ABI Decelerates But Still Holds Good For Johnson Controls’ Building Efficiency Segment

The Architecture Billings Index (ABI), a leading indicator for nonresidential construction activity in the U.S., is an important indicator for Johnson Controls‘ (NYSE:JCI) Building Efficiency segment since growth in nonresidential construction activity directly impacts the segment’s revenue. In its most recent release, the American Institute of Architects (AIA) reported that the ABI had decelerated to 53.7 in October from 55.2 in September. ^[1] We believe that despite the decline, the news will not be a cause for concern for Johnson Controls’ Building Efficiency segment, which manufactures heating, ventilation and air-conditioning (HVAC) equipment.

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Despite decline, ABI still indicates expansion in nonresidential construction

The ABI is derived using a monthly survey conducted by the AIA Economics & Market Research Group, wherein architecture firms report whether billings in the previous month increased, decreased, or remained the same compared to the prior month. If an equal number of firms report an increase and a decrease, then the score for that month is 50. A score above 50 indicates an increase in billings, therefore implying expansion in nonresidential construction activity. The opposite is true for a score below 50, which indicates decline in billings.

Despite a decline in October, the ABI still remains above 50, which means that non residential activity in the U.S. continues to expand. The ABI has now remained above 50 for seven consecutive months since May. ^[2] Since Johnson Controls’ Building Efficiency segment is largely exposed to the nonresidential construction sector in the U.S, a continued expansion in the sector, as indicated by the ABI, bodes well for the company. Johnson Controls has already begun to see the impact of the expanding sector on its Building Efficiency segment. In the fourth quarter 2014 (fiscal year ends on September 30), Johnson Controls reported a 2% increase in new orders. This excludes the contribution from Air Distribution Technologies and impact of foreign exchange.

The ABI leads construction spending by approximately 11 months. Therefore, we can expect to see a turnaround in Johnson Controls’ Building Efficiency sales in the next year.  You may recall that Building Efficiency revenues have been declining for quite some time due to weak commercial HVAC markets in North America. The trend continued into the fourth quarter, wherein, excluding the contribution from Air Distribution Technologies and foreign exchange, the segment’s revenue declined 3%.

Expanding nonresidential construction market could make up for the divestiture from GWS

Johnson Controls recently announced that it is planning to divest from its facilities management business, Global Workplace Solution (GWS). ^[3] We believe that the company has taken this decision due to the business’s declining revenues and loss of customers. GWS revenue grew 16.1% and 26.3% in 2010 and 2011. ^[4] However, revenue growth drastically slowed down to 3.4% in 2012 and then declined 0.7% in 2013. In the first nine months ended June 30, 2014, revenue declined 5.6%.

Johnson Controls’ revenue is expected to decline by 10% after divesting from GWS. However, we believe that given the indications of an expanding nonresidential construction market in the U.S, growth in Johnson Controls’ Building Efficiency sales of HVAC systems and services in North America could partially offset the impact of the divestiture on overall revenues.

What is more important to note is the likely increase in revenue trickling down to the bottom line. Building Efficiency profits have remained suppressed due to the low single digit profit margins of the GWS business. However, post divestiture, the segment’s margins will likely increase by 2%. Profit margins could improve further driven by the expansion in nonresidential construction which could generate cost synergies due to scale as Johnson Controls manufactures more and more HVAC equipment to fulfill demand.

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1. U.S. Architecture Firms’ Billing Index Lower in Oct, www.bloomberg.com [↩]
2. AIA Architecture Billings Index, www.aia.org [↩]
3. Johnson Controls Plans to Sell Building-Management Business, September 30, 2014, online.wsj.com [↩]
4. Johnson Controls SEC Filings, www.sec.gov [↩]