Penn Wealth Publishing

2018.03.25 Penn Wealth Report Vol 6 Issue 01

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10 Penn Wealth rePort voluMe 6 issue 01 25 Mar 2018 Penn Wealth RePoRt Copyright 2018. All Rights Reserved. investMent intelligenCe Johnson Controls, PLC Engineering & Construction The content of this report reflects the per- sonal views, opinions, and research of Penn Wealth Publishing. While measures are taken to help assure the accuracy of data, no guarantees can be made and the firm is not liable for any losses incurred by subscrib- ers. This is not a solicitation to buy. Always consult your investment professional before investing any money. Opportunity cost: the loss of potential gain from other alternatives when one alternative is chosen. Take a look at the graph on the follow- ing page, showing the one-year return of Penn Global Leaders Club member Johnson Controls compared to the performance of its benchmark index, the S&P 500. It under- performed to the tune of roughly 30%. For a 12-month timespan, that is pretty lousy. (That being said, it could have been worse: GE investors watched as that stock under- performed the benchmark by more than 60%!)This disparity between JCI and the S&P, among other factors, has led us to reevaluate our position. With an improving economic outlook, both domestically and globally, we are over- weighting the engineering and construction industry. While we are doubtful that President Trump will get the $1 trillion public/private infrastructure investment he wants, infra- structure spending will, we believe, absolutely go up substantially over the next several years. And we believe JCI will be a beneficiary. Additionally, we like the automotive seg- ment going forward, and JCI is the world's leading provider of automotive batteries— producing 152 million per year. However, the company's start-stop enabling AGM (advanced glass mat) batteries aren't used in the burgeoning electric vehicle world, which is advancing more quickly than most realize.* Global headwinds Tax reform in the United States will help a lot of US companies; not so much those US companies which have already moved their headquarters overseas to take advantage of a lower corporate rate. One of the catalysts for JCI's acquisition of Tyco back in 2016 was the fact that Tyco already had its headquarters in Ireland, which allowed Johnson Controls to trigger a "tax inversion." Both Democratic nominees for the White House slammed the deal on the 2016 campaign trail. Not that the acquisition was a bad one, but with tax reform now a reality in the US, it is fair to say that the $16.5 billion Johnson paid for Tyco was too much, as the tax advantage the company would have gained over US-based competi- tors is essentially gone. The rising cost of commodities is another headwind JCI will be facing in 2018. We are now calling for a mini-boom in commodity prices this year, which will raise the cost of the steel, aluminum, copper, and other metals needed for the firm's building efficiency divi- sion. Not to mention the impact of rising fuel costs on the manufacturing process. The operating margin—what is left over after paying the costs of production—is relatively slim for JCI. Compare the compa- ny's 10.54% margin to GE's 12.58%, Emerson Electric's (EMR) 17.36%, and 3M's (MMM) 24.73%. No doubt about it—Johnson Controls has underperformed expectations since the Tyco merger. Based on the sub-par performance and the other headwinds mentioned, we are placing a stop-limit on JCI at $38.50/$32, and will reevaluate the company once again in late spring—assuming the stop hasn't hit. *How to potentially take advantage of tHe need for ev batteries Investors interested in battery pro- duction for electric vehicles should look at FMC Corp (FMC) and Tesla (TSLA, think gigafactory). For the lithium needed in the batteries, look at North Carolina's Albermarle Corp (ALB), a leading supplier. We still believe in the growth narrative at JCI, but performance and tax reform put it on the watch list While tax reform in the US will help a lot of American firms, those which have already "inverted" for tax purposes are going to lose this competitive advantage.

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