RESIDEO TECHNOLOGIES, INC. annual report, FY2019

Resideo Technologies, Inc. — 2019 Form 10-K

Business context and reporting period. This annual report covers the fiscal year ended December 31, 2019; it is not a standalone fourth-quarter filing. Resideo, spun off from Honeywell on October 29, 2018, operates Products & Solutions (comfort, residential thermal and security products) and ADI Global Distribution (low-voltage security and related products). The financial statements combine pre-spin-off periods with post-spin-off consolidated results, so prior-year comparisons are affected by the separation and are not fully like-for-like.

Financial performance and position

Metric	2019	2018
Revenue	$4.988 billion	$4.827 billion
Gross profit / margin	$1.190 billion / 24%	$1.366 billion / 28%
Operating profit	$258 million	$493 million
Net income	$36 million	$405 million
Diluted earnings per share	$0.29	$3.30
Operating cash flow	$23 million	$462 million
Cash and cash equivalents at year-end	$122 million	$265 million

• Revenue grew 3% as reported; volume and price each contributed 3% and 2%, respectively, while foreign currency translation reduced growth by 2%.
• Cost of goods sold rose 10%, faster than revenue. Management attributed the gross-margin decline principally to product and channel mix (200 basis points), material and labor inflation and fixed production costs, including inventory write-downs (100 basis points), and costs shifted from pre-spin-off corporate allocations (100 basis points).
• Net income in 2018 included a $301 million income tax benefit; 2019 tax expense was $35 million, with an effective tax rate of 48.6%. Non-deductible expenses materially affected the 2019 rate.
• ADI Global Distribution external revenue increased 6% to $2.813 billion and segment Adjusted EBITDA rose 15% to $188 million. Products & Solutions external revenue was nearly flat at $2.175 billion, while segment Adjusted EBITDA fell 32% to $314 million. Segment Adjusted EBITDA is a non-GAAP measure defined by the company.
• Fourth-quarter 2019 revenue was $1.304 billion, gross profit $292 million and net loss $9 million, compared with 2018 fourth-quarter revenue of $1.266 billion, gross profit of $330 million and net income of $16 million.
• Year-end current assets were $1.785 billion and current liabilities $1.494 billion. Accounts receivable were $817 million and inventory $671 million; inventory reserves increased to $69 million from $25 million.
• Debt was $1.203 billion in principal payments due, or $1.180 billion net of unamortized financing costs on the balance sheet. The company had $122 million cash, no revolver borrowings or letters of credit, and a $350 million revolving facility. Approximately $803 million of debt carried variable interest rates.
• Investing cash outflow was $112 million, including $95 million in capital expenditures and $17 million for acquisitions. Financing cash outflow was $53 million, including $22 million of debt repayment.

Material changes, outlook and management commentary

• On October 22, 2019, Resideo began a comprehensive operational and financial review focused on product costs, gross-margin improvement and simplifying general and administrative expenses. The filing provides no quantified savings target or earnings guidance from this review.
• Management reported strong Security performance and continued ADI growth, offset by weakness in Comfort and Residential Thermal Solutions. Comfort declines were primarily tied to lower thermostat sales; RTS was affected by softer OEM demand and regulatory changes. Management also cited lower sales of non-connected thermostats following a product transition and competitive losses.
• Products & Solutions Adjusted EBITDA was pressured by unfavorable mix, inventory variances and write-downs, production cost increases, high rebates under a pre-spin-off contract, Honeywell trademark license fees and acquisition impacts. ADI benefited from volume growth and productivity.
• The company recorded $37 million of restructuring and related expenses in 2019 and reported $31 million cash spending on restructuring actions. It expects $70–$80 million of 2020 capital expenditures, excluding potential spending arising from the operational and financial review.
• No 2020 revenue or earnings guidance is provided. Management stated existing cash and credit resources were expected to meet operating and capital needs for at least 12 months, while noting that additional funding could be required or chosen.

Risks, contingencies and unusual items

• Honeywell environmental reimbursement: Resideo recorded a $585 million liability at year-end for its agreement to reimburse Honeywell for 90% of specified environmental and related payments, net of defined recoveries, subject generally to a $140 million annual cap. The obligation relates to about 230 sites and could continue until 2043, subject to contractual terms. Ultimate costs and timing remain uncertain; the auditors identified this estimate as a critical audit matter.
• Other environmental obligations: Resideo recorded approximately $22 million for sites it owns and operates. The company said future costs could be material to results or operating cash flows, although it did not expect environmental matters to materially adversely affect its financial position based on existing reserves and experience.
• Litigation: Four purported securities class actions were consolidated in January 2020. The complaints allege misleading statements about performance, supply-chain efficiency, separation-related operational issues and 2019 financial guidance. Resideo said it could not predict the outcome and may incur significant costs. It recorded $21 million of legal expense in 2019 and an $8 million legal reserve at year-end.
• Leadership and execution: The board was searching for a CEO successor; the former CFO’s employment ended in 2019 and an interim CFO was appointed. Management turnover and the execution of the operational review could disrupt operations and customer, supplier or employee relationships.
• Debt, Honeywell agreements and liquidity: Debt covenants constrain borrowing, dividends and other actions. A November 2019 credit amendment raised leverage limits and increased applicable interest margins by 25 basis points. Honeywell disputes Resideo’s view that certain amended credit-agreement terms automatically amend corresponding reimbursement-agreement terms. Payment obligations, consent rights and tax-related restrictions may limit financing and strategic flexibility.
• Other material exposures: Risks include competition and connected-home disruption, customer and supplier concentration, raw-material and labor cost inflation, weather and housing-market sensitivity, cyber and privacy incidents, product liability and recalls, foreign-exchange and international risks, and goodwill impairment. Products & Solutions goodwill was about $2.004 billion and its tested fair value exceeded carrying value by only 10%; no impairment was recorded.
• The company reported effective disclosure controls and internal control over financial reporting, and the auditor issued unqualified opinions on the financial statements and internal controls.

Most important facts for investors to verify

• Whether the operational and financial review delivers sustained gross-margin and cost improvements, and what costs are required to achieve them.
• Whether Products & Solutions stabilizes after its 32% decline in segment Adjusted EBITDA, including performance in Comfort and RTS and the effect of thermostat competition and rebates.
• Whether operating cash flow recovers from $23 million and working-capital needs, inventory reserves and cash conversion improve.
• The timing and cash burden of Honeywell reimbursement payments, changes in the $585 million recorded estimate, and resolution of the contractual interpretation dispute.
• Developments in the securities litigation and any related costs, settlements or effects on management and the business.
• Debt covenant headroom, variable-rate interest exposure, refinancing needs and the availability of the undrawn revolver.
• Assumptions supporting the Products & Solutions goodwill valuation and the sensitivity of that valuation to operating results and market conditions.