Honeywell International Inc (HON) — Q3 2016 Earnings Call Transcript

Good morning and welcome to Honeywell's third quarter 2016 earnings conference call. With me here today are Chairman and CEO Dave Cote and Senior Vice President and Chief Financial Officer Tom Szlosek. This call and webcast, including any non-GAAP reconciliations, are available on our website at 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 ask that you interpret them in that light. We identify the principle risks and uncertainties that affect our performance on our form 10-K and other SEC filings. This morning we will review our financial results for the third quarter and share with you our guidance for the fourth quarter and full year of 2016. And as always, we will leave time for your questions at the end. With that, I'll turn the call over to Dave.

Good morning, everyone. As we previewed during our update call two weeks ago for the third quarter, we reported earnings per share of $1.60 or $1.67, excluding the $0.07 we deployed to restructuring. We expect to return to double-digit EPS growth in the fourth quarter which yields our full-year EPS growth target of 8% to 9% that we communicated on October 7. Q3 was a quarter of important changes in many areas that positioned the Company for better performance next year. These include the split of the former automation and controls solutions segment, ACS; the acquisition of Intelligrated; the sale of our government services business, HTSI; and the spin of resins and chemicals. Combined with nearly $250 million in restructuring actions, these changes are lasting improvements to the portfolio that yield benefits beginning in the fourth quarter and into 2017 when we expect year-over-year benefits exceeding $175 million from the restructuring actions alone. In the fourth quarter, we'll lap the impact of our U.S. Postal Service project and productivity solutions, the UOP return to growth and expect a continued ramp of our Solstice low global warming product sales. Darius and Tom will provide more details about 2017 during our annual outlook call in December, but we have a favorable setup. The fourth quarter momentum continues, our long cycle businesses are improving and our inflections start to kick in. It remains a slow-growth environment, but we've continued to invest heavily in the business, in capital projects, research and development, hiring salespeople, winning content on new aerospace platforms, improving our growth profile through strategic M&A and divestitures and executing on restructuring projects to improve our fixed cost position. With all the work we've done to improve the growth profile and our continued emphasis on the Honeywell operating system and our performance culture, we're well-positioned for long term growth and are committed to creating long term shareowner value. On October 7, we communicated all the changes or moving parts that occurred in the quarter. In our attempt to lend transparency to all the moving parts, we lost sight of the importance of conveying our confidence in our future, the fourth quarter, 2017 and beyond. For that miscommunication, I take full responsibility. Last week we released a number of charts explaining why we were confident in our future. We've included several of those charts in this morning's package because we wanted to explain a bit behind each of them. We've continued to invest heavily, seed planting, if you will, and the returns will be there. We've outperformed historically and will continue to do so. We largely discussed the third quarter a couple weeks ago, so much of today's presentation focuses on the future and why we think Honeywell is an exciting place for you to be. So with that, I will turn it over to Tom.

Good morning. I'm now on slide 3 with a quick recap of our third quarter results. Reported sales of $9.8 billion increased 2%, primarily reflecting the impact of acquisitions. On a core organic basis, sales were down 3%. Our growth was led by process solutions, transportation systems, and home and building technologies, but was more than offset by softness in business jets, defense and space, productivity solutions, and UOP. The softness in UOP has moderated throughout the year to the extent that in the fourth quarter we expect high single-digit sales growth in that business. The decline in segment margins in the quarter reflects the impact of OEM incentives, M&A integration costs, and the lower volumes partially offset by benefits from previously funded restructuring. Earnings per share were up 4% to $1.67, excluding the restructuring charge deployed from the retroactive portion of the stock compensation accounting change. The individual restructuring projects in the third quarter have an average payback of about two years and provide attractive accretion in both 2017 and 2018. Free cash flow in the quarter was $1.3 billion. That's 103% conversion on net income. We continued to put substantial capital to work for our shareowners, our CapEx and reinvestment ratio was 150% this quarter and we bought back approximately $1.9 billion worth of Honeywell shares through the end of the third quarter. Let me move on to slide 4 to discuss the segment performance. In aero, the sales decline is consistent with what we previewed. The negative 6% headline number reflects the softness we described in our business jet OEM revenues and in defense and space, but also to a larger degree the increase in OEM incentives. I'll discuss the incentives more later, but in the third quarter, the year-over-year increase in OEM incentives drove 4% of the minus 6% decline in the top-line growth for aerospace. Excluding the impact of OEM incentives, the commercial aviation OEM business was down 8%, with the business jet softness being partially offset by steady growth in air transport. Our commercial aftermarket business was up 1% on a core organic basis. We're seeing continued repair and overhaul demand within air transport, but the softness in the business jet market is impacting the aftermarket and we've seen fewer engine repair and overhaul events as a result. Defense and space was down 6% on a core organic basis, driven by program completions in U.S. space and international defense and lower volumes for commercial helicopters, primarily related to oil and gas. While disappointing, we're encouraged by the double-digit increase in defense and space year-to-date orders and backlog, although as you can appreciate, much of this activity is longer term in nature extending into 2017 and beyond. Transportation system sales increased 3% organically in the quarter, driven by new program launches in light vehicles gas segment where we saw growth of nearly 20%. Aerospace segment margins were down, reflecting the increase in OEM incentives and lower volumes. In home and building technologies, sales were up 5% on a core organic basis driven by growth in both products and distribution businesses. The products business grew 1% organically thanks to more than 15% growth in China and strength in the Americas environmental and energy solutions business. The distribution business was up 8% organically in the quarter, driven by continued strength in the global distribution business and energy and services contracts within building solutions. The segment margin rate declines, excluding the impact of M&A, were primarily due to the mix of products versus distribution revenues this quarter. In performance materials and technology, sales were down 3% on a core organic basis driven by UOP, partially offset by strong global megaproject conversion in process solutions which was up 3% organically. UOP sales were down 10% on a core organic basis, driven primarily by declines in gas processing and licensing and partially offset by higher catalyst shipments. Notably, UOP's backlog was up 15% at the quarter end. Demand for our catalyst continues to be strong, driven by reloads as a result of increased refinery turnarounds. Advanced material sales were down 2% on a core organic basis as demand for our Solstice line of low global warming materials within fluorine products continues to be strong, partially offsetting the significant market pricing headwinds within resins and chemicals. These resins and chemicals headwinds are obviously now behind us as a result of the AdvanSix spin. EMT segment margin was up 80 basis points to 21.6% driven by strong productivity and cost controls, higher catalyst shipments and the favorable impact of acquisition integrations. Finally, in safety and productivity solutions, sales were down 8% on a core organic basis. The safety business was down 3%, primarily due to softness in the general personal protective equipment business and lower demand for retail products. The productivity solutions business was down 12% on a core organic basis due to a tough comparison in the third quarter of 2015 and continued channel headwinds in productivity solutions. We will not face the U.S. Postal Service headwind next quarter as we've said. Segment margin was down 90 basis points, excluding M&A, to 15.2%, primarily reflecting the lower volumes. Slide 5 shows our path to the fourth quarter EPS of $1.74 to $1.78. It's very consistent with what we have previously articulated a couple of weeks ago. We expect UOP to grow at high single-digits on a core organic basis driving significant sequential quarter-to quarter EPS improvement. Catalyst sales are expected to be up about 20% in the quarter and licensing and equipment sales will be up about 15%. Additionally, in process solutions, we expect to see the normal fourth quarter pickup in our short cycle products and services businesses. We continue to closely monitor the oil and gas market, but all in all, our outlook has improved. We expect a 2% to 3% improvement from safety and productivity solutions and $0.03 to $0.04 from restructuring. I spoke earlier about the rapid paybacks we expect on the restructuring we funded in the third quarter. All in we have a funded pool of more than $400 million in restructuring projects. All other is a $0.05 to $0.06 headwind reflecting the removal of resins and chemicals and the government services business from the portfolio, the normal one-time M&A cost from Intelligrated and an expected lower number of option exercises resulting in lower income tax benefits. This works to a Q4 earnings range of $1.74 to $1.78 per share. That's a 10% to 13% increase from the same period in 2015. Let's turn to slide 6 to provide some further color on our fourth quarter outlook. We expect that sales declines in aerospace will continue into the fourth quarter, particularly in business jets and defense and space. We expect our total commercial OEM business to be down nearly 20%, with growth in air transport and regional more than offset by declines in business and general aviation. In our aftermarket business, repair and overhaul will moderate slightly on lower events and lower aircraft utilization, while growth in spares should be steady, primarily due to the new jet wave installations and channel and customer demand. The backlog in defense and space, as I said, is improving as we head into the fourth quarter, but we still expect the business to be down in the mid-single digit range on lower volumes globally. And finally, in transportation systems, we see continued global gas turbo penetration offset by slower diesel penetration which would drive flat to slightly higher core organic sales in the quarter. In HBT, we expect organic growth in the low single-digit range in both the products and distribution businesses. The reported growth is much higher, reflecting the Elster smart energy business, where we have significant rollouts in the UK and expected strength in the Americas gas business. On the product side, sales in environmental and energy solutions business will continue to improve driven by new product introductions in the Americas and strong double-digit growth in China and India. In the distribution segment which consists of the global distribution business and building solutions, we expect strong backlog conversions, specifically in our energy business and in EMEA and China. Our global distribution business will grow at a slower rate due to very tough comps from the fourth quarter of 2015 when this business grew nearly 12%. Margin expansion will be driven mostly by productivity net of inflation, the benefits of restructuring, higher volumes, and commercial excellence offset slightly by the impact of the Elster acquisition. In PMT, we see a return to growth in UOP driven by continued strong orders. Orders were up 9% in the third quarter, particularly in the catalyst business. We also see some traction on the equipment side. Our orders over the past three months were over $700 million and we're expecting a similar amount in the fourth quarter. Importantly, we see oil prices stabilizing in the $50 range. Generally, activity is picking up across the globe including in China and some projects that had been delayed or stalled are now resuming. Our year-to-date book-to-bill is 1.1 and was closer to 1.3 in the third quarter and our win rates across all lines of business in UOP are strong. UOP should grow by high single digits in the fourth quarter as a result. In process solutions, sales will be down in the mid-single digit range on lower megaproject sales growth. However, this should improve in 2017 as we replenish the backlog on anticipated healthy project orders in the fourth quarter. Finally, in advanced materials core organic sales growth will be north of 10% driven by Solstice which will grow considerably this quarter and from higher volumes in specialty products across all lines of business. The significant increase in segment margin will be driven by the higher catalyst shipment content, volume growth in fluorine products from Solstice and the favorable margin impact from the spinoff of AdvanSix. In safety and productivity solutions we're finally past the headwinds associated with the U.S. Postal Service deployment and as a result we expect the business will be flat to slightly down in the fourth quarter which represents a nearly 800 basis point improvement sequentially. This is also supported by a slightly easier setup in industrial safety driven by prior-year oil- and gas-related declines. We should see things improve overall from here, especially with the addition of Intelligrated which we continue to be very excited about. We've taken aggressive cost actions to address the slowdown in the third quarter. This should provide additional runway for margin expansion in the fourth quarter and into 2017. With more than $1.9 billion in share repurchases this year, our share count will be approximately 1% lower in the fourth quarter. And finally, as a result of last quarter's adoption of the stock compensation accounting standard, we now expect that our tax rate will be approximately 25% in the fourth quarter and about 24.5% for the full year. Let's turn to slide 7 to discuss our expected full-year segment margin. On a reported basis, we expect to be down approximately 70 basis points, but this belies the significant operational improvement we expect to deliver approximately 80 basis points. We continued to realize volume leverage in our growth segments and work with our suppliers to drive down material costs. Additionally, by deploying the Honeywell operating system and our restructuring capacity, we continued to reduce our fixed costs throughout the enterprise, including in our plants and our administrative functions. These are permanent improvements in our cost structure that will drive significant margin expansion as growth more fully permeates the portfolio. Offsetting this operational goodness are the upfront effects of investments we're making to improve the future. You'll recall that we're completing the first year of our nine recent acquisitions. This first year is heavily burdened by costs for inventory accounting, amortization of intangibles, deal costs, and integration costs. This will be an approximate 50-basis point headwind this year. OEM incentives are a 60-basis points headwind. I have a later slide on what these OEM incentives mean for our future growth, but given the conservative accounting we deploy in this area, we're experiencing a $0.25 EPS headwind in 2016 that will not repeat. Finally, the foreign currency movement from 2015, principally the strengthening of the U.S. dollar, has driven approximately 40 basis points of margin rate headwind. Based on our hedging positions, we expect this to turn to a similar size benefit in 2017. So as you can see, we expect to end the year with segment margin at 18.1%, but are well positioned for 2017, as the favorable operational impacts from the Honeywell operating system continue and the impact from the other factors recedes or flips around. Now on slide 8, we're reaffirming our full-year EPS growth target of 8% to 9% or $6.60 to $6.64, excluding the anticipated fourth quarter pension mark-to-market adjustment of about $1.5 billion. This is based on current discount rates and asset return assumptions as of September 30 and is driven primarily by the decline in interest rates. The sales and segment margin guidance you see here is consistent with a preview from October 7. With a lower than anticipated net income, principally in aerospace, we now expect that free cash flow will be between $4.2 billion and $4.3 billion for the full year. Slide 9 summarizes the end market dynamics that we anticipate in 2017 versus what we're experiencing this year. First in homes and buildings, we'll continue to see steady growth driven by new product introductions, connected offerings, and the expansion of our install base. Next, the dynamics we describe for commercial aviation will continue in 2017, including declines in the business jet market, steady performance in air transport driven by program ramp-ups including on the A350 platform and a reasonably stable aftermarket. What will change in commercial aviation is that the massive 2016 headwinds from OEM incentives will become a modest tailwind. We expect the declines in defense and space will moderate a bit in 2017, but we anticipate that demand in our commercial helicopter and domestic space businesses will continue to be slow, will no longer have the impact from our government services businesses following the sale of HCSI and in addition, our long cycle backlogs are improving, as I noted earlier. More than three quarters of our expected fourth quarter sales are firm which is above where we were at this point heading into the third quarter. To moderate the effects of the overall declines in aerospace, we've made significant improvements to our cost structure while investing for growth, including sales headcount, research and development and in new products like JetWave. We anticipate stronger performance in our businesses that serve the industrial and workers end market. We'll no longer have the U.S. Postal Service comp and Intelligrated will contribute to growth. We also expect our safety sales to improve over the course of the year. The vehicles market will continue to be strong, with increasing global penetration of turbos and growth in light vehicle gas applications. We also expect modest improvements on the commercial vehicle side in 2017 and on a global basis, we expect turbo penetration to be approximately 40%. Lastly, advanced materials will be a strong contributor, highlighted by more than 25% growth in our Solstice products. Solstice is meeting or exceeding all expectations and is expected to be about a $1 billion business for us by 2020. Let me turn to slide 10 for a preview of 2017. We've not finalized our 2017 planning and as Dave said, Darius and I will provide a full update in December upon the completion of the process. We expect a continued slow-growth environment, but also believe that the inflections we've mentioned are still intact to enable us to grow faster than the markets we serve. With that said, we're taking a conservative approach to the planning framework, specifically relative to business jets, defense and space, and commercial helicopters. While we're targeting double-digit EPS growth, we're not counting on a recovery and need specific end markets to achieve that. We continue to work on the things we can control and we see the result of this in the forecasted 45 to 75 basis points improvement in the margins on low single-digit core organic sales growth. Still, we're constantly pressed on why we feel confident in our ability to deliver in 2017. Let's spend a few minutes explaining the rationale underlying our outlook. Let me move to slide 11. First off, we've continued to deploy large amounts of shareowner capital. We've increased our dividend 15% in each of the last two years and including the $0.5 billion that value created through the spinoff of AdvanSix, that's nearly $2.4 billion of dividends alone in 2016. And we're committed to further growing the dividend faster than our rate of earnings growth. On share repurchase, we've been very active in 2016 and have already matched our total repurchases for all of last year. You'll recall that it takes about $1 billion of repurchases each year to keep our share count flat and we've been doing twice that amount. M&A activity has significantly accelerated over the last 18 months. For the past few quarters, we've been dealing with the incremental acquisition and amortization costs from these deals and as that begins to roll off, the contribution from this M&A will really be felt. And the M&A benefits do not even take into account the sales and commercial synergies we expect from combining sales forces, leveraging Honeywell's channels and high growth regions and from general commercial excellence that we drive in our own businesses. Needless to say, we expect M&A will be a significant value driver in 2017 and for many years to come. Slide 12 recaps the deals we've completed. Each of these businesses participates in an attractive fast-growing market where they are perceived as leaders in their space. They're accretive to Honeywell's growth rates. We believe there's a big opportunity for us to expand a number of these businesses into high growth regions given the Honeywell presence, leadership teams, and infrastructure already in place. Many of these businesses also have a strong technology and software component and that will drive superior growth and improving gross and segment margins. I also don't want to lose the point that we continue to find strong new talent through our acquisitions that makes the combined companies better and further drives our software and technology initiatives. Let me turn to slide 13. We've talked extensively about OEM incentives. What you need to remember is one, they're investments that have gotten us on a number of attractive new business jets and air transport platforms that build upon our already strong installed base. Two, we expense these incentives to our P&L as they're incurred, a more conservative treatment than most of our peers. Three, there's a very clear visibility to the incentives. They're negotiated years in advance and any accelerated recognition of the cost does not change the aggregate cost, only the timing of the recognition as you saw in the third quarter. And lastly, 2016 is our peak for these investments. They're still significant, but they begin to decline in 2017 as you can see on the chart. We're excited about the extensions to our aerospace franchise that these investments are enabling. You can see on slide 14 some of the other investments that we've made to grow our business. We've talked extensively over the past few years about our capital expenditures. We have been investing in about 1.6 times depreciation for the last several years. The returns on the incremental investments like Solstice are phenomenal, twice that of any M&A deal we could do. And while they do temporarily dilute free cash flow, the investments are essential to our growth. We're nearing completion of this investment cycle after which we expect the reinvestment rate to normalize to between 1.0 and 1.2 times depreciation. We also continue to invest in research and development at a rate that's approximately 7.5% of sales, including R&D that's customer funded. Our R&D is fueling the next generation of Honeywell products, including our software offerings. And to ensure we have enough feet on the street to win in our end markets, we're also investing heavily in our sales force. You may think of this as a short term investment, but it's not. A salesperson really isn't productive enough in his first year on the job, so we have to ensure we have enough sales employees in place today to support tomorrow's business. The same applies in our high growth regions, where our headcount has grown nearly 14% in the last three years and we appointed more than $260 million to restructuring so far this year. Slide 15 has more detail about capital investments in performance materials and technologies. These projects add capacity to our highly profitable businesses like Solstice within flooring products and catalyst within UOP. They deliver returns in the 30% to 40% range and we expect more than $1 billion in Solstice revenues per year by 2020. After that, and this is timely, we'll see additional demand generated by the Kigali Amendment to the Montreal Protocol which was just agreed to this week. In UOP, we continued to add catalyst capacity in the U.S. and abroad to support our large installed base in both refining and petrochemical segments. On slide 16, we profile another breakthrough technology that we're investing in, the connected aircraft. Our vision is to create a fast, seamless online experience for passengers, pilots, and operation staff on the ground. To supplement our core product, we've invested in M&A in this space with EMS, Aviaso, SatCom1, and Com Dev and those investments are beginning to pay off. With Com Dev's content on 95% of commercial satellites, we have insight into the networks and services that are going to be needed for connectivity now and in the future. EMS and SatCom1 provide us with antenna, modem, and router technology which is helping us to optimize the way data travels through the aerospace ecosystem, providing our customers with incremental value versus the competition. Lastly, Aviaso provides the software and data analytics necessary to service airlines. We have recent wins with Etihad Airways, Finnair, and Lufthansa Cargo to support this. With all these capabilities, we're now able to supply an aircraft with a big data pipe, JetWave, that is 1,000 times faster and costs 20 times less per megawatt than the previous systems. No one has the solution that we do with JetWave. Combined with our legacy expertise around avionics, mechanical equipment, and services we're positioned to win in the emerging $7 billion connected aircraft space. As you heard Tim say, we anticipated the connected aircraft business would be larger than $1 billion for us by 2020. Let's turn to slide 17 to talk about another great position in a good industry; turbo chargers. As you've heard us say before, we're in the golden age of turbos, turbocharger adoption continues to be driven by regulations around fuel economy and emissions. To comply, automakers are downsizing engines. But to preserve engine performance, they look to our technology which provides 30% more torque, 25% greater fuel efficiency, and 20% lower carbon dioxide emissions. In the graph on the right, you can see that these factors are driving incredible growth and penetration. Today, more than one-third of all vehicles have a turbocharger and by 2020 we anticipate roughly half of all vehicles will have one on board. And every year when we look at our data, our long-term forecast for turbo penetration improves. This is a fantastic growth story for us both in the short term and long term, particularly as adoption of our light vehicle gas applications continues to ramp up. We continue to win more than 40% of the OEM platform competitions globally. Slide 18 highlights another aspect of why we're so well positioned for the future, our software capability. We've been developing software for a long time, much longer than the industrial Internet of Things became popular. More than half of our 23,000 engineers globally are developing software. More than 75% of our HOS Gold breakthrough goals are software-related. While our expertise has traditionally been in software that is embedded within our products, we also have about $1 billion of highly profitable stand-alone software revenue. That number is expected to grow significantly over the next five years. The engineers are building on our strong industrial heritage to blend physical products with software. Last year, Honeywell became the first and only large western company to announce that it is 100% compatible with Capability Maturity Model Integration, that's CMMI level 5, across all global operations and in every business. This is a big deal. It means we can develop products faster and at a lower cost than many of our competitors. We also continue to make investments in our engineering base to ensure we have the best pool of talent driving the software growth at Honeywell. Let me turn to slide 19 and talk about high growth regions which represent about 40% of the world GDP and collectively are growing north of 4%. When you compare that to the other 60% of the world, which is growing at less than 2%, it's clearly essential that we're there and we need to be local if we're going to be successful in HGRs. We saw these trends early and made the right investments to ensure that we'd get our fair share of growth. Since 2003, we've increased our census in high growth regions by 220%. Our presence is impressive, with 140 offices, 70 manufacturing facilities, and over 58,000 employees. Thanks to our investments, Honeywell's business in high growth regions has grown at a 12% CAGR. Today, HGRs represent about one quarter of our overall sales growth and we expect that number will continue to grow. Slide 20 conveys the attractive trends and dynamics for the markets in which we participate. Light hours are growing and passengers are demanding an on-the-ground experience when it comes to connectivity. Our aerospace business is leading the way with JetWave. Turbo penetration is increasing. We have the global scale and industry-leading technology that is being adopted by automakers around the world. When it comes to the Internet of Things, we have over 11,000 engineers working on valuable software solutions that are helping our customers optimize their operations. In high growth regions, we're addressing demand in the world's fastest growing economies through innovative local products and solutions. In PMT, we've invested for growth through capital expansions. It's too early to call a recovery, but we're seeing signs that the bottom may have been reached in oil and gas, including month-over-month improvement in recounts and drilled but uncompleted wells and a stabilizing oil price. We have a broad catalyst portfolio that allows us to capture a large percentage of upcoming catalyst reloads in areas where we participate. We also have leading modular gas processing technology for midstream gas applications and strong positions in refining and petrochemicals. We've also invested in capacity for Solstice which is being rapidly adopted by automotive and building customers throughout the world to meet the demand for low global warming products as HFCs are phased out. Nearly half of Honeywell's current portfolio is dedicated to energy efficiency. The future is bright for Honeywell. The people and technologies we have and the investments we've made are tied to favorable trends in fast-growing industries. All this is going to drive future growth. With that, I'll turn it back over to Dave.

So to summarize, we've made the right investments. We've taken the right portfolio actions and we have industry-leading products and services in the right markets. The future will be quite good for us. We continue to invest heavily to drive positions on winning platforms in aerospace and research and development to bring new breakthrough products and technologies to market, in salespeople and repositioning and in capacity expansions and highly profitable businesses, including UOP and fluorine products. We'll see the benefits of this next year, 2018 and many years to come. You'll hear Darius and Tom talk a lot more about this in the outlook call that we'll have in mid-December. With that, let me turn it over to Mark for Q&A.

We'll take our first question from Scott Davis with Barclays.

You've had a few weeks now, we've had three weeks in October and UOP is a pretty lumpy business. I mean your confidence seems to be really high that comes back in 4Q. Is that based on what you've actually started to see in October or just a function of the backlogs there so it should start to get released?

This is mostly orders that are already there and that the guys have actually been doing a fair amount of the production already to be able to ship into the fourth quarter. So we have a high level of confidence on UOP. Tom, anything you want to add?

No, the visibility to the install base is pretty good. Much of the business is reload activity and we're tied at the hip with the customers.

I understand your point. Let me phrase it differently. I've followed your company for a while, and it's common for timelines to shift, like moving deadlines from December 20 to January 3rd. Given that, I know you have the orders in place, but can you share your level of confidence regarding seeing those in the fourth quarter versus the first quarter of 2017, considering what you've observed in October? Has your outlook changed? That's what I meant to ask, although I didn't word it quite right.

No.

No meaning, confidence is better.

No, no, no. We're in the same place we were. We feel good about it. I suppose there's always that chance that it can happen, but the lumpiness is not so much moving from that we missed a shipment as it is that when the shipments are going to occur. They're already planned. They've already got the orders. They're already producing. We don't see any issues there.

Okay. I was just trying to get my arms around that. It's tough for us to model it. My only other question is the PMT capacity investments you've made, when you roll that stuff out and you start producing in 2017, do you make a margin on that right away or do you have to hit a certain level of capacity utilization before you really start to make a margin in that?

There's typical startup costs, but it's a disciplined startup process. I mean, of course in the first few months you're not running at full optimization, but it isn't very long after that you do achieve the impacts of the volume that are coming through.

That's true. Yes, it's not a drag from the beginning.

Okay. I was just trying to get my arms around it. Thank you, I do appreciate it.

Thanks Scott.

And we'll go next to Steve Tusa with JPMorgan.

Funny we're talking about slippage on this call. You have done a pretty good job over time of calling annual guidance over the last ten years, so just an interesting question. But when it comes to aerospace, you're exiting the year at a pretty negative trend line on organic. I mean, just to think about the comps next year that gives you confidence that you can hold aero close to the flat line organic. I'm just kind of thinking about the direction of that business definitely suggests that it should be down next year organically, just kind of the early read on that.

Let me provide some context for 2017, as I anticipate this question will arise. We plan to approach sales with a conservative outlook based on our observations this quarter, particularly regarding aerospace, which appears to be trending negatively in business jets and commercial helicopters. It’s important to align our sales planning with these insights without being overly optimistic. Additionally, HTSI and RNC, comprising our government services and resins and chemicals businesses, will be transitioning out after contributing for three quarters in 2016. On the positive side, we anticipate benefits from restructuring and a decline in aerospace incentives. We will also consider the first-year impacts of our acquisitions, which typically affect us negatively initially. Interest expenses are expected to be favorable. Areas such as UOP, SPS, and Solstice should also contribute positively. We will discuss these aspects in greater detail in December, once we have gone through the annual operating planning. Darius and Tom will lead this effort. Therefore, despite the slower macro environment and the more challenging aerospace conditions for business jets and commercial helicopters, we feel confident in our statements regarding 2017. I hope this clarifies things.

No, that helps a lot and thanks for the follow-up, allowing me to ask another question. Do you think that's included in the low single-digit guidance you're providing? Is it still possible to grow the Company with aerodynamics down?

Yes.

Okay. And then one last question for you. When it comes to buyback and capital allocation decisions, who's steering the ship right now? I mean is that collaborative with Darius? Is that, who's making the call on perhaps doing the bigger buyback? The stock obviously took a hit, your presentation on Mad Money suggested it was overdone, so who's making the call on the buyback at this stage?

In line with our longstanding approach over the past 15 years, I generally make these decisions independently. However, it is a collaborative process. We always seek input from everyone involved to ensure that all perspectives are considered. Naturally, we engage in extensive discussions, and occasionally, we involve Darius for his insights. This is a team effort, with involvement from Darius and Tom, and we consult with the Board. While our decisions may sometimes catch external parties off guard when announced, we aim to be thoughtful in our approach. Our aim, not just regarding buybacks but in all our decisions, is to gather diverse opinions, whether they agree or disagree, so that we can ultimately make the best possible choices. I believe our performance is assessed based on the quality of our decisions rather than on who was correct from the outset, and we apply the same principle to our buyback decisions.

I was just going to add one element to that, Steve. I mean we're obviously subject to the blackout periods in trading of our stock, so that comes into play from a timing perspective. But as we've referenced in the past, we do have some programmed 10B51 types of plans in place that do a modest amount of activity based on certain levels of trading in the stock.

Yes, that's fine. You don't need to make it some big splashy headline. Thanks.

And we'll go next to Nigel Coe with Morgan Stanley.

Good morning. I do want to echo the comments from Steve. It's amazing how quickly a decade of execution gets lost in noise and the transparency provided around this second half mess I think is well appreciated. So I just wanted to say that. So aerospace the near term outlook is pretty ugly. Biz jet we all know how bad that is right now. When do you see the crossover point between biz jet moderating, the decline moderating and then the ATROE starting to pick up? Is that a second half 2017 event or do you think it's earlier than that?

The ATR side has actually performed fine and we're going to continue to see things like A350 pick up, so that's going to be a benefit to us. The biz jet side and commercial helos should, I would suspect, are going to continue to be a market drag for us next year. When we put all that together, aerospace is still going to be an important performer for us overall. You saw a fair amount of the restructuring also occur there and we think it's going to be a good performer for us in the long term. But 2017 is still going to be little bit tougher overall, I think, when you put all that together.

Is it too early to have confidence in growth or is it too touch and go to make that call?

For 2017 we want to go through the AOP planning to make sure that we understand all the pieces, but at this point I think we're probably going to plan this more conservatively than less. So I'd say overall probably lower sales next year than this year will be the way that we'll plan for it. We really haven't gone through all our planning process yet.

And then as a follow on, the $1 billion forecast for Solstice in 2020 is obviously a big number. Can you just remind us where is the backlog right now for Solstice? What is the current revenue base and how do you think the Rwanda agreement, how do you think that expands the scope for Solstice?

Yes, in rough order of magnitude we're probably a $400 million or so business currently and that continues to grow nicely as we've said. I mean it's more right now mobile air conditioning which is a brand new segment for us, but as we continue to progress through it, we get into buildings and blowing agents and other things. So it becomes a broader application for us. As far as the new regulation, it remains to be seen how that agreement will impact us, but our forecasts are not dependent upon anything that happened this past week. We do see it as potential opportunity, but we need to sort through and fully understand those impacts close to 2020.

I would say though, Nigel, it's clearly a good development and world’s focus on low global warming potential products makes a difference. If you take a look at the HFCs that our product replaces, HFCs are over 1,300 times worse than a single-molecule CO2. If you take a look at HFOs, our invention, it's actually 0.8 molecules of CO2, so like 1,500 times better than what you would see from HFCs. So it's a significant new product. There is a recognition that HFCs do have a big negative impact on global warming potential and Solstice, our HFO is just a tremendous solution for it. And the faster it gets adapted, the more quickly governments will actually be working to stem the tide of global warming. So we think it's going to be quite important.

And we'll take our next question from Andrew Obin with Bank of America Merrill Lynch.

I missed the preview call because I assumed nothing bad was going to happen. So I was out of the office. So I'm going to have a follow up question to that. Just on these incremental aero incentives, my understanding is that these are in fact tied to faster shipments to customers than previously agreed. And if that's the case, what's the impact on revenue and profit for aero in 2017 from taking higher incentives in 2016?

So Andrew, let me clarify that. The incentives become due and are recorded and recognized in our financials when the milestones that govern that incentive are reached. The milestones are generally development or performance-related milestones. They vary by customer. So for example, if you hit the first test flight or entry into service or other types of engineering milestones, those could trigger an incentive being owed and due and it's recognized in our financials. When you look at 2016, our P&L has been significantly burdened by, to the tune of $0.25 as I said earlier, of EPS, by incremental OEM incentives. Next year, this is the peak year and it starts to tail off next year. We get a modest tailwind and then it really accelerates into 2018 and 2019 in terms of the tailwind, yes.

No, I just want to understand the accounting relationship. Do incentives, because my understanding is that incentives, higher incentives do rely on hitting milestones earlier as you said, does translate ultimately into faster shipments to the customers. Is that the right way of thinking about it? Is there a connection?

It's not a direct connection because our incentives are mainly related to the development process and getting the aircraft into production. While you may achieve incremental improvements in production speed, you still need to secure orders and engage in sales, and these cycle times are generally not influenced by those activities.

Andrew, I should add these are good investments for us to be making. We expense everything as incurred. We don't put it on the balance sheet, so we take our hits as they're occurring, unlike others who put it on the balance sheet and you see it over time. So for us while it's painful in the short term, it sure helps where you're going in the long term. And these were decisions that we made several years ago to make sure that we were on the right platforms with the right kinds of products and services going forward. So this is pretty smart money. It's painful in the short term, but it's smart money and positions us extremely well for the future.

And just a follow-up question on connection between global airline passenger traffic and your commercial aviation aftermarket. You were up one. My understanding is that global passenger traffic was up mid-single digits. Is there a reason for the disconnect? Is there destocking, deferred maintenance, or anything else driving the difference? Thank you.

Well, this is one that's always kind of interesting when you look at aftermarket versus flight hours, because while flight hours develop pretty consistently over time and they tend to go up 3% or 4% a year; even in a bad time, they'll go down for a single year and then pop back up again. So that trend is always relatively smooth. The aftermarket stream associated with it, though, bounces around in sometimes crazy directions. If you recall the recession, for example, where flight hours were down 3% or 4%, aftermarket was down something like 20% or 30% in that same year. So the long-term trend is generally consistent with what those flight hours are. In the short term, it can bounce around quite a bit, so being able to explain the difference between say 3% and 1% is easily within the realm of typical variability.

The other thing I'd add to that Andrew, is that you've got a combination of both air transport and business jets in that 1%. We talked a little bit about the slowdown in the business jet RNO activity. I was going through the slides and that has contributed to this.

We will now take our next question from Steven Winoker from Bernstein.

I just want to get my head around restructuring for 2017, not benefits of what you've already accomplished, but new actions. I think on the slide if I interpret it correctly, you're saying the tax rate benefit from the share accounting change will be restructured away. I'm wondering if we should expect the same for any pension benefits that flow through on service costs and are those the two main toggles that would actually define what your restructuring would be next year or do you have some other expected danger, other things? Anything you can frame there would be helpful.

Yes, the way I would think about it, Jeff, is you probably noticed that over a long period of time we do a lot of restructuring. If we've got some kind of unusual gain, we usually use it to restructure. We take a lot through operations generally every quarter. It's one of those things where we want to constantly be investing. We're not going to run out of ideas. I wouldn't want to go into too much detail until we've had a chance to go through all our AOP planning, but I would be surprised if next year we didn't also have additional restructuring ideas as we went along and that we'll find a way to fund them.

It's meaningfully not lower number than it was in 2016?

In 2016, we experienced a significant boost due to our successful restructuring efforts in the third quarter. I do not expect to replicate something of that magnitude next year, but I remain open to possibilities. Our focus will continue to be on maintaining a robust pipeline of ideas and figuring out how to finance the most promising ones, ensuring we are planting seeds for the future.

And just back to the OEM incentives maybe one more time, obviously the accounting is very conservative. Just wonder if you could give us a little thought though on the return metrics as you think about making the investments. Obviously the ultimate success or failure of the investment is going to depend on the commercial success of the airplane and units sold and all that, but what kind of return thresholds do you use when you think about these investments? And what kind of cushion versus weighted average cost of capital or whatever metric you use to decide if you pull the trigger on this sort of stuff?

Yes, there are a few factors we consider. I won't specify a number for the return because I believe that's not advisable to share publicly. However, this project must have a high return, similar to any internal investment, as it's fundamentally what it is. We closely analyze the platform and assess what we believe will transpire. We don't solely rely on external perspectives or customer opinions; instead, we evaluate the potential ourselves to ensure it will yield a strong return for the company. Our team does an excellent job selecting the right platforms, and the concessions we make reflect our commitment to this approach. These will be high-return projects with very favorable internal rate of return outcomes, and we feel confident based on our previous experiences and observations.

Jeff, the way I think of it is we have a very disciplined process when it comes to considering whether we compete for a new platform that's a potential opportunity for us. It's as disciplined as an M&A process, so we consider all of the investments. These incentives are one aspect of that. I mean there's a lot of engineering time and project management time that also goes into the outflows or the investments that you're making. And then of course you consider all the future revenues and the models and so forth. It's as disciplined as M&A. And as Dave said, we have internal returns that we look to as the hurdles. We'll go ahead with the ones that do meet those attractive rates.

And for what it's worth, Jeff, we're very conscious of the time value of money.

And we'll take our next question from Joe Ritchie with Goldman Sachs.

So my first question is on slide 7, when you take a look at your margin bridge for next year and you see all the headwinds that are basically going away, it's about 150 basis points. You're doing a bunch of restructuring this year, you think growth is going to get better next year and yet where the planning for next year is 45 to 75 basis points it seems really conservative. What am I missing here?

I believe we have provided extensive commentary on 2017, more than usual. Please stay tuned for the December outlook call where we will discuss everything in greater detail, with Darius and Tom explaining what to expect and why. We are very aware of the challenges we faced this year and, although I thought we were being cautious from the beginning, it turns out we were not cautious enough. Thus, as we develop our plan for 2017, we want to ensure it avoids the unforeseen issues we encountered this year.

That's fair, Dave, and it's definitely wise to be cautious looking ahead to next year. My follow-up question pertains to the M&A activity you've engaged in. Tom, you mentioned during the previous call that growth was at about high single digits and that the accretion was leaning toward the higher end of your forecast. I'm curious about how much of the deal-related costs and inventory step-up will diminish next year. Additionally, are we still expecting to see the same growth and EPS rates for this year?

Yes, if you look at the deals we integrated this year, most were finalized in the fourth quarter or the first quarter. We incurred significant startup costs, particularly in the first three quarters. Intelligrated, which we closed in late August, will contribute to these one-time costs. However, when you factor in amortization and inventory accounting, the year-over-year impact will be positive for those deals. The critical point is that the operational and cost synergies typically begin to ramp up in the second half of the first year and into the second year, leading to margin rate improvements. We will discuss the details in December, but this should positively contribute to our performance in 2017.

And we'll take our last question from Christopher Glynn with Oppenheimer.

I'll get my two up front. Dave, had a question on your sales employee census data up 10%, didn't look like it grew much in 2015 despite higher M&A. The increase looks like a big organic component. Just wondering where the raw headcount is and where it's especially ROI sensitive. And then my second question would be probably a follow on to Joe's, if you'd quantify what the purchase accounting burden is in 2016 in terms of EPS?

Yes, regarding salespeople, many have been assigned to what we call high growth regions. The reason I mention this is that hiring salespeople requires training and acclimation, meaning they aren't immediately effective. The benefits from these hires will show up in the future. It's challenging to determine their value for the upcoming year and beyond at this moment. However, this represents another investment where we incur costs upfront, as we must pay them even when their sales do not yet justify their salaries in those initial years. This is a positive step for us, enhancing our presence in high growth areas, yet it's a future investment. As for restructuring, I understand we've provided some information, but it's not related to restructuring.

Purchase accounting, yes. Tom, I don't know that I want to go too much more than what we've already disclosed here. Yes, I think we will maintain an overall contribution. For 2016, we guided a contribution of $0.05 to $0.15 to EPS from our M&A activities. This figure includes all one-time costs as well as pure operations. In 2017, you can expect this number to increase significantly as many of those costs will no longer be a factor. We will provide more details on this in December.

That concludes today's question-and answer-session. Mr. Cote, at this time I will turn the conference back to you for any additional or closing remarks.

Yes, thank you. On October 7, we went out of our way to be transparent. With our focus on transparency, I lost sight of how important it was to also convey our confidence in the future. Hopefully, our confidence in that future came across today. We look forward to sharing more with you in our December outlook call. Thank you.

Thank you. This does conclude today's conference. Please disconnect your lines at this time and have a wonderful day.