Honeywell International Inc. (HON) Q3 2012 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Honeywell Third Quarter 2012 Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the call over to your host, Elena Doom, Vice President of Investor Relations. Please go ahead.

Thank you, Stephanie. Good morning, and welcome to Honeywell's Third Quarter 2012 Earnings Conference Call. Here with me today are Chairman and CEO, Dave Cote; and Senior Vice President and CFO, Dave Anderson. This call and webcast, including any non-GAAP reconciliations, are available on our website at www.honeywell.com/investor. We ask you to note that elements of this presentation do contain forward-looking statements that are based on our best view of the world and of our businesses as we see them today. Those elements can change and we would ask that you interpret them in that light. We identify the principal risks and uncertainties that affect our performance in our Form 10-K and other SEC filings. This morning, we will review our financial results for the third quarter of 2012, share with you our outlook for the remainder of the year and provide a framework for how we're thinking about 2013. And finally, we'll leave time for your questions. With that, I'll turn the call over to Dave Cote.

Thanks, Elena. Good morning, everyone. As you've seen from our press release this morning, we delivered another strong quarter, and it's driven by the strength of our balanced portfolio mix. We have a relentless focus on new products and geographic expansion and of course, our disciplined cost controls. In a more challenging economic environment, our margins expanded 110 basis points to 15.8% on 2% organic sales growth. We delivered strong earnings growth and margin expansion, while continuing our investments, our seed planting for the future, despite a deceleration of growth across a number of our end markets. Earnings per share of $1.20 included approximately $0.06 of tax favorability versus our normalized effective tax rate of 26.5%. Excluding the tax benefit, EPS would have been $1.14 near the top end of our previously communicated guidance range. When you compare the $1.20 to last year's $1.10, which had approximately the same tax rate, that's 9% operating growth. Or if both years were normalized at our 26.5% rate, it's an 8% operating growth. So no matter how you slice it, pretty impressive performance considering the terrific growth we had last year and the slow growth environment we're in today. That increase in margins reflects our continued focus on driving productivity from our key process initiatives, the conservative planning assumptions around cost and our proactive restructuring. The businesses have done a great job controlling their indirect and discretionary spending, and we're also seeing further traction on our key process enablers, such as the Honeywell Operating System, Functional Transformation, Velocity Product Development and Organization Effectiveness or OEF. The upshot is that we're just starting to hit critical mass in some of our business -- biggest businesses and the benefits will continue to provide a tailwind for margin expansion even in a slow growth or no…

Thanks, Dave, and good morning, everyone, and thanks for joining us on the call. Let me start out on Slide #4 entitled Third Quarter Financial Summary and just take you through some of the highlights. Now, as Dave mentioned earlier, sales were up slightly year-over-year. We had 2% organic growth, Acquisitions contributed 1% growth, while currency yielded a 3% headwind in the quarter. And of course, that's been a challenge this year as FX -- and by the way, a point, kind of jumping ahead to 2013 is something Dave, too, that we would add. We don't anticipate the same headwind for foreign currency in 2013, which hopefully will help us in that environment. Sales were lower than expected for the quarter, driven in large part by lower sales in Resins & Chemicals and also the ACS short cycle businesses, and we're going to talk more about each of those in just a moment. Overall, we saw a deceleration in growth rate in nearly every region in the quarter. However, we're continuing to benefit from the strength of our long cycle businesses, namely Commercial Aerospace, the ACS Solutions businesses and also UOP. Now segment profit was up 8% in the quarter. Margins expanded an impressive 110 basis points to 15.8%, matching our quarterly record that we set in the second quarter. Margins expanded in 3 out of our 4 businesses, reflecting strong productivity and also just another demonstration that our playbook of disciplined cost controls is working in this environment. Now as a reminder, in the third quarter of last year, we took an accrual for a change in the active medical benefit design. We took an accrual of $30 million. And by the way, this accrual was fully offset in the third quarter of 2011 by the CPG gain,…

Thanks, Dave. Stephanie, you can open the line and we'll take our first question.

[Operator Instructions] Our first question comes from Steven Winoker from Sanford Bernstein. Steven E. Winoker - Sanford C. Bernstein & Co., LLC., Research Division: Just maybe one detail question, then I'd like to back up for a higher level one. On the detailed side, just how are you thinking, what's your visibility into pension for the fourth quarter? And how you're thinking about that these days?

Well, I think, on the pension side, we're looking at numbers right now, Steve, mid-80s in terms of a funded percent status. That means we're going to be in a pretty healthy mode going into 2013. So on the contribution side, we're just plan to play that by ear. There's no determined amount or required amount of funding in 2013, so we'll play that by ear. From a mark-to-market standpoint, we're going to have some mark-to-market expense undoubtedly at least in terms of where rates are right now. But the fact of the matter is and you've heard us say before, but the reality is we're going to have a rate tailwind at some point. So we're going to play that smartly, continue to look at that as something that we're going to manage very, very carefully, but frankly, we feel very good about the position that we're in overall regarding the funded status and the funding requirements for pension. Steven E. Winoker - Sanford C. Bernstein & Co., LLC., Research Division: Okay. And then just backing up, Dave, you talked about starting to hit critical mass in the businesses and we're seeing continued cost control and margin expansion and I'm sure that pricing dynamics are based into -- baked into that, too. But as you sort of look at the quarter in the face of all these headwinds, can you talk a little bit about what you mean by critical mass here and how it affects the margin side of the business a little bit? And in light of the current environment and other dynamics, how you're thinking is evolving or continuing to evolve on the margin expansion side from a kind of peak-to-peak perspective?

Yes, on the -- what I mean by critical mass is -- I mean, you've heard me use this phrase a lot, this goes slow to go fast, so when it came to HOS, we wanted to make sure we got it right and it was more important to get it right so that it was sustainable for a long period of time. So in the beginning, it was kind of slow, as you know, and it took us time to build that up, and in the beginning, actually cost us something, eventually got to neutral, then started to provide some benefit. Now we're starting to see the benefits really come through, because when you start getting to 70% of your manufacturing sites at bronze or better, you really start to see some big benefits from it as we've said before. When it comes to margin expansion, as you know, we've always said that, that was going to happen. We put out the 5-year plan and we felt pretty confident about being able to do that given all the seed planting that we've done, not just on the cost side, but on the growth side also to help mitigate some of the growth headwinds that we see. So between the kind of the growth plan that we've done and the seed planting that we've done on the cost side with the process initiatives, that's what's allowing us to be able to drive these kind of margin rates on slower sales growth and still be investing in the R&D and the CapEx that we need to keep growing. So we actually feel pretty good about that. And I'm sure you recognize that making the change to the growth plan the way we did to focus on margins was very timely given that we expected we were going to be seeing something like this economically and we wanted to provide that assurance externally that we did understand and we were willing to put our compensation on the line to deliver it. So we feel pretty good about it. Steven E. Winoker - Sanford C. Bernstein & Co., LLC., Research Division: And just the pricing dynamics, a little bit more sort of near term, what you are seeing out there?

From a pricing perspective, it's still okay. As you know, we're not a -- you're never going to see a 7% price increase from us, unless it's driven by raws like in R&C. But by and large, we still expect that it should be -- that it should work out just fine for us.

Our next question comes from Scott Davis from Barclays.

Dave Cote, in your opening remarks, you seemed a little bit more optimistic about the macro picture, the demand picture, than maybe some of your peers and some of the other calls we've had the last week or so. I mean, what are you seeing out there that gives you some confidence that China is, in fact, kind of making a turn and that the U.S. isn't getting worse here? When you cited short cycle businesses, can you be more specific, I guess?

Well, I'd, I guess, divide that into 2 pieces. On the macro side, I don't believe there's a recession coming. But I do believe that there's a slow growth environment most likely to occur just because the world democracies are in gridlock over debt, whether it's Japan, India, the EU, the U.S., we're in gridlock. And I do believe there's the potential in the U.S. and maybe even in the world for a good economic recovery if government would actually do their job here and resolve the fiscal cliff and the debt. By the same token there's a potential disaster if they handle it poorly. All that being said, we're going to look at it as if it's just more of the same and you can't count on these guys doing what they need to. And we need to think about it in terms of, all right, what's the kind of conservative way to plan this? So we're going to plan conservative macros like we normally do. But overall, I still believe global GDP grows next year. When it comes to China, in particular, we grew again in China and we saw it both on the short cycle and the long cycle, more driven by long cycle. At the end of the day, I think we have to factor in this leadership transition that's going to occur. And as you know, there's 2 offices, one in October and the other transition is in the first quarter some time. And I see, in my view, China is making the right kinds of decisions and they recognize what they need to do to make the changes that are economically required. So I don't think it's smart to bet against them on this. And we've done a lot on kind of thinking about how to manage through that. So that's on the global macro side. On say kind of the Honeywell micro side, all the growth initiatives, the seed planting that we've been doing for years, because you don't just turn this on in 3 months, is what causes me to feel that even in a tough global macro environment, we can do pretty well. So we're not counting on booming sales growth next year, but we do believe that there will be growth for us even in that tough environment.

Good. That explains it. Can we move back to cash reinvestment? And I think most would agree the Thomas Russell deal looks pretty interesting. I mean, can -- you talked about having a pipeline, but no real rush to do anything or not. I think the words you used was nothing was needed per se, nice to have not needed to have or something. But I mean, if you had -- on this trajectory, you're going to be sitting on a fair amount of cash at the end of the year on your balance sheet. I mean, at what point do you say, "Hey, the market is not giving us enough credit here for execution. We're going to start buying in our own stock or getting a little bit more aggressive with some of that cash"?

Well, hopefully, you'll be impressed with the consistency of my answer over the last few years. But we're still going to play that on kind of an opportunistic basis. I don't have a number in mind that says, "Okay, this is way too much cash. We need to do something." I also think in uncertain times, it certainly doesn't hurt to have cash. I prefer to have it than not. We're going to continue to focus on how do we pay a good competitive dividend as you know and that's important. It's an important return to shareowners. And when it comes to acquisitions and repurchases, we're going to continue to look at both because to the extent we can do Thomas Russell type acquisitions, man, that is a real value adder for the company and I think you'd want us doing that. So I don't have a particular number in mind. Dave, I don't know if there's anything you can add.

No, I think that's very well said.

Our next question comes from Jeff Sprague from Vertical Research Partners.

Just picking up on that point a little bit, well understood what you said. But it does sound like the pipeline is active and although you don't have must-haves, it sounds like there's a lot of like-to-haves out there. I mean, how would you handicap the likelihood of you repeating a couple of these Thomas Russells over the next 6, 12, 18 months, however you want to frame it?

Well, it's always tough to know, Jeff, because I said we always maintain a good pipeline and it's stuff that we want for the company, so it's not a case of "Hey, look, that's for sale, let's go take a look." This is more stuff that we plan for. You just never know when all the conditions kind of strikes, so that you have a property that make sense and most especially at a price that makes sense. And that's always tough to predict. So I'd have a tough time handicapping that one and I would just say, we're going to keep our eyes open. If something makes sense, we'll do it. If it doesn't, we won't. It's just a tough thing to predict.

And I know you don't want to get too far out over your skis on the 2013 outlook, but I think Dave Anderson said 2013 EPS could look like -- the growth could look like 2012. I mean, what kind of revenue growth is predicated by that statement?

I think we're looking at a low -- clearly, a low single-digits kind of number, Jeff, for 2013 given the...

The sales growth.

The sales growth -- sorry, organic sales growth, the way that we're looking at the exits for -- exit rates for each of our businesses for 2012. So that's the way we're thinking about next year. So it comes back, as Dave said, it really puts the onus on the playbook of operational discipline, continuing to emphasize value adding new products, which give us a lot of leverage in the marketplace and continuing to grow in the highest growth markets. So that's what we're going to do and...

Just to add to that, I'd say in 10 years of doing this, we have never once been bitten by being conservative in our sales outlook. So we'd prefer to be on the conservative side of this. And we'll look at -- okay, global macro is not a big help. FX we don't expect to be a big hit. We've got the geographic, the new product expansion that Dave was referencing, and when we put all of that together, we say, "Okay, the smart thing to do here as you plan your cost profile is to assume low single-digits sales growth," as Dave was saying.

And just part of backing that up, obviously, is the restructuring and just other internal operational execution things you've been working on. It seemed like maybe there was an allusion to some additional restructuring, I don't know if that was the intent. But are there some other things that are potentially in the pipeline the next quarter or 2?

I mean, it's always possible and part of our model is an ongoing active review of restructuring opportunities. We think that's very, very healthy and in best interests of continued margin expansion, earnings growth, value creation. What we've had on a year-to-date basis, Jeff, has been above what we would have expected on a gross basis, and we've been able to do it as a result of strong operating earnings and also as a result of better-than-expected performance on previously funded repositionings. So we've actually had a greater rate of attrition and other benefits that have allowed us to reduce the accruals on previous and take credits on credit for previously reserved restructurings, which have actually helped us fund new restructuring. So we've had -- as you know, we continue to increase our guidance for 2013 in terms of what the incremental repositioning benefit will be. And as I said today, we're now looking at $150 million of incremental operating income lift in 2013 versus '12 as a result of the repositioning pipeline. So that's very -- it's a very good point to bring up and very, very much part of the playbook.

We're looking out for it, Jeff, to Dave's point, but we've got a pile of stuff already funded that we need to -- we're in process of getting done. So there's no need to do anything, but we're certainly always going to be looking for opportunity.

Our next question comes from Nigel Coe from Morgan Stanley.

Yes. I just want to pick on the point on repositioning. So Dave, I think you mentioned $150 million for 2013, the year-over-year benefits. Does that mean that 2012 has gone up similarly to if that was $150 million, where is that now standing for 2012?

I think it's about $175 million, the number for 2012.

Okay. And with the bulk of that in the second half of the year, I would assume?

There's a lot, yes, it increases over the course of the year, Nigel.

Okay. So now we know why your margins are so good.

Well, yes. It's certainly one of the contributors. It's another good point.

Sure, absolutely. And then, if we just switch to 2014. You've been very helpful in 2013 already, but you're already starting to bump up towards the lower end of your 2014 margin targets, and I'm wondering and I know you're not going to change that, but can we now think about the midpoint of the margin range as now the most probable target for 2014?

I would say, Nigel, I know my story and I'm going to stick to it. I'm going to -- the 5-year target is the 5-year target and it's my intent in 2014 to be able to show you, "Look, we did what we said and here's our new 5-year plan," so that hopefully, you all look at it, and go "Wow, it's been almost 15 years of these guys doing exactly what they say. Maybe we should give them the benefit of the doubt this time."

Okay, that's the story. So are you still planning to put out another 5-year plan, Dave?

Yes, when the time comes.

Okay. And then within the plan, I think you've mentioned that you want to get friction back to breakeven by 2014. And I'm wondering, how does -- how is the deterioration in the European auto market impact that plan? And maybe you can just give us some color around that?

Well, it certainly doesn't help, but at the same time, the transformation program we have is very much on track so we feel pretty good about that. And if there's any kind of sales help at all, it will just make it better. But certainly, we're planning to and think we can get to.

Our final question comes from Shannon O'Callaghan from Nomura.

So on PMT margins, we have a lot to choose from this year in terms of what a normal run rate is because you've got 22.6% in the second quarter, going down to 18.6% and then you're implying a significant sort of decline in the fourth quarter to the midpoint of the guidance. Can you give us kind of the sequential dynamics of what you see going on 2Q to 3Q and 3Q to 4Q and then maybe a little flavor on what you're thinking next year there?

Well, just to give you, I guess, a sense for it, is it's a little bouncy between quarters in a year. But as you might imagine, Andreas is definitely planning and thinking about a margin rate increase next year and we all recognize the significance of that star performance. One of the things that is going to help that is that UOP win rate in backlog is just terrific. These guys just keep doing a great job. Ever since we started kind of more of that horizon 3 investing and the geographic reach, man, it's really paid off. So I would expect more goodness to come from that. Dave, I don't know if there's anything you want to add.

Yes, just the one thing I think I would add in terms of just a detailed item and it's something that we've talked about previously, it's just, Shannon, it's just the anticipation from UOP of less para-xylene, particularly catalysts, also some licensing in the fourth quarter. And that's just associated, we've used this term lumpy in the past as we've talked about UOP. It's something that we've anticipated. Therefore, their margins will be a little bit lower than the run rate they've experienced on a year-to-date basis. I've talked about that significant organic growth, that 19% year-to-date revenue organic growth in UOP through the first 9 months. So basically a flat top line and from, if you will, a makeup of their business, some of the less of the more profitable elements of their business in the fourth quarter, so -- but that's going to correct itself. As Dave said, that's all going to -- as we look forward to 2013, we're looking for a very strong start to the year out of PMT and out of UOP.

And you're also, I guess, going to have some -- these Thomas Russell deal costs will also hit in 4Q. Is that part of the 4Q pressure?

Yes, there's a little bit of that in terms of margin diminution that will occur because we'll get some revenues without a lot of earnings or no earnings from Thomas Russell in the fourth quarter. But we're actually looking for Thomas Russell to be accretive in 2013.

Right, okay. And then just -- can you talk maybe a little more color on this slowdown in backlog conversion and the push outs? I mean, are these things that are being tabled for quite a while or just pushed out of quarter and where are you seeing them?

Well, specifically, what we referenced is in the Process Solutions business, as well as in the Building Solutions and for different reasons. It's really, on the Building Solutions, it's really energy and energy retrofit. Some of that has to do with just the regulatory requirements to enable some of the funding on the energy retrofits. That's become more cumbersome, more complex, more time-consuming, so we're seeing some delays. The demand is still there. We feel very, very good about our overall positioning, but it's going to create a slower growth profile for that business in 2013. And on the Process Solutions side, what we're seeing is just some delays in terms of project funding, which is impacting their order rate, which in turn, will cause some near-term slowing in terms of the outlook that we have for them on the revenue side. But again, fundamentals remain very good, very positive. The pipeline of activity is excellent. So it's just that we want to make sure that we're tempering, if you will, some of the top line outlook for both of those businesses as we transition from '12 to '13.

I'd now like to turn the call over to Dave for any final comments.

Yes, thanks, Elena. As you can probably figure out by now, we're quite pleased with our performance in the quarter and I certainly hope all of you are also. And it's our intent to continue outperforming in the future. The reason for all of that is the seed planting that we talk a lot about and that we're going to continue to do. We were able to get this kind of margin performance even while continuing to invest the way that we need to, whether it's geographically or new products. And that seed planting, it's just going to keep on going, whether it's how do we grow or how do we make ourselves more efficient and it continues to pay off over time. We're going to plan on a slow growth environment because we just think that's the prudent thing to do. If we get any kind of macro help at all because, we'll say, the world's democracies actually start dealing intelligently with their debt, this could be even better and we're hopeful that, that will happen, but we're sure as hell not going to count on it. So we're excited about the future of Honeywell and where we're going and what we think we can do and I certainly hope you are also. Thanks for listening.

Thank you. Ladies and gentlemen, that does conclude today's conference. You may all disconnect, and have a wonderful day.