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Edited Transcript of JCI earnings conference call or presentation 31-Jul-19 1:00pm GMT

Q3 2019 Johnson Controls International PLC Earnings Call

Cork Aug 28, 2019 (Thomson StreetEvents) -- Edited Transcript of Johnson Controls International PLC earnings conference call or presentation Wednesday, July 31, 2019 at 1:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Antonella Franzen

Johnson Controls International plc - VP and Chief IR & Communications Officer

* Brian J. Stief

Johnson Controls International plc - Executive VP & CFO

* George R. Oliver

Johnson Controls International plc - Chairman & CEO

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Conference Call Participants

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* Andrew Alec Kaplowitz

Citigroup Inc, Research Division - MD and U.S. Industrial Sector Head

* Charles Stephen Tusa

JP Morgan Chase & Co, Research Division - MD

* Deane Michael Dray

RBC Capital Markets, LLC, Research Division - Analyst

* Jeffrey Todd Sprague

Vertical Research Partners, LLC - Founder and Managing Partner

* John Fred Walsh

Crédit Suisse AG, Research Division - Director

* Joshua Charles Pokrzywinski

Morgan Stanley, Research Division - Equity Analyst

* Julian C.H. Mitchell

Barclays Bank PLC, Research Division - Research Analyst

* Nigel Edward Coe

Wolfe Research, LLC - MD & Senior Research Analyst

* Noah Duke Kaye

Oppenheimer & Co. Inc., Research Division - Executive Director and Senior Analyst

* Timothy Ronald Wojs

Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst

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Presentation

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Operator [1]

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Welcome to the Johnson Controls Third Quarter 2019 Earnings Call. (Operator Instructions) This conference is being recorded. If you have any objections, please disconnect at this time.

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

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Antonella Franzen, Johnson Controls International plc - VP and Chief IR & Communications Officer [2]

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Good morning and thank you for joining our conference call to discuss Johnson Controls' third quarter fiscal 2019 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'd 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 discussion, 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.

The results of Power Solutions for the month of April are reported as discontinued operations. The focus of this call will be on continuing operations.

GAAP earnings per share from continuing operations attributable to Johnson Controls' ordinary shareholders was $0.16 for the quarter and included a net charge of $0.49 related to special items, which Brian will address in his comments. Adjusting for these special items, non-GAAP adjusted diluted earnings per share from continuing operations was $0.65 per share compared to $0.54 in the prior year quarter.

Now let me turn the call over to George.

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [3]

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Thanks, Antonella, and good morning, everyone. Thank you for joining us on today's call. I'm going to start with a few strategic highlights from the quarter, beginning on Slide 3.

Looking at our results for the quarter as a whole, we remain encouraged by the ongoing progress we have seen over the last several quarters. We delivered another strong quarter of organic revenue, order and backlog growth and also delivered on our commitment to generate $600 million in adjusted free cash flow. These results reflect the continued emphasis on driving underlying fundamentals focused on innovation and new product development, talent management, enhancing commercial excellence across the organization and optimizing our cost structure. As I think about the reinvestments we have made and continue to make to support future growth, I am confident that we are strategically strengthening our market position.

As we highlighted in the examples we provided to you last quarter, our objective to lead the evolution of smarter, more efficient and more sustainable buildings and infrastructure is coming more into focus every day. In pursuit of developing our strategy in connected buildings, we are actively partnering with our customers, technology providers and integrators to create comprehensive digital solutions with attractive value propositions that assist our customers in achieving their goals and missions. Our broad portfolio of smart EDGE devices, connected equipment and systems and cloud-based data analytics capabilities provides Johnson Controls a unique competitive advantage as the industry begins this transition.

With the closing of the Power Solutions sale at the end of April, our ongoing portfolio transformation will be focused on optimizing the alignment of our portfolio with our longer-term strategic vision around connected buildings and infrastructure. For example, this quarter, we made the decision to divest a business within our EDGE distribution portfolio, which was deemed to be noncore.

Lastly, we made significant progress on the deployment of the Power Solutions proceeds, successfully completing both the equity and debt tender. Brian will provide you more detail later in the call, but we redeployed nearly 2/3 of the $11.6 billion within 45 days of completing the transaction between the $4 billion share tender and the $3.4 billion of debt paydown. More to come on that, but I am extremely pleased with the execution from our teams on returning capital to our shareholders.

Turning to orders on Slide 4. Order growth returned to the mid- to high single-digit range as expected with organic growth of 6% in the quarter on top of 8% growth last year. Our order pipeline remains robust with an attractive mix of service and a balanced profile of small and large projects. Our short-cycle book-to-bill ratio was up slightly in the quarter.

Brian will provide more details on order performance by segment, but from a high level, we continue to see good underlying growth in our core HVAC and Fire & Security end markets across most of our regions. Although we are continuing to monitor the macro uncertainty, our end markets generally remain healthy, and we are well positioned to continue to gain share. Backlog ended the quarter at $9 billion, up 7% organically versus the prior year, which supports our Q4 revenue assumptions and also provides better visibility into 2020.

Turning now to Slide 5. Let me provide a quick recap of the financial results for the quarter. Sales of $6.5 billion increased 6% on an organic basis with solid growth across all 4 segments. Adjusted EBIT of $809 million grew 7% on a reported basis, which includes a headwind from FX of approximately $20 million in the quarter. Adjusted EBIT grew 11% on an organic basis driven by solid 7% growth in segment profit as well as lower corporate expense.

I would note that segment EBIT on margins came in a bit below what we were expecting in the quarter due to mix in our North America business. Brian will provide more color on North America, and I will provide updated guidance later in the call. Overall, underlying EBIT margins expanded 60 basis points year-over-year, excluding the impact of FX and M&A.

Adjusted EPS of $0.65 increased 20% over the prior year driven by solid top line performance as well as the initial benefits from the capital deployment actions related to the utilization of proceeds from the Power Solutions sale.

Adjusted free cash flow of just over $600 million in the quarter represents conversion of 109% and brings our year-to-date free cash flow to nearly $650 million, keeping us on track to reach our targeted 95% conversion for the year.

With that, I will turn it over to Brian to discuss our performance in more detail.

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Brian J. Stief, Johnson Controls International plc - Executive VP & CFO [4]

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Thanks, George, and good morning, everyone. So starting on Slide 6, let's take a look at our year-over-year EPS bridge. Operational performance, including synergy and productivity save, contributed $0.10, which was partially offset by $0.02 of continued product investments in the fiscal '18 run rate sales force additions we talked about in prior quarters. Other below-the-line items contributed a net $0.03 to our Q3 results of $0.65, which is up 20% year-on-year.

Moving to Slide 7, let's review our segment results on a consolidated basis. Sales of $6.5 billion increased 6% led by 7% growth in products and 5% growth in our field businesses. During the quarter, we saw solid service growth in North America and tempered growth in EMEA/LA and APAC. Overall, service growth was 2% in Q3, and we continue to convert our project backlog, with installation revenue up 6% led by solid growth across all regions.

Segment EBITA of $992 million grew 7% driven by volume leverage from our field and products businesses as well as productivity and synergy save.

Q3 segment EBIT margin provided 20 basis points to 15.4% as volume leverage across our businesses, favorable mix in global products and synergy and productivity save was partially offset by a 30 basis point headwind related to mix in North America that George mentioned. As you can see in our margin waterfall, underlying operational improvement contributed 60 basis points, which was partially offset by continued product and run rate sales force investments.

Now let's take a look at each of the segments in more detail. Starting with North America on Slide 8, sales grew 4% driven by continued strength in both install and service, which were up 4% and 3%, respectively. Q3 growth was led by strong high single-digit growth in our applied HVAC & Controls businesses as we saw a double-digit increase in applied equipment sales. Our Fire & Security service and install businesses grew low single digits on a tough prior year compare of 7%. Our Performance Solutions business declined high single digits in the quarter.

Adjusted EBITA declined 3%, and EBITA margin decreased 90 basis points to 13.3%. Benefits from synergy and productivity save as well as volume leverage were more than offset by unfavorable mix within the individual platforms and the year-over-year impact of our run rate salesforce additions.

So just to comment on mix as this was the primary driver of the North American margin headwind we saw in the quarter. You may remember that in Q3 last year, we benefited from very favorable mix in our North America segment. This was the result of high-margin Fire & Security businesses growing at a faster pace than our HVAC business. Additionally, within Fire & Security, our high-margin retail business had a very strong Q3 last year driven by several large shipments to big-box retailers. In this year's quarter, in addition to install growing at a faster rate than service, we also saw our HVAC businesses grow faster than our higher-margin Fire & Security business. In total, mix was a 90 basis point headwind to North America's year-over-year margin rate.

As expected, orders in North America were very strong in the quarter, increasing 6%. Orders for applied equipment were up low double digits aided by a strong rebound in equipment, but this was also on an easier prior year compare. You may recall we had a decline in equipment orders in Q2 due primarily to the timing impact of price increases between the years. Year-to-date HVAC equipment orders are up low double digits. Fire & Security field orders were relatively flat in the quarter, while our Performance Solutions business saw order growth of over 20%. North American backlog of $5.7 billion increased 6% year-over-year.

Now let's turn to Slide 9 where we saw another solid quarter from EMEA/LA team. Sales grew 6%, with service up 2% and a strong install up 10%. Growth was positive in most regions and across most lines of business, with the only soft spot being in the Middle East HVAC. We saw Europe grow high single digits led by mid-single-digit growth in our Fire & Security businesses, which accounts for 2/3 of our revenues in region as well as mid-teens growth in Industrial Refrigeration and low double-digit growth in HVAC. Orders in Europe increased high single digits led by strong demand in IR and Fire & Security.

In the Middle East, revenues declined mid-single digits as modest growth in service activity was more than offset by softness in HVAC project installations, and the Latin America revenues increased low double digits led by strength in Fire & Security.

Adjusted EBITA increased 14%, and EBITA margin expanded 60 basis points to 11.2%, and this includes a 30 basis point headwind from foreign currency. Similar to the past few quarters, underlying margins increased 90 basis points in EMEA/LA as favorable volume and productivity and synergy save more than offset the salesforce additions.

Orders in EMEA/LA increased 8% led by continued strength in Europe and Latin America across both service and installation. And EMEA/LA's backlog ended the quarter at $1.7 billion, up a strong 11%.

Moving to APAC on Slide 10. Sales grew 6% led by higher demand for project installations, which grew 9% in the quarter. Install activity was led by continued strength in our core HVAC and BMS platforms, with sales in China up mid-single digits. Sales for our core service offerings were 1% in the quarter, which included high single-digit growth in China.

Adjusted EBITA increased 4% with margins now at 14.2% as we saw favorable volume leverage partially offset by the higher install mix and run rate salesforce additions.

Asia Pacific orders increased 1%. A strong service growth of 10% was substantially offset by mid-single-digit decline in installation orders due primarily to the timing of some certain project awards. APAC's backlog increased 7% year-over-year to $1.6 billion.

So moving to Slide 11. Overall global product sales increased a strong 7% on top of the 7% growth in the prior year quarter. Let's take a look at the pieces.

BMS once again grew low double digits with continued strength across all 3 platforms: controls, security and fire detection. Sales across our HVAC and IR equipment businesses grew mid-single digits. Global residential HVAC grew mid-single digits in the quarter. North America residential HVAC revenue increased mid-single digits on a low double-digit compare, benefiting primarily from strong price realization and favorable mix. I would note that volumes were down low single digits in the quarter given the negative impact from the cooler wet weather. Looking to Q4, although July weather has been more favorable, channel inventories at the end of June were relatively high, and our business grew just over 20% in Q4 last year.

Our light commercial unitary business grew high single digits in the quarter, with North America also up high single digits. IR equipment declined low double digits in the quarter against a tough prior year compare of low double digits, and our applied HVAC equipment business grew mid-single digits, reflecting continued strength in our chillers business and the indirect channels in North America and Asia. And finally, Specialty Products grew high single digits on strong demand for our fire suppression projects -- products, particularly in North America.

Products segment EBITA increased 12%, and EBITA margin expanded a solid 100 basis points driven by leverage in higher volumes, favorable mix, positive price costs and the benefit of cost synergies and productivity save, slightly offset by product investments in the quarter. I would point out that we do expect a higher level of planned product investments in Q4, which will impact our year-over-year margin compare.

On Slide 12. Corporate expense was down 13% to $90 million driven primarily from the benefits of synergy and productivity save but also from the early actions we've taken to reduce costs given the recent Power Solutions divestiture. For the full year, we now expect corporate expense to be in the range of $370 million to $380 million.

So let's turn to free cash flow on Slide 13. Free cash flow from continuing ops for Q3 was $500 million on a reported basis and slightly above $600 million on an adjusted basis. We continue to make good progress on trade working capital, which is as a percentage of sales is down 20 basis points year-over-year. As we expected, we did see a seasonal inventory build, which supports the continued growth in our HVAC businesses. Year-to-date adjusted free cash flow was nearly $650 million, up 29% year-over-year. And for the full year, we remain on track for 95% conversion.

So let's turn to the balance sheet on Slide 14. With the closing of the Power Solutions transaction, there were a lot of moving pieces in the quarter. Most notably, we repaid over $5 billion in gross debt, and we completed over $4 billion of share repurchases in the quarter. I'll provide you with more detail on each of these, but before I do that, I would just like to remind you that our net debt to EBITA leverage will remain well below the target range of 2 to 2.5x as we deploy the balance of the Power Solutions' net proceeds. It is our intent to let our net debt to EBITA multiple gradually move back to our target range throughout fiscal '20. Having said that, should the need arise to conserve more cash on our balance sheet, we will maintain that flexibility.

So let's turn to Slide 15, and let me walk you through our debt paydown bridge. As you know, we started fiscal '19 with gross debt of $10.9 billion. During the first half of 2019, we increased short-term debt by $1.5 billion, which is a combination of higher STP as well as a $750 million term loan. This increase funded our first half seasonal cash outflow and also supported our $1 billion in share repurchases. As we committed to you, we repaid $3.4 billion in debt using a portion of the $11.6 billion in net proceeds from the Power sale. This included $1.5 billion debt tender and $1.9 billion in paydown of other short-term securities. This debt paydown was completed as planned and is expected to generate $100 million in annual run rate and for savings on a go-forward basis.

In addition to the $3.4 billion paydown, I would like to point out that we did repay the $750 million term loan that we secured in early fiscal '19 I mentioned earlier, and we've now terminated all TSarl debt-related agreements having repaid all TSarl financial obligations a bit earlier than originally planned. We now expect net financing charges for the year to be in the range of $295 million to $300 million.

Slide 16 provides a walk of our share repurchase activity. As you know, we successfully completed the $4 billion tender in early June, buying back about 102 million shares at a price of $39.25. Shortly after the completion of the tender, we entered into an open market repurchase program and repurchased an incremental 2 million shares in the final 2 weeks of Q3 for a total cost of $100 million. Year-to-date, we've now repurchased 135 million shares for $5.1 billion.

Looking ahead into fiscal Q4 and into 2020, we are moving forward with the plan to continue repurchasing our stock. Our current plan provides for an OMR of $3.1 billion throughout fiscal '20 and leaves us flexibility for the remaining $1 billion. We will continue to update you on future calls on our share repurchase plans as we move through the next several quarters.

Before I turn it back over to George for an update on Q4 guidance, I did want to provide some commentary on the significant special items that we had in the quarter that are outlined on Slide 17. Let's start with the tax indemnification reserve release of $226 million. This was a historical reserve that was recorded by Tyco several years ago related to a prior year divestiture, which was favorably resolved in the quarter resulting in no cash payments.

Secondly, as part of our continued portfolio reviews, we recorded a $235 million noncash impairment charge related to the planned sale of a noncore business in our air distribution portfolio.

Third, after conducting a comprehensive review of our environmental exposure related to our facilities in Marinette, Wisconsin, led by third-party environmental consultants, we recorded environmental charge of $140 million. This reserve will address the cost of environmental remediation related to contamination resulting from the use of firefighting foams containing PFAS compounds at our fire training facility in Marinette. The cash impact of this charge is expected to occur over multiple years and will be funded through our normal annual cash generation.

The fourth item relates to a discrete tax charge of $226 million associated with newly enacted regulations on June 14, 2019, related to the 2018 U.S. tax reform. We expect a substantial portion of this charge will not result in cash taxes and will be paid in future years.

Fifth, in connection with our $1.5 billion debt tender that I mentioned earlier, we had a $60 million charge related to the early extinguishment of that debt, which was funded with the proceeds from the Power Solutions sale.

And then finally on a disc ops basis, we recorded a $5.2 billion pretax gain on the Power Solutions sale.

With that, let me turn it back over to George for guidance.

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [5]

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Thanks, Brian. Before we open up the line for questions, let me provide you an update on our 2019 guidance, starting with our EPS walk on Slide 18. Just a couple of changes versus what we shared with you last quarter. There is no change to the EPS benefit from operations, synergies and investments in salesforce additions. You can see the impact of our capital deployment on net financing charges and share count. Compared to our EPS guidance range last quarter, there is $0.04 of additional benefit at the midpoint of the range. This primarily relates to a benefit in net financing charges due to favorable interest income rates and less interest expense given our significant debt paydown activity during the quarter as well as a start to right size corporate costs resulting from the sale of Power Solutions. As a result, we are tightening our EPS guidance to the high end of our previous range and now expect the EPS before special items to be in the range of $1.93 to $1.95, representing EPS growth of 21% to 23% year-over-year. This includes an expected Q4 adjusted EPS range of $0.76 to $0.78.

Turning to Slide 19. We have updated some of our operational assumptions as well as the below-the-line items to reflect our year-to-date performance and current outlook for Q4. For the full year, organic growth is now expected to come in at the high end of our previous range, up 5% to 6%. Given the higher expected revenues, coupled with the Q3 mix in North America, our segment EBITA margin expansion is now expected to be approximately 30 basis points for the year.

As I mentioned earlier, we are continuing to see top line momentum across the businesses, and our focus remains on driving the fundamentals both from a P&L and cash perspective.

With that, let me turn it over to our operator to open the line for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Jeff Sprague with Vertical Research Partners.

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Jeffrey Todd Sprague, Vertical Research Partners, LLC - Founder and Managing Partner [2]

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Just on cash use and kind of the outlook for that. Clearly, on the repo, it looks like you're holding back, and Brian actually used the term like if we see the need to preserve cash. So can you just give a little bit of color on what you're thinking? Do you see something more worrisome from a macro standpoint? Or are there some particular reason you're kind of keeping $1 billion in your back pocket here?

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Brian J. Stief, Johnson Controls International plc - Executive VP & CFO [3]

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No. I think what I was trying to communicate there, Jeff, was simply that we've got a formal program right now for $3.1 billion, and our plan is to make sure that gets executed during fiscal '20. As we move through the year, we could very well use that other $1 billion for share repo as we move into the back half of next year. But we are going to just maintain a bit of flexibility both from a macro standpoint to see how things play out, and there might also be some product line gap fillers or other M&A that we want to look at as well. So we just didn't want to fully commit right now the entire $4.1 billion, but we're going to do the $3.1 billion, and the remaining $1 billion we'll kind of keep you updated on as we move throughout fiscal '20.

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Jeffrey Todd Sprague, Vertical Research Partners, LLC - Founder and Managing Partner [4]

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And then maybe as a follow-up on that, George, what are you thinking on the M&A front? Do you have an active bolt-on pipeline, anything moving through that pipeline?

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [5]

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Yes. Let me start, Jeff, by saying relative to our performance, as we've communicated, we're continuing to focus on execution, delivering on our commitments and delivering results. But all being said, we continue to look at M&A with bolt-ons that as we're reinvesting with our organic reinvestments, we're making sure we're supplementing that with strategic bolt-ons. So there is a pipeline that we've been working. A lot of that is in the Building Management Systems as we build out our capabilities within our digital solutions, and so we are continuing to pursue acquisitions.

As Brian said, we do believe that the environment -- we still see a very good environment pretty much across our markets, and we're continuing to capitalize on that as we are converting not only the pipeline to orders but now the orders to growth. And so we're going to stay focused on execution. We're going to make sure that we're also keeping track relative to what's happening in the M&A. And as we go forward, we want to continue to strengthen what we're doing organically.

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Operator [6]

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Our next question comes from Andrew Kaplowitz with Citi.

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Andrew Alec Kaplowitz, Citigroup Inc, Research Division - MD and U.S. Industrial Sector Head [7]

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George, we know you had a relatively significant mix issue that you talked about in Building Solutions North America. You mentioned Fire & Security is growing more slowly than HVAC & Controls, but it did slow down a little bit in Q3 versus Q2. You mentioned the difficult comparison on retail this quarter, but is any of the store growth a little slower U.S. retail economy? And how much would you expect that 90 basis points of mix headwind on the business to improve in the quarters ahead?

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [8]

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Yes. So as we look at what took place in third quarter, as you said, it was mainly driven -- because the last year, we had very strong growth in Fire & Security and within that, very strong growth in retail. And then year-on-year, although we were outperforming the market in Fire & Security in 2019, it's at a much lower growth than our HVAC business, which we're continuing to execute very well. And so as we now project North America going forward, we see in fourth quarter roughly about 30 basis points with the mix that's going to come through in third quarter. And for the year, it may now be relatively flat for the year.

Now when you look at the year, it suggests that our productivity and synergy is offsetting the investments we're making in salesforce as well as the pension headwind. And then the volume that we're achieving now is offsetting some of that negative mix. But we're very confident with the fundamentals we have in place, the way that we're driving improved fundamentals to be able to, on a go-forward basis, see improved leverage as we go into 2020.

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Andrew Alec Kaplowitz, Citigroup Inc, Research Division - MD and U.S. Industrial Sector Head [9]

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And George, maybe if I could follow up on that. The incrementals in your products business were much stronger than usual. We know that price versus cost is strong, but did you actually have lower investment than usual in the quarter in that segment? And can you talk about incrementals in products getting up to 30% over time? I know you mentioned you will up investment in Q4, but you're actually ahead of the schedule and improving the execution on the portfolio of the products in that segment.

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [10]

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Yes. When you look at our product business year-on-year, this is where a lot of the work that we've done around price/cost has come through. And as you know, we had significant commodity headwinds as well as tariffs, and we've done a nice job ultimately driving price as well as productivity to get positive price/cost. And that, within the quarter, is about 40 basis points. So overall, that has been a big strength for us.

Now with the leverage, when you look at our investment profile, it is -- it was pretty much spread through the year, and as Brian said, we'll see some additional reinvestments in fourth quarter based on the timing of our product launches. But it's not -- it's in line with what we expected.

So as we look at these businesses, what I would say is we're building the fundamentals, we're getting a lift with the reinvestments we're making, and that's coming through the growth and that we're executing very well the price/cost, which is adding to the overall margins. On a go-forward basis, we believe with the continued performance with growth, with the work that we're driving fundamentals, we're going to be positioned to be able to leverage product. The leverage margins will be 25% to 30%.

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Andrew Alec Kaplowitz, Citigroup Inc, Research Division - MD and U.S. Industrial Sector Head [11]

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And you see that 40 basis points being pretty stable going forward, the price/cost?

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [12]

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Yes. I mean based on what we see today, I mean you can't predict all of what's going to happen in the future, but I feel confident now that we're -- we have a good understanding of what's happening from a cost standpoint, what's happening with tariffs and that from a pricing standpoint, we're now pricing -- taking that into account on a go-forward basis.

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Operator [13]

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Our next question comes from Steve Tusa with JPMorgan.

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Charles Stephen Tusa, JP Morgan Chase & Co, Research Division - MD [14]

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Can you maybe talk about what you're seeing on the global applied markets, what your order pipeline looks like for the next several quarters including in China?

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [15]

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Yes. What was the -- which markets were you referring to?

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Charles Stephen Tusa, JP Morgan Chase & Co, Research Division - MD [16]

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Global applied, applied equipment, just the order pipeline there, HVAC applied.

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [17]

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Yes. So let me just give you a perspective on our overall HVAC businesses globally. When you look at our performance, our orders were up 6% globally. Our revenues, we converted revenues at 7%. And when you look at our pipeline, we're continuing to build pipelines pretty much across the globe that are up kind of mid- to high single digits both in our commercial and residential businesses. So overall, I feel very good about the work that we've done to be able to take advantage of that market.

When you break out into the segmentation, you see our commercial HVAC businesses are growing 7%, and that's been driven by applied as well as with the service that we're getting as a result of the installed base that we're putting in place. And then when you look at resi, we're up kind of mid-single digits, and that's a combination of our UPG business up kind of mid-single digits in North America in our Hitachi business, so high single digits -- up high single digits globally. And so overall, Steve, we still feel very good about the pipeline, how we're converting the pipeline and then how that's setting us up here as we go forward in 2020.

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Charles Stephen Tusa, JP Morgan Chase & Co, Research Division - MD [18]

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Okay. And any specific comments on China, what you're seeing in China commercial HVAC?

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [19]

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Yes. So China, when you look at the China market, it continues to perform. I mean we're seeing kind of orders in the mid-single digits. We're seeing a little bit better in service, which is high single digits. So we're watching this closely. But as you know, we have a strong presence there. We have a strong position from a market share standpoint, and we've been making sure that we've got the right product and we're ultimately capitalizing on the growth that's occurring. So we have not seen any significant change in the activity or the pipeline that we're building. And as I said, we're continuing to build our service business, which, over the cycle, is very important to make sure that we're getting the recurring revenues.

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Antonella Franzen, Johnson Controls International plc - VP and Chief IR & Communications Officer [20]

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Yes. Steve, the only thing I would add is that China specifically, orders were very strong in China. So although APAC was up 1%, China orders were really strong, and it was a mix between install and service.

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Operator [21]

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Our next question comes from Nigel Coe with Wolfe Research.

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Nigel Edward Coe, Wolfe Research, LLC - MD & Senior Research Analyst [22]

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I want to go back to the North America building installations and the retail headwinds. You've obviously covered that already, but can you just recap us on how big is the retail exposure there? And it does feel like a typical footprint of the retail factor is starting to shrink in an exhibited pace. So I'm just wondering how you're thinking about that business going forward in light of this online transition that seems to have recovered.

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [23]

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Globally, Nigel, the retail business is about a $1 billion business. It is a global business with a significant piece of that in North America. What happened last year, we had very strong growth in the quarter last year. It was mainly driven by some significant product shipments in the quarter, which obviously didn't repeat this year.

Overall, as you know, we've got multiple businesses there. We have the antitheft security business as well as we've been building a digital traffic business and as well as our inventory management business. Those businesses are performing well. Certainly, with the slowdown and some of the challenges in retail, some of the projects have been pushed out, which we've seen here in third quarter and we're watching that closely for fourth quarter. But as you know, overall, this is -- it's a good business. We've had a lot of growth. We had a lot of growth last year, obviously seeing the impact this year, but we're going to watch this closely.

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Nigel Edward Coe, Wolfe Research, LLC - MD & Senior Research Analyst [24]

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Okay. Great. And then just a quick one on the NCI line. It's up quite a bit from your prior guidance. I'm just wondering what's -- what business is driving that.

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Brian J. Stief, Johnson Controls International plc - Executive VP & CFO [25]

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So those would be the Hitachi businesses where we own 60% of those ventures, and they perform -- continue to perform very strong and that Q3 and Q4 and even into fiscal '20, we're going to continue to see that NCI line move up simply because of the strong performance of Hitachi.

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Nigel Edward Coe, Wolfe Research, LLC - MD & Senior Research Analyst [26]

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And then just, Brian, quickly, is that better revenue or better margin? And where do we stack up right now in getting cash out of those JVs?

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Brian J. Stief, Johnson Controls International plc - Executive VP & CFO [27]

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Yes. So you probably saw in the quarter, if you look at the cash flow statement that was attached to our release, we did get a big dividend in the quarter as we expected. We -- because I think I've mentioned on this call in the past, the second calendar quarter of each year is when we have certain of the Board meetings related to the Hitachi entity -- entities, I should say, and we did receive a large dividend in the third quarter as we had planned.

So the good news is it's a larger amount than we've got in prior years, and we continue -- on a go-forward basis, we'll have to work on getting out of similar level of dividend, or again, as I've talked about in the past, it may require some reinvestment in Hitachi business to support the growth. So on a go-forward basis, we're just going to have to monitor the level of dividends that we get out of Hitachi joint venture, but in the quarter, we've got a large one.

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Operator [28]

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Our next question comes from Julian Mitchell of Barclays.

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Julian C.H. Mitchell, Barclays Bank PLC, Research Division - Research Analyst [29]

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Maybe just the first question on the corporate expense, very, very good progress there again. And when we think about the sort of go-forward run rate, I think we've been thinking maybe another $50 million-or-so reduction into next year. Does that sound about right? So the sort of go-forward run rate is closer to, I don't know, $330 million figure like that?

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Brian J. Stief, Johnson Controls International plc - Executive VP & CFO [30]

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Yes. It might be a little heavy. I would just say that I was very pleased with the actions that our corporate team took immediately after the Power sale to begin taking costs out to right size. I would say, this year, there's probably going to be $10 million taken out. Realistically, as we transition through fiscal '20, I would say that costs will be taken out during the course of the years. So if you assume we take them out prorated, that's going to probably give you another $20 million minimum. And if we can accelerate some of that, maybe $30 million to $35 million would come out next year. And then the full run rate of $50 million we'd see as we move into 2021. So I think more along the $30 million to $35 million is probably a better number to work with.

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Julian C.H. Mitchell, Barclays Bank PLC, Research Division - Research Analyst [31]

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That's helpful. And then just a quick follow-up. I'm not sure how specific you can get, but you did book that $140 million environmental reserve in the quarter. So maybe just give us a mark-to-market of where the environmental reserves sit now in total at present at JCI. And this charge obviously cleaned up that Wisconsin issue. You mentioned in the Q the noise on AFFF around municipal and individual actions. Any upcoming events you think we should watch for or points on that as they pertain to JCI?

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Brian J. Stief, Johnson Controls International plc - Executive VP & CFO [32]

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Well, let me comment on your first question regarding environmental reserve, and I think we're appropriately reserved for the Marinette issue based upon all the work that we did in the quarter. Incremental to that $140 million reserve, I believe we've got reserves globally for other matters less than $100 million. I want to say between $50 million and $100 million. There's a footnote disclosure on that in the Qs and Ks. But this particular matter in Marinette at $140 million is the largest one that we'll manage over the next several years. So I think from an environmental reserve standpoint, we feel comfortable as where we are.

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [33]

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Yes. And Julian, let me address the other part of the question on the civil litigation. I think we need to put this in perspective. Tyco and Chemguard make lifesaving firefighting foam, not PFAS chemicals. They purchase the compounds that contain trace amounts of PFAS, which they then blend to make the foam. And the firefighting foam is made to exactly military standards. So majority of the foam at issue is specified and used by the U.S. government and military and therefore subject to the government contractors' defense. And Tyco and Chemguard have always acted responsibly in producing these firefighting foams, and we feel very confident in our ability to defend these clients.

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Operator [34]

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Our next question comes from Josh Pokrzywinski with Morgan Stanley.

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Joshua Charles Pokrzywinski, Morgan Stanley, Research Division - Equity Analyst [35]

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So you made a comment earlier, George, about some of the channel inventories in the unitary side just still being high at the end of the quarter. How long do you think it takes to work those down? And have you seen any pushback or softening in the price environment just as other folks in the system as well are trying to move inventory along a little bit in the back half of the cooling season?

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Brian J. Stief, Johnson Controls International plc - Executive VP & CFO [36]

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I think we should see a normal bringdown of that inventory during Q4, and I don't think it's going to have any impact on our pricing in the market at all. So I think it's more seasonal that will come down here as we move through the fourth quarter.

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [37]

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And we've been managing the inventory as this has played out over the last quarter, and some of the impact of weather and the like we've been managing that appropriately. We're watching that close as we get into the latter part of the season here. But we are positioned as we have planned.

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Joshua Charles Pokrzywinski, Morgan Stanley, Research Division - Equity Analyst [38]

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Got it. That's helpful. And then just a follow-up on the retail Fire & Security exposure there. I guess new mix was strong last year. I didn't appreciate exactly where that came from. But just thinking about the pipeline in that piece specifically, does that tend to be lumpy over time? Are there any other quarters that we should keep in mind over the past several that have had outsized mix there that as you comp that could be a challenge?

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [39]

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When I look at -- I've been part of the business for a number of years. When I look at the profile of the business, you do have some year-on-year compares occasionally because of the way the projects are executed with retailers. There is a seasonality onto the business as you look at the 4 different quarters. So I don't think it was anything unusual based on what we've seen. Certainly, we're pretty much aligned with all of the big retailers given the presence that we have in retail, and we're staying close to what their plans are relative to their investments and the like. So I don't see anything that's significantly unusual at this stage.

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Operator [40]

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Our next question comes from Deane Dray with RBC Capital Markets.

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Deane Michael Dray, RBC Capital Markets, LLC, Research Division - Analyst [41]

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I'd like to get some color as you see it in North America nonres construction, just kind of trends. There's some anxiety in some sectors that the macro uncertainty is weighing on project releases. And just -- are you seeing anything along those lines? And just to be clear on the retail pushouts that you've seen, is that more retail sector-specific? Or would that be attributed to some of the broader macro uncertainty?

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [42]

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So let me start with your first question there, Deane, relative to the environment. I think when we look at all of our indices, whether it be ABI, Dodge forecast, what the overall activity is, it's still -- given where we play, and a lot of that is in the institutional space, we see continued expansion. Now we've also expanded our sales force and our footprint. So I think at this stage, you could -- it would suggest we are picking up some share.

So our pipelines are continuing to grow. We're converting those to orders. Our North America orders were up -- North America orders in total up 6%, but HVAC was up double digits, and so we're -- high single digits. We're performing well in creating a backlog, and we feel confident that we're going to see that continuing here at least in the near term.

As it relates to retail, the discussion around retail is retail-specific. I mean this is project by project. As we look at our customer base and what their plans were and what ultimately played out, it's specific to the retailers. And so as I said, we have pretty good visibility, especially with the large retailers, what their plans are and we're going to monitor that as we go forward.

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Deane Michael Dray, RBC Capital Markets, LLC, Research Division - Analyst [43]

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Great. And then just what's embedded in the 4Q guide. You typically see during summer months some verticals make bigger project implementations like K through 1, colleges. Are you seeing that those projects going through as expected?

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [44]

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Absolutely. I mean when we look at our growth, as we suggested, we're going to grow mid-single digits in Q4, and that will get us to 5% to 6% organic growth in total. And when you look at the compare, that's over a 7.6% growth last fourth quarter. So when we look at our current pipeline of projects that we're executing to deliver on that, those are all moving forward as planned.

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Operator [45]

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Our next question comes from John Walsh with Crédit Suisse.

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John Fred Walsh, Crédit Suisse AG, Research Division - Director [46]

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So we were actually talking to a couple of integrators, and they were really excited about a new product release you guys have put out, enterprise management 2.0. And what they were basically intimating to me is it seems like JCI and Honeywell are really taking the lead on smart buildings AI and really bringing additional capability to occupants. Is there anything you can point to around metrics you've seen, not necessarily specific to this product but other control products? Obviously, there's been good growth there that we're actually going to see building owners willing to upgrade and pay for some of these newer services that you're offering.

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [47]

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Yes. So this is core to our overall strategy for the company as you think about our portfolio leading in our HVAC equipment and then leading in Building Management. In Building Management, it's how -- this is on top of what we're doing to integrate all of our digital platforms, create a data layer with our Digital Vault and then to be able to create new solutions on top of that data to be able to create value for our customers.

And so what you're referring to the enterprise management is what we call our JEM, which is Johnson Controls Enterprise Management, taking all of that data and positioning that data to be able to deliver and execute for our customers things that they ultimately see value in. And so we've got that deployed now across a number of installations and very successfully. And as we think about not only that, but we've got a number of other digital solutions that we're deploying today that we can take our installed base that we have with our service business, be able to add on these digital solutions and be able to accelerate our service growth with the customers that we're currently supporting. So as you said, it's core to the strategy, how we ultimately create more value for our customers and then leverage all of our digital capabilities to do that.

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John Fred Walsh, Crédit Suisse AG, Research Division - Director [48]

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I guess maybe as a follow-on, do you have any numbers around the size of the business, either what your pure software component is, things like that, that you can share?

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [49]

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We don't segment our revenues today. But as you know, across our business, we have a lot of software embedded in the products as well as the solutions that we bring to the market. So when you look at that, we have software within our building controls, within our security platform, within our fire platform. And what we're doing now is taking all of that, integrating that as well as building a data platform that enables us to be able to create apps and be able to create new outcomes, and ultimately, it's going to create service growth for us.

So we don't segment it that way. But as we go forward, that's something as we look at how we're taking our Building Management solutions forward, it's something that we'll focus on and how we can create some metrics so you can track the progress that we're making with the investments we're making.

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Operator [50]

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Our next question comes from Noah Kaye with Oppenheimer.

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Noah Duke Kaye, Oppenheimer & Co. Inc., Research Division - Executive Director and Senior Analyst [51]

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Just going back to China, you talked about service maybe outpacing install. Just your thoughts on, I guess, one, install coming back, reasons for any kind of delays there and then your confidence and ability to drive price and favorable mix on the business you're quoting.

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [52]

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The comment on the low single digits was in orders. So I think overall, our orders were somewhat flat on the install side with service being a little bit higher. But as we project what we're going to do there when you look at the overall growth in the pipeline, we suggest that we're still going to see kind of mid-single-digit growth in both orders as well as revenue and that from a service standpoint, we're continuing to put resources in place to be able to accelerate the service off the installed base that we've got in place there.

And so this, for us, is a big market for us. It represents -- in our field business, it's about -- represents about -- well, in the overall buildings business, 6% of our revenue and in the field business in APAC, it's about 35% to 40% of our APAC business, so obviously a very important market for us.

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Noah Duke Kaye, Oppenheimer & Co. Inc., Research Division - Executive Director and Senior Analyst [53]

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And I guess not just in generally -- not just for APAC but generally, can you talk about some of your initiatives to drive greater recurring revenues? Your previous comments on software, and obviously there are tools here to make business more sticky. But just generally, how should we think about kind of the growth of recurring as a percentage of the total?

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [54]

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So in total, when you look at the overall company, service represents a little bit better than 25% of the revenue. About 60% of that is recurring and how we contract that revenue, and a lot of that is supported by software. And so as we have been driving our service strategy, it's a couple of key components: Making sure we've got the right sales force that we're deploying globally, and as you know, we've made tremendous progress over the last year, 1.5 years with the sales force; getting the right footprint in the key markets that we're looking to grow within, which we've been expanding our footprint; and then enabling that with the right solutions, leveraging our technology and capabilities. So it's a combination of all 3. We've been able to get to a run rate over time that's roughly been about mid-single digits.

And our goal is obviously not only to continue to grow at the same rate that we're growing installs but also grow with a higher percentage of recurring revenue. So that 60% that we contract that's recurring and then creating more stickiness with the digital solutions that we can ultimately deploy that becomes more recurring longer term with the solutions that we put into place. And that's the overall strategy.

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Operator [55]

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Our next question comes from Tim Wojs with Baird.

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Timothy Ronald Wojs, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [56]

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Just -- maybe just one question I had on the investments that are -- that you're kind of incurring right now. What's the right level of kind of ongoing incremental investment that we should think of as we kind of think in the out years? It was a 60 basis point headwind in the margins last year. I think it's probably closer to half of that this year. How much of that can kind of go away over time? And how much of that will kind of continue incrementally each year?

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [57]

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Well, there's 2 elements that drive that reinvestment. The first is the sales increase that we were adding ahead of the growth actually coming through, and that's been the headwind for the last 2 years. We are now adding at a rate that is sustainable so that the cost as a percent of revenue now has flattened out, so we shouldn't see any additional headwind going forward relative to our sales cost.

The other big bucket is our reinvestment in R&D in new products. And as you know, we've been ramping that up over the last 3 or 4 years. We're now ending -- as we get through this year and we project going forward, we should be able to maintain that level of reinvestment as a percent of product revenues more flat. So we shouldn't see any significant headwind there on a go-forward basis.

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Timothy Ronald Wojs, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [58]

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Okay. So if we kind of look into 2020, the investments that you've seen over the last couple of years, you would actually think that would be more kind of flat on a year-over-year basis versus the headwind.

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Brian J. Stief, Johnson Controls International plc - Executive VP & CFO [59]

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That's correct.

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [60]

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Yes. As a percent of revenue. So we'll be spending more dollars, but as a percent of revenue, we won't have the headwind on the EPS bridge.

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Timothy Ronald Wojs, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [61]

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Right. Right. Exactly. Okay. And then, Brian, just -- what's the -- just on the debt paydown, what's the average cost of the remaining debt now?

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Brian J. Stief, Johnson Controls International plc - Executive VP & CFO [62]

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About -- of the remaining debt, there's 97% of it that's fixed, and it's an average rate of just a little bit above 3%.

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Antonella Franzen, Johnson Controls International plc - VP and Chief IR & Communications Officer [63]

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

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [64]

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So again, I want to thank everyone for joining our call this morning. As you see, we're pleased with our continued momentum in growth orders and backlog. As I mentioned earlier, we are keeping a close eye on the macro environment, but overall, our end markets are remaining healthy and our order pipeline robust. And I certainly look forward to seeing many of you soon. So operator, that concludes our call.

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Operator [65]

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Thank you for your participation in today's conference. Please disconnect at this time.