Warning Signs at Johnson Controls (JCI)
A forensic accounting deep dive turns up several red flags
Every forensic accountant knows the story of Tyco as one of the classic tales of financial fraud in the early 2000s. CEO Dennis Kozlowski went to prison after being found guilty of a long list of financial chicanery including overstating results by as much as $1 billion through the manipulation of reserves established in the course of acquisitions and taking massive loans from the company which were later “forgiven” to fund his substantial art collection.
After the scandal, the company was streamlined to focus on its core business of fire and security solutions through a series of divestitures and restructurings. This included the sale of medical products giant Danaher (DHR). Finally, in 2016, Tyco was acquired by Johnson Controls (JCI), the leading maker of building efficiency solutions and HVAC systems and the subject of this report.
We want to emphasize that we are not inferring that the financial fraud of the Kozlowski era has somehow found its way into Johnson Control’s current business- but it’s always informative to know the back story of the company you are looking at buying.
What Drew Our Attention to JCI
JCI was among the companies we discussed as having concerning signs in its warranty accruals in our January piece They Break It, You Buy It which we recommend readers review for a detailed description of warranty accounting. Just a week later, JCI’s name turned up again in our January piece Bill and You Shall Receive (Most of the Time) examining companies with anomalies in their bad debt reserves. Readers can enjoy a thorough look at how to analyze a company’s receivables and bad debt reserves.
These red flags prompted us to take a closer look at JCI as we have always found that a company with unusual accounting-related benefits is a great place to look for more serious concerns. We were not disappointed.
The JCI Bull Story
JCI uses third-party distributors for a large percentage of sales. It saw the problems many companies experienced during and after Covid from supply-chain bottlenecks and shortages. Low supply caused customers to place larger orders to ensure delivery which caused JCI to try to build inventory and order more from its suppliers. As bottlenecks broke, customers and distributors worked off excess inventories and JCI’s sales volume faltered. This is expected to work itself out in 2024.
Meanwhile, JCI depends heavily on new construction or renovations for much of its demand. This includes commercial real estate in the US as well as around the world and apartments and other industrial real estate demand. All these areas are in various stages of recovery and decline.
Going forward, JCI is guiding to orders recovering causing volumes to turn positive and pricing to stick. However, guidance for the year is very back-loaded with mid-single-digit growth for the full year following -1% in 1Q24 and 0% in 2Q24.
Our Concerns
JCI normally hits earnings forecasts on the nose or beats by only one cent:
This by itself can be a warning sign and means almost any small tweak to reserves or discretionary spending can make the difference in meeting or missing forecasts. JCI cut its fiscal 2024 guidance by 5 cents when it reported 1Q24 results seeing weak China problems.
Our review turned up several concerning signs that may indicate the potential for another disappointment in upcoming quarters. The company has made recent changes to its disclosures which is always a bad sign. We also noted several other red flags that call into question the quality and sustainability of recent results.
Let’s get Behind the Numbers…