Honeywell (NYSE:HON) is one of our favorite industrial conglomerates on a fundamental level. Its aerospace products are used on virtually every aircraft, while its building solutions are in over 150 million homes. The company's prospects for turbo in its Transportation Systems division are also very attractive. Let's evaluate the firm through the DCF and apply the Valuentum process to shares in this article.
But first, a little background to help with the understanding of some of the terminology in this piece. At our boutique research firm, we think a comprehensive analysis of a firm's discounted cash flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolios. These stocks have both strong valuation and pricing support. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.
Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas -- as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.
We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF -- that's why we focus on relative value -- and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking common sense.
Honeywell's Investment Considerations
- Honeywell's business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very positively.
- Honeywell is a conglomerate operating in the following areas: aerospace, automation and controls solutions, performance materials and technologies, and transportations systems. We like its exposure to aerospace the most, and we outline why below.
- Honeywell has a good combination of strong free cash flow generation and manageable financial leverage. We expect the firm's free cash flow margin to average about 11.6% in coming years. Total debt-to-EBITDA was 1.4 last year, while debt-to-book capitalization stood at 33.6%.
- Honeywell is targeting a long-term compound annual sales growth rate of roughly 4%-6%, and it expects segment margins to continue to expand. Though we expect continued margin improvement, our forecast for sales expansion is slightly lower than the midpoint of management's goals. This implies upside to our fair value estimate if we use the high end of management's guided range in our valuation model.
- Honeywell is targeting segment margins north of 20% for each of its four segments. Transportation Systems (turbo) is poised to grow the fastest and experience the largest margin potential. We're monitoring this segment closely.
- At the Valuentum methodology's core, if a company is undervalued both on a discounted cash flow basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on the scale. Honeywell posts a Valuentum Buying Index score of 6, reflecting our "fairly valued" DCF assessment of the firm, its neutral relative valuation versus peers, and very bullish technicals. A score of 6 is not as good as a 9 or 10 (the equivalent of a "we'd consider buying" rating), but it is better than most in our coverage universe. We'd grow more fond of Honeywell if it were to score higher on the index, though we note that the firm is a solid fundamental holding in any case.
Why We Like Honeywell's Aerospace Exposure
In the world of investing, the strength of the industry in which a firm operates is sometimes as important as the company itself. A strong industry backdrop offers the potential for fundamental upside as the industry revenue pie grows. Said differently, it is much easier for a firm to do well in an expanding industry, where both the industry's revenue pie is growing and market share opportunities are available, than it is for a firm to do well in a shrinking industry, where it may have to battle entrenched competitors in a pricing death match to gain share. Though commercial aerospace will always be cyclical (as it relates to order trends) and pricing competitiveness will always be present, the massive backlogs of unfulfilled orders (already booked) at the airframe makers is simply remarkable - with the better part of a decades' worth of orders already in hand.
Boeing (NYSE:BA) showcased its enviable revenue visibility when it posted strong first-quarter results. The company ended the quarter with a total backlog of $440 billion, nearly five times the high end of its revenue guidance range for 2014 ($90.5 million). This measure is roughly flat from the end of 2013, up from $390 billion in 2012, and $355 billion in 2011 (shown in image below). Compared to revenue of just a few years ago, the current level of backlog is nearly 8 times 2011 revenue, for example - a staggering multiple given that 2011 can likely be considered mid-cycle performance, despite Boeing almost being over its head developing and producing the 787 Dreamliner at the time.
Image Source: Boeing
During the first quarter, the firm booked 235 net commercial airplane orders, and its commercial backlog swelled to over 5,100 planes valued at $374 billion. The value of the commercial backlog is more than 6 times the expected top-line results of its Commercial Airplanes segment in 2014, and the tally of unit orders is roughly 7 times expected deliveries for this year. Boeing has significant flexibility to fill delivery slots in the years ahead, and the aerospace giant's nice position will have spillover benefits to suppliers, including Honeywell.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Honeywell's 3-year historical return on invested capital (without goodwill) is 31.9%, which is above the estimate of its cost of capital of 10.1%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Honeywell's free cash flow margin has averaged about 6.9% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Honeywell, cash flow from operations increased about 66% from levels registered two years ago, while capital expenditures expanded about 19% over the same time period.
Our discounted cash flow model indicates that Honeywell's shares are worth between $71-$107 each. Shares of Honeywell are trading just north of $90 each at this time, which is slightly above the midpoint of the fair value range. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. If Honeywell were trading below the low end of the fair value range on improving technical/momentum indicators, we'd grow very interested in shares. They'd also register a very high Valuentum Buying Index rating under those conditions.
The estimated fair value of $89 per share, the mid-point of the fair value range, represents a price-to-earnings (P/E) ratio of about 18.1 times last year's earnings and an implied EV/EBITDA multiple of about 11.3 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 4.6% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 5.4%. Still, we think a 4.6% annual growth rate estimate in the top line during the next five years is a rather reasonable assumption for Honeywell (it's also within management's forecasted range of 4%-6%).
Our model reflects a 5-year projected average operating margin of 16.6%, which is above Honeywell's trailing 3-year average. We're expecting nice operating leverage as the industrial conglomerate benefits from aerospace industry tailwinds and margin expansion in its Transportation Systems division. This should drive strong earnings expansion.
Beyond year 5, we assume free cash flow will grow at an annual rate of 2.7% for the next 15 years and 3% in perpetuity. We tie Honeywell's long-term growth rate to expectations of the pace of global GDP, which we view as a reasonable assumption for the global conglomerate. For Honeywell, we use a 10.1% weighted average cost of capital to discount future free cash flows.
We understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money managers -- those that drive stock prices -- pay attention to a company's price-to-earnings ratio and price-earnings-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. For relative valuation purposes, we compare Honeywell to peers 3M (NYSE:MMM), Danaher (NYSE:DHR), Tyco Inc (NYSE:TYC), and United Tech (NYSE:UTX).
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $89 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Honeywell. We think the firm is attractive below $71 per share (the green line), but quite expensive above $107 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Honeywell's fair value at this point in time to be about $89 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Honeywell's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $115 per share in Year 3 represents our existing fair value per share of $89 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.