Will Honeywell's Buybacks Truncate Dividend Growth?

| About: Honeywell International, (HON)
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There has been a lot of controversy over what may happen to Honeywell's (NYSE:HON) distributable cash flow -- whether share buybacks or dividends will become more important in the years and decades ahead (these are two of the ways a company can return cash to shareholders). Management was intent on bolstering its buyback program (see here), but should dividend growth investors now be worried? Let's dive in.

But first, a little background on dividend growth investing. History has revealed that the best-performing stocks during the previous decades have been those that shelled out ever-increasing cash to shareholders in the form of dividends. Unfortunately for the individual investor, most dividend analysis that we've seen out there is backward-looking - meaning it rests on what the company has done in the past: how long it has raised its dividend, etc.

Although analyzing historical trends is important, we also think assessing what may happen in the future is even more important. That is why we created a forward-looking assessment of dividend safety through our innovative, predictive dividend-cut indicator, the Valuentum Dividend Cushion™. We use our future forecasts for free cash flow and expected dividends and consider the company's net cash position to make sure that each company is able to pay out such dividend obligations to you -- long into the future. In this article, let's evaluate the dividend growth prospects of Honeywell.

Image Source: Valuentum

First of all, Honeywell's dividend yield is solid, offering a 2% annual payout at recent price levels - we prefer yields above 3% and don't include firms with yields below 2% in our dividend portfolio. But for a company as solid as Honeywell, we're keeping a close eye on the firm. And here's why.

For starters, we think the safety of Honeywell's dividend is GOOD. We measure the safety of the dividend in a unique but very straightforward fashion. As many know, earnings can fluctuate in any given year, so using the payout ratio in any given year has some limitations. Plus, companies can often encounter unforeseen charges, which makes earnings an even less-than-predictable measure of the safety of the dividend in any given year. We know that companies won't cut the dividend just because earnings have declined or they had a restructuring charge that put them in the red for the quarter (year). As such, we think that assessing the cash flows of a business allows us to determine whether it has the capacity to continue paying these cash outlays well into the future.

That has led us to develop the forward-looking Valuentum Dividend Cushion™. The measure is a ratio that sums the existing cash a company has on hand plus its expected future free cash flows over the next five years and divides that sum by future expected dividends over the same time period. Basically, if the score is above 1, the company has the capacity to pay out its expected future dividends. As income investors, however, we'd like to see a score much larger than 1 for a couple reasons: 1) the higher the ratio, the more "cushion" the company has against unexpected earnings shortfalls, and 2) the higher the ratio, the greater capacity a dividend-payer has in boosting the dividend in the future. For Honeywell, this score is 2.6, offering both a nice "cushion" and revealing excess capacity for future dividend growth (above and beyond our existing dividend growth projections--please view bottom right table in the image above). The beauty of the Dividend Cushion is that it can be compared apples-to-apples across companies. For example, Wal-Mart (NYSE:WMT) scores a 1.5 on this measure. We often use the dividend cushion as a key decision component in choosing companies for addition to the portfolio of our Dividend Growth Newsletter.

Now on to the potential growth of Honeywell's dividend. As we mentioned above, we think the larger the "cushion" the larger capacity it has to raise the dividend. However, such dividend growth analysis is not complete until after considering management's willingness to increase the dividend. As such, we evaluate the company's historical dividend track record. If there have been no dividend cuts in 10 years, the company has a nice growth rate, and a nice dividend cushion, its future potential dividend growth would be EXCELLENT, which is the case for Honeywell.

However, we don't just stop there -- we make it easy for the individual investor to view the health of a dividend with a simple view of a matrix. Also in the image above, one can see that Honeywell has a very solid dividend--the cross section of its GOOD safety and EXCELLENT future potential growth scores. And because capital preservation is always an important consideration (and prudent necessity for investors), we assess the risk associated with the potential for capital loss (offering dividend growth investors a robust and straightforward picture). In Honeywell's case, we think the shares are fairly valued, so the risk of capital loss is MEDIUM. If we thought Honeywell was undervalued, we'd consider the risk to be LOW.

All things considered, we like the potential growth and safety of Honeywell's dividend. The only issue we see right now is that its yield is a bit low to get us excited. We'd wait for a dividend increase or a pullback in the shares to consider it a nice income play. We don't think Honeywell's management will sacrifice dividend growth for its ambitious share buyback program. Free cash flow is quite robust.

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