Not All's Well At Honeywell

| About: Honeywell International, (HON)

Summary

Honeywell has sold off amidst wider fears that industrial companies will struggle to find growth in 2016.

Honeywell's exposure to aerospace and non-residential construction should support one of the stronger growth outlooks in the industrial conglomerate sector.

With a fair value in the range of $106 to $116 on the basis of mid-to-high single-digit FCF growth and mid-20%'s ROEs, Honeywell looks priced like a good long-term holding.

Honeywell

American industrial conglomerate Honeywell (NYSE:HON) has a lot of positives going for it - the company is leveraged to several markets that look relatively healthy going into 2016, management has credibility when it comes to margin improvement efforts, and the balance sheet is in pretty good shape. That said, investors are bailing out of industrials left and right, and Honeywell shares have fallen about 10% from my midyear update. What's more, the health of key markets like aerospace, construction, and auto aren't exactly guaranteed and industrial markets look to be in for a weak run.

Between the prospects for a recession in manufacturing in 2016 and management's relatively conservative guidance for the year, I suppose I can understand why fund managers aren't eager to hold Honeywell right now. Nevertheless, I think this may well be a case where individual investors can benefit from not having that need to respond/report to clients with hair triggers; buying a dip usually means you're buying into trouble, but unless you think the world is in for a really bad stretch, I think this is the sort of opportunity that investors can exploit to get Honeywell shares at a more attractive price.

Can Aerospace Do The Heavy Lifting?

I expect commercial aerospace to be one of the stronger markets in 2016 and Honeywell generates about 30% of its revenue in this market (including defense). It's also generally a pretty lucrative business for Honeywell, as it typically competes with the Performance Materials business for the top spot with margins (which have recently been above 20%).

And yet, when Honeywell gave guidance for 2016 back in December management guided to a relatively disappointing 1% to 2% revenue growth figure. I think it's first worth noting that management could be putting in a conservative number; there is certainly a risk that economic weakness will lead to lower air traffic and lower demand for aftermarket parts and services, but that's not a given yet. I would also note that Honeywell is going to be at the starting line with some multiyear OEM contracts and the concessions/incentives that Honeywell had to offer are going to weigh on reported growth in 2016.

Longer term, I think Honeywell is in a good place with this business. Honeywell generates about half its aerospace business in avionics, a high-margin business that the company generally only has to split with Rockwell Collins (NYSE:COL) and a bit with General Electric (NYSE:GE) and Thales (OTC:THLEY). I'm also looking for improving capacity utilization in the coming years. Honeywell lost some share to Rockwell, GE, and United Technologies (NYSE:UTX) over the past decade due in large part to less competitive bids, but increased activity from new wins should be good for margins. As part of that process, I think Honeywell can also look forward to increased unit content - Honeywell used to make about $1.2 million in revenue per plane in the past decade, but content should improve by 10% or so as new programs like Airbus A350, Embraer L500, and Boeing 737 MAX should carry over $2 million/plane in Honeywell content.

A Turbo Problem Revving Up?

I think it is worth noting that Honeywell's Turbo Technologies business is reported as part of Aerospace and there are some risks to growth here. A large portion of this business consists of selling turbochargers for passenger vehicles and the Volkswagen scandal has definitely made an impression on the business. It doesn't sound as though Honeywell has any meaningful exposure to Volkswagen's U.S. diesel passenger car business, but over 50% of new auto sales in Europe are diesel and there is a threat that this scandal could decrease demand for diesel turbochargers.

Construction Should Help Offset Weak Automation

Management was likewise conservative with its Automation and Controls business, guiding for just 1% to 2% growth in 2016. The company's process automation business (about 20% of the segment) is likely to be weak; as observed with Rockwell Automation (NYSE:ROK) and ABB (NYSE:ABB), process automation in oil/gas and petrochemicals has fallen off sharply and other industrial process automation markets are starting to slow noticeably.

On the other hand, the company's environmental and building controls businesses should fare well in a relatively stronger North American and European non-residential construction market. I think mid-single digit growth is possible in both markets, and I think Honeywell is well-placed relative to Emerson (NYSE:EMR), UTX, and Johnson Controls (NYSE:JCI) on the basis of new products and integrated solutions.

Energy, Chemicals, And General Industrial Are Weak Spots

While I think aerospace and building controls have the potential to outperform expectations in 2016, I'm not as comfortable or confident with the outlook for Honeywell's businesses in energy, chemicals, and general industrial. On the positive side, ongoing use of natural gas as a fuel for electricity will help part of the catalyst business and the Solstice air conditioning product seems to be performing well.

On the negative side, demand for refining catalysts, other flourine products, specialty chemicals, and products for the electronics markets is not likely to improve much if at all. Honeywell is also likely to see ongoing weakness in oil/gas/chemical process automation markets and industrial demand for safety, scanning, and sensing products could underwhelm as part of an overall general industrial slowdown.

Sticking To Its Knitting

Honeywell management has seemed calm and prepared for what is likely to be a weaker 2016 than investors were expecting around mid-2015. Integrating the large Elster acquisition will keep senior management busy, but here too I think the company has set expectations at a "beatably" conservative level. More to the point, I don't see any sign that Honeywell is going to deviate from its long-term plan, and given the results seen to date I don't see why they would want to.

On the M&A front, Elster is the big deal that investors wanted to see, and I'd frankly be surprised if Honeywell took another big swing in M&A in 2016 - though they have the resources to do so if the right opportunity falls into their lap. Instead, I think the priority will be smaller deals like the recent acquisition of the outstanding 30% stake in UOP Russell. This isn't a sexy deal, but UOP Russell has been a good business for Honeywell, and this is the sort of deal that has virtually zero incremental integration or operational risk.

Instead of big disruptive moves, I expect Honeywell to stick to its long-run focus on global themes like energy efficiency, increased urbanization, and increased air travel. I also expect the company to continue working on operating cost reductions as it targets 20% corporate operating margins, though a lot of progress has already been made here.

With the weakness in general industrial and process markets in 2016, I trimmed my expectations for 2016 a little bit, but as I said above I do believe that aerospace and non-residential building will be good markets for the company. My long-term revenue growth expectation is still around 4% and I'm still expecting the company to approach a mid-teens FCF margin over time. That supports a fair value of around $106 today, while a ROE-driven price/book model gives me a target about $10/share higher.

The Bottom Line

There are cheaper stocks in the industrial space, but I think Honeywell offers better quality than Ingersoll-Rand (NYSE:IR) and more security than names like ABB, Rockwell Automation, and Atlas Copco (OTCPK:ATLKY). I don't need big discounts to fair value to like high-quality names like Honeywell, and while I don't want to leave a false impression that there aren't risks to this name as well (particularly in aerospace demand), I think this is a good candidate for a long-term holding. That said, investors buying today have to accept the risk that the economic outlook for 2016 (and 2017) is still too high and that Honeywell could sell off further before finding bottom.

Disclosure: I am/we are long ABB.

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.