We’re huge fans of Honeywell. The company’s Aero operations are its crown jewel, and while Boeing is facing some troubles these days, we don’t expect much impact on Honeywell at all. In fact, we expect commercial aerospace to remain strong, even in the face of broader industrial weakness. The risks to the company’s HBT business could be starting to mount given some concerns in commercial real estate, but management isn’t really seeing any signs of yet, pointing to only moderating growth in 2020. The SPS division, while a headwind, probably won’t be a factor next year, but it could bounce back as inventories are cleared from the channel.
By Brian Nelson, CFA
Honeywell (HON) has facilitated a number of changes during the past couple years. In October 2018, the company completed the separation of its Transportation Systems business, which had been a part of its Aerospace division. That month, Honeywell completed the spin off of its Homes and Global Distribution operations, the segment of which had been part of its Home and Building Technologies division, a division that has now been renamed Honeywell Building Technologies.
The New Honeywell
Honeywell now operates four business segments: Aerospace, (“Aero”) Honeywell Building Technologies (“HBT”), Performance Materials and Technologies (“PMT”), and Safety and Productivity Solutions (“SPS”). Its Aero segment supplies products and software–including auxiliary power units, propulsion engines, integrated avionics, flight safety, and the like—to original equipment manufacturers (OEM). Its HBT segment delivers building control sensors and switches, control systems, video surveillance, and fire products to keep buildings safe and energy efficient.
The company’s PMT division makes performance chemicals and materials, process technologies and automation systems. Within this division is UOP (formerly Universal Oil Products) that offers customers catalysts and adsorbents to make gasoline, diesel and jet fuel, among other petrochemicals and fuels. End markets in this division include oil and gas, refining, pulp and paper, among others. Honeywell’s SPS division makes personal protection equipment, apparel, and other gear to improve productivity and enhance workplace safety.
Aero tends to be very cyclical, and while Boeing (BA) continues to navigate negative headlines with respect to its 737 MAX, orders ebb and flow with economic activity and global air travel demand, as they always have. That said, the current aerospace cycle is rather interesting relative to those of the past because the order books of unfulfilled deliveries (backlog) at the airframe makers Boeing and Airbus (EADSY) are so large. This means that any downturn in aerospace sales at Honeywell may be rather mild, as delivery trends appear to be more recession-resistant today than arguably at any time in history. Defense spending tends to mitigate cyclical tendencies in commercial aerospace demand, too.
The bigger concern investors in Honeywell must consider is the impact any slowdown in commercial construction may have on overall operations. More recently, our team talked about the severe risks in the event of WeWork (WE) filing for bankruptcy or otherwise negatively impacting the commercial real estate market. WeWork is one of the world’s largest lessees, and an adverse outcome for this company could impact Honeywell’s HBT division as overcapacity could become a problem. HBT accounted for ~16% of total sales during Honeywell’s third-quarter performance, report released October 17.
Third-Quarter 2019 Results Solid
Image Source: 3Q 2019 Earnings Release
Honeywell’s third-quarter earnings release showed organic sales advancing 3% and operating margin increasing 370 basis points, to 19.3%. On a reported basis, the numbers were a little messy given the impact of the aforementioned spin offs in 2018, but the core business remains solid. Honeywell continues to augment this strong performance by buying back stock and hiking its dividend, the latest increase by 10%–its tenth consecutive double-digit increase. Honeywell’s quarterly dividend of $0.90 now implies an annualized forward yield of 2.14%. In the quarterly press release, management also raised the outlook for the rest of the year:
As a result of the company’s performance in the first three quarters and management’s outlook for the remainder of the year, Honeywell updated its full-year financial guidance. Organic sales growth is now expected to be in the range of 4% to 5%; segment margin is now expected to be 20.9% to 21.0%, up 20 basis points from the low end of the prior guidance range; and adjusted earnings per share is now expected to be $8.10 to $8.15, up fifteen cents from the low end of the prior guidance range.
The crown jewel in the third quarter was Honeywell’s Aero operations. Sales in the division advanced 10% on an organic basis thanks in part to increased Defense and Space business, but high-margin commercial aftermarket and OEM demand also helped fuel the year-over-year sales increase. Management was able to leverage this strong top-line expansion in the division into 350 basis points of segment margin expansion, to a very healthy 25.6% for the division. Honeywell’s Aero sales accounted for 39% of revenue during the third period.
The company’s HBT division is showing no signs of the impact of any potential slowdown in commercial construction activity that may be looming. The division witnessed revenue increase 3% on a year-over-year basis thanks to ongoing strength in commercial fire and building products. Impressively, segment margins leapt 390 basis points, to 21% thanks in part to shedding its lower-margin Homes and Global Distribution operations in October 2018. Honeywell’s PMT business also showed strong organic performance, in part helped by strength in licensing and refining catalysts at UOP. PMT accounted for 29% of sales during the third quarter.
The only weakness in the third-quarter report came from the firm’s SPS segment, where organic revenue fell 8% and the segment operating margin deteriorated 320 basis points. Management pointed to distributor destocking as the reason for the weakness, and while the SPS division, at 16% of sales, is not as large as its Aero or PMT segments, the weakness may continue to provide a modest headwind to Honeywell’s overall performance given what management describes as “illegal…imports into Europe” and as inventory in the channel is liquidated.
Honeywell’s Financials Make It a Top-Tier Industrial
Image Source: 3Q 2019 Earnings Release
It’s hard not to like Honeywell’s financials. The firm’s third quarter showed strong organic sales and margin performance, but the real story comes down to whether it can successfully convert such operating dynamics to free cash flow. Honeywell delivers in this area, too. The firm generated $1.3 billion in adjusted free cash flow during the third quarter, and the executive team noted that it expects to “deliver $5.7-$6 billion in adjusted free cash flow” for the year. Almost all of the free cash flow generation has gone to share repurchases, dividends, and M&A, year-to-date. As noted previosuly, management upped its adjusted earnings per share target for 2019, to the range of $8.10-$8.15.
Honeywell’s outlook for 2020 came in largely as expected. Management pointed to “ongoing uncertainty in the macroeconomic environment,” “tariffs, trade tensions, and economic instability,” and the “Europe recession and Brexit risk” as headwinds, but it also noted that commercial flight hours are expanding, defense spending is stable, and even pointed to “non-residential construction growth with slight moderation.” The executive team is expecting robust order trends and margin expansion next year, too. The industrial giant remains well positioned, in our view.
Concluding Thoughts
We’re huge fans of Honeywell. The company’s Aero operations are its crown jewel, and while Boeing is facing some troubles these days, we don’t expect much impact on Honeywell at all. In fact, we expect commercial aerospace to remain strong, even in the face of broader industrial weakness. The risks to the company’s HBT business could be starting to mount given some concerns in commercial real estate, but management isn’t really seeing any signs of yet, pointing to only moderating growth in 2020. The SPS division, while a headwind, probably won’t be a factor next year, but it could bounce back as inventories are cleared from the channel.
Honeywell’s business model and financials make it a top-tier industrial entity. Strong adjusted free cash flow is well in excess of cash dividends paid, and while the company holds a very modest net debt position, Honeywell is a wonderful credit with considerable borrowing capacity, if needed. Shares, however, aren’t cheap at current levels (our fair value estimate stands at ~$150 per share), but investors could be paid to wait as the firm continues to compound economic returns. A healthy dividend yield of 2.14% may be hard to pass up, but we’re still on the sidelines given the context of existing holdings in the newsletter portfolios that we feel are more undervalued.
Aerospace & Defense – Prime: BA, FLIR, GD, LMT, NOC, RTN
Aerospace Suppliers: ATRO, HEI, HXL, SPR, TDY, TXT
Building Materials: CSL, LPX, MAS, MHK, MLM, OC, OSB, VMC
Conglomerates: DHR, GE, HON, MMM, UTX
Electrical Equipment: A, EMR, GRMN, LII, PH, PNR, ROP, TRMB
Electrical Equipment – Industrial: ABB, AME, AOS, CPST, ETN, FELE, LFUS, ROK
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Brian Nelson does not own shares in any of the securities mentioned above. Majority shareholder of Valuentum, Elizabeth Nelson, owns shares of Honeywell in her retirement account. Some of the other companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.