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Honeywell International's Management Hosts 2014 Outlook Conference (Transcript)

Honeywell International, Inc. (HON) 2014 Outlook Conference December 17, 2013 9:00 AM ET


Elena Doom

David James Anderson - Chief Financial Officer and Senior Vice President

Thomas A. Szlosek - Vice President of Corporate Finance


Steven E. Winoker - Sanford C. Bernstein & Co., LLC., Research Division

Jeffrey T. Sprague - Vertical Research Partners, LLC

Jeffrey T. Sprague - Citigroup Inc, Research Division

Nigel Coe - Morgan Stanley, Research Division

Charles Stephen Tusa - JP Morgan Chase & Co, Research Division

Howard A. Rubel - Jefferies LLC, Research Division

Andrew Obin - BofA Merrill Lynch, Research Division

Deane M. Dray - Citigroup Inc, Research Division

John G. Inch - Deutsche Bank AG, Research Division

Joseph Ritchie - Goldman Sachs Group Inc., Research Division


Good day, ladies and gentlemen, and welcome to Honeywell's 2014 Outlook Call. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to introduce your host for today's conference, Elena Doom, Vice President of Investor Relations.

Elena Doom

Thank you, Zach, and good morning. Welcome to Honeywell's 2014 Outlook Conference Call. Here with me today is Senior Vice President and CFO, Dave Anderson; and Vice President of Corporate Finance, Tom Szlosek.

Today's call and webcast, including any non-GAAP reconciliations, are available on our website at honeywell.com/investor.

Note that elements of today's 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 ask that you would 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'll review our financial expectations for the remainder of 2013 and discuss our 2014 planning, building on the framework we gave you back in October, and of course, allow time for your questions.

With that, I'll turn the call over to Dave Anderson.

David James Anderson

Thanks, Elena, and good morning, everyone. Thank you for participating in this morning's call.

Let's begin on Slide 3. And here, we're confirming the fourth quarter, which is advancing as expected with about 2 weeks left in the year. Order rates continue positive in the short-cycle businesses, specifically Turbo, as well as the Energy, Safety and Security businesses of ACS. And our long-cycle businesses are maintaining their healthy backlogs.

As a result, we're reaffirming our full year 2013 estimate for sales of $38.8 billion to $39 billion; and earnings per share of $4.90 to $4.95, up 9% to 11% on a pro forma basis and consistent with what we gave you back in October. And lastly, we're also expecting free cash flow of approximately $3.7 billion for the year. Of course, those numbers are prior to any NARCO-related cash outflows and any cash pension contributions.

So 2013 is certainly shaping up as a good reminder of the importance of Honeywell's portfolio, the balance that we have, which is helping us offset some of the headwinds that we've experienced over the course of 2013, specifically in Defense and also in the Advanced Materials business of PMT. And the businesses, importantly, all executed very well this year, delivering margin expansion in every SBG in each business in 2013.

Now the key -- some of the keys are obviously new products, geographic expansion, traction on process initiatives. All of these are contributing to growth in each of our end markets, enabling pricing power and delivering further margin expansion. Another important driver is, of course, the productivity we've seen this year, which continues to be partially benefited from previously funded restructuring or repositioning actions.

We continue to be proactive about maintaining a robust pipeline of repositioning projects and we think this is critical to supporting our sustained margin growth in 2014 and beyond.

And of course, the continued focus on top line. We're investing in new products and technologies, investing in expansion in high-growth regions and we're also investing in high ROI capacity to build the growth momentum in our businesses.

We're expecting another year of modest macro growth in 2014 to serve as continuation, I guess, you could say, of the slow climb upwards that we've all experienced. But we're going to have pockets of short-cycle positives and we've got encouraging order pipelines.

I'm going to take you through a bottom-up portfolio view today and also an end market build building that 2004 (sic) [ 2014 ] outlook. And we're going to keep utilizing, of course, the playbook that you've all become familiar with, with Honeywell, focusing on investing for the future, delivering productivity enhancements and staying flexible, which has allowed us to leverage upside in any market conditions as they occur.

Turning to Slide 4. I just want to briefly recap 2013. On the left side of the page, what you can see is sales up roughly 1% to 2% organic or 3% to 4% reported, again, consistent with our guidance. If you exclude Defense & Space where the challenges are well known and the declines, of course, over '13 exceeded initial expectations, organic growth would have been more than 1 point better. So in other words, in the 2% to 3% range for the year with improving trends as we exit the year. We're going to take you through those improving trends in just a moment.

if you move to the middle of Slide 4. Segment margins is 16.2% to 16.3%, up 60 to 70 basis points, and of course, above the high end of the guidance that we set 1 year ago. And we're achieving slightly above the low end of the 2014 segment margin targets. We're achieving that a year early. And again, those targets are the ones we set back in 2010. Tom is going to take you through the highlights of that performance a little bit later this morning.

And then finally, on the right side of the slide, EPS up 9% to 11% for 2013, another year at roughly double-digit EPS growth and right at the high end of the guidance range that we set for you this time last year.

So 2013 clearly shaping up to be another successful year for Honeywell. And while certainly not done yet, we feel very good about how we're exiting the year and the implications for 2014.

Building on that theme, let's turn to Slide 5. Now the title of the slide is obviously 2013 performance and we wanted to spend a moment here because of what it implies and sort of sets up for our 2014 discussion.

On the left-hand side of the chart, you can see the quarterly growth rates for total Honeywell in the blue bars, as well as the cut of the portfolio, which we've shown you before that breaks out our short-cycle businesses, again comprised of ESS, the Energy, Safety and Security of ACS; Advanced Materials of PMT; and all of Transportation Systems. Also shown, the long-cycle ex Defense, which would include the commercial Aero OE, Process and Building Solutions and UOP and the commercial Aero aftermarket and Defense & Space businesses.

Now, as a reminder, we track these because each of these elements behaves a little bit differently in the cycle. And we think this really illustrates the inflection points and trends we're seeing.

Generally speaking, you can see that the pace of growth over 2013 has been improving, both for total Honeywell, as well as for the respective elements.

So starting with where we've seen the biggest headwind. Defense sales are lower year-over-year, no surprise given the sequestration and budget-related headwinds. And the quarterly results have been lumpy due to the some challenges we've talked about during the third quarter conference call. However, we're expecting moderation in the rate of decline in Defense in the fourth quarter, reflecting better execution and stabilization in demand.

Now long-cycle growth has also varied from quarter-to-quarter due to the timing of a few catalyst shipments in UOP. However, orders are positive, particularly in UOP and HPS, contributing to the confidence that we have for those businesses and Honeywell overall for 2014.

We're seeing some modest improvement in the commercial aero aftermarket. We started the year, if you recall, with lower ATR spare sales. But we're now seeing growth recouple the flight hours despite what will be another tough quarter for ATR spare comps in the fourth quarter, which, of course, suggest an overall improvement in the aftermarket in 2014.

And finally, the short-cycle businesses, which represent about 45% of the portfolio, have really shown acceleration. ESS has benefited from strengthening in the residential end markets, as well as a nice uptick of new products while higher passenger vehicle production globally, combined with platform launches, have driven the growth that we've seen in Turbo. And Advanced Materials got off to a tough start with organic sales in the first quarter down 9%. However, the second half volumes have improved due to higher production rates in both RNC and Fluorines and both are expected to contribute to the improved sales performance in the fourth quarter. So overall, encouraging exit rates as we transition into 2014.

Let's now go to Slide 6. Here, what we've done is we've laid out our GDP growth by region reflected in real terms. Now these are the latest numbers -- what you see here are the latest numbers from Global Insight. And while the numbers are a little more conservative, we found that -- our numbers are a little more conservative, we have found in the past that Global Insight's forecast have been pretty useful. As you can see, we're expecting modest improvement in growth across most major geographies. You can also see that we remain focused -- while we remain focused on increasing our high-growth region exposure with both China and India, again both expected to contribute nicely to global growth.

In total, it would suggest that global GDP growth is likely to increase by a little less than 1%, which is still not as robust as we'd like, but certainly an improvement over 2013. So with that backdrop, in terms of the GDP assumptions, let's go into some specific industry drivers. Let's go to Slide 7.

Slide 7 is focused on the indicators that are the most applicable to the industries, which we serve. The gray bars reflect our estimates of the 2013 versus 2012 change and the blue bars represent our expectation for 2014.

So starting on the upper left. You can see flight hours are expected to be slightly stronger in 2014, aided by fleet growth and better usage rates across higher value aircraft. If you move to Defense spending, the current U.S. budget request, subject to sequestration, would equate to spending declines of about 4% while the rest of the world is projected to be up.

Now as a reminder, international budgets continue to grow and D&S is well positioned to drive enhanced mission capabilities with existing technology, adding a lot of value for the customers at attractive margins for Honeywell.

Switching gears to construction spending. ACS has been the beneficiary in 2013 of residential improvement spending increases, sort of think about, if you will, as the residential aftermarket as evidenced by the strong growth in ECC and security and we're expecting that to continue into next year. We also see the non-res pickup in the U.S. trending positively off already relatively depressed levels. So while we continue to plan conservatively, increased order activity on the res retrofit and non-res construction gives us growing confidence in good growth in ESS and parts of Advanced Materials.

Moving to the bottom of the slide. You can see we're highlighting some of the Transportation Systems indicators, including vehicle production, both light vehicles and commercial vehicles, as well as Turbo penetration. Light vehicle production should be strong again in 2014 with Europe inflecting to the positive. In the commercial vehicles, we're expecting a modest recovery. And as for Turbo penetration, light vehicle diesel is expected to be roughly flat year-over-year on a global basis with modest European decline from peak levels, partially offset by increases in other regions. Gas, however, continues to see healthy Turbo adoption rates, particularly in the U.S. and China, and gas penetration will grow in 2014.

And finally, we wanted to highlight some of the capital spending as a key indicator for our industrial portfolio, including UOP and Process Solutions. We're in the enviable position, obviously, of having a robust backlog in these businesses that cuts across refining, petrochemical and gas verticals, which is also a leading indicator -- from UOP, a leading indicator of growth yet to come in the Process Solutions business of ACS where orders turned positive midway through 2013 and we think bodes well for higher spending in 2014. So for Honeywell, somewhat more positive macros for 2014 leading to modestly better growth next year.

So let's take a look now at Slide 8 and we'll give you sort of an indication of what type of growth we expect through that same portfolio lens we showed you earlier.

On 8, we've shown our outlook for 2014 organic growth broken down by portfolio grouping. Again, the same cuts that we showed you earlier. So starting in the upper left. The short-cycle businesses are expecting sales growth of 3% to 5% organic as a result of the improving industry macros we discussed earlier, also benefiting from new product launches in many of our businesses, and of course, geographic expansion. These we partially offset by some modest pricing headwinds, both in Advanced Materials and Transportation. So overall, a continuation of the trends that we're seeing as we exit 2013.

In commercial aero aftermarket, we're expecting 2014 an organic growth of 3% to 5%, driven by growth in the air transport flight hours and also continued high-value RMU sales in business aviation. And of course, we've seen really a very nice uptick in that in 2013.

Moving to the upper right. Our long-cycle business ex Defense are expected to grow sales 2% to 4%, supported by robust backlogs as we exit the year. And if you think about the pieces for a moment, UOP growth will moderate to mid-single-digit organic. Very tough comps, obviously, 2014 compared to 2013 strengths. HPS and HBS are expecting better growth in 2014. And commercial aero OE growth will slow, again, lapping the more challenging comps and also you've got continued regional OE declines anticipated in 2014.

And finally, on the bottom right of the page. D&S sales are expected to be down approximately 1% to 3% in 2013, driven by U.S. budget declines, partially offset by modest international growth. And by the way, at this time, the likelihood of any meaningful change in our outlook based on the recent U.S. budget developments is small. So we're seeing, hopefully, appropriately conservative here and hopefully some positive trends and some positive upside coming out of that. But as yet, we think it's much too early to do given the details of what need to be worked out in terms of the line items of the budget.

So with that backdrop of sort of the macro view of the portfolio, let's go to slide 9 on key productivity drivers.

Obviously, a common question that we get from all of you is so how much juice is left? I mean, the terrific track record that's been built in terms of margin expansion and growth at Honeywell. So it's an understandable question, which consider that performance over the recent years and also the relatively muted top line environment.

So what we've done here on Slide 9 is highlight some of the items that give us confidence that we can continue this momentum. You can start on the left. HOS, the Honeywell Operating System. It's a key enabler, which is continuing to mature across our businesses. And while we're approaching 85% of our cost base under Bronze coverage HOS, the Silver certification is just really now gaining traction. And as a reminder, HOS doesn't just take you through a new plateau in productivity, it also increases the rate of improvement. And that's why the sustained performance achieved in Silver is such a big deal. These are the businesses that have proven they can make lasting improvements.

Moving to the center. OEF, the organizational effectiveness and efficiency. We continue to be very focused on overall people costs. We want to make sure we're disciplined in managing those costs while attracting and retaining the very best people. And as you can see, we've done a good job of that over the last few years. We've grown sales faster than our fixed costs. We've maintained our flexibility to respond to changes in market dynamics. OEF productivity in 2013 was a significant contributor to margin expansion and we're expecting similar improvements, positive improvements, in 2014.

And finally, on the right side of the chart, you can see the cumulative savings from restructuring where we've seen a stream of steady, incremental benefits from the projects we've funded. What's important to note here is that almost $140 million of gross funding through the third quarter of this year, which will contribute over $125 million of added savings or incremental EBT -- EBIT in 2014. These projects range in scope and complexity, but the quality of the project pipeline and the ability to execute is key. And these savings are a real credit to that.

So in summary, with think there continues to be opportunity on the margin front. We're going to continue to keep executing the Honeywell playbook that got us here, delivering again in 2014 and beyond.

So let's now go through highlights of the outlook for each of the businesses on Slide #10, so the 2014 segment outlook. Now what we've provided you with is the expected sales growth and the segment margin expansion that we're anticipating and is built into our overall guidance by business. Let's go through a few of the details.

In Aerospace, we're expecting sales to be up slightly as a result of continued good commercial growth, partially offset by lower Defense sales. Commercial aftermarket should be up in line with utilization. And despite lapping more challenging comps, air transport and BGA OEM deliveries are expected to be up again next year. And as we discussed, D&S sales will be down in 2014, but at a lesser rate than we saw this year. And overall, Aero margins, which has been a great story for 2013, are expected to be up in the range of 40 to 70 basis points, driven by further benefits from continued HOS maturity, as well as supply chain improvement.

In ACS, we're expecting sales to be up 5% to 7%. Think of that as 3% to 4% on an organic basis. For ESS, we're expecting to see continued benefit from new product introductions and high growth region penetration. But we're also expecting modestly improved macro environment, as we talked about earlier, based on the indications in non-res construction. And in HPS, we're expecting mid-single-digit growth, capitalizing on higher margin wins, software and services growth. And in BSD, we're expecting another year of slow top line growth as funding for energy projects remains weak.

Margins for ACS are expected in 2014 to be up 30 to 60 basis points, including the impact of the Intermec acquisition. If you exclude that, 70 to 100 basis points of improvement in margins. So very good conversion anticipated for ACS.

For PMT, we're expecting sales to be up 4% to 6%, segment margins up in the range of 20 to 50 basis points. The new CapEx projects we're funding are scheduled to come online over the next couple of years, 2014 to 2016. And during the start-up of those new facilities, there'll be some lower utilization, as well as lower absorption. However, we still see margins growing and the backlogs for both UOP and Advanced Materials remain strong.

We're in the enviable position of needing to increase capacity to meet that demand. In 2014, we expect some pricing headwinds in PMT, but we'll look to offset those with higher volumes and also higher value applications.

And finally, for Transportation Systems, we're expecting sales to be up 3% to 5%, driven by another year of strong new launches, improved light vehicle production in Europe and also increased Turbo penetration globally, particularly on gas applications in the U.S. and China. Segment margins for TS are expected to be up 110 to 140 basis points as a result of increased volume leverage and also productivity, including the benefits of the ongoing Friction transformation. These will be partially offset by continuing pricing headwinds.

So with those details of the businesses, sort of the summary of the key assumptions for each of the businesses, let's go now to Slide 11 and total things up in terms of the total 2014 financial guidance.

You can see that we're expecting sales growth of 4% to 5% versus our expected 2013 base. Now that's based on a euro-to-dollar rate of roughly 1.30 at the midpoint with the high end of the range closer to 1.35. But I would point out that other currencies will also have an impact. Segment margins are expected to be up 30 to 60 basis points, driven by continued productivities, supported by the things we talked about earlier: HOS, a combination of OEF and FT and also restructuring benefits, as well as improved volume leverage.

Excluding acquisitions, margins for Honeywell would be up in the range of 50 to 80 basis points. So another year of strong performance.

And finally, EPS for 2014 we're expecting to be in the range of $5.35 to $5.55, up 8% to 12% on a pro forma basis assuming a tax rate of approximately 26.5%, including the expiry of the R&D tax credit and share count roughly flat to 2013 levels. So in other words, including the absorption of the lack of benefit of the tax extenders.

We expect higher pension income in 2014, driven by higher asset returns and discount rates. In fact, we're now thinking that we could experience a tailwind of approximately $100 million in 2014, which we expect to be more than fully offset with incremental reconstruction and the absence of this year's OPEB curtailment. So in other words, we expect that incremental positive pension to be more than offset with restructuring and again the absence of this year's OPEB curtailment, the net of those 2. All other below-the-line items are net slightly favorable, driven by lower interest, expense and also M&A expense. And as always, we would look to offset any onetime gains with further repositioning actions.

So with that, let's spend a moment talking about cash flow and also deployment on the next slide. I know that's a topic that's of high interest to you.

On Slide 12, if you start with free cash flow. We obviously generate a lot of cash, which enables us to deploy capital in a number of proven areas that add incremental shareholder value. I thought it might be helpful to just think of 2013 and '14 in the context of the history of the company. So I just want to take you through some of the highlights of the last 10 years.

Since 2002, our cash flow distribution, the cash available for redeployment, cash from operations, 50% of that cash has been returned to shareholders, 50% roughly has been reinvested for growth in CapEx and M&A. We've grown the dividend at a compound annual rate of approximately 10%. And we've returned almost $9 billion of cash to shareholders through share buyback net of share issuances. It's an impressive track record, demonstrating we were good stewards of capital. And we've gotten, obviously, particularly positive feedback on our M&A performance.

Turning to '14. We expect free cash flow to be in the range of $3.8 billion to $4 billion next year, which would represent mid- to high single-digit growth over expected 2013 levels. And that while this implies free cash flow conversion slightly less than 100%, it's a result of the higher CapEx that we've been discussing for some time, which is expected to be in the range of $1.2 billion or up roughly $300 million from this year, primarily to support high ROI growth projects.

Moving to the right side of the page. Supporting organic growth continues to be our #1 priority for cash redeployment. We're going to continue to invest in the businesses, therefore, driving the next leg of sales and margin growth as we work towards our 2018 targets. We're also 100% committed to paying a competitive dividend through the cycle, returning cash to shareholders during good times and bad. And we built on that record here in the fourth quarter by increasing the dividend 10% effective in December.

We'll continue to pursue M&A, building a robust pipeline of U.S. and international targets with our businesses and our corporate development teams with, of course, returns at the Honeywell standards. And while M&A is never easy, we'll continue to be very disciplined in our approach and follow it up with flawless integration. And finally, you should expect us to hold share count roughly flat again this year, which employs about $1 billion of our cash flow.

So a balanced cash deployment strategy, one you come to expect, one that we've successfully deployed over the last 10 years and one that we'll be flexible in, subject to changing market dynamics and will continue to be a strong proven cash generators and will provide excess returns for our shareholders.

Now speaking of expectations, I'd like to turn the call now over to Tom Szlosek to appraise you of our 2014 guidance and how that stacks up against the long-term targets that we issued back in 2010. Tom?

Thomas A. Szlosek

Thanks, Dave, and good morning, everybody. As you're probably all aware, 2014 will be the fifth year of the 5-year targets we issued in early 2010. And I'm on Page 14 (sic) [ 13 ] , which provides an update on where we stand on those targets.

So starting on the left. You can see our expectations for sales based on the 2014 guidance.

Our guidance for next year implies roughly 6% compound annual growth over the 5-year period. And while it looks like we're going to be just slightly shy of the low end of the target range for sales, when you consider the macro environment over that time frame, especially the unanticipated headwinds in Defense and in Europe, we think the performance against the target is pretty good.

Moving to the right side of the chart. You can see our segment margin expansion versus the target of 16% to 18%, reflecting over 300 basis points of margin lift since 2009. Our guidance for 2014 puts us well into the middle of the 2014 target range. And as you know, we're expecting to be above the low end of that range a year early in 2013. So a very strong performance on segment margin targets.

Taking a step back. This target achievement demonstrates a performance culture that penetrates deep into the organization. Back in 2010, the company received a lot of feedback as to the achievability of these metrics, predominantly on the margin side. And having been in the businesses during this time frame, having been in ACS during that time frame, I can attest to you we definitely felt the challenge.

So delivering this level of margin expansion, especially in a lower-than-foreseen growth environment, underscores not only our commitment to these targets, but also the strength of execution and momentum that's building from the organization's maturity of culture, processes and portfolio. That's obviously something we're very proud of.

So with this in mind, let's turn to Slide 15 (sic) [ 14 ] where I'll talk a little bit about the performance of each of the businesses relative to the 5-year target. So just like we did on the prior page, you can see the 2009 baseline, our 2014 guidance and our 2014 targets. As you can see, we had big improvements across-the-board with every business contributing solid sales and margin growth. And as I said earlier, we did see some anticipated sales headwinds relative to our macro assumptions, particularly in Aerospace. Sequestration wasn't part of our vocabulary back then. And while Aerospace is doing a nice job of aligning their cost structure to that new reality, they've obviously had to overcome lower sales, in addition to higher R&D, reflecting their segment margins as a result of all the business wins on the commercial side. ACS and PMT have done a nice job of capturing growth in their respective end markets, both organic and inorganic. And TS is recovering from lower automation production -- lower automotive production, especially in Europe. All 4 segments benefited from their continued focus on innovation and technology differentiation.

And what you've seen is that this has had very positive impact on margins. ACS and TS are expected to be roughly in line with the 2014 framework, offsetting lower macro growth. PMT has significantly overdriven relative to our expectations, supported by both UOP becoming a larger piece of the segment and margin expansion in Advanced Materials. And Aerospace, which is coming in slightly below our initial framework, has made great progress expanding margins above that 20% threshold with more room to run.

So let me turn the call back over to Dave to summarize things before we open it up for your questions.

David James Anderson

Tom, thanks for taking us through it. I mean, it's worthwhile just to stand back and reflect on what we just went through in terms of the substance of the performance, the transparency of the review and our performance over that period, as well as the recap you just provided. So it's -- I mean, it's a great source of pride. And obviously, we've delivered terrific shareholder return during that same period. So really good.

So Slide 15. Let's just go through the summary. 2013 was another very good year for Honeywell. It was a much more challenging environment than anybody anticipated in the beginning of the year, much more dynamic than anybody could have anticipated, but we're delivering again. And despite limited help from the macro environment, we're delivering at the high end of our commitments while also investing for the future.

All the businesses are executing well. We're finishing the year strong with fourth quarter performance tracking to the guidance that we gave you in October. And as our attention turns to 2014, we feel we have a strong foundation for continued outperformance. We've got Great Positions in Good Industries. We're investing both organically and inorganically to grow faster than the markets we serve. And we'll stay the course on seed planting, as well as on our continuous improvement initiative.

As a result, the restructuring pipeline remains full as the businesses continue to elevate new ideas. We're investing in R&D, in sales and marketing resources globally and these are well aligned to the new products and technologies that are coming to the market that will benefit 2014 and the future years.

Our mantra is to continue to stay flexible, leverage the Honeywell playbook, make the smart choices that will allow us to deliver on our 2014 project while also setting us up for another 5 years of outperformance, which we'll speak to you about in March when we set our new targets for the 2014 to 2018 period.

And so with that, Elena, let's go to Q&A.

Elena Doom

Thanks, Dave. Zach, if you can now open our line, we'll take our first question.

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