When a company reports its quarterly earnings, management often presents just a sketch of how the company performed. But equally important for investors is the conference call where management's commentary colors in the sketch, providing the full picture of the company's recent performance.
UOP turning up
Housed in the performance, materials, and technologies segment, UOP, which provides technology and services to the oil and gas industry, accounted for 7.7% of Honeywell's $38.6 billion in net sales for fiscal 2015. A victim of the downturn in the oil and gas industry, UOP reported a 7% decrease in sales from 2014 to 2015, and that slide is continuing well into 2016.
For the first and second quarters, UOP reported, respectively, year-over-year declines of 38% and 18% in sales. On the conference call, though, management suggested UOP may soon be rebounding.
According to David M. Cote, Honeywell's chairman and CEO, he and the rest of management have "highlighted the market headwinds in our oil and gas businesses in UOP which bottoms out in 2016." And looking to substantiate his optimism, Cote reported that "UOP backlog was close to 10% higher than the second quarter of 2015."
But optimism is relative, and management isn't suggesting UOP is out of the woods just yet. In fact, later in the call, Cote estimated UOP's losses were "expected to moderate in the third quarter but still be down double digits on a year-over-year basis."
See you, EU
Although news of Britain's exit from the European Union is no longer dominating the headlines, management took time on the conference call to discuss how it was attempting to mitigate risk following the Brexit. With the U.K. accounting for 4% of Honeywell's sales -- and the rest of Europe accounting for 18% -- management is adopting a cautious approach as it faces increased uncertainty in the short term. According to Cote, the company "will continue to be cautious in our sales planning and stay conservative in terms of our cost structure and investments in the region."
According to management, foreign currency adversely affected EPS by $0.04 during the second quarter and will amount to a $0.15 headwind for fiscal 2016. To protect the company from further foreign currency complications due to Brexit, management is taking additional steps in its foreign currency hedging approach. For 2017, it implemented two new hedges: 75% of its euro exposure hedged at $1.15, and 50% of its GBP exposure hedged at $1.44.
Zeroing in on aerospace
Reporting $3.78 billion in revenue -- a 1% decrease year over year -- aerospace expanded its segment margin (excluding M&A) 80 basis points (bps) during the second quarter; moreover, this translated to a 2% increase in segment profit. Next quarter, according to management's guidance, won't be as successful in terms of growing the segment margin. In fact, it is expected to contract between 30 bps and 50 bps (excluding M&A).
Although it recognizes that there are some clear challenges in the aerospace market, management tried to accentuate the positive. In an attempt to expand its presence in the commercial aviation OEM market, the company has been offering extensive incentives.
Working to increase its install base comes with costs, though. Management estimates that, in addition to adversely affecting EPS by $0.03 for Q2, the incentives will amount to a $200 million reduction in sales for fiscal 2016.
Management claims the adverse impact of the incentives will be similar in 2017 as in 2016, but it will be a worthwhile investment. In terms of the long-term benefit, Thomas Szlosek, CFO and senior vice president, noted that, "In fact, it helps us that we're building install base and it drives the future service business for that business."
In addition to focusing on incentives, management noted the adverse impact of the commercial helicopter business on the aerospace segment. Falling 7% year over year, the defense and space division, which includes the commercial helicopter business, is yet another area of Honeywell's portfolio that's suffering from the decline in the oil and gas industry -- an area expected to suffer through the rest of the year, but improve at some point. Speaking to this, Szlosek opted for optimism and responded to an analyst's question by saying:
Your guess is as good as ours in terms of where oil prices are going and when the volumes will turn. But we feel pretty confident that we're at or close to a bottom in UOP and we expect that to kind of prevail through the rest of our portfolio as well. So we expect to see this improve.
There was plenty to address on the Q2 conference call -- UOP, Brexit, and difficulties in the aerospace segment were just some of the issues facing the company. Realignment of the automation and control solutions segment and extensive M&A activity were also thoroughly discussed.
As expected, management tried to paint a rosy picture, but savvy investors know everything should be taken with a grain of salt. Management's optimism that the oil and gas industry will turn around at some point is merely stating the obvious -- few people, presumably, would argue that the oil and gas industry will never recover. However, it will be interesting to see how much the company benefits from the incentives it has (and will continue to) offer to expand its install base in the aerospace segment.