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Executives

Dave Cote - Chairman and CEO

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Steven Winoker - Sanford C. Bernstein

Honeywell International, Inc. (HON) Sanford C Bernstein Strategic Decisions Conference May 29, 2013 9:00 AM ET

Steven Winoker - Sanford C. Bernstein

Good morning and thank you all for joining us at Sanford C Bernstein Strategic Decisions Conference. I am Steve Winoker, US multi-industry and electrical equipment analyst and we are delighted to welcome Dave Cote who we finally coaxed to be here, chairman and president and CEO of Honeywell, a company with about $39 billion of sales expected this year, we thought expected segment operating margin of about 16% and return on capital of low teens with the dividend payout ratio of about 33% or so. Dave’s 2014 targets call for $41 billion to $45 billion of revenue and segment margins of 16% to 18%. Dave took Honeywell over in February of ’02, 2002, so now more than 11 years or maybe it sometimes feels like 45 quarters and over the last decade the stock is up some 226% compared to 76% for the S&P, or almost 15,000 basis points of outperformance.

So with that, I’d like to remind all of you that after Dave speaks, we have some anonymous index cards for you to fill out questions, raise them up, we’ve got runners who will bring them up to me for Dave and I will do my very, very best to prioritize those and not my own and get to as many as possible. Thank you. Dave?

Dave Cote

Thanks Steve. I just wish Steve wrote about me as nicely as he just spoke about. I think it’s a nice trend. So why we’ve been successful along the lines is what Steve was just talking about. It’s really the application of this business model, starting over on the right hand side, upper right, starting with a great portfolio and then down the bottom focusing on our internal processes and to both of those applying left side which is our culture.

Starting with portfolio, I think we’ve been in great positions and good industry. If you are in a good industry you have a tailwind for growth and you will see – we describe that little bit more later on. And a good position, because then you have critical mass and things like feet on the street, R&D, backroom office allows you to be able to gain share. If you take a look at the acquisitions and dispositions we’ve done, we’ve done about our 125 transactions, about 75 acquisitions that added about 10 billion in sales, about 50 divestitures that reduced it by about 6 billion. Significant for that is $6 billion were in industries that were growing zero to 1%. The $10 billion were in industries growing 5% to 7%. So that did a lot to help change the composition of the $22 billion portfolios started with. Balance is pretty good. You will see on the long and short cycle and early and mid-late cycle, so we can sustainably perform. And we want to make sure we are in places where we could globalize. So it starts with a great portfolio.

The second piece though is making sure that you have internal processes that are superb and the way I frequently talk about my own guys is part of the leader’s job is just make sure the machinery works. We have 130,000 people, you can’t just assume the machinery is working. You got to pay attention to it all the time because all those people out there in your operations they are the ones getting the job done everyday and you need to make sure they have the right tools, the right processes to get their job done. As a result of that the company moves forward.

Left side of the page, a very different from where we were 11 or 12 years ago. And I would say something that’s generally underappreciated when it comes to looking at the company, and that’s, does it have a culture that will perform? We did not have one of those. You all understand about where we started 10 or 11 years ago. If you take a look at where we are today with our five initiatives and 12 behaviors, the one Honeywell drives, how everybody is driven to perform because they want to, not because they are being forced to do it, it’s something they want do, the trick is in the doing, we talk a lot about this. There is a huge difference between compliance with words and compliance with intent. As everybody can use all the words, we all read the same manual and magazines on customer service, how to do new product introduction, how to do auditive delivery, they are all the stuff that’s important.

We all know the same stuff might get as we’re talking company to company manuals look pretty much the same because we all know the same stuff. The really issue is how good a job you actually do in making that happen. And that’s why talk a lot about trick is in the doing. Then seed planting is something we talked about a lot for a long time because I don’t to make just this quarter, I want to make this quarter next year, three years from now, 10 years from now, that means that we need to be planting seeds now whether it’s geography, product, macro trend, business that we need to be planting those process, we need to be planting those seeds now so they perform later on. And you could see it’s worked.

If you take a look at our sales number, that a 10-year period sales were up 6% a year, margin expansion has been 55 basis points a year, and there's on the far right-hand side what Steve was talking about in terms of our overall shareowner performance. And if you take a look at it versus our peers over the last four or five years, without growing on sales, op margin rate which is an opportunity because while our – the slope of our line is greater, the fact is we’re still not as high as our high margin rate peers. And I've always looked at that as this is not a case where we're going on to unfraud ground rather there is opportunity here because others are already there and we’ve got the right kind of portfolio and internal processes to make that happen. And you could see what’s happened to our earnings-per-share as a result.

Starting with on what we call GPGI great -- good industries on the far right, you want to be in places where there are strong macro trends that over the next 20 years most likely those trends are going to continue. And that’s how we pick good industries. Great positions, we put a lot of thought into this. I want to be able to differentiate with technology but not technology that changes so fast somebody can totally supplant me with the new product introduction three years from now, and I go from whatever share I have to less than 40% of that in a couple years. So I want sustainable IP driven technology.

All our positions are very defensible. If you take a look at it business by business, brand channel, technology, how we’re positioned globally we do very well. We stay away from businesses that require a lot of government subsidy. You never saw us putting a lot of money, for example, into wind or solar because it’s tough to explain how those would ever justify themselves economically without the tax credit. Then in M&A we’ve been very disciplined in how we’ve gone about doing this and I would say we are one of the few companies out there that have a good track record being able to do this and it’s because of that discipline and rigorous process.

This breaks out the end markets for our portfolio and you can see it’s pretty well spread out reflecting the significance of diversity of opportunities. I often times say there’s never one thing that I can point to and say this is what makes the company for the next five years. But by the same token there's never going to be one thing that you can point to that says that’s when a rhyme caused the company to fall down or stumble. At the end of the day we have a lot of good bets in a lot of good places, there’s no one big thing that drives us, but there's no one big thing that have ever hurt us even. And you can see we’re pretty well spread out even in homes and buildings, you can see a big part of that is driven by install base and we just have a huge installed base which caused us to be able to moderate pretty well during difficult times.

Commercial aerospace broken out so is oil and gas, you can see the US defense department is only about 8% of our sales and when it comes to vehicles, a big part of that is, about 75% is passenger and a lot of that is Europe right now, which is what’s been causing us to be a little slower in turbo than we’d like. Then on the industrial light about 21% but diversity of opportunity is another thing you will hear us talk a lot about.

Global expansion has been a big part of our story. We've gone from about 41% of our sales outside the US to about 54% out the US today. A significant to that there’s still 75% to 80% of the world’s GDP is outside the US, meaning still lot of upside for us to be able to continue to grow globally. And you can see on the left hand side, how well we’ve done with high-growth regions and expanding outside the US. That’s going to be increasingly important as you look at the right side, because about 60% of world’s GDP growth over the next 10 years is going to come from those high-growth regions. Now we do all that focusing on sales while not forgetting costs and it’s really a pretty simple formula. Sales minus costs equal income, we all know that. We focus on the sales side and we focus on the cost side in order to make that happen.

We really simplified how we look at costs. There is a tendency to make it more complex than it needs to be as you start breaking things out into R&D, SG&A, how do you breakout cost of goods sold. At the end of the day there’s only two drivers of costs. One is suppliers you pay. The second is people that you pay. And when we start looking at that simply it’s amazing how that's changed this discussion with our own folks in our businesses as we look at how do we do a better job in all these areas? It also is if you take a look at OEM organization’s effectiveness where we concentrate all our labor costs, and that's whether it's direct, indirect salary non-exempt hourly, we count it all together. But we are big believer in that one of the ways to drive margin rate growth is to grow sales while holding fixed cost constant. And if you take a look at variable margins in the 35% to 65% range, and if you take a look at fixed costs where 65% to 90-95% of fixed cost of people, you end up seeing if you do a good job managing overall people costs while still having the best organization and whatever sales growth you have fall through, it’s amazing the margin rate impact you can have. So we look at cost across-the-board simply.

The Honeywell operating system is going to be a huge advantage for us going forward. We were really I’d say thoughtful and careful about how we deploy this because I really wanted something that would be a 20-year competitive advantage which means you need a cultural change to accompany it. It’s not just a bunch of tools, or process tools of Japanese names and you control around the lingo, then you're all of a sudden HOS compatible rather the culture has to change. And you can see from the bottom left that you end up with not just higher plateau of productivity but a higher rate of acceleration after that as you go from being before HOS to getting to what we call full scale deployment to becoming a bronze site to becoming silver.

Functional transformational on the right-hand side, I think that is the Honeywell operating system or HOS, but it’s a staff function like finance, IT, HR et cetera. We’ve got a very good job at reducing our overall costs as a percent of sales while improving service level. Now the trick is that even where we are in 2012, I think there's another one and half to two full point of margin expansion available just by doing a good job in functional transformation as we still haven’t fully deployed SAP. When it comes to cash deployment always a question and my guess is even though I will discuss it here, Steve won’t be able to resist asking me about it.

The first thing is, we are good cash generator, it starts with that and you'll see we have very high quality earnings and our free cash flow conversion this decade has averaged over 125%. First priority is to invest in our businesses, second is to make sure that we pay a strong competitive dividend and you have seen this basically growing at about 10% a year. Then doing a good job on M&A and making sure that we stick with our rigorous disciplined process, which works. We understand the importance of opportunistic share buyback and you saw us start that in the fourth quarter and continue on into the first quarter. And the nice thing about pension is that given where we are on a funded position and we're basically ahead of our peers at this point when it comes to our funded position. There is no contributions required for the next three years, it’s very unlikely that anything would happen there.

So we have a lot of cash that we can deploy to further bolster returns. Our 2013 guidance you saw we beat our first quarter and you saw us raise the low end of guidance for 2013 and everything on the slide is just what we said in our first-quarter earnings release. And in the long-term outlook, which we promulgated in 2010 for what our five years were going to be. You can see we’re on track to achieve both the sales goal and to exceed the margin rate goal and we've done that despite the headwinds that we encountered. If you take a look at the GDP growth assumption that hurt by about $3 billion and we got hurt on the global growth side, even on the margin rate side. Despite that we’re still going to meet the sales goal. It looks like for sure to exceed the margin rate goal. I’d say it feels pretty good to be able to make that happen.

And to conclude, we think we got a very good job growing and we think we still have a terrific runway to be able to keep doing that going forward. Our one Honeywell culture is working well and we’re able to take that culture and apply both to our internal processes and to a portfolio that is significantly better than what we had before. As a result of that, we think we’re going to be able to perform for us long time to come. So with that, I will hand over to Steve.

Question-and-Answer Session

Steven Winoker - Sanford C. Bernstein

And just as a reminder if you could just take your card, hold them up and it will be collected and get to me up here. While we are waiting for some of those, Dave, you’ve led a decade-long turnaround now at Honeywell. Where do you see the company in a stage of transformation really backing up looking about the big picture and to what extent is that more about growth going forward in margin and the balance between the two?

Dave Cote

I would say for the – well, first of all versus say where we were even five years ago, 10 years ago we’ve got a much better base to build from today. Number one, the portfolio is lot better than what it was in either of those times. The second thing is our internal processes have progressed a lot over these last five years. You first heard me talk about the Honeywell operating system eight or nine years ago and we’re just now at a point today where about 70% of our sites are brown, meaning that’s a base to build from. If I take a look at the next five years then, I’d say our growth rate will be better than what it would have been with a portfolio that we had before, and we still have room for a lot of margin rate expansion because we’re not even where – anyway we’re still 300 basis points behind where our high-margin peers are. So for least the next five years I’d say the story is going to continue to be the same but with a better portfolio.

Steven Winoker - Sanford C. Bernstein

And I didn’t hear today, I am curious why, when are you – for premium multiple from investors, right and how far away from that you think you are and looking forward how do you think about it being warranted at this point?

Dave Cote

Well, it’s tough to predict exactly when it will happen but I am really pretty convinced that if I continue to overwhelm investors with a cash and earnings that at some point you say geese, this really does deserve that a multiple premium. We've started to see some impact of that as the discount that we used to carry has largely disappeared. But at the end of the day we still have the opportunity for that premium because we've outperformed the last 10 years and I think there is increasing confidence in our ability to keep doing that going forward. And laying out that five year plan for example back at 2010, despite some of the comments I got from a number of sale siders about nice to see aspirational ambitious goals, what do you really think you're going to do. At the end of the day it really pissed me off at the time and I said how many years do I have to do exactly what I say before you are going to believe me and I think Steve, we were able to talk about the next five year plan is going to generate even more enthusiasm.

Steven Winoker - Sanford C. Bernstein

Outstanding.

Dave Cote

I didn’t say that, you said that.

Steven Winoker - Sanford C. Bernstein

No, no, that’s okay. We will leave it there. But didn’t you say that I am going to get you with this one. From early and I’ve got the audience question too quickly, from early on you talked about Honeywell as the company with great franchises in good industries, okay, to what extent is that more or less true today and good implies not great, okay, where the gap and to what extent can you migrate the portfolio in that direction?

Dave Cote

Well, if you go back to the first analyst day which I ever did, big investor day, I actually did talk about great positions in great industries because I thought we had some really great industries we were in. But I got too many – too much quibbling from analysts about, wait a minute that’s not a great industry, here is how I define a great industry, there is not worth arguing about my strategy is not going to change with the great positions in good industries. I feel very good about our portfolio. The only one that I would point to and say okay, you could argue that’s not a good industry, it’s our friction materials business which is about $800 million on $39 billion base. So not a big driver. If I take a look at the rest of our industries, what we do in aerospace and commercial side, both biz jet and big jet looks very good. If I take a look at the defense piece of that we’re pretty much at the bottom this year because of some of the hits that we’ve already taken. So we actually even with sequestration see a slight return to growth in defense overall, including international.

Housing, if I take a look at control side of it, housing is starting to come back a bit in the US, we’re starting to see quote activity pick up on the non-resi side, which is pretty typical. Doesn’t mean it’s turned in orders yet but at least quote activity is improving. Petrochemical and oil and gas industry doing very well which affects both our process controls business and UOP and our performance materials and technologies business. And the turbo business is stripped down to a point with the orders that they won, they are winning somewhere between 40 and 50% of worldwide orders every single year. That includes everything, large, small diesel gas, they’re really positioned for explosive growth at some point but you just get some industry volume. I feel very good overall about the portfolio.

Steven Winoker - Sanford C. Bernstein

Since you are on that, and you’ve mentioned some of the end markets, some of the audience questions, one of them is how do you see current economic conditions and your customer's confidence to spend, thinking about that geographically and by your businesses?

Dave Cote

I can tell you how I think about it just based upon what I read in the papers, the governments that I deal with and customers and suppliers that I talk with is that this is a better time to be cautious than to be bullish if you are investing as a company or hiring. And the way we think about the next three years and we try always to plan conservatively when it comes to sales and economic growth is we think about the US as a 2% growth economy, Europe as the zero economy, India around 4% and China in the 6% to 7% range. And that’s the way we’re continuing to plan the company and I think it’s worked pretty well so far. One of the reasons that we've been able to do so well this year is one, the seed planting that we've done over a number of years which allows – if you haven't done it, then you’re never going to be able to get it when the time comes. So we did a lot of seed planting.

The second one is we started to restrict external hiring about a year ago and just letting attrition worked for us and as a result of that has put us in a better position. I don't think we're the only company that’s thinking that way and acting that right now because there’s just you want to believe and there is economic news that looks better it’s still just not enough to say, okay start putting people on and start with the big CapEx programs. So we’re still in that, we’re going to play this cautiously.

Steven Winoker - Sanford C. Bernstein

You do have CapEx still going up in a number of areas, maybe talk about why those to be the exception?

Dave Cote

Well, CapEx is really going up in our performance materials and technologies business, is really driven by two things. The good thing about bulb is that those plants are already full. They are not even built yet and they're already full. We already have long-term commitment orders in UOP and our flooring business. For UOP we won so many orders over the last four or five years that we've won the plant, we won the process technologies and down the road you have to be able to supply the catalysts and the assortments that allow that process to keep operating at peak efficiency. We just don't have enough capacity to be able to do that. So we have to expand the plant. Same thing is occurring in our flooring business where we've invented this not just non-Ozone depleting refrigerant but also low global warming refrigerant. And we already have the SFOs as we call them. We already have the orders for this, we already got the long-term commitments, we have to build the plant and that’s the only reason I’d be putting in that kind of money is that I've got – we’ve already got the orders for the plant but the plant is full before we built it.

Steven Winoker - Sanford C. Bernstein

Maybe talk a little more broadly then about your view of what is cheap gas to for Honeywell, for your customers, it doesn’t matter, and how you’re sort of thinking about the US more broadly in that front?

Dave Cote

I would say when it comes to cheap gas I guess you’re going to have to quantify what the cheap is because the cheap is 2.50 to three in the US, then I'm afraid exploration just dies because it’s not going to be able to keep doing it. If cheap is in that $4 to $5 range then you really do have something that can transform the country and the world energy positions. And my guys, we do a lot when it comes to shale gas, Thomas Russell acquisition that we did, and my guys at UOP would say that even with the superior technology that we have today is allowing us to access the shale gas. We’re still only getting somewhere between 10 and 15% of the shale gas just down there. In other words, with further technology advancement there is even more shale gas available. So I think this is a trend that lasts for a long time.

Now at the end of the day you’re never going to see me they will make this huge total company bet on shale gas for the same reason we talked about before on diversity of opportunities because it just seems like no matter how much a trend looks terrific and like it’s going to be wonderful forever, something happens and I will point natural gas seven or eight years ago when it was five bucks and all the experts knew it’s going to 10 or 15, that people were buying companies based on those kinds of numbers. Well, shale gas happens goes down to 250, 3 bucks and all of a sudden it doesn’t look so smart. I still – you’ll never see me make such a big bet there that says, okay, this is forever, I can count on it because you just never know and I want to make sure that we can generate that sustainability of earnings growth.

Steven Winoker - Sanford C. Bernstein

So some related or end market questions here on China specifically, given concerns and mixed opinions on China's growth rate and the threat of a significant slowdown, please give us an updated view of demand trend there especially since high-growth region countries are a big part of the story?

Dave Cote

Yeah I would say I would break that up into two pieces. I think there is a short-term question and a long-term question in there. In the short-term there is no doubt demand has decreased especially as (inaudible) and his crew have been trying to get more control of the economy overall. There’s also no doubt that there are things you need to change how the SOEs are run, how the banking system runs, corruption and all those things need to be worked out of the system. And as a result of that I do believe you’re going to see some kind the ups and downs and some people will say it’s fine, others will say it’s horrible, they are in recession and the data themselves reflect that. I don’t think the data is that bad, my guess is that when they report GDP it could be off one or 1.5 points from what they are reporting. I do believe there is that kind of noise in the numbers but I don’t think it’s a draft because they report 7% and they are actually in recession.

If we take a look at our own numbers, our first quarter was tough for us in China overall on the short cycle side. But we actually built backlog on the long cycle stuff like aerospace, oil and gas and petrochemical. So on the short term I think there are going to be some ups and downs but I do believe they are working their way through that. Longer-term I am one of the people who does believe that China has the ability – really does have the ability to become the biggest economy in the world and that will take 25 or 30 years, they could still grow at a great rate for another 20 before they achieve our GDP per capita. So it seems to me it’s a mistake not to be there and it's really important to become the Chinese competitor which you will hear us talk a lot about and that’s to become local in everything. So from general management to local design authority, the staff people that you use, sourcing the manufacturing, everything has to be local because you have to be able to beat your Chinese competitor in China because if you're not you’re going to be facing that person in Europe or in the US. I really do believe that for just about every business today your next big global competitor is more likely come from China than any place out. So you got to be able to win them.

Steven Winoker - Sanford C. Bernstein

And Dave, another related question here on the growth side, at least recently you can see that our organic growth in aggregate has moved higher, and is the debate certainly depending on the peer group you use about whether you are in line with the peer average, you’ve moved up to the peer average or above the peer average but in any case, you talk about seed planting in R&D is now up to I think close to 5% of sales CapEx under 3%, why do you expect to see such a material difference between Honeywell growth rate and the peer group that is not really a debate anymore? How do you think about it?

Dave Cote

That’s another tougher one to predict that if you’re growing at 1% when everybody else is at zero and that’s really brag-worthy. Yeah at the end of the day that’s making sure that you get the right kind of growth in the right places and you got your cost position in line and that where I think almost all of us are today. That’s really tough to predict when exactly that kind of growth rate breakout happens. I can promise you though that with the kind of portfolio we have and the internal process work we’ve been doing I do expect our overall EPS cash flow performance to continue.

Steven Winoker - Sanford C. Bernstein

Question from the audience, your role as fixed to debt spokesman, do you think the US is turning the corner on its fiscal position?

Dave Cote

Well, another one yes and no, it certainly – just need to fix the debt it is a group that I became a part of following the citizen board commission that I was on, and one of the things that surprised to be on citizen board commission is, I’d say financially conversant CEO relative to the CEO population out there given my background and I was still found that how bad things we get over the next 10 years even with economic growth. Well, that’s kind of been happening that way and we’re really proud now that the deficit could only be $600 billion in the year, and while that’s encouraging it doesn’t do anything to fix the long-term problem and the long-term problem is entitlements. If you take a look at the Medicare and Medicaid in particular and some on social security that while debt as a percent of GDP is we’ll say around 75% today and under the new estimate grows to 83% by the end of the decade, a lot of people would say yeah, why fool of it. You take those same numbers, go up to the next decade and it goes to 135% debt as a percentage of GDP largely driven by the baby boomer generation retiring which no politician Republican or Democrat really wants to talk about. They’re more than willing to say we got to reform entitlements but as soon as you say well like what, that’s when they all start to back off because they don’t want to anger the voters.

But voters are going to become angry at some point because when debt gets to that kind of level then the reductions they’re going to have to make are truly draconian and the people who are already getting those benefits that's not a good position to be in, that you could be making those changes today, so that before people ever see the stuff it’s already gone and we just don’t get the same kinds of effect then. I think you can also make the system better in the process. So while there is a lot of holes that we’d just like to say thank god, that’s done. The fact is it’s not. And I do believe that one of the things that we could do to stimulate the US economy and I think provides the leadership to debt ridden countries in the rest of the world because if you look at the EU, India, or Japan they all have the same problem that we can provide some leadership. If we could actually resolve our entitlements problem and yes there will probably be another tax increase that would go along with it, I think that could do a lot to finally provide that spark to the economy that says, geese everybody is serious down there, they are really going to do something make the place better.

Steven Winoker - Sanford C. Bernstein

But here is – this is probably the second card I’ve received in five years, was signed by an audience member, I am going to read it, not the name. But I am going to read it. What would you say to Warren Buffett who wants to be in defensive businesses backed by governmental subsidies that is in some ways opposite of your view?

Dave Cote

I actually didn’t know that was his point of view, I suppose you can’t argue whatever you’re doing is not working for him, it seems it’s not right for him. But I would say that anybody who’s put a lot of money into wind and solar for example, recently is not all that pleased with either, just like the big natural gas investment seven or eight years ago. So we’re going to stick with our policy and say that whatever industries we’re going into, they have to be able to economically justify themselves on their own.

Steven Winoker - Sanford C. Bernstein

So let’s move to the portfolio if I can get to your cash questions you are expecting. First, given the recent M&A landscape in the last couple of years obviously companies like [Eden Cooper, Ty Glas] many of these other, what’s your overall appetite for acquisition? Is it getting larger, Honeywell get larger, what should investors expect and maybe more importantly what does do -- where does the line get drawn, everything is above this line or below the line, guys don’t worry, sleep well, how should we think about it?

Dave Cote

First of all, our strategy as a company is not acquisition driven. And if you take a look at our five-year plan that we put forward I guess three years ago now we only assume something like one or 1.5 billion of sales coming from acquisitions out of this 10 to 12 that we showed as potential growth during that time. I don't measure any of my people on the acquisitions that they do, in terms of that they have to get a certain number done. At the end of the day we only do them if they make sense, and we believe that financially it’s going to be a highly remunerative to our shareowners. So if I did – couldn’t do another acquisition that would be fine, we’d be in a fine position to continue growing, so we don’t worry about it.

When it comes to one of the things that we look at size wise I never say never on anything, we’ll big like $10 billion number that seems to be classified as big but you’ve also never seen me do one either because I can never justify it. One of our learnings has been that if you are going to pay 12, 13 times EBITDA for a business you need 6% to 8% of sales as cost synergies in order to make that pay. And we don't allow sales synergies to be used anywhere in the financial model, then nobody can count on sales synergies. I want to know what they are, because I want to know there is some potential upside, I don’t want anybody counting on it because they just seem several but it’s there in the review and it never seems to be there in the actual and we've gone through and done any of the analysis. So first thing is, it has to be accretive in the second year. And whenever anybody says their industrial acquisition is accretive from year one, they are excluding something. Because there is no way in hell that’s going to happen, between the restructuring charges you have to take the inventory write-down, you have to take the intangible write-offs, there is no way how that’s accretive in the first year unless they are putting commercial paper type rate on it as opposed to your blended average. So I require that it’s got to be accretive in the second year.

Second one, it has to exceed your cost of capital which is probably the easiest one to make up but impressive how finance people can make IRR stand as they want to. So that’s an easier hurdle. The third one though which is really the toughest one, it doesn’t sound like it as they have booked ROI all in everything included be in excess of 10% in the fifth year because you really have to be delivering on an acquisition you end up with a very good IRR if you're able to do that on fifth year on booked ROI. So our discipline is it’s not going to change, we’ve never really done anything over $1 billion, it’s not to say that we won’t at some point. But whatever we do have to satisfy all of those conditions. So far we haven’t been able to find that property.

Steven Winoker - Sanford C. Bernstein

You did mention, I don’t want you guys do anything big, I am not suggesting that here, okay but you did mention 6% to 8% cost synergies were in your hurdle that sometimes you have to get over to the larger businesses, it does strike me that almost every acquisition I have seen you guys actually report on in years two, three and four, are well in excess of those kinds of number, is that still true or – I got that wrong?

Dave Cote

No, no, that’s correct. Because we like – we will have our – here is our base plan no synergies 6 to 8% of sales as cost synergies so that I know even if this thing doesn’t do everything that I hoped it could be it’s still a good deal. We still do fine. Beyond that what the businesses, if you were to talk to Roger for example, he would tell you in every case while he had his plan that says this is what I have committed to Dave as an absolute minimum that I will achieve, he has his high end plan, that has higher cost synergies where he will also measure the sales synergies that he’s expecting to get to make sure that those happen. I think that’s one of the reasons we've been able to do so well with it, is we don't do a deal unless that absolute minimum base case is very solid we know we’re going to get the money even if the rest of it doesn’t work.

Steven Winoker - Sanford C. Bernstein

So let’s stay on the portfolio, it’s one of the biggest levers, one of the questions from the audiences is, as you look at your portfolio of businesses do you see any opportunities to carve out and spin off any of these standalone entities, if not where do you see opportunities to unlock value?

Dave Cote

I’d say the biggest one that I think we can do – it doesn’t quite fit is friction materials business that we talked about before. When it comes to spin-offs or carve-out I have to say I am less excited about doing something like that, it’s not to say that is the beyond the tail when it comes to thinking about it. But at the end of the day it seems to me that one of the reasons you want to be able to buy Honeywell and one of the reasons that justify the premium multiple at some point is the fact we can sustainably out deliver when it comes to cash and earnings. That means you need a really good portfolio and one that isn’t just dependent on any one thing, and that’s why way we’re going to be pretty much driven in our thought process.

Steven Winoker - Sanford C. Bernstein

Does that mean the portfolio in two to three years as you fast forward look largely like it does today with some adjacencies or how do you – how should I think?

Dave Cote

I think that’s the right way to think about it is, things have a way of changing. So whatever I say today if circumstances change significantly over the next 2 or 3 years, yeah, like I said before Honeywell is not for sale but somebody comes up and says we’ll give you $200 a share, okay, I can reconsider. Same thing happens with businesses. So I would never say never on anything but it’s got to be sort of thing that really makes a lot of sense for our shareowners. If I go back to the beginning 10 or 11 years ago I got a huge amount of investor push to just get rid of what we called specialty materials at the time and for any of you who would've been in the audience at this time my comment was always look this is a bifurcated portfolio. This is a baby in a bath kind of thing, there is some really good stuff in here, some really bad stuff in here. Why do I want to give somebody else’s shareowners the benefit of this obviously that can be done. Well when you take a look at performance materials and technologies today, if you take a look at the $3.5 billion that we start with only 2 billion of that is original from that timeframe. All right, we’re up around $7 billion today, it’s really starting from that $2 billion base and building it up because there really was some good stuff to build on. So I don’t want to ever be just too quick to say carve-outs, spin-offs whatever, when what I want to do is sustainably drive increases in cash earnings over a long period of time.

Steven Winoker - Sanford C. Bernstein

Another question from the audience, when addressing cash you didn't address NARCO, what your expectations with respect to NARCO funding at least probably the audience know what it is.

Dave Cote

The reason that we didn’t – I haven’t talked much about NARCO is not that big a deal anymore, it was 11 or 12 years ago when – it addresses half of our asbestos liabilities with the 524G trust that we were able to do it basically siphon off that liability. We struck a deal about 10 or 11 years ago and it’d taken this long to work its way through the court system, which has been a good thing for us because we hung on to the cash this whole time. If you – showed in the first quarter, first quarter earnings it’s pretty much still the numbers. We don’t know anything more than we do today. But that will be the outer limit of what any of those cost will be. So on that total basis it’s minimal.

Steven Winoker - Sanford C. Bernstein

But I think it’s also important that you’re putting your arms around, so there is retaining -- retained legacy issues and being able to carve out now –

Dave Cote

So we've been knocking down all these legacy issues as Steve talked about, whether it was pension, asbestos or environmental over the last 10 years, and as a result of that the environmental issues that we have as a 100 year old chemical company are pretty much all addressed at this point. When it comes to asbestos we’ve been able to show that exposure very much managed, NARCO exposure deal is going to through and eliminate that. and pension as we didn’t show this chart but it’s in some of the stuff that we have online, we are in a better position than almost all of our peers. So I think we have been able to do away with most of that and at the same time when you have more than double the earnings and cash flow with the companies impact of all those things on a percent of total is significantly less.

Steven Winoker - Sanford C. Bernstein

So you’re asking to get the cash flow, so on that a little bit, first of all, you are less than one times I think net debt to EBITDA around there, balance sheet often characterized as highly conservative, it’s good to have a strong balance sheet obviously but the question is how strong, how do you draw the line, how do you think about how far you can push that you don’t have to worry about jeopardizing big company but you're giving, you’re maximizing the opportunities –

Dave Cote

As you probably heard me say I am not going to let this get to apple proportion but you don’t have to worry about that, I recognize that we are not even close to that yet. So – I like having to shut the windows so the cash flows get blown out the windows. At the end of the day I would I am really struck by that 2007 timeframe when I did do a big share buyback and spent about $2 billion to do it because I could see the future based on where our strategic plan was going and how we’d always beaten our strategic plan, it was that same reasoning, let me put out a five year plan that I believed in back in 2010 because I have seen what we have done in the past when it came to achieving our strategic plan. And obviously I was really, really wrong because when we got into 2008 and ’09 while I could argue the financial theory that says, return the cash to shareowners, I issued shares and pension plan, the shares did very well eliminating the valuation problem we had there. At the end of the day I would much prefer to have $2 billion in cash going into that recession. I don’t think the times are so certain yet that it makes sense to say, okay, now is the time. And I would have much preferred to have been able to have $2 billion in cash at the bottom of the recession that either fund my pension or to buy back shares then.

So I am little less I guess – I always say there was three uses of cash, dividend, share repurchase and acquisitions. I kind of put a fourth one in there that says letting some cash build on the balance sheet is not always the worse thing to do. So you do run into a time where you say this is the right time to deploy it, and I don’t mind looking that as an alternative. I am not against share buybacks as you know, we’re doing them in the fourth quarter and first quarter but I felt like in 2007 I fell right into that 80% of companies and CEOs that least time their share repurchase but I much prefer this kind of dollar cost averaging approach that we are taking now.

Steven Winoker - Sanford C. Bernstein

Question on margin opportunity and SAP, what benefits have you seen thus far or what’s the next opportunity for deployment or maybe you will add, how big a deal it is?

Dave Cote

SAP is a big deal for us especially where we had three companies in culture, being brought in at the same time. Again with our kind of caution when it comes to investing I do want to invest in SAP just because it was going to be great and we all know it’s going to be great because everybody will have information, what I really wanted is everything to be able to just -- all those investments to be able to be justified based upon cost take-out, in order words, people reduction, that you have to be able to demonstrate that you’re going to be able to reduce cost by a certain amount once the module went in. As a result of that SAP has worked very well for us, whether it's driving functional transformation or the work we’re doing in manufacturing and SOFs, because everything has to be justified as if I put in 100 bucks in SAP, you better be able to show me at least 20% IRR on the cost reduction you’re going to get.

The thing that we're just starting to get into and you can see this happening in both PMT and TS where SAP is fully deployed, the information impact is big. Once you can actually get it and you can get the analyze the data and know exactly what’s happening. There is a big benefit that comes from that and we are just starting down that path, because if you take a look at aero, I think they are about 85% deployed at the end of this year and ACS, the controls business is about 65% deployed by the end of this year. And they're just starting to get into application of those analytical tools.

Steven Winoker - Sanford C. Bernstein

So your five year plan targets are coming up next year right and how do you even think about resetting them going forward, what the different criteria that are going into your head (inaudible) discussion so that you're at a comfortable level?

Dave Cote

I feel very good about the business’ ability to outperform. So in every single business because you heard me say this before but I am a big believer and that if you have a strong consistent strategy and you execute that said strategy day by day, quarter by quarter it’s amazing where you get to in just a few years. And you should be aware of the company or the business that every two years as a brand-new wonderful strategy to take advantage of whatever the new fad is. That’s not a good place to be. So I feel very good about our ability to continue to outperform. The real question is I think to me is going to be so what kind of economic environment are we going to be outperforming in, and that’s going to be the tougher one and I am going to want to stay on the conservative side of that because I want to be able to do the same thing that I did just now and be able to say look even in this environment that where we were conservative and it was tougher we still achieved it. And that for me is still going to be the bigger question that we have done aggressively.

Steven Winoker - Sanford C. Bernstein

But by nature that means you’re going to have at least some growth out there and you’re going to have at least some margin expansion is going to have to result from that –

Dave Cote

Yes.

Steven Winoker - Sanford C. Bernstein

So what do you think is best practice in terms of leadership succession for large industrial conglomerate and examples that you might point to?

Dave Cote

Well I would say – I don’t want to go point any examples now but I would say that at the end of the day it’s little early and thinking about it a lot and thinking about not just -- it's really tough to gauge leadership in my view because there are three things that are important to get done. And only one of them is really visible. The first one is you need to be able to mobilize a large group of people, that’s the easiest one for people to see and easiest one for people to measure and get a sense for like that person or I think they do a good job. But there’s two other things that are required that are really tough to get a sense for unless you watch it over time. The first of those two, is you got to be able to pick the right direction. Because if you pick a leader who is charismatic and to mobilize people but you spent 40 years wandering in the desert because that person picks the wrong direction that’s a horrible position to be in.

The second important one is that you can mobilize a group, you can pick the direction, but can you make the machine work to actually get everybody taking step in that direction and in a way where they all head off in the same place? Those last two are much tougher to measure but they are I would say even more important to the success of an enterprise going forward than that first one because you can mobilize a group without being charismatic and exciting and invigorating, so the last two that are tougher one to measure and I have spent a lot of time thinking about that trying to figure that out.

Steven Winoker - Sanford C. Bernstein

And just to follow up on that quickly before the last question, and does that mean you favour a much more internal candidate than external?

Dave Cote

Yes.

Steven Winoker - Sanford C. Bernstein

I am going to end with an audience question here, which is please describe the culture and what differentiates it from others?

Dave Cote

Yeah culture is, (inaudible) where you can write down all kinds of stuff, and we have our stuff written down to like the 12 behaviors and our five initiatives but it really is – the couple of phrases I really like and I talk about a lot is the trick is in the doing and it’s also compliance with intent, not compliance with words. And just people being able to understand the difference between those two things or being able to understand that, okay I agree with you on the process that you are looking at but just overall at the end of the day I am still going to measure you on the result because if it doesn’t happen and what you're saying sounds reasonable to me but I am fully expecting a result to come out of this, because we reward results not effort. And just getting people in fact to recognize that and act that way which takes a significant amount of time, you don’t just do that overnight, looking at something like Honeywell operating system for example is driven entirely by that and having everybody involved, understanding that they are participants that the trick is in the doing, it’s a matter of how well do they get this done, it’s not a matter of having a really nice kaizen event or everybody getting along but rather they actually have to see the overall plant performance improved and they have some contributed to it. It’s a tougher thing to measure but it’s very real when you have it.

Steven Winoker - Sanford C. Bernstein

Do you have any closing comment?

Dave Cote

Yeah, the same one I use all the time Steve, that’s by now while supplies last. Thanks.

Steven Winoker - Sanford C. Bernstein

Thanks Dave.

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