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Honeywell International, (NYSE:HON)

Q2 2011 Earnings Call, Jul 22, 2011

July 22, 2011 9:30 am ET

Executives

David James Anderson - Chief Financial Officer and Senior Vice President

Elena Doom -

David M. Cote - Chairman and Chief Executive Officer

Analysts

Howard A. Rubel - Jefferies & Company, Inc., Research Division

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

John G. Inch - BofA Merrill Lynch, Research Division

Christopher Glynn - Oppenheimer & Co. Inc., Research Division

Shannon O'Callaghan - Nomura Securities Co. Ltd., Research Division

Jeffrey Sprague - Citigroup

Operator

Good day, ladies and gentlemen, and welcome to the Honeywell Second Quarter 2011 Earnings Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to introduce your host for today's conference, Elena Doom, Vice President of Investor Relations.

Elena Doom

Thank you, Jovan. Good morning and welcome to Honeywell's Second Quarter 2011 Earnings Conference Call. Here with me today are Chairman and CEO, Dave Cote; and Senior Vice President and CFO, Dave Anderson.

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

Note that elements of today's presentation do contain forward-looking statements that are based on our best view of the world and of our businesses as we see them today. Those elements can change, and we would ask that you interpret them in that light.

This morning, we will review our financial results for the second quarter, as well as share with you our expectations for the third quarter and the remainder of the year and, of course, allow time for your questions.

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

David M. Cote

Thanks, Elena. Good morning, everyone. As you saw from our press release, we had another outstanding quarter with better-than-expected performance, reflecting terrific execution and continued momentum in our key end markets, yielding EPS above the high end of the range. While there's some accounting geography complexity because of how we are required to account for discontinued ops and launch payments, and Dave will take you through all that, the overall results certainly speak for themselves, with sales up 15%, EPS up 40% and guidance again raised for the year.

Now before we get into the financials, I'm pleased to report on the progress that we've made in the quarter on the CPG divestiture. We have received regulatory clearance and anticipate the sales of Rank Group to close early in the third quarter. Dave will take you through more details in a moment, but we've transitioned to reporting CPG in discontinued ops, and we expect to smartly deploy the book gain and sales proceeds in the third quarter, which will deliver tangible benefit in 2012 and beyond. So our reported sales with the discontinued ops treatment of CPG were $9.1 billion, up 15%, reflecting continued advancement in our new products, high-growth regions, continued strength in end market and growth from acquisitions.

Segment margins expanded 70 basis points to 14.3% in the quarter, including $80 million of payments made to Aero BGA OE customers in the quarter. We had very robust new product launches. So if you look at the commercial and business and general aviation side whether it's Embraer, Gulfstream or Dassault, we have a number of large platform wins with high content.

We generated earnings per share of $1.02, up an impressive 40% over 2010, and free cash flow of nearly $1 billion in the quarter, reflecting 120% net income conversion. This really reinforces the quality of our earnings performance, volume leverage and continued cost controls while maintaining our growth investments and our seed planting for the future.

Given the strength of our first half financial performance and positive outlook for the second half, we are again raising our full year guidance. We now expect earnings in the range of $3.85 to $4 per share, reflecting a 28% to 33% increase in earnings over the prior year. We think this is top-tier performance amongst our multi-industry peer group, and we're confident in our ability to generate strong earnings growth again in 2012.

The momentum we've seen across our end market is being supplemented by the results of our seed planting initiatives throughout the portfolio. Aerospace's commercial aftermarket continues to see a robust recovery, with spares up 30-plus percent and R&O significantly outpacing flight hours. Further, we're seeing the resurgence of the commercial OE cycle, where we're smartly positioning the business to capture new business opportunities. That means having the latest innovative new products and technologies like our recently announced joint development with Safran to provide green electric taxi capabilities for new and existing aircraft, saving airlines millions in fuel costs and slashing carbon and other emissions created during runway taxi operations.

Our short-cycle businesses, including Advanced Materials, ACS Products and turbochargers, continue to show a healthy pace of growth; while our longer-cycle businesses, like Process Solutions and UOP, are starting to kick in with double-digit growth in the quarter. Further, our investments and focus in emerging regions continue to pay off. Sales in China were up over 20%.

Our strong quarterly performance and improved outlook for 2011 reinforce that our strategy is working. Having great positions in good industries, the power of One Honeywell, our consistent focus on improving every year in each of our 5 initiatives, it really makes a difference.

So with that, let me turn the good news over to Dave.

David James Anderson

Thanks, Dave. Good morning, everybody, and thank you for joining us this morning. I'm going to start on Slide 4, and I'm going to take you through the summary of the results for the second quarter, first on a pre-disc ops basis, meaning that we would have reported as if CPG were included in our continuing operations and importantly, consistent with the way in which we guided for the quarter.

So as you can see on Slide 4, sales were up -- sales, rather, of $9.3 billion were up 14%, of course, reflects the high end of the guidance that we last communicated to you in early June. It reflects 7% organic growth with greater-than-expected growth in every region. The Americas were up 4% organic, Europe and Africa up 8%, and China, as Dave said, up 20%. Importantly, emerging markets remained very strong, with growth above 20% year-to-date on a constant-currency basis. Acquisitions contributed 3% growth, and currency yielded a tailwind of approximately 4% in the quarter.

Segment profit was up 20%. Segment margins, at 14.2%, reflected margin expansion in every segment when you exclude the Aero OE launch payments that Dave highlighted. And I'm going to take you through some of that detail when we get into Aero just -- but very quickly, in the quarter, Aero realigned milestones to better reflect business aviation -- several business aviation customers' platform development schedules.

Now as a reminder, and this is important when you look at the Honeywell financials, our Aerospace business does not capitalize payments to OE manufacturers to offset preproduction costs. Now as a result of the recognition of these expenses, we recorded about $80 million in the quarter, significantly higher than we guided for Aero this year. And importantly and strategically, it gives the company more capacity for R&D spend at a time when program funding, positive wins, et cetera, are a positive for the Aerospace business and the growth outlook for the commercial aerospace OE cycle.

And as I take you through the business highlights, you'll see that all of the businesses are doing a terrific job executing and delivering on those commitments and while continuing to invest for growth. And we'll take you through each of those business unit highlights in just a moment.

As Dave referenced, earnings per share of $1.02 were up 40%, above the high end of the guidance range. And just to refresh, we've guided on a same basis, $0.94 to $0.98 for the quarter. The upside in the quarter was driven by robust commercial aero aftermarket sales and another outstanding quarter from Specialty Materials.

Now a couple of items to point out. In the quarter, we recognized also $61 million in OPEB curtailment gains. These resulted from the resolution of ongoing labor negotiations and planned amendments in the quarter. We also had $7 million of net repositioning expense, which by the way, brings total repositioning to $51 million year-to-date, mostly covered with gains. And of course, consistent with our strategy to utilize onetime below the line gains, we're expecting to fully deploy the third quarter CPG sale gain with repositioning and other actions. And I'll touch on that a little bit later in our review this morning.

Lastly, on the income statement, the effective tax rate for the quarter was 27.6%, roughly in line with last year. Free cash flow, we were very pleased, $973 million, essentially equal to last year and an impressive 120% conversion of net income. And importantly, we absorbed higher CapEx investments, growth investments in the quarter primarily, as well as higher cash taxes versus the same period last year.

So in summary, another terrific quarter for Honeywell, better-than-expected earnings performance driven by higher commercial aftermarket sales, better conversion, primarily in Specialty Materials. And the below-the-line gains were more than offset by the recognition of the Aero OE payments and the repositioning actions we took in the quarter.

Turning to Slide 5. Now let's look at the same results on a post disc ops basis. Just quickly, we've recast both the second quarters of '10 and '11 to reflect the discontinued ops treatment of CPG. So the net earnings impact of CPG has been included in EPS from discontinued operations. And of course, sales, segment profit margin all reflect the change in both comparable periods. So in 2011, you can see $234 million of revenue from CPG, $22 million of segment profit has been removed and reported as net earnings per share from discontinued operations of $0.02.

CPG contributed roughly the same amount of net earnings in '10 as '11, so there's no change to reported free cash, and there is no change to reported free cash flow. So when you exclude CPG, you can see sales increased 15% year-over-year, 8% organic, and segment margins expanded 70 basis points year-over-year. And of course, going forward, we'll be reporting the financial results for Honeywell with CPG in disc ops and recast prior periods to reflect comparable performance.

So now let's move to each of the businesses, starting on Slide 6 with Aerospace. For the quarter, reported sales for Aerospace were up 6% to $2.8 billion. That would have been 9% in the absence of the increased launch contributions made in the quarter. We saw strong commercial aftermarket growth, partially offset by lower commercial OE sales due to the BGA OE payments I referenced earlier. Now the commercial OE sales decreased by 5%, but were up 11% excluding the OE payments made in the quarter.

We saw good growth from higher air transport, OE build rates and the continued uptake of airline selectables, along with the continued rebound in business aviation aircraft, driven by our strong positions in mid to large cabin classes. Think of that prominently as Gulfstream and Dassault. Going forward, we expect commercial aero OE growth of about 25% in the second half of 2011. Commercial aftermarket sales were up 21% in the quarter, reflecting strong spares figures, higher aircraft utilization rates and also RMUs.

Let me just take you through some of the details on the commercial aftermarket. Air transport regional flight hours were up about 5.7% in the quarter, and we're still expecting flight hours to grow about 5% for the full year, partly a function of robust delivery schedules, as well as the increased utilization of the existing fleets. Spares were particularly strong, up 30% in the quarter following a first quarter increase of 28%. In addition, we're seeing the older aircraft, which need more repair and overall, return to service and to the shop floor. R&O was up 15% in the quarter, more than twice the rate of flight hour growth.

Looking at the entire commercial aftermarket, the first half sales were up 17%. And we expect the second half growth rates to moderate somewhat, but we still expect mid-teens growth for the total commercial aftermarket in the second half of the year.

Defense and Space was up 1% in the quarter, and we're tracking ahead of plan year-to-date for D&S. We saw particularly strong international spares demand, partially offset by program completions, as well as anticipated program ramp downs. We continue to plan for further U.S. defense budgetary pressures in reprogramming, and we reiterate our forecast for low single-digit decline in D&S for 2011.

And again, while segment profit grew 2% in Aero, margins were significantly impacted by the BGA OE payments that I referenced earlier that we recognized. And if you exclude the impact of these payments on a year-over-year basis, margins would have been up 110 basis points to 17.1%. Now again, what that analysis reflects is the difference between launch contributions second quarter 2011 and the same launch contributions in the same period last year.

Let's now turn to Slide #7 and the Automation and Control Solutions, that's ACS. ACS, as you can see, sales were up 20% in the quarter reflecting 5 consecutive quarters of strong organic growth. Acquisitions, mainly Sperian, added 8%. Foreign exchange contributed 6%. The ACS continued to see good emerging market penetration, sales up over 25%, led by China and the Middle East. The ACS products businesses, up 23% reported, 6% organic, reflecting growth across the portfolio despite continued softness in the construction markets.

Now we continue to see good growth in industrial, the PPE business, the personal protection equipment business, gas detection, sensors controls, ECC, environmental controls. Further, the HVAC controls, security and fire products, pieces of ACS, saw meaningful improvements in June with an uptick in retrofit activity, driven primarily by new product introductions, energy efficiency, competitive wins and code requirements.

The Solutions business were up 16% reported, 5% organic, double-digit reported growth in Process Solutions as they execute on their large global project backlog. Building solutions is expected to accelerate to mid- to high-single digit organic growth in the back half of 2011 as some of the large wins from late 2010 we will begin to convert from backlog to revenue. And by the way, the backlog in the total Solutions businesses remained strong, up mid-teens organically in the quarter.

ACS sales conversion was about 15%. Segment margin up 40 basis points to 12.8%, reflecting strong volume increases in productivity, partly offset by inflation and the investment for growth across the portfolio. And significantly, you'll recall the investments that we began to make in this business since we saw the resurgence in the second half of 2010.

Now lapping these investments in the Sperian close last year, the ACS expects higher conversion rates in the back half of the year, however, partially offset by the dilutive impact of the recently announced EMS acquisition. We now expect full year margins for ACS to be up approximately 50 basis points over 2010.

Let's now transition to Slide 8, Transportation Systems. Again, when you look at Slide 8, CPG is no longer being reported within the Transportation Systems segment. In the quarter, TS sales were up 26%, driven by volume increases primarily in turbocharger sales. Turbo sales continue to outperform the industry macros. During the quarter, light vehicle production declined 3%, but importantly, European diesel penetration expanded 3 points compared to last year. However, turbo unit sales were very strong, up high teens in the quarter. This performance reflects the high win rate on both new gas and new turbo diesel platforms globally.

To put it in perspective, about 1/3 of the growth that we saw in the quarter came from favorable industry macros, 2/3 of that came from the benefit of successful new launches. Segment profit for TS was up 45% from last year. Margins expand 160 basis points to 13% due to volume increases in productivity. These were partially offset by higher commodity costs.

Let's now go to Slide 9, Specialty Materials, which obviously saw another terrific quarter. Double-digit growth in both UOP and Advanced Materials and high incremental sales conversion. Sales in the quarter for SM in total were up 12%. Segment margin was again very high at 20%. Now sales at UOP for the second quarter were up 12%. We saw a growth in services related to the ongoing front-end engineering and design work, or FEED, with Petrobras, as well as higher licensing and refining catalyst revenues.

We continued to see the recovery and benefit from the recovery in the global refining, as well as the continued strength in the petrochemical industries. UOP's book-to-bill ratio remains above 1, and we expect to see growth in UOP accelerate in the second half, driving full year growth towards the high teens.

Now Advanced Materials sales in the quarter were up 12%. We saw strong end market demand and tight supply conditions still prevalent in many of our key segments. We saw strong demand for caprolactam resins in Asia. Fluorine products were up 8%, driven by seasonally strong demand for refrigerants and tight industry supply conditions. And Specialty Products is also up an impressive 14% in the quarter with above-market growth led by penetration of new product introductions.

Segment margin for SM continued to be high in the second quarter due to favorable prices over raw material spreads, higher licensing revenues and also continued productivity, partially offset by investments that we're making for growth, as well as the continued investment in plant reliability and upgrades. And while we continue to expect a good year from SM, the margins, as we've said before, we don't believe are sustainable at this rate due to both seasonal factors, as well as supply-demand and commodity inflation factors, which we believe will adjust over the rest of the year.

Additionally, of course as a reminder, the acquisition of the phenol plant from Sunoco, which we expect to close imminently, will be dilutive to margin rates and will add about $250 million of sales to the second half with little to no profit this year.

So as a result of the better-than-expected conversion we again saw in SM, we're now planning SM margins over 18% for the full year, excluding the dilutive impact of the phenol plant acquisition in the third quarter. And again, this represents -- this acquisition represents about 250 basis points of improvement. I'm sorry, the margin rate that we're now forecasting for SM represents about 250 basis points of improvement over 2010 in spite of continued investments for growth and plant reliability.

Now let's go to -- having gone through the 4 segments for the second quarter, let's go to Slide 10, talk about an update for our end markets, what we're seeing and what we're expecting. Now given the pace of the strong second quarter performance and the economic uncertainty that still lingers, obviously, we'd like to take just a few minutes to just give you some more backdrop of how we're thinking for the remainder of the year.

So starting with Aerospace, the commercial spares and R&O continue to gain traction, with total commercial aftermarket up 7% sequentially from the first quarter. Airlines and business jet operators are catching up on deferred maintenance. We've seen a moderate amount of restocking of inventory at the airlines. The commercial OE backlog is robust, and we think will provide a tailwind for growth for 2012 and beyond in spite of the expected declines in defense. We're planning for low-single digit declines there, driven by further defense budget pressures and reprogramming.

For ACS, we continue to see the positive impact of industrial recovery supported by increases in manufacturing production. However, we're seeing growth moderate as we lap tougher comps in several businesses, including S&C, scanning and mobility and ECC, where they're already at or exceeding prerecession highs. The developed market external indicators continue to show softness in the commercial construction end markets for ACS though we've seen some improvement in residential construction, but we're still planning for a soft and slow recovery there. And in the emerging markets, we continue to see a plan for good organic growth.

For the ACS Solutions and UOP businesses, we're executing on large project backlog and obviously, wins to date. And these long-cycle businesses will continue to experience positive multiyear growth cycle, with book-to-bill ratios currently above 1.

And SM's Advanced Materials business is benefiting from a healthy global end market. The growth in profitability, however, as I've said earlier will moderate as supply-demand conditions and price to raw spreads stabilize while volume growth will still be robust.

And lastly, for the global automotive outlook, we see production rate stabilizing after several initial adjustments from the Japan earthquake which affected numbers earlier in the year. However, we expect turbocharger sales growth to continue to outpace the industry macros, given the success of new launches. However, we expect the rate of growth to moderate as production schedules and diesel penetration rates level off.

So with that backdrop, that summary backdrop, let's go to Slide 11 and talk about first half to second half comparison. What we're showing here in the bars are the actual and forecasted first and second half 2011 sales growth rates for each of the major businesses. These are intended to highlight the expected linearity in each of the businesses. We've broken out the estimated impact also, as you can see, from acquisitions as well as foreign exchange. So you can see the organic growth acceleration and deceleration across the portfolio.

And what stands out clearly is -- on the slide, is Defense and Space with the anticipated decline there, the continued strength in commercial Aero, continued good organic growth in ACS Products and Solutions, slowing growth as we talked about in TS in the back half of the year with tough year-over-year comps and finally, very strong growth planned in UOP and Advanced Materials. And you can see for Advanced Materials, we've adjusted that for the phenol plant acquisition in the second half to give comparability on a half-over-half basis.

Let's now go to Slide 12 and talk now about translating that outlook in terms of outlook for financial performance in the second half. So we expect continued good organic growth in the range of 5% to 8% compared to 9% in the first half, and total sales growth in the range of 9% to 12%. We expect a slight tailwind from foreign exchange with the euro in the range of $1.35 to $1.40 and a favorable impact from net M&A.

Now we had strong pricing and productivity in the first half, growing segment margins 90 basis points over 2010 levels. We expect the second half sales conversion will be slightly lower due to tougher year-over-year comps, moderating price to raw spreads in SM and the dilutive impact of acquisitions.

Also it's important to provide you with an update on our tax rate assumptions. You'll recall the first half tax rate was slightly higher than our usual ongoing rate of 26.5%. And there's always obviously variability from quarter-to-quarter, but we're planning for about 26.5% for the full year with the various planning initiatives yielding a slightly more favorable rate in the second half.

And lastly, we're well on our way to achieving our full year target of 795 million weighted average fully diluted shares. During the quarter, we deployed $500 million to share repurchases, and it puts us on track to achieve the roughly $1 billion in share buyback that we're planning for the full year.

So with that framework for the second half, let's go to Slide 13, quickly review our third quarter sales outlook. In total on Slide 13, we're planning for company sales in the range of $9.1 billion to $9.4 billion, up 12% to 15% from the third quarter. We talked about many of the drivers for our businesses, including Aerospace and ACS and SM, those are all consistent themes. One item we're pointing out on this slide is we anticipate third quarter sales in TS to be sequentially lower as a result of seasonal summer shutdowns at the European OEMs, which is consistent with our view also of stabilizing diesel penetration and production rates. And you'll recall last year in the third quarter, we had abnormally high production rates in the third quarter with lower-than-normal seasonal shutdowns at the European OEMs.

Slide 14, the third quarter earnings guidance. Let's take a moment now to review our third quarter EPS guidance, which we've reflected as a [indiscernible] from our strong second quarter operational performance. So we'll start with the $1.02 for the second quarter. Layering on our normal seasonality and the continued growth we're expecting, we're forecasting $0.04 to $0.08 higher operating earnings. And as I mentioned earlier, we're also expecting pricing and seasonal headwinds from Fluorines products and normal summer shutdowns by the European automotive OEs affecting turbo. This translates into sequential, approximately $0.06, headwind.

Depending upon the timing within the quarter, we think the EPS dilution associated with the loss of CPG, as well as the dilutive impact of the EMS acquisition in the third quarter, will be in the range of $0.03 to $0.04 compared to the second quarter. Therefore, we'll arrive at an all-in third quarter guidance range of $0.96 to $1.01.

And now let's go to Slide 15 and now fold in the impact associated with the CPG sale. So consistent with what we've said previously, we'll book a gain of approximately $150 million after tax associated with the CPG sale. Think of that as $0.19. And we expect to fully redeploy that gain with repositioning and other actions in the third quarter. So for reporting purposes, the gain on the sale of CPG will be recognized in discontinued operations, while the redeployment of the gain will be netted in continuing operations. So to ensure there's no confusion, what we've shown you on this slide is both our all-in EPS guidance for the third quarter, as well as our continuing operations EPS guidance, both including and excluding the gain redeployment.

So moving to the right of the page, we're still planning to efficiently and accretively redeploy the proceeds of approximately $950 million. About $400 million will be allocated to the U.S. pension plan, or to the extent it offsets, the cash tax gain on the sale. This will bring our 2011 cash pension contributions to approximately $1.4 billion, and the funded status to approximately 90%, which significantly closes the gap on future funding obligations. The remainder of the proceeds will be directed to buybacks to continue to fund our share repurchase plan of approximately $1 billion for the year. Again, as Dave said at the outset, we're very pleased with the progress we've made on this transaction and expect it to close early in the third quarter.

So let's go now to Slide 16 and talk about the full year financial guidance there and some of the important updates, as well as the kind of the puts and takes, if you will, on that guidance. We've increased our sales outlook for the year importantly to $36.1 billion to $36.7 billion, and again, now assumes discontinued operations treatment for CPG for the entire year. So versus our prior guidance of $36.0 billion to $36.6 billion, we're now excluding roughly $500 million of previously assumed sales from CPG. The revised outlook reflects an increase in core revenues of approximately $600 million at the midpoint. It's an organic increase of about $150 million spread across all of our business segments, about $100 million from favorable foreign exchange relative to our prior guidance. And again, we're using the range of about $1.35 to $1.40, so think of that as the midpoint of that range. And about $350 million from announced acquisitions.

We've also shown the full year split between continuing and discontinued ops, with a gain residing in discontinued ops and the offset in continuing operations. Given the first half performance, the momentum we're seeing in the businesses, we're raising our full year 2011 earnings outlook by $0.05, so the bottom of the range moves from $3.80 to $3.85 and the top of the range moves from $3.95 to $4. It reflects a gross increase of $0.08 on the low end and high end as we're now absorbing approximately $0.03 to $0.04 of dilution from acquisitions that wasn't in our prior guidance. We're also confirming our free cash flow outlook for the year in the range of $3.5 billion to $3.7 billion prior to U.S. pension contributions, cash contributions.

Now in our revised outlook for the year, we think that we've maintained a balanced view given the uncertainties that surround the global macro environment and the volatility in the commodity and foreign exchange markets. While we expect UOP growth to accelerate further in the second half due to the project nature of UOP and the lumpy shipment timing, you could expect there could be some volatility quarter-to-quarter, and project timing could delay. On the other hand, on the positive side, we're encouraged by the rate of improvement and uptick on the commercial aerospace market. And if pricing holds, we believe SM could be even better than we've guided.

So as we sit here today, we feel we have a path to a high end of the outlook range. We're also appropriately covered on the downside should the economy slow and the euro move lower.

So just summarizing then on Slide 17. Obviously, another terrific quarter for Honeywell, reflecting continued positive momentum across the portfolio. The businesses are executing well, they're delivering on their commitments, and they're continuing, very importantly, to invest for future growth. Our order rates remain positive. But as we experience tougher comps in the second half of the year, the organic growth will obviously moderate. The commercial aerospace recovery is clearly underway. And as Dave mentioned earlier, we continue to see exciting new opportunities across the businesses to feed incremental growth. We're also pleased with how the mid to late cycle businesses are firming up, with the growth in UOP and ACS Solutions accelerating into the second half of the year. All in, it's shaping up to be a great year with every segment contributing to top and bottom line. And as a reminder, the third consecutive guidance increase that we've made for the year.

So in closing, just another backdrop to a positive quarter and outlook. We've just finished our strategic planning reviews with each of our businesses. We came energized about the outlook for 2012 and beyond. We saw evidence of sharp execution, the benefits from seed planting, productivity initiatives, tailwinds from the smart redeployment of gains we think will add to that as we redeploy smartly the CPG sale proceeds. And we're encouraged by the quality of the acquisitions that we've been able to complete and the accretion that those set up for us for 2012 and beyond.

So with that, Elena, let's turn over to you for Q&A.

Elena Doom

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

Question-and-Answer Session

Operator

[Operator Instructions] And first on the line, we have Jeffrey Sprague with Vertical Research.

Jeffrey Sprague - Citigroup

Dave Anderson, could you give us a little more color on how exactly you're going to deploy the gain through disc ops? What form of restructuring and other actions you're going to take? And how we should think about payback on that as we look into 2012 especially.

David James Anderson

Yes. Well, Jeff, we're still -- one of the benefits obviously of the timing of the close is we've had the opportunity for continued refinement in terms of the redeployment of the gain. And I think now that it's kind of here in black-and-white, so to speak, we're going to see the businesses, I think, really step up. We've got a lot of good proposals, a lot of good suggestions, in terms of repositioning suggestions. But I would submit, Dave, that we're going to see a lot of continued recommendations in terms of opportunities to smartly redeploy the gain. My view today, as we sit here today, is we're going to see most of this go in to repositioning. And Jeff, I think it's going to be across most of the businesses. I think we'll see redeployment of the gain across most of the businesses. Importantly, I think some of those actions are going to be a little bit longer payback because some of it is just some of the tougher, tougher stuff that inevitably the size of gain, et cetera, the all-at-once nature of it will support. So my guess is that we'll see something in the neighborhood of 20% of that providing incremental benefit to 2012. And on the average, probably payback in the range of about 3 to 4 years, I would think, in terms of what we'll be looking at for this. But definitely, we'll see accretion in positive for 2012 as a result of redeployment of the gain. The other thing to remind you is IRR projects -- and the other thing, I think, to point out. By the way, Dave makes a very good point because the difference between book where we'll be writing off facilities potentially and everything could have longer paybacks. When you really look at the cash IRRs, Dave makes a very good point in terms of IRRs. The other thing I think to keep in mind is we've also got the tailwind of other repositioning that we've done. As I mentioned earlier in terms of total year-to-date, it's about $51 million, most of that covered by gain. That will also benefit 2012, 2013.

Jeffrey T. Sprague

What is the prospect of additional OE payments? And I didn't quite understand the comment that, that's giving you more bandwidth, so to speak, to ramp up the R&D. Could you explain that?

David James Anderson

Sure. Well, the way we look at it is this: Number one, the launch OE payments are really a by-product, as you know, of the significant platform wins that we've experienced, particularly in business aviation. And we expense those as milestones are incurred. We do not capitalize those.

David M. Cote

Unlike most of our peers.

David James Anderson

Unlike most of our peers. During the quarter, we booked significant incremental launch contributions, Jeff. On a year-over-year basis, it represents about $36 million of increased launch contribution which translates to about a 110 basis point impact for the quarter. Now importantly, what we're able to do is to reschedule certain milestones with our OEs to be able to recognize those launch contributions in the quarter, which otherwise would have been -- about $70 million or so of that would have been 2012 expense. From our perspective, what that does is it simply creates more, on a same earnings basis for 2012 for Aerospace, just creates more capacity for R&D spend against growth platforms. And given the very robust nature now of the commercial OE cycle and what we're seeing in terms of opportunities, of what we have in, if you will, portfolio today, as well as opportunity going forward, strategically this is the smart thing to do. So importantly, we wanted to just point that out to you as well. And again, a smart redeployment of some of the positive below-the-line items that we're able to manage to achieve in the quarter.

Jeffrey T. Sprague

And just one last little, just kind of stylistic question. I think obviously, people this morning are kind of struggling with getting their head around the gain being in disc ops and the cost and redeployment being in continuing. The math is there, I think the dust has settled, but just stylistically, was there any reason to put this in disc ops? Why couldn't CPG have just stayed in operations until it was actually out the door?

David James Anderson

Our controller forced us.

David M. Cote

It's just the way the accounting works, Jeff. Believe me, we asked the same common sense questions that you are asking, but common sense doesn't prevail here, accounting rules do.

Operator

Our next question comes from Steven Winoker with Sanford Bernstein.

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

On the margin side, if you could dive a little bit further into the pricing experienced in ACS, for example, versus the material inflation, maybe break that out, give us a little color there, that would be helpful, as you think about how that is progressing going forward. And pricing pressure overall across your businesses, is it accelerating or decelerating?

David M. Cote

Pricing's doing well across all our businesses. We've had a constant focus on it for 10 years now, and it really pays to just keep doing that. So we don't see pricing pressure affecting us all that much. And when it comes to raw material price in the other direction, that's something that would be anticipated. And we're not seeing anything that we didn't anticipate. I would say to Dave's point, one of the nice things we have seen is the supply/demand imbalance in Specialty Materials, which has helped us in a couple of product lines when it comes to pricing, demand exceeding supply. But I would say we're not seeing anything negatively untoward in here. Dave, have you seen…

David James Anderson

No, not at all. And Elena, you've got some color, I think, on the...

Elena Doom

For ACS, sure. Steve, for ACS, I think they saw roughly 100 basis points of improvement on net price over raw spread. And when you net that against obviously, their labor inflation, they would roughly offset.

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

Okay. All right. And overall, because you talked about it, I think the equivalent is 210 basis points of volume mix and productivity versus a 280 headwind in Aero also. So on the Aero side, what productivity numbers are you putting up there in terms of how much of the benefit's productivity?

David James Anderson

Very good productivity. Yes, I think productivity really offsets inflation in Aerospace in the quarter.

Elena Doom

Yes. And higher R&D investments as well.

David James Anderson

Yes.

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

Okay. And you're expecting that to continue going forward in the back half of the year?

David James Anderson

Yes.

Elena Doom

In conjunction with favorable mix, Steve, from obviously the growth that's coming out of the commercial aftermarket.

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

Okay. And just looking at the ACS Products versus Solutions mix in the back half of the year, with Solutions growth picking up pretty significantly on that slide you've got. Is the mix impact, how negative is that, are you anticipating?

Elena Doom

About 50 basis points maybe in terms of the overall ACS margin in the second half of the year. But it's not an event.

David James Anderson

And you will have some headwind obviously, as we pointed out, from the EMS acquisition in the second half. But we'll see -- I think we'll see, Steve, as I mentioned earlier, we'll see attractive margin rates and see attractive conversion, particularly as we progress through the remaining 6 months for ACS.

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

And just last question, you mentioned, you commented on residential construction seeing some recovery in that, which is certainly a mixed bag from what we've heard elsewhere in other competitors, and still being a soft market. Could you maybe clarify where you're seeing some kind of positive signs there?

Elena Doom

Yes. First, Steve, I think it's really specific not so much to the end market because you're right, the data would suggest that it's in fits and starts. But where we are seeing obviously benefits in residential are more on the retrofit side, obviously within ECC, HVAC and also in our security products, where we have a lot of new products. And they're just executing well. And that seemed to come through more in the month of June.

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

So is it replacement of control systems and things like that for energy prices?

David M. Cote

Retrofit.

Elena Doom

That's right. Plus, you add on the sort of lifestyle management [indiscernible] offerings.

Operator

Our next question comes from John Inch with Bank of America Merrill Lynch.

John G. Inch - BofA Merrill Lynch, Research Division

Let's start with Specialty Material. How much did favorable spreads, kind of on a year-over-year basis, benefit that business versus last year? And maybe you could just -- if you could just maybe identify the trajectory. Because I believe you benefited from favorable raw purchasing last year, if I'm not mistaken. Just how does that play into first half versus second half?

David James Anderson

[indiscernible] introduce, just talk about that a little bit. What we saw is a number of positives, John, including very importantly, favorable price in Tier 1. We saw customers restocking inventory in floorings. We saw Asian customers converting to HFCs. Think of that as forwards MA [ph] rather than later. And also we benefited because there was, on the supply side, still some bottled-neck production, which created market tightness. So all of those created kind of a terrific window for us in terms of positive in Fluorines. We also saw very strong demand, as I mentioned in my comments, for caprolactam, particularly Asian demand for caprolactam. And of course you know, again we're the global low-cost producer there. So we saw a very good set of market conditions. We will continue to see pretty good end markets. And interestingly enough, when you look at the acquisition adjusted growth rate for Advanced Materials in the second half, it's about the same as the first half of 2011. But importantly, it's more volume driven in the second half, more price driven in the first half. Because what we're seeing now is evidence of more normalization, as I said to you, in terms of the supply-demand rebalance. We're seeing more of the Asian production now on the Fluorine side come online. So we'll still see very good end markets we believe, John, but it's going to shift in terms of the volume versus price contribution to that growth. As a result, we won't see the same level of margin in the second half that we saw in the first half. That's the basic story.

Elena Doom

Maybe to put some of that into perspective on the numbers. So we actually saw, for example in Fluorine products, prices peak in the April to May timeframe, and it's actually small, about 10% over the last few months. So in terms of the numbers, in the first half, Specialty Materials probably saw close to 500 basis points of margin lift from positive price of the raw spread. And that's going to moderate down to maybe 100 basis points in the second half.

John G. Inch - BofA Merrill Lynch, Research Division

But you also saw very favorable raw buying, did you not? Or experienced favorable raw buying that also dissipates. Is that part of this sort of downshift in margins?

David James Anderson

That's right, John. What we had was, you'll recall, smartly, we pre-bought one of the ingredients that's now on the Fluorine side in the second half of 2010. That benefited us in the first half of 2011. That's now pretty much worked its way through the system. So we won't have that benefit as well. So a variety of positives that really led to very, very strong first half margin performance, particularly in the Advanced Materials piece of that. We see good end market conditions but less favorable supply-demand conditions, which will translate, as I said, to just lower margin rates in the second half.

David M. Cote

And there’ll be upside.

John G. Inch - BofA Merrill Lynch, Research Division

Yes. And what kind of acceleration are you expecting at UOP in the back half? And does that also sort of translate in terms of the volume contribution benefit to the margins there?

David James Anderson

It does. We had about between 12% and 13% growth in the first half. We're going to see much stronger...

Elena Doom

20% to 25%.

David James Anderson

20% to 25% in the second half, John. So we'll see, as always, mix is a factor that will influence that. We are seeing favorability in terms of catalyst, particularly catalyst reloads. So we're expecting a good second half out of UOP. Now as I've stated, as we put on the full year guidance slide, on the sort of the puts and takes, one of the considerations would obviously be, and always is, UOP timing. So will it be as robust? Potentially not. On the other hand, we clearly have, we think, net upside particularly on the SM and Advanced Materials side and probably the Aero aftermarket. But UOP is very well positioned. We've got now a very strong book to bill. I think book to bill is at 1.3 now in UOP. So it's good numbers, and that's going to translate into a strong second half '11 and strong 2012.

John G. Inch - BofA Merrill Lynch, Research Division

And do you think -- I was going to say that carries through to '12. And just to be clear, some people may be thinking this is a function of the Petrobras win. That's probably not true, is that accurate? It's broader based than that?

David M. Cote

It is broader based, yes.

Elena Doom

Petrobras this year, John, think about that adding about half of the growth. So half of the, call it, 18% to 20% that we're expecting for the year is coming from the Petrobras contract.

David James Anderson

And by the way, that book to bill, John, and it's about 1.0 at this stage. So it's built up to now 1.0 for UOP.

John G. Inch - BofA Merrill Lynch, Research Division

I'm sorry. What was the 1.3? That was just a misstatement?

David James Anderson

That was an error. 1.0.

John G. Inch - BofA Merrill Lynch, Research Division

Okay. And then just was curious on your European businesses. Some companies have talked about Europe. I'm presuming because of the impact of some of these non-northern Nordic countries slowing things a bit, I mean, are you -- kind of what are you guys seeing overall? I know you'd never planned, Dave Cote, for Europe to be all that great. I'm just curious. Are you seeing business sort of decelerate at the margin? And all else equal, I mean, would the focus of some of this restructuring be in Europe just because obviously, the trajectory there could be a lot slower over time than it has been?

David M. Cote

Actually, our businesses have been growing pretty well in Europe, and better than we had expected. I would say that the economy you could point to is that Northern Europe tends to be much stronger for us than Southern Europe. And when it comes to restructuring possibilities, we'll be looking at that across the world. So it's probably too early to say where we might do something or not at this point.

John G. Inch - BofA Merrill Lynch, Research Division

Just lastly, where was defense better? And is that sustainable, or are you still thinking the down numbers kind of come back in the second half?

Elena Doom

John, you're referencing -- defense and Space is up 1% in the quarter, but we are still forecasting a low-single digit decline in Defense for the year. And the strength really came from the international spares business.

David M. Cote

It's another one, John, where I'd say we've done better than we expected, but we think the smart way to plan for Defense is to assume it's going to decline. It's just everything that's going on with the debt deficit, it's hard to imagine it doesn't get affected somehow.

John G. Inch - BofA Merrill Lynch, Research Division

Okay. But just so I'm clear, the international spares, that was -- why is that better? I mean, I guess the question is, I realize what you've sort of described in the outlook, but obviously, Defense, Space is longer-term in structural headwinds. I'm talking the industry, not necessarily Honeywell. So is this kind of a short-term benefit to who still -- what's the long term kind of slow bleed, or do you think there's some other opportunities here that maybe caused your thinking to change a little bit?

David M. Cote

I'd say you were correct in what you were saying in terms of how we're looking at the year. However, I think internationally, there is going to be something more for us there as we've said in the past. Just because quite honestly, we didn't pay that much attention to it. Now that we are, it's surprising, the opportunities that we're uncovering for ourselves. You could argue we should have grabbed it years ago, but we didn't. It's certainly coming at a good time now though, when we're looking at how do we offset the anticipated U.S. defense declines.

Operator

Our next question comes from Shannon O'Callaghan with Nomura.

Shannon O'Callaghan - Nomura Securities Co. Ltd., Research Division

So just to clarify. So on the $80 million, that hits the same in the revenue and the profit line, right? For the launch costs?

David James Anderson

Yes.

Shannon O'Callaghan - Nomura Securities Co. Ltd., Research Division

Okay. So I mean, that's a pretty big number, $80 million. I mean, it's -- what was the number for all of 2011?

Elena Doom

It was about a hundred -- in terms of 2011, Shannon?

Shannon O'Callaghan - Nomura Securities Co. Ltd., Research Division

I'm sorry, 2010. What was it last year?

Elena Doom

Yes, I think it was about $110 million.

Shannon O'Callaghan - Nomura Securities Co. Ltd., Research Division

Right. So what happens -- I guess what happens to launch costs in the second half, given that there was such an unusually large number in 2Q?

David James Anderson

Well, it's going to be a lot lower obviously. I mean, I think the full year number we're looking at, Elena, it's probably in the $100 million to $110 million range for this year. So it's going to be a lot lower in the second half. And importantly, Shannon, as we talked about earlier, it's not completely, but significantly cleared the decks then for 2012. So we think that's a very smart thing to have done. The geography is a little bit complicated as you point out because it's a net deduction and a reduction in both revenue and operating income segment profit for Aero in the quarter. But I think people see through that. They understand the purpose and the benefit of doing it, and the fact that we've been able to offset it in the quarter.

Shannon O'Callaghan - Nomura Securities Co. Ltd., Research Division

How should we think about, I mean, incrementals I guess? And just -- I don't know, what's your new sort of Aerospace target for the year? What are you thinking for the back half? Because we've had this big item you're talking about, some offsets from R&D. But x the administrative launch cost, your Aero margin would have been like 18.4%. Obviously, you don't have no launch costs in the coming quarters, but that's a big number to offset with R&D. I mean, do you expect -- what's the range of margins you're now expecting for Aerospace as we look from here?

Elena Doom

The range, it's roughly about 17.5% at the midpoint for the margin rate for the year, Shannon. And the way I would think about the conversion, obviously, the second half would be higher than the conversion rate we got in the first half. I think on an adjusted -- so if I adjust it for the Aero launch contributions in the quarter, they would have done about 22% from an incremental sales conversion rate in the second quarter. So it will get better in the second half, and we're on path to about 17.5% for the year.

David James Anderson

Yes, think of the first half segment margin as around 17.2% on adjusted basis for Aerospace versus the 16.7% reported. So obviously, to Elena's point, we've got lift in Aerospace segment margin in the second half into the 18.2%, 18.3% kind of range to be expected, arriving at that 17.5% for the full year.

Operator

Our next question comes from Howard Rubel with Jefferies.

Howard A. Rubel - Jefferies & Company, Inc., Research Division

I have 2 and I'll try to keep it there. One, Dave, every time I turn around, I seem to be seeing biofuels on every commercial aircraft, in more and more places, especially in Europe. What are you doing in terms of -- I know you've been at the forefront of this, but it is a big deal and it looks like it's becoming bigger faster.

David M. Cote

Yes, I think it's a brilliant idea. And it's one where unlike the biodiesel that everybody always talks about, biodiesel's very corrosive to engines, pipelines, to sensing devices. So you can't blend it to more than 10% to 15% with petro fuel. The stuff we have is also made from second-generation feedstock like camelina, jatropha, algae and can be used as a drop-in replacement in cars, trucks, ships, that kind of thing. When it comes to aviation, it has to be blended to 50-50 because of the aeromatics that you need from the petroleum products. But at the end of the day, our stuff's been used extensively, and we've even flown jet fighters at supersonic speed, as you know. So the stuff works. I think it's something that I always thought was going to proceed pretty slowly just because there's infrastructure required when it comes to how do you gather up the plants to be able to generate the oil. The process works great, but you still got to be able to get the oil. That being said, it's accelerating a lot faster than I expected largely because of pull from the aviation industry, as they start worrying about carbon footprint and how do they reduce emissions and all that kind of thing. So we're not counting on it for a lot, and we haven't, because when you have a new technology like this, sometimes it can be slower to adapt than you might expect. But I'd say the way everybody's starting to pull on it now, it's quite encouraging.

Howard A. Rubel - Jefferies & Company, Inc., Research Division

No, fine. I appreciate that. And then second, I think in the release, you talked about organic growth being good, and then I thought about the fact that you’ve talked about you just finished sort of your strategic planning. Could you share with us a little bit of what kind of marching orders you gave to your businesses in terms of the organic growth targets you'd like to see out of them for the next 12 to 18 months?

David M. Cote

Well, this is going to sound kind of boring to you, Howard, because it's going to be pretty consistent with what I always say. I think when it comes to can you really forecast on out, within 2 or 3 percentage points, what your growth, organic growth, is actually going to be -- is a exercise in futility because you just really don't know. The thing you want to do is make sure that you've set up all the dynamics so that you will take full advantage of whatever markets do occur and that you can gain share in those markets. Interestingly, you've heard me say a lot, consistent strategy, execute day by day, quarter by quarter, and that's pretty much what the message was to everybody in our strategic planning discussion. The plans they have make a lot of sense. They are, we'll say, 90% consistent with what they've said the year before and the year before that. There's always some tweaking you do. But largely, the message to all of them was just keep doing what you're doing and do what you said in this plan, and things will be great.

Operator

Our next question comes from Christopher Glynn with Oppenheimer.

Christopher Glynn - Oppenheimer & Co. Inc., Research Division

I have a question on the ACS lower margin guidance. How does that split up between the acquisition impact and maybe higher growth investment that you've ramped into the system?

David James Anderson

Chris, are you talking now about the full year guidance in terms of the segment margin guidance for ACS?

Christopher Glynn - Oppenheimer & Co. Inc., Research Division

Yes, I am.

David James Anderson

So we're looking, Elena, I guess somewhere in the 13.3% to 13.4% range.

Elena Doom

Yes, that's right. With margins up about 50 basis points year-over-year.

Christopher Glynn - Oppenheimer & Co. Inc., Research Division

And the EMS acquisition impact?

Elena Doom

It's probably in the 40 to 50 basis point range. And obviously, in terms of the growth investments, those because they're weighted more to the first half, they affect the first half more, Chris, than they will in the second half. So you'll see again, conversion in ACS dramatically improving in the fourth quarter once we've lapped both the Sperian closing date on September of 2010, as well as the growth investments that were made late last year.

Christopher Glynn - Oppenheimer & Co. Inc., Research Division

Okay. And then the licensing revenues at Specialty Materials, I believe it’s straight drop through. And I'm just wondering how recurring that is, and if there's really an expanded run rate of that business there.

David James Anderson

Well, it's a lumpy business when you look at it on a quarter-to-quarter basis. Annually, it tends to operate pretty close to what we guide or what we plan. The long-term trajectory is very positive. What we have is continued growth outlook in terms of major projects. And Chris, obviously, as a very significant player in the global refining and petrochemical industries, we're going to win a meaningful rate of the both projects and catalysts for those new projects. But I think you just have to look at UOP as a growth business. And as we said, about 13% during the first half, probably 20% plus in the second half. So I think that's just underscores -- and that 1.0 book to bill that I referenced really underscores the long-term growth rate. There's going to be a distribution between licensing projects...

Elena Doom

Equipment.

David James Anderson

And products, other products, catalysts, equipment, in terms of the mix. But all of that portends very positive with the basically structural market forces, portends strong growth outlook for UOP.

Elena Doom

All right. I'd like to hand the call over to Dave Cote for any closing comments.

David M. Cote

Well, we're very happy about the results for the quarter and what we can do for the year. And we're going to continue to deploy those gains smartly to make the businesses even better going forward as we have historically. Now as I was saying to Howard earlier, our consistent strategy, constantly deployed day by day, quarter-by-quarter, year by year, it does continue to propel us to just great places.

We'll continue to do the seed planting in new products and services, geographic expansion, process initiatives and restructuring that continues to build just a great future. We are wrapping up our strategic planning process now, and we're excited about where all that seed planting is taking us.

So thank you for listening today, and we hope you enjoyed the quarter's results, and have a good summer. Thanks.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program. You may all disconnect. Everyone, have a great day.

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