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Summary

  • Honeywell's shares hit fresh high in the wake of solid second quarter results.
  • Multi-year plans, organic growth, margin expansion and valuation multiple increase all benefited shares in recent years.
  • I wonder what could drive shares higher, not finding the current risk-reward too appealing given the cyclical nature of the business.

Investors in Honeywell (NYSE:HON) were pleased with the release of a solid set of second quarter results which pushed shares to fresh all-time highs.

Shares have benefited from the economic recovery, margin expansion and general increase in stock valuations thanks to lower interest rates. All of this, combined with ambitious multi-year programs, leave me wondering what, if any, could be the next driver for shares to go higher going forwards.

Second Quarter Highlights

Honeywell posted second quarter sales of $10.25 billion, up 6% compared to the year before. Sales came in ahead of consensus estimates at $10.19 billion.

The company improved segment margins by another 60 basis points towards 16.7%, while reported earnings per share rose by 8% to $1.38 per share. Earnings beat consensus estimates by two pennies.

The automation and control business posted the steepest sales growth, reporting a 10% increase in sales to $3.6 billion. Note that acquisitions were a big driver behind sales growth with organic growth coming in at 3%.

Transportation sales rose by 8% to $1.0 billion, combined with strong margin expansion of 310 basis points. Organic growth in the segment totaled 4%.

Sales at performance materials and technologies rose by 6% to $2.6 billion thanks to UOP catalyst and gas processing growth as well as increased sales of Fluorine products. Margins rose by another 30 basis points to a very impressive 18.0% of sales.

Perhaps a bit disappointing was the flattish sales growth at the aerospace business with sales coming in at $3.0 billion. The very modest commercial growth was offset by a decline at the defense activities. Margins improved by another 30 basis points to 19.8% of sales.

Updating On 2014 Targets

For the current year, Honeywell has adjusted its full year targets. Sales are now seen at $40.2-$40.4 billion which would imply a 3-4% increase in annual sales. Previously, the company guided for sales of $40.3 to $40.7 billion.

Despite the softer revenues, Honeywell sees segment earnings improving towards 16.8% to 17.0% of sales. Previously, the company guided for margins of 16.6% to 16.9% of sales.

Earnings per share are now seen at $5.45 to $5.55 per share on a non-GAAP basis which means that the lower end of the range has been raised by five cents.

Trading at $97 per share, equity in Honeywell is valued at $77 billion. This values the company's equity at 1.9 times anticipated sales and 17-18 times adjusted earnings. Despite having $6.6 billion in cash, Honeywell operates with a modest net debt position of $2.6 billion.

2014-2018 Plan

In a youtube.com video, Honeywell released its new five year plan for the period 2014-2018.

The company aims to post sales of $46-$51 billion by 2018 thanks to a 4-6% compounded annual increase in organic sales. This should be driven by relentless focus on innovation while the company also targets $10 billion in total merger & acquisition activity over this time period.

Current segment earnings, targeted at 16.8-17.0% for this year, are set to improve towards 18.5-20.0%. At the midpoint of this range and given the anticipated sales growth, total earnings should grow at 40-45% on a cumulative basis. This translates into annual growth of about 10% for earnings, with anticipated share repurchases pushing growth potentially even higher.

Based on the current valuation, Honeywell's 2018 targets values equity in the business at 1.6 times anticipated revenues and 13-14 times anticipated earnings. Note that this excludes the accretive potential from any share repurchases.

Final Takeaway

Investors in Honeywell as well as other high-end industrial conglomerates have done well in recent years. Honeywell has posted solid organic growth, accompanied by bolt-on acquisitions and targeted margin expansion.

Combined with greater shareholder payouts and valuation multiple expansion by the market in general, this has pushed up the share price. Shares fell from highs of $60 before the crisis to lows of $25-$30 by the end of 2008. One steady march higher has pushed shares to current highs of close to $100 per share.

While I applaud all of management's intentions, I am wondering what could be the next driver behind a potential higher valuation. The company has benefited from sales growth, margin expansion and a general higher valuation of companies in the market. While continued improvements are anticipated in the new five year plan, shares are priced at rich valuation of 17-18 times adjusted earnings.

While this is in line with the general market, don't forget that despite all the good intentions, Honeywell remains a cyclical play. I would urge investors to consider how much revenues dropped during the 2009 recession, and notice that only by 2012 revenues came back to the same levels as 2008.

While management is making all the right moves, they simply cannot keep up with creating value amidst the strong multi-year momentum in the shares. I remain cautious and remain on the sidelines.

Source: Honeywell - Little Appeal As I Cannot Identify The Next Value Driver