No, this post is not about Apple. But instead, the Apple of Industrials – Honeywell, an internal benchmark that its erstwhile CEO, Dave Cote, had set after pulling it off from the verge of bankruptcy into one of the most admired companies of America.
I’ve been a Honeywell shareholder for the last three years when Dave Cote’s transition to Darius Adamczyk, its current CEO, created a short window of opportunity. Under Dave’s 16 years at the helm, Honeywell’s market cap soared from $20 bn to $120 bn, generating a CAGR of 14% (20% CAGR since its foray into software in 2013), creating thousands of 401(k) millionaires alongside. That time, even the thought of Dave Cote’s retirement sent shivers to investors, especially when none of the large-cap Industrials have had successful CEO transitions in 20 years. For me, the confidence stemmed from the company’s embracement of the digital revolution, mostly unknown to the investment community then, with Darius spearheading the Sentience platform, a cloud-based IoT industrial platform. Leaving the fundamental deep-dive for some other time, let me, for now, share my notes from one of the most engaging books I’ve read in recent times – “Winning Now Winning Later” by Dave Cote (thanks to a recommendation from Greenwood Investors).
Treasure trove for everyone to turn you into performance machines
From an airline’s cockpit avionics to the software for your smart buildings, Honeywell products indirectly touch most of the world’s population. While the book’s central tenet is that a company can invest both for the short-term and long-term without impacting long-term competitive advantages, I was amazed to find tons of treasure to make better life decisions. Whether you are a small business owner, an executive in a firm with a small team or a senior C suite employee – the book provides candid wisdom to recharge you into performance machines! For investors, it offers many qualitative checklists that are hard to come across in investing courses such as MBA and CFAs. Even though I might have read all annual reports to management conversations as back as possible, what blew me off reading the book was that there was so little of this captured in them.
I. Initial years at HON
Joining a sinking ship with a “make the quarter” mindset
Very few people remember that a highly successful HON once was on the verge of bankruptcy in the early 2000s. Thanks to a botched merger with AlliedSignal in 1999, asbestos liabilities, a couple of CEO transitions, and failed attempts to sell the company to United Technologies and then to GE. When Dave joined HON in 2002, he discovered the company’s good fundamental was all a facade. HON was a train wreck and on the verge of failure. It had billions in environmental liabilities, a woefully underfunded pension, a “make the quarter” mindset, cultural warfare, depleted leadership ranks, significant underinvestment in new products, and the list went on and on.
…to only make the situation worse
But it got worse. Strangely, the Board and the outgoing CEO refused Dave any access to financials until July 2002, when he became chairman. And when he gained access, he was hit almost immediately with a bombshell to reduce earnings commitment.
Not the first choice either
Having worked with GE, he wasn’t a finalist in the competition to succeed Jack Welch as CEO at GE, and not be the first to run HON either. The situation was so precarious that none of the Board’s first choices were ready to take the challenge for the top job, fearing a career risk. Finally, the reluctant Board settled with their last option – Dave. Neither did he find any support from Wall Street with the CNBC commentators lambasting, opining that he wasn’t equipped to run Honeywell.
II. Successful habits to charging yourself
I’m a great fan of learning from the habits of successful people. Out of the many discussed in the book, the below had a profound impact on me:
Blue Book sessions
Like many successful people around, Dave was no different in taking out a significant amount of time for him only to think. He called it Blue Book sessions. He’d have a habit of carving out time for himself, putting aside the daily pressures of his job, and just think about the company. These were the times that helped him to put HON on a better path. There have been numerous examples of either breakthrough products or process improvements that came via these sessions
You don’t have to be genius
You don’t have to be a genius or have some magic formula to achieve remarkable performance. You do have to believe you can achieve (here the two seemingly conflicting objectives short-term performance and long-term investment). And then, on a daily operational level, you have to dedicate yourself to actually doing it, pushing yourself and others to go beyond what they think is possible, every small step of the way.
Are you giving too long presentations?
Dave always advocated rigorous analysis rather than intellectual curiosity through long presentations. He finds this missing at many corporates. He shares an example of his travel to Arizona to meet the head of its Aerospace division. The team came up with a thick 150 pages long presentation, full of charts and tables. Moreover, when he started asking questions, the team was more interested in completing the presentation to justify the effort that went into it. Had Dave not asked to stop them from asking tough questions to their discomfort, he wouldn’t have learned how the pressure to report short-term results led to aggressive bookkeeping and special aerospace deals with customers.
Are you not asking tough questions?
While working as CFO at GE’s appliances business, he recounts how previous managers’ effort to reduce “inventory employed” used to fail perennially. Once a unit reduced inventory, customer delivery suffered, customers complained, and the sales force applied pressure on the business to stock more products. Eventually, inventory levels were right back where they had been. Inventory levels and customer satisfaction were directly related. When Dave was given a task to reduce $1 bn in inventory at GE, failure was anticipated. However, he explains that asking tough questions helped shrink the inventory cycle by weeks without compromising customer satisfaction.
Take Your Three Minutes
If you have five minutes to solve a problem, use the first three to figure out how you’re going to do it. I liked this approach, and something I’d like to try in my personal life. Such was an impact that just when the company was about to finalize a $600 m acquisition in its aerospace business, its head said, “I’d like to take my three minutes. Can I get back to you Monday?” After poring through the details of the deal yet again, he decided to proceed. About five months after the deal closed, his team landed a $2.4 bn order the team hadn’t included when valuing the company. That extra three minutes really paid off!
An Avid Reader to push others to think innovatively
Being an avid reader, he reads five newspapers a day and books and publications on diverse topics such as IoT, AI, law, and social media. It was not to become an expert but to ask intelligent questions to experts that made them think more creatively. This reminds me of Charlie Munger’s quote – “In my whole life, I have known no wise people who didn’t read all the time. Asking your leaders to make decisions more rigorously meant that the leaders, too, had to put in more work.
Why “X” days matter for unstructured thinking
In a world ubiquitous with distraction, it’s a big challenge to remain focused. It’s hard to think, read, and learn when endless meetings clog up your day. He developed a practice of designating two or three days each month as “X” days, during which he wouldn’t schedule ANY meetings. He’d spend some of those days, alone, only thinking. This is something he recommends to everyone to dedicate time each month to engage in unstructured thinking.
How to avoid long meetings?
If you haven’t gotten serious about tightening up your calendar, now is the time to start. Do you really need all those meetings? Are there ways to minimize the length of essential meetings and still make progress? His favourite technique to encourage shorter meetings was that teams provide him with a summary page at the beginning of the meeting to get the issue’s gist and recommendations upfront rather than waiting for the story to unfold. Nice hack 😊
III. The unorthodox management style
Perpetual restructuring – unconventional way to work the reinvestment flywheel
Dave brings the concept of ‘Perpetual Restructuring’ – restructuring businesses to make growth investments gradually. This might hurt in the beginning, but once they stuck, momentum performance gains, leading to a flywheel of additional investments. He gives an example of the turbocharger business (now Garrett Motion). Despite being a diesel engine leader, the team resisted into gasoline engines, fearing short-term R&D hit into profits. But in 2007, they started a perpetual restructuring program, investing just a portion each year to R&D for gasoline turbocharges. After a decade, Honeywell claimed a 30% market share of gas, with the business doing so well that they spun-it off into a new company.
Explaining to the Sell-Side
Perpetual restructuring allowed Honeywell to boost R&D from 3.3% of sales in 2003 to 5.5% in 2016. It also spent each quarter on restructuring to improve its processes. Sell-side analysts initially wondered when this restructuring would end, and they didn’t like the answer: never. Few of Honeywell’s biggest investors understood this approach. Over time operating margins jumped from 8% in 2003 to 16% in 2018 while almost doubling sales. This was possible by working on strategies that worked in the short term while giving resources needed to plant seeds for the future. Analysts who had formerly doubted perpetual restructuring became firm believers eventually.
Art of dealing with environmental liabilities
Being in operations for more than a century now, it was apparent that Honeywell had its own set of environmental liabilities. But what Dave inherited was not only criminal charges from poor handling of these liabilities but also a poor public perception. After all, Honeywell should be seen as a world leader in sustainability as its products help reduce emissions, generate green energy, and protect the ozone layer. Honeywell spent a gigantic $ 3.5 bn over 15 years during his tenure versus his original $ 2bn projection over 10 years. He illustrates some great lessons on how he leveraged sales growth to lower the 2% annual spending percentage to significantly lesser.
Onondaga Lake in Syracuse, NY, has often been called the most polluted lake in America. Honeywell went much beyond its obligations with a billion-dollar worth of clean-up
Are jet planes a bad business expense?
His predecessors hadn’t travelled very much, but he felt the need to work on ‘One Honeywell’ culture. In one of his first tours to Europe, he realized that his business leaders were so disconnected that they barely knew one another’s names. To encourage everyone to get out more, he decided to purchase two Gulfstream 550 jets. These planes were very lovely and designed for intercontinental travel. While some observers might have thought this an extravagance, he saw it as a small price to pay for the cultural benefits he’d reap if its leaders had more frequent contact with far-flung offices and customers.
IV. One Honeywell culture
Experience is overrated – Finding the next Tom Brady
It’s easy to write off people in your organization for big jobs because they don’t have the experience, or because they never got an MBA or got an MBA from a second-tier state school instead of Harvard. Experience is overrated. Just a little bit of experience combined with a lot of raw talent is worth far more. For HON’s hiring process, he made sure that the team was always asking themselves, “Could this person in our ranks be the next Tom Brady?”
Tom Brady is the greatest quarterback of all time because of a record number of plays and wins in the Super Bowl by any player in NFL history. And to one’s surprise, no one knew him when he joined the New England Patriots, sitting on the bench. It was only when the star quarterback got injured he got his chance of making history after that
Are you taking career risks to succeed?
Despite putting my money on Darius, I was awestruck to know that the CEO search process actually lasted more than a decade. Such was the amount of meticulous planning that went behind the search. People were identified without their knowledge and given bigger assignments to see their performances without letting them know. They asked a young leader to run a $4 bn business located in Switzerland to see how he did. The leader declined the job, perceiving it as too risky a career move. He was eliminated from the list—if you didn’t handle the risk inherent in that job assignment, you wouldn’t succeed as CEO.
India success story – go local for global
One of the aspects that differentiate Honeywell is a thriving business in China and India. Many leaders are afraid to do R&D in places like India, fearing that the engineering work quality will suffer. He’d challenges convincing business leaders to source their R&D needs out of India. He pushed his CTOs to travel to India and China to see R&D quality. What helped India’s advantage was its facility was CMMI (Capability Maturity Model Integrated) level 5 certified for years, a topmost quality metric that wasn’t explored at Honeywell earlier. Today there are 10,000 employees at Honeywell Technology Solutions (HTS) in emerging countries that have not only helped save costs but build a more in-depth knowledge of local markets.
The balance between culture and hiring – China success story
When Dave wanted to increase the census of leaders in China by 50%, he was resisted that it was impossible as it was tough to find people who’d fit with ‘One Honeywell’ values. A clear message “to find 500 people among 1.3 billion who think like we do” went a long way in putting up the foundation. Today it has 13,000 employees and only 75 expats in China. Lesson: It’s not just possible but necessary to hire for the culture you want, no matter the nature of your business, the size of your workforce, or where in the world you operate.
How culture played a big part in Honeywell getting its current CEO
The story of Darius, the current CEO, was quite compelling to read. A native of Poland, he came to the United States at age eleven knowing no English and made his way through elite American institutes. Moreover, he became part of Honeywell in 2008, through the acquisition of Metrologic, a scanning technology company. As per the acquisition terms, he was required to run the business for a year. After that, he could go on to pursue other jobs or ventures. Dave liked Darius and wanted him to stay, but he knew that wasn’t likely. Having worked previously at GE and Ingersoll Rand, he had little desire to work for a massive company again and was annoyed that HON had tied him down for a year.
For the first month, he did the bare minimum. Over the next several months, as he interacted with others, he liked the organization more than ever thought. He had expected a hard-edged culture in which everyone was in it for themselves and playing politics. He found a place where everyone focused on serving customers and making smart short- and long-term decisions.
Apple of the Industrials sector
From having worked at his father’s garage doing odd jobs to working as a carpenter in Michigan, Dave Cote learned the importance of customer satisfaction and working without an ego early on in his life.
Honeywell has a branded initiative called the “Honeywell User Experience” (HUE) to achieve its stated goal of becoming the “Apple of the industrial sector.” As a part of the program, managers within Honeywell were reluctant to send engineers into the field to spend time with customers or a two-day program. A relentless push by Dave, however, led to its success. An example is the Experian Orion Console. A control panel inside an industrial facility’s control room functions very much like the cockpit in an aircraft. The industrial control operator receives visual data about the plant’s operations and can intervene when issues arise.
V. Accounting Manipulations checklist
Is your company doing aggressive bookkeeping?
HON wasn’t doing anything illegal. Instead, it was gaming the accounting practices to make numbers each quarter. With Wall Street’s focus on EPS, it is a common practice for companies to manage it. It is therefore imperative for us to identify if any of our holdings is guilty of this. A crude yet effective way to measure is a simple cash conversion rate, i.e. free cash flow as a percentage of net income. For example, HON’s conversion rate was just 69%, or in other words, for every dollar in earnings, HON only generated sixty-nine cents in cash, reflecting aggressive bookkeeping. As a result, its leaders lacked a clear and honest picture of their businesses.
Distributor loading
Now, this one sheds light on a fascinating accounting gimmick at GE. The company offered special prices or payment terms to distributors during the last week of the quarter. The practice pumped up earnings, but at a considerable cost. Distributors learned they could get better prices if they strategically timed their purchases. Instead of buying early, they piled their purchases into the last week, receiving a discount or better payment terms. These large orders disrupted GE’s businesses because to fulfill them, the company had to inflate inventories and then scramble to ship everything on time. In some businesses, 25% of the quarter’s sales occurred in the last week. And because there was pressure to replicate in future, the problem worsened over time.
VI. A strong selling discipline
Never shy of getting rid of an underperforming business, the following framework was set up by Honeywell.
1.Is it in a good industry?
2.Does it occupies a great position in that industry?
3.Does, it delivers a strong ROI?
An “A” rating meant that a business boasted a great position in a good industry with a good ROI. A business received a “B” if it didn’t meet the above but had the potential. “C” rating was given if there was no potential to turn it into A.
None of these ratings were disclosed externally and only to limited internal audiences. Over time, they sold off as many as the “C” businesses as possible. But no shedding was done quickly. Instead, Dave explains how in one of his blue book exercises, he realized that selling discipline needed to follow a PE approach, similar to a buying discipline.
…that even was respected by Third Point
After my investment in the company, one of the most respected activists, Third Point also build a position asking for spinning-off the Aerospace business. Dave mentions how after discussions both Darius and Third Point came out of mutual respect to understand each other. Finally, Garrett Motion and Resideo were spun-off. And guess what, the transaction was so well executed that we got $5 bn out of thin air without the share price being impacted. Even if we exclude $3bn in dividends received, the process was amazingly tax efficient. Btw, I sold off both these companies upon listing.
VII. An unconventional approach to Long-Term Compensation
Along with the scorching returns for investors, the company made around 2,500 of its employees 401(k) millionaires, with 95% below the executive level and the lowest compensated, earning an annual salary of only $43,000. When it was difficult for the company to motivate employees in the turnaround phase, they used cash compensation and, lately, a smart way to beat the Black-Scholes math options.
When paying in cash is not bad!
LTC was tricky in a turnaround situation for Honeywell. This meant that stock options or restricted stock didn’t mean much because the prospect of potential gains seemed too hypothetical. To overcome this and boost employee morale, he ensured people got cash instead of stock. The plan proved a great success with a welcome increase in retention and leaders receiving up to 200% of their salary and bonus if they exceeded organic sales and ROI growth metrics.
*Recently, 10-K Diver and Chris Bloomstran explained the concepts of LTC (types & motivation) in the most lucid way available out there on the internet. I’ve included the link below. After reading them you’ll appreciate how Honeywell’s well thought of LTC plans helped achieve a seemingly conflicting objective of maximizing shareholders’ value and motivating employees.*
However, he met resistance from his directors and compensation consultants; a plan paying out more than 100% suggests it isn’t rigorous enough. Although he didn’t succumb to the pressure.
Learning: If your compensation plan is always paying out 100% of compensation, you risk disappointing your exceptional leaders, who feel they’ve been outperforming but are not being paid for it. If the performance is there, pay for it! Fairness requires nothing less.
Behavioural models to beat Black-Scholes math
Employees value stock options (which only gain value if the company performs well) much less than restricted shares (which have some value even if the company is underperforming) because options were inherently riskier than stock. And HON hadn’t performed well historically. Conventional wisdom using Black-Scholes math (a pricing model commonly used in the analysis of options) held that four stock options equaled the value of one share of restricted Honeywell stock. Rather than simply assume this rule’s validity, he ran a survey and found that his people, in fact, valued stock options much less—in their minds, ten options equaled one share of restricted stock. This made sense: given HON’s poor performance in recent years, many leaders felt uncertain at best at our future prospects. Considering this behavioral bias, he increased the proportion of restricted stock for lower-level leaders, issuing at the rate of six options to one restricted share instead of the conventional four. As a result, the company issued fewer shares than the Black-Scholes math said it should. Leaders liked it, retention improved, and the company wound up saving money.
Result
There’s an interesting chart from Honeywell’s proxy statement that shows the effectiveness of the compensation plan. Since 2003, while the sales have more than doubled and EPS quadrupled, the annual incentive compensation (ICP) incentive compensation has only grown 14%, and the number of eligible candidates down 14%. A Win-Win for both the shareholders and the company!
Noteworthy additional readings
1 David Novak’s podcast episodes with Dave Cote and Tom Brady
2 Best primer on Stock-Based Compensation (SBC), explaining types, motivation and Black-Scholes are available from the tweet threads of 10-K Diver and Chris Bloomstran.