Honeywell: My interest is growing, the value is tempting (NASDAQ:HON)

These are challenging times for multi-industrial companies as Wall Street gradually accepts that short-cycle industrial end markets may not see the recovery hoped for in the second half of the year and process end markets are also beginning to weaken. Meanwhile, themes such as aerospace are old news, even though the multi-year sales and profit growth potential here is still quite high.

In the approximately 18 months since my last report Honeywell International Inc. (NASDAQ: HON), shares of this leading multi-industry company have lagged the broader industrial sector, up 11% versus around 22% for the sector as a whole. Likewise, certain names such as Eaton (ETN), Emerson (EMR) and Parker Hannifin (PH) have all outperformed. Granted, Honeywell’s valuation hasn’t been modest and some of that underperformance can be seen as a move away from that premium, but it’s underperformance nonetheless.

I am a fair bit more interest in Honeywell today. While I still think expectations may be too high for short-cycle markets, I like the longer-term leverage in aerospace, automation in buildings, factories and process industries, and materials science. If 5% long-term revenue growth, high-double-digit FCF margins, and EBITDA margins of nearly 30% in 2028 are all valid assumptions, these stocks have some appeal in a sector that doesn’t offer many obvious bargains.

Process automation is holding up and industrial automation will recover

The weak capital spending in a number of short-cycle markets seems to have surprised many companies and analysts this year (that was one of my core theses for 2023…) and has certainly had an impact on market participants, from ABB GmbH. (OTCPK:ABBNY) via Eaton to Honeywell Siemens (OTCPK:SIEGY) to Rockwell (South Korea).

Honeywell is not generally considered a factory/industrial automation company, and in fact, direct comparisons with companies like ABB, Rockwell or Siemens are rather limited. Nevertheless, demand for security, shipping and workflow automation is susceptible to the same short-cycle trends, which has negatively impacted the business.

More significant was the sharp decline in factory automation. I spoke about this in connection with Cognex (CGNX), but following a surge in warehouse construction and automation to facilitate expanded e-commerce, major companies such as Amazon (AMZN) have been rapidly cutting spending. I don’t see much to cheer about here for 2024, but Cognex has mentioned signs of stability and the pain should ease somewhat in the coming quarters (at least the comparisons will be easier).

Beyond 2024, the level of automation in warehouses and distribution centers is still relatively low, and I think Honeywell has a good long-term opportunity. Not only should further re-shoring lead to more warehouse/DC activity, I also expect some of Intelligrated’s warehouse automation technologies to make their way to the factory floor (to automate inventory and movement of components and products).

I’m more optimistic on the process side in the near term, although Honeywell doesn’t have the best blending presence. Chemical spending has definitely slowed, and that’s one of Honeywell’s strongest areas, and the same is true for pulp/paper. Pharmaceutical spending is significantly weaker this year, and Honeywell is the second-biggest player here behind Emerson. Meanwhile, oil/gas and refining spending appear to be pushed back to 2025, and those are strong areas for Honeywell. I’ll also note that metals/mining and utilities are two of the stronger segments, and Honeywell isn’t as competitive there.

Aerospace is a multi-year driver

Investors have largely turned away from the aerospace theme, and that is understandable, as I think everyone fundamentally understands the drivers for accelerating narrow-body and wide-body aircraft production by major OEMs such as airbus (OTCPK:EADSY) and Boeing (BA) in the next five to ten years.

However, that does not mean that it is not still a relevant driver for Honeywell. While Honeywell has not shown quite the same impact on the stronger aftermarket demand as companies like crane (CR) and Melrose (OTCPK:MLSPF), the company has seen strong original equipment sales. In addition, the defense business has grown strongly and the company has reinvested here through mergers and acquisitions, including the recent acquisition of CAES Systems, a leader in high-reliability RF technologies.

While the commercial aerospace industry cycle is well understood by Wall Street, I doubt it has been fully priced in, especially given the recent production issues at Airbus and Boeing. If those production issues resolve, I think Honeywell will deliver steady growth and positive incremental margins, and I think the upside potential in the defense and commercial aerospace industries is underestimated.

Active again in the M&A sector

Honeywell’s tone has shifted back toward prioritizing growth over the past year or two, and management has become more active in mergers and acquisitions. In addition to the CAES deal mentioned above, the company spent $5 billion on Carrier Access Solutions and its portfolio of commercial access and electronic locking products, $700 million on Compressor Controls (turbomachinery controls with capabilities in areas such as carbon capture), and an undisclosed amount on SCADAfence, a cybersecurity company for operational technology (or OT) and industrial control systems (or ICS) security.

I like that all of these deals complement and fill gaps in Honeywell’s existing technologies and capabilities. SCADAfence in particular could be an invaluable asset, as I believe industrial cybersecurity still requires more investment in many industries – just look at the devastation caused by the recent cybersecurity breach at CDK Global and imagine the chaos that a break-in at a refinery or chemical plant could cause.

I expect Honeywell to continue to be active here. I would expect the company to add more sensing, scanning, mobility and sustainable energy capabilities for industrial automation, more control and monitoring for building automation, and probably more tuck-ins for defense (especially more on the electronics/RF side). I also wouldn’t be surprised to see green technology/sustainable energy offerings for energy and sustainability solutions.

The outlook

I still see some downside risk to 2024 revenue estimates as I don’t believe a short-cycle recovery in the second half of the year is as likely as Wall Street would like to believe. I would also note that Wall Street has consistently overestimated the buildings and industrial automation segments, so there may be some downside risk here. On the other hand, there may be upside in the aviation sector due to improved production plans and a healthier business cycle over a longer period of time.

I expect revenue growth of about 5% to 6% over the next five years and about 5% growth over the long term, with all segments contributing significantly to this forecast. While Honeywell is not directly dependent on building electrification, its building automation control and automation products are tied to this trend. I have outlined my views on aviation and I think industrial automation has long-term growth potential.

I expect operating and EBITDA margin improvement over the next five years, with margin leverage driven by mix (more services and software), volume leverage in aviation and the recovery in automation demand, as well as operational improvements. In addition, I expect mid-double-digit free cash flow margins for a few years and a gradual improvement toward 20% over time, leading to double-digit long-term FCF growth.

Between discounted cash flow and margin/return-focused EV/EBITDA, I get a fair value range for Honeywell of about $220-$240. While my forward EBITDA multiple for Honeywell would be around 14.5x, not all things are equal – Honeywell is in a relatively rare area of ​​above-average operating margins, ROICs, and revenue growth, and companies that meet all of these criteria typically command a 100-300 basis point premium to their multiple (I use 100 basis points).

The conclusion

Honeywell isn’t necessarily a bargain, with a fair value of just under $220 (the low end of my range) only about 5% above today’s price. Still, there aren’t many bargains in the high-quality industrials space today. While I have concerns that the market and the industrials sector could both be at risk of deeper declines, I still think Honeywell is an above-average option.

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