Honeywell Aerospace Inc. (HONA) Earnings Call Transcript & Summary

Okay. Great. Good morning, everyone. So lots of exciting things in industrial world at Morgan Stanley, but things are looking up for sure. So I'm Kristine Liwag, Morgan Stanley's Head of Aerospace and Defense Equity Research. I'm very excited to host our next panel. And for our next panel, we have Jim Currier, CEO of Honeywell Aerospace. But before we get started, we'll do the standard disclosure for easy -- you'll probably memorize them by end of day. So for important disclosures, please see the Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, and I'm not sure anybody ever actually did have questions, but please reach out to your Morgan Stanley sales representative. So with that, very excited to have Jim here with me. Jim, good morning.

Good morning. How are you today?

So you've now been the CEO of Honeywell Aerospace as a stand-alone company for about 2.5 months. Can you share with us what have been the biggest surprises, either positive or negative that you've come across in your tenure?

Yes. I mean, first thing -- first and foremost, I'll hit on the negative. I mean it's undoubtedly very clear. The most negative thing that has happened since the separation was the fact that we had to revise our guidance on a full year basis for 2026. Some of the things that we were expecting from a supply base standpoint to unlock and some of the transformation initiatives that we had in works were not materializing at the pace that we had expected them to. And it's as largely attributable to a couple of things, some delays in transitions that were occurring, some delays in second sources that were coming online and then also some yield and quality issues that were occurring with those transitions and/or those second sources. And so as a result of those moving to the right, it required us to do an adjustment to our guide for 2026. And I would say, understandably, and that is the most negative thing coming out of the spin relative for us in the first couple of months. On a positive note, coming out of that revised guide, it's really kind of reflective of the speed at which we can move as well as a stand-alone as opposed to being a part of the conglomerate. So the way we've reacted as a result of that issue that we have encountered with our supply base and the fact that some of those transitions we were moving to the right is the speed at which we were able to change the operating system, the speed at which we've been able to change some of the ways we wanted to invest in the supply base to continue to unlock more going forward. Those are things whereby without the layers of the conglomerate to have to go back and sort of see how we want to invest and where we want to move capital and the like, that allows us that ability with none of those layers in place to be able to move at speed. And so that's actually been a very positive as a reaction from this. And I think the second positive I would make mention of is the resiliency of the demand that we have coming into Honeywell Aerospace. I mean, even though we've had an inability to meet the current demand profile as required by our customers, whether it's commercial or whether it's defense, what we've noted is that the resiliency of that demand, the resiliency of the order book, the resiliency of the backlog that we have has been untouched and is actually at record levels for us on a go-forward basis. So I think those are the two that I would say are very positives, but obviously offset by the major negative that we had to do.

Yes, super helpful, Jim. And so now that you're a stand-alone company with the separation, has anything changed in your thinking about your top 3 priorities in the next 12 to 18 months?

From a priority standpoint, I don't think anything has changed. The way we attack those priorities is changing as a result. And I'll go back to the supply chain issue that I mentioned a moment ago. How we were addressing it, the level of focus that was being applied to it, the operating system that we have built around that is changing. Case in point is that as a result of what transpired here, we have roughly 10 or so suppliers that we consider to be constrained. Those are suppliers that just cannot meet the demands for our products and our portfolio across both commercial and defense. And so I personally spend my time with them as a result of that, going to their facilities, working with my counterparts at those sites, looking at the root causes, identifying the action plans associated with resolution and then a weekly cadence of follow-ups with them, making sure that we're on plan. And we're seeing the benefits of that materializing as well as a result. We have sunrise meetings, sunset meetings. Sunrise meetings are associated with truly what is needed for this week, next week, the following week. The sunset meetings are strategically around the transformation initiatives that we have in place. And so that's how we're reenergized and refocused around the operating system to attack those particular issues. The priorities are the same. It's just the way we are going after them with a much higher sense of urgency and speed and reinvestment profiles is really what has changed.

Super helpful. And supply chain has clearly been a pain point, and this pain is more acute for you versus some of your competitors today. Can you take us back in time for some of the investors who may not have followed Honeywell before the spin? What is the root cause of the supply chain? Why is your supply chain more fragile than peers? And any sort of tangible examples of what's really happening in these watch suppliers?

Yes, it's a really good question. And I think we have to go on a little bit of a historical journey here as part of the conglomerate of Honeywell as we were operating within. It really goes starts back in about the 2010 time frame. From 2010 to 2019, as the industry for A&D was not growing at the levels that we see today there was an initiative that was launched around maximizing our supply chain efficiency, maximizing the productivity. So we went very heavy in single sourcing across the supply base. We went very heavy on outsourcing across our supply base. And I'm not saying that others in the A&D industry did not do that, but I would argue did they do it at the same scale at which we were doing it. And the way I kind of look at that as the data point, if you look at how our margins were growing over that period of time compared to our peers, is sort of indicative of the scale upon which we exercised that operating playbook and the depth and the breadth that we did across that playbook. Now you pivot into like the 2020, 2022 time frame, COVID hit, that was really a huge distinguishing moment between ourselves and the rest of our A&D peer group. Now again, as part of the conglomerate of Honeywell, the focus was preserving margins at all costs. And so there was a substantial amount of cost cutting that was occurring across the organization and doubling down on that supply chain initiative that I mentioned a moment ago. In the aerospace part of the business, we fully recognized that demand was going to come back. The difference was our A&D peers did not follow that same sort of mantra around deep cost cutting. And therefore, they were preparing over that 2-year period for when the demand cycle was going to come back. And so you think about, you know, where we are, and when I came into this role back in 2023, I pivoted around to now, we are going to invest back into our supply base. We're not going to continue what we were doing from 2020 to 2022. And put in over $1 billion over the last couple of years, we've been unlocking the supply base as a result of doing that across our entire breadth of our portfolio of electronics and mechanical. And we've been continuing on that path for quite some time. The net-net of all of that is that we're running about 18 to 24 months in, that period of time between 2020 and 2022, where we were deep cutting where others were not. So we're running about 18 to 24 months behind our peer group. But now as a separated entity and a stand-alone, we control our ability to continue to invest and at the CapEx levels that are necessary for the business, and we'll continue to do that in the manner that we've been doing it over the last couple of years under my tenure.

So Jim, it's great to hear that some of these progress initiatives have started in 2023. So why is it that forecasting the recovery has been more difficult? And when you think about what drives your confidence in your ability to meet your forecast, what has changed? Did it change regarding the approach, your inventory approach? Any sort of change within your expectations that will help drive some of that confidence?

It's the complexity of the transformations that we are underway at the moment, which tends to have a little bit of more ambiguity around the completion thereof and then the eventual ramp. So last week, we put out a scorecard. We kind of provided a lot more detail and granularity as to what is happening within our supply base across Honeywell Aerospace. And if you would have looked at that scorecard at the start of 2023, it would have looked very different. I mean, today, we have about 70 suppliers that we consider to be critical or constrained. Critical being you have the capacity to deliver to our needs, but you just have an inability to do it reliably and consistently and you have an undue impact on our revenue for the cost of the commodity that you provide to us. A constraint being those 10 that I mentioned a moment ago, kind of fall into the four categories of complex machining, castings, forgings and bearings, right? That's kind of been where we're at this particular moment in time. That scorecard that we put out, if we would have recreated that scorecard back in 2022, the 70 that we're talking about would have been in the hundreds of suppliers that we were dealing with at the time. Those investments that we've made from 2023 have whittled that down to resolving our electronics portion of our supply base, a large portion of the mechanical portion of the supply base, and now we're down to these four commodities. And these four become very, very complex. And it's not like we're starting that journey now. We've been on this journey for some time. But when these start to materialize from the moment that you initiate them can take anywhere from a couple of months to a couple of quarters, depending upon if it's CapEx-related, tooling-related and the like. And so these become very complex. And so even though we started some of these about a year ago for these high critical areas, the point in time where they're materializing because they are incredibly complex. And as you ramp, we started to see yield and quality issues at the supply base, it ended up pushing that to the right as a result. So because of that yield and quality that we were dealing with as part of the transitions, either from supplier going from site A to site B or bringing on a second source has made the predictability of that to be much more complicated than what we had envisioned it to be just a few months ago. However, the action plans that we have launched as a result of what has transpired, we're starting to see the benefits of those, particularly across those four commodities.

Jim, it's really helpful to get these KPIs from you going from 100 to 70. That's a clear measure of progress. And now down to these 10 companies, four commodities. I guess, are there additional detailed KPIs that you could share with us to see your progress in addressing these four constrained areas? And can you share what you've seen in the most recent data to give confidence for your outlook for the rest of the year?

Of course. And so some of it was in the KPIs that we shared a little bit last week in the presentation that we've put out there and it's available to everyone. It kind of focuses around, as you would imagine, supplier output. Are they growing year-on-year? Are they meeting the demands of our business? So not only are you growing. So if you're growing 5%, that's interesting. But are you growing 10%, 15%, 20%, which is what we need out of the supply base to drive the growth and for the demand that we have coming in within the business. But how is your yield looking? How is the quality? How is the scrap? How are your detailed plans coming together relative to that? So those are all a set of KPIs that we track on a regular and recurring basis, particularly around these key four areas of constraint that exist within our supply base. Now what have we seen in terms of some benefits that have been realized here as we have focused around these four, they have different problem statements associated with them. When you think about complex machining, we have two very specific suppliers within our supply base where we represent a very disproportionate amount of their business overall, and their constraint is skilled labor. They have no issues of getting the material. We have no issues of getting the material to them. It's just critical skilled labor that they're unable to recruit in the areas that they're at to meet the demands. And so what we have done is we've actually taken dozens of our own skilled labor, moved them out of our factories, and we have embedded them within these suppliers as a result, therefore, enabling a second shift operation to be realized or a third shift or weekend shifts. And the output transition that we've seen over the last 30 to 45 days, just off of that low-hanging fruit of just injecting the right skilled labor has been about a 30% increase year-on-year as what we've seen over the last 30 to 45 days. If you pivot down to castings and forgings, our tooling is now that we had invested in is starting to come online. And so we're starting to see the benefits of capacity output increases because the tooling that we're putting in place is to replace older tooling that has worn and started creating yield and quality issues as a result. Now we've been able to get rid of some of the quality issues, get rid of some of the yield issues and then by natural effect of that is the output increases as a result of doing that. And then in the area of bearings as an example, one of our suppliers did a transition from within one of their facilities has had additional capacity at one location, so they wanted to move one of our products over there. And we had a second source come online as well. Well, now they're coming online. That transition is materializing. The second source is materializing. And what we've seen on the bearings side is that 35% of our total annual demand that is necessary for bearings has all come in the last 90 days. So in 1 quarter, it's all come in. And so we're seeing that progression of increases in output from them as a result of these investments that we're making. And that's going to set us up very well for 2027 because as the supply base is unlocking, under those critical commodities as a result, it will set us up so that our 2027 looks very different than 2026.

Great. Thanks, Jim. One of the key areas of focus for investors right now has been air traffic flattening. But at the same time, when you look at the spares market, the constrained supply really provides very scarce supply coming into that market. Can you give us a level set us in terms of where are you able to ship today versus where that demand is? And what does that demand curve look like, especially as air traffic flattens this year as a result of what's happening in the Middle East?

Yes. I think it's important to understand our commercial aftermarket a little bit here and just our commercial business overall because there is -- tends to be over-indexed onto the air transport market for a moment. And I think that's where Honeywell Aerospace is somewhat unique. If you look at our commercial OE business, half of that business is air transport, half of that business is business aviation, with two completely different sets of economics associated with them. Now pivoting to the commercial aftermarket, as you mentioned a moment ago, 60% of our commercial aftermarket is air transport. 40% of our commercial aftermarket is BizAv. And where we are positioned in business aviation is exceptionally well in the high-growth aspects of the market segments within business aviation that are growing. That's going to be anywhere from super midsized category to long range to ultra-long-range aircraft, where we have our HTF engines and our APUs and our avionics and environmental control systems and cabin pressurization control systems. So albeit we're seeing some pressure globally in the industry around the air transport, we've seen 0 decline in our entitlement relative to that as we measure that on a month-over-month basis as well as what we're seeing is this continued growth in business aviation, which has been highly resilient, particularly in the categories of aircraft that I'm mentioning a moment ago. So our demand in commercial aftermarket has been exceptionally strong and is actually above what our entitlement is in that particular business. So as we look, however, around supply output. As the OE is growing and our aftermarket is growing, if we're not getting the supply output that is necessary to support both, we have to make some decisions at that point in time. And one of the key tenets within Honeywell Aerospace is that we will not allow an aircraft to go out of the production site missing any Honeywell parts at the end of the day. So if that means we need to allocate more to the OE, which is what we've been having to do here over the last few months, particularly in Q2, that means less goes to spares for the aftermarket that, hence, it creates a little bit of a depression for us in that transitory period that we're going through. But you don't need a tremendous amount of additional output to be able to feed the aftermarket side and get a nice lift in your revenue because, as you know, the economics in the aftermarket are very, very different than the OE, particularly as it pertains to spares.

And Jim, do you think when supply comes back online and you're able to deliver, do you expect a catch-up period for spares? Or is this kind of period more of a lost revenue and you go back to a more normalized trajectory? How do we think about that curve?

Yes. I think I would anchor it first on 2030 for a moment. We are still committed to our 2030 financial targets that we had set out at Investor Day, which was that 6% to 8% CAGR between 2026 through 2030. Now clearly, with the reset of our guide to 4% to 5% that we've had to do for 2026, what that means is there will be a period of catch up. And that period of catch up will start in 2027 as we get more output from the supply base due to the initiatives that I mentioned a moment ago. And then our ability to now start allocating more to the aftermarket, which again has those different set of economics. And therefore, that's why we say '27 is going to look very different than 2026.

Super helpful. Going back to margins, you called out earlier with the actions that Honeywell has taken from that 2010 to 2019 period, that yielded in significant margin expansion. So when we think about the supplier initiatives that you have to do today in order to increase output, how do we think about the balance of margins for those components because presumably, they could cost more than the previous strategy? And then also the balances of additional initiatives you have for reducing costs and also you have significant volume as well. How do we balance these items? And where should margin trajectory be in the next few years?

Yes. So it's still going to be on that path that we committed to our 2030 targets that we mentioned at Investor Day. Now granted, going through this transitory period, it does create some margin pressures as a result through the investments that we are making through the fact that we're not able to allocate as much to the aftermarket, which again has those very different set of economics associated with them. It does create those pressures. But as we look upon 2027 and beyond, the unlock of just having more supply going in through our factories and the productivity efficiency that is enabled, productivity enhancements that are enabled, the fixed cost leverage that we get, the volume leverage that we get from that more than offset through our analysis more than offset the costs that we are incurring at the moment. At present, our factories are operating very inefficiently due to the disruptions that are coming in. When we stabilize that, and as that output increases, it drives a tremendous amount of productivity and volume leverage for us that's going to be able to mitigate those concerns going forward. And then there's the element around price. I mean price will change for us starting in 2027 and through that 2030 period of time, which also becomes an enabler for us as well. So we're still very confident on our 2030 algorithm for the financial targets, both top line and bottom line.

Going back to the supply chain, we've seen a major competitor of yours acquire a large casting house. When you think about the pain points that you have in your supply chain, you've talked about the actions you're taking and some in-sourcing. But do you see the need of potentially buying additional suppliers, taking them in-house? And can you share some sort of magnitude of the pain points that you have and what it takes to just buy machines yourself versus buying additional companies?