Honeywell International Inc. (NYSE:HON)
Gabelli & Company Aircraft Supplier Conference Call
November 19, 2013 8:00 a.m. ET
Mike Owens - Vice President of Integrated Supply Chain
James Foung - Gabelli & Company
James Foung - Gabelli & Company
We are delighted to have Mike Owens. He is the Vice President of Integrated Supply Chain for the Honeywell Aerospace business and sitting in the back is Elena Doom, Vice President of Investor Relations and Corporate Finance. Honeywell operates as a diversified technology and manufacturing company. And their aerospace system provides turbine propulsion engines, auxiliary power units, electrical power and engine systems for the aerospace and defense market.
Mike is responsible for all aspects of Honeywell's integrated supply chain, including manufacturing, quality control, repair and overhaul, materials management, supply chain management, as well as healthy environmental safety systems. Previously he was Vice President of Aerospace Americas in which he provided strategic leadership to a network of 30 original equipment and aftermarket services companies. By way of background, Honeywell has about 787 million shares and about $90 a share, $70 billion in market value. The company has $3 billion as net debt giving them about $72 billion in capitalization. Mike, I will give it to you.
Okay. Well, thank you very much, Jim, and thanks Gabelli for having us here. Before I get started, I had met Patrice [ph] earlier this morning and he said, you are first up, you got to warm up the crowd. That’s a really tough challenge for a supply chain guy. We don’t warm up very much. Right. In this industry supply chain is a very integral and important function that is typically at the backend of the thought process relative to technology and the customer side.
So before I get started here I do want to point out that what you will see in our charts are some forward-looking statements. They are based on our best view of the world as we see it today and so I would ask you to keep that in mind as we go forward.
Okay. The business overview. I am going to spend a little of time talking about where we see our business in aerospace and where we see our business in Honeywell. And then I will spend most of our time talking about what our story is right now, which is primarily margin expansion. We are in a period of time where the industry is changing. And we are going to spend some time talking about how the integrated supply chain and how aerospace at Honeywell is transforming to accommodate the new structural changes that are out there and expand our margins.
You can see that we are between $38 billion and $39 billion company, as of total Honeywell. Aerospace represents about $12 billion of that. What we are doing right now is on a relatively flat sales basis we are expanding our margins. You can see really nice margin progression there to 19.8%. Hopefully, you can see that, I apologize, I am not used to the podium.
One of the things that we are seeing, is that we are seeing good, steady, early growth in the ATR market space around flight hours. We are seeing our business in general aviation market expand in the segments that we are in, not as an industry in total. And we are seeing our defense and space industry acting about as predicted in terms of declines that we would expect from sequestration and government shutdown. So from a Honeywell aerospace business perspective, nothing here is unexpected for us.
So on the air transport and regional side. What you will see here is some key production rates, as Jim mentioned earlier, the rates going up at Boeing and Airbus. That’s the primary driver in our aerospace -- in our air transport and regional business segment. We are seeing regional transport doing as expected by declining. Regional transport has been relatively slow over the last couple of years and we are seeing that as well. But our high content in the Boeing and the Airbus narrow-bodies and the wide-bodies is significant. It makes a lot of our lives better in the supply chain because we have more rate there then we have in other program.
We have had about $2.5 billion of wins that are seeding our future. You will hear Dave Cote and our senior management talk at presentations like this about seeding the future. That’s what we are doing. So we are executing to make room that we can plant those seeds, that we can win on the new platforms that we need to win on to continue our process. A350 being probably one of our most significant. We have been heavily investing in A350 over the last couple of years from RD&E standpoint. It enters into service in the second half. Big deal for us, big deal for the industry. And so we are looking forward to that as well.
Couple of other things here. We are coming out with much more integrated approaches to the air transport market. So onboard connectivity, big deal for us. We did MN&A activity in EMF industries a year or so ago, along with our ACS component of Honeywell. And that provides us the ability now to start really connecting the aircrafts. So we are already a large portfolio player on every airplane from nose to tail. Now we are starting to be able to connect not only the passengers need for services onboard but we are also starting to be able to connect all of our systems to other offerings in the marketplace. So it's a good business for us.
Business and general aviation. I mentioned this before. Honeywell continues to execute on a very well purposed strategy that was put forward before I got to the company, but made the decision to be on the large -- mid and large aircraft, cabin aircraft in the business and general aviation space. Very very important segment because that’s the segment now that has backlog. If you want to go order one of the large aircraft in business and general aviation, the Dassaults, the Gulfstream, some of the larger Bombardiers, you are going to get in line and you are going to wait for your order.
If you wanted one of the smaller, very light business jets, there are a lot of green tails still in the market, you could get them fairly quickly. We are not heavily content on those smaller aircraft. So we made some decisions doing best in the mid and large aircraft business, it's really paying off for us. And what it's really allowing us to do is do what we call retrofits, mods and upgrades. That’s the RMU that you see down the bottom of the page. That’s a significant business for us. It's really taking hold because it allows to upgrade all the aircrafts that are out there in the market today. And many of them are software only upgrades that allows us just to get on the airplane without disrupting the operators.
So it's a very significant value proposition for us. It continues to expand. And as the fleet continues to fly longer and longer ranges, that ability to upgrade and provide new functionality is critical to the operators.
Defense and space. Again, I mentioned earlier that it's acting as we thought it would. So we fully planned for sequestration. We didn’t hedge it. We knew that it was facing us. We knew that the current environment in Washington DC is going to be [indiscernible]. We need to plan for the conservative downside for sequestration and that’s the way we planned our business plan. At the same time, when we mentioned this seeding the investment, we started repurposing our employees to the international defense market. We knew that that was an tapped market and we knew that that was an area that we had to go, expand in a greater way. And that expansion is not only in the sales force and the business development people but it's also in the supply chain.
So we started putting forward stocking where we needed to, to basically provide for those international customers. But we also started deploying our design for supply chain people into those market spaces to look and see what we needed to do to localize the supply bases there. And we haven't done a lot of localization yet in those market spaces but we are in the prospecting stages right now as we try to develop suppliers there and to be able to support this larger international market space.
A couple of things other to note here. Defense and space, we have a limited, by design we have a limited content on each program so that we are not in a position of living program to program. So we have limited our investment in each program to somewhere between 3% and 4% of content in any one program so that if a program gets cancelled, we still have a viable and growing business. So it's a very purposeful strategy to make sure that we are not overly invested in any one program. And we do that with our partnerships with our tier one suppliers. So Lockheed Martin's of the world, the Boeing defense and space. Those customers of ours who are very significant in the programs, we go in and work them on what technology offering do we have and we make sure that we are spread across all the programs, so that we have a good business space to build from.
Okay. You may have seen this slide before if you have been to other conferences. We continue to win in a big way in the market space. So between '10 and '12, 2010-2012, we had $28 billion of wins in the air transport and regional business. About $19 billion in the business and general aviation business and about $15 billion in the defense business. So we continue to grow and build our book of business if you will, for the future, which is what's allowing us to then spend the time execution wise to start working on our margin expansion.
Knowing that we have that future business, knowing what the definition of that future business looks like, allows us to work internally and with our supply chain to make sure that we are actually working on margin expansion, working on elimination of the waste and the inconsistency that we see historically in the aerospace industry.
So what is productivity mindset for aerospace? We have approximately 84 product lines that we, just for a marketing sense, we group those into ten product families. Those are kind of functionality families. And what that does is that provides us a way to outlet. We have about 80,000 scalable SKUs in the aerospace sector at Honeywell. About 700,000 active part numbers that we manage across about 3,200 suppliers in the direct supplier base and over about 100 locations. So with all that synchronization that’s required, it's pretty important that we understand how we integrate all that with the strategic road maps. And our marketing and product management organization that manages 84 product lines, they set the marketing strategy, they set the investment strategy and then we as a function come in and work with them on how we produce the margins.
We are in 17 countries. We have about 41 countries on sourcing but as I mentioned earlier on the defense and space side, we are expanding our outlook at localizing suppliers. Probably most significant is our HOS deployment. So I want to just preface this with a definition for you of how we think about the Honeywell operating system. And I have been involved in other operating systems in other industries. What really makes us different is this thought process. And that is the value is only defined by what the customer is going to pay for.
So we don’t get into this internal/external customer stuff that you see in companies, trying to decide whether you are value add or you are not value add. If the customer is going to pay for it, it has value. If the customer is not willing to pay for it, it falls into one or two categories. It's not value added at all and needs to be eliminated and that’s how we grow margins, or it's not value added but necessary to run the business. Think about finance, HR, procurement, marketing, IT. Those are functions in the business that you have to have to run your business but they are non-value added. So you try to minimize the dilution on the margin by making sure those are the most efficient. The most efficient tools, the most efficient strategy where you are going to invest your time and energy.
Our Honeywell operating system then is the, if you will, the mechanism of developing the culture so that we start delivering that value in the most efficient way. And what we do is we try to eliminate waste. Most of you have heard about lean tools, try to eliminate waste. But we have spent a lot of time, and this is what differentiates the Honeywell operating system from others, is we spend a lot of time on eliminating inconsistency and a lot of time on eliminating strain.
Strain is the concept of, if it's hard to do, humans will try to work around it. That becomes your hidden factory, and if you have hidden factory you will then develop inconsistency and you will have periods of great performance and you will periods of lesser performance. And by getting rid of the inconsistency you make sure that you are establishing a great performance all the time. So for us, the Honeywell operating, we will have about 70%, a little more than 70% of our conversion cost under the Honeywell operating system at the most mature phases. You will see it slide later here where the most mature phases give us about a 25% improvement in quality, about 15% improvement in inventory, and about 100 basis points improvement in productivity.
So it's more than just altruistic. We believe in the Honeywell operating system. It is what's making us productive and it's what's allowing us to continue to invest in our future markets.
Velocity Product Development. So I mentioned the concept of value. Velocity Product Development is about speed. So how you get to that value quicker. So this is at the front end of the business, typically engineering, but it's in the new product introduction. And so what we are trying to do there is we are trying to capture that value as fast as we can. The processes are very similar. It looks at how we streamline and look at the critical operations necessary to deliver that new product introduction and make sure that we get to the value as soon and as quickly as possible. Right now a big part of that strategy obviously would be, like many of you, it's going to be SKU reductions, it's going reuse of parts and it's going to be reuse of core technology platforms.
Globalization. I mentioned the international business. Big, significant effort for us. Untapped market as far as Honeywell aerospace is concerned and we are starting to make really some strong inroads in getting to the globalization activities around defense and space.
And then the Honeywell operating system. You know clearly there are companies out there who do the lean and they do the Lean Sigma. So do we. But we consider those tool sets. This concept of cultural work around the inconsistencies and the strain is where we think it differentiates the Honeywell operating system from others. It allows us to engage 40,000 minds in the process of improvement of margin expansion and it allows us to use the lean tools and use the Six Sigma tools but only where they are needed. So the way we kind of look at it is, Six Sigma tools are used for variation that you can't see and lean is used for variations that you can see. But the real key is the knowledge of knowing when to use either.
I think this is conceptually what we are talking about. Here we are going from top down management to participative management, from autocratic leadership to servant leadership. And that’s the transformation that’s going to be required as the industry structurally changes to a much more cost competitive type of industry as it relates to supply chain activities and less about technology advancement. So we are going to need all of our employees to be engaged. As a matter of fact at Honeywell, in aerospace, we require each of our employees in the integrated supply chain to have two implemented continuous improvement suggestions per month. In order to have two implemented, they are turning in an average of 12 to 14. That’s part of their performance review. So we are actively engaging our employees in the continuous improvement efforts to grow our company.
There was a famous physicist once who said, there is nothing more dangerous than an idea if it's the only one you have. And that’s our concept as well. We do not want to be just autocratic top down leadership, we want our employees to progress the company with us.
So here is our journey. A journey never stops by the way, but here is where we are in terms of maturity. We will be a little bit over 70%, 71%-72%, of our conversion cost. Most importantly as we grow our market space, we have 59 of our 77 or so sites that produce products and service that are now under the Bronze plus. That’s our measurement of maturity. And those 59 sites then have, since 2009, have about halved their time of implementation because as get the lessons learned, it just continues to build.
We now have about 13 deployments in our supply base as well. We are actually going out and teaching our suppliers how to do it. So one of the things about the supply chain and the aerospace industry is, all of us suffer from the fact that it's been a growing and technology led type of industry. So a lot of this work when it comes to productivity has to begin way back in the supply chain and overcome some of the decisions that were made earlier in the engineering efforts. So we routed [ph] our supply as we repurposed about 180 of our people away from buying and administration and now we have actually hired in supplier development engineers and we are actively pursuing our supply base to help them grow and mature with us.
So here is the improvement chart. 25% improvement versus our full-scale deployment. Full-scale deployment for us are less than bronze maturity which means they are in the learning process. We go through phases one through four. At about phase four is when they start doing the Kaizen work that you are familiar with and at that Kaizen work we start expecting results. At the bronze plus level we expect consistency in those results. We actually task them in our annual operating plans with these kind of improvement factors.
So we multiply the normal productivity we would expect from a site by these improvement factors to get a higher productivity expectation out of the sites that are at the more mature stages, again helping us grow the margin.
So, in summary, and then I will turn it over for some questions. We think we are growing in the right spaces. Our air transport and regional is undergoing some structural change in the market space and we know that. We know that there is lot of cost pressure. We know that there is a lot of price pressure. We know that that pressure translates into productivity requirements from the supply chain and the executing functions of aerospace. But we think we are well positioned to do that. We continue to win. We continue to win at a competitive way and we are making our business teams successful as they go out to bid on these new programs.
On the business in general aviation, we continue to provide better offerings and more scope of offerings to existing planes and we continue to pursue and win on the larger aircraft, larger cabin aircraft. In defense and space, it's all about maintaining the stability that we have in the domestic space and taking our offerings international. From a structure and capability standpoint, we think we have some of the best people in the industry but more importantly we are enabling them with the Velocity Product Development, the Honeywell operating system and in the functional transformation efforts.
And we are uniquely positioned we think to overcome the near-term macro headwinds. So the government uncertainty, the sequestration, the political unrest in the market space, the changing of the workforce to the millennial workforce. All of that is in our thinking from a strategic standpoint on how we go forward and making sure that we are setting up our operations to be as productive as possible to absorb and accommodate these structural shifts. And I guess I look forward to seeing you all again sometime in the future and talking about the great things that Honeywell is doing.
So at this point I can turn over for questions, Jim.
James Foung - Gabelli & Company
Let me start with first question here. You talk about improving margins by working with your supply chain. Could you just kind of give us some details as to how you go about doing that, trying to work with your suppliers and improving the operation in the chain.
The interesting thing about the aerospace industry, and I have been at a couple of different industries. I have been at hi-tech, I have been in metals as you see from my background, in the consumer electronics. In this industry there is an awful lot of decisions that are made early in the program design and development. And those decisions are trade-off decisions, about is it worth from a time and entering into service standpoint. Making a more efficient supply chain 20-years from now. That you'll make a decision in the new product development that is going to have a trade-off effect for the legacy of that program, typically.
You can go through requalifications, we all know that. But what we have to do then is to go into the suppliers and look for where those trade-off decisions were made off, and where we can value engineer those decisions through some change activity in our engineering work. Or where we can look for the waste, the inconsistencies and the strain that we know exist because of those decisions and see if we can eliminate them. So for us, a big part of our effort right now in our supply base is mistake proofing.
We know when you have product that was intentionally decided to put into the market space with a 70% to 80% first pass yield, we know that there is going to be inherently 20% to 30% variability. And so the only way to overcome that variability is one, design change it out, or two, improve the operations that are doing it and put in mistake proof that will actually contain that so that it becomes much more predictable. Once you have the predictable containment, then you can go after the changes in a more thoughtful way. So that’s really what we are doing. We have repurposed a significant amount of our purchasing effort into value engineering and productivity improvement.
James Foung - Gabelli & Company
Maybe you can just kind of expand on that. With Boeing's Partnering for Success program, does that kind of change what you have been doing today in terms of getting more margin for both you and Boeing in this program.
Yes. I think, well, clearly Boeing has taken an approach that is not dissimilar from other large OEMs. They call it different program and they have been doing it in phases whereas Boeing's program tend to be, was a single phase and in a bigger way. But has it changed the way we think about the supply base? It really hasn’t changed the approach. What it has done is it has accelerated the urgency at which we deploy that approach. So we need our suppliers to be competitive with us and Boeing needs us to be competitive with them and that’s what's allowing those production rates to increase as you saw up here. Without a competitive offering, they wouldn’t be expanding those rates on the production side. So really what it's done for us is that hasn’t the approach but it's made the urgency more prevalent.
James Foung - Gabelli & Company
Is there like targets in terms of what Boeing wants regarding margin giveback or price concession [ph]?
Well, I should be very careful here. They are not really talking about margins swap. That’s not what they are looking for. They are looking for value for value type of arrangement where what value ideas can you bring that will provide value to both Boeing and also you as a supplier. So for example, a very simple example from a supply chain guy, hardware. So if you have large variation in the types of hardware you are using and you can get it down to where you use a single type of bolt or a single type of nut. Wouldn’t that be great and you won't have to carry as many SKUs, you won't have as much buying activity, you won't have as much inventory. Those kinds of ideas are what we are submitting into the Boeing operation, which is much more about simplification of the supply chain and with that simplification we are allowed to strip out cost.
James Foung - Gabelli & Company
I guess one last one and then we'll move off the supply chain [indiscernible] I guess. I guess you alluded to the higher production, that 787,737. Do you need to make investments in order to get to that higher build rate that Boeing has talked about going out to 2020?
For us, we are reinvesting our capital year, is what I would tell you. And we are reinvesting at about a consistent rate. Your specific question is, do I need to expand my operations from a capital investment standpoint to accommodate these rate increases? The answer is no. We are rate ready for these and actually at a little bit higher rates than what you see up here. So we have a very close relationship with Airbus, with Boeing, with Embraer. And we stay very close to the forward looking rate requirements and we are investing ahead of that if we need to. But in the case of these rates, primarily because of our productivity, our productivity is expanding our capacity to a position where we don’t need to make a significant investment.
James Foung - Gabelli & Company
Okay. Do you have any questions from the audience? Okay. And then maybe you could just talk about your opportunities for the 777X. I know it's kind of early, but what are some of the things you might be bidding on as you look at the new aircraft with a redesigned wing and the engine system.
Well, clearly we are not into big iron engines. I mean we do the business in aviation [ph] engines but all the support systems, we are a large incumbent on the current 777. So clearly all the packages that we have on this current 777, we are going to be going after on the 777X. And part of the participation that you know we have with the Partnership for Success was setting ourselves up to be in a very strong and competitive position to win on the 777X. So we will go after all of our packages that are in our incumbent position into the future [indiscernible] as well.
James Foung - Gabelli & Company
Great. Congratulations on those big wins and we think you are to be very successful in getting some of that 777 business.
We hope so.
James Foung - Gabelli & Company
Thank you very much, Mike.
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