The conventional wisdom in defense and aerospace is to simply stay away as budget cuts loom. My thought is just the opposite, and I encourage to buy when fear has unreasonably discounted stocks. Moreover, many companies that are engaged in defense and aerospace are meaningfully diversified in other capital goods industries. The problem is that some industrial companies are actually quite expensive.
Honeywell International, Inc. (HON), while an excellent company, trades high at 23.2x past earnings and 3.9x book value. Emerson Electric Co. (EMR) is nearly as expensive as the S&P 500 (SPDR S&P 500 Trust ETF: SPY) on a P/E basis, while its generous dividend yield of 3.4% will become less seductive when the Obama 164% tax hikes kick in next year. One industrial with investments in aerospace and defensive that I recommend backing is United Technologies Corporation (UTX). At 13.1x and 11.3x past and forward earnings, respectively, the company is rightfully rated a "buy" on the Street (source: FINVIZ.com). Below, I review each of these companies.
Honeywell international, Inc.
The industrial company gained 6.7% on Thursday after releasing excellent 2Q12 information. Earnings momentum was complemented by solid 150-bps margin expansion. 4% annual organic growth showcased the company's strength in navigating short-cycles and late-cycles. America has held up better-than-expected, while China has delivered a modest uptick.
Honeywell has delivered top performance and thus merits its premium. Equipped with $4B in cash, management should also consider buying back shares to confirm value to shareholders. European headwinds are also becoming less of a growth issue as momentum continues in Performance Materials & Technology.
I am also attracted to the company's increased exposure in the energy sectors. Honeywell recently released a new control system that will enable oil and gas plants to reduce installation costs by as much as one-third of normal levels. If you are thus looking for diversification, Honeywell represents an attractive growth play. But, at current multiples, I would suggest looking elsewhere for a value play.
United Technologies Corporation
United's Hamilton aerospace business continues to deliver strong double-digit growth. Pratt and Whitney, however, are disappointing and need to be downscaled to allow for greater expansion elsewhere. FX headwinds are also limiting value creation.
The company is currently undergoing a transformation, and I am optimistic about the synergistic potential from integrating Goodrich and expanding the fuel cell business. Over the years, investors have struggled to understand United's holdings; the portfolio adjustments go a long way in helping investors re-focus on aerospace and building prospects. Asset sales and high double-digit EPS growth will help bring back even more investments weary about getting involved in something too complex to value.
While the Otis modernization sales in Europe are weaker than anticipated, I am optimistic about the future market reaction to China's stimulus efforts. The Otis business in China continues to experience impressive growth and more diversification in emerging markets will eliminate some of the headwinds arising from slowing economies.
Emerson Electric Co
Emerson trades at 15.1x and 12.3x past and forward earnings, respectively. The dividend yield of 3.4% is also very generous when coupled with 14.6% annual EPS growth expected over the next five years. Under consensus estimates, the company will have a future stock value of $86.87 at a 15x multiple. Discounting backwards by 10% yields a price target of $53.94, which is at around a 15% premium to the current multiple. This is not as incredible an upside as United's.
While I do not believe that Emersion is undervalued, I think it foots the bill as a steady grower. Dividend distributions have consistently gone up over the years since they were first offered nearly a quarter of a century ago. In fact, dividends have increased by 6.4x since 1988. It would suffice to say then that management is committed to returning free cash flow to shareholders.
In terms of the financial position, Emerson is also solid. It has a leverage ratio of 2.3 and a debt-to-equity ratio of 0.56. Corporate debt ratings of A and A2 from S&P and Moody's further open opportunities for accretive takeover activity.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.