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Edited Transcript of JCI earnings conference call or presentation 9-Nov-17 4:00pm GMT

Thomson Reuters StreetEvents

Q4 2017 Johnson Controls International PLC Earnings Call

Cork Nov 13, 2017 (Thomson StreetEvents) -- Edited Transcript of Johnson Controls International PLC earnings conference call or presentation Thursday, November 9, 2017 at 4:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Antonella Franzen

* Brian J. Stief

Johnson Controls International plc - CFO and EVP

* George R. Oliver

Johnson Controls International plc - Chairman & CEO

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Conference Call Participants

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* Charles Stephen Tusa

JP Morgan Chase & Co, Research Division - MD

* David Lu

RBC Capital Markets, LLC, Research Division - Associate VP

* Gautam J. Khanna

Cowen and Company, LLC, Research Division - MD and Senior Analyst

* Jeffrey Todd Sprague

Vertical Research Partners, LLC - Founder and Managing Partner

* Joshua Charles Pokrzywinski

Wolfe Research, LLC - Director & Diversified Industrials Analyst

* Joshua Charles Pokrzywinski

The Buckingham Research Group Incorporated - Analyst

* Richard Michael Kwas

Wells Fargo Securities, LLC, Research Division - MD & Senior Equity Research Analyst

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Presentation

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Operator [1]

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Welcome to Johnson Controls Fourth Quarter 2017 Earnings Call. (Operator Instructions) This conference is being recorded. If you object, you may disconnect at this time. I will now turn the call over to Antonella Franzen, Vice President of Investor Relations. Please go ahead.

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Antonella Franzen, [2]

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Good morning, and thank you for joining our conference call to discuss Johnson Controls fourth quarter and full year fiscal 2017 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 transaction and integration costs as well as other special items. These metrics are non-GAAP measures and are reconciled in the schedule attached to our press release. All comparisons to the prior year are on a combined basis, which excludes the results of Adient and includes the results of Tyco, net of conforming accounting adjustments and recurring purchase accounting. GAAP earnings per share from continuing operations attributable to Johnson Controls ordinary shareholders was $0.93 for the quarter and included a net benefit of $0.06 related to special items. These special items primarily related to mark-to-market pension and postretirement gains and discrete tax items partially offset by restructuring, impairment and integration costs. Adjusting for these special items, non-GAAP adjusted diluted earnings per share from continuing operations was $0.87 per share compared to $0.76 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. Let me begin with a look back at our first year as a combined company. And the message that I hope you walk away with is although our financial results came in at the low end of where we would have expected in fiscal 2017, we made significant progress on the integration of a historic merger with Johnson Controls. I'm extremely proud of the work our teams around the globe have done and what we have accomplished throughout the year. We completed a major reorganization of our operating structure across the globe, most recently in North America. We made significant strides in aligning our cost structures, generating $300 million in incremental cost synergies and productivity savings, driving 90 basis points of margin expansion for the year.

Despite the substantial amount of integration taking place, we also maintained rigor around optimizing our portfolio and capital structure. We completed the spin-off of Adient and divested ADT South Africa and Scott Safety as well as several other small noncore assets. We redeployed the proceeds from those divestitures into paying down a substantial portion of the merger-related TSARL debt.

Additionally, we pursued opportunistic share repurchase in an effort to offset the coming dilution related to the Scott Safety transaction, and we finished the year with approximately $650 million of share buybacks.

That said, as we have identified on the right side of Slide 5, there are areas in our performance where we need to improve as we move forward: accelerating organic growth in orders and Buildings, expanding gross margins in Buildings, improving free cash flow conversion and consistently delivering on our commitments.

If we turn to Slide 6, I'll tie those areas of improvement to the changes we have already implemented to enable us to put shareholder value creation at the forefront of everything we do. First, as you may have seen in a press release this morning, we announced a change in our General Counsel with the departure of Judy Reinsdorf. I've worked with Judy for well over a decade. She was instrumental in my time as CEO of Tyco and has been a crucial voice throughout her transitional role for the past year here at Johnson Controls.

I'd like to sincerely thank Judy for her many years of service and wish her all the best. I'd also like to take this opportunity to welcome John Donofrio to the team who's joining us from Mars Incorporated. With this and a few other recent appointments, our senior leadership team is coming together and will be held accountable for driving execution.

Beginning in fiscal 2018, we plan to change our compensation incentives to be more closely linked to our performance and aligned with shareholder expectations. Specifically, we plan to tie compensation incentives to the key performance areas that we are focused on: organic revenue growth, EBIT growth and free cash flow conversion. When it comes to accelerating organic sales and orders growth in the field businesses, tracking sales capacity and sales productivity metrics are essential. Growing the field businesses requires a strong and expanding sales force by business and by region with continued productivity. It sounds simple but demands intense focus and consistent monitoring by our business leaders, including myself.

With the combination of reorganization of the Buildings businesses, we have remixed the sales force and reinvested in areas of growth. For the full year, we were short of the increased capacity required to accelerate growth. However, in the fourth quarter, we enhanced the process and achieved net adds of 50 salespeople. As we move forward in our new structure, we are targeting 400 net sales adds in fiscal 2018, which will be core to accelerating orders in organic revenue growth. This investment is in response to a strong positive feedback from our customers with respect to how our technologies and solutions are helping our customers enhance their businesses. This will put a bit of pressure into the first half of the year as the new salespeople ramp up, but the increase in capacity will ultimately drive improvements in execution and higher growth. As we move through the course of fiscal 2018, we will keep you posted on our progress.

Additionally, not all revenue growth is created equal. And similar to how I operated at Tyco, we will be focused on profitable growth. This starts with going after the right projects, remaining disciplined on pricing to ensure that we are being paid for the value that we provide to our customers and rigorous project management down to driving change orders. With the installed base we create, it is critical that we continue to accelerate our service growth, which enhances our margin profile.

As we look at the underlying fundamentals of our backlog, there is some gross margin pressure we expect to see as the backlog turns in our North America field business. To put this in context, the size of backlog in our North America field business is $5.2 billion, and I would say we are entering the year with roughly 75 basis points of gross margin pressure. We have put in place a more strict approval process for large installation projects and are realigning the incentive compensation structure for the entire sales organization. We plan to weight sales incentives more towards gross margins and sales growth so that we can ensure our teams are targeting more profitable growth.

With more discipline on price, sales productivity, project management and service acceleration, we expect to drive both improved margins and increased profitability. When it comes to improving free cash flow conversion, we had an intense focus in the fourth quarter to ensure we met the expectations set. I, together with Brian, established a weekly meeting to drive the importance of this metric and closely monitored our free cash flow generation. Additionally, we are in the process of establishing a cash management office reallocating internal talent to solve some of our working capital challenges and focus solely on achieving the targets we have set out. While we saw improvement in our free cash flow generation in the fourth quarter, we know we have a lot more work to do to increase our cash flow conversion.

As we move forward, we will also be more selective in our CapEx spending, focused on high return projects and reducing our reinvestment ratio.

In terms of capital allocation, you can expect us to remain disciplined when it comes to returning cash to shareholders with a near-term focus remaining on opportunistic share repurchases and over time, a more balanced approach between accretive M&A and buybacks.

We have leading market positions and are strongly positioned to win across our core businesses. That said, we will continue to look at the portfolio both within Power and Buildings, ensuring we are allocating resources in areas where we can generate the highest returns and divesting businesses that are noncore. With all of these key business fundamentals I have discussed, we have established discipline and accountability from which we set grounded expectations. We know where performance needs to improve. And as a management team, we are entirely focused on executing on the actions I have outlined.

I am humbled and honored to be leading this organization, and I want to reiterate that this team is intensely focused on driving execution and creating shareholder value. My personal mission as CEO of Johnson Controls is to lead with clarity, simplicity and confidence, and my intent is that those same values permeate beyond the executive management team throughout the entire organization. I remain confident that, with the organizational changes over the past year, we are well positioned to lead the evolution of Building Solutions and battery technologies.

Turning now to Slide 7. Let me recap the results for the quarter, and Brian will provide more detail in a few minutes. Overall, another quarter of solid earnings growth with strong EBIT margin expansion driven by continued progress on synergy and productivity actions. Sales of $8.1 billion increased 4% on a reported basis in the quarter. Excluding the impact from divestitures, FX and lead pass-through, sales increased 2% organically, led by strong performance in our Power Solutions business as well as our Global products business within Buildings.

Adjusted EBIT of $1.1 billion grew 10%, driven by cost synergy and productivity realization. EBIT margins were up 80 basis points year-over-year on a reported basis or up 110 basis points excluding the impact of FX and lead.

Turning to our EPS bridge on Slide 8. You can see synergy and productivity savings adding $0.09 to the prior year, in line with our expectations. Volume and mix added $0.01 and strong volume in Power Solutions was partially offset by increased logistics and distribution costs, hurricane disruptions and price cost pressure. The lower effective tax rate year-over-year also added $0.02, and strategic investments were an incremental $0.01. Overall, this resulted in a 14% increase in adjusted EPS year-over-year.

Just a quick mention on synergies and productivity on Slide 9. As we have been detailing for you throughout the year, synergy and productivity savings came in at the high end of our original $250 million to $300 million range or $0.27 in 2017. As we look to fiscal 2018, we are planning for an incremental $250 million in savings.

With that, I will turn it over to Brian to discuss the performance within the segments.

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Brian J. Stief, Johnson Controls International plc - CFO and EVP [4]

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Thanks, George, and good morning. Let's start with our new segment structure within Building Technologies & Solutions on Slide 10. As you can see, Buildings has 2 main components: Building Solutions and Global products. Building Solutions, which has annual revenue of about $15 billion, is our field business and direct channel. We operate in a regional structure and report 3 segments: North America, EMEA/LA and Asia Pacific. Global products has $8 billion of annual revenue and will be reported as our fourth segment within Buildings. This is our indirect channel with its sales through distribution and storefronts. I will speak to the new segments as I go through the results for Buildings.

Now let's get into the details of the quarter on Slide 11. Total building sales in the quarter of $6 billion declined 1% year-over-year on a reported basis. However, excluding the impacts from FX and divestitures, sales grew 1% organically. The impact of the hurricanes, the earthquake in Mexico and some final sales-related purchase accounting adjustments impacted sales growth by approximately 60 basis points in the quarter.

So let's start by unpacking the 1% organic decline in Building Solutions, which again represents our project and service-based field business. In North America, our largest region, sales declined low single digits. Our fire and security field business, which comprises about half of the revenue in North America, is relatively flat year-over-year. HVAC and controls installation and service activity, which typically accounts for about 35% to 40% of sales in North America, grew low single digits. However, this growth was more than offset by a decline in large projects within our solutions business, which declined low double digits in the quarter. And I'd just point out that about half of that decline was driven by weaker sales to the U.S. federal government.

Turning to EMEA/LA, we saw low single-digit growth in the quarter. Growth in Europe was led by solid project activity in fire and security. In the Middle East, sales inflected to positive growth in the quarter driven by HVAC. Latin America also grew low single digits with balanced growth across fire and security, HVAC and controls. In Asia Pacific, organic growth was flat in the quarter as strong growth in service was offset by lower project installation spend year-over-year, particularly in China.

Turning to global products. Sales increased 3% organically year-over-year with growth across building management, HVAC and refrigeration equipment and specialty products. Building management, which is about 15% of global products revenue, includes controls, security and fire detection, and we saw a nice growth across all 3 of these product lines. HVAC and refrigeration products, which comprises about 65% of global products revenue, includes unitary and applied HVAC equipment and products, our Hitachi joint venture products, as well as industrial refrigeration and marine equipment. Within these businesses, resi and light commercial HVAC grew low single digits where a low single-digit decline in resi HVAC was more than offset by low teens growth in light commercial where we saw a significant growth in our national accounts business. I would point out that the resi HVAC decline was impacted by a tough prior year comparison with fiscal '16 Q4 growth north of 20% as well as lower cooling degree days. For the full year, our resi HVAC business grew high single digits organically, benefiting from new product launches in the spring of 2016. Our applied business grew in the mid-single digits range in the quarter with strong performance from North America and larger projects in the Middle East. Finally, we continue to see solid growth in our Hitachi joint venture as well as a pickup in our industrial refrigeration businesses led by the improving natural gas and food and beverage markets.

The remaining 20% of revenue in global products is specialty products, which includes fire suppression and Scott Safety. This platform saw low single-digit growth in the quarter and, as you know, Scott Safety was sold to 3M in early October.

So let's turn to EBITA. Buildings grew 5% year-over-year in both the reported and adjusted basis to $904 million with margins expanding 80 basis points year-over-year to 15.1%. This growth was led by cost synergies and productivity savings, partially offset by price cost pressure as well as continued investments we're making in new products in our channels.

Over the course of 2017, we launched 14 new chiller products globally and expanded our factory direct distribution business by adding 17 new storefronts across North America. And I just point out that for the full year, Buildings EBITA margin expanded 50 basis points.

So let's turn to Slide 12. Orders grew 2% organically year-over-year, led by the 5% growth in our products business. Field orders were flat as high single-digit growth in Asia Pacific was offset by a low single-digit decline in North America and EMEA/LA. Backlog of $8.5 billion at year-end grew 4% year-over-year on an organic basis.

So let's move to Power Solutions. Sales of $2.1 billion increased 18% year-over-year on a reported basis, but this includes a significant tailwind from lead pass-through. Excluding lead and FX, sales grew 9% organically, led by strong shipments to the aftermarket channels across all regions. Global battery shipments increased 5% year-over-year with aftermarket unit growth of 8%, partially offset by a 5% decline in our lease shipments, which is consistent with the lower auto production in our 2 biggest markets, the U.S. and Europe. China rebounded nicely versus last quarter with total shipment growth of nearly 40% with strength across both OE and aftermarket.

Global shipments of Start-Stop units increased 30% led by strong growth in China and the Americas. EMEA Start-Stop units increased 7% due primarily to strong aftermarket growth, which is more than offset by a low single-digit decline in OE.

Segment EBITA of $431 million increased 4% on a reported basis or 5% excluding the impact of FX and lead. Power's margins declined 260 basis points year-over-year to 20.2% on a reported basis, but this includes 170 basis point headwind from lead. Excluding the impact of FX and lead, Power's margins declined 80 basis points. In the quarter, leverage and higher volumes, favorable mix and productivity savings were more than offset by ongoing product investments, start-up and launch costs and increased logistics and distribution costs, including the disruptions related to the hurricane.

For the full year, Power's margin declined by 60 basis points to 19.5% on a reported basis, but this includes 150 basis point headwind for lead. Excluding the impact of lead and FX, Power's margins expanded a strong 100 basis points for the year.

Moving to Slide 14. Corporate expense was down 25% year-over-year to $107 million, benefiting from continued synergy and productivity savings as well as a lower compensation expense versus the prior year. For the full year, corporate expense was $465 million on an adjusted basis, better than the $480 million to $500 million guidance range we provided last December. I am pleased with the progress in reducing our overall corporate expense, and we expect to see continued improvement in fiscal '18.

Now let's turn to free cash flow on Slide 15. In the quarter, we generated $1 billion in reported cash flow. Excluding $100 million of transaction and integration costs in the quarter, adjusted free cash flow was $1.1 billion. This out-performance versus the $900 million Q4 target we provided in July resulted primarily from the strong Q4 volume growth in Power Solutions, which allowed us to work through a portion of the inventory build from the end of the third quarter, and we also saw a reduction in receivables across our businesses.

As George mentioned, we are in the process of establishing internal cash management office. This team will be dedicated to improving our overall cash management and forecasting process and will report directly to me. This team will be comprised of individuals from corporate, treasury, our shared service center groups and the business units. This area is one of our top priorities for fiscal '18, and we remain committed to delivering adjusted free cash flow conversion of 80-plus percent, which excludes net onetime cash outflows of $800 million to $900 million related primarily to integration, restructuring and income tax payments. Let me stop there just for a second and give you the components of the onetime items.

We've got restructuring and integration costs of roughly $500 million, which is probably $100 million higher as a result of us accelerating or pulling forward some of these actions to Q4 of '18 versus fiscal '19. Secondly, we've got about $100 million of executive severance and the (inaudible) unfavorable arbitration award that occurred in the fourth quarter. We've got the $50 million worth of Scott Safety tax payments. And then we've got about $350 million, which is broken into 2 buckets in the tax area. One would be $200 million outflow related to a Mexican tax law change regarding they'll no longer accept consolidated filings in Mexico. There's a deconsolidation that's required, that will cause $200 million of cash outflows in the first quarter of fiscal '18, and there were some specific tax planning in the U.S which was $150 million outflow.

So in aggregate, that's about $1 billion. And as you may recall, 200 -- originally, we thought $300 million was going to be the tax refund in the first quarter of fiscal '18. That number is now $200 million, but the $600 million that we expected in 2019 has now increased to $700 million. So essentially, where we are now is we've got about $1 billion worth of cash outflows and $200 million related to the tax refund in the first quarter, which gets you that $800 million number. And again, I just point out that as we move into '19, we now expect $700 million of tax refunds related to the Adient tax that was paid in the first quarter of '17. Similar to recent years, we expect our adjusted free cash flow to be much more weighted to the second half of the year with an outflow in Q1 and our largest inflow in Q4.

Moving to Slide 16. We ended the year with a net debt-to-cap of 39.3% versus 41.2% at June 30. During the quarter, we again took advantage of the low interest rate foreign debt environment and issued $310 million of yen-denominated 5-year notes and $175 million euro-denominated 1-year note. During the quarter, we used the strong cash flow generation as well as the debt issuances to repay $1 billion in commercial paper and $150 million bond maturity. Additionally, we repaid $165 million in TSARL debt with Tyco-related cash flows. As everyone knows, the Scott Safety sale to 3M closed in early October, and we repaid $1.9 billion of TSARL debt with the net proceeds from this transaction. These payments, along with the proceeds of the ADT South Africa sale in the second quarter of this year, reduced our original $4 billion in TSARL debt to a current balance of $1.8 billion.

During the quarter, we repurchased $225 million in stock or about 5.5 million shares. For the year, we repurchased just under 16 million shares for $650 million. I'd also mention that we completed another $150 million of buybacks during the month of October. And as we move through fiscal '18, we will, at a minimum, buy back stock to offset the impact of option dilution.

On Slide 17, we provided details in the appendix related to the Q4 special items, all of which have been excluded from our adjusted results. And as I mentioned earlier, the building segment change was effective in the fourth quarter, and we -- and the revised fiscal '17 quarters are provided in the appendix as well. And just finally, the House U.S. tax reform proposal was released last week, and the Senate proposal is expected shortly. Interest deductibility and repatriation taxes on foreign earnings will be headwinds for us, but we are in the early stages of reviewing the overall pluses and minuses [to Johnson Controls] as well as other available tax planning opportunities.

So with that, let me turn the call back over to George to review our fiscal '18 guidance.

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

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Thanks, Brian. As I mentioned earlier, we have made significant progress over the past year related to the merger integration, but we still have plenty of work to do. Fiscal 2018 will be a year of change. We will intensely focus on driving execution.

Turning to Slide 18. We expect total sales to be in the range of $30.1 billion to $30.7 billion. Based on current exchange rates, this includes a $265 million tailwind related to changes in foreign currency as well as a $70 million tailwind related to lead prices. Additionally, the impact of recent divestitures are expected to be a $700 million headwind to sales. We expect overall organic sales growth to be in the low single digits.

Going through our expectations for Buildings and Power, let me start with Buildings. Based on current backlog, we expect organic growth in the low single digits as we begin to ramp our sales capacity in fiscal 2018. From an adjusted EBITA margin perspective, we expect the benefit from synergies and volume growth to be partly offset by gross margin pressure within our North American field business backlog, which I spoke to earlier, as well as continued incremental investments in our products and channels. Overall, we expect adjusted EBITA margin expansion in Buildings of approximately 10 to 30 basis points, including a 40 basis point headwind related to the divestiture of Scott Safety. Underlying margins are expected to increase 50 to 70 basis points.

In Power Solutions, we expect organic sales growth in the low to mid-single digits, driven by volume growth in the aftermarket. We expect volume mix and productivity benefits to be offset by higher lead prices and incremental investments including launch costs. We expect adjusted EBITA margins to be relatively flat on a year-over-year basis.

As Brian mentioned earlier, we expect to see continued reductions in corporate expense and are targeting an incremental 5% to 9% reduction, which would bring our adjusted corporate expense down to a range of $425 million to $440 million.

Overall, we expect adjusted EBIT margins to increase 30 to 50 basis points to 12.2% to 12.4%, which includes a 30 basis point headwind related to the divestiture of Scott Safety. Underlying adjusted EBIT margins are expected to increase 60 to 80 basis points.

As we move to the below-the-line items, we expect to see a tailwind to interest expense related to the pay down of the TSARL debt from the Scott Safety proceeds. This decrease is expected to be mostly offset by an increase in variable interest rates. In total, we expect net financing charges to be in the range of $460 million to $475 million. Additionally, we have seen very nice growth from our joint ventures, particularly Hitachi over the last few years and expect to see our noncontrolling interest increase to $200 million to $210 million. Based on these items, we expect adjusted EPS to be in the range of $2.75 to $2.85, which represents a 6% to 10% increase in earnings per share versus fiscal year 2017. As Brian mentioned, we expect adjusted free cash flow conversion of 80-plus percent, which includes CapEx of up to $1.3 billion.

Consistent with prior years, we expect our earnings per share to be stronger in the second half of the year due to the normal seasonality of our businesses. We expect our quarterly EPS cadence to be similar to last year with a slightly lower percentage of earnings in the first quarter, given the ramp-up of our sales force and lower margin backlog in Buildings and the lead price movements in Power.

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 of Vertical Research.

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

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George, just first on the portfolio and maybe putting Power aside, which is a whole other discussion. You've only been in the CEO seat for 2.5 months or so but obviously, you've been evaluating the portfolio as COO all along. I wouldn't expect you to name names on what might be a candidate to be divested, but can you give us a general assessment of your view? Is there 5%, 10%, 15% of the portfolio that's kind of a question mark in your mind? Just some way to kind of frame how you're thinking about that. And if you do have some additional thoughts on Power, would love to hear them, too.

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

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Sure. So what I would say, Jeff, starting out is certainly over the last couple of months the opportunity to really take a fresh look at the portfolio, I've been working very closely with the business leaders and really understanding the core businesses, adjacencies and complementary type businesses. We've got incredible platforms in both Power Solutions and Buildings. But as we look at the portfolio that there are opportunities for potential divestitures where we could take those proceeds and double down on some of our core businesses. And as I've always demonstrated in the past, as we do this, we certainly will continue to focus on how do we create the most long-term shareholder value in the remix of the portfolio. So what I would say is starting out here, just with the type of businesses that you've seen us looking at here, in that kind of high single-digit, mid- to high-single digits potentially as some opportunities here that we see that are kind of outside of our core that would raise capital and be able to position us to be able to double down from an investment standpoint in our more core HVAC and building system businesses within our Buildings portfolio.

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

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Mid- to high-single digits within Buildings not relative to total?

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

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That is correct.

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Jeffrey Todd Sprague, Vertical Research Partners, LLC - Founder and Managing Partner [6]

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Yes. And I was wondering also, just shifting gears on tax and cash flow and the like, really kind of a couple questions, or related, anyhow, for Brian. How do we get comfortable that there's -- it's Mexico next year and it's not something else the year after, so to speak? And I wonder if you could just elaborate a little bit more on the magnitude of pressures you see on U.S. tax reform relative to your initial analysis.

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Brian J. Stief, Johnson Controls International plc - CFO and EVP [7]

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Yes. So let me start with U.S. tax reform. And I think the 2 areas that I commented on providing the most headwind are probably the limitations on interest deductibility as well as the repatriation taxes on foreign earnings. And we are -- we are in the early stages, Jeff, of taking a look at the implications of the proposal, and we'll see what comes out from the Senate as well. But those 2 items certainly do put pressure on our effective rate in the mid-teens where it is today. But I'd also say that until we really sit back and study all the provisions of it, we really aren't in a position today to comment on what the ultimate effect will be because I'm sure there'll be tax planning opportunities that we'll have in front of us as well. So I think this is one we're going to probably just have to keep front and center with you and everyone on the call. And the more information we get and as ultimately the regulations come out, we'll address it at that time. As far as your comment on Mexico, the calculations that were completed on the specifics around deconsolidation of Mexican returns, I mean the tax law changed, just to give you a little bit of color here, was that in Mexico, no longer can you file a consolidated return and get group tax relief, but you've got to file individual returns. And that payment is required to be made for us in our first quarter of fiscal '18, and we didn't finish the calculations on what that net payment was going to be after unpacking all of these individual returns until just recently. And so the one thing I would point out there is that the payment that we're going to make of $200 million, the way these regulations are working in Mexico, we will recoup that payment over a period of time of up to 7 years. So it's something we'll get back over time, but it was a onetime payment that's large enough that we called out in our commentary here.

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Operator [8]

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Our next question comes from Steve Tusa of JP Morgan.

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Charles Stephen Tusa, JP Morgan Chase & Co, Research Division - MD [9]

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So just wanted to kind of dig into these first half margin dynamics. You said you're adding some new salespeople. The backlog margins are down. So can you just give us some color on kind of how that -- at a higher level, just perhaps in an operating margin level, how that will play through here in the first half to make sure people are kind of level set on the expectation as these costs and this lower margin revenue rolls through?

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

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Sure. So let me start with North America. As I said, we have about $5.2 billion in backlog there. And as that flows through, there's probably about 75 basis points of headwind in that and combined with the investments we're making in the sales and we're making good progress there, that certainly is going to create some pressure in the first half as we're ramping up the orders and that begins to convert to revenues. So that's the -- that's one big part of it. And then the other is when we look at our reinvestment, we are -- last year, we had about $0.06 of reinvestment mainly into our products. And that's beginning to really start to show performance as we look at our products organic growth, and that will continue here through '18. And we're estimating somewhere around $0.06 or $0.08 of reinvestment into our products. Those are the 2 large pieces as we think about 2018 guidance. Brian, maybe you want to comment?

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Brian J. Stief, Johnson Controls International plc - CFO and EVP [11]

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I would just comment on Buildings, that's correct, George. And then when you look at Power Solutions given the spike up that we have seen in lead over the last few months here, there's probably a bit of headwind as we look at just Q1 impact. But as we've kind of commented on before, when it spikes like that, we can have an individual quarter impact based upon the arrangements we've got with our customers to pass on those lead increases over the course of the year that tends to normalize, and we wouldn't expect that to be a big number for the year. But there could be a little bit of an impact in Q1 from the spike in lead prices as well, Steve.

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Charles Stephen Tusa, JP Morgan Chase & Co, Research Division - MD [12]

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Got it. So when I look at this kind of EPS growth trajectory for the year, $0.06 to $0.10 off of the $0.48 in 1Q -- or sorry $0.53 in 1Q '17, I mean will you be growing earnings here in the first quarter?

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [13]

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Yes, I think the way to think about this is we've historically been around 20% in the first quarter. And then it's probably been maybe slightly less of that in the second quarter. And so I think, for the first quarter, you can probably dial it in maybe a little less than where we've been before, but that's kind of the general guidance we'd give.

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

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Okay. And then one last question for you. The whole comp discussion around what you're getting paid for, I guess it's EBIT, organic growth and conversion, is there any -- so if like tax rates go up and your net income is impacted by that and your free cash is impacted by that, that doesn't impact your -- the kind of incentive package you guys have. Is that correct?

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Brian J. Stief, Johnson Controls International plc - CFO and EVP [15]

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On the AIPP side, that's correct. On the long-term side, it could have some impact. But the short-term bonus here, it would be 1/3 on EBIT growth, 1/3 on organic revenue growth and 1/3 on free cash flow conversion. And then there could be some modifiers that might also address things like EBIT margin improvement to ensure that we aren't just chasing revenue dollars, that we're chasing profitable growth.

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

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And that's adjusted conversion?

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Brian J. Stief, Johnson Controls International plc - CFO and EVP [17]

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Correct. Correct.

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Operator [18]

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Your next question comes from Deane Dray of RBC Capital Markets.

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David Lu, RBC Capital Markets, LLC, Research Division - Associate VP [19]

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This is David Lu on for Deane. So on the cash flow for 2018, could you parse out sort of what the increase or the ramp-up from 2017 and 2018 will be? Is it more on the working capital side? I know you gave some color around CapEx, but how should we think about the different buckets that leads to the sequential increase in cash flow?

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Brian J. Stief, Johnson Controls International plc - CFO and EVP [20]

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Yes. So CapEx is going to be still in the range of about $1.3 billion -- up to $1.3 billion. The way to think about that is if you look at where we are this year and adjust for the items that we talked about in the third quarter, what happened in the fourth quarter here, we were able to flush through about $100 million or so of the inventory build that we saw at the end of the third quarter in Power Solutions, and we also saw about $100 million reduction in receivables. So if you recall at the end of the third quarter, we talked in terms of a couple of hundred million dollars in inventory we thought we could take out and $100 million worth of receivables. So $200 million to $300 million, we were able to take out in the fourth quarter here. So there's really $100 million more that we expect in the inventory side. And then I would tell you that would get you up to that 80% plus range. And beyond that, it would be the additional effort that our cash management office team is going to put in place to continue to drive trade working capital improvements and look at payment terms and billing terms to our customers. So right now, we're looking at around 80% plus.

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David Lu, RBC Capital Markets, LLC, Research Division - Associate VP [21]

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Great. And then for my follow-up, can provide an update on the nonresidential sector either in the U.S. or globally, how has it trended? How do you expect it to trend in 2018, is it accelerating or decelerating? Just any color around that would be great.

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [22]

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Yes. So when we look at our nonresidential, we get pretty good presence across all the regions. If you break it out into regions, North America is going to -- as we said, we see lots of opportunity there. We're expanding our sales force here to be able to capitalize on that. If you look at the metrics, there has been plus or minuses here recently, but we're starting to -- we still see a very strong pipeline for growth and that's what we're ultimately positioned to do to accelerate orders through the course of the year and then begin to turn that as we go through the year. Regionally, when you look at EMEA/LA, our businesses in EMEA/LA, we're actually performing pretty well. We've seen some nice progress in Continental Europe offsetting some little bit of pressure we've had in the U.K. And as we plan for 2018, it's still going to continue to grow low single digits. Latin America has been pretty strong for us in -- with the investments and the expansions we've been making there. That's been a bit better than the EMEA region. If you look at -- in Asia Pac when we look at our business there and the investments we're making, we see nice progress here in 2017 with the new products that we're bringing into that market and the footprint expansion. And so I would say that we are continuing to look at kind of mid-single digits opportunity there with the market continuing to play out as we expected and then with the investments we're making. So overall, a fairly solid position as far as a market standpoint. And then with the investments we're making, we're going to be positioned to capitalize on that on a go-forward basis.

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Operator [23]

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Your next question comes from Andrew Kaplowitz of Citi.

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Unidentified Analyst, [24]

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This is (inaudible) on for Andy. So Building Solutions was down 1% in the quarter and orders were flat. So can you talk about your outlook for Building Solutions business within the low single-digit organic growth for Buildings overall?

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [25]

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Sure. When you look at our business here, let's looks at fourth quarter in Buildings, we are seeing some nice progress in our products businesses pretty much across the board. And that's an output of some of the fire and security markets coming back and those businesses performing well in the fourth quarter. And then with the investments we've been making in HVAC and controls and the regionalization of some of those products, we're beginning to see the pickup, and that also would include the work we've been doing with Hitachi. So we see that with those investments continuing in 2018. When you look at the field businesses, that's where the pressure has been. We were down about 1%, and that was driven by our performance solutions business in North America as well as we did see some timing of some of our projects in Asia, we saw a little bit of slowdown there, but we got a very robust pipeline of opportunities and we're seeing the orders coming through there. So don't believe that that's a longer-term concern. So when you look at what we're doing from a sales capacity standpoint, where we fell short in 2017, we've now, over the last few months, picked up our activity in being able to add salespeople not only driving projects but also service. And so as we now project what that's going to mean, we'll see accelerating orders through the course of the year and start to see better conversion of the backlog that we have in place. Backlog was up 4% year-on-year so that does give us confidence that we'll begin to see the acceleration of revenue through the course of 2018. And while we're driving increased secured orders, that also gives us confidence that, as we plan for 2018, we'll be in a much better position to continue that acceleration of growth.

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Unidentified Analyst, [26]

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Got it. That's helpful. And then in terms of synergies, can you talk about any progress you're seeing on the revenue synergies with any cross-selling opportunities that continue to progress?

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [27]

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Sure. I mean what's happening is we -- within our business, we have very strong relationships with the customers that we've served historically, whether it be HVAC controls or whether it be fire and security. And we've seen nice progress here in the first year with pipelines, pipelines developing and then the conversion of those pipelines across the board. And what I would tell you is most of these projects are in -- it's anywhere from less than $1 million to $5 million or $10 million. These are customers that have expansion that -- they're executing on expansions that we're bringing in, our combined capabilities to truly differentiate how we can serve their needs within the new space, and we're starting to see some really nice traction. And so on a go-forward basis, when we originally laid out the longer-term plan, we did say that the first year was going to be about securing orders and that the second and third, we'd start to see the conversion of revenue. So that's what's going to happen. We'll start to see a pickup of the -- now that we're beginning to see orders, we're going to start to see the acceleration of the turn of those orders into revenue here in 2018.

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Brian J. Stief, Johnson Controls International plc - CFO and EVP [28]

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And I would just comment -- I would just add to that, that we've got -- there is a lot of momentum that we've got in the back half of this year. So we aren't seeing benefit in '17 from the revenue pull-through. But given the third and fourth quarter activity, we'll get some benefit on the top line in '18.

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Operator [29]

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Our next question comes from Rich Kwas of Wells Fargo.

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Richard Michael Kwas, Wells Fargo Securities, LLC, Research Division - MD & Senior Equity Research Analyst [30]

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On CapEx, so up to $1.3 billion, what does that imply for the Power CapEx? I thought there was some build -- some expansion of facilities in China. So what's the latest on that?

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Brian J. Stief, Johnson Controls International plc - CFO and EVP [31]

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So we've got -- for Power Solutions next year, we've got $500 million in the plan, and that would include the construction of the facility that will be part of our Bohai Piston joint venture. The other facility that we've talked about in China will be starting late in '18, maybe even into '19. So the second facility in China will probably not have a big impact on the cash flows in fiscal '18.

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Richard Michael Kwas, Wells Fargo Securities, LLC, Research Division - MD & Senior Equity Research Analyst [32]

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So Brian, I know as we think about '19, is this still kind of the peak-ish year for CapEx as you look out the next couple of years or is there still bit of a ramp in '19?

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Brian J. Stief, Johnson Controls International plc - CFO and EVP [33]

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No, I would say this is the peak. I mean, I could see depending upon levels of the Buildings investments, I would say that we're probably looking at the $1.3 billion being a peak. I mean, it would have to be something very opportunistic for us to not have a peak at the $1.3 billion. Even at that level, we end up with the reinvestment ratio that's [1.4, 1.5], something like that. So we're working to get that down into the more [1.1, 1.2] range.

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Richard Michael Kwas, Wells Fargo Securities, LLC, Research Division - MD & Senior Equity Research Analyst [34]

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Okay, good. And then just on the synergies, so $300 million for '17. It was better than expected. The guide includes $250 million. Is that a conservative number? Or is it a reasonable number? I mean, how should we interpret that, considering you had upside last year? And I know there's moving parts with regards to projects and whatnot, but how do you feel that in terms of potentially delivering some upside to that later in the year?

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Brian J. Stief, Johnson Controls International plc - CFO and EVP [35]

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I'd say we guided $250 million to $300 million last year. We ended up at the high end. I would tell you the $250 million is a number that's pretty much what we've got road map for fiscal '18. I mean as we go through the year, could there be some upside? Maybe. But right now, we've got the teams focused on the $250 million, which is exactly what we've got in our trackers, and we're working toward delivering that. So I think that's where we are, Rich.

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Richard Michael Kwas, Wells Fargo Securities, LLC, Research Division - MD & Senior Equity Research Analyst [36]

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Okay. And then quick last one. What's the lead price assumption for the year?

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Brian J. Stief, Johnson Controls International plc - CFO and EVP [37]

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$2,100.

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Operator [38]

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Our next question comes from Gautam Khanna of Cowen and Company.

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Gautam J. Khanna, Cowen and Company, LLC, Research Division - MD and Senior Analyst [39]

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Congratulations, George, on the new job. So 2 questions. First one, if you could expand upon why pricing in the backlog's softer in North America. Is it a function of chasing [worse] projects? Or is it just the demands conditions warrant that? And if you could just expand that comment to pricing in the applied market abroad as well? And as a follow-up, Brian, will adjusted free -- will actual free cash flow, all in, in 2019 exceed adjusted free cash flow? And if so, by how much, given the $700 million Adient tax recovery? Any color there on both of those questions?

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [40]

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Sure, Gautam, I'll take the margin pressure. As I said in my prepared remarks, the incentive systems that were in place were incentivizing purely sales in the past. And what we've done, we've changed that now on a go-forward basis that it's sales and margins. So we weren't consistently applying that concept across the board. And so over the last -- it's really been over the last 18 months, there certainly was a deterioration of [book] margins. And as a result, that backlog then plays out over the course of 18 months, and you've got pressure in gross margins. That all being said, we've got the discipline in place, the accountability that's going to ultimately drive improvement. And then with all of the other cost actions that we're taking, we'll get benefit also in addition to the pricing to be able to improve that gross margin through the course of the year. And so -- and then the other element is service growth. As I talked about, making sure that we're getting the right mix of service growth, which as you know is higher profit growth within those field businesses, we had -- it was very low single-digit growth in 2017. I believe, and we're working across the board to accelerate that service growth, which is going to be a very attractive part of the business on a go-forward basis. So it's really those 2 elements that contribute to the overall margin rate. And I have confidence with the actions that we've taken that we will be positioned to execute well on that.

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Gautam J. Khanna, Cowen and Company, LLC, Research Division - MD and Senior Analyst [41]

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Pricing outside the U.S. as well? Just on pricing outside the U.S. as well?

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

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Yes. So we've been -- we have had a little bit of price cost as it relates to some of the HVAC equipment, and you've seen that with some of our competitors. We've been very disciplined around price and continuing to put a lot of intensity and driving out cost. And so what I'd say is the price cost in the fourth -- it was in the fourth quarter, it was about $20 million or 30 basis points within our building segment, we're going to see a little bit more of that in the first quarter. But based on all of the reviews and the details I've seen, with the price actions that have been taken, with the other cost actions, that we'll start to see that improve in the second quarter and beyond within 2018.

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Brian J. Stief, Johnson Controls International plc - CFO and EVP [43]

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Gautam, so on cash flow for '19, I mean it's a bit early to talk about '19, but I guess I'll give you my thoughts as we sit here today. That $600 million refund from the Adient tax payment is now $700 million that we're going to get in '19. And I think we've talked in the past, we hope to get that in fiscal '19. Whether it's fiscal '19 or calendar '19 really depends upon how quickly we can get it through a joint committee because, given the size of the refund, it's got to go to joint committee. But obviously, we're targeting to get it in fiscal '19. So that $700 million, when we look at the other onetime items that could be out there, it'd be restructuring and integration, and I would expect those to be well below that $700 million number as we move into fiscal '19, there's probably a bit of a wildcard, right? Relative to tax reform and what that might mean. I guess we just need to sort through that. But I guess the short response is I would expect adjusted free cash flow or reported cash flow to exceed adjusted free cash flow in fiscal '19.

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Operator [44]

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Your last question comes from Josh Pokrzywinski of Wolfe Research.

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Joshua Charles Pokrzywinski, Wolfe Research, LLC - Director & Diversified Industrials Analyst [45]

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Just to continue on some of the comments that you guys made on the margin pressure, gross margin pressure in the backlog. George, I think at Tyco, you went through a similar phenomenon when you took over there trying to bring up backlog margins and enhance some bidding discipline. I think there was a period of time where that selectivity showed up in growth. Is that something that you guys are anticipating in the current outlook? Is that something that over the next couple of quarters could be kind of a slow or uneven handoff as you just work that through the system?

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [46]

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Not at all. We're doing both. I mean -- I think what's different is that during that period of time, maybe the markets weren't as strong. And when we did the selectivity, it resulted in a net decline obviously with margins significantly improving. What I would tell you in the current environment is the market is pretty strong. We're adding salespeople, talking to our customers. We're getting a lot of good feedback that there's a lot more we can do for our customers and making sure that now we got the capacity to go after that and staying focused on projects that ultimately create the most amount of value. And then certainly from a price standpoint, we get the proper return for the projects that we actually deliver. And so I think it is different than what we went through in Tyco. Some of the same principles apply. It's more focus and discipline and making sure that the incentive systems are aligned to ultimately what we're trying to achieve both in growth as well as margins.

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Joshua Charles Pokrzywinski, Wolfe Research, LLC - Director & Diversified Industrials Analyst [47]

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Got you. That's helpful. And just a follow-up on the cash flow, it seems like the mix of growth that you guys are projecting for '18 between more growth in Asia, more growth in Power or Asia on the -- or on the building side, those would be, I guess, your lower cash generating businesses since Asia has Hitachi, if that's a big component of the growth and obviously Power is a working capital consumer. Is that something that factors into maybe a suboptimal mix of cash flow growth this year and that could normalize something better than 80%? I'm just trying to calibrate. It seems like the mix of growth is not your best case scenario for free cash generation.

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Brian J. Stief, Johnson Controls International plc - CFO and EVP [48]

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I don't think that's going to impact it in a big way. I guess the way to think about this right now is we're looking at the Buildings business globally. Target's about 85% free cash flow, and Power Solutions is around 70% today with the growth investments we're making. I think as we work through some of the growth investments that we've talked about on this call at Power, I think moving toward the 90% target we've got in 2020, that's still where we're headed. But I don't think the mix that you're referring -- the geographic mix you're referring to is going to be a -- is going to impact that in any significant way.

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Antonella Franzen, [49]

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

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George R. Oliver, Johnson Controls International plc - Chairman & CEO [50]

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Thanks, Antonella. And again, thanks, everyone, for joining our call this morning. As I mentioned earlier, I'm even more excited about the future opportunity as we look at 2018 and beyond and certainly look forward to engaging with many of you here over the next coming weeks. So, operator, that concludes our call today.

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Operator [51]

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That concludes today's conference. Thank you for your participation. You may now disconnect.