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Honeywell (NYSE:HON)

Q2 2007 Earnings Call

July 19, 2007 10:00 am ET

Executives

Murray Grainger - VP, IR

Dave Cote - Chairman & CEO

Dave Anderson - SVP & CFO

Analysts

Shannon O'Callaghan - Lehman Brothers

John Inch - Merrill Lynch

Jeff Sprague - Citigroup

Deane Dray - Goldman Sachs

Nicole Parent - Credit Suisse

Robert McCarthy - Banc of America Securities

Howard Rubel - Jefferies

Nigel Coe - Deutsche Bank

Presentation

Operator

At this time I would like to welcome everyone to the Honeywell conference call. This is the Q2 '07 earnings release. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session (Operator Instructions).

I would now like to introduce Murray Grainger, Vice President of Investor Relations and turn the call over to him. Sir, you may begin your conference.

Murray Grainger

Thank you, Matthew. Good morning and welcome to Honeywell's second quarter 2007 earnings conference call. This is Murray Grainger, Vice President of Investor Relations. With me here 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, www.honeywell.com/investor.

Note that elements of this presentation contain forward-looking statements that are based on our best view of the world and of our businesses as we see them today. Those elements can change and we would ask that you interpret them in that light. This morning, we will review our financial results for the second quarter and our expectations for the remainder of the year, and of course, allow time for your questions. With that I'll turn the call over to Dave Cote.

Dave Cote

All right, thanks, Murray. Well, folks, it's another marvelous quarter from Honeywell. Second quarter sales were up 8% to $8.5 billion with 8% organic growth, and we're continuing to benefit from our global footprint and great positions in good industries. Segment profit was up 10% to just over $1.1 billion and segment margin was up 20 basis points.

The growth in segment profit combined with reduced below-the-line expenses resulted in a 17% increase in net income from last year. When you add in the impact of lower share count, EPS was up 24% to $0.78 a share, $0.03 over the high end of our previous earnings guidance for the quarter. And we generated $820 million of free cash flow, which calculates at 134% conversion. And that means year-to-date free cash flow is up 42% from last year.

At the business level, Aerospace had another great quarter with continued new commercial and defense wins and strong sales growth across each of its businesses. ACS generated 10% organic growth in the quarter with continued momentum in the businesses and benefit from strong market conditions in Europe and Asia.

In Transportation Systems, Turbo had another quarter of growth and continued wins to benefit the future. The challenges at CPG and our continued investment this year to support all the new Turbo launches negatively impacted total business results. And in specialty materials, though sales were down for the quarter due to a tough comp on UOP sales from last year, overall performance came in as we had anticipated and forecasted and the full year still looks great.

During the quarter, we took the opportunity to aggressively repurchase stock and we bought back about 40 million shares for $2.3 billion. We reduced the second quarter average fully diluted share count to 779 million shares and we expect the average fully diluted share count for the full year at around 775 million shares, that's down 6% from last year.

As a result of our continued performance, benefit from share repurchase, and the confidence that we have in our business results for the second half, we are again increasing our full-year sales, EPS, and free cash flow guidance. We're taking sales guidance up $400 million to $33.9 billion, our EPS range up to $3.10 to $3.16 a share from $3.00 to $3.10, and free cash flow up $200 million to 2.8 to $3 billion for the year. Now let me turn the call over to Dave to go over those wonderful financials. Dave?

Dave Anderson

Good morning, thanks. And thanks to all of you, again, for participating in our 2Q conference call. As you can see on slide 4 and as Dave said, sales up 8% in the quarter, 8% organic growth rate. We came in about $100 million better than we guided, driven by foreign exchange and also stronger Aerospace performance. Segment profit was up $100 million or 10%, with a 13.3 segment margin. We'll take you through the details by business in terms of that buildup in just a moment.

Net income was up 17%, reflecting the $100 million increase in segment profit, as well as lower aggregate below-the-line expenses and I'll go through some of those highlights, mostly related to lower pension and post retirement medical expense partially offset by higher interest, repositioning, and some other charges. Earnings per share up 24% to $0.78, $0.03, as Dave said, over the high end of the range we communicated to you last quarter.

The increase, of course, driven by strong segment profit in net income growth, as well as the lower share count resulting from our second quarter repurchases. Finally, free cash flow of $820 million. Strong conversion, 134% conversion, and again, as Dave said, 42% up on a cumulative year-to-date basis from prior year. So in summary, another strong quarter with very good across-the-board performance and really now representing a terrific second half or first half, rather, for the Company.

Let's go now to slide 5. It's worth spending a minute summarizing our share repurchase program to date and also the plans we've got for the remainder of the year. As you can see on the left side of slide 5, since '03 we've deployed approximately $7.3 billion to repurchase over 163 million shares of our stock. In the second quarter, we repurchased over 40 million shares, bringing our aggregate year-to-date purchases to about 66 million shares, a spend of about $3.5 billion for the first six months.

Now the average fully diluted share count in the second quarter as a result of our ongoing share repurchase program and the second quarter program is 779 million shares, and the incremental impact to our 2Q EPS guidance, so in other words compared to the guidance we would have given you for this quarter at the end of last quarter, the 2Q EPS guidance benefit from the repurchases is approximately $0.02. Now, the repurchases during the second quarter will also benefit 2007 full-year EPS by approximately $0.08 and are built into the incremental or increased full-year guidance that Dave referenced of $3.10 to $3.16.

Now on the right-hand side of slide 5, we've summarized the cash deployment strategy for the year, which incorporates continued investment in our businesses as well as a, obviously return of cash to shareholders. Our CapEx and dividend plans are unchanged. We're continuing, obviously, to make bolt-on acquisitions. We've got $600 million of transactions that are announced year-to-date, including Burrtec, Endraft, and also Dimensions International.

We've utilized both available cash as well as incremental debt to execute our repurchase strategy and we finished 2Q with a debt balance of approximately $7.5 billion. By year end, we expect the debt balance to be approximately $7 billion, transplanting into a debt to capital ratio of about 45%. Finally, Honeywell's Board has authorized an additional $3 billion of share repurchase. And let me just explain that a minute.

We will utilize the remaining 200 million from the current authorization and part of this new authorization, the new 3 billion authorization for share repurchases in the second half. Now, we expect that second half repurchase activity to essentially maintain a flat share count for the remainder of the year. So that strategy would result in a full-year average, fully diluted share count of approximately 775 million shares, down from the 826 million shares last year.

Let's go now through each of the businesses, starting with slide 6, Aerospace. Overall sales for Aero were up 13%, segment profit up at 27%, margins up 190 basis points. As you can see on this slide, commercial sales were up 15% in the quarter, defense and space up 9%. Now, those OE sales, commercial OE sales up 18%, driven by continuing strong demand by our OE customers to support production of both new air transport as well as business jets. The ATR OE sales were up 21%, and the BGA, the business and general aviation OE sales were up 14% in the quarter. Strong numbers across the board for the commercial OE business at Aero.

On the aftermarket side, we also had very good performance in the quarter. Sales up 12%, the AT&R, the air transport and regional aftermarket sales were up 10%, in excess of the approximate 6% increase in global flying hours, due to stronger spares and maintenance demand and also a favorable comp from last year.

You'll recall actually last year, 2Q of '06, we were actually down in this segment. B&GA aftermarket sales were up 17% in the quarter, driven by a favorable comp from last year, higher engine utilization, spare parts sales, and also maintenance events. Defense and space revenues up 9% in the quarter, primarily related to surface vehicles and also a continued ramp-up in space, where we're also getting the benefit, as you recall, of the Orion crew exploration vehicle activity. And CEV represented $10 million of revenue in the quarter.

On the margin side, volume growth, price, and productivity more than offset Aero's inflation to drive the 190-basis point increase in segment margin. So again, a terrific quarter for Aerospace and we continue to feel very good about this business for the remainder of '07, which incorporates strong OE demand, continued global flying hour growth, defense funding, the completion of the Dimensions International acquisition, and also good operational execution across the business.

As a result, we've raised our full-year sales guidance for Aerospace by $200 million to $12.1 billion and our segment margin guidance by 20 basis points to approximately 17.8%. And I'll go through that a little later on a summary table in which I give you each of the business segments.

Turning now to ACS on slide number 7. The momentum that you've been seeing in this business continued in the second quarter. Sales were up 10% with 10% organic growth for ACS. Now, the product side of the business had 9% reported and organic growth in the quarter.

Strong growth in life safety, security, as well as in environmental combustion controls, the ECC business. The products businesses continue to benefit from the acquisitions we've made over the last several years, as well as strong market conditions in Europe and Asia, which more than offset less favorable conditions in the U.S., although we had a another quarter of growth in ACS in the U.S.

The solutions business generated double digit orders and backlog growth in the quarter and continued to translate that growth to sales. Reported and organic sales growth for the solutions business a combined 11% with continued strength in U.S., Europe, and Asia and they had another very good order growth in the quarter.

ACS segment profit up 16%, driven by volume growth and productivity savings, which offset inflation, moderately unfavorable mix, and also some dilution from acquisitions. The segment margin was up in total, as you can see, 50 basis points in ACS, strong performance.

Overall, an excellent quarter for ACS. Good, organic growth, good execution, and we expect that to continue with good growth and solid operational performance in the remainder of the year, and we're raising our full-year sales guidance by about $200 million to approximately $12.2 billion now at a full year for ACS with segment margin guidance at about 11.5%.

Let's go now to Transportation Systems on slide number 8. Sales were up 5% for TS, a 9% increase in Turbo sales and flat CPG sales in the quarter. Market conditions in Europe were favorable for the Turbo light vehicle business, with diesel penetration and production both, as well as success of several platforms and just continued benefit from consumer pull in terms of our platform positions.

This growth was partially offset, this passenger vehicle, light vehicle growth was partially offset by the expected decline in commercial vehicle sales which is consistent with the North American class A market conditions. Turbo also continued to invest in and win important new platforms, importantly in the quarter two additional major platforms with start of production expected in the 2011 time frame.

CPG sales, as I said, were flat, impacted by softness in consumer purchases in North America, as high retail gas prices negatively impacted the sales of automotive aftermarket products. TS segment profit was also impacted by some of the challenges at CPG. Total TS segment product as you can see was down 5% year over year, margins down 130 basis points as a result due to increased spending for new products, the impact of inflation, which more than offset pricing actions and productivity savings. Now looking to the full year, we're maintaining our full year TS sales and segment margin guidance at $4.9 billion, approximately, and margins of approximately 12.6%.

Let's go now to Specialty Materials on slide number 9. Sales were down 3% for SM in the quarter, driven by the anticipated reduction, and you'll recall the discussions we've had about UOP and the variability that we'll continue to see in some of the quarterly numbers for UOP. But the anticipated reduction in UOP product sales in the quarter versus last year. As a result total SM revenues of $1.2 billion in-line with the guidance that we gave you for the quarter. UOP continued to book new wins in the quarter, reflecting strong energy and refining demands and also the advancement of new technologies, including green technologies. Sales were down for UOP 9%, reflecting the tough comp to an all-time record sales in 2Q last year, and also the quarter-to-quarter variability that I've referenced and that we've continued to discuss.

Total sales for other Specialty Materials businesses were essentially flat with last year. Overall, the segment profit for SM was down 19%, margins down 290 basis points due to lower volume and mix, principally related to UOP, but also inflation and lower productivity, including the impact from a temporary plant outage in the resins and chemicals business, and these were partially offset by higher prices. So for SM, a tough quarter, but one that was in-line with our expectations and guidance. SM continues to be on track for strong results for the year, we continue to anticipate full-year revenues at $4.7 billion and segment margin in the range of 13.7%.

Now let's go to the full-year financial summary and really highlight the numbers that Dave referenced at the opening. We're looking now at revenues for the full year of approximately $33.9 billion, up 8% on both a reported and organic basis from 2006. Segment profit should grow in the 4.6 to $4.7 billion range, up 12 to 15% with margin increasing between 50 and 90 basis points. The increase in segment profit together with essentially flat, below-the-line expenses should drive a 14 to 19% increase in net income.

In the range of 2.4 to $2.5 billion for the full year. And that net income growth combined with the lower share count that we've referenced, using full-year average fully diluted shares of 775 million shares, those are the key drivers for the Company's earnings growth, which we now expect to be up 23 to 25% to a range of $3.10 to $3.16 for the year. Finally, we've raised our full-year free cash flow expectations to 2.8 to $3 billion, reflecting again the very strong outlook we feel for the Company.

Now let's go to just the highlights for the segments, showing you kind of a recap of what I referenced earlier for each business for the full year. We've raised, as I said, our sales guidance for both Aero and ACS to reflect acquisitions, performance, and a little bit the benefit of foreign exchange. We've also raised segment margin expectations for Aero, to reflect the more favorable business performance, both revenue and also we see positive mix in the second half of the year. The overall company sales and margin expansion theme remains consistent with what I shared with you at our investor conference in February.

A little more color on the third quarter. If you go to slide number 12, for the third quarter we expect revenues up about 8%, 8 to 9% growth at Aero, ACS, and transportation. Now, the Aero sales growth should be more balanced in the third quarter, reflective of a slightly tougher comp from last year. And you'll recall the strengthening of the Aerospace business in the second half of last year. In ACS, we anticipate more solutions-driven growth given the strength of the order growth there. And in transportation, CPG will continue to be a challenge, but continued strength on the Turbo business.

Finally, we expect Specialty Materials to benefit from a favorable outlook at UOP. Total sales up around 2% on a reported basis, but you'll recall the impact of exited businesses and exited low margin sales. If we adjust for those in the quarter, SM would actually be up 4%. So in total for third quarter, we expect revenues of approximately $8.6 billion.

To help you a little bit just fine-tune some of the guidance, go to slide 13 and you can see we've shown the quarter, the two quarters for the second half and the second half totals for revenues and EPS. We anticipate continued strong growth in each of the quarters, sales up in aggregate about 7%. As you can see, we also anticipate strong EPS growth in each quarter with overall second half EPS up 20 to 25% versus last year. So continuation of great numbers and a continuation of our very positive outlook for Honeywell for the remainder of the year.

So in summary on slide 14, we're pleased to report, obviously, 2Q, another really good quarter. The businesses continue to execute well, we're confident in our outlook for the remainder of the year. We successfully repurchased a significant amount of stock in the first half, really reflective of not only our strong cash position, but the confidence that we continue to have in the outlook for the business. We look forward to the remainder of '07, we're confident in our ability to execute and deliver strong performance. As a result of that and the benefit of our repurchases to date, we've raised our financial guidance for revenues, earnings per share, and cash flow, and of course that EPS increased guidance is the second time this year we've raised that guidance.

Now before we go to Q&A, let me just take a minute to talk about the transition in the Investor Relations role. Murray, of course, you met through his introduction here this morning. He joined Honeywell in 2004. He's got a terrific background, and in fact, in part of that background worked with me previously and supported in the areas of strategy, Investor Relations, and also financial analysis and M&A. At Honeywell, he's been a great resource in our corporate M&A functions since joining us and has brought a number of transactions to closure and been a big support for our businesses, so we're excited to have Murray transition to the Investor Relations role.

Of course, I want to say thanks to Nick Noviello for all he's done over the last three years in the IR role. He's brought just a terrific discipline to the function, he's strengthened our relationship with investors, both here in the U.S. as well as outside the U.S. And we really wish Nick all the best in his new role. Nick will be moving into the CFO for the Global Aero, Air Transport and Regional business, about a $4.8 billion business. So we really, Nick, want to express appreciation and best of luck to you as your career continues to grow with the Company. With that, operator, let's turn it over now to Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Shannon O'Callaghan with Lehman Brothers.

Shannon O’Callaghan - Lehman Brothers

Good morning, guys.

Dave Cote

Hi.

Shannon O’Callaghan - Lehman Brothers

First, a question on cash flow. Conversion has been really strong, I think it's the third time this year you raised up the free cash guidance. Could you talk a little bit about where you're seeing the strength there, how sustainable it is, and also just, you mentioned a little bit about keeping the share count flat, but just some thoughts on capital structure and uses of cash, whether it be acquisitions or maybe a little more share repurchase than you're guiding to?

Dave Cote

A couple of comments and I'll turn it over to Dave. Free cash flow feels really good for a couple of reasons. Our quality of earnings is very high, and that's always a good thing. So we're seeing good flow through that way. The working capital initiative that we drive, as a result of that we don't end up with much usage there, even as we're growing 8 or 9% a quarter. And we're doing that by improving our operating routine so that our customers are seeing better delivery and performance at the same time that we're taking down working capital and we still think there's a lot of juice left in that lemon. Then I'd say it's also the discipline that we exercise on CapEx. We make sure that we're investing to support our businesses, but we're also smart about how we do it. So I feel very good about ongoing free cash flow outlook and Dave and I both consider cash flow to be an important metric on how we run the business, and that's reflected by everything our teams do also. On the repurchase side, I'd say it's consistent with -- really nothing new to add beyond what Dave had to say. I don't know if there's anything else you want to add on either one of those, Dave.

Dave Anderson

I would just say, maybe just to add a little bit of color to my reference on the debt balance. As I said, Shannon, during my remarks, $7.5 billion, approximately of debt balance as of June 30. That's up about 20% since the beginning of the year. It's really reflective of two things. I think, again, Dave said the strength of our cash performance and also the continuation of the balance that we're achieving in terms of our use of cash for both return of cash to shareholders and reinvesting in the businesses. We anticipate by the end of the year that debt balance would be in the range of about $7 billion which translates to that 45% debt to capital that I mentioned to you. That gives us ample opportunity to continue to fund acquisitions, continue to fund our dividend for the remainder of the year, and also given the increasing cash balance we've actually got about $400 million more cash balance at the end of June than we did in the beginning of the year. That gives us also that capacity to buy back shares for the remainder of the year to essentially hold share count constant.

Dave Cote

Things are pretty good.

Shannon O’Callaghan - Lehman Brothers

I would say so. Just on ACS a little bit. Dave, you mentioned a couple times the order strength and solutions. Can you give a little bit more sense where that's coming from? Is it the building side or the process side? Are you guys seeing anything from commercial building efficiency drives or what?

Dave Anderson

We had about 16% increase in orders on average in the quarter, 15 to 16% for the Total Solutions business in the quarter. When you look at where it's coming from, it's really coming from a blend of both our process business and our building solutions business and frankly we're getting both good growth in the U.S. as well as outside the U.S. So it's really a global strength that we're seeing. As I mentioned to you, the thing that I think we need to be mindful of, is of course, that that will generate higher revenues in the second half, most likely compared to our guidance would be compared to our products business. Despite that, we anticipate for ACS to be in the range of about 11.5% in terms of full-year margin.

Shannon O’Callaghan - Lehman Brothers

Okay, great. In terms of the ramp then on the margin for that in the second half of the year, is anything in particular that goes away expense-wise, or is it normal pattern?

Dave Cote

I would say normal.

Shannon O’Callaghan - Lehman Brothers

Okay. All right, thanks a lot, guys.

Dave Cote

You're welcome.

Operator

Your next question comes from the line of John Inch with Merrill Lynch.

John Inch - Merrill Lynch

Thank you. Good morning.

Dave Cote

Hi.

John Inch - Merrill Lynch

Hey. So first on Specialty Materials. If you were to ex UOP out of the mix, would the Specialty Materials margins have been up year-over-year, Dave?

Dave Anderson

Do we disclose that?

Dave Cote

No. I don't think we go into that kind of detail, John, sorry.

John Inch - Merrill Lynch

But just conceptually. Was UOP the bulk of the year-over-year drag, or were there others…

Dave Cote

Conceptually, UOP, yes , we have said before, and we mentioned this even at the beginning of the year, is that the second quarter was just very full, and as Dave mentioned, there's more variability in UOP earnings, and that's a very good business.

John Inch - Merrill Lynch

And were the UOP profitability, would you have associated or would you have seen as you look at those numbers significant negative leverage based on the down year, or did it do better than expected?

Dave Cote

You can triangulate it as many ways as you want, John. But at the end of the day, UOP is a very good business, it does drive good profitability for us, and that variability will drive variability in SM margins so take it from there.

John Inch - Merrill Lynch

That's fine. I want to go back to some of the points you were making vis-a-vis backlog and ACS. If you think about these businesses and their later-cycle nature, is there any reason to think that as you guys look ahead, these businesses couldn't continue to show a degree of improvement, or is this a steady-state type of outlook. And I'm talking ex process solutions, I'm talking about the core kind of stuff tied to commercial construction, the rehab stuff, the project businesses. Maybe talk a little bit about that and where we are in the cycle.

Dave Cote

ACS benefits from a number of things, John. The first is what they're doing internally. There's been a real change in that business. You go back three, four years ago, this was the business that's spent -- the way I'd say it is they played the game on their heels. Now they play the game on the balls of their feet, meaning they're a lot more aggressive in their new product pipeline, which takes two to four years before it really comes to fruition. They started that about four years ago. So it's really starting to come together. And new products make a difference here.

Globally, they've also done an outstanding job of broadening their footprint. So when you look at everything's that's happening around the world, when it comes probably ACS more than any other benefits from that dispersion that they have, that exposure around the world. And there are still a lot of upsides to that ACS business there. When it comes to all the trends that affect them, whether it's construction, retrofit, industrial economy, it really again is affected more by how things are going in the world and things are going pretty well. I suspect that they're going to continue to do well for a while. Dave, anything you want to add?

Dave Anderson

No, that's good.

John Inch - Merrill Lynch

Maybe one more quick one, then. This really to Dave Cote. You've been commendably buying your stock and the markets are beginning to sort of shift their perspective toward 2008. So there's obviously, and Dave Cote, you've mentioned this before, there's really no obvious large transactions or portfolio shuffling on the horizon. So my question to you is, is there any reason, presuming the cash continues to come in based on your initiatives, is there any reason to think that somehow you can't continue the trajectory of share repurchase throughout 2008?

Dave Cote

Well, you may be appalled by the consistency of my answer on this one, but at the end of the day, we always look at our excess cash flow and the first priority is to invest in our businesses, which we do, then we look at making sure that we pay a good, competitive dividend, and we've done that, and then we will always look at excess cash flow to say what makes sense with our repurchases or acquisitions depending upon what seems to be the best decision for us at the time. I think after the four or five years we've been at this we've shown a pretty good discipline in our capital allocation. And without making any commitments one way or the other, there's not much I think that we'd want to add there. When it comes to repurchases, we've committed to holding our share count flat with where it is today and we'll do that. Anything beyond that, we'll see as things come down the line. Dave, anything you want to add?

Dave Anderson

No, that's good.

Dave Cote

Sorry, John, I know you'd like more.

John Inch - Merrill Lynch

No, that's fine. You're basically say it's contingent or your cash flow generation capacity. So it…

Dave Cote

…opportunities out there.

John Inch - Merrill Lynch

Okay, thank you.

Dave Cote

You're welcome, John.

Operator

Your next question comes from the line of Jeff Sprague with Citigroup.

Jeff Sprague - Citigroup

Hi. Thank you, good morning.

Dave Cote

Hey, Jeff.

Jeff Sprague - Citigroup

Just a couple things on Aero. Now that the A350 is flushing out a little bit more, I think things are still moving around, but are you guys still firmly in place for the APU on the A350? And can you give us any indication of what may be playing out in other systems or other R&D that you need to think about relative to that program?

Dave Cote

I'd say it's too early to talk on any of that. What we do is say that we're consistent with whatever the customer has announced at this point.

Jeff Sprague - Citigroup

What I think about Aero R&D, is it up in '07 versus '06 or down?

Dave Anderson

Basically even, Jeff.

Jeff Sprague - Citigroup

And should we expect any meaningful changes as a percent of sales as we look out over the next year or two?

Dave Anderson

I think what we would do, we're in the process now, obviously, of very early review of 2008, but we're really doing that in the context of the '08, to '012 time frame as part of our strap process. As you know, we provide pretty specific guidance and we'll address that in our December guidance a little later this year when we prepare a more detailed review of 2008. Continued opportunities, obviously. Growth opportunities. It's really a matter of working through which one of those and how much funding falls in '08, '09, '010, et cetera.

Jeff Sprague - Citigroup

And could you give us a little color, ACS, obviously, a lot of things pointing the right way. You did single out U.S. products as being soft. How soft was it, and is it primarily in security, or is it somewhere else?

Dave Cote

I think soft is a relative term.

Dave Anderson

Yes.

Dave Cote

If you were to look at it, we had, across the board we had good growth in the U.S., very good in Europe, and I would say excellent in Asia.

Dave Anderson

Yes.

Dave Cote

That global footprint, which is still just a lot more opportunity for us that really make sure that we post those great revenue numbers.

Dave Anderson

The other thing, Dave, just sort of a minor thing, but we had a couple points in the U.S. just on a year-over-year basis on a reported for ACS just reflecting a divestiture of a noncore piece of FT. You adjust for that and the numbers actually are quite good. So, Jeff, overall for ACS, very good growth, as Dave said in each of the regions and on a relative basis, the U.S., the Americas is lower, but still a good number.

Jeff Sprague - Citigroup

Then just finally, for me, on UOP, can you give us a sense of the size of the order growth and backlog growth that you saw in the quarter?

Dave Cote

It's very good. I don't have the specific percentage with me, but it's something that you'd certainly be pleased with, Jeff, just like we are.

Dave Anderson

Yes. I would say Jeff, the other thing is consistent with the expectation that we've provided in terms of the favorable outlook for UOP for the second half of this year.

Jeff Sprague - Citigroup

Great. Thanks.

Dave Cote

You're welcome.

Operator

Next question comes from the line of Deane Dray with Goldman Sachs.

Deane Dray - Goldman Sachs

Thank you. Good morning.

Dave Cote

Hi.

Deane Dray - Goldman Sachs

Dave Anderson, all the rollup and analysis that you give by segment is very helpful on how you get to your guidance for the year. Just to clarify, for the updated '07 guidance, what's the FX assumption? And at the high end of your guidance, is that still 8% organic revenue or is that something above?

Dave Anderson

It would be at about 8%, Deane, in terms of the revenue growth for the guidance. I think in the second half, we're actually looking at closer, I think it's around 7% on a combined basis for the business on the second half. When you look at the FX rate, I think we were looking at about 135 now. That compares, obviously, favorable to the guidance that we gave at the end of the first quarter, which, as you recall, we increased that 130 compared to 125 that we used originally. So we got about $50 million of benefit in the second quarter and we're anticipating about $100 million in the second half. Call it $50 million per quarter of FX benefit in the second half and that's again, built into the numbers that we provided to you.

Deane Dray - Goldman Sachs

Great. Then in terms of the businesses within consumer products, you mentioned that this is challenging. Is this a time to take a look at CPG in terms of its strategic value for Honeywell? What's the technology edge and do you really want to be that exposed to consumer or gas prices?

Dave Cote

Well, at the end of the day, what we've said about CPG really hasn't changed. We've always said that when we talk about great positions in good industries, what we really have here is a great position in an okay industry in the U.S. Historically, the business has performed very well and the management team has performed well and we still think that there's more opportunity there and once we get through some of these issues.

Deane Dray - Goldman Sachs

When you say more opportunity in terms of new product introductions or how are you thinking about that?

Dave Cote

Yes, new product introduction, shelf space, as we think about how some of this might apply globally. So we still think there's more play in that CPG business.

Deane Dray - Goldman Sachs

And are there synergies? Can you address the synergies across, perhaps in Specialty Materials?

Dave Anderson

With what…?

Deane Dray - Goldman Sachs

In terms of some of the formulas?

Dave Anderson

You mean between CPG and SM?

Deane Dray - Goldman Sachs

Yes.

Dave Anderson

No, not really.

Deane Dray - Goldman Sachs

So it's very much a stand-alone business?

Dave Anderson

Sure.

Deane Dray - Goldman Sachs

Okay, thank you.

Dave Anderson

You're welcome.

Operator

Your next question comes from the line of Nicole Parent with Credit Suisse.

Nicole Parent - Credit Suisse

Good morning, guys.

Dave Cote

Hi, Nicole.

Nicole Parent - Credit Suisse

Just a follow-up, I guess, on two questions. The first one would be, I guess, Dave Cote, big picture when you think about just the health of the international markets, and maybe give us a perspective on European strength versus U.S., how long that can continue, and with respect to orders as opposed to sales, have you seen any deceleration?

Dave Cote

Well, for us, actually, as you can see, things have actually been going pretty well on all fronts. The global push that we've had has worked quite well as we've expanded our position with acquisitions and just paying more attention to it. And we see things pretty balanced overall. For the first half, while our U.S. performance has been good, it's been really good in Europe and Asia because of that expanding footprint. So even as those economies, Europe was a little slow, has been getting better. Even in that slower economy, we're still doing very well. So it's a combination of things. It's not just being there and how the industry is doing, but we're expanding our presence at the same time.

Nicole Parent - Credit Suisse

That's helpful. I guess with respect to residential versus nonres, kind of your view on where we are in both cycles and how you see that playing out over the next say 18, 24 months.

Dave Cote

On the residential side, you'd have to say the prospect of having a lower housing market through '08 is not unrealistic. That's probably as good a bet as any. Nobody can forecast exactly when the bottom hits, but through '08 I don't think is unreasonable. For us, as Dave has mentioned before, our total exposure to U.S. housing, new construction is 2% of sales.

Dave Anderson

2% of total Honeywell sales.

Dave Cote

So it's not a big thing for us. The retrofit market is a bigger deal. On the nonresidential side, the whole world actually looks pretty robust there still. It doesn't look bad and vacancy rates on office construction with new office construction still low. I think that trend stays pretty good for a while too.

Nicole Parent - Credit Suisse

On the nonres side, what is the lag time between your sale and the actual installation of products?

Dave Cote

I guess it depends on the size of the building.

Dave Anderson

I think probably a good rule of thumb is somewhere between a year, a year and a half, 12 to 18 months, Nicole.

Nicole Parent - Credit Suisse

Okay, that's great. Just one last one, Dave Anderson, on the R&D in the quarter in Aerospace, was there any meaningful change versus a year ago?

Dave Anderson

No, there really wasn't, Nicole. It's really been pretty consistent with the discussions and guidance that we've given you before. I'd say sort of summarize it steady as she goes in terms of the R&D investment in Aero.

Nicole Parent - Credit Suisse

Okay, great. Thank you.

Dave Anderson

You're welcome.

Operator

Your next question comes from the line of Robert McCarthy with Banc of America Securities.

Robert McCarthy - Banc of America Securities

Good morning, everyone.

Dave Cote

Hey, Bob.

Robert McCarthy - Banc of America Securities

First I would like to focus on ACS, if we could. I'm looking at this great slide you put out at your ACS day, talking about your core margin assumption for 2007 around 14.1%. Would you say that's a little bit higher now in terms of the underlying run rate given these results today, or how do you think about your core margins in that business and what are the key headwinds right now?

Dave Cote

Well, overall, they're on a core margin expansion plan also, just like everybody else is and you're starting to see that getting reflected in their performance and we expect that it continues. I don't have the specific number that correlates to that 14.1 for the first half and I don't know that we'd share it at this point anyway.

Dave Anderson

I would say, Dave, for Rob's benefit, the analysis that we did is consistent with the margin guidance that we gave for ACS for the full year 2007 and as I said earlier, we're tracking towards it. Clearly, very pleased with the margin expansion.

Robert McCarthy - Banc of America Securities

Are there any areas where you're tracking a little bit ahead in terms of SAP, in terms of the return on your sales force, or just the acquisition integration?

Dave Cote

They do a pretty good job of doing exactly what they said.

Robert McCarthy - Banc of America Securities

Okay. Then just looking out going forward, I guess you're thinking about a modest, obviously, you're facing a modest mix headwind on the solution side. You think about compares going into '08, you could probably see potential reversal there, particularly if you start to see some acceleration in products, right? So we could see some incremental acceleration in margin improvement in 2008, which would be, I think, a little bit better than what you were initially forecasting?

Dave Anderson

Possible, but it's early.

Dave Cote

Exactly.

Dave Anderson

Again, I think it's consistent with our discussion on an earlier question, is we'll really get into the details of that as we progress through this year and do our detailed planning for next year, and Rob, share that with you in December when we give you our guidance.

Robert McCarthy - Banc of America Securities

Any update on facilities rationalization there, or in terms of the update on the phase? Was there any booking, a gain on the sale of facilities that ran on the segment or other income?

Dave Anderson

First of all, we had about $44 million of repositioning spend in the quarter, so we like the first quarter, we took the opportunity to invest back in the business that's really going to benefit and support us in 2008 and 2009. As Dave has said and as I've said in the past, we apply a very strict discipline to the review of the repositioning in terms of the strategies of the businesses and the quality and time frame for the payback associated with repositioning. In terms of other items, we had a small gain on the sale of a facility that was offset by another entry, so really in terms of other income, I think the net was positive about $3 million. It really was insignificant in the quarter.

Robert McCarthy - Banc of America Securities

Yes. I would say your overall repositioning was a tad higher than what I was expecting. What other areas did you focus on incrementally to spend on repositioning?

Dave Anderson

We spent a little more on environmental in the quarter. We spent $60 million, which brings the total spend on a year-to-date basis to 120. If we take that now, some of those below the line items in terms of our full-year guidance and expectation, we're now looking at environmental is probably going to be in the range of about 220 for the full year. Asbestos was favorable in the quarter, in the mid-20s, we would expect asbestos for the full year to be about 120. And in terms of repositioning, given the fact we've spent about 120 on a year-to-date basis, we'd look at full year now probably closer to 150 in repositioning, depending upon performance, depending upon continued tail winds and the opportunity to reinvest, that number could go higher, but I think that's a good number for modeling right now and for planning purposes.

Robert McCarthy - Banc of America Securities

Any general update overall in terms of the asbestos situation for the Company?

Dave Anderson

The claim rates continue to come down. We continue to do a very good job of managing there. In terms of the Narco Trust, the expectation is that that's likely now to move over into 2008 at the earliest. So that will benefit us a little bit this year in terms of cash outflow, but overall it's a good news story in terms of asbestos. As I mentioned earlier, our full-year guidance compared to where we started the year, where we had asbestos in the 130 to 150 range, we're now talking about asbestos in about approximately the 120 range in terms of expense for the year.

Robert McCarthy - Banc of America Securities

Finally, on just free cash flow, it looks like it's tracking very well for the full year. Could you competent on the acquisition environment, what you're seeing in terms of multiples to expensive liquidity, et cetera? How do you feel about the underlying acquisition environment right now?

Dave Cote

Well, it is more pricey than it was. There's no doubt about that. But at the end of the day, we still spend a lot of time combing through a lot of businesses and companies to find the right ones that appeal to us and at the right price and we still exercise the same discipline and walk away from stuff where it's getting too heady on price or getting too heady on terms. We just won't do it. It's not the right thing to do long-term. As we said earlier in the call, we've got good alternatives.

Robert McCarthy - Banc of America Securities

Thanks for your time.

Dave Cote

You're welcome.

Dave Anderson

You're welcome, Rob.

Operator

Your next question comes from Howard Rubel with Jefferies.

Howard Rubel - Jefferies

Thank you very much. I want to go back to...

Dave Cote

Howard, could you speak up just a little bit?

Howard Rubel - Jefferies

Sure. Thank you. Is that better?

Dave Cote

Yes.

Howard Rubel - Jefferies

Thank you. I want to go back to get a better understanding or appreciation for the decision behind increasing your leverage today and to buy the stock so aggressively. You're not going to get me to complain, I just want to understand the rationale of it.

Dave Cote

Well, as you might imagine, we just feel good about the long-term outlook for the Company and it seemed like a good time to buy. It's as simple as that. Dave, I don't know if there's anything you want to add.

Dave Anderson

Yes. Howard, as you know, we monitor our, obviously, free cash flow-to-debt relationship and are continually in communication, active communication with the rating agencies, which is important obviously constituent. We felt, as Dave said, just very good about the opportunity and very good about the outlook for the Company.

Howard Rubel - Jefferies

Are you going to keep the short-term debt at, what is it $2.5 billion or thereabouts, or are you going to fund some of that out? And are you thinking that 45% debt to cap is where you would like to be going forward?

Dave Anderson

Let me give you a quick response to that. I would say number one, in terms of terming out any of the short-term debt, that's really a TBD. We'll just continue to evaluate fixed versus floating and look at the market opportunistically in terms of our debt structure. And then second, with respect to a targeted number, for us, really, again, we're really more focused, while we shared with you the debt-to-cap figure, we're really more focused on that relationship between free cash flow and our debt. Obviously, free cash flow minus dividends or funds from operations minus dividends divided by debt as being a key metric. So we monitor that, we feel good about our performance there, and very, very good about the outlook for the Company.

Dave Cote

I guess I would add to that, Howard, with the share repurchases that we've done, debt-to-capital becomes a less useful metric.

Howard Rubel - Jefferies

That's fair. With the asbestos obligation for funding being pushed out, you've got more financial flexibility than you had before. The second thing is, when you read the press release, there's a lot of discussion on, we'll either call it energy efficiency or green or other opportunities, either at ACS or in Aerospace. Dave Cote, could you just talk a little bit about what you're seeing in terms of the organization responding to customer needs in this area and can this be something more meaningful than buzz words and how can you put some meat around what I will call the buzz.

Dave Cote

Yes, the energy efficiency push around the world is actually a very good thing, a very good dynamic for us. Yet, ACS is one that's obvious out of the box with its focus on home, buildings, and industrial plants and including the generation side with, through better process controls, getting better efficiency and getting more output per barrel, if you will. That's a very good dynamic for us.

On the jet engine side, things like Primus Epic or Aerospace side, things like Primus Epic where you reduce weight, things like the new more fuel-efficient jet engines, all good for us. When you look at Specialty Materials, the new foam insulation that they're able to do that creates an R value of about R30 and gives you better structural integrity, also a big win. The Turbo charger business, also very good. And we see, particularly with its impact on diesels. We're starting to see a lot more discussion around the world about dieselizing economies. Europe, as you know, more than half of passenger cars are diesel today. You see China making the shift to diesel, India making the shift to diesel and increasing discussion about it in the U.S., so we think that trend plays pretty well for us.

When you look at UOP, going back to Specialty Materials, same thing again with their invention of something called green diesel, which you've probably seen in press releases, and very different from biodiesel. You think of biodiesel as stuff that generally you need a different type of engine or you need to blend it with something. What our guys have been able to come with up is in this green diesel is from crops, so corn or soybeans or something like that, able to develop drop-in diesel fuel. So diesel fuel that you don't need new types of pumps, you don't need new types of engines, it's actual drop-in. In fact, we've got a number of projects working there, including the launch of a refinery in Italy, in Livorno, Italy with E&I to actually produce it. So all those trends are extremely good for us.

Now, I would say, though, at the same time, it's a slow market take-up, there is generally more discussion than there is actual commitment at this point overall. So we think that our results at this point are able to -- we've got great upside there because still while there's a lot of discussion, the take-up isn't huge yet. But we think it will be. Howard, that may have been a more complete answer than you were looking for, but thems the facts.

Howard Rubel - Jefferies

I appreciate it. Thank you very much. I'll follow-up later.

Dave Cote

Okay.

Operator

Your next question comes from the line of Nigel Coe with Deutsche Bank.

Nigel Coe - Deutsche Bank

I think most of the bases have been covered. You talked about a nice buildup in the UOP backlog and I'm just wondering, how much visibility -- when you look at that backlog, how much visibility do you have with the second half of the year and perhaps going into 2008?

Dave Anderson

Pretty good visibility, Nigel. Particularly for the second half. The nature of UOP's business is that it got a significant line of sight in both their projects and the products business, but what you do see as we've talked about is variability in any particular quarter. So we do the best we can in terms of providing that guidance. Actually I think we're doing a pretty good job if you look at the guidance to date in terms of our ownership, our full ownership of UOP. But right now feel very good in terms of the outlook for the business for the remainder of 2007.

Nigel Coe - Deutsche Bank

Okay. When you look at that backlog, be it in terms of mix or pricing, do you see margins expanding within UOP or flat? How does that look?

Dave Cote

Things look good at UOP in general. Who knows how things will work out exactly, but we feel very good about that business, the outlook for the business, the cycle is extending. It's just -- everything's positive there.

Nigel Coe - Deutsche Bank

Okay, great. Just a follow-on on the debt level. Dave, you mentioned that debt-to-cap is a less meaningful metric and free cash and EBITDA are probably better. Do you intend, going forward, to maybe raise debt levels in-line with free cash and EBITDA growth?

Dave Anderson

Clearly, it gives us the opportunity to do that. As the Company grows, as we increase our net income and maintain very strong cash conversion, we grow into the ability to have more absolute debt.

Nigel Coe - Deutsche Bank

And is this a signal that you're far more comfortable with legacy liabilities, be it asbestos or environmental?

Dave Anderson

Clearly. We clearly, I think, indicated that the management that we've had, the approach that we've taken over the last four to five years on those items and you can see it in the numbers, number one, they're managing to be even to down in terms of absolute level and of course on a relative basis, are really reducing significantly over time. That's just going to continue. One of the things that's a variable, of course, as we've talked about, is the 524 G asbestos trust, the Narco Trust. Assuming the formation of that trust sometime in 2008, there will be some funding required. They're both trust-specific related cash obligations, as well as prebankruptcy requirements in terms of cash obligations, in terms of claims. So there will be that outflow, but really other than that, when you look at the long-term in the '08, '09, '10, '12 horizon for the Company in terms of cash, we're really enthusiastic in terms of our cash-generating ability.

Dave Cote

If I could add something to that, Nigel, I'd say that, when you mentioned our comfort with it in the future, we've actually always been pretty comfortable about what we were forecasting and how things were going to play out, I'd say the discomfort was more on the analyst side with was it going to play out the way we said it would, and I think hopefully we've established some real credibility there at this point, that it's pretty much played out as we've said. And the nice thing about it is with the kind of growth we've had as a company, these expenditures are a smaller and smaller percent of the total.

Nigel Coe - Deutsche Bank

Right, exactly. Just a quick housekeeping question. Do you have the year-end share counts? Sorry, the quarter-end share counts?

Dave Anderson

You're talking about quarter-end share counts?

Nigel Coe - Deutsche Bank

Quarter end.

Dave Anderson

Quarter-end share count on a basic basis is about 750 million shares, in terms of the outstanding shares.

Nigel Coe - Deutsche Bank

Okay, great. Thanks, Dave.

Dave Anderson

You're welcome.

Operator

Ladies and gentlemen, we have reached the end of the allotted time for questions today. I would now like to turn the call back over to David Cote for any closing remarks.

Dave Cote

All right, thanks. The way I think that everybody ought to be thinking about this is that our goal is to in a short amount of time having all of you say, gee, I could have bought those shares at 60, I wish I had. So my admonition to you would be the same as it always is and that's to buy while supplies lasts.

Murray Grainger

Thanks for everyone joining the call.

Operator

This concludes today's Honeywell conference call. You may now disconnect.

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Source: Honeywell Q2 2007 Earnings Call Transcript
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