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

Steven Winoker - UBS Securities LLC Nigel Coe - Wolfe Research LLC Jeffrey Todd Sprague - Vertical Research Partners LLC Julian Mitchell - Barclays Capital, Inc. Joe Ritchie - Goldman Sachs & Co. LLC Rich M. Kwas - Wells Fargo Securities LLC Deane Dray - RBC Capital Markets LLC.

Welcome to Johnson Controls Third 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 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 third 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'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.

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 $0.78 for the quarter and included a net charge of $0.03 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 $0.81 per share compared to $0.71 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 the call today. Let's get started with a high level review of the strategic highlights in the quarter starting on slide 3. Last quarter we began laying a foundation based on the theme of building momentum.

As I think about the progress we have made in the third quarter, I would say the momentum continues on each of our key initiatives.

Starting with sales capacity, based on our success in attracting high performing talent during the first half, we continue to accelerate the pace of sales adds in the third quarter, hiring an incremental 375 sales professionals.

This brings our year-to-date net additions to the Building direct channel and indirect sales force to about 775 globally versus our previous expectation of 500 to 600 net adds. We expect to end the year with 900 net adds.

By leveraging the Johnson Controls commercial excellence programs throughout the organization, the hallmarks of which are an appropriately designed attractive incentive compensation structure, proper onboarding and training models as well as ongoing sales management and coaching, we have seen a significant increase in the productivity of our new and existing sales teams.

That, in turn, improves the customer experience and drives order growth as evidenced by the continued acceleration in Buildings orders and organic revenue growth. Our initiatives surrounding our sales force resegmentation and improved pricing discipline continue to bear fruit with further improvement in margins on orders secured in backlog.

For example, margins on new orders in North America increased 110 basis points year-over-year, which compares to the 70 basis point increase we saw in Q1 and 100 basis point increase we saw in Q2.

Despite a more difficult prior year comparison, our Global Products team continued to accelerate top line growth, reflecting outstanding execution and converting on the substantial investments made in capital deployed over the past several years into engineering, R&D and expanding our distribution footprint.

I should also call attention to the aggressive pricing actions we have taken, particularly over the last six months to combat rising raw material and other input costs.

We have achieved above average levels of price realization relative to our announced price increases year-to-date, which has enabled us to move into a modest positive price/cost position earlier than expected. Based on the timing of price recovery and assuming recent levels of inflation, we are well positioned into the fourth quarter.

Buildings service revenue growth accelerated once again in the third quarter to 5% year-over-year compared to the 3% growth we experienced in the first half.

I'm extremely pleased with our execution in our service businesses across the globe, particularly given the intense focus we have had on expanding our commercial capabilities and strengthening operations, while increasing our service technician capacity.

At Power Solutions, we had strong organic performance in both the OE and aftermarket channels, benefiting partly from the new platform wins we discussed with you last quarter. The success in ramping shipments on the new wins can be directly attributed to the Power team's solid execution and commitment to serving our customers.

On free cash flow, we continued to drive operational improvements and I am very pleased with our progress in establishing sound fundamental processes and metrics across the organization. Cost synergies and productivity savings remain on track. At this point I would say these initiatives are well-weaved into the fabric of Johnson Controls.

We delivered nearly $70 million or $0.06 of incremental savings in the quarter, as expected. We are on track to deliver our $250 million savings target in fiscal 2018. Lastly, let me provide you an update on the strategic review of our Power Solutions business.

As we previously discussed, we are analyzing multiple options, including a spin or a sale versus retaining it as part of our portfolio. We are analyzing the viability and benefits of a tax-efficient spin of the business and, in parallel, have been discussing the potential sale of the business with interested parties.

Management, along with the Board of Directors, have decided to continue to explore these alternatives and expect to conclude the review by the release of our fourth quarter earnings. We will communicate more details when a final determination has been made. Let's turn to slide 4 for a quick look at the macro environment.

Despite recent FX volatility, inflationary pressures and trade policy concerns, the macroeconomic environment generally remains supportive of continued growth across most of our key geographic regions. By most accounts, U.S. economic fundamentals continue to strengthen; spending in non-residential construction markets remains favorable.

Despite recent choppiness in a few of our macro indicators, the forward looking components are still pointing to modest growth over the next 12 months and we are seeing that in our orders, led by strength in the institutional verticals.

Trends in Europe remain somewhat mixed with lower growth for construction markets in larger developed economies and higher growth in the Eastern European economies, where those countries continue to invest at rates above their GDP.

The sustained rebound in oil prices continues to support investments in 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 is an area we are monitoring closely, given the potential for trade disruptions with the U.S.

that continue to escalate. Although China's economic growth has slowed somewhat, it remains one of the fastest growth regions and recently-announced government policies aimed at reviving growth may start to take shape over the next several months.

China non-residential construction starts remain flat overall, with continued weakness in commercial verticals, offset by continued growth in the industrial and infrastructure verticals. In Power, global auto production is stabilizing, particularly in the U.S. and Europe, and the recent platform wins position us well to gain share.

The increasing electrification in vehicles, combined with a regulatory environment still pushing for stronger efficiency standards, are supportive of our core battery technologies.

Changing demographics also remain favorable, as evidenced by the growth we are seeing in China, which continues to outpace the market and has been a source of growth in both channels. Overall, the underlying fundamentals within most of our key geographies remain supportive of continued order and revenue growth momentum.

Turning over to slide 5, Buildings Field orders accelerated again in the quarter, up 8% year-over-year organically with continued strong quoting activity. This compares to low-single-digit average growth in fiscal 2017 and 6% average growth in the first half.

Underlying order strength was most notable in our North America and EMEA/LA businesses across most of our core product domains, and including bookings for both installation and service. Our North America Fire business experienced its highest bookings quarter in over two years.

Our growth in backlog provides confidence in continued improvement in revenue growth. Turning now to slide 6, let me recap the financial results for the quarter. Sales of $8.1 billion increased 6% on both a reported and organic basis, with 5% organic growth in Buildings and 10% in Power.

Adjusted EBIT of approximately $1.1 billion grew 6% on a reported basis and 12% when adjusting for the impact of the Scott Safety divestiture, foreign exchange and lead. Favorable volume mix and the benefit of cost synergy and productivity savings more than offset incremental organic investments back into our business.

Between incremental product and sales capacity investments, we initially planned to spend approximately $35 million in the third quarter and we came in closer to $45 million, taking into account the significant number of sales adds I discussed earlier.

Overall, EBIT margins expanded 10 basis points year-over-year on a reported basis or 70 basis points excluding the impact of the Scott Safety divestiture, FX and lead. Adjusted earnings per share came in at $0.81, up 14% over the prior year.

Adjusted free cash flow in the quarter was just short of $650 million, which when added to our first half free cash flow, which was north of $300 million, brings us to $1 billion year-to-date. Turning to our EPS bridge on slide 7, as I mentioned earlier, synergy and productivity savings added $0.06 to the prior year.

Volume and mix contributed an additional $0.08, driven by solid growth in both Buildings and Power. The cumulative benefit of synergies and volume/mix was partially offset by incremental investments. Lastly, the combined benefit from lower tax and FX was offset by below-the-line items. Overall, this resulted in $0.81 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, everyone. So let's start on slide 8 and take a look at the performance of Buildings on a consolidated basis.

Total Buildings sales in the quarter of $6.3 billion increased 5% organically with Products up 7% and Field up 4%, led by strong 5% growth in service across all geographies and a return to growth of 2% on project installations.

A three percentage point headwind from M&A, primarily related to the Scott Safety divestiture, was partially offset by a 2% benefit of FX in the quarter. Buildings consolidated EBITA of $954 million grew a strong 10% organically with balanced growth across our Field and shorter cycle Products businesses.

Buildings reported EBITA margin expanded 20 basis points versus the prior year to 15.2%, but this includes a 40 basis point headwind from the Scott Safety divestiture and a 10 basis point headwind related to foreign currency. On a normalized basis, the EBITA margin expanded a solid 70 basis points in the quarter.

As you can see in the margin waterfall, the combined benefit of 130 basis points from synergy and productivity save, volume leverage and mix was partially offset by 60 basis points of planned headwinds from incremental product and sales capacity investments.

As expected, gross margin pressures from the conversion of lower margin backlog and price costs were not significant in Q3. And in fact, as George mentioned, we ended the third quarter with a positive price cost variance. Field orders increased by 8% organically year-over-year with backlog, up 7%, now standing at $8.5 billion.

Now, let's turn to each of the individual segments within Buildings and starting on page 9 with North America. Sales of $2.2 billion grew 5% organically with strong growth in our applied HVAC & Controls and Fire & Security platforms each growing mid-single digits.

Our Solutions business, which represents less than 10% of North America's revenue, declined low single-digits in the quarter on a tough prior year compare.

Service revenue North America grew mid-single digits organically led by increase in activity in both HVAC & Controls and Fire & Security, while project installation revenue also grew in the mid-single digit range led by strength in Fire & Security.

North America adjusted EBITA of $318 million grew 10% year-over-year with EBITA margins expanding 60 basis points to 14.2%. We saw the benefit of volume leverage and favorable mix and synergies and productivity being partially offset by higher than planned investments in sales force capacity and the residual lower margin backlog conversion.

Orders in North America increased 8% organically, another great quarter for our North American team as we saw strong bookings in both our conventional HVAC & Controls and Fire & Security businesses, including strength in project installation as well as service. Backlog of $5.4 billion increased 7% year-over-year. So let's move to slide 10, EMEA/LA.

As expected, sales of $926 million were flat organically year-over-year as we started the fiscal year with lower project backlogs in both Europe and the Middle East.

Europe declined in the low single-digits driven by lower project installation backlog in our Industrial Refrigeration and HVAC businesses; however, orders did increase in the mid-teens organically in Q3 led by strong demand in IR, fire suppression and security.

In the Middle East, revenues grew low single-digits as low double-digit growth in service activity was substantially offset by continued softness in project installations. Latin America revenues increased mid-single-digits led by strength in our recurring security monitoring business and fire suppression.

Adjusted EBITA of $98 million increased 10% and EBITA margins expanded 60 basis points to 10.6% including a 40 basis point headwind related to foreign currency. Underlying margins increased 100 basis points driven primarily by productivity and synergy save.

Orders in EMEA/LA were up a strong 13% with solid growth across all regions and across both service and project installation, driven primarily by strength in IR and Fire & Security. Backlog in EMEA/LA ended at $1.6 billion up 6% organically. So let's turn to slide 11 and discuss APAC.

Sales of $681 million grew 4% organically, largely driven by low double-digit service growth led primarily by China and Southeast Asia. Project installation revenue grew low single-digits driven by Fire & Security and IR.

Adjusted EBITA of $97 million increased 15% over the prior-year with margins expanding 90 basis points, and this includes a 50 basis point headwind related to foreign currency.

The underlying margin improvement of 140 basis points reflects the continued benefit of productivity and synergy save as well as favorable volume and mix, partially offset by investments in sales force.

Asia Pacific orders did decline 1% in the quarter primarily due to a tough prior-year comparison of 9%, but also reflective of an increasingly competitive market dynamic in the region, especially in China. Backlog increased 9% to $1.5 billion.

I would point out that, based upon what we see today, we expect continued competitive and margin pressures as we move through Q4 and into fiscal 2019.

Turning to Global Products on slide 12, sales increased a strong 7% organically to $2.4 billion, led by high-single-digit growth in both Building Management Systems and HVAC & Refrigeration Equipment and mid-single-digit growth in Specialty Products. In BMS, we saw strong growth across our controls, fire detection, and security businesses.

In HVAC & Refrigeration Equipment, global residential HVAC, which does include sales through our consolidated Hitachi JVs, primarily in Japan and Taiwan, grew high-single-digits in the quarter. Our North America residential HVAC revenue grew in the low-double-digits despite a tough low-double-digit compare in the prior year.

Favorable weather in the latter part of the quarter drove higher replacement demand, and we are seeing strong price realization in the channel. Based on continued favorable weather trends, we do expect strong North America residential market demand will continue in Q4.

Global light commercial HVAC grew mid-single-digits in the quarter led by high-teens growth in North America on a relatively easy prior year compare, but this does reflect strong growth in our national accounts.

Our VRF business saw high-single-digit growth in the quarter with strong double-digit growth in our unconsolidated Hitachi joint ventures in China, which continue to perform exceptionally well.

IR also had a strong quarter with high-teens growth, and our applied HVAC equipment business grew high-single-digits led by solid growth in APAC and North America, partially offset by a decline in EMEA/LA.

Mid-single-digit growth in Specialty Products was driven by increased demand for fire suppression with solid growth in EMEA/LA and APAC, partially offset by a modest decline in North America on a tough prior year compare. Segment EBITA of $441 million was up 11% excluding the impact of Scott Safety.

The reported segment EBITA margin declined 30 basis point, but this includes a 90 basis point headwind related to Scott Safety. Underlying margins expanded 60 basis points to 18.2% as higher volume leverage and the benefits of cost synergy and productivity save was partially offset by 70 basis points of continued product and channel investment.

As mentioned earlier, price cost inflected positive in the third quarter, but really didn't have a significant impact on the margin rates in Q3. So let's move to slide 13 in Power Solutions. Sales of $1.8 billion increased 10% organically, driven by higher unit shipments as well as favorable price and technology mix.

Global battery shipments increased 6% year-over-year with both OE and aftermarket up 6%. The growth in OE shipments outpaced market growth as we began shipping units on several new business wins, which we expect to continue over the next several quarters.

Aftermarket shipments increased 6% driven primarily by higher demand in Europe, reflecting a benefit of a modest pull forward in customer orders as lead prices began to rise toward the end of the third quarter. Growth in the China aftermarket channel was also strong.

We continue to outperform in the China market with units up 30% in both OE and aftermarket as well as across the various technologies. Global shipments of start-stop batteries increased 30% year-over-year with strong growth in the Americas, China and EMEA/LA. Segment EBITA of $310 million increased 7% organically.

EBITA margin declined 200 basis points to 16.9%, but this includes a 150-basis-point headwind from FX and lead.

Power's underlying margin declined 50 basis points as the higher volume leverage, favorable mix and productivity save were more than offset by planned product investments, startup and launch costs and the continued headwinds from higher transportation and logistic costs.

Freight costs do remain at an elevated level; and although, we made further progress in our pricing and productivity initiatives in Q3, we did not fully offset these costs. Looking to Q4, we expect continued margin pressure related to transportation costs in Power Solutions.

So turning to slide 14, Corporate expense was down 16% year-on-year to $102 million as we continue to see the benefits of the synergy and productivity savings. For the full year, we now expect Corporate expense to be approximately $415 million, slightly below the low end of the range we previously provided.

So turning to cash flow on slide 15, we generated free cash flow of roughly $450 million in the quarter.

Excluding approximately $200 million of planned integration and restructuring cash as well as a planned non-recurring tax payment, Q3 adjusted free cash flow was approximately $650 million; two back-to-back quarters of very solid cash flow performance. Year-to-date adjusted free cash flow is now $1 billion, up $800 million over the prior year.

We are very pleased with our Q3 progress and are on track to deliver our 80%-plus adjusted free cash flow conversion for the year, excluding the net one-time items we've previously discussed with you.

It is clear that our cash management office now has traction across the enterprise and is making improvements on various trade working capital initiatives and aggressively managing our CapEx spend. Turning to the balance sheet on slide 16, our balance sheet position continues to improve with net debt down $150 million, sequentially, to $11.7 billion.

Our net debt to EBITDA leverage of 2.4 is well within our target range and our net debt to cap declined slightly to 36%. During the quarter, we purchased 1.6 million shares for approximately $60 million, in line with our normal pattern, and this brings our year-to-date to repurchasing 6.5 million shares for just over $250 million.

Our outlook for Q4 assumes another $50 million of share repurchases, which will bring the full year to around $300 million, consistent with our original plan. On slide 17, let me touch on just a couple of other items. Our Q3 results do include a favorable impact from a lower effective tax rate.

At the beginning of the year, we expected our fiscal 2018 rate to be 14%. Given additional tax planning specific to fiscal 2018, we now expect our annual tax rate to be 13%. This resulted in a $0.01 benefit in the quarter versus our planned rate of 14%.

I would also point out that the benefit for Q1 and Q2 has been excluded from our Q3 results and reported as a special item only for this quarter. We do expect the tax rate for Q4 to also be 13% as well as the full year, which will result in a $0.03 benefit versus our previous guidance.

Finally, I wanted to touch on a new revenue recognition Accounting Standard that will become effective for Johnson Controls in the first quarter of fiscal 2019. The impact of this Standard on our Buildings business is not significant.

For Power Solutions, although there is no material EBIT impact, the reporting classification of battery core returns changes and will now be included as an increase to sales versus a contra cost of sales item, thereby grossing up sales and impacting our EBITA margin rate by 200-plus basis points.

Again, this will be effective for Johnson Controls beginning the first quarter of next year and we will provide disclosure on a quarterly basis regarding the revenue gross-up and the related EBITA margin rate impact. With that, let me turn the call back over to George..

Thanks, Brian. Before we open up the lines for questions, I wanted to provide a quick update on the tariffs and make a few comments regarding our full year outlook. Starting with slide 18, retaliatory tariffs related to Section 232 Steel and Aluminum were announced at the end of May.

As I mentioned on our last earnings call, the direct impact related to steel and aluminum tariffs are nominal and will be fully offset. In terms of Section 301, the first phase of tariffs was enacted in early July. A second phase is currently under comment period. Given the evolving changes, we continue to monitor developments and update our analysis.

Included in the tariffs are compressors, electronics, motors and valves, which impact our Buildings businesses. As I mentioned last quarter, we do not expect much of an impact at all in Power Solutions. As part of our ongoing assessment, we are simultaneously identifying mitigating actions to minimize any direct impact. We expect minimal impact in Q4.

As we look further ahead, we are well-positioned given our existing global and regional supply chain and sourcing strategies. Additionally, we are actively managing price, both within the Supply Chain and externally.

Based on the analysis we have done so far related to our exposure and mitigating actions, we have already worked this down to a very manageable level. We will continue to monitor developments. Turning to slide 19, 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 gaining momentum and we expect an incremental $0.06 benefit related to higher revenue growth.

Given our traction with the incremental adds to the sales force, and the productivity we are gaining from our new and existing sales force, our overall investments will be about $0.03 higher than previously planned.

Additionally, as Brian mentioned, transportation costs continue to rise, which drives an incremental $0.01 of pressure net of cost recovery. As you can see in the last column, there are various puts and takes between FX and below-the-line items which net a $0.01 benefit. This takes the midpoint of our previous range to $2.81.

We are tightening our full year guidance range for diluted earnings per share before special items to $2.80 to $2.82. Again, I am pleased with the underlying momentum in our operations and the improvement in the fundamentals we have been able to achieve this year. Operator, please open the line for questions..

Thank you. Our first question comes from the line of Steven Winoker, UBS Financial. Your line is now open..

Thanks very much. Good morning..

Good morning, Steve..

Good morning, Steve..

Hey, so it's good to see the growth, but I want to focus on free cash flow, given I think, George, you said it's how you started most of your meetings. The step up that is implied in the fourth quarter to hit that 80%-plus number, I think it's about $1.1 billion, if my math is right, which is – sounds like the same as last year.

But last year, you also had some puts and takes around inventory, et cetera, in the fourth quarter. What are some of those dynamics in this fourth quarter? And maybe you could put that, also, in context of some of the initiatives and actions that are in place..

Yeah, Steve, you're right. Last year in the fourth quarter, we generated $1.1 billion and the implied fourth quarter based upon our 80%-plus this year is also $1.1 billion. Last year, we did have the benefit of having a $100 million reduction in inventory related to the build that we saw in Q3 last year.

And there was also a $100 million reduction in the fourth quarter of last year for receivables. So you could argue that the comparable number is really $900 million last year going to $1.1 billion this year. There's really three buckets that bridge that for you. There's probably about $50 million, round numbers, in growth just in income.

There's another $50 million that we've got line of sight to in Power Solutions inventory flushing in the quarter. And then, there's another $100 million of very specific CMO initiatives that we've got planned for Q4. So that really kind of bridges you to the $1.1 billion that we expect this year to get us to the 80%-plus free cash flow..

Okay. That's helpful. On the Building Solutions North America front, you mentioned a lower gross margin conversion on the backlog.

Are we – how far through are we kind of the pre current regime new pricing approach? I'm just trying to get a sense for what kind of product I'm looking at in terms of – I mean, what kind of pricing levels I'm looking at here, or were there cost issues or – maybe dig into that a little bit for us?.

Yeah, Steve, George here. When we started the year, we laid out that we had roughly about 75 basis points of pressure in our backlog in North America. And with that, we laid out a plan here to be much more disciplined in how we're pricing projects and through the year that we'd be able to turn positive.

So through the year, that would have amounted to about $40 million of pressure coming through 2018. And about three-quarters of that was felt in the first two quarters. We did see some impact in the third quarter and that's going to – we have a little bit of an impact in the fourth quarter.

What's important to note is that the orders that we booked in the year were up about 70 basis points since the beginning of the year that we put into backlog. And more recently, in the quarter we're up 110 basis points.

And so, we feel very good about being able to – as we get through this year, position for 2019, that our margin rates will continue to accrete now on a go forward basis with the mix that we put into backlog, with the service mix, and feel very good about that as we move forward.

And this has been driven by – we changed the incentive plan this year not only in line with delivering on the revenue or the booked orders, but also making sure that we're focused on booked margins..

Okay. That's helpful. Just before I pass it on, one more question, George. It's been – I guess it's been almost two years since the Tyco deal closed with JCI, so we're normally well into kind of the cost side on synergies. It sounds like revenue is starting to pick up.

Maybe just give us a little of an assessment of where you see things as you kind of stand apart in terms of the road map, how far we are – how much – how far you say we have to go, that kind of thing..

Yeah. What I would say is when we started the year, we knew that we had – this was going to be a transitional year. We had lots of headwinds that we needed to overcome; and then, from an operational standpoint, making sure that we're positioned not only for growth, but continued margin improvement across all of the businesses.

And what I would tell you, Steve, I'm very pleased with the progress we've made, with the way the team has come together and really focused on fundamentals of the business. We've created this growth machine on the front-end and our ability to be able to not only add capacity, but make sure that we're getting productivity out of that capacity.

And that's playing out extremely well. We're getting 8% booked orders in Buildings; and the work that we've done in Power, we've been able to add new platform wins in Power. So that is going extremely well.

In the Field businesses, we knew that we needed to pick up service because, with the installed base that we create, we create a lot of value not only for our customers, but for our shareholders with the service growth. We've created a service council and that is going extremely well. And we're going to continue to accelerate there.

We've put a big focus on price cost and, although we've had headwind in the first half, I think you can see from the results we've made a lot of progress here over the last nine months. And I'm confident that on a go-forward basis, strategically, we're going to be pricing ahead of cost on a go-forward basis.

And then, on the productivity and synergies, we have executed well on the integration and been able to achieve or perform at what we thought we would be able to achieve when we started the merger.

I believe that, although we've made a lot of progress now as we've been able to focus the organization on fundamentals, there's still a lot of room for improvement as we continue to not only drive growth, but continue to drive our margin structures to be able to deliver accretive margin rates..

Thank you..

Thank you. Our next question is from the line of Nigel Coe, Wolfe Research. Your line is now open..

Thanks. Good morning and congratulations, George, on a good quarter..

Thanks, Nigel..

Yeah. So just wanted to turn to the portfolio, and I understand that probably there's been some reports of interest on (29:47) probably on the call, but maybe just talk about – maybe this is a question for Brian.

You've got a large NOL and I'm wondering that if you do decide to spin or sell this asset, to what extent do you think you can utilize that NOL against any gain that you might realize on the sale?.

Yeah. The NOL that exists today would not be available to be used against any gain on the transaction, so – it's specific by jurisdiction, right, so we'd have to unpack all that.

But right now, I think we'd look at the major NOL that's disclosed in the footnotes to the financials, which I assume you're referring to, and that would not be available in a meaningful way to offset the tax costs..

Okay, okay.

And then, just to follow-on, sticking with Power, so with the revised guidance for this year, and then the impact of the new Account Standard on revenues, are we looking at maybe a 16% to 17% margin for next year, all things being equal? Is that a normalized margin run rate for Power going forward or do you still think high-teens is where this business contracts?.

You're referring to the Power Solutions margins?.

Yes..

Power Solutions – the impact of the new standard in fiscal 2019 will be between 200 basis points and 240 basis points, in that range. I mean, it's a gross-up of about 10% to 15% on revenue, and so you do that math off this year's expected margins and that's where we would expect to be in fiscal 2019, plus or minus..

Okay, thank you..

Thank you. And our next question, Jeffrey Sprague, Vertical Research Partners. Your line is now open..

Thank you, good morning..

Good morning..

Good morning, Jeff..

Good morning, everybody. Hey, just back to Power, just the nature of the deal with Tyco, the inversion and the like, I thought that precluded the ability to do a tax-free spin possibly for a five-year timeframe.

Should we assume, if you're moving forward to spin, you've found some way to make it tax free, or is there the possibility that we could be looking at a taxable spin here?.

So Jeff, when we were referring to the five-year limitation in order to do a tax-efficient spin, that would be based upon a straightforward spin of the Power Solutions business in September of 2021 or beyond.

There are structured transactions that could be put together that would potentially allow a spin prior to that time, but when you put together a transaction of that nature, it would be very complex and there could very well be tax risk associated with that structure.

And so, one of the things that we're doing as part of this evaluation of our options is also evaluating any tax risk that would be associated with a structured spin. And so, it's an option, but we're evaluating it in line with the other options that are on the table..

I guess I would take that to then maybe believe the offer on the outright sale side is not that appealing, the fact that you're going down that path?.

spin, sale versus retaining it. We have been evaluating, as Brian discussed, a tax-efficient spin and, in parallel, discussing with potential buyers. And we do expect, with the progress we've made, that we'll be able to be more definitive here by the release of our Q4 earnings.

And so, I think at this point, we don't want to make any further comments until a specific determination has been made, but I would tell you that I'm very pleased with the progress the team has made..

I wouldn't read anything into it, Jeff. I think we continue to look at all the options. I wouldn't read anything into the spin versus sale. I think we're trying to look at everything on a detailed basis and we'll conclude that review some time before our earnings call in Q4..

Thanks. Totally unrelated, if I could ask another one, just interestingly today, Fortive is spending 20-25 times EBITDA for a business that pulls data off of equipment for facilities management, asset management, and the like.

I would think some of that type of information comes off of BMS; some of it might even – some of those capabilities might be resident inside of BMS. I'm not expecting that you saw this Fortive deal this morning, but do you have the capabilities to do that sort of thing in your existing business? And perhaps, give us a little color on that if you do..

Sure. As we have put the businesses together, Jeff, we have an incredible position with our Building Management Systems. And as you've seen the growth as we go-to-market today in multiple systems, we've had strong high-single-digit growth across all of our Building Management Systems.

In parallel to that, we're putting all of those systems together into an integrated platform.

And we are making incredible progress in being able to simplify the platform, be able to set it up so that we can collect all of the data not only off our platforms, but any other systems that connect to our Building Management, and we can now tailor specific solutions to each of the verticals that we support, depending on the problem that customers want to solve.

We're going to – on a go-forward basis, because of the growth that we're achieving in this space, the investments that we're making organically, we're going to be positioned to be able to segment this revenue to show that it is beginning to accelerate in the strategy of putting these businesses together.

We're going to be positioned extremely well to be able to support the building in incorporating all of the data that's collected within a building..

Great. Thank you..

Our next question comes from the line of Julian Mitchell from Barclays. Your line is now open..

Thanks. Good morning.

Maybe just starting on the Buildings business, George, as you said, you've had some sort of clean-up work to do around gross margins and such over the past nine months or so, but when you're looking forward on Buildings with those issues behind you now that the entity has got to grips with price cost, what kind of incremental margins do you think Buildings can generate with this portfolio mix, leaving aside any remaining cost synergies from the transaction?.

Like I said, I'm very pleased with the progress we're making.

When you look at our margin structure about – when you look at our product businesses, we're getting nice leverage on our product businesses with the strong growth that we're achieving and the volume mix and productivity is offsetting a significant reinvestment in that business; and that business was up 60 basis points net of that.

And so, we see that continuing with the reinvestments that we're making. When you look at the Field businesses, we have, as we discussed, significantly improved our service businesses. We've been focusing not only in segmenting the markets that we serve, building out the sales force, and then building out our field capacity with our technicians.

And I would tell you, based on where we started at the beginning of the year and where we are today, we have made incredible progress. We have an installed base that's second to none to be able to mine and be able to build services. The growth that we've achieved in the first half was about 3%.

We ramped up to 5% in the third quarter and I see that continuing going forward. And then, the other piece of that is how we're booking installation projects across the board. We're booking at a higher rate, making sure that our sales force is focused on the value that we deliver with the projects that we deploy and ultimately execute on.

And with the progress we've made in – I highlighted North America up over 110 basis points in the quarter. The combination of the higher book margins in backlog, the service mix and the leverage we're getting on our technology and investments in our products, the three will combine to very attractive margin accretion here as we go forward..

Thank you very much. And then, my second and last question would just be around the EMEA and Latin America region, specifically. The margins there are some way below the other two regions within Building Solutions.

Do you see that as anything structural or it just requires a lot of heavy lifting and self-help and you should be able to get to the mid-teens margin range in the medium-term?.

Yeah. Our team in EMEA/LA has done an incredible job as we took the businesses, put them together and we've gone through a very large restructure here over the last year. If you look at the overall performance, although it's flat, organic sales in the quarter, service was up 3% and that will continue.

Install was down because we did have a lower backlog within our HVAC and Industrial Refrigeration. The orders in the quarter was up 15%, and that's with strong demand both in Industrial Refrigeration and Fire & Security.

I have complete confidence with the work – and then, when you look at margins, although reported they're up 60 basis points, they're up 100 basis points ex-FX.

With the work that we've done to restructure the business, with the volume that's beginning to come through, we're going to be in a good position here to be able to get much more leverage and to get to much more respectable margin rates on a go-forward basis. And so, I feel very good about the progress we've made over the last nine months..

Thank you very much..

Our next question is from Joe Ritchie from Goldman Sachs. Your line is now open..

Thanks. Good morning, everyone..

Good morning..

Good morning, Joe..

Good morning..

So obviously, really nice to see the organic growth acceleration and the investments paying off. George, maybe you can touch on what you think the incremental investment will be in 2019.

Where do you plan to continue to invest, whether it be in the sales force or on the product channel side?.

Yes, so as a percent of revenue, we're going to begin to see leverage on all of these costs as we go into 2019. So recall, this year as we started the year, we were relatively flat last year in our sales force. And so, we've had a significant ramp up here through the course of the year.

We have a lot of – from a mix standpoint, we have a lot of new sales leaders and sales people that are now getting up to speed. We're seeing tremendous momentum. And so, on a go-forward basis from a sales standpoint, we now have segmentation of the markets that we're serving.

We're making sure we have the right footprint and that we're getting not only the productivity, but we're adding in line with the market growth that we expect. So we've made a lot of progress this year.

So on a go-forward basis, you'll see much more leverage on that cost that we've put into place this year and we'll be adding sales to offset attrition and be able to get net productivity and then some incremental sales adds to that. So on that basis, I feel a lot of improvement here as we go forward.

On the Products side, as you can see, we're getting tremendous results from the investments that we've made over the last two or three years. And so, I see, as a percentage of revenue, we're going to continue to accelerate our revenue growth and the incremental reinvestment will be levered.

We're not – as a percent of revenue will continue to come down. And so, we're beyond where we're adding or reinvesting more heavily than our revenue is growing. I believe that we're now at that peak where we start to see leverage on the investments we're making..

Okay. That's good to hear. And I guess my follow on question, as you kind of think about cash flow next year, obviously there are a bunch of one-time items that you guys have highlighted this year, roughly $800 million to $900 million that are excluded from the cash flow number.

How does that number step down in 2019? And are there other opportunities from a working capital perspective that you're working on as well for 2019?.

Yes. So as far as 2019, you probably recall we did make a payment related to the Adient spin that was like $1.2 billion or $1.3 billion, and we knew that we were going to get that back in a couple of tranches, one of which we'll get back either in the fourth quarter of fiscal 2019 or the first quarter of 2020.

Assuming we get that back in the fourth quarter – and the reason there's a question on that is because the refund is in that $600 million to $700 million range. And given the size of that, it needs to get special committee approval in order to release that refund to Johnson Controls.

And so, we think we'll get it in the fourth quarter, but it could move into the first quarter of 2020. Given that inflow of cash and given the one-time special items that we've got for ongoing restructuring and integration, clearly our adjustments in 2019 should be favorable relative to where we've been historically.

So our reported cash flow in fiscal 2019 should actually be better than the adjusted cash flow, because we'll adjust out the one-time refund we get related to the Adient tax payment..

Got it. Thank you..

Our next question comes from the line of Rich Kwas from Wells Fargo. Your line is now open..

Hi, good morning, all..

Good morning..

George, on revenue synergies relative to the $500 million that was talked about a couple of years ago, how much would you say has been realized to-date at this point?.

So we're tracking well. Originally, when we started we had identified it was about $0.5 billion to $1 billion over time that we'd be able to achieve. I'd say, as we've integrated the teams, we have a much more seamless structure as we're working – as the businesses have come together.

I think when you look at our pipeline of opportunities, our pipeline is up over double digit pretty much across the board. And this is a result of these teams now working together. We've segmented the markets to make sure that we're positioned to serve the markets appropriately to capitalize on the growth.

The leads come in into a central process, and now the teams are executing well. So it's hard to begin to segment that because now we're operating seamlessly, but I would tell you from a pipeline development it's been a big contributor to being able to create that base that we're working to be able to convert into orders..

So is the way to think about this is there's probably not that much in current backlog, but your quoting staff and that's a function of this targeted focus combining the teams, etcetera.

So as yet – more or less yet to come in the backlog?.

Yeah, we're beginning to see it. I would tell you that if you look at Fire & Security, Fire & Security businesses are up mid-single digits across the board. And I think this is a result of the strong footprint that we had with the customers that we're serving within HVAC & Controls and being able to bring in Fire & Security.

So we've had very strong growth in our Fire products with fire detection and suppression up high single digits. And then, when you look at – Security is still up, but up to kind of low to mid-single digits. That is definitely a reflection of these synergies that we're getting in the sales force in being able to create those leads..

Okay. Okay. And then, just a quick follow-up on – can you level set us on China, your exposure in Building Solutions percentage of sales. Obviously, that's going to be a headwind here for the time being.

How much is that going to eat into some of the improvement you're starting to see in North America on margins as we think about 2019?.

Yeah. I'd start by saying we have a extremely strong position in China, both commercially as well as with our residential HVAC. And that's combined with our strong partnerships that we have, our JV partnerships. As Brian talked a little bit about, there are some new competitors. Some of those are local competitors.

We are positioned well locally with how we're not only designing new products, but also with our supply chain and manufacturing footprint and being able to serve the market.

We are – we have, like I said, a strong position and we're continuing to invest, and I believe from a cost structure standpoint we're going to be well positioned to be able to continue to deliver there. Short term, we have seen some projects that have come through at lower margins, but I don't believe that that's systemic.

I believe that the work we're doing, we're going to be able to continue to grow and continue to grow profitably, and we're going to continue to invest..

Okay, thank you..

Next question is from Deane Dray, RBC Capital Markets. Your line is now open..

Thank you. Good morning, everyone..

Good morning, Deane..

Good morning..

Hey, there's lots of discussion about the investments in the sales force.

I'm just – I'd be curious to hear what is the typical timeframe for a new salesperson? When do they start being productive? And then, a bit more about the allocation of these resources, are they going after new customers, like middle market? Are they generalists? Is there specialty sales? And maybe some color there because this is a significant investment that you've laid out..

Yeah. So, Deane, we started right out of the gate this year. This was our top focus here. We've lead it with a sales leadership council. We've made incredible progress and it starts with understanding our markets and how we serve our markets, and then making sure that we've got the right sales structure to be able to serve the markets.

We've made a tremendous amount of changes in doing that, and then understand, now, where we're adding, we see line of sight to significant growth. And so, with the adds we've made, it typically depends on whether it be installed projects or enterprise type projects, versus, let's say, T&M and service.

So there's a varying level of skill sets that we're recruiting to be able to capitalize on what we see as the biggest opportunities. So the cycle time of getting a sales – a new salesperson up to speed, it can be months in the service side or it can be one to two years, depending on the complexity of project sales that we're doing.

And so, I would tell you, is that we have metrics across the board. We're actually ahead of our metrics on the onboarding and then the production that we're getting out of our new sales force as well as getting strong performance out of our veteran sales force.

And so, what I would tell you is that, based on where we started the year, where we are, we're actually ahead of where we thought we would be..

Great. And just one follow up on Power, and I can imagine what the answer is, but just – it's worth asking is – you're in this period of, I'll use the word, limbo on the disposition or potential retention of Power.

Have you lost any talent? Are the OEs – with the feedback from them of any of your competitors making inroads and using that against you? Doesn't seem like it is, especially in China, but it's worth asking..

Not at all. I mean, let me start – go back to – this is a great business. The people in the business are very proud of the business and very passionate about what they do. We're winning across the board. We're winning in both OE as well as aftermarket. We're winning across the regions, gaining share. The team is executing well.

We've minimized the distraction that this has caused within the business. And so, when you have a business like this that is positioned well for a long term, you've got leaders that are very committed and very passionate and are very understanding that as we go through this process, we want to minimize disruption.

So we have not seen significant attrition as a result..

That's helpful. Thank you..

Thanks..

Thanks, Deane..

Operator, I'd like to turn the call over to George for some closing comments..

Yeah. Just to wrap up today's call, I want to thank everyone for joining the call this morning. As you can see, we've made a tremendous amount of progress this year, not only improving our fundamentals, but as we're leading with clarity, simplicity and confidence and certainly look forward to seeing many of you soon.

So operator, that concludes our call..

Thank you. That concludes today's conference call. Thank you all for joining. You may now disconnect..