Recommendation: HOLD Target Price until 12/31/2016: $112 1. Reasons for the recommendation I recommend holding Honeywell International for 3 reasons: the company s 1) strong earnings trajectory; 2) attractive risk-return profile, backed by disciplined capital deployment; 3) growing portfolio of differentiated technologies for a broad base of end markets. During its Q3 2015 earnings conference, Honeywell warned of 2016 headwinds similar to 2015: DoD budget constraints; low oil prices; lackluster global commercial growth; and foreign exchange uncertainty. The company s conservative short-term outlook is magnified by global geopolitical and economic instability. However, Honeywell has also demonstrated its ability to grow profits under top-line contraction through an efficient operational system and strategically diversified portfolio. Ultimately, Honeywell s skilled management team is the heart of its value proposition, something that is not easily duplicated by competitors. Profitability The proprietary Honeywell Operating System entered a new phase this year, aptly termed Honeywell Gold. Beginning in 2012, operating and net income expansion translated into 3 consecutive years of strong EPS growth against a backdrop of modest revenue growth. History is not always an indicator of the future. However, Honeywell s ability to deliver margin growth during revenue contraction signals its operational strengths. Despite a 5% YTD decline in revenues for 2015, Honeywell has delivered margin expansion across all 3 segments compared to the same period last year. Even in PMT, the segment with the worst top-line contraction due to low oil prices and customer project delays, Honeywell s raw materials pass-through pricing in Resins and Chemicals enabled segment profits to grow. Capital Structure and Allocation Honeywell s capital structure and allocation are key differentiators. Since 2011, Honeywell has decreased its Debt/Equity ratio while growing ROE and ROC annually; at the end of 2014, the total book value of shareholder equity represented more than twice the total book value of debt. During the same period, the company s Goodwill ratio shrank from 0.30 to 0.28 without a net increase to asset impairments, 1 one measure of the effectiveness of Honeywell s acquisition strategy. Honeywell s modest leverage and strong cash flows make it a lower risk investment relative to its peers; this is reflected in its below market-risk beta, unique to the diversified industrial sector. 2 Further, Honeywell has a record of rewarding investors assumed risk through ROE. To date, our holding period active return for Honeywell versus the sector ETF (XLI) is 85%; compared to the S&P 500, the active holding period return is 98% 3. At the November 4, 2015 Goldman Sachs Industrials Conference, CFO Tom Szlosek ranked capital allocation priorities as: 1) Capex, 2) Dividends, 3) M&A, and 4) Share Buybacks. Since 2011, Honeywell has grown its retention rate, held its payout ratio relatively flat, and increased its yearly dividend all while growing ROE and maintaining a solid restructuring reserve of unspent funding. Honeywell s strong 1 Analyst calculation of BV Goodwill/Total Assets, using 5-year historical data from company 10-Ks. 2 Data from Yahoo! Finance. HON beta compared to GE, JCI, MMM, SIEGY, and UTX. 3 Based on November 23, 2015 closing prices for HON, XLI, and SPY pg. 1
cash position assures investors that it can deliver a consistent 2%+ dividend yield. Moreover, Honeywell has grown ROE and EPS through reinvestment and acquisitions rather than buybacks. Over the past 5 years, the company s modest buybacks were primarily netted by employee stock options, a strategy that Szlosek affirmed would carry forward. While the company acted opportunistically in the late Q3 market downturn, lowering the outstanding share count roughly 2%, its overall reinvestment strategy underscores a more sustainable method for dispensing shareholder gold. Strategic Portfolio Alignment for Future Growth Honeywell management has proven itself adept at steering the portfolio of businesses toward an allocation that maximizes shareholder value. Over the past decade, CEO David Cote has led a transformation of the company away from low-margin consumer businesses (primarily automotive) toward high-margin differentiated technology businesses. This year, Cote launched the Honeywell User Experience, or HUE, a program designed to expedite software prototyping and development with a focus on the customer experience, leveraging the company s 22,000 engineers and Level 5 CMMI achievement. This will help lead Honeywell into the era of digital industrials. In addition, the milestone $5.1B acquisition of Elster builds on the strength of the Automation and Control Solutions (ACS) segment. Elster will provide Honeywell greater access to growing energy markets in Europe and emerging economies, capitalizing on energy regulations and infrastructure rollout in the regions. The potential upside of this deal equates to $5-8B in total revenues by 2018 and 8% cost synergies realized over a 3-5 year time horizon, a forecast buoyed by Honeywell s existing operational competencies. The acquisition also allows for adjacencies in PMT, particularly in the Process Solutions arm, which provides technology licensing and engineering services across the natural gas value chain. The successful integration of companies like EMS (2011), Intermec (2013), and Datamax-O Neil (2014) underscores the company s focus on connectivity and smart building technologies in ACS. In addition, Aerospace has become increasingly aligned around in-flight connectivity, highlighted by the recent acquisitions of Aviaso, COM DEV, and Satcom-1. Differentiated Aerospace technologies tied to noncommercial and Space-related markets have a strong upside for Honeywell, offering higher margins and stickier end markets in the fragmented aircraft parts manufacturing space. Turbochargers, now integrated into Aerospace, should also become a long-term catalyst for growth as fuel-efficiency requirements in automobile manufacturing play out. A Solid Hold Using a multiples analysis, I forecast a target price of $112 for December 31, 2016. This equates to capital gains that, combined with a dividend yield of 2.25% 4, would provide an expected annualized holding period return of 8.27%. 5 Honeywell currently trades at a premium to my intrinsic value calculation of $96. This calculation may exhibit a downward bias; using my forecasted 2016 EPS of $6.13 (in line with the company s $6.10 guidance), this implies a P/E of 16, which is below Honeywell's 10-year historical average of 18. While I like the stock for its proven profitability and disciplined 4 Data from Yahoo! Finance as of November 23, 2015 5 Based on November 23, 2015 closing price of $104.59 pg. 2
acquisition strategy, the 1-year outlook is more uncertain and the valuation implies a less attractive buy. For these reasons, I recommend a hold over a buy. 2. Company Analysis Honeywell International is a diversified industrial conglomerate that operates through 3 business segments: Aerospace (39% of 2014 revenues), Automation and Control Solutions (36% of 2014 revenues), and Performance Materials and Technologies (25% of 2014 revenues). One of Honeywell s core strengths is the management team. David Cote s GE credentials prepared him for the adept execution Honeywell s operational transformation, one that increased efficiencies and realigned the portfolio segments. However, all eyes should be on the recently appointed Vice Chairman, Roger Fradlin. As CEO of the ACS segment, Fradlin oversaw a series of value-creating acquisitions that expanded the segment s global reach while narrowing the gap between ACS and Aerospace revenue and profit contributions. As of 2014, Aerospace s contribution to revenues trumped ACS by less than 3%; 2015 forecasted revenues (based on YTD performance) narrows the spread to 2%. In his new role, Fradlin will oversee the company-wide M&A target of $10B by 2018, a role for which is well prepared. The success story of ACS is shared with the segment s former CFO, Tom Szlosek, who now serves as Honeywell CFO. Further, Honeywell s employee compensation program is over 90% incentive based. While this does not eliminate the possibility of agency problems, it helps to align the interests of managers with shareholders. While Honeywell excels in generating profits, revenue growth has been weak since 2012 expanding at approximately the same rate as global GDP. Since 2012, Aerospace s contribution to total revenues has declined 1.5% annually due to the combined impact of DoD contraction, increased Original Equipment Manufacturer (OEM) incentives, and unfavorable foreign exchange. In 2015, revenue contraction became more pervasive, as the UOP and Process Solutions arms of PMT suffered respective 16% and 15% Q3 declines (compared to 2014 Q3) and ACS faced unfavorable currency exposure. Over the past decade, Honeywell has increased its global exposure dramatically; including U.S. exports, 55% of 2014 total sales came from non-u.s. regions, with an estimated 6.5% coming from China. While the company engages in hedging strategies that mitigate the impact of exchange rates on profits and losses (the current $1.24 Euro rate hedge, for example), currency headwinds will continue to impact the top line. Honeywell s global exposure is also a source of opportunity. Urbanization of developing economies, rising energy costs, and increasing energy efficiency regulations in Europe play into the ACS portfolio of businesses. The threat of damage caused by extreme weather, particularly to critical civil and governmental infrastructure, along with the long-term expectation of rising energy costs, bolster Honeywell s energy and safety and security related businesses. Growing demand for energy efficient products across a spectrum of markets plays into Honeywell s entire portfolio: PMT s Solstice line of low-emissions materials, Aerospace s turbochargers, and ACS s automated climate control and building systems. Environmental stewardship is both an opportunity and a threat for Honeywell. Honeywell s past is rife with environmental remediation related to mercury, lead, and chromic acid. Further, Honeywell is still settling asbestos claims related to its former NARCO and Bendix businesses. Fortunately, mercury and asbestos are in Honeywell s past (and the trust established to pay claims is well-funded). Honeywell has pg. 3
the opportunity to establish a new environmental record, building on the success of its Solstice line of low-emissions propellants and refrigerants. The entry of new competitors is an ongoing threat to Honeywell, particularly in the fragmented Aerospace parts sector. Honeywell s focus on differentiated technology in this segment is a strategy for beating the competition through high switching costs and subscription-based software sales. While geopolitical instability poses an overall threat to Honeywell, in Aerospace, the strong growth of International Defense markets is directly tied to rising global threats, particularly in Europe and Asia. PMT experiences the opposite effect: natural gas businesses are ultimately tied to geography, and resources are often (not coincidentally) tied to conflict regions. This threat is exacerbated by the volatility of oil prices. 3. Industry Analysis Honeywell s 3 segments serve a range of commercial, industrial, defense, and consumer end markets principally tied to aerospace, industrial production, construction, transportation, and oil and gas. Honeywell manufactures systems and parts that facilitate commercial and industrial productivity, but also relies on commercial and industrial activity to drive its businesses. Honeywell sustains its diversified model through a lean operating system, which creates greater agility in reacting to industry outlooks. However, due to its scale and scope, Honeywell competes against massive conglomerates with wide moats (GE); faces increasing industry pressure to consolidate; negotiates with a virtual duopoly of buyers in the Aerospace Commercial OEM arm (Boeing and Airbus); is subject to shifts in Defense spending and some of the most stringent oversight and regulations, namely from the FAA, EPA, and DoD; manages an extremely complex global supply chain; and is vulnerable to currency and commodity price volatility, particularly oil and non-ferrous metals such as nickel and aluminum. Further, Honeywell leads the market in only one segment: Thermostat Manufacturing. Fragmentation dominates the Aerospace Parts Manufacturing and Electronic Access Control Systems markets; by contrast, a handful of players dominate the markets for Turbochargers (Cummins and Borg Warner), Petrochemicals and Resins (Dow Chemical and Dupont). The median 5 year annualized growth rate for 14 of Honeywell s primary industry segments in the U.S. is 2.8%. 6 This rate is in line with the World Bank s global GDP growth rate estimates for the next 3 years of 2.8-3.3%, indicative of the mature segments in which Honeywell operates (World Bank Group, 2015). There are also winners and losers on the horizon: Turbocharger Manufacturing and Electronic Access Control Systems are among the winners, while Aircraft Maintenance, Repair and Overhaul (MRO), Plastic and Resin Manufacturing, and Respiratory Protection Equipment Manufacturing (driven by mining) are among the losers. This disparity underscores Honeywell s recent portfolio positioning toward ACS s Energy Safety and Security arm, as well as the integration of Turbochargers into its stagnant Aerospace segment. Globally, there are mixed signals. Honeywell has been riding on the rapid economic growth of developing markets like China, which is now facing contraction. The Asia Pacific region, and particularly China, has been experiencing a surge of capital outflows to Europe and North America under the cloud of currency 6 See appendix for IBISWorld projected industry growth rates pg. 4
depreciation and market instability. While demand for energy efficiency is strong in Europe due to incentives and regulations, large capital outflows could disrupt the global market for Honeywell s ACS segment. Despite the declines in industrial production and construction, China still has a booming demand for domestic air travel. The rush of new regional carriers, along with China s first Large Carrier Aircraft (LCA), COMAC, has helped lift the global Aerospace segment. Overall, Asia Pacific s share of air passenger travel is expected to grow 42% in the next 20 years (Mergent, 2015a). By contrast, Europe is facing the highest breakeven load factors of all regions due to extreme regional competition, and in the US, 4 major airlines control prices and experience the industry s highest margins. The proposed 2016 DoD budget currently under review calls for a 4.5% YOY increase in total spending, driven by an uptick in Operation & Maintenance and Procurement for the Air Force and Navy. 7 Responding to China's South Seas activities, maritime surveillance is a top priority, along with threats to Space assets and cybersecurity segments served by enhanced satellite communications. Elevated global "threat levels" and related air strike intensification could also bolster passage of the proposed budget. In light of the DoD spending contraction, Honeywell has been expanding into high-growth International Defense segments tied to regions with geopolitical instability: India, South Korea, Turkey, and Israel. International Defense contributes 25% to the Defense arm of Aerospace, and thus remains a relatively small portion of the overall segment. However, it is also growing at a rapid rate as global threats increase and international defense budgets expand. Escalation of the crisis in Syria may accelerate the 12% CAGR Honeywell anticipates for this arm over the next 3 years. In June, the World Bank reported that emerging markets are exposed to increasing domestic and external vulnerabilities, one of which is currency depreciation (World Bank Group, 2015). With over half of its revenues coming from non-us regions, Honeywell s profits are tied to both the health of China s economy and the TWI (Trade Weighted Index). When the dollar strengthens against foreign currencies, as it has in the past year, Honeywell s bottom line suffers. In 2014, Honeywell reported a 1% YOY profit loss in both its ACS and PMT arms due to exchange rates; so far in 2015 this profit reduction has increased to 5%. With impending tightening of US monetary policy, and continued slowdown of emerging market growth, the TWI is bound to increase, posing another threat to Honeywell. Honeywell s industries will also be impacted by congressional decisions regarding the Export-Import Bank and the passage of the Trans-Pacific Partnership trade agreement (TPP). The recent renewal of the Ex-Im Bank will help overseas buyers of U.S. products finance large transactions particularly buyers in emerging economies. The reenactment of this agency should benefit Honeywell, considering the company s global sales exposure and strategic emphasis on high growth regions. One of the controversies surrounding TPP is the relative easing of foreign vehicle importation. However, passage of this trade act would have direct benefits to Honeywell s turbocharger business, which serves a number of foreign automobile manufacturers. While it is too early to predict the TPP outcome, significant momentum has built up around its passage, bolstering the likelihood of approval. 7 Data from: http://comptroller.defense.gov/budgetmaterials/budget2016.aspx pg. 5
Appendix: Inputs into valuation using multiples 2010A 2011A 2012A 2013A 2014A 2015F 2016F 2017F Stock price 52.98 43.73 64.33 112.77 101.52 110 112 120 Basic EPS 2.61 2.65 3.74 4.99 5.40 6.13 6.60 7.05 Sales 32350 36529 37665 39055 40306 38472 40767 42244 Sales per share (basic) 41.82 46.78 48.14 49.66 51.38 49.92 52.90 54.06 P/E 20.30 16.50 17.20 22.60 18.80 18.00 17.00 17.00 P/S 1.2 1.2 1.3 1.9 2 2.1 2.00 2.00 Analyst's own calculations. Source of basic data: company's 10-K; Yahoo! Finance and Morningstar Inputs into valuation using Discounted Cash Flow (DCF) method Cost of Debt 3.89% Rf 2.89% S&P credit rating Spread 1.00% Cost of Equity 9.97% beta (as of 11/20/15) 0.98 US revenue weight 45% Europe revenue weight 30% Asia-pacific revenue weight 25% US market risk premium 5.81% Europe market risk premium 9.19% Asia-pacific market risk premium 8.99% Overall market risk premium 7.62% WACC 9.30% book value of debt (in millions) $8,683 market value of equity (in millions, as of 11/20/15) $81,408 weight of debt 9.64% weight of equity (using market values) 90.36% Assumptions Assumption re change in NWC 0.14% Assumption re capex 3.14% Assumption re long-run growth rate 3% Assumption re tax rate 26.1% Analyst's own calculations. Source of basic data: company's 10-K; Yahoo! Finance; FINRA; A. Damodaran A pg. 6
2015F 2016F 2017F 2018F 2019F Aerospace Revenue 14974 15274 15732 16204 16690 YOY growth -4.0% 3% 3% 3% 3% ACS Revenue 14197 16043 16685 17352 18046 YOY growth -2.0% 13% 4% 4% 4% PMT Revenue 9301 9301 9673 10157 10665 YOY growth -9% 0% 4% 5% 5% Total Revenue 38472 40618 42090 43713 45401 YOY growth -4.55% 5.96% 3.62% 3.85% 3.86% Analyst's own calculations. Source of basic data: company's 10-K Honeywell* versus analyst forecast of future revenue growth rates by segment 2015F 2016F 2017F 2018F 2019F Aero: HON 3-5% 3-5% 3-5% 3-5% 3-5% Aero: Analyst -5% 3% 3% 3% 3% ACS: HON 4-5% 4-5% 4-5% 4-5% 4-5% ACS: Analyst -2% 13% 4% 4% 4% PMT: HON 5-6% 5-6% 5-6% 5-6% 5-6% PMT: Analyst -9% 0% 4% 5% 5% *Data Source: HON Investor Conference Presentation, March 4 2015 IBISWorld 5-year Projected Annualized Industry Growth Rates in the U.S. Turbocharger Manufacturing 8.8%* Electronic Access Control Systems 4.2% Petrochemical Manufacturing 3.5% Aircraft, Engine & Parts Manufacturing 3.3% Protective Eyewear Manufacturing 3.1%* Petroleum Refining 3.1% Gas Detection Device Manufacturing 2.9% Thermostat Manufacturing 2.9%* Pressure Sensor Manufacturing 2.7% Air Purification Equipment Manufacturing 2.4% Personal Protective Equipment Manufacturing 2.1% Plastic and Resin Manufacturing 2.0% Aircraft Maintenance, Repairs & Overhaul 1.9% Respiratory Protection Equipment Manufacturing 0.9%* * 2014-2019 pg. 7
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