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

Good afternoon, everyone. Just quick disclosures. For disclosures, please see the Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley representative. So this morning, I'm happy to introduce Vimal Kapur, Chairman and CEO of Honeywell Technologies; and Michal Stepniak, CFO; and Vimal is going to kick it off with some opening remarks.

Thank you very much, and good to be back in Laguna I would say we are 75 days as a new company. It looks like a 100-year-old company, and -- but we are definitely reinvented ourselves with the changes of completed spin of aerospace and advanced materials. I'm not going to belabor that. I think everybody is aware of the story. I think where we are focused on is as a new company, how we execute on the commitment we made on our Investor Day on our very simple investment thesis we're a pure-play automation. -- coming out of the gate, playing into 3 end markets, building process and industrial and building and mining installed base is our business model. We live with that every day. we are accelerating growth of our installed base by moving towards verticals which are growing at a higher rate. and mining installed base using much more AI-based tools so that we can get more value out of it. The good news is our strategy execution is in at a rate better than we had expected, the Q3 start for the first 2 months have been good or very good, depending on how you want to say it. So we have good momentum. We expect to start the first quarter at the upper end of 4% to 6%, which is a great place to start and have similar momentum for Q4, which will make a good -- so where we sit today, we are executing the strategy. The momentum is good, and we think we have a good setup for imminent 2 quarters ahead. We want to have a good start and then gave a good setup for 2027 ahead for us. So look forward to the discussion and drill into any direction you want to go into.

Yes, that's great. Thank you. So talk about the portfolio transformation and a little bit what's different about the company now versus a year ago? What do you think the market still doesn't fully appreciate about the new company?

Mean it's fair to say that, first of all, we are a newer company. portfolio change has been substantial. We separated 3 businesses apart from the spin and we acquired 6 businesses. So I think just appreciating our portfolio, it requires work. I'm not saying it's good or bad. It's just being a newness. But fundamentally, we as a company needs to prove we can grow at a high rate, which organic growth rate is -- was not a feature of Honeywell. We did a great job of earnings growth through margin expansion, which we haven't forgotten. We still know how to do that. But adding to that feature organic growth and delivering that near term is the best way to prove it. So if we can -- and we feel confident that next few quarters continue to be upper end of 4 to 6 more towards 6. We established credibility that we can grow organically through the strategy we have put in place. So that fundamentally is different for us too, but also market will appreciate that as we have a couple of quarters under our belt in which we prove those numbers.

SP1 Yes. Historically, as you said, you guys have struggled to kind of hit the higher end of that range. So can you go a little more into detail on what structurally has changed about the business to drive that 4% to 6% growth?

Two things have changed. I would say the first is the portfolio itself. I mean if you have the right portfolio, that helps you to grow at a higher rate as we have seen some of the businesses. So changes in the portfolio we made was intentional to a certain degree. So that certainly is different. And second is making growth as our first priority. That's our goal number one. It means how we think about growth enablers, which to me is fundamentally more and more pivot towards in our mix of our business towards high-growth verticals and to mine our installed base, how we are structurally doing more and more penetration that becomes our priority that we are thinking every day that are we mixing up our business towards higher-growth verticals? Are we penetrating more towards services and software. And to do all both these, we need new products. And that becoming our primary focus area is different from what is in the past. The portfolio is different. -- strategy execution focus is different, which gives us the confidence that we are going to deliver what we committed $12 earning 2029 and I should have said it earlier, where we sit today, Mike cited during Investor Day, that to us is more of a floor. We are here to beat that flower and perform at a better rate over a period of time.

That's great. On the high-growth verticals how much of that 4% to 6% growth is coming from the portfolio mix shifting towards those verticals versus improving execution within the business?

So today, let's kind of the benefit of everybody. We defined in each of our segments, higher-growth markets -- so in buildings, it's data centers, it's hospitals and it's hospitality. And in case of process, it is LNG and life sciences and so on. So we identified 8 markets. They constitute 20% of our mix today. But these markets in 2026 are growing at a rate of net 15%. Some of these markets are well known like LNG market is growing at a higher rate in process. data center is growing at a high rate. Semiconductor is 1 of the identified high-growth vertical in industrial. So the answer to your question is we -- our view break is today, it's 80-20. 80% of the business come from more mature markets, which are growing at a GDP rate. So they should grow at 3% to 4% rate, depending upon the geography and the market. And then the 20% growth at a 15% rate and that's a math. So if 80% growth at 3% and 20% grow at 15%, we are going to hit that 6% mark. We are conscious of the fact that it's better if that 20% becomes 25% or even higher -- and that's 1 of the commitments we made during Investor Day, we want the high-growth verticals to be 25% of our mix. We expect to finish this year from '20 to '21. So we are heading in the right direction. Hopefully, next year, we go from 21% to 23. So we're just mixing it up. And more mixing up, we do lesser growth now we need from this higher growth even versus 15%. So I think we are headed in the right direction. And we don't want to forget the fact that the base business also has to grow for us to deliver. It's not Ankush, it's not audit and. So base business is to grow well. We have to do good customer service. We have to innovate new products. That's how the base business grows. and a high-growth vertical you basically built offering in which we can compete and then looking cetagainst your competition.

And then the new strategy also requires monetizing the installed base through services, software and new products. how undermonetized is that installed base today? And where is the largest dollar opportunity you see?

So today, 40% of our revenue comes from services and software. We want that to go to -- we want that to be 45%, Why? First, it's higher margin. And second, it's more durable. You can predictably say that revenue is going to be in your revenue stream next year, given the nature of the long-term contracts we have there. So to your question, it's less about -- I mean we obviously have a variety of businesses which are less penetrated are more penetrated. So if it's less penetrated, the answer is obviously get penetrated more. For example, in our process automation and technology business, the process technology side of the house is not penetrated well. They license technology to build energy infrastructure and did not sell service contracts. -- there's no real logic behind it. This was not their focus because the business model was not built in mind installed base, nobody focused on that. Now we are. So their opportunity is penetrate more. But if you look at Building Automation business, which has good penetration on the project side of the business, we are doing more upsell, cross-sell, right? It means you have to build more offerings. So you need to find our opportunities both in terms of penetrate more or upsell more depending on where you sit. But both strategies are working for us. One big change we made is -- we have -- we built an enterprise level system for our installed base last year. Now should look very table stakes to say what's a big deal about it. I mean, don't you know where the installed base is. Of course, we know we always knew about it. But a company of our scale, if we have about 15 businesses, everybody has their installed base and their own system. So we may have 10 plus systems or 15 system where a system of record exists -- so we cannot have a common metric on penetration. We cannot have what asset is due for out of warranty. There's no common standard. So the way all companies have an ERP system or a CRM system, -- we build what's called EAM, enterprise asset management system, where our installed base data is there. So that basically allows us to ask the question, which you're asking where we have penetrated less. What can we do about it? And if you penetrated more, that's good news, what can be upsell on top of that and how we're building offerings. So a combination of those will allow us to get towards from 40% to 45%. I think we feel highly confident about it. And this year, our offerings, specifically on the software side, they are trending very nicely.

Appreciate that. Pivoting to data center and AI. Obviously, everyone in Industrial is talking about AI and data center. You guys talk about physical AI with Forge. What can Honeywell do with AI that a horizontal software provider cannot? And where do you expect AI to show up first in the P&L?

So AI is already maybe later part of the question. Our Force platform revenue this year will be about $1 billion that's $1 billion ARR. We expect that to grow at 15%. So it's already in our P&L. And it's about 5% of our revenue, will grow more. To your question, what is different about us and how we think about it. We think about this being a capability by which we serve our customer, through our services and software strategy. Again, as a reminder, our strategy is build and mine installed base. And when you go to the mine side of it, monetize side of it, you need to have offerings which are more contemporary. Customers today want to use a genetic system as part of their operation. They want to have agents. They -- and if we do not offer them agents on top of our system, we are not contemporary. So we have to think about it in context of the market need versus we're trying to catch up on something. Now what's different is you can say why a generic tech company would not be able to do this? Why you need Honeywell to do this are a physical AI. Physical AI has 2 unique features compared to, say, traditional AI. The first is the data in the -- our domain is not in public domain. Data is in our control system. So you can't go to Internet and get the data and train it. There's nothing to train. So if we do not become a capable company, we are ourselves becoming as a kind of a deterrent to scale AI. So that's factor 1. The factor to is large language models can do a great job to contextualize data, but they do not have domain knowledge to make sense out of that. So I can have a large language model in which you can put in real-time data for we are sitting in a hotel here. So how is the chiller performing in this hotel what the ERP data are telling us in terms of the maintenance or some pictures. Yes, you can give it all to an LLM, But LLM doesn't understand what a chiller does. So that's a domain knowledge. It's companies like us possess in the segments we operate. So building a physical AI requires that last mile expertise to get that intelligence out of that data. So the combination of the friction of the data, not being in public domain and domain knowledge, really becomes a value proposition for us. So companies like us now, we partner with cloud providers and AI model providers to take their capability to build an offering which our customers can use. So that it's an economic value for them and they can make money out of it versus they are shopping around from other sites. So it's an important part of our proposition. It plays right into the heart of our business model. And therefore, we believe that it's something which is critical for us to be successful as part of our business.

And on the data center side, they become an increasingly important growth vertical how large is Honeywell's addressable content per data center today? And how much can that be expand beyond the traditional building control of fire, et cetera, you guys sell?

Yes. So I would say our journey in data center has been interesting. We -- the automation content in a data center in the data hall is not very large. It's about 1.5% to 2% of the capital. So we are a little over 5% of building automation business come from data centers, right, today, and it's growing at a rate of, I would say, north of 20%, even higher at this point of time. But the base is also small, I'll acknowledge that. What's changing interestingly for us is that data centers are now want to have aspiration to build their own power generation, which has started very recently because of our interconnection problems and everything else. Because the power generation is becoming integral product data center, our entitlement has grown because our Process Automation business also have room to play in the power island apart from the data hall where building automation business was playing. So if that thesis plays out, our growth rate would further accelerate because now this is a new driver in the market. And we already have active engagement with few data center builders who want both which improves our value proposition because there are not many companies who do both the core data center and the power generation summit. There are 1 or 2, but they are very few people. So we see that as an extra enabler. Other growth enabler we see in data center is we being a global company. We absolutely are benefiting from data centers becoming global. So we see a lot of activity in data center built out in Europe. We see early days of a lot of data center build out in Korea in India. Good news is Honeywell has a deep penetration in each of these locations. So as these will scale, we'll also benefit from that. So there's a geographic footprint expansion momentum in our favor. -- and scope expansion momentum in our favor. So we do expect that even though it's a smaller portion of our revenue, but certainly is net helpful to us in the market.

Great. And then pivoting to another high-growth vertical LNG. That remains 1 of the more differentiated parts of the Honeywell story. And on the most recent earnings call, you said the proprietary LNG equipment is sold out for the next 3 years essentially. What is essentially driving your strength and right to win in that market? And what does that imply for growth in years 28, 29 ?

LNG growth is coming on the strength of 2 acquisitions we made over the last 2 years. We bought an asset from Air Products for the core technology, which converts gas to liquid it's the heat exchanger. So think of it as a large refrigerator. You put gas on this side and liquid comes on the other side, and that's the core technology, which we possess -- and we also acquired a business called Sundin, which could as special compressors, which are acquired in LNG plant. So a combination of those is giving us sort of growth. We are spending our capacity. So when I mentioned that comment, it was in the context that when we acquired a business, it has a certain capacity. So if we took that capacity, we kind of are booked for till 29, 28, 29. We are expanding that capacity substantially so that we can create more opportunity to benefit from the growth which is coming ahead of us, and that's mostly already deployed, so we can now serve a much bigger market because demand is very strong. Interestingly, the demand for LNG was already secular ahead of Iran war, what Iran War did was an incremental demand signal that people want to diversify their sources because there's a risk perception now from certain supply base and people don't want to reply on 1 supplier, they want to have resiliency, which is creating even more demand for LNG compared to what was forecasted earlier. So we think the cycle will remain strong at least for next 3 to 4 years. What you can see ahead of you, I can't see beyond 2030. So it's hard to say what will happen beyond that time. But fundamentally, as the word energy mix is zooming from coal to the gas, that's a fundamental driver and we see strong demand in the business, and our acquisitions are playing out to our strength there.

That's great. So at the most recent Investor Day, you highlighted a new framework of 4% to 6% organic growth. And then also margin expansion of 60 basis points annually. While 2026 is going to benefit from portfolio actions and stranded cost reductions and a little bit of that in 2027, once those are out of the way, what are they going to be the durable drivers of that organic margin expansion?

Sure. So there are a few and we talked about at the Investor Day, but obviously, price is a big 1 than productivity. Everything we -- that Venmo talked about as far as mixing the portfolio to higher growth verticals, more focus on services and software ARR, that's also, I would say, will allow us to drive margin expansion. And finally, it's just good old productivity. And if you think about the accelerator what Honeywell deploys as far as productivity. That's really the big driver of our cost out and margin expansion as we grow at the higher levels. .

Great. Shifting to more near-term dynamics. You saw double-digit order growth in Q2, especially across the short-cycle segments and backlog up almost double digits as well. How much of that strength reflects improving underlying markets versus Honeywell-specific execution and share gains?

I would say it's both. I think markets remain very reliant across the board. We -- as I mentioned, we had a strong booking quarter in quarter 2. But first 2 months of quarter 3 has also gone very well. So the momentum continues, both in short cycle but also in the long-cycle demand. And our backlog continues to grow. So we are benefiting from strength in the markets we play, but also continue to keep our position or gain share in some pockets, which is net helping us. So we have been gaining share in building automation for multiple quarters. That momentum continues, which is helpful. So self-help here. We're also seeing trend lines now of industrial automation business normalizing and stabilizing we had share loss problem in that in 2025 and earlier period, but that's reversing. So that's definitely helping net because we are no more losing share, but stabilizing ourselves -- and the process market, as we talked, is extremely in up cycle at this point. Our backlog in process automation technology is up 25%. And -- that's a historic high, which positions us well for second half of '26 but also for 2027. So markets being strong is net positive. -- and self-help to a certain degree where we can differentiate ourselves and at least keep share or gain share in some pockets is also providing us tailwinds.

And in Q2, you also highlighted software ARR being up mid-teens. What is driving the acceleration there? And how large can software become relative to the overall company over the next few years?

So as I mentioned, our software ARR by end of '26 will be about $1 billion. It's pure play software ARR because I think earlier, we -- we mentioned big numbers that they are part of our other revenue streams. So I think it's better to keep it simple on AI-driven offering, which is about $1 billion. I think driver for that is new offering as we launch. -- and adoption rate of those offerings. The market adoption rate on AI is variable. -- few customers want to do faster, a few not, it's not in our control. what's in our control is, are we innovating at a pace and speed at which we are differentiated in the market. So that when the market wants to adopt it, we are #1 in the priority because we are the most advanced. So I do see that the primary driver is continue to build new applications, which customers are willing to pay for. And our aspiration is to keep growing that at 15%. It will remain a smaller portion of Honeywell technologies revenue. However, this revenue pulls through the rest of our offering because this is a differentiating feature, which allow us to grow our core at a higher rate. And we don't want to forget that. This cannot be look in isolation of rest of the portfolio. We have to look it all together. And therefore, this innovation is critical for our overall growth algorithm.