Honeywell To Break $70, GE Capital Gets A Boost

Includes: GE, HON
by: Takeover Analyst

I previously argued here that General Electric (NYSE:GE) will gain from strong fundamentals in energy and technology. After GE Capital purchased $7.5B worth of deposits from MetLife Bank, the story has somewhat changed.

Since my article was first published, the conglomerate appreciated by 13.3%, outperforming the Dow Jones by around 1,050 basis points. The shift toward financials will add risks to the business at a time when investors were starting to appreciate the focus on infrastructure. With that said, the transaction does have notable benefits in terms of synergistic value. A safer bet, however, could be found in Honeywell (NYSE:HON), which has notable expansion opportunities in margins and ROIC.

From a multiples perspective, GE is the cheaper of the two. It trades at a respective 15.3x and 11.9x past and forward earnings while offering a dividend yield of 3.7%. Honeywell, on the other hand, trades at a respective 17.2x and 12.4x past and forward earnings while offering a dividend yield of 2.7%. Both companies are rated near a "strong buy."

In addition, the two diversified industrials have had solid operational performance recently. On the third quarter earnings call, GE's CEO Jeff Immelt noted strong performance:

"We had a solid quarter in the third quarter with earnings up 11%. Growth was fairly broad-based. Organic revenue growth was 8%, and orders were very strong. Energy, which has been a drag so far this year, should turn positive in fourth quarter. The environment was more volatile, particularly in Europe and with U.S. housing, and this had a negative impact on both healthcare and appliances. However, emerging market growth was very strong. We have a strong balance sheet, and we continue to execute a balanced capital allocation plan. Significantly, we retired the Berkshire preferred shares and those improved EPS by $0.03 in 2012. So in all, it was a good quarter in a volatile environment.

Orders grew by 16% in the quarter, which is a good indicator for the future. Organic orders growth was 6%. Order pricing is flat versus the previous year, which is a positive sign. We ended the quarter with $191 billion of backlog and this is the highest in our history. Our market momentum gives us confidence and solid organic growth going forward in 2012 and beyond, so overall we think it is a very good orders story."

Greater expenditures on capital orders are anticipated and analysts are bullish about GE's development of next-generation aircraft. One of the reasons why investors should be attracted to the conglomerate is because it has been able to rationally shrink business while maintaining earnings potential. The acquisition of MetLife Bank deposits will move the company away from wholesale funding. According to Sterne Agee, regulations are not likely to increase at GE Capital as a result of the transaction.

Consensus estimates for GE's EPs are that it will grow by 19.1% to $1.37 and then by 14.6% more in both of the following two years. Assuming a multiple of 15x and a conservative 2012 EPS of $1.49, the rough intrinsic value of the stock is $22.35, implying 19.8% upside. If the multiple were to fall to 12x and 2012 EPS turns out to be $1.40, the stock would fall by 9.9%.

Honeywell, in my view, has more favorable risk/reward based on earnings potential and its premium. Third quarter earnings crushed expectations with EPS above the high-end of guidance. Sales grew by 8% organically and the firm proved successful in penetrating high-growth markets. At the same time, Asia is decelerating and the fourth quarter update was somewhat disheartening. Even still, the company has implied headline margins of around 30% and its R&D strategy, coupled with successful operational restructuring, will drive fee cash flow.

Consensus estimates for Honeywell's EPS are that it will grow by 34% to $4.02 and then by 10.7% and 11.7% more in the following two years. Assuming a multiple of 16x and a conservative 2012 EPS of $4.42 the rough intrinsic value of the stock is $70.72, implying 28.2% upside. Note that I am raising my estimate. Even if the multiple were to plummet to 13.6x and 2012 EPS turns out to be 2.7% below consensus, the stock would still appreciate. Accordingly, Honeywell merits its near "strong buy" rating.

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

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