Honeywell: Margins Are The Real Story Here

Summary

• HON shares have outperformed the broader margin by a wide margin over the last year, and investors should expect more of the same in the quarters ahead.
• The company reported impressive Q3 2017 financial results and management guided for a strong finish to the current year.
• HON shares are a long-term buy at today's price, even after the recent run-up.

Honeywell (NASDAQ:HON) is a company that has been in the news a lot over the last six plus months, and for good reason. The company has reported impressive quarterly results over the last year and the market recently cheered management's plan to spin off two business units by the end of 2018. As a direct result, HON shares have greatly outperformed the broader market.

(Source: Nasdaq)

The recent run-up has been nice but, in my opinion, HON shares still have a lot of room to run so I would not let the current price tag keep you from investing in a company that has promising long-term business prospects. It helps that the company's most recent results also supports the long-term bull case for Honeywell.

The Q3 2017 Results, Margins Are The Real Story Here

On October 20, 2017, Honeywell reported inline EPS ($1.75) on better-than-expected revenue of $10.1B. For comparison purposes, the company reported EPS of $1.60 on revenues of $9.8B in the same period of the prior year. The YoY earnings growth was impressive, but, more importantly, the company also reported improvements almost across the board.

This company is firing on all cylinders and it is important to note that all of its operating segments are currently contributing to the impressive top- and bottom-line growth. However, the company's expanding margins are the real story to be told, of course, in my opinion.

There were two segments that expanded their margins by well-over 100bps (three if you exclude M&A), with the company's most valuable segment, i.e. Aerospace, leading the charge with margins up 290 bps when compared to Q3 2016. Mr. Darius Adamczyk, CEO, and team have been laser focused on improving operational performance over the last year and their focus has already yielded strong results.

Prior projects to improve margins are coming into play but let's also remember that software is a key driver to expanding margins. This is actually a topic that Mr. Adamczyk covered during the conference call when asked about Honeywell's transition to an industrial software company:

You're right overall I'm very pleased in terms of how our Connected Enterprises is progressing this year. It is up double-digit which is very much in line of expectations. Margins are up even higher than that. In terms of acquisitions and landscape we continue to look at all segments of the business including our software plays. We've made one acquisition actually in the software area in Q3 which is pretty exciting cyber technology that although the business itself is relatively small we have very, very big growth opportunities for it and it's actually exceeding our expectations. So the software acquisitions in general will be more of the bolt on variety, those are the kind that we're looking at but overall we continue to make progress both on the P&L on Connected Enterprise continues to make progress on the build out of our Sentience platform and signing up more partners as we go. So we continue to be very excited about what we're doing. And the most important part of that it’s generating the right kind of results.

In "Honeywell: Becoming A Software-Industrial Company", I touched on the benefits of the Sentience platform (i.e. improving the cost structure) but, more importantly, I touted Mr. Adamczyk as the perfect guy for Honeywell in today's environment (the "software guy"). So far, so good.

Management also mentioned that previous divestitures are having a real impact on margins and they fully expect for margins to improve as we head into 2018. This is actually one of the main reasons why I am bullish on the upcoming Transportation Systems and Homes And Global Distribution spinoffs. This management team has a proven track record of being able to squeeze out costs and get rid of businesses that pressure margins, so I anticipate for the 2018 spinoffs to be more of the same.

Looking forward, I do not see Honeywell slowing down anytime soon and management is on the page, as the full-year EPS guidance of $7.05-$7.10 (a range that has been raised several times over the last two quarters) was re-affirmed. Management expects for Honeywell to report strong results from top to bottom.

As shown, the company is expected to report 2%-3% sales growth while improving EPS by 9%-10%, as share buybacks and cost reductions are going to have material impacts. But again, margins are the real story as we progress through Q4 2017. For full-year 2017, margins are expected to come in at 19%, which is very impressive for an industrial conglomerate.

As I previously described, Honeywell's story continues to get better and I do not see anything getting in the way anytime soon. Therefore, investors that have been shying away from HON shares because they are trading close to a 52-week high should consider this, Honeywell is well-positioned for 2018 and beyond.

Valuation

Based on current year estimates, Honeywell is trading at a slight premium compared to its peer group.

HON PE Ratio (Forward) data by YCharts

The company is trading at a slight premium to United Technologies (UTX) and General Electric (GE), a company that is going through some things, so I believe that the premium is more than warranted. Additionally, Honeywell has shown the ability to increase earnings over the past five years so the company will likely outgrow its current valuation in short order.

(Source: 2016 10-K)

The company's capital return story - increasing dividend and large buyback program - is another reason for shareholders to stay long.

Bottom Line

There was a lot to like about Honeywell's Q3 2017 results, but, in my opinion, the real story is the company's expanding margins. This company has squeezed out costs and has reported improving margins since Mr. Adamczyk took over for Mr. Cote, so it appears that Honeywell has the right guy leading it. Plus, the beat is expected to go on as management guided for a strong finish to the current year.

The long-term bull story is obvious: Honeywell is an industrial conglomerate that has great businesses in industries that have promising long-term prospects. Moreover, Honeywell appears to have the right management in place and its focus on software (i.e. Industrial Internet of Things) is already paying huge dividends. Need more? If so, Honeywell also has a growing dividend (recently increased by 12%) and a board that is committed to buying back shares. Lastly, the upcoming spinoffs have the potential to create a tremendous amount of value. Therefore, investors should treat pullbacks as long-term buying opportunities.

Full Disclosure: All images were obtained from Honeywell's Q3 2017 Earnings Presentation, unless otherwise noted.

Author's Note: Honeywell is a core holding in the R.I.P. portfolio and I have no plans to reduce the position in the near future.

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Disclaimer: This article is not a recommendation to buy or sell any stock mentioned. These are only my personal opinions. Every investor must do his/her own due diligence before making any investment decision.

Disclosure: I am/we are long HON, GE. 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.