis will be roughly 15%-16%. As far as free cash flow on a continuing ops basis, Steve, that would be in the 95% level.
Okay. You're going to be guiding to the $1.65-$1.75 when you said you're going to change guidance? Will you incorporate some stub period for debt pay down or something like that?
Yeah. On our first quarter call, what we're trying to do on page six of the deck here is just to kind of lay out what continuing ops looks like prior to any application or deployment of the proceeds. We'll take into consideration the remaining portion of the year and the expected close date at the end of the first quarter when we provide that guidance. Yeah, you're correct. It would be off the $1.65-$1.75.
Okay. That's very helpful. Thanks a lot, guys.
Yeah. All right, Steve.
Thank you. Our next question comes from Jeff Sprague of Vertical Research Partners. Your line is now open.
Great. Thank you. Good morning.
Morning, Jeff.
Hey. Congrats. It's a very solid headline price. That leads me to my question. Is this a totally clean break? Are there any, I don't know, environmental liabilities or pension or some other liabilities that remain behind with JCI in the wake of this transaction?
Yeah. Jeff, the transaction is structured pretty much as a clean break. There are a couple areas, two of them you mentioned. There's a few sites from an environmental standpoint that we will retain, and there's also some pension liabilities that we'll retain as well, but those are not significant to the overall transaction value. Very few ongoing liabilities that we need to worry about.
Okay. Can you size those, Brian, at all? Are we talking hundreds of millions or less than that?
One moment please. Let me check. One moment.
Hello?
Please stand by. I think our main speaker got disconnected. One moment. Please stand by, participants. Hello?
Hello.
We can hear you.
We're back. Jeff is still there.
Jeff is still there.
I was always here.
I was wondering if you could size those at all. You're saying they're not significant, but are we talking tens of millions or hundreds of millions? Is there any kind of way to think about the liability that remains behind?
Yeah. I think the pension obligations and capital leases and asset retirement obligations and environmental, all those aggregate to $100 million or less. pretty small number relative to the size of the deal, Jeff Sprague.
Okay, great. Just one other follow-up from me. Then the corporate cost reduction is just a planned restructuring given the shrinkage of the company to get after other costs. Should we expect that to be something you can get after relatively quickly, or is there some other kind of color around that number we should be aware of?
Jeff, I would say that, working up to the transaction date and the separation of the business, there's a fair amount of effort that'll go into that. To be honest, I think the $50 million cost reduction in corporate is probably going to take place following the transaction. Certainly, we'll move as quick as we can, and I would think within 12 months we'd have those costs out.
Okay. Thank you.
Thanks.
Thank you. Our next question comes from Stephen Volkmann of UBS. Your line is now open.
Thanks. Good morning, congrats everybody.
Thank you
I know it was hard and long to get here, so that is great to see. Just a quick cleanup on that last question from Jeff. The $50 million, I know you said it will take a year. Is this representative of just a lot of Transition Service Agreements between the two companies still? Or to what extent are you still intertwined beyond closing?
Yeah. There will be some TSAs that will probably extend 12, maybe maximum 24 months. There are some level of costs that will just have to come out gradually as we move off those TSAs. If you think about it within the context of, in round numbers, our corporate cost number this year, I think ended up around $380, $390 million. We are talking about taking that down by $50 million or so, Steve.
Okay, that is helpful. You mentioned the 95% free cash flow target. This was always a point of skepticism for, I think, a lot of investors about how quickly you would be able to get there on the building side. Maybe just talk, George, also a little bit about where you are on that path and where you think you are headed, and the need for additional step-up in any particular areas that were maybe a little bit difficult while you still had Power. Just, I think that might help folks.
If you look at the 88% free cash flow conversion we had in 2018, that was roughly low 80s for Power Solutions and probably low 90s for the buildings business. From our perspective, when you look at continuing ops at buildings on a go-forward basis, we think something in the mid-90s is pretty achievable. The other thing I'd just point out is, as we've talked about in the past, we've got a joint venture with Hitachi that is a large joint venture of ours, and we have been in a position historically where our equity income from that joint venture, we are not getting 100% of the dividends out on that JV.
If we were to get to a point where we could get 100% of the dividends out on an annual basis versus our equity income, we would be at that 100% number pretty quick. I think 95% is a pretty good number on a run rate basis for buildings on a go-forward basis.
Steve, to your question relative to the progress we're making, as we updated everyone last week, we've made tremendous progress around our cash processes, and across all of our working capital metrics, we have accountability to the lowest level. I think you're beginning to see that now with the operational improvement. Your question, about how do I feel, I think we've got a lot of momentum, and we're going to be positioned here to be able to achieve what Brian laid out.
Okay, great. Thanks and congrats again.
Thanks.
Thanks.
Thank you. Our next question comes from Nigel Coe of Wolfe Research. Please proceed.
Good morning, everyone. This is Christian filling in for Nigel.
Hey, Christian.
Good morning.
Congrats on the deal. I know there was a bit of overhangs. It's good to kind of get past that. Just want to go back to the M&A talk. I know you guys are focused on execution, but can you maybe provide some color on what areas of buildings look attractive and what areas maybe look not so attractive? Thanks.
Hi, Christian. The focus that we've had is, we've got an incredible position in HVAC equipment, right from residential right up through the large applied systems. We continue to reinvest and make sure that we're in a position to lead and gain market share across each of the platforms. Within our building management systems, as we did this, the merger of JCI and Tyco, it positions us to be able to lead in the whole digital infrastructure within buildings. Having building controls, electronic fire, electronic security. Again, we're reinvesting truly to lead in that space. As we're looking at opportunities here, short term, it's been focusing on the execution organically with the reinvestment we're making, and then looking at bolt-ons that fill some of the gaps from a technology standpoint, as we execute on that strategy.
I don't want to speculate, but there's a lot of speculation on industry consolidation. All I would say is that as we're continuing to execute, that we are going to make sure that we're positioned in the right way to be able to capitalize on any consolidation that were to happen, because we believe that when you look at the strength and breadth of our portfolio from a technology and product standpoint, as well as our channel, that we're positioned extremely well. With the reinvestments we're making, we're beginning to see the growth coming from that. That's our overall strategy.
Got it, George. That's very helpful. If I could just squeeze one more in here. Just on the potential buyback, the $7 billion, $8 billion. Is there any way you might do a special dividend, instead of a buyback, or are you guys kind of focused on that allocation strategy? Thank you.
I think we'll just consider that along with the other options that we'll review as we move throughout the year. I think what we're trying to illustrate in the deck here is a number, an EPS number, that you'd get to assuming you could do all the buyback at a point in time. Obviously, that's going to take several quarters to do a buyback of that magnitude. A special dividend would be something we'd consider. As George mentioned, we're also going to consider the optionality that we have within the buildings space for portfolio moves. I think they'll all be on the table, and we'll just give more color on that as we move throughout the year.
Got it. Thanks so much.
Thank you. Our next question comes from Deane Dray of RBC Capital Markets. Please proceed.
Good morning, everyone. This is David Luan for Deane Dray.
Hey, good morning, David.
Morning, David.
Hey, congrats on the deal. I wanted to ask, is there any way that you would start the debt paydown or even the share buybacks a little earlier than the deal closing to kind of get a head start on that $0.75 of accretion potential?
Yeah. We are going to do the $1 billion in buyback that we mentioned on the call last week. We are going to move forward with that, probably on a 10b5-1 basis pro rata during the year. I guess the way I view that is it's a bit of a pull forward from the share repurchase that's shown in the deck here. I do think that we will continue down that path on the share repurchase that we talked about on our call last Thursday.
Got it. The debt paydown, would you be able to start that a bit sooner?
Probably not. I think, given our cash flows that Johnson Controls, as you probably know, early on in the first and second quarter, we tend to be ± break even to $300 million positive. Given that, and given the timing of this close, I think the debt paydown will probably take place at the time of its closing.
Got it. Then my follow-up is just on the capital intensity of the RemainCo . Out of the $1 billion of CapEx in 2018, how much of that was for buildings and how much was Power Solutions?
About one-third, two-thirds is the way to think about that. One-third Power Solutions and two-thirds buildings and corporate.
Great. Thank you very much.
Yeah.
Thank you. Our next question comes from Noah Kaye of Oppenheimer. Your line is now open.
Thanks, good morning. Maybe just a quick question or two on the mechanics of the transaction. Can you talk about some of the key puts and takes that stretches this closing out to June 30th? Can you give us some color on what you would expect for timing of the outflows for the tax bite on the deal?
Yeah. I think as far as the tax on the transaction, the number that's shown here of $1.1 billion are cash taxes that will be paid after the transaction closes. The other part of your question, I'm sorry, was what?
kind of walk through maybe some of the key regulatory milestones or other considerations that we should think about in terms of timing of the deal. Obviously, it's a large transaction, but just bringing this into June of next year.
I think we're pretty confident. Everything we know now, I would think that seven months is a pretty reasonable timeframe to get this transaction done. I think why does it take seven months? I guess when we did the Adient spin a couple of years ago, I guess we've got some experience in how long it takes to really stand up and separate a business or get it ready for sale. I think based upon our experience, as well as some tax planning that needs to be done in connection with the transaction, we think a period of about seven months makes sense. I don't think there's any big hurdles in our way, though.
Okay, thanks very much.
Thank you. Our last question comes from Joe Ritchie of Goldman Sachs. Please proceed.
Thank you. Congratulations, everyone.
Thanks, Joe.
Thanks, Joe.
Hey, Brian, maybe just following up on that last question. Just regionally, are there any potential issues, given that you have a pretty large presence in China in the Power Solutions business? Any kind of approvals that are necessary in that regard over the next few months?
None of significance that we think would impact the seven-month timeframe based upon the work we've done.
Okay, fair enough. Just going back to that question around the debt, are there any potential prepayment penalties for any of the debt that you plan to retire, the $3 billion-$3.5 billion?
Yeah, there are some make-whole payments on some of that debt, that number is going to be less than $100 million.
Okay, got it. We should think about the debt retirement going out to the 2020s, that'll probably be the tranche of debt. That and Tyco debt will be the debt that you guys end up paying back?
Still under review as to the specific debt pieces that we'll pay down. We can provide more color on that as we draw closer to the closing.
Okay, great. Thanks, guys.
Operator, I'd like to turn the call over to George for a closing comment.
Yeah, I just want to thank everyone for joining the call today on short notice. Certainly look forward to following up and talking to many of you in the near future. Again, have a great day, everyone.
Thank you.
Operator? That concludes our call.
Thank you. That concludes today's conference. Thank you all for joining. You may now disconnect.