Honeywell: Slowing Growth But Sweet Dividend

| About: Honeywell International, (HON)


Honeywell recently trimmed its full-year earnings per share guidance for 2016 and noted that core organic sales are now expected to be down 1-2% for the year.

Honeywell has its hands in a lot of end markets, and as the commercial aviation cycle matures, growth continues to slow.

Honeywell pays a strong, competitive dividend, in our view, and the safety of its payout is top notch as measured by its Dividend Cushion ratio.

Let's take a look at the firm's investment considerations as we walk through the valuation process and derive a fair value estimate for shares.

By The Valuentum Team

Honeywell (NYSE:HON) continues to be an M&A story, as organic growth trends have been under pressure as a result of a global economy that has failed to stack up to expectations. During the past 15 years, for example, Honeywell has completed ~90 acquisitions and divested ~70 businesses. In 2015 alone, the company spent ~$5.8 billion in cash for the acquisitions of Elster, ComDev, Satcom, Sigma, and Aviaso. In August 2016, Honeywell completed the buyout of Intelligrated (automation solutions business), and unconfirmed reports suggest it is interested in acquiring JDA Software for $3 billion. Honeywell also spun-off AdvanSix (NYSE:ASIX), its resins and chemicals operation, where shareholders received one share of AdvanSix for every 25 shares of common Honeywell stock they owned. It recently sold its government service provider to KBR (NYSE:KBR).

Profit taking in Honeywell's shares became more prominent October 2016, as the company trimmed its full-year earnings per share guidance for 2016 and noted that core organic sales are now expected to be down 1-2% for the year. We find the bottom-line revision a little troubling because Honeywell had announced a $5 billion stock buyback program in April 2016 as a strategy to deploy cash. The buyback program in itself was peculiar and may have been the catalyst for CEO Cote's impending departure. One doesn't have to look much further than Cote's 2015 annual letter to shareholders to see that there may have been some disagreement in the board room regarding opportunistic share buybacks:

"As you may know, there has been significant Analyst support over the years for 'meaningful' share buyback. To the consternation of several analysts and likely many short-term holders, we took a different path than many of our peers. We chose instead to keep our powder dry for the day when opportunity and pricing came together, limiting our buyback activity to periods where opportunistic market conditions existed and largely to keep share count flat over the long term. While that same $5.8 billion deployed to share buyback would have yielded higher EPS, I don't believe it would have made us a better long-term investment. And as it turns out, on top of the $5.8 billion deployed for acquisitions, the market conditions (particularly in the late third and early fourth quarters) presented an opportunity for us to repurchase almost $2 billion of our outstanding shares in 2015, almost twice the amount we have historically done."

Honeywell has its hands in a lot of end markets, and as the commercial aviation cycle matures, growth continues to slow. Its defense and space end market has also proved challenging, as oil and gas markets continue to be dislocated as a result of the collapse in energy resource pricing through much of the past 18 months. We like the visibility of commercial aerospace in light of the massive backlogs at the commercial airframe makers, but we're less enthused at the prospects of a resurgence in the defense/space and oil/gas markets. New products in homes/buildings should help offset some of the weakness, and prospects in turbo remain strong thanks to increasing penetration rates. Still, core organic growth remains under pressure.

Image Source: Honeywell

Despite the slowing growth, we think Honeywell pays a fantastic and competitive dividend, with a yield (~2.2%) that makes its impressive Dividend Cushion ratio of 2.9 simply too high to pass up. Management continues to target high ROI capital spending as it pursues key process initiatives and productivity improvements, a healthy combination for ongoing segment margin expansion. We're huge fans of its commercial original equipment and aftermarket business in light of the massive backlogs at the airframe makers, and there's not much that looks poised to derail Honeywell's dividend strength, at least in the near term.

Image source: Valuentum

Image source: Valuentum

Honeywell's Investment Considerations

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Investment Highlights

• Honeywell is a conglomerate operating in the following areas: aerospace, automation and controls solutions, performance materials and technologies, and transportation systems. Its aerospace products are used on virtually every aircraft, while its building solutions are in over 150 million homes. The company was founded in 1920 and is based in New Jersey.

• Honeywell is targeting segment margins north of 20% for each of its four segments. Transportation Systems (turbo) is poised to grow the fastest and experience the largest margin potential. We're monitoring this segment closely.

• As part of its five-year plan released in 2013, Honeywell is targeting sales to be $46-$51 billion in 2018 in addition to its segment margin targets. Currency and slow global GDP growth have provided material headwinds to top-line growth, but the firm expects a growth inflection to begin at the end of 2016. Margin enhancing initiatives have worked very well for the company.

• For 2016, Honeywell is expecting core organic sales to be approximately 1%-2% due to slow global economic growth. Though it is not expecting a material recovery in the global economy in 2017, the company is anticipating core organic growth to accelerate to 4%- 5% in the year.

• We like CEO Dave Cote a lot, and the executive team's focus on investing in high ROI capex is all that stakeholders could ask for. Paying a competitive dividend is icing on the cake, and the company's M&A track record speaks for itself.

Business Quality

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Economic Profit Analysis

In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Honeywell's 3-year historical return on invested capital (without goodwill) is 36.9%, which is above the estimate of its cost of capital of 9.2%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.

In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate

Image source: Valuentum

Image source: Valuentum

Cash Flow Analysis

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Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Honeywell's free cash flow margin has averaged about 10.1% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG.

The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Honeywell, cash flow from operations increased about 27% from levels registered two years ago, while capital expenditures expanded about 13% over the same time period.

Valuation Analysis

We think Honeywell is worth $106 per share with a fair value range of $85-$127.

The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of 4.2% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 0.8%.

Our model reflects a 5-year projected average operating margin of 19.2%, which is above Honeywell's trailing 3- year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.2% for the next 15 years and 3% in perpetuity. For Honeywell, we use a 9.2% weighted average cost of capital to discount future free cash flows.

Image source: Valuentum

Image source: Valuentum

Image source: Valuentum

Margin of Safety Analysis

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Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $106 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.

Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Honeywell. We think the firm is attractive below $85 per share (the green line), but quite expensive above $127 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

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We estimate Honeywell's fair value at this point in time to be about $106 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Honeywell's expected equity value per share over the next three years, assuming our long-term projections prove accurate.

The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.

The expected fair value of $133 per share in Year 3 represents our existing fair value per share of $106 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

Disclosure: I/we 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.

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