Honeywell International Inc.
Q2 2015 Earnings Call Transcript

Published: 28 Jul 2015

[Operator:]

Welcome to the Honeywell Investor Conference Call. [Operator Instructions]. At this time, I would like the to turn the conference over to Mr. Mark Macaluso, Vice President, Investor Relations. Please go ahead, sir.

[Mark Macaluso:]

Thank you, Rebecca. Good morning and welcome to Honeywell's conference call to discuss this morning's announcement of the acquisition of Elster. Before we get started, I remind you this call and webcast are available on our website at www.honeywell/investor. Note that elements of this presentation 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 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, Senior Vice President and Chief Financial Officer Tom Szlosek will discuss Honeywell's acquisition of Elster announced earlier today and we will leave some time for your questions at the end. With that, I will turn the call over to Tom.

[Tom Szlosek:]

Good morning, everyone. We're very excited to share more about the acquisition we announced this morning. We have reached an agreement with Melrose Industries PLC in London to acquire its Elster business for GBP3.3 billion or approximately $5.1 billion. The Elster business is principally based in Mainz, Germany. The price translates to approximately 12.6 times Elster's estimated 2015 consensus earnings before interest, taxes, depreciation and amortization and the acquisition is anticipated to close in the first quarter of 2016. Of course, the agreement is subject to customary closing conditions including regulatory review and the Melrose shareholder vote. Elster is an approximately $2 billion leading provider of thermal gas solutions for commercial, industrial and residential heating systems and gas, water and electricity meters, including smart meters as well as software and data analytic solutions. Elster also manufactures flow computers and regulators for the gas transport industry. Let me start by explaining our strategic rationale for this acquisition and I am on page 3 of our presentation. We regularly talk about having great positions in good industries and Elster competes in a very good industry. Across the globe, natural gas continues to grow in prominence, driven by a number of factors, including its efficiency, environmental friendliness and regulatory support and technologies for controlling, measuring and heating are critical to the natural gas value chain. Measurement technology, particularly electronic and connected smart meters, are also important for other resources, besides natural gas, such as electricity and power and the demands for data management and analytics around things like consumption and quality are, as you know, on the rise. Elster has great positions in these spaces. Across its portfolio, Elster has very strong brands, including Kromschroder, Eclipse and Elster itself. It also has an extensive install base and a great product portfolio. First, its gas heating assets will strengthen Honeywell's gas combustion portfolio and create a full solution offering. Second, it’s smart metering technology has leading global positions, particularly in the gas and electricity areas. Third, Elster's gas flow control technology has unique positions that will enhance Honeywell's products portfolio in process solutions. And fourth, its extensive data and analytics capabilities will present a nice synergy with our own software expertise. We believe the deal will create significant value for our shareowners. We have been very patient and diligent in our M&A approach, steadfastly seeking deals where, one, we know the industry and property well; two, where we believe the price is fair; and, three, where we have a strong conviction in our ability to deliver our required returns. This deal hits all three of those parameters. In addition, the transaction will put to work a significant amount of our balance sheet cash which, as you know, is mostly held outside the U.S. Our deployment of HOS Gold across the Elster enterprise will be the linchpin to achieving the integration benefits which will include break-through growth and stronger sourcing, operation and back office capabilities and efficiencies. Further, even though we do not incorporate sales synergies in our deal models we're, in fact, planning on them for this deal like we do in most others. Elster has already demonstrated strong core growth which will continue as adoption of the smart meters and data analytics coupled with regulatory mandates in Europe, China and other major regions take place. We believe we can enhance that growth with our own R&D capabilities, Channel pull-through, high growth region presence and software capabilities. Last, it is worth it. This creates new M&A adjacency opportunities for Honeywell. So having explained the strategic rationale, let me talk more specifically about the Elster portfolio and the markets it serves. Slide 4 provides an overview of Elster. In 2014, Elster generated approximately $1.6 billion in global revenues and delivered operating margins of nearly 20%, driven by the company's flagship gas portfolio which grew over 6% in 2014 on a constant currency basis and nearly 9% in the second half of 2014 alone. The numbers you see on the page are the 2015 estimates. Elster is aligned with similar global macro trends as Honeywell, including energy efficiency, regulatory mandates and urbanization in high growth regions. Its extensive product portfolio across the gas value chain provides superior future growth prospects. Elster employs over 6800 people throughout the Americas, Europe, Africa and Asia and has presence in over 130 countries today. Many of these countries have their own unique local product standards, especially around safety, reliability and accuracy, so Elster's local presence and know-how gives it a unique competitive advantage. You can see that approximately two-thirds of the Elster business is in the gas business, with the remainder split between electricity and water. Slide 5 provides more specifics on each of the businesses. Think of the gas business as consisting of three pieces. The first is a combustion portfolio that includes precision burners for commercial and industrial applications, controls for gas quality and emissions reduction and valves that regulate and direct the flow of gas through the burner system. The second part of the gas business is the gas flow control technology you would see in the gas transport area, including industrial meters, regulators and gas analysis monitors. The third part of the gas portfolio consists of basic and smart meters which measure the volume of gas consumed by commercial, industrial and residential users. These meters are electronic and more often than not are connected. As I suggested at the outset, there are a number of positive macro trends for the gas business, including its efficiency, environmental friendliness and regulatory support, particularly on the metering side in Europe and China. In addition, infrastructure investments, increasing gas consumption in high growth areas like India and China and the emerging need for LNG and gas storage and transport applications bode well for the entire gas portfolio. The electricity business also includes smart and basic meters which measure the volume of electricity consumed by commercial, industrial and residential users. Also, energy management software which helps customers manage energy consumption The U.S. is already a big player, with China and Europe continuing to drive smart meter adoption, along with software and data analysis. This is driven by a need for more efficient meter reading technologies, as well as smart grid management to monitor and maintain network infrastructure, demand-side analytics to influence commercial and industrial customer usage and consumer consumption analytics to lower energy costs and maintain a comfortable environment. The water business consists of basic and smart meters to measure the volume of water consumed. It could be mechanical or electronic and, if connected, do not require manual reading. The global growth in this segment is driven by the need to better monitor, utilize and conserve water, particularly in increasingly water-stressed areas in both developed and emerging markets. Also, water utilities continue to migrate from mechanical to automated, connected meter technology to drive operating productivity. Slide 6 gives an overview of the deal. I already talked about the offer details and multiple and, again, deploying a significant amount of non U.S. cash. We have shared with you in the past our three principal deal hurdle requirements, IRR greater than our cost to capital, year-five book ROI, including amortization of intangibles and other purchase accounting items greater than 10% and earnings accretion in the year two after close. This acquisition will meet all three of those requirements enabled by the expected 8% plus cost synergies. Once again we have not modeled in any of the anticipated sales synergies into these returns. With the deal expected the close in the first quarter of 2016, we expect any dilution on 2016 to be minor and for earnings accretion to accelerate in 2017. I want to touch a little bit more on the 2016 dilution. There are a couple of variables at work here. One is timing and the other is our deal conservatism. While we're expecting a first-quarter close and will make every concerted effort to get it done sooner, the fact is there are antitrust approval requirements, the timing of which are obviously not entirely in our control. Second, our model is all-in. It is GAAP based and assumes that all integration resources are incremental costs in the deal. So we have included the deal cost, upfront purchase accounting like inventory step-up, the incremental amortization, a good chunk of the restructuring costs and a conservative assumption on integration resources. Everything in year one, we don't distort the expected impact by selectively excluding any of these items. Third, when it comes to the financing burden we put on the model, we're also very conservative. We do that purposely, so that the deals in our pipeline stand on their operating merits and are not dependent on the low-cost financing environment to get done. When you consider the source of the financing for this deal, particularly the non U.S. cash, but also a small element of U.S. commercial paper and you consider the actual cash financing cost associated with those funding sources, the dilution that we will experience, if any, becomes even more modest. So overall, the upfront dilution is quite manageable and this is a very attractive opportunity for Honeywell that will significantly enhance our earnings and free cash flow. So moving on to the summary on slide 7, we're very excited about the opportunities this acquisition brings to Honeywell and its customers and its shareowners. Elster is a strong fit that complements both our ACS and PMT portfolios and allows us to enter attractive new markets while bolstering our position in product offerings in the markets we participate today. The acquisition of Elster provides further runway for future organic growth and additional M&A in the combined business. Our deployment of HOS Gold will provide upside and incremental opportunities to drive further growth in margin expansion, similar to what you have seen from Honeywell in recent quarters. Today's announcement continues to build on our strong acquisition track record and provides a solid platform for future growth. With that, Mark, let's turn it back to Mark for Q&A.

[Operator:]

[Operator Instructions]. Your first question will come from Scott Davis of Barclays.

[Scott Davis:]

I want to back up to the beginning here. Can you help us understand, was there an auction here? What was the process?

[Tom Szlosek:]

Well, we termed it a public company process. But the reality is we worked very closely with Melrose and we actually had private company-type due diligence. We're very comfortable with the access that we had and it was a fairly lengthy process. And we're comfortable on the basis on which we made the decision.

[Scott Davis:]

Okay. My understanding - I knew this asset once upon a time. I almost brought them public. But my understanding was there was always a big pension liability attached to it. Can you help us understand, is that in your $5.1 billion sales price or is there still a big pension associated with this asset?

[Tom Szlosek:]

Yes, there is a pension. I mean the company does have pension across its portfolio. It has schemes in Germany and UK, basically seven countries, but most of it is in Germany and the UK. Most of the plans are closed to new entrants and the benefits' accruals are frozen. As of the end of December, the official underfunding was about GBP166 million. The actual underfunding at close should be lower; but obviously, we will wait until we get there. And we think the cash contribution requirements are minimal. We have got that factored into the returns we've talked about.

[Scott Davis:]

Just lastly, I mean I think Melrose has done a pretty nice job with this asset. If you look at the history, the margin trajectory has been pretty impressive. Have they taken all of the low-hanging fruit or do you see some initial synergies that can help get this thing kicked into high gear by the time you get through 2016?

[Tom Szlosek:]

Again, I think the work that we have done on our due diligence gives us a high degree of confidence. The Melrose guys obviously did a very nice job of integrating these businesses. But based on our look, there's plenty of opportunity for us to apply a Honeywell operating system and all of the productivity initiatives that come along with that. We have also got significant purchasing scale. And some other things that we will bring to the table, I think will give us a real nice advantage.

[Operator:]

And from Morgan Stanley, we will go to Nigel Coe.

[Nigel Coe:]

So, obviously you had mild dilution in 2015. Can you maybe help us understand the impact of the one-off accounting and the transaction charges? If we back those out, what is the magnitude of the run rate EPS and more importantly, the cash flow synergies?

[Tom Szlosek:]

Yes. Nigel, we will get into the specific details on the impacts on 2016 as we get closer to the end of the year when we provide our guidance. But I think your instincts are right. When we talk about mild dilution, again, we have been very conservative; our financing cost is an example. We modeled these deals with somewhere between 2% and 3% type of financing costs. The reality is that we have got our Europe cash that's earning very little we will put to work on this. And we also have U.S. commercial paper that is very fair. It is a smaller part of it, but it is also very low cost. So when you consider those two factors, I think your instincts are right on the dilution. We will talk more about it in our December outlook call.

[Nigel Coe:]

And obviously, you’re using both like somewhere between $4 billion to $5 billion of both these cash. You are going to have about $10 billion of cash by year end, so there is still plenty of capacity on the balance sheet. Do you think that we're done now for M&A for the balance of this year or do you see the possibility of one or two more deals coming through?

[Tom Szlosek:]

I don't think we're done. I don't really think this changes our focus on it, the efforts that we're devoting towards it, our pipeline. We have got, like we said, a number of attractive things; and we're going to keep going. So we're excited about the environment, as we kind of alluded to in last couple of calls. And we're going to keep pushing forward here.

[Nigel Coe:]

Okay. And then just finally, Tom, we heard a lot about on the gas side, I mean, gas is over two-thirds of the sales mix. It seems that water is a bit more of a different story. I mean, how interconnected are these different businesses? And do you see attractive growth in all three segments?

[Tom Szlosek:]

Yes, if you look at some of the water results, you will see some sales pressure. Some of that was intentional efforts by Melrose to exit some low-margin businesses. I think the run rate on the water business does provide some reasonable growth prospects. They have a very nice cost position which we think we can improve even further. So we're considering that in its entirety. I would also say that the three businesses are run individually. I'm not exactly sure what Melrose's plans were in terms of manage that in its portfolio, but three distinct businesses in three different types of spaces. So that will provide further opportunity for us.

[Operator:]

From JPMorgan, we will hear from Steve Tusa.

[Steve Tusa:]

Just maybe a little more detail around the 8% of synergies. What's R&D at this business? I didn't see it in their filings, two questions.

[Tom Szlosek:]

I don't know that we have that to disclose at this point. Mark, do you have that?

[Mark Macaluso:]

Yes.

[Tom Szlosek:]

Maybe we could follow up on that with you, Steve.

[Steve Tusa:]

Okay. And then what is your current interest rate on cash right now? What are you currently earning?

[Tom Szlosek:]

You could do the math on your own, looking at the commercial paper rates and bank rates. But with a significant proportion or almost all of our cash overseas, it is in that 1% or less range kind of thing.

[Steve Tusa:]

Okay, so if I am kind of putting the math together here or getting something in 2017 in the range of $0.30 to $0.40 accretive? Is that kind of the right ballpark? And then how fast do those synergies ramp? Is that 8% back-end loaded or should we think about that as kind of linear?

[Tom Szlosek:]

I think it will be somewhat linear. I think the upfront, getting ourselves organized and working on the integration opportunities, will take a bit of time. I wouldn't put them in year one or year two. We definitely have accretion from synergies over a five year time frame is the way I would think about it.

[Steve Tusa:]

Okay. So the $0.30 to $0.40 in 2017, is that the math we should be running?

[Tom Szlosek:]

Yes, we will be more comfortable in December talking about that, Steve. But from a fully-integrated basis, some of the estimates that I've seen from the analysts have not been too far off from what our expectations are. But there is timing that comes into play. I mentioned the antitrust and other factors as we get into it. I'm not really in a position to be tied down on a specific range. But I think in December, we will be happy to go through it.

[Steve Tusa:]

Okay. But I guess if you said you were going to deploy $10 billion and get $1 in accretion from that balance sheet deployment in 2018, this would be in line with that kind of profile on that model?

[Tom Szlosek:]

Yes, I think when we talked about that, we talked about getting $5 billion to $8 billion of revenues. Obviously, the multiple on this is a little bit different. On the other hand, we feel the EBITDA multiple is very attractive. So on balance, it is pretty much in line with what we said at that time frame.

[Operator:]

Next we will hear from Jeff Sprague with Vertical Research Partners.

[Jeff Sprague:]

Just a couple of other thoughts, just in getting after the synergies, you spoke to day-one restructuring. But is there a lot of heavy restructuring that is required to kind of get you to the 8% target that you are talking about? And presumably you would have offsets and gains and such to deal with it. But can you size that? Is there a lot of footprint heavy lifting that's required here? Yes, we need to get through the integration process and the integration planning. But it is not different than the nature of the synergies that typically come with the acquisitions that we have done in the ACS space. You definitely have the scale of Honeywell at work there. Now, whether it is in sourcing, whether it's in our supply chain, whether it is in distribution, it will touch on all of those areas and we will do a thorough comprehensive job on extracting the opportunities that we think exist. And then if you think about sales synergies, it is logical there should be some. But where do you see the biggest opportunities across the portfolio, particularly in markets? Any other color you could provide there?

[Tom Szlosek:]

There are a few of those, Jeff. First, I'd point to the combustion portfolio that we think is very complementary with ECC. There's not too much in terms of overlap. So we think that a lot of the products that we have in each other's channels can go to the other, for starters. And we've talked a lot about process solutions and our desire to get more products and to build out a products portfolio. We think this is a nice complement to some of the products that we have there. You will remember the RMG acquisition that we did back in the latter part of the last decade which has some complementary products in that midstream space that will very much come in handy. And then I think the high-growth regions - they're present in lots of countries, but we think the channels that we have in places like India and China will be very attractive.

[Jeff Sprague:]

One last one now, you said you still are pressing on M&A pretty hard and expect to do more. Does ACS have the ability to do more on top of this deal? Or should we think about things in the other segments here in the more near term?

[Tom Szlosek:]

We certainly have the capital capacity; and we certainly have the pipeline in ACS, as we do in other places. I think it is a matter of finding deals that are number one or hit those three screens that I talked about earlier. So it has to be a deal that's executable, one that we think is affordable and one that provides the highest returns, that's how we're comparing deals. We're as active in ACS even after this deal as we were before, as we're in PMT and Arrow.

[Operator:]

Next we will hear from Steven Winoker with Bernstein Investors.

[Steven Winoker:]

Can you first clarify the answer to Scott's question around pension? Is it in the 12.6 times EV to EBITDA multiple? I assume it is not, but I just want to clarify that.

[Tom Szlosek:]

It is in the valuation.

[Steven Winoker:]

So it is in the enterprise value in your EV to EBITDA that you are giving us? Because you gave it on 2015 consensus EBITDA and it is in the EV side of it?

[Tom Szlosek:]

Yes, it is.

[Steven Winoker:]

And then, on the growth profile here, if I look at Elster's past and I like this industry a lot. I like Elster a lot. But they have definitely seemed to have struggled for growth. Up until this year they were down 3% in 2013; they were up 1% ex currency last year. They're certainly up significantly more the first half of this year. So maybe help us - and it might be the European weighting - with how you looked at the prior growth profile here before coming into the new look that you have got?

[Tom Szlosek:]

When you say the prior look, Steve, can you clarify?

[Steven Winoker:]

Just the historical growth up until now.

[Tom Szlosek:]

You mean for Honeywell in Europe?

[Steven Winoker:]

No, just Elster.

[Tom Szlosek:]

Got you. No, we think what you are starting to see is the impact of the attractiveness of their portfolio. As well as on the metering side, as an example, some of the regulatory impacts that they have got in their favor. They have got wind at their sails and that's going to become more pervasive in both developed and emerging regions. And they really have a nice advantage there, in terms of the competencies, to deal with what the requirements are. They're big - the regulation around safety and accuracy and reliability are big factors.

[Steven Winoker:]

So the low growth that you saw in 2013 and 2014, you think is over and the company's inflected now?

[Tom Szlosek:]

Yes, let's remember it is not just the European business. It has got presence in globally, 130 countries. And we believe that the weighted growth profile that we have in the model reflects that global weighting.

[Steven Winoker:]

Okay. Lastly, no one has asked this; I guess I have to ask it. Around 2012 and the last time you might have had a look at this or certainly it was available and Melrose bought it, you were deep in the sector and the industry and very familiar with them then. Why not then and what happened and why now?

[Tom Szlosek:]

It is easy to second guess and do what ifs on this. The fact is, we had other priorities at the time; and it certainly was something on our screen. But you have to consider the other opportunities we had, other items that we had going on in our business at the time, that is the best I can say about that.

[Operator:]

Ladies and gentlemen we have time for one final question and that will come from Joe Ritchie with Goldman Sachs.

[Joe Ritchie:]

So help us understand a little bit the first cash flow dynamics of this business and then also, Tom, maybe if you can kind of speak to the regulatory tailwinds affecting Elster and how you think about the stability of this business.

[Tom Szlosek:]

Okay, cash flow; it is a good cash flow generator. Putting the pension aside, these guys are comparable to Honeywell in that 90% to 100% type conversion range. And that's what we would expect going forward. Again, on the regulatory dynamics, each country is - and some are further along than the others. I mean, in the U.S., obviously, smart metering is very pervasive. In Europe, you can look at each country and each of them are on a different path in terms of when that will play out. For example, in the UK by 2020, every home has to have a smart meter. So you can schedule out like Italy, France, Germany, Netherlands. They all have similar programs. And you will start to see that as well in China and in other emerging and developed countries.

[Joe Ritchie:]

Okay. And then you mentioned earlier, you had to cross some antitrust hurdles. If you could provide more color, where maybe there's a greater deal or overlap with your portfolio and where you could see some uncertainty there as you are going through the process?

[Tom Szlosek:]

Yes, as you can imagine, we have done a careful screen on that. We don't think there are any material antitrust issues that are on our screen. But obviously, it is a process we don't control. You have got the big three regulators that we need to deal with, the U.S., Europe and in China. We're going to pull out all the stops to get this done as fast as we can. We have got Melrose' commitment on that as well. We, knock on wood, hope that will not be a major factor in this.

[Joe Ritchie:]

I guess maybe said differently, are there any regions or pieces of your portfolio where you have a high concentration, high market share?

[Tom Szlosek:]

No. Like I said Joe, we're confident there's no significant overlap that's going to present an issue there from an antitrust perspective.

[Joe Ritchie:]

Okay. And then, Tom, I may have missed this earlier, did you give specifically how much of this deal you are going to finance with data commercial paper? I may have missed it if you said it earlier.

[Tom Szlosek:]

No, I didn't give a specific split, Joe. It is a good question. Generally you can think of us funding the deal consistent with where the revenues are generated. There are tax considerations in terms of how you fund that. So with more than two-thirds of it outside of the U.S. or roughly two-thirds of it outside the U.S., you would expect the non-U.S. cash to be about 60% to 70% of the funding and then commercial paper to represent the rest.

[Mark Macaluso:]

Operator, I think we're finished. Thank you very much for joining the call and of course, we will be available for calls at any time this afternoon. Thank you.

[Operator:]

Ladies and gentlemen, that does conclude today's presentation. We do thank everyone for your participation.