Since they reported last week, all I’ve been hearing is “Caterpillar (CAT) reported terrible numbers and so did Honeywell, undermining the global growth thesis, causing the massive 300+ selloff in the Dow.” Ok, I own CAT, which wasn’t pretty. I guess I’m just glad it didn’t take a 16% shallacking like it did same quarter last year (on my birthday no less!) Honeywell however, I thought was pretty darn good given headwinds such as the massive Dreamliner 787 delay and the housing recession. The headlines on Reuters reads: Honeywell sees subprime hitting industry-paper.
Just had to tag on the word “subprime” to scare the bejesus out of investors. Interesting choice of highlighting this tiny tiny part of the whole conference call. Well, why don’t we focus on all the great things Honeywell did in this quarter and where we can look for opportunities? (I’ve already talked up Honeywell enough in my past posts and I continue to put my money where my mouth is, but we lets look at other related industries shall we?)
Yes, aerospace and defense continues to do great and the outlook is strong for the coming years.
“For the year, we anticipate aero sales of around $12.2 billion, up approximately 10% for the year; by the way reflects an increase of about $100 million from a previous estimate and we expect continued margin expansion in the fourth quarter at aero, and we expect full year margins for aero to expand 500 basis points from full year 2006 to just below 18%.”
But the business segments that really seemed to excite the management team were the ACS (Automation and Control Systems). The ACS industry is also the reason I had bought Johnson Controls a while ago, but swapped into Honeywell because JCI had too much auto exposure and no aerospace business. Here’s the management team’s summary of Honeywell’s ACS business this quarter:
Sales for ACS were up 12% in the quarter, 11% organic, which includes 4% from foreign currency translation. We had positive growth across all the regions in ACS. And by the way, I think it’s notable, this is the 10th consecutive quarter of double digit reported revenue growth for ACS.
On the product side, we had particular strength in life safety and security, which continued to perform well benefiting from our strong global presence and also the robust demand in emerging regions. The solutions businesses continue to experience significant growth. They were up 18% in the third quarter. They are benefiting of course from strong energy retrofit projects and again also robust demand in markets, in refining commercial building as well as I have said energy retrofit.
The segment profit for ACS was up 13%. It’s a 10 basis point increase in margin to 11.7%. And when you do the math and we’ve discussed this with you on numerous times previously, when you do the math, it really is the mix impact, so volume and productivity loss by inflation and the very high solutions growth that nearly doubled or more than doubled solutions versus products growth in the quarter. So another great quarter for ACS, continued momentum and continued strong execution across the ACS portfolio.
While we slowly ride the aerospace cycle, with an occasional pause to wait for Dreamliner deliveries,the ACS business is a great growth area for Honeywell and one of the top reasons I own the stock. Buildings in developed nations only get older. Now, more than ever, they have to be retrofitted and made more energy efficient with oil near all time highs. New buildings popping up all over China, Korea, South America, Europe, etc. all need to be energy efficient as well. Other plays in these areas include United Technologies’(UTX) Carrier brand, American Standard's (ASD) Trane brand, and Johnson Controls (JCI).
The risk with these other players is they have more business in the hardware components of a building’s HVAC (heating ventilation air conditioning) systems such as air conditioning units and chillers. These, of course, require expensive materials, exactly the metals and materials that sacked Caterpillar this quarter.
A related play on energy efficiency, as I wrote about previously, is ABB, which not not only builds power grids and innovates new ways to harness energy such as from the ocean. ABB also provides the automation and control that allows factories to be streamlined and efficient. Oh, and T. Boone Pickens owns ABB. I like that!
Moving on to Honeywell’s call, management was also excited about the Specialty Materials business:
Let’s go now to slide number 8, Specialty Materials. Sales are up 6% for SM; segment profit increased 43% driving 340 basis point improvement segment margins to 13%. UOP had a great quarter; sales grew 28% compared to last year and UOP continues to experience strong demand for its proprietary technologies refining and petrochemical market conditions remain favorable, and we continue to leverage a strong market positions and global presence in UOP. Chlorine [ph] products were down 15% in revenues in the quarter due to softness in refrigerants, which is impart of course due to continued weak demands in the U.S. housing market, strong advanced fiber sales within specialty products were offset by declines at resins and chemicals due to a plant maintenance outage, so those two are essentially offset; specialty products and resins and chemicals.”
Ok, there were some weakness related to the weak U.S. housing market. But I am loving the strong demand for refining and petrochemical technologies reaffirms the lack of refiners and oil processing facilities world wide.
This is still a real shortage of overall refining capacity out there. And there is a lot of refineries on the drawing board all of which are going to be good for UOP. So I feel pretty good about the prospects of this business for a while.” ~David M. Cote, Chairman and CEO
This means The Shaw Group (SGR)’s outstanding quarter was not an anomaly, and other engineering and construction firms such as Foster Wheeler (FWLT), Fluor Corp. (FLR), and Jacobs Engineering (JEC) can all still be bought. Even though The Shaw Group has a decent mix of businesses, I believe it's not as well diversified with 46% of its backlog in Fossil and Nuclear plants and 77% domestic business.
Following my thesis that the strong economies of the world (not the U.S.) and those making money on this run in commodities (South America, Australia, Mid-East) will be the best customers for engineering and construction firms, Foster Wheeler and Fluor Corp are my two favorites. These foreign countries are growing the fastest, need the infrastructure, and their big stockpiles of money means they’ll pay construction companies just about anything to complete the projects.
This is a nice tailwind domestic companies just don’t have. Same reason why Halliburton was forced to move its headquarters to Dubai. Both Foster Wheeler and Fluor corp are very well-diversified geographically and have the most business in the strongest sectors. This is important for Engineering and Construction companies since the time for project completion varies, sometimes due to the complexity of the projects and sometimes due to unforeseen complications. Thus, revenues realized from completed projects are lumpy quarter to quarter but diversification may make for a smoother ride when no one project can cannibalize earnings.
Here’s the breakdown of Foster Wheeler and Fluor’s portfolio for year ‘06, choose your favorite:
Geographic: North America (25.1%), South America (3.5%), Europe (28.5%), Asia (11.8%), Mid East (13.5%), Other (17.7%).
Businesses: Power generation (38%), oil refining (20%), pharmaceutical (3.7%), oil and gas (19%), chemical/petrochemical (11%), power plant operation and maintenance (3%), environmental (2%), other and eliminations (2.3%).
Geographic: United States (35%), Canada (6%), South America (11%), Europe (17%), Asia Pacific (3%), Autralia (5%), Mid East (21%), Africa (2%)
Businesses: Oil and gas (40%), industrial and infrastructure (24%), government (21%), global services (12%), power (3%).
Foster wheeler’s the one stop shop for all engineering services. However, since I already have a significant position in ABB for power generation, I would be looking to Fluor corp as a better fit for my portfolio so I’m not too overweight in power generation and have more oil and gas.
Here’s a great article by Ryan Krueger of Minyanville.com: “Follow the Money. In this case, follow the petrodollars.”
Disclosure: author has positions in HON, CAT and ABB