Antonella Franzen - Johnson Controls International Plc George R. Oliver - Johnson Controls International Plc Brian J. Stief - Johnson Controls International Plc.

Julian Mitchell - Barclays Capital, Inc. Steven Winoker - UBS Securities LLC Charles Stephen Tusa - JPMorgan Securities LLC Jeffrey Todd Sprague - Vertical Research Partners LLC Gautam Khanna - Cowen & Co. LLC Andrew Kaplowitz - Citigroup Global Markets, Inc. (Broker) Deane Dray - RBC Capital Markets LLC.

Welcome to the Johnson Controls second quarter 2018 Earnings Call. Your lines have been placed on listen-only until the question-and-answer session. This conference is being recorded. If you have any objections, please disconnect at this time.

I will now turn the call over to Antonella Franzen, Vice-President and Chief Investor Relations and Communications Officer..

Thank you. Good morning, and thank you for joining our conference call to discuss Johnson Controls second quarter fiscal 2018 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.

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 have 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 these items.

In discussing our results during the call, references to adjusted EBITA and adjusted EBIT margins exclude restructuring and integration costs as well as other special items. These metrics are non-GAAP measures and are reconciled in the schedules attached to our press release and in the appendix to the presentation posted on our website.

GAAP earnings per share from continuing operations attributable to Johnson Controls ordinary shareholders was $0.47 for the quarter and included a net charge of $0.06 related to special items. These special items primarily relate to integration costs.

Adjusting for these special items, non-GAAP adjusted diluted earnings per share from continuing operations was $0.53 per share compared to $0.50 in the prior year quarter. Now let me turn the call over to George..

Thanks, Antonella, and good morning, everyone. Thank you for joining us on today's call. I would like to begin this morning with a quick review of the strategic highlights in the quarter which will set the tone for this morning's call as well as what you should expect from us over the next couple of quarters.

A consistent theme you will hear today is that we are building momentum across the organization.

Starting on slide 3, as we have discussed over the past couple of quarters, we have been intently focused on reinvesting for growth, transforming the sales organization, driving synergy and productivity benefits, improving free cash flow conversion, and optimizing our portfolio.

Based on the results of the second quarter, I'm even more confident that the steps we have taken and the investments we have made are beginning to pay off. We saw another quarter of strong traction with respect to increasing our sales capacity.

In fact, by the end of the quarter, we have already achieved our target to add 400 salespeople net of attrition. Additionally, we are seeing better than expected productivity from our new sales ads which has contributed to increased sales orders.

The resegmentation of the sales force along with our initiatives to improve pricing discipline have resulted in an improvement in margins on orders secured and backlog.

For example, in the second quarter, margins on new orders booked in North America increased approximately 100 basis points year-over-year, which compares to the 70 basis point improvement we discussed last quarter.

Based on the progress made to date and to better position us heading into fiscal 2019, we plan to continue to add sales capacity in select regions and businesses. Consistent with the first quarter, organic growth in our Global Products segment increased 6% year-over-year.

The significant investments in capital we have deployed over the past several years into areas such as engineering, R&D, and distribution footprint continue to convert to higher Global Products sales growth, and we expect the momentum to continue as we launch new products and technology into the market.

Building service growth increased 3% in the quarter. We made significant progress expanding our commercial capabilities and strengthening operations while increasing our field technician capacity.

In Power Solutions, although we have experienced a softer than planned start to the year, I am encouraged by the progress our team has made securing new OE and aftermarket business. We will see the benefits of those wins beginning in the second half as top line growth accelerates to 5-plus percent.

The underlying fundamentals within the Power Solutions business are extremely strong, which will help deliver solid volume leverage as growth accelerates. Another area we continue to see very good progress is on the synergies and productivity front.

Year-over-year, we had an incremental $0.05 of savings in the quarter and $0.10 year to date, and that will increase in the second half. We continue to expect $250 million or $0.23 of incremental savings in fiscal 2018. In addition to the cost side, we continue to benefit from cross-selling wins.

In the quarter, we were awarded a sizable project for our fire and controls products as well as the installation for a new mega-resort in Asia which will include multi-function and convention halls as well as two luxury hotels. This is just one example of the everyday joint efforts of our one team approach.

We are also seeing some momentum building on cash conversion, as Brian will discuss a bit later in the call. We generated approximately $300 million in adjusted free cash flow during the first half of fiscal 2018, a significant improvement versus the prior year.

Clearly there is more work ahead, but as I have committed to you over the past couple of quarters, improving cash conversion is one of our top priorities. Lastly, I wanted to comment on our ongoing strategic review of Power Solutions.

Power Solutions is a strong franchise with very strong positions in proven advanced Battery technologies with long-term relationships with both OE and aftermarket customers around the globe. We continue to work closely with our external advisors, and we are making good progress.

We are committed to positioning Power Solutions for long-term success and optimizing shareholder value. Let's turn to slide 4 for a quick look at the macro environment. The macroeconomic environment generally remained favorable across most of our key geographic regions, supported by rising global GDPs.

North American non-residential construction markets are growing steadily, led by the institutional verticals. Global demand for our commercial HVAC & Controls products is strong, highlighted by continued order strength in Asia, the Middle East, and North America.

The sustained rebound in oil prices continues to ease regional budgetary constraints across the Middle East, and is also driving increased demand for our fire protection and suppression products that serve the harsh and hazardous end markets globally. China remains one of the fastest growth regions.

Non-residential construction starts in China remained flat overall with declines in commercial offset by double digit growth in institutional, infrastructure, and industrial verticals. In Power, lower auto production particularly in the U.S. and Europe has put pressure on industry unit shipments year to date.

The moderate weather has weakened aftermarket demand. However, China continues to outpace the market and has been a source of growth in both channels. As we look to the back half, we expect production levels to stabilize, and we are encouraged by the pace of new business wins over the last six months.

Overall, the underlying fundamentals within most of our key geographies remain supportive of continued order and revenue growth momentum throughout fiscal 2018. Turning over to slide 5, Buildings field orders accelerated again in the quarter, up 7% year on year organically with continued strong quoting activity.

This compares to low single digit average growth in fiscal 2017 and 5% growth last quarter. Underlying order strength was broad-based across the three regions as well as all domains including installation and service. Our growth in backlog provides confidence in continued improvement in revenue growth.

Turning now to slide 6, let me recap the results for the quarter. Sales of $7.5 billion increased 3% on a reported basis in the quarter and 1% organically led by products and service which, as I mentioned earlier, grew 6% and 3% respectively.

Adjusted EBIT of $740 million grew 4% as the impact from the Scott Safety divestiture and anticipated headwind from lower gross margins and incremental investments were more than offset by cost synergy and productivity savings. The headwinds we anticipated played out pretty much as we expected.

The conversion of our lower margin backlog in North America resulted in a $10 million headwind. Price/cost was expected to be a $20 million headwind. We actually came in better than expected, less than $10 million, resulting from strong realization on the announced price increases.

Between incremental product and sales capacity investments, we planned to spend approximately $30 million in the quarter, and we came in closer to $40 million.

Despite those margin pressures in the quarter, EBIT margins expanded 10 basis points year-over-year on a reported basis or 30 basis points excluding the impact of the Scott Safety divestiture, FX, and lead. Adjusted earnings per share came in at $0.53, up 6% over the prior year and in line with the framework we provided you last quarter.

In addition, adjusted free cash flow in the quarter was approximately $600 million. Turning to our EPS bridge on slide 7, you can see synergy and productivity savings adding $0.05 to the prior year. Volume and mix added an additional $0.02 driven by solid growth in Buildings and a mix benefit with higher growth in products and service.

The cumulative benefit of synergies and volume mix was partially offset by expected gross margin pressure and incremental growth in sales investments. Net FX and other added $0.01. Overall, this resulted in $0.53 in adjusted EPS for the quarter. With that, I will turn it over to Brian to discuss the performance within the segments..

Thanks, George, and good morning. So starting on slide 8, let's take a look at the performance of Buildings on a consolidated basis.

You can see sales in the quarter of $5.6 billion increased 2% year-over-year and 2% organically, with Products up 6% and Field down 1% where we saw solid growth in service more than offset by slower backlog conversion on project installations.

On the Buildings top line, a 4% headwind from M&A, primarily related to the Q1 divestiture of Scott Safety, was fully offset by the benefit of FX in the quarter. Buildings consolidated EBITA of $630 million was flat year-over-year but up 3% excluding the net impact of the Scott Safety divestiture and FX.

Buildings EBITA margin decreased 10 basis points versus prior year to 11.2%, but this includes a 40 basis point headwind from the divestiture of Scott Safety. On a normalized basis, the EBITA margin expanded a solid 30 basis points.

As you can see in the margin waterfall, the combined 130 basis point benefit from cost synergy and productivity savings, volume, and mix was partially offset by 100 basis points from the expected Q2 headwinds related to conversion of lower margin backlog, price/cost pressure, and incremental product and sales capacity investments, all generally in line with the Q2 expectations we set for you last quarter.

As George mentioned, organic field orders increased by a strong 7% year-over-year with backlog up 6% to $8.5 billion. Now let's review each segment within Buildings in more detail.

Turning to slide 9, North America, sales of $2.1 billion grew 1% organically driven by low single digit growth in our commercial HVAC & Controls businesses and modest growth in our Fire & Security business. We did see our Solutions business down low single digits in the quarter.

Overall service revenue grew 3% organically with installation revenue up modestly.

North America adjusted EBITA of $244 million increased 7% year-over-year and EBITA margins expanded 60 basis points to 11.6%, but I would note that this includes a 50 basis point benefit due to a lost contract charge that we talked with you about in the prior-year quarter.

Excluding that benefit, the underlying margin expanded 10 basis points as the benefits of synergies and productivity, volume, and mix were substantially offset by the 70 basis point headwind from the planned lower margin backlog conversion and our sales force investments.

Orders in North America increased 4% organically, including improved margins on those orders, and we saw strong order intake in both our conventional HVAC install and service business as well as Fire & Security. Backlog of $5.3 billion increased 5% year-over-year. So let's move to slide 10, EMEA/LA.

As expected, sales of $907 million declined 3% organically given the lower project backlog we had entering fiscal 2018 in Europe and the Middle East. Europe declined in the low single digits, driven primarily by lower installation revenue in Industrial Refrigeration and HVAC.

However we did see double digit order growth in Q2, led by demand for Fire & Security and Industrial Refrigeration. In the Middle East, revenues declined mid-single digits driven by a decline in HVAC installation while in Latin America, revenues increased low single digits led by the strength in our subscriber business.

Adjusted EBITA of $78 million declined 1% and EBITA margins declined 30 basis points to 8.6% as our productivity savings and cost synergies were more than offset by the volume deleverage. Orders in EMEA/LA increased a very strong 10%, led by growth in continental Europe and Latin America with backlog up to $1.7 billion.

Moving to APAC, sales of $586 million declined 2% organically due to high single digit declines in installation activity, but this was versus a tough compare of a 12% increase last year. This was partially offset by high single digit growth in service.

Adjusted EBITA of $71 million increased 6% with related margins expanding 20 basis points including a 40 basis point headwind related to foreign currency. The underlying margin increased 60 basis points, reflecting cost synergies and productivity save and favorable mix partially offset with costs associated with our ongoing sales force additions.

Asia PAC orders also increased 10%, and I would just comment that it was up 5% excluding one unusually large order we secured in Q2. The 5% was driven by solid increases in service, Industrial Refrigeration and HVAC, and our backlog now is up 15% to $1.5 billion. So let's turn to slide 12 and go through Global Products.

Their organic sales increased 6% to $2 billion with mid-single digit growth in Building Management and HVAC & Refrigeration Equipment and low teens growth in Specialty Products. Let me provide you with a bit more color on each of these businesses. In Building Management, we saw solid growth across the board in controls, fire detection, and security.

In HVAC & Refrigeration Equipment, North American residential HVAC grew revenue in the high teens despite a tough compare in the prior year of plus 19%, very strong performance by our North America residential team.

Global residential HVAC which includes sales through our consolidated Hitachi JVs with operations in Japan and Taiwan increased mid-single digits in the quarter. Light commercial HVAC was up low single digits against a tough compare in the prior-year quarter.

Our VRF business in Asia saw low single digit organic growth in the quarter but we did see strong double digit growth in our unconsolidated Hitachi joint ventures in China.

Industrial Refrigeration also had a very strong quarter with double digit growth while our applied HVAC distribution increased modestly as growth in North America and the Middle East was partially offset by a decline in EMEA/LA.

Low teens growth in Specialty Products was driven primarily by increased demand for fire suppression in North America and APAC. Segment EBITA of $237 million declined 6%, reflecting the impact of the Scott Safety divestiture, with related EBITA margins declining 100 basis points. However, this includes 120 basis point headwind related to Scott Safety.

The underlying segment margin expanded 20 basis points to 11.6% as the benefits from cost synergies and productivity and volume leverage was more than offset by 110 basis points related to the planned product and channel investments and the 40 basis points of price/cost pressure we've talked to you about before.

So let's move to slide 13, Power Solutions. Sales of $1.8 billion declined 2% organically as favorable price and technology mix was more than offset by a decline in unit shipments. Our global battery shipments declined 5% year-over-year with declines in both OE and aftermarket.

The overall 2% decline in OE shipments is in line with lower global auto production in the quarter. Aftermarket shipments declined 6%, primarily due to Q2 weather impacts in the U.S. and Europe. We continue to outperform in the China market with units up mid-teens and continued strong growth in both OE and aftermarket.

I would also note that in Q2, we did see global shipments of start-stop batteries increase 14% year-over-year with another strong growth quarter in the Americas and China and a modest increase in EMEA.

Segment EBITA of $314 million increased 4% with related margins declining 90 basis points year-over-year to 17%, but again this includes a 60 basis point headwind from FX and lead.

Powers underlying margin declined 30 basis points as favorable mix and productivity savings were more than offset by product investments, start-up and launch costs, and increased transportation and logistic costs, all planned for the quarter.

As expected, we continue to see higher freight costs in Q2, while this headwind declined as we moved through the quarter, and we do not expect this headwind to be significant in the back half of the year. Let's move to slide 14.

Corporate expense was down a strong 14% year-over-year to $110 million as we continue to see the benefits of synergy savings and productivity savings. For the full year, we continue to expect corporate expense in the range of $425 million to $440 million.

Turning to slide 15 on free cash flow, we generated free cash flow of approximately $400 million in the quarter. Excluding $200 million of integration restructuring cash, adjusted free cash flow was a solid $600 million, primarily reflective of timing between the quarters in fiscal 2018.

Free cash generated in the first half was essentially flat on a reported basis but $300 million on an adjusted basis. We are clearly beginning to see the early benefits of the cash management office and are on track to deliver the 80%-plus adjusted free cash flow conversion for the year.

Moving to the balance sheet on slide 16, our balance sheet position continues to improve with net debt down another $100 million in the quarter to $11.8 billion. Our net debt to EBITDA leverage of 2.5 times is now within our target range and our net debt-to-cap declined slightly to 36.2%.

Finally, during the quarter, we repurchased 1.3 million shares for approximately $50 million, in line with our normal pattern. For the first half, we have now repurchased 4.9 million shares for around $200 million and our outlook for the back half of fiscal 2018 assumes another $100 million of share repurchase as originally planned.

I would just comment in summary here that from my perspective, it was a very solid quarter from an operational standpoint, and we've got clear momentum building in each of our businesses and across all of our key initiatives as we look to the second half of fiscal 2018. So with that, let me turn it back over to George..

Thanks, Brian. Before we open up the line for questions, I wanted to make a couple of comments on the impact of tariffs and what we are seeing related to price/cost. Starting with tariffs on slide 17, as you are aware, Section 232 steel and aluminum tariffs were enacted in March of 2018.

Our direct buy of steel and aluminum totals approximately $225 million on an annual basis. All steel purchases are sourced in-country and 70% of our aluminum needs are supplied in-country. As such, the direct impact related to steel and aluminum tariffs are nominal and will be fully offset. We are reviewing the proposed Section 301 tariffs.

Given the fluid nature of the proposal, we continue to monitor developments and update our analysis. Included in the proposal are motors in various electronic components which would impact our Buildings businesses. We would not expect much of an impact at all in our Power Solutions business.

As part of our ongoing assessment, we are simultaneously identifying mitigating actions to minimize any direct impact. Based on the analysis we have done so far related to our exposure in mitigating actions, we have already worked this down to a very manageable level.

The more relevant impact from the recent tariff discussions has been on raw material inflation and our price/cost position. As I mentioned earlier, we entered the March quarter planning for a price/cost headwind of $20 million to $25 million based on the raw material inflation we were projecting at the time.

Despite slightly higher material inflation during the quarter, we exited the second quarter with a price/cost headwind of less than $10 million with the outperformance driven primarily by achieving higher price realization. We have announced a couple rounds of price increases so far in fiscal 2018 across various product categories and end markets.

For example, as many of you are aware, we proactively announced a 5% to 12% increase in North American based unitary and applied HVAC equipment to get in front of some of the recent material inflation.

We have made good progress yielding price so far this year, which will continue over the course of the year, and we expect to be in a net positive price/cost position in the second half.

As we roll forward our outlook on price/cost for the full year, factoring in continued inflationary headwinds and our expectations for price realization in the back half, we are currently tracking ahead of plan relative to our guidance for a $40 million headwind for the year.

Translating that to a margin rate, $40 million would equate to roughly a 50 basis point headwind to Global Products margin and a 20 basis point headwind to the consolidated Buildings margin.

Between the pricing actions we have road mapped in our plan and the incremental direct materials productivity, we have an opportunity to close the gap even further. Turning to slide 18, let me take a minute to highlight a few changes to our underlying assumptions as it relates to our full-year guidance.

As I mentioned earlier, our operating performance is on track. First half results played out largely as anticipated, underlying fundamentals continued to improve and we are building momentum across the organization. We have a strong and growing backlog in Buildings, and the quality of the backlog continues to improve.

The changes we have made to the sales and service organizations are helping to drive increased order pipelines, and service growth has returned to more normal levels. We are beginning to see more material returns on our investments in products with growth continuing to accelerate.

And although commodity inflation is higher than we anticipated at the start of the fiscal year, we have strong pricing and productivity actions in place and we are in a position to drive positive price/cost variances in the back half. In Power, we have secured key new customer wins and order activity which should begin to flow through the back half.

With all of this said, we are well positioned for the second half, and I am confident in our ability to deliver on our full-year commitments. We have slightly adjusted our revenue expectations for the year, factoring in additional FX and lead tailwinds, but continue to expect overall organic growth in the low single digit range for the year.

No changes to our underlying assumptions within the consolidated Buildings segment. Given the sustained rise in lead versus our initial plan, we are updating our revenue and associated margin impact for Power. Despite the volume pressures in the first half, we are on track for low single digit organic growth for the year.

Given the continued rise in lead prices year-over-year, we have adjusted our lead assumption for Power from $2100 per metric ton to the expected average for the year of $2445 per metric ton. As you know, lead is a pass-through cost.

The increase in lead prices will increase our top line, but has minimal impact on our EBIT dollars and therefore no impact to adjusted earnings per share. However, this does put 70 basis points of incremental pressure on Power Solutions margin rate.

Additionally, some of the headwinds we saw in Power in the first half related to transportation is an incremental 40 basis points. As Brian mentioned, we do not expect transportation costs in Power Solutions to have a significant impact on our second half performance.

As I mentioned earlier, we expect Power Solutions top line to grow 5-plus percent organically in the second half which will lever very nicely. On a reported basis, we expect Power Solutions margin to be down 100 to 120 basis points year-over-year, again primarily related to the flow-through of increased lead prices.

We are reaffirming our full-year adjusted earnings per share guidance range of $2.75 to $2.85 which represents a 6% to 10% increase year-over-year. With that, operator, please open the line for questions..

And our first question is from Julian Mitchell from Barclays. Your line is open..

Hi. Good morning..

Good morning, Julian..

Good morning. Maybe just a question firstly on the slide 24 with the first half/second half bridge items. So I just wanted to double-check that we're thinking about it roughly the right way. The gross margin and investment pressures in the first half were collectively about $0.13, I think, year-on-year.

So do we assume that those shrink sort of drastically in the second half as a year-on-year headwind and then you get an extra sort of $0.04 or $0.05 each from currency and extra synergies? Is that the right way to get to that $0.13 tailwind?.

Yeah, so, Julian, I'll take that. When you look at our performance, we typically are 40%/60% split first half and second half. This year, we are a little bit more skewed to the second half, about 38% on the first half, 62% on the second half.

And so as you look at – and as we planned the year, we knew we had a lot of headwinds in the first half, and those headwinds were the backlog conversion on gross margins coming through mainly in the first half and a little bit in the second half.

We had the price/cost pressure of about $40 million, most of which was in the first half, we're going to turn positive in the second half. The sales force investments were weighted to the first half as we added significant capacity within our sales channels. And the product investments also were weighted to the first half.

And then when you take into account the transportation headwind that we had in Power, and then net all of that with the productivity and synergies, when you look at that, we had headwind of about $0.02 in the first half.

As you play out the year as we begin to accelerate our – we begin to convert backlog, we continue with strong product growth, we accelerate service and we start to pick up significant volume in our Power business, when you look at the overall benefit in the second half, it's about $0.13.

And so the net impact of first half to second half is a delta of about $0.15..

Understood. Thank you.

And then just within the free cash flow, as my follow-up, was there any particular color between the two segments in terms of that better free cash flow performance in Q2 or were the improvements in cash pretty even across Buildings as well as Power?.

Think it was generally spread pretty evenly across the businesses. We did see a slight increase in inventory in Power Solutions as a result of some of the lower volumes we talked about. But they did a really nice job on the receivable front in Power Solutions and as well as the Buildings performance in receivables was strong as well.

The reason that we've commented that this is really timing between the quarters is there is a little bit of pull-forward, I would say, on the collection of receivables, and we pulled forward a bit of our harmonization of our vendor payment terms in the Buildings business as well.

And I would also say that when you look at the CapEx delta between first half, second half, there might be $50 million to $100 million worth of timing there as well. But we're still going to spend the $1.3 billion for the year..

Great. Thank you..

Thank you. And the next question is from Steven Winoker from UBS. Your line is open..

Thanks. Good morning, all..

Good morning, Steve..

Hey. So I just wanted to spend some more time on the cash question. Again, obviously, there's a lot of investor skepticism or has been around the ability of JCI to drive sustained cash flow conversion improvement. And while it's early days and you just addressed across segments, George, maybe talk about the cultural shift.

And I'm not sure I – I understand the CapEx dynamic that you talked about, but I don't see why you wouldn't be able, even if there was a little bit of timing here, why you wouldn't be able to sort of sustain into 2019 some of the actions that are going on now given kind of the major improvements in the organization on this front..

Yeah, so I would start, Steve, that this, as I said in my prepared remarks, this is one of the top priorities for the company, and this topic comes up in every meeting that we have and is front-and-center as far as a deliverable for all of our teams across the businesses.

And so what I would say is we're making – and we've put the accountability of the cash, we've reinforced that with all of our incentives across the business. So we definitely are going through a cultural change. This is front-and-center.

And no matter what element of cash, I can tell you that wherever I go across the globe, whether it be sales leaders making sure that they're enabling and helping to collect on the receivables, whether we're looking at entitlements of inventory and pushing out production and balancing production more with our sales demand, whether it's our sourcing teams that are matching our payables in line with our contract terms, we've made significant progress.

And so I would tell you that every step of the way, we've got full engagement. We've got the accountabilities in place. We've got the incentives reinforcing that. And I would tell you we are making really good progress..

Okay. George, that's helpful..

And, Steve, on CapEx, if you look at the first six months of the year, our CapEx was about $500 million, and our guide for the year is $1.3 billion.

And so I would just tell you that there's still going to be spend closer to the $1.3 billion level for the full year, but there probably has been a bit of a delay on a few projects that have moved from what were planned to be in the first half of the year to the back half of the year. But the guide is still $1.3 billion..

Okay. That's helpful. And then you mentioned last quarter, I think you had about 30 basis points in backlog margin expansion due to some of the initiatives.

Where are you now?.

Yeah, we're making good progress, Steve. As I said last quarter, we had booked margins about 70 basis points better. This was a big focus in North America. That's where the pressure was coming into the year. We had roughly $40 million of pressure, which was about 75 basis points on a backlog in North America that was about $5.2 billion.

And so with that performance in the first quarter, we had increased the margin and backlog about 30 basis points. This quarter in Q2, we were able to book margins about 100-plus basis points, and that brought up the margin in backlog about 40 basis points.

And so that gives us a lot of confidence that, as we now project the turn of these orders in the margin, we're going to start to see a pickup in the margin rate on a go-forward basis..

Okay. All right. That's helpful. I'll go back in queue. Thanks..

Thanks..

Thank you. And the next question is from Steve Tusa from JPMorgan. Your line is open..

Hey, guys. Good morning.

How are you?.

Hi, Steve. Good..

I think you mentioned the applied business on revenue was kind of low-single digits, I guess, in North America in the quarter.

What were the orders for your applied business in North America? Just roughly year-over-year?.

Yeah, so orders, when you look at our – we track our products, our applied products as well as the revenues that are achieved in our channels across the globe. And orders were up about 5%, mid-single digits roughly across the base.

We are seeing, if you look at the overall applied HVAC equipment revenue globally, we're actually up about 2%, and that includes all of our revenues achieved with the applied technology and conversion of that into projects.

And what's very encouraging, as you all know that we've launched our new chiller, and when you look at the chiller orders coming through in the second quarter, we're seeing very strong demand. And so that's across all of the – most of the regions.

We're seeing very strong demand and I'm projecting that that's going to continue with the success that we've seen to date..

Okay. And as far as pricing in commercial, I mean, obviously, all you guys are doing a good job of banking on offsetting this raw material headwind in the second half.

I would assume that means commercial pricing is holding up reasonably well?.

Absolutely. Absolutely. You saw the price increases we've taken. I can tell you we have a regular rhythm of not only with the increases that have been made, making sure that we're getting the full yield on those increases. And what I would tell you is that we're progressing very well.

And that gives me confidence that we're going, from a price/cost standpoint as we get through the second half, we're going to have positive price/cost in the second half..

Okay. One last one.

Seasonality on the rest of the year, should we assume that 3Q and 4Q are normal seasonally from an EPS perspective? Or is there anything that's slipping in and out of either quarter to make that performance unusual?.

No. Except for some of the headwinds and tailwinds that we discussed earlier in the call, what I would say is that we have normal seasonality with volumes coming through. We are seeing good progress, as I said, with products. I'm very encouraged by the new product launches and the technology we're bringing into the market. The 6% was strong.

And a note on products, we actually had a 9% increase in Fire & Security products within the quarter. And so the investments that are being made are paying out.

The service we brought within the field businesses, the importance of service and the ability to be able to create more value for our customers, at the same time being able to really drive mix. And that 3% service growth we're looking to continue to expand that as we go through the second half.

And then we begin to see the turn on our installation base, and so that's where we've been a little bit behind where I'd like to be to date. But with the backlog that's been built, we're up 6% and the margins in backlog are better. That's going to start to come through.

And then in Power, we'll see the normal pick up here on the volumes in the third and fourth quarter and a lot of that is in anticipation for the next season here with replacement batteries and the like.

And so I am encouraged that when you look at the year-on-year, we're going to continue to see momentum, and we'll be well positioned to deliver on the commitments..

Steve, just the one thing I would add in terms of as you're modeling out Q3 and Q4, keep in mind that Q3 is the seasonal high for Hitachi so we typically have a higher non-controlling interest number in the third quarter..

Okay. Great. Thanks a lot, guys..

Thank you. The next question is from Jeffrey Sprague of Vertical Research. Your line is open..

Thank you. Good day, everyone..

Hi, Jeff..

Hi, Jeff..

Hey George, just back to the idea of backlog margins. What has the experience been recently on execution of backlog, right? These are booked margins, but you've got a lot of new people and new organizations executing on projects.

Has the actual experience versus booked expectation been playing pretty much as you've expected?.

Absolutely, Jeff. What I would say is that we always – when we book, we always do better than what we book through execution. We've been very much focused, especially with some of the headwinds in what we're doing from a productivity standpoint, to be able to continue to bring down the cost of the conversion of the project. And so I'm encouraged.

This is something we're going pretty deep into to make sure that as we're projecting the cost of these projects with the inflationary pressure that we have seen, that we've got that grounded and then we're taking other actions whether it be through sourcing or other execution that we can not only meet the margins but continue to execute better through execution.

So I'm encouraged that that trend is continuing. Like I said, we went into the year, we had some pressure, but as we're now remixing the backlog and beginning to convert, we're now starting to see the pickup in the margin rate..

I was also wondering, the last couple years we've seen kind of an elongated disconnect between orders and actual sales conversion.

Do you see that normalizing in the next several quarters? Or is there something in the nature of the business, bigger projects? Or how should we think about order growth or backlog growth converting to sales growth the next few quarters, let's say?.

Yeah, so what I would tell you is that as we looked at the backlog, there were – last year there were some larger orders that were longer cycle projects that ultimately has created the pressure as we get into 2018.

What I would tell you is that through the sales excellence that we have driven across the businesses, we're now segmenting our sales team with the proper incentives. So we're getting the full mix of the overall projects. And so you have transactional projects, you've got long term, you've got upgrades, you've got longer-term developments.

And what I would tell you is that through that process with the sales excellence that we've been driving, we're getting much better line of sight to the mix of projects that we're putting into backlog. And so, therefore, you can then project on a go-forward basis how that backlog is going to convert.

So I would tell you that on a go-forward basis, those two lines over a cycle will start to converge..

And then just finally from me, you said the strategic review you're making progress.

Obviously it hasn't come to conclusion or you'd have an announcement, but how do you define progress? Does that mean you're seeing avenues to do something more tax efficient? Or you're seeing more combination options than you originally conceived? What if anything does that really indicate?.

Yeah, I would start, Jeff, by saying we are working closely with advisors, with our board. When we launch this, we're going to look at all opportunities and ultimately how do we position the business not only long-term but also to create the most amount of shareholder value.

When we announced this, we said we would provide an update when the process was finalized. We're right in the middle of the process, working through it, and so there's not much more I can add at this point. But, certainly, as we reach a decision and complete the analysis, we'd be positioned to be able to update and communicate to all of you..

Great. Thanks a lot..

Thanks, Jeff..

Thanks..

Thank you. And the next question is from Gautam Khanna of Cowen and Company. Your line is open..

Yes. Thanks. Good morning, guys..

Good morning..

Good morning..

Hey. I was curious if you could expand upon the field order growth that you saw, the plus 7%, and just thinking about how much was the lift due to better pricing, if you will. Because when I look at the next couple quarters, you have fairly easy comparisons in terms of field order growth.

I'm just wondering like what the pricing actions will net us just before even considering volume?.

Yeah, so when you look at what we're going to be yielding here in the second half, we have been ramping up pricing not only in how we're pricing projects, but also when we talk price/cost. It's mainly focusing on our product businesses. What I would say is in the second half, we're going to be continuing to get a lift here in margins.

So on the sales orders secured, we're probably picking up 1% to 2% as far as real pricing within that backlog. And then, as we're converting, we're executing better on that and achieving better margins. And so there could be – on the overall pricing side, could be 1% or 2% impact to the overall booked orders..

Got it. Okay. That's helpful. Brian, I was wondering if you could give us a little bit more granularity on what we should anticipate for free cash flow in Q3 versus Q4. And then, if you can update us on the recovery timing of the tax payment related to Adient this year and next.

I remember some of it moved into next year, but if you could quantify it?.

So the Adient tax payment, we received $200 million, as you know, Gautam, in the first quarter of this fiscal year. We expect the remaining portion, around $700 million, to be received either in the fourth quarter of fiscal 2019 or the first quarter of fiscal 2020. There really isn't an update on the timing yet.

It really depends on how it goes through committee and what that process will entail. Given the size of the refund, it's one that could move from one quarter to the other, but we're confident that we're going to get that money by the end of calendar 2019.

As it relates to cash flow, first half, second half, we had $300 million outflow Q1, $600 million cash inflow Q2. I would expect Q3 cash flow to be within the range of Q2 cash flow. And then, we would finish it out in Q4, which is always our strongest cash quarter to get to the 80%-plus free cash flow conversion..

Thank you very much. Good luck, guys..

Thanks..

Thanks..

Thank you. And the next question is from Andrew Kaplowitz of Citigroup. Your line is open..

Good morning, guys..

Good morning..

Hey. Good morning..

George, if we think about the Building business over the last couple years, it's obviously had some noise, whether it be the salesforce integration or the lower margin project backlog. But it does seem like in the last couple of quarters, the noise level in the business has started to die down.

So can you talk about your confidence level that JCI really is out of the woods in terms of bigger noise in Buildings quarters, and now you have good visibility into what's really going on in the overall business?.

Yeah, as I've discussed here in my prepared remarks, as well as through the Q&A, we have made significant progress in getting to fundamentals of the businesses that are totally visible across the organization and ultimately is what we're focused on in driving improvement.

And that starts right from the sales process and making sure that we're now all on one common system, tracking pipeline development, conversion of pipeline to orders, understanding the segmentation of those orders, large projects, small projects, service, service contracts, transactional service.

And so we now have line-of-sight to how we're now taking our strategic initiatives. We're bringing those to market, and we're ultimately now converting those from a sales standpoint. From an operations standpoint, as far as margin structure, we know exactly what's coming through our margin structure.

And as a result, we've been very proactive in taking pricing actions to be able to offset the inflationary pressures we've had. And normally, we get very strong productivity which, in addition to that, contributes to increased margins year-on-year.

And then the last is the conversion of cash, as Brian talked about, getting the fundamentals across the businesses, line-of-sight with the accountability throughout every functional organization and then across each of the businesses so that we know exactly how we ultimately deliver on the cash.

And so what I would tell you is that the visibility, the accountability, the incentives that are in place all position us to be able to deliver on those fundamentals and deliver on the commitments we've made..

Thanks for that, George. And can you quantify how much of the new – you mentioned original equipment and aftermarket ones in Power Solutions that will help you inflect to grow 5% in the second half of the year. As you guys know, it's been a more difficult business to forecast lately.

So what's the visibility there? How much do these new wins help you in the second half of the year? And how exposed is the business going to be to weather, as it always is?.

Yeah, so we're certainly we're positioned well across the globe with very strong positions. We have a pretty good line-of-sight to what our customers are doing, not only in the OE base, but also as we serve the aftermarket.

And so we work very closely in understanding what they're projecting on point of sale and what do we need to do to make sure that they've got the inventory to be able to achieve their sales plans.

And then as we go through that planning, we then make sure as we're executing, we balance that with the ability to pivot if we need to, depending on how volumes come through.

And so what I would tell you is through the early phase here, we've done that with all of our customers, both OE as well as aftermarket, and all of that suggests that, given what I would tell you, is that with the softer demand that we saw in this last cycle, some of that converts to higher demand depending on how the weather plays out in the next cycle.

And so making sure that we are positioned to capitalize on that opportunity and then working closely with each of our customers to make sure that they have the right supply, the right service to ultimately fulfill the sales for them..

And, Andy, it's Antonella. The only thing that I would add is keep in mind that OE production decline started last year in Q3. So as we get into our second half of this fiscal year, that starts to stabilize as well..

Got it.

And it's fair to say this is an unusually high amount of wins that you got in the quarter? That's kind of why you called it out?.

That's correct. Absolutely..

Thanks, guys..

Thanks..

Thank you. And the next question is from Deane Dray from RBC Capital Markets. Your line is open..

Thank you. Good morning, everyone..

Good morning..

Good morning, Deane..

Hey.

Could we just stay on the Power Solutions topic? And George, could you just put a finer point on some of the nuances when we talk about weather? How precise can you get? Is this on a degree-day basis versus normal weather patterns? Just what is that visibility and how does that translate?.

Yeah, so there's some correlation there, and what we've been working to do is try to make it a little bit tighter. But what I would tell you is the way the battery fails is you have a severe heat, and then you have severe cold. And a normal cycle in a winter, you typically have two or three cycles of severe cold.

And therefore, that's what makes batteries fail. This year, when you look at what happened in the two big bases that we have within Europe and North America, we didn't have those cycles. And so therefore it did impact our volumes in those two key markets.

And so what I would tell you, Deane, that we always hope to have a nice hot spell in the summer and then two or three cold spells in the winter, and that typically is what correlates to the failure of batteries and ultimately our demand..

Got it. Well, it looks like New York is about to get its first hot spell this week. So that may bode well. And then just a follow-up.

On the point regarding the better margins in backlog, I'm curious to hear what internally are you doing in terms of like the traffic cop on what types of projects will you pass on? Is it an iterative process on pricing, or it's just, hey, this business does not have enough follow-through in a potential aftermarket? But just the kind of decision-making on what projects you'll reject..

Yeah, Deane, what I would say is our goal is not to reject projects, our goal is to make sure that we're positioned with the right solution that leverages our technology and capabilities so that we can create the value that the customer is expecting, and then we ultimately get paid for that value.

So there's different levels of solutions that we bring into the market leveraging our technology. And so what I would tell you is that there's a lot more discipline upfront now relative to how we serve the customer and ultimately develop the projects that ultimately will fulfill their need.

And so with that, there's incentives from a sales incentive standpoint that's incentivizing our sales teams to get that margin upfront, right, and that ties to making sure that we've got the right solution, the right product and that ultimately we book it at that rate.

And so it isn't necessarily walking away from volume, it's making sure that we've got the right proposal, that we're pricing that proposal and then ultimately converting that to higher secured margins..

That's helpful. Thank you..

All right. Operator, as we're at the top of the hour, I'm going to pass it over to George for some closing comments..

All right. Thanks again, everyone, for joining our call this morning. As I said, we are building momentum. I do expect a very strong second half earnings and cash flow, and I'll certainly look forward to seeing many of you soon..

Operator, that concludes our call..

Thank you, everyone, for joining today's conference call. You may disconnect at this time..