Recommendation: HOLD Target Price until (06/30/2016): $113 1. Reasons for the Recommendation Future incremental repurchases Positive As of March 31, 2015, Honeywell s cash and debt position was $8.3 billion and $9.6 billion respectively resulting in a net cash position of -$1.3 billion, a positive increase of 21% over the last year. The biggest contributor to the change was assets available for sale with an increase of 89% through the year. The company is nearly debt free and plans to hold $1 to $2 billion in net cash position as reserves. Honeywell expects to reach its cash reserve target by the fall of 2015 if no acquisitions are made. However, if acquisitions are made, and based on historical net cash position data for the past 6 years, the company will reach the cash reserve target by 2017. Excess cash will be used for future incremental share repurchases. Due to Honeywell s strict M&A policy, the company is unlikely to engage in an acquisition spree that restricts net cash position growth. They may enter in an acquisition in the billions such as the acquisition of Sperian Protection for $1.4 billion in 9/2010 or announce a repurchase plan. Although Honeywell s first priority is M&A, their 5-year average annual increase in net cash position of 35% is greater than their 9% 5-year average annual increase of M&A cash towards acquisitions. Reiterating that by 2017, the company will be announcing a repurchase plan. The reason for Honeywell s future stock buyback is their uncertainty about future investment opportunities as they continue to be conservative with M&A strategy. The stock repurchase will benefit shareholders in the form of a price increase since Honeywell will move towards its optimal net cash position. The buyback will be independent of operations executed on a dollar cost averaging basis. Healthy future cash flows from pipeline Positive Contract wins for Honeywell over the past few years will begin to generate sales during 2015 to 2018. The Aerospace segment typically is spending over 5 years with a return on the 6 th thru 8 th year. The COMAC 919, to Honeywell supplies parts, will first fly in 2015 and hit the market by 2018. After the first successful flight, Honeywell will begin to see returns from the contract. Other noticeable segment backlogs are the Boeing 737 MAX, Airbus A350 and Boeing 777X. The PMT will begin to see substantial returns on CAPEX in 2017. The majority of Honeywell CAPEX spending goes into PMT to produce pipeline products such as gas-to-chemical technologies, foams and refrigerants. Over the last three years, Honeywell has spent $1.3 billion in PMT CAPEX accounting for 46% of the total. CAPEX returns are seen one to three years after commitment. ACS s pipeline is diversified in the business, residential and industrial sectors. Recent wins are the supply contract of up to 225,000 scanners to USPS valued between $100 and $250 million and the partnership with StarTex Power to supply thermostats to their electricity consumers in Texas. Conservative M&A strategy Positive The company employs a general M&A strategy to pay 12 to 13 times EBITDA for an acquisition if it generates 6% to 8% of sales as cost synergies (operating cost savings). This operating synergies strategy assures a successful integration by adding capabilities to the acquisition thru Honeywell s technology, Honeywell operating system (corporate production system), or multichannel multi-brand management. Honeywell has a positive acquisition track record of around 80 companies historically. Guidance indicates spending of more than $10 billion (22% of Q1-2015 total assets) from 2014 to 2018 with a price range per pg. 1
acquisition between $10 million to $4 billion. During the last 5 years, the company has paid an average of $490 million per major acquisition for a total of $4.4 billion (13% of Q1-2009 total assets). These acquisitions were nine publicly announced companies and four acquisitions with an undisclosed price. In 2014, the company did not make any acquisitions. The last acquisition purchased was on March 15, 2015 for Datamax-O Neil at $185 million. Through acquisitions, the company has created new capabilities from 13 companies in the area of scanning and mobility, life safety, gas detection and gas processing. Over the last 5 years, 7 out of 13 acquisitions have contributed to this pipeline. Historical M&A trends do not indicate the company will spend the remaining $10 billion in the next four years unless they make a few multibillion-dollar deals. Furthermore, year-to-year organic growth trends are not declining over the last four years suggesting that Honeywell s push for M&A is due to increasing net cash position. Growth based on High Growth Regions Negative Honeywell is expanding its business to High Growth Regions (HGR), namely, Asia, Africa, Latin America, the Middle East and Eastern Europe through 2018. The company is expecting HGR to contribute to 50% of growth. The biggest exposure to the region is China where Honeywell aims at becoming a Chinese competitor followed by the Middle East and India. HGR contributed to 23% of the company sales in 2014 of which 41% was to the PMT segment. HGR have a large potential at the cost of high risk. Honeywell is increasing its portfolio position to the region, thus increasing its exposure. In particular, China is problematic because of the high incident in IP theft. In 2013, China accounted for 80% of IP thefts from U.S. based organizations. Because Honeywell is a technology company, if they do not protect their IP correctly in China, they can potentially lose world market shares to the Chinese. Political stability of HGR countries is concerning. Many countries in HGR have unstable political systems and economies that tend to default. With the most recent decline in oil prices, some HGR, such as Russia, are vulnerable to a crisis. Honeywell s HGR exposure is largely PMT, which requires CAPEX over several years to fill backlogs. The concern here is that over those years, negative region events can either pause or halt CAPEX projects in the region. U.S. defense sector challenging for multinationals Negative Honeywell is under investigation due to their participation in a government Joint Strike Fighter program. The investigation is about Honeywell supplying parts manufactured in the UK and China for use in the US F-35 fighter jets. The cost of the potential adverse effects of the investigation cannot be estimated at the time. As Honeywell continues to expand globally, U.S. defense contracts will become more challenging. DoD business must comply with the international traffic in arms regulations, which regulates the export of military articles to foreigners and other countries. In a multinational company, complying with this regulation is challenging and violations result in fines based on net income such as the 2011 $78 million penalty to BAE Systems. pg. 2
2. Company Analysis Honeywell International, Inc., (HON) is a diversified technology and manufacturing company. The company currently operates through the following three business segments: Aerospace (AERO); Automation and Control Solutions (ACS); and Performance Material and Technologies (PMT). Each of these segments delivers products or services to their respective industries. As of 2014, the companies geographical breakdown of total revenue consisted of 59.3% U.S. revenue, 24.5% European revenue and 16.1% other foreign revenues. Of the total revenue generation 55% went to international customers. Country export sales accounted for 14% of total sales. Honeywell has 67.1% of its long-lived assets in the U.S. while Europe and other countries have 13.7% and 19.1%, respectively. Honeywell s revenue growth for the last 3 years has remained steady at just above 3%. From 2009 to 2014 gross profit margin for the company has ranged between 22-28%. Product and service margins range from 19-26% and 32-36% respectively and have increased over the last three years. During these three years all business segments have increased gross margin resulting in the overall company gross profit margin increase. In 2014, Honeywell achieved the highest operating margin over the past six years at 10.76% due to high gross profit margin and lower selling, general and administrative expense. The AERO segment serves primarily the automotive market, business, regional, government and general aviation, commercial and military aircraft manufacturers, spacecrafts and aviation, military and space operations. This segment offers fifteen (15) product lines. In 2014, the AERO segment generated $15.59 billion in revenue representing 38.7% of Honeywell s total revenue. Revenue was split between 69.1% product sales and 30.9% services. Operating income in 2014 was $2.91 billion representing 42.1% of Honeywell s total operating income. Defense and space systems, which the government is the primary customer, contributed to 30.5% of total revenue for the AERO segment followed by commercial aftermarket at 29.3% for services such as repair, overhaul activities and retrofits. Commercial original equipment manufacturing (OEM) products contributed to 16.7% of total revenue of the segment. Revenue generation in the Transportation Systems line was $3.66 billion representing 23.5% of total revenue. The ACS segment delivers products and services for use in residential, industrial and government sites. This segment serves primarily OEMs, contractors, distributers, various manufacturing firms, retailers, homeowners, processing firms, utilities, and government agencies, amongst others. There are five (5) product lines in this segment. Revenue generation for 2014 for the ACS segment was $14.49 billion representing 35.9% of Honeywell s total revenue. This segment revenue was generated from 67.2% Energy Safety and Security business and the balance from Building Solutions and Distribution. Operating income in 2014 was $2.20 billion representing 31.7% of Honeywell s total operating income. The Performance Material and Technologies (PMT) segment researches, develops and manufactures specialty chemicals and materials. Major clients include refineries and the polymer/composite industry. The segment carries fifteen (15) product lines. In 2014, the PMT segment generated $10.22 billion in revenue representing 25.4% of Honeywell s total revenue. The UOP division generated $3.19 billion in sales; the Advanced Materials generated $3.90 billion in sales, and the Process Solutions generated $3.12 billion in sales. Operating income in 2014 was $1.82 billion representing 26.2% of Honeywell s total operating income. These segments create a diversified portfolio for Honeywell and contribute to one of the company s strengths. The portfolio protects the company from any individual industry downfall. Another company strength is their standardized production system. Via the corporate Honeywell operating system, they are pg. 3
able to lean operations maintaining quality through six sigma industry practices and lean manufacturing resulting in margin expansions. The last strength is the company s sound financial performance that has lead to a five-year cumulative total return on investment of 187%, outperforming the S&P 500 by 82%. Weaknesses of Honeywell are its non-growing international exposure, asbestos liabilities, bad environmental record and growing net cash positions. The company has claimed that its operations in some international countries such as India, Brazil and Africa, have not seen any growth. Potential political instabilities in these countries could result in future losses. Honeywell has been held liable for the funding of an asbestos fund for claimants exposed to asbestos products of past Honeywell companies. Honeywell also has outstanding claims due to bad environmental practices at Onondaga Lake in New York. The last weakness of the company is the growing net cash position increasing the likelihood of Honeywell misspending its cash. Honeywell has several opportunities for growth through acquisitions and high growth regions. If the company s net cash position continues to increase, they will move into a better position to make a deal that results in future capabilities and growth. China is one of Honeywell s wagers for growth in their high growth region portfolio. China GDP growth is averaging 10% per year. Oil and gas price volatility poses a threat to Honeywell s UOP and process solution division as customers may pause or cancel their capital spending. Another threat to Honeywell is that the strengthening of the U.S. dollar will result in decreased U.S. exports. Raw material price fluctuations also threaten Honeywell s ability to meet customer commitments and may affect operations. Future U.S. regulations may affect the PMT segments causing plant stoppages or imposed upgrades. Lastly, foreign currency exchange risk is a threat to Honeywell as they operate in a multinational basis. pg. 4
3. Industry Analysis Each business segment of Honeywell International, Inc. services many industries due to its global diversified manufacturing operations. The following industry analysis will only cover the industries that the company has a major market share or contribute the most to revenue. The AERO segment primarily serves three industries: the aircraft engine and engine parts manufacturing, the space vehicle and missile manufacturing, the aircraft maintenance, repair and overhaul, and the turbocharger manufacturing industries. The aerospace, engine and parts manufacturing industry develop and produce aircraft, engine, propulsion systems and all auxiliary equipment required for aircraft operation. The industry also provides overhaul of aircraft, engine, propulsion systems and auxiliary equipment. Competition in this industry is reaching high levels with four major companies dominating the industry accounting for 70% of its total revenue. Size advantages in the industry play a key success role as economies of scale benefit from cost in production and operations. In the service area, the aircraft maintenance, repair and overhaul industry provides maintenance, repair and overhaul to air transportation operations. Services range from performing aircraft maintenance to aircraft ferrying between departure stations and taxiways. Competition in this industry is high largely due to the fragmented nature of the industry and the moderate barriers of entry. The competitive horizon in the industry is strengthening. This results in possible future mergers and acquisitions. With the projected improvement of economic conditions and the increase in demand for air travel, the industry is expected to grow slowly over the next five years. The space vehicle and missile manufacturing industry manufactures missiles and space vehicles including all underlying parts of each system. Contracts are issued mainly by the DoD and are typically given to the four major players due to their existing relationships and performance. For this reason, and the high initial investment cost due to the nature of the products, the competition in the industry is moderate. The industry outlook is largely dependent on U.S. government funding. However, potential demand for commercial applications and international sales will slightly offset the dependence and a 1.0% annual growth is expected over the next five years. The turbocharger manufacturing industry produces turbochargers that enhance the performance of engines by boosting compressed air in the combustion chamber. Internal competition is moderate dominated by two major companies. Increasing demand for fuel efficiency has increased external competition as new players such as Mitsubishi Heavy Industries try to enter this industry. This industry is expected to grow as future regulations and oil price volatility will demand more fuel-efficient vehicles. Because of the diversity of products and markets, the ACS segment serves the industries that follow. The electronic access control system and the navigational instrument manufacturing industries both manufacture related products in electronics control technology. The electronic access control system industry focuses on card, audio, video or keypad-based access control systems such as smart cards. The navigational instrument manufacturing industry is less focused and produces instruments and controls for appliances, aeronautics, laboratories, testing equipment and navigation and guidance systems. Competition in these industries is high as concentration levels are low. Both industries are expected to grow in the next five years with a forecast of 3.0% and 4.2% annual growth for the navigational instrument and electronic access control system manufacturing industries, respectively. Growth is primarily due to recent corporate spending on research and development, which drives innovation, increase in government consumption, demands from growing emerging markets, increase in construction activity, and new business activity. ACS also serves the pressure sensor, thermocouple, and the thermostat manufacturing industries. ACS is a major player in the thermostat manufacturing industry. This industry manufactures temperature controllers and regulators for a variety of applications. Competition in the thermostat manufacturing industry is moderate with moderate concentration and moderate barriers of entry. Temperature controller and relay technology is standard across the industry pg. 5
and therefore competition focuses mainly on price, quality, reliability, delivery, customer service, product innovation and foreign manufacturing. The need for smarter and energy efficient thermostat technologies will drive industry growth for the next five years. ACS also serves the safety manufacturing industries, which are the personal protective equipment, protective eyewear and respiratory protection equipment industries. These industries produce personal safety equipment such as safety glasses and goggles, gas masks and fall protection equipment among others. Competition in these industries is moderate focused on quality products that will ensure safety to the user. The outlook for these three industries is continued growth, as safety standards will continue to be enforced in all industries. The PMT segment serves the petroleum refining industry, the petrochemical manufacturing industry, the plastic and resin manufacturing industry, and the synthetic fiber manufacturing industry, among others in the U.S. The petroleum refining industry performs fractionation, straight distillation of crude oil and cracking. The petrochemical manufacturing industry produces chemicals derived from petroleum products and liquid hydrocarbons such as ethylene. The petroleum refining industry is continuously competing for the lowest price because household consumers generally base their decisions on product cost. This industry also competes to a lesser extent against international refineries and alternative sources of fuel such as biodiesel and ethanol. The petrochemical manufacturing industry also competes for price in addition to location. The plastic and resin manufacturing and synthetic fiber manufacturing industries produce plastic material such as thermoplastics, and resins such as thermosetting resins, synthetic rubbers, cellulosic fibers, such as rayon, and noncellulosic fibers such as spandex. The petrochemical manufacturing industry also competes for price in addition to location. Outlook for the plastic and resin manufacturing industries is sustained demand as disposable income per capita is expected to increase and unemployment decrease thus increasing demand for manufactured goods. However, the synthetic fiber manufacturing industry is in the declining phase of its industry life cycle. pg. 6
Appendix: Inputs into valuation using multiples 2009A 2010A 2011A 2012A 2013A 2014A 2015F 2016F 2017F Stock price 34 43 55 53 80 94 101 113 126 EPS (basic) 2.06 2.61 2.65 3.74 4.99 5.40 5.43 5.90 6.38 Sales. (Million $) 29,951 32,350 36,529 37,665 39,055 40,306 39,300 40,391 41,518 Shares 753 774 781 782 786 784 784 784 784 Sales per share (basic) 39.80 41.82 46.78 48.14 49.66 51.38 50.10 51.49 52.93 P/E 16.60 16.92 20.36 15.78 15.87 17.39 19.94 20.64 21.24 P/S 1.14 1.37 1.48 1.57 2.03 2.33 2.57 2.81 3.04 * Analyst's own calculations. Source of basic data: company's 10-K; investor conference presentations and webcast; earning release webcast, company s proxy statements; company s website news release; The U.S. China Business Council pg. 7