We believe that there are other stocks in the industrials sector that are currently better valued than Johnson Controls (NYSE: JCI). Johnson Control’s current price-to-operating income ratio (P/EBIT) of 44x is much higher than levels of under 17x for Deere (DE), and 15x for Northrop Grumman (NOC). Both of these stocks have a lower valuation (P/EBIT) compared to Johnson Controls, while both of them have seen higher revenue and operating income growth. This disconnect between valuation and performance could mean that you are better off buying DE and NOC vs. JCI. More specifically, we arrive at our conclusion by looking at historical trends in revenues, operating income, and P/EBIT for these companies. Our dashboard Better Bet Than Johnson Controls Stock: Pay Less To Get More From Sector Peers DE, NOC has more details – parts of which are summarized below.
1. Revenue Growth
Johnson Controls’ revenue declined at an average rate of 0.7% over the last three years, as compared to average revenue growth of 7.1% for Deere, and 12% for Northrop Grumman. Even if we look at the revenue growth over the last twelve month period, Johnson Controls’ top-line decline of 8.3% is much lower than a decline of 4.8% for Deere and revenue growth of 8.7% for Northrop Grumman.
- Johnson Controls’ revenue decline over the recent past can be attributed to the impact of Covid-19 on the overall construction activity, primarily on the non-residential side, resulting in lower demand for the company’s building solutions and products. However, this trend is now expected to reverse, given that 45% of the U.S. population is fully vaccinated, and it appears that the economy will open up sooner. This will bode well for Johnson Controls with a rise in number of project installations and higher demand for heating, ventilation, and air-conditioning (HVAC), primarily on the commercial side.
- Looking at Deere, the coronavirus crisis induced lockdowns, increased unemployment, and lower oil & gas demand, adversely affected the overall construction activity, weighing on Deere’s top-line growth in fiscal 2020, primarily for its construction equipment segment, which saw a 20% y-o-y decline in 2020. However, unlike Johnson Controls, Deere has already seen a sharp rebound in demand, evident from its latest quarterly results. Deere’s fiscal Q2 revenue surged 34% y-o-y to $11.0 billion, led by a strong demand for both construction as well as agricultural equipment. In fact, Deere has a more promising outlook over the coming years, given that the age of farming equipment in the U.S. is now above average, and farmers will be looking to upgrade them over the coming years.
- For Northrop Grumman, its Aeronautics and Space segments have observed strong growth in recent years driven by higher demand for its manned & autonomous aircraft systems and strategic missile systems. Notably, the company’s order backlog almost doubled in recent years, from $42 billion in 2017 to $80 billion in 2020, assisted by a rising defense budget (note that the U.S. government contributes around 85% of the company’s top line) and high demand for space systems, a trend expected to continue in the near term.
2. Operating Income Growth
The three-year average operating income for Johnson Controls declined by an average of 4.0%, much worse than average growth of 9.3% for Deere and 2.4% for Northrop Grumman. Better revenue growth for the latter two as well as margin expansion for Deere led to higher operating income growth for these companies.
Looking at the last twelve month period, Johnson Controls’ 1.1% growth in operating income is much lower than the 11% for Deere and over 42% for Northrop Grumman. This can be attributed to improved margins for Deere and Northrop Grumman. While Deere’s operating margins have expanded over the recent past led by better price realization, the margins for Northrop Grumman have been bolstered by lower overhead rates on the company’s fixed price contracts. Johnson Controls has also seen its operating margins expand over the recent quarters, led by lower SG&A expenses.
The Net of It All
It is clear that Deere and Northrop Grumman have seen higher growth in revenues and operating income compared to Johnson Controls in the last twelve months as well as in the last three years. Yet, they appear to be valued significantly lower than Johnson Controls. Why is that? Some gap in valuation is understandable given the long term focus of Johnson Controls on providing energy efficient building solutions and a lower carbon footprint. However, the current gap in valuation appears to be very large.
Furthermore, it is not that these numbers are biased due to the pandemic. Even if we were to look at revenue and operating income growth a year ago, both Deere and Northrop Grumman fared better and even then they were valued much lower than Johnson Controls (as shown in the image below).
While there is no denying that Johnson Controls will see a rebound in sales, as the Covid-19 crisis winds down, but that factor applies to the other companies as well, especially Deere, which has already shown a sharp rebound in demand. Also, given that there has been a persistent underperformance in revenue and operating income growth for JCI when compared to DE and NOC, it reinforces our conclusion that JCI stock is expensive compared to its peers. Overall, we think that this gap in valuation will eventually narrow over time to favor the group of comparatively less expensive names. As such, we believe that DE and NOC stocks are currently better buying opportunities compared to JCI stock.
While DE and NOC stocks may outperform JCI in the near term, 2020 has created many pricing discontinuities which can offer attractive trading opportunities. For example, you’ll be surprised how counter-intuitive the stock valuation is for Cirrus Logic vs. Northrop Grumman.