Honeywell Sees Strong Upside, Dwarfing Emerson

 |  Includes: EMR, HON
by: Takeover Analyst

Over the last three months, Honeywell (NYSE:HON) has outperformed Emerson Electric (NYSE:EMR) by 1,240 basis points at a return of 20.5%. The Street still rates Honeywell a "buy" (ratings source: T1 Banker). Based on my review of the fundamentals, DCF model, and multiples analysis, I find significant room for industry-wide appreciation.

From a multiples perspective, Emerson is the cheaper of the two companies. It trades at a respective 16.3x and 12.8x past and forward earnings, with a dividend yield of 3.1%. Honeywell, on the other hand, trades at a respective 25.4x and 11.9x past and forward earnings.

Undervalued targets Electro-Sensors (NASDAQ:ELSE) and Mesa Laboratories (NASDAQ:MLAB) both have technical factors pointing in their favor and trade at a respective 25.4x and 22.6x past earnings. These smaller companies, including Schmitt Industries (NASDAQ:SMIT), have less volatility than both the broader market and their bigger competitors, while offering the benefits of improved recognition on the Street. As informational flow picks up, I expect the two to close their discounts to intrinsic value.

In the meanwhile, Emerson and Honeywell have already attracted the Street's attention, and still have room to appreciate.

At a shareholder / analyst call, Emerson's management noted the strong global footprint:

"In the emerging markets, we're looking at less than 6% for the first time in a while. China, being reasonably strong, I think they'll probably be more like 7% or 8% with the upside depending on what stimulus they put in place, which I think they will put in place as we go forward here in the calendar year. India, around 3% to 4%. They have their own problems. Eastern Europe, Russia, around 5%. Latin America, around 5%. Middle East, Africa, around 5%. So we're looking at only around 6%. And looking at probably only 3% to 4% underlying GFI growth for our markets. Some markets better, some markets worse…

So what we look at right now, unfortunately, as I said a rear-end-loaded forecast, with a strong backlog, with some pace of business around the world. Our diversification is going to help us. Today, 35%, 36% of our sales are in emerging markets. And the key thing for us is to execute within the backlog".

China is expected to pick up sometime around the second half, as the company gains momentum in achieving its 5%-7% organic growth target. During the call, the firm notably addressed its operational challenges. From the Thai floods to sector-wide inventory disruptions, Emerson has showcased unusual vulnerability. The company will be able to turn over a new leaf and optimally drive value creation through the restructuring of Network Power. Embedded Computing and Power are losing money to the tune of $90M on a run-rate basis; thus, it would not surprise me to see a strategic play here to be part of the $2B-$3B divesture effort.

Consensus estimates for Emerson's EPS forecast that it will grow by 7.4% to $3.48 in 2012, and then by 14.4% and 11.1% in the following two years. Assuming a multiple of 15x and a conservative 2013 EPS of $3.81, the rough intrinsic value of the stock is $57.15, implying 12.3% upside. Modeling a CAGR of 10.9% for EPS over the next three years, and then discounting backward by a WACC of 9%, yields a similar price target.

In my view, Honeywell has greater risk/reward. Unlike its competitor, Honeywell posted a strong performance in the most recent quarter, with 7% organic growth in sales pushing EPS to the high end of guidance. An impressive $1.4B in free cash flow was generated, as emerging market returns kicked in. Going forward, ROIC, net cash flow, and margins are all anticipated to increase, given productivity improvements.

Consensus estimates for Honeywell's EPS forecast that it will grow by 9.6% to $4.44 in 2012, and then by 11.9% and 12.5% in the following two years. Assuming a multiple of 15x and a conservative 2013 EPS of $4.89, the rough intrinsic value of the stock is $73.35, implying 23.8% upside.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and prospectively commissioned. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence. Always discuss investments with a licensed professional before making any financial decision. Statements made within this report may include “forward-looking statements” as stipulated under Section 27A of the Securities Act of 1933, Section 21E of the Securities Act of 1934, and the Private Securities Litigation Reform Act of 1995. Since these statements are uncertain, actual results may be materially different from those expected.