Honeywell International Inc. (HON) Earnings Call Transcript & Summary

Good morning, everyone. This is Sheila Kahyaoglu with the Jefferies Aerospace and Defense Equity Research team, and we are kicking off the Jefferies 2020 Industrials Conference with Honeywell. Early bird always gets the worm. We're lucky enough here today to have Greg Lewis, who's Senior Vice President and CFO of Honeywell. Greg has been at Honeywell since 2006 holding various financial roles. We'll start it off with a few brief slides and then kick it off into a fireside chat. Greg?

Great, good morning, Sheila, and thanks for hosting us today. Really appreciate you taking the time. If you just turn to the first slide, I've just got 3 quick ones here. Just wanted to start by reflecting on the Honeywell execution track record. And essentially, what you've got here is how we responded to the global financial crisis in '08 and '09. Our long-term financial performance, including our shareholder return over the last 3 and 5 years up through to 2019, and again just a quick recap on what we highlighted in our earnings call related to the way we've set ourselves up here in the second quarter as we look forward to the recovery. And what I hope you can see from this is in both the short and the long term, Honeywell continues to deliver. We always take swift action when the market shifts, and you saw that in '08, '09 where we took out over $1 billion of cost in '19. We were able to grow adjusted free cash flow through that recession. We actually shored up our pension plan quite nicely and continued on focusing for the long term. And that really played out by delivering profitable growth and strong cash flow through that period past the recession of '08 and '09. And again, you can see that with the segment margin expansion over 700 basis points in that time frame, a 12% adjusted EPS CAGR and over 650 basis points of free cash flow margin improvement as a percent of revenue. And that shows up in our TSR, 69% for the 3 years up to 2019 and almost 500% for the 10-year period. So -- and as I hope you would expect, we've done again in 2020 which is probably or hopefully, the most challenging period we'll face with the global pandemic, but we've again focused on both the short and the long term, taking the actions that we talked about with our fixed cost plan, taking out almost $700 million in the first half and a full year commitment of between $1.4 billion and $1.6 billion. Very proud of the fact that we were able to actually grow margins in 2 of the 4 businesses while we limited our decrementals to 33 for the company overall. And we talked about the $1.3 billion cash flow and the investment of over $225 million of CapEx. So we continue to invest, and we're focused on growing, not just here in the short term but really more getting prepared for what's to come beyond 2020. And that's really where our focus is, managing for the short term but making sure that we're prepared for what's next. So if you flip to the second slide, this just highlights our balance sheet strength and liquidity position, and we've often talked about taking advantage of the opportunity should the markets have a dislocation just like this and being ready to be able to do that. And liquidity was a major priority for us in that March-April time frame. As you can see here, we really strengthened our balance sheet with putting the term loan in place. Originally, it was a $6 billion term loan. We actually went out to the markets and floated a $3 billion bond to extend the maturity of half of it over a longer period. And that's got us in a great position where we've got over $15 billion of cash on the balance sheet and still less than 1 turn of net leverage. So we're in a terrific position. And as you can see, we're not shy about deploying capital. We deployed over $34 billion in the 5-year period preceding 2020, greater than our free cash flow. So we continue to deploy capital smartly. And again, once again, we've put ourselves in a great position to further strengthen the portfolio as opportunities become available. And Darius and I talked about it in the earnings call, we're very much ready and willing to deploy capital with the right opportunities. So if you flip to the next slide, this is just what gets us excited about the company going forward. I mean the benefits of having a broad portfolio is something that we've always leveraged. Now is no different. We've done I think as much as any company in this crisis to respond to new COVID-related needs. And you see some of those solutions on the left-hand side of the page. We've moved very quickly to get some of these products and solutions into the market and into the hands of those in need, whether it is the expansion that we've done in mass production, getting new solutions out like the UV cabin system, getting solutions out in mobility for things like our CT40 scanner that's in the health care segment that not only has high data security, but also is very resilient with now people needing to clean all of their mobile devices. So the ThermoRebellion solution, of course, is available for screening for temperature for people as they're entering into, could be a building facility, into a airport, et cetera. So here are the things that we're trying to do to address the COVID needs of the customer. But our portfolio more broadly continues to be very well aligned to a lot of the macro drivers that are going to be relevant in the future: e-commerce, health care worker safety, all of those things are very relevant. And I would tell you that our 3 transformations that we talked about quite extensively, whether it's Honeywell Digital, our supply chain transformation and our Honeywell Connected Enterprise, all are going to be big value drivers in the recovery and then what's to come in 2021 and beyond. So we feel very good about where we are from a portfolio perspective. We've got some great solutions. As I mentioned, in high-growth areas like e-commerce and health and safety. The breakthroughs, we're always working on not just what's relevant right at this moment, but working on investing in breakthroughs for the future, whether it's things like smart cities. We talked about our sustainability solutions that we opened up. And I think what you'll see is, again, not a surprise, but the short cycle, high-margin businesses as the economic conditions improve, those will lead to recovery. And I would expect we'll see some -- just like we're seeing some mixed pressures on the way down, we ought to see some mix favorabilities on the way back up, and we'll be taking advantage of that time, of course, of the leverage that's associated with the almost $1 billion of permanent fixed cost reductions that we've announced and are executing. So when you tap on to that, the substantial capital deployment optionality, and again, I think our bias is more towards M&A than buybacks. We talked about being willing to, in the short term, keep share count constant to where it is today. But we would love to go and add something to the portfolio. So these are challenging times, of course. I think we've done the necessary things to prepare, to outperform and the recovery that is ahead of us. And we're excited about what Honeywell can bring to bear in the years ahead. And that's really what we're focused on. We'll manage through the difficult challenges that we're all facing in the year now, but we're really positioning ourselves to outperform in the future. So with that, I just wanted to open up to you, Sheila, for discussions. So back to you.

Okay, thanks, Greg. So to start off, I guess there's no doubt Honeywell is the cost-cutting guru, but I wanted to ask a few top line questions. How do we think about the recovery? You just mentioned you'll have the favorable leverage mix on the way up. How are you thinking about the slope of the recovery across Honeywell's various end markets?

Yes, yes. So that -- I mean, that's -- when you have 38 GBEs and you're touching so many end markets, it's really hard to paint a simple picture of that. But when we think about it, certainly we're actually growing through the downturn in a couple of areas, as you know, with Intelligrated and portions of our business inside of SPS, in particular, associated with the PP&E space. Obviously, in some of the shorter cycle businesses, as business activity picks back up, automotive activity will pick up, and that will help us in places like our fluorine products businesses. Ultimately, travel is going to be one of the bigger things that's going to have to continue to recover in order for demand for fuels to go up. And of course, the -- we're all very aware of the aftermarket in aerospace, of course. And so we expect that to be paced with the recovery that's going to be, as we talked about, really highly leveraged to a medical solution for what's happening with the coronavirus. So our short-cycle businesses, I would expect them to lead the way and then with the strength that we have in a couple of the longer cycle businesses like defense and Intelligrated continuing to grow through the downturn and into 2021. And then as you would expect, things that are going to be exposed to oil and gas and the commercial ATR space will be probably on the slower end of the recovery path.

Sure. And then just to touch upon Slide 4, Honeywell has an impressive array of digital offerings. This extends a little bit beyond Slide 4, but what are you seeing in terms of customer uptake post COVID as firms try to adjust and do more digitalization? What are the main areas where Honeywell thinks you could see an uptake in automation and the strategy there?

Yes, it's really exciting because anything associated with -- you could broadly think about it as remote operations is going to be big for us. So whether it's remote operations of buildings, our healthy building offering is something that we're trying to get very quickly into the marketplace because that can help in so many different context. It can help in the education context, people getting back-to-school. It can certainly help anything related to buildings. We're all interested in getting back to work. And so being able to monitor air quality and temperature and so on is going to be important for people for their safety. Our worker safety and also worker productivity, connected worker operations and solutions are starting to really kick in, which is terrific. And then as you can imagine, cyber is going to continue to be an ongoing or accelerating theme, I think. And so our cyber offerings, we're seeing a nice uptick in there. So anything really when -- enterprise performance management is what Que talks about when she highlights the value of Forge and what the connected offerings bring more broadly and anything that has to do with, again, what you could broadly think about as remote operations, I think, is going to be very relevant for us as we step forward.

Got it, thank you. And then just moving on to profitability. On the Q2 call, decrement -- I think it was mentioned that decremental margins would see a narrowing in the second half, with businesses starting to see some recovery. I guess which businesses lead the recovery? Which businesses lag the recovery in terms of profitability and decremental margins?

Yes. So we're talking about that in broad strokes for Honeywell. And when you think about it, it's -- again, the places where we've had the most substantial impacts in top line, of course, have been in PMT and aerospace. And so those have taken the biggest hit, if you will, in terms of deleveraging. That's also where we have the preponderance of our cost programs. We've been trying to be very judicious about where we're taking out cost. And aero and PMT are probably on the leader end of that. So as we come out, we will expect to see growth in margins. Again, we've already had growth in margins already in both SPS and in HBT, even though HBT is declining. So I think what you're going to see is aerospace and PMT will need to contribute to that. And that as the more permanent cost actions for those 2 businesses kick in, in the second half of the year, I think we'll start seeing that as well. So -- but broadly speaking, we feel like, in 2021, as an example, we're going to be right back on the path for our sustainable margin improvement. Darius, and I talk a lot about our overall financial framework, and part of that includes 30 to 50 basis points of margin expansion every year. And we expect to be in a place where we ought to be able to recover or resume that kind of profile as we go into 2021 and beyond.

That's helpful. And then just on that last point you made, Phase 2 of the restructuring is quite small at $200 million. Do you think this is enough cost takeout given some of the prolonged recovery expectations we have, both within aerospace, commercial construction and then PMT's oil and gas markets?

Sure. Yes, I guess 2 things on that. I mean, first off, just keep in mind that the $200 million is really 2020 benefits. And so these are programs that literally only have 6 months or less of time to be enacted. So there'll be a carryover effect of that into 2021. But we talk about our overall cost program as between $1.4 billion and $1.6 billion, of which 60% to 70% of that is permanent. And that's where I mentioned the roughly $1 billion of permanent cost takeout and that's really just rough math around that range and that percentage. But I think that's actually a very healthy amount of cost removal. Again, you have to keep in mind, we did this in the '08, '09 time frame as well. We want to make sure we take out the right amount of cost. It would be easy to make a knee-jerk reaction and just cut indiscriminately, but we're trying to make sure, as we had done before, that we're being responsible in the short term, but also we're not taking away our ability to react as the business environment recovers in 2021 and beyond. So I think we've done a very good job of positioning ourselves as we go into next year. And we're going to -- it's not like we ever take our eye off that ball. If things were to have a downturn again, if the virus gets worse, we'll be there to make sure that we're acting accordingly.

And then just to wrap it up on margins, Greg, the 2 highest margin businesses have the most near-term pressure, as we've discussed where maybe the biggest mix, the biggest impact across the segments from a margin range of product to services versus where there are the most opportunities to really drive more margin opportunity given incrementals coming out of the COVID disruption base?

Yes. Well, so I mean the obvious mix just in terms of broad strokes, is going to be the aftermarket and the aerospace business is obviously high margin, that's the model, right? So as that begins to recover, we'll mix up on the way up into that. And same is going to be true with PMT. As the refining business begins to recover, we'll see catalyst shipments and catalyst business improve. And of course, that's going to carry a nice margin with it as well. And so those will be the 2 most obvious product mix aspects of it. But what -- I guess what I would tell you is our overall productivity program is intact. And I mentioned it in the opening, when you think about the 3 transformations of Honeywell Digital, our supply chain transformation as well as our connected enterprise efforts, all of those things are margin drivers. Honeywell Digital will not only help us drive the front end growth because, as we've talked about, that's as much an enabler to the front end of our business, when you think about the CRM platforms that are enabling our sellers to operate in this work from home environment. When you think about the platform we put in place for our customer experience teams to be able to engage with our customers during this period. So there is a growth element to Honeywell Digital, but there's also going to be a back-office productivity aspect of it as we continue to take advantage of opportunities to automate. So there will be a G&A productivity lever there. And then with Torsten and this supply chain transformation, we continue to work the footprint for our manufacturing base. We continue to try to become less capital intensive. That obviously is going to continue to drive down our manufacturing cost as we get more productive as well, which will help us from a gross margin perspective. And then again, we look to try to drive 20% type of growth on the Honeywell Connected Enterprise. And again, that's predominantly a software business, it carries above line average margins. And so as that grows and it outpaces the top line of the overall company, we would expect to get leverage in that in that way as well. So there'll be some very specific product-related mix up as the recovery advances. But we're going to continue to run our productive -- our productivity playbook and drive profitable growth as a rule across the whole portfolio.

Perfect. And then just to touch upon each of the segments, one question each, starting off with aerospace. What do you think the sweet spot of Honeywell Aerospace aftermarket is? I mentioned this because you talked about used serviceable material on the earnings call, whether it's PMA or accelerated retirements. Can you help us frame Honeywell's aftermarket and where you think the sweet spot is?

Yes. I mean, listen, if you think about it, probably the most unassailable aspect is our Avionics platforms. I think the Avionics platforms are the brains of what runs the cockpit. And so I think that's a big part of strength for us as we go forward. We also have a terrific -- we have a terrific franchise with our APU business. So also a very strong suit for us. I think as we look outwards to the dynamics of used serviceable materials and what will happen in the aftermarket recovery more broadly, that's really going to depend on the behavior of the airlines themselves. And I think each of them will have some different dynamics which as we spoke about in the earnings call, still, I'm not exactly clear given all of the changes that are happening in terms of even stimulus and support for them in the marketplace. But we'll have to see how all of that plays out here over the next 2 to 3 quarters. But we feel good about our position in the market. We -- part of the way that we've been successful over the long period of time is to make sure that we've got great technology offerings. I mean that's really -- we've said it all the time. We're not here to compete on scale. We're here to compete on technology, and we think we bring terrific technology solutions to our partners and customers.

And then moving on to SPS, this is one of the segments that's actually growing through the downturn. You grew slightly in Q2 and faster as expected in Q3. What kind of incremental margin should we expect in this business as the recovery gains some more momentum?

Yes. So again we're not going to quote specific incremental margins for the business overall, but we're very pleased with the fact that, that business is growing margins sequentially and year-over-year. And we would expect that to continue. We have a long-term margin target that we've highlighted previously. That's probably 300 to 400 basis points above where we are today and we are going to march towards that target in a very methodical way through both the advent of our productivity plans as well as continuing to drive more software through that business. Keep in mind, the entire business model around Intelligrated, which is going to be our greatest grower there, is about capturing installed base and then ensuring that what follows behind it is a strong services and software business. And while the initial sale for a lot of the project work on the front end maybe on a lower margin profile, what we expect and hope to retain on an ongoing basis should be very strong margins as that takes on much more of an HPS like business model of services and software.

And then on PMT, maybe 2 questions on this one, actually. The first part would be which of the 3 subsegments within PMT, where are you expecting to see the trajectory of the recovery?

Yes, well we have the most short-cycle exposure in the advanced materials portfolio. And again, particularly with the Fluorine Products businesses exposure to the automotive business. I would expect that AM will probably show us growth on probably earlier side from a recovery standpoint. There's portions of HPS, which, again, I expect to be very resilient with our service business. And then the projects business that we've discussed before, we do expect that some of those projects will be pushing to the right. We highlighted the fact that we're not really seeing people cancel projects, but certainly, they're being cautious here in the short term. So that may lag a little bit in terms of that growth reaccelerating. And then again, UOP, the oil and gas business. That actually, as the gas processing, I would expect that to recover in 2021 as the need for unconventional gas resumes. I think that will happen. And when it does, we'll be there to capture that. And as I highlighted earlier, as the broader Petrochem business stays relatively moderately good so far. And as the refining business begins to recover, I would expect to see our catalyst business recover with that.

That's perfect. And then just in terms of margins on PMT, given it is a higher-margin business, it seems more volatile to this cycle versus the 2014, 2015 oil and gas downturn. How do we think about the margin outlook given this is Honeywell's second most lucrative business?

Yes. Yes, I would say we've talked about it a number of times. The margins can bounce around in PMT and UOP has a big part to play in that. And so we've talked about it before, you can't really plan from one quarter to the next in terms of sequential stair steps because large catalyst business can move the needle from one quarter to the next. But again, we're taking the right actions from a cost perspective to resize the fixed costs in the business to the level of revenue that we think will have coming out of the recovery. We're going to continue to drive software and services through that business, just like others. I think our connected plant solutions are going to be -- they're going to have a lot to do with our success going forward. I talked a little bit earlier about cyber. Our cyber business runs through PMT. So that will be helpful as well. So I expect we will get back to a nice margin progression in PMT as well as the top line settles out.

And I just wanted to touch upon HBT for the last one. We touched upon this a little bit, whether it was cyber or more remote access. Longer term, there's some work from a home element that could drive a broader change to the commercial real estate market. And obviously, HBT is very levered to this. Maybe if you could size the commercial real estate exposure. How does that align to maybe how HBT is operating, whether that's potential risks and opportunities?

Yes. So to be honest, we think about that as an opportunity because all of the things that we have been developing as it relates to connected buildings and the offerings associated with it. We expect those are going to be demand generators as we drive through this recovery. I highlighted it earlier, whether it's an airport, an office building, could be a train station. All of these places, people are going to need to go, and they're going to need to feel safe and have things to give them confidence in their ability to stay healthy. And I think when you think about our offerings, whether it's the sensing technologies that we have, whether it's our Forge offerings, whereby we can create connected solutions. Que and the HCE team working very diligently on creating apps that are going to be players in this space as we go forward, with things like contact tracing and so on. I mean we are going to play in that healthy space. So I actually see that -- there's no doubt there's going to be some changes to the way people work. But I think that, broadly speaking, our portfolio is going to be poised to actually provide solutions that are going to help and are going to be a net positive as we go forward.

Perfect. And then just the last 2 to touch upon your portfolio a little bit more. You took out $6 billion of debt in the quarter. I saw that slide with $15 billion of cash and short-term investments. This seems pretty conservative given the free cash flow profile in one of your -- probably the toughest quarters that you just passed by. So even with the debt issuance, your net leverage is under 1x, one of the lowest in my coverage, you've been very strict with M&A criteria in recent years. Is there any sense with low rates and a new head of M&A? Is there maybe some appetite to loosen that criteria? How are you thinking about that?

Yes. Yes, I don't see the problem as having to loosen the criteria. I mean we've talked quite a bit about the fact that multiples had been very high for some time. And so it was getting difficult to make some deals work financially. But we're really excited, as you mentioned, I'm glad you brought it up. We're really excited to have Emily McNeal join us. She joined us in June. She's going to be a great addition to the team. And I would tell you that between Emily, myself, Darius and the business presidents, we're all really excited to go out and take advantage of our balance sheet in this market. And I think there will be good deals to be had. Now we're going to continue to be diligent. That's -- our investors count on us to act in responsible ways, and we'll continue to do that. But you're right. I mean we're obviously taking into consideration the lower cost of debt, that lowers our cost of capital a little bit. So that does give a little bit of freedom versus maybe where things were a year ago or more. But we're very excited to leverage our balance sheet for M&A to improve the portfolio. And I think we're not going to become undisciplined in the process but we will want to be active in this market. This is what we've talked about previously when and if there's a dislocation like this in the market, I would expect that multiples will come down and deals will get a little bit easier to make.

Then just last one for you, Greg. Free cash flow this year is in the 80% to 90% range, great conversion. Maybe can you talk about what businesses are above and below that average and where there are areas of opportunity in the next minute or so, if you can.

Yes. Sure. Yes, I would tell you that the HBT, SPS and PMT businesses are all firing on all cylinders. Aero a little bit tougher because the long cycle nature of that supply chain, we've got some work to do on the inventory side overall, and that's what we're focused on here, particularly in the second half of the year, is starting to work that supply chain and inventory level down. But again, I think for us, cash flow has been a hallmark of certainly Honeywell, but particularly Darius' tenure, and we're going to continue to drive, as I mentioned, not just profitable growth but also working capital and free cash flow efficiency as we go forward. We are going to continue to invest in our own business, though, and that's one thing our investors have asked us about from time to time, we're not going to marry ourselves to 100% conversion as a must have. It's our long-term target. It's something that we generally aim for. But if we've got great opportunities to invest internally and we talked about having over 100% IRRs on some of these internal opportunities, we're certainly going to invest in CapEx in our own business.

Thank you so much, Greg, for kicking off our conference. And with that, that concludes our webcast.

Okay, thanks, Sheila.