Johnson Controls Needs to Take Charge

03/08/2013 5:00 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

The company hasn't yet made the changes Wall Street has been begging for, but a second-half rebound could happen regardless, writes MoneyShow's Jim Jubak, also of Jubak's Picks.

Shares of Johnson Controls (JCI) popped early Wednesday on the rumor that the company was looking to sell its auto interiors business—at 51% of sales, the unit is the company’s largest, but also shows the lowest operating margin of Johnson Controls' three major businesses.

But when the company clarified the rumor and confirmed that it had indeed hired JPMorgan Chase to look for a buyer for part—not all—of the auto interiors unit, investors lost part of their enthusiasm. The stock, which had been up by as much as 7.4% during the day, finished ahead by just 2.6%. Yesterday, the shares closed up another 2.39%.

The early enthusiasm is easy to understand. Johnson Controls shows an operating margin of just 3.7% on its auto interiors business...and operating margins of 14.2% on its battery business and 6.2% on its building efficiency business. Selling the lower-margin auto interiors business would give the company billions to invest in the more profitable units.

Investors were then disappointed to learn that the company was only interested in selling a relatively small part of the auto interiors unit. Johnson Controls was shopping its automotive electronics unit that sells infotainment systems, instrument clusters, and electronics that control door locks and monitor tire pressure. Those products generated about $1.4 billion of the $21 billion in revenue produced by the auto interiors business in 2012.

Analysts estimate that the sale could bring in about $1 billion—a nice hunk of change, but hardly transformative for the company.

And Wall Street has been looking for something transformative from the auto interiors business. It’s been a laggard at Johnson Controls. The company has made repeated promises of a turnaround in margins for the business, but hasn’t yet been able to deliver.

Wall Street has, frankly, lost patience and wants to see some dramatic action. That’s what analysts thought they’d heard in the early rumors, but that’s not what the company has delivered.

Although this isn’t the big move that Wall Street wants from Johnson Controls, selling off the automotive electronics business makes lots of sense. The company doesn’t have the heft in the space to keep up with rapidly advancing technologies without hurting margins further. I think it’s a good move to sell this business.

That said, the reason to continue to hold Johnson Controls is that the turnaround in the global auto industry will result in rising revenue and operating margins for the auto interiors unit. Much of that improvement is back-end loaded into the second half of 2013.

As of March 7, I’m keeping my target price at $37 a share until I see some evidence of increased revenue and margins. (Johnson Controls is a member of my Jubak’s Picks portfolio.)

Some of that hoped-for second-half story is already in the stock—the shares are up 19% for the last three months as of March 6. That’s slightly ahead of the 16.2% gain for the auto parts sector as a whole. (The S&P 500 is up 9.6% in that period.)

But I think actual evidence of a turnaround in revenue and margins for the unit would push the stock up sufficiently from here to make it worth holding on for six months or so, just to see if the company can deliver on its promises.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. The fund may or may not now own positions in any stock mentioned in this post. The fund did own shares of Johnson Controls the end of September. For a full list of the fund’s holdings as of the end of September, see the fund’s portfolio here.

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