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Honeywell Continues to Deliver the Kind of Performance We Expect From This Wide-Moat Gem
Honeywell Continues to Deliver the Kind of Performance We Expect From This Wide-Moat Gem
Analyst Note | by Joshua Aguilar Updated May 01, 2022
Wide-moat-rated Honeywell had a solid first quarter, and nothing in its latest results alters our long-term view of the firm. Furthermore, nothing in the first-quarter print caused us to make much in the way of adjustments to our near-term assumptions. This was welcomed given all the supply chain disruptions plaguing the broader industrial sector, and we think it speaks to Honeywell’s ability to execute on its targets both in good and tough times. We raise our fair value estimate by $1 to $231, but that’s exclusively due to time value of money. We now expect $36.3 billion in sales, $8.72 in adjusted EPS, and $5 billion in (unadjusted) free cash flow for full-year 2022. Further, we continue to believe that Honeywell is among the premier multi-industry firms in our global coverage.
During the first quarter, Honeywell increased organic sales by 1%, which was at the top end of the guidance range for the year, but would have been up 3% when excluding the impact of respirator sales. Clearly, the declining mask sales is a byproduct of waning COVID cases in the U.S after peaking mid-January. Additionally, adjusted EPS of $1.91 exceeded the top end of prior guidance, which was also nice to see given all the raw material and logistics inflation the company and broader category faces. That said, strong price realization allowed Honeywell to stay ahead of the inflation curve, a testament to Honeywell’s pricing power based on the strength of its intangible assets.
While organic sales marginally improved, orders managed to grow 13%, including long-cycle order growth of over 20%, which was led by aerospace, process solutions projects, and warehouse automation. Clearly demand is strong as Honeywell’s book/bill rates have been strong, exceeding 1 times for the past six quarters.
Business Strategy and Outlook | by Joshua Aguilar Updated May 01, 2022
Honeywell is one of the strongest multi-industry firms in operation today. We think the firm has successfully pivoted to capture multiple ESG trends, including the need to drive energy efficiency, reduce emissions, and e-commerce, among others. We predicate our thesis mostly on a) increased demand for warehouse automation solutions; b) new digital offerings that promote data analytics in powerplants, as well as remote security management, and energy savings in building solutions; c) an increasingly automated world in mission critical end-markets like life sciences. Over the next five years, we think Honeywell is capable of mid-single-digit-plus top-line growth, incremental operating margins in the low-30s, low-double-digit adjusted earnings per share growth, and free cash flow margins in the midteens.
We believe Honeywell is capable of meeting our assumed targets through a combination of portfolio refreshes, powerful new product introductions, breakthrough initiatives, and strategic partnerships in areas where the firm has domain expertise, a focus on high growth regions that'll help the firm grow faster than its core markets, continuous improvement initiatives centered on fixed cost reduction, on-time delivery and simplified design, supply chain automation, and an increasing shift toward software with a recurring revenue stream. In our view, Honeywell was wise to continue investing aggressively during the height of the pandemic, which we think will reward the firm with share gains.
Despite appreciable headwinds in about 40% of Honeywell's portfolio from the pandemic, in some ways, we believe COVID-19 has only accelerated the need for automation, particularly in warehousing given the strong secular trend toward e-commerce. Many of Honeywell's automation solutions offer customers meaningful ROI payback in a truncated period of time. Furthermore, we think Honeywell is strongly positioned to lead in carbon capture given its large installed base and investments in solvents.
Finally, Honeywell's early stage investments like quantum computing represent a leapfrog in technology, and we think they have multiple use cases in fast growing industries like cybersecurity.
Economic Moat | by Joshua Aguilar Updated May 01, 2022
We view Honeywell as one of the highest-quality companies in the diversified industrials space and assign the firm a wide economic moat. We attribute this rating primarily to intangible assets and switching costs, and secondarily to cost advantage. Over a normalized cycle, which includes 10-year historical figures and our explicit five-year projections, we estimate that Honeywell earns about a 19% to 20% return on invested capital, inclusive of goodwill, or about 11 percentage points above our weighted average cost of capital of 8.5%. Furthermore, in none of these historical years, including the global financial crisis in 2008 nor the pandemic-induced recession of 2020, did Honeywell's ROIC ever fall below our estimated cost of capital. As such, we have a high degree of confidence in Honeywell’s ability to generate excess returns 10 years into the future, and believe it is more likely than not it will continue to do so 20 years into the future.
Key to Honeywell carving a wide moat, in our view, is the firm’s increasing ability to leverage its software technology across its massive industrial installed base. This software technology is integrated into both mission-critical operations, as in cockpit control during commercial aircraft flights, and in customer operations, through diverse offerings like warehouse automation in factories or connected solutions in buildings.
In our opinion, aerospace is Honeywell’s widest-moat business, both from a qualitative installed base perspective, and from a quantitative returns-based perspective.Importantly, the segment has maintained outperformance even through periods of top-line contraction, which increases the confidence in our rating. Furthermore, Honeywell boasts one of the largest installed base in the industry, including over 36,000 auxiliary power units, 25,000 engines, 20,000 wheels and brakes, 20,000 flight management systems, over 100 connected offerings, and over 10,000 units of satellite communication hardware.
Aerospace is traditionally a razor-and-blade model. To beat competitors selling the razor and ultimately add to the installed base, Honeywell relies on its intangible assets. Specifically, these include superior technology, know-how, its long record of success, customer relationships, and to a lesser extent, patents. We think its superior technology stems from research and development, which we estimate represents about 4.5%-5% of the segment’s sales, is appreciably larger than at most other diversified industrials across our coverage (which on average, spend about 2%-3% of sales).
Honeywell’s R&D expense as a proportion of sales, however, undersells the benefit Honeywell derives from R&D endeavors. The firm also gets a lift from its government relationships, primarily with the U.S. government. We consider the U.S. government relationship vital when coupled with Honeywell’s long record of success, such as its historic contributions to American spaceflight. The U.S. government typically adds an additional 50% to the firm’s R&D investment, funding Honeywell’s total spend of just over 7% of its annual sales. In other words, Honeywell gets the sales benefit from this research without having to incur the additional expense. Because of its R&D efforts and technical know-how, Honeywell has virtually shut out other competitors in awarded contracts for avionics (aviation electronics), auxiliary power units, and mechanical systems (for example landing gear) since 2013. Over the 10 years (from 2008 to 2017), Honeywell captured a 35% increase to its aircraft installed base. From 2018 to 2022, the firm anticipates it will have 2.7 times the amount of avionics, 2.1 times the amount of auxiliary power units, and 1.5 times the amount of mechanical systems on new aircraft deliveries relative to its competitors, based on awarded platforms.
Relatedly, switching costs are strongly associated with higher-margin aftermarket sales. Aftermarket sales can broadly be broken down into two subcategories--the conventional aftermarket, the blade in the razor-and-blade model, which is tied to traditional flight-hour service contracts for maintenance, repair, and overhaul--as well as decoupled offerings, which break away from the traditional razor-and-blade model and relate more to discretionary spending customers make for aircraft upgrades. For either model, we think Honeywell benefits from switching costs given its equipment’s strong integration into customers’ airframes and landing systems. For the conventional aftermarket, the additional installed base has allowed Honeywell to have 30% more content per aircraft, and an increased share of maintenance service contracts, providing the firm with an annuitylike revenue stream. The firm’s decoupled offerings have high switching costs given they perform tasks associated with a high cost of failure. These include in-flight health monitoring via satellite communication and landing assistance software.
We think performance materials and technologies, or PMT, is another wide-moat segment. We think this segment benefits both from intangible assets thanks to superior technology, regulatory barriers, and intellectual property, as well as switching costs from recurring revenue in aftermarket services. PMT is a mix of three business lines with large installed bases, including universal oil products, or UOP, which sells catalysts and adsorbents to the oil and gas industry, process solutions, which sells industrial software solutions, and advanced materials, where it sells fluorine products like its Solstice molecule, as well as chemicals and polymers. The firm’s acquisition of Elster, which partially folded into PMT in 2015, for example, gave it access to 200 million utility metering modules in portions of the U.S. and Europe, deployed over 10 years prior to its IPO in 2010. Honeywell is rapidly transforming this industrial installed base and overlaying it with software and data analytics on the heels of energy efficiency initiatives and mandates. We suspect that this will benefit Honeywell by allowing it to stay a step ahead of its competitors through enhanced visibility over its installed base. Our best quantitative evidence of switching costs from the segment’s installed base, given its exposure to the oil and gas industry (at nearly 50% of revenue), is its ability to turn a profit even during large drops in the price of oil. During 2015-16, segment profits grew 14% even as the price of oil dropped by 55%, all while PMT maintained larger margins than peers.
For the segment’s intangibles, we think the forest matters more than the trees, but believe the Solstice molecule represents a good example of the firm’s know-how and research and development efforts put into practice. This is a duopoly business with Chemours. The Solstice molecule is a chemical compound used in a variety of cleaning and aerosol applications--specifically medical, metal, and electronic applications--that complies with high safety and environmental standards but is as effective as hydrofluorocarbons. Moreover, Solstice remains a liquid for an extended period compared with alternatives, given its low boiling point but high heat of vaporization. Additionally, the Solstice molecule’s unique properties give it a low surface tension but a high degree of solvency, allowing it to clean tight spaces. Importantly, it is the only U.S. Environmental Protection Agency-approved product designed for use in machine flushing operations in HVAC and refrigeration cleaning. While this product may seem imitable given sufficient resources, according to Reuters, Honeywell began developing HFC alternatives as far back as 2000 and committed $900 million total to this research effort. The environmental impact is also minimal relative to HFCs, with a global warming potential of less than 1 versus 1000 for HFCs.
As for the building technologies segment, we believe it merits a wide moat. We think the same moat sources are at work with a connected installed base created by intangible assets like superior technology offerings, valuable relationships with contractors, and a well-regarded reputation from over 100 years of operations, followed by recurring revenue on the heels of aftermarket service requirements indicating switching costs. Additionally, building technologies has moved away from single product sales to an ecosystem of smart commercial products. Unlike winner-takes-all markets, we believe the commercial device market is one where a few players can thrive playing in the same sandbox. Honeywell’s building technologies integrates functions with high risks of failure, like security and fire monitoring, with other critical business operations, like energy usage and climate control. These solutions have the added benefit of alerting customers in the event of occurrences like power outages or maintenance needs, which provide the segment with additional recurring revenue (for example alarm monitoring or service dispatch in the event of alarm).
Additionally, we think safety and productivity solutions, or SPS, has a narrow moat, even as we believe it offers the conglomerate the most promising sales growth prospects. While we see the same moat sources in play as in the rest of Honeywell’s segments, we assign a narrow-moat rating because: (1) just over half of SPS’ revenue base is in new markets with a less certain future, given earlier life cycles; and (2) service revenue only constitutes about 5.5% of segment revenue (compared with a midteens percentage mix for HBT and PMT, or 30%-plus for aerospace). These early-cycle products and services include the firm’s warehouse automation offerings, for example. Specifically, warehouse automation refers to automating a variety of aspects of repetitive and error-prone operations, from storage and retrieval to software systems. Warehouse automation is one of the last frontiers where companies can significantly reduce their long-term manufacturing costs. According to St. Onge, only about 5% of warehouses are automated in the United States. This market is still fragmented but is increasingly consolidating, and we’re convinced Honeywell strengthened its competitive position and will remain on top after its acquisition of Intelligrated, a top robotics company that will fit well with Honeywell’s previously limited handheld and voice recognition portfolio. The other portion of the SPS includes more old-world products, which we consider moatier given their comparably greater history of excess returns, including personal protective equipment and high-risk safety equipment that depends on intangible assets--specifically, brand recognition and a reputation for reliability.
Finally, we think Honeywell at the conglomerate level benefits from cost advantage due to economies of scale, specifically due to a common IT stack that stores massive amounts of data and a shared platform of data analytic tools through Honeywell Forge.
Fair Value and Profit Drivers | by Joshua Aguilar Updated May 01, 2022
Following first-quarter results, we raise our Honeywell fair value estimate by $1 to $231 due exclusively to time value of money. Honeywell had a solid quarter, which was nice to see given all the supply chain disruptions plaguing the broader industrial sector, and we think it speaks to Honeywell’s ability to execute on its targets both in good and tough times. We now expect $36.3 billion in sales, $8.72 in adjusted EPS, and $5 billion in (unadjusted) free cash flow for full-year 2022. Strong price realization allowed Honeywell to stay ahead of the inflation curve, a testament to Honeywell’s pricing power based on the strength of its intangible assets. Our 2022 projections imply a free cash flow conversion of over 85% in a trough year and free cash flow margins of just under 14%.
Longer-term, we still believe Honeywell is capable of driving mid-single-digit-plus organic top-line growth over the next five years given multiple vectors in higher-growth opportunities. We think the firm is well positioned to capture long-term secular trends, like emission reductions, energy efficiency and savings, the energy transition, and e-commerce, among others. We value Honeywell at about 26.5 times our 2022 adjusted EPS estimate of $8.72.
From 2021 to 2025, we expect segment profit (non-GAAP) margin expansion of over 60 basis points per year based on supply chain automation, simplified design, and additional digitization, adjusted EPS growth at a low-double-digit CAGR, free cash flow conversion over 90%, and Honeywell hitting a 24% segment profit margin in 2026 (meaning its 25% aspiration will come after our explicit forecast).
To get to our figures, the most meaningful movers from a contribution and high-growth outlook include increasing automation sales in both the process and warehouse industries given significant "white space" due to macro factors like wage inflation, worker safety concerns, customer production costs and the need to drive better throughput, and so forth, as well as new product and breakthrough initiatives that are additive to Honeywell's core building offerings, which are driven by general commercial construction trends. Additionally, we think Honeywell is well positioned in its carbon capture efforts given its expertise in solvents, and we still expect its Solstice molecule and other legacy offerings will continue to drive above-market refrigerant growth in end markets like the auto sector.
Risk and Uncertainty | by Joshua Aguilar Updated May 01, 2022
We assign a medium uncertainty rating to Honeywell, with a greater level of uncertainty to the upside given the firm’s increasing exposure to software offerings.
Raw material inflation can have an impact on its cost inputs, which may be difficult to offset with increased pricing in certain markets. Aerospace, furthermore, is a long-cycle business that can have a prolonged downturn period depending on global demand for air travel, as well as military defense spending, which can face headwinds like sequestration threats in the United States. Home and building technologies, moreover, faces headwinds in the event of a slowdown in global residential and commercial construction, and performance materials and technologies faces similar prospects with downturns in the oil and gas market. That said we’re less concerned about normal ebbs and flows of the macro environment, given that Honeywell’s business is split 60/40 between operating expenditure and capital expenditure cycles.
In SPS, the biggest concern we have includes rapid changes in technology, which can obviate the impact of some of Honeywell’s software investments and translate into diminished returns on capital projects relative to the firm’s expectations. In the near term, the biggest risk is the fallout related to the global coronavirus pandemic on Honeywell's aerospace business, as well as the drop in the price of oil per barrel to well below what we saw in the industrial recession, and its effect on Honeywell's PMT segment.
Finally, ESG risks we flag include legacy site environmental liabilities, asbestos liabilities, a Foreign Corrupt Practices Act investigation by the U.S. Department of Justice related to UOP's former third-party contractors in their dealing with Petrobras, and any potential embargo from the sale of defense systems. Of these, we think the biggest risk comes from asbestos and environmental liabilities, but these are known and baked in to all three scenarios of our model.
Capital Allocation | by Joshua Aguilar Updated May 01, 2022
We assign Honeywell’s management an Exemplary capital allocation rating based on its sound balance sheet, exceptional investments, and appropriate shareholder distributions. The firm has one of the strongest balance sheets in our coverage, with a net debt to EBITDA level that typically runs below 1 times. Second, we commend management for making promising growth capital expenditures investments at the height of the pandemic to take share from competitors. We expect the firm will earn significant economic profit from these investments. Finally, we like management's disciplined M&A process and its unwillingness to overpay for growth.
After a multiyear search, Darius Adamczyk was selected as president and CEO of Honeywell on March 2017 after serving for a year as COO. Adamczyk was also elevated to Honeywell chairman on April 2018. Our stewardship rating extends beyond one individual but also emphasizes our positive impression of Honeywell’s corporate governance. Specifically, we were impressed by the board’s thoughtful selection process identifying Adamczyk. That selection process began with identifying desired talent attributes and potential candidates for the role a decade ago. Over time, Honeywell placed potential leaders in increasingly important positions of responsibility, and spoke with retired executives from successful competitors.
Adamczyk also impressed us at the Electrical Products Conference when he spoke and declared “war on fixed costs," which the company has focused on through its "power of one" plan that aims to reduced net fixed costs at 1% per year. We expect him to continue enacting restructurings to make Honeywell's costs increasingly variable-based. Adamczyk’s words are backed by a long record of results. He immigrated to the U.S. from Poland at the age of 11 without speaking English. Even so, he still managed to graduate with an MBA from Harvard and begin his career as an electrical engineer at General Electric. During his tenure at scanning and mobility, sales doubled from 2008 to 2012 and margins expanded an astounding 12 points. In process solutions, Adamczyk oversaw 550 basis points of margins expansion by revamping the new product introduction process and adding margin-accretive software solutions. Finally, in PMT, Adamczyk was able to expand margins during an oil and gas market downturn by diversifying the portfolio and aggressively monitoring costs.
Adamczyk’s record of success has extended to his current role. While in the short term, the market is often a poor barometer of success, in this instance, we think the stock’s rise has been justified since his installation. Adamczyk has been diligent about buying back shares of stock which we've approved of given periods of undervaluation. We endorse his decision to repurchase at least $4 billion in shares since the stock trades at a 15% discount to underlying value as of April 2022.
We also think Adamczyk responded incredibly rationally to outside pressure from activist investors, which tested him early during his tenure. We point to Third Point’s call to spin off aerospace, which we have long viewed as the firm’s moatiest segment. Activists often call for spinoffs and pressure under the rationale that near-term volatility weighs down multiples, and ultimately, shareholder returns. While we’ve agreed with Third Point in the past and acknowledge spinoffs can sometimes serve as positive catalysts to help close the gap between price and value, we think it's management's job to figure out over the long term whether business declines are secular or cyclical, if they ultimately fit in with a conglomerate’s strategic goals, and if keeping or separating a business ultimately adds or detracts to returns on capital.
After a comprehensive portfolio review, management responded by announcing its intent to spin off two business units in homes (Resideo) and transportation (Garrett). We agreed with management's response given that our fundamental analysis revealed that aerospace is a long-product-cycle business that has consistently provided high returns on invested capital, including goodwill of 30%-plus. That said, from a strategic standpoint, it made sense to us that Honeywell spun off its automotive turbo technologies unit, given that it never really fit in with the rest of the aerospace segment.
Finally, while some corners of the market have pressured Honeywell to find bolt-on M&A opportunities to supplement some of its future lost sales, we like Adamczyk's discipline given the prior rich multiple environment. Most M&A acquisitions are invariably value-destructive, and if prices are too high, we would rather Adamczyk continue to buy back shares, or in the alternative, increase its dividend, as it did for the 11th straight year in 2020. Assuming the price is right, we support Adamczyk’s efforts to add to Honeywell’s software-industrial offerings inorganically, particularly those exposed to strong secular trends like e-commerce and clean energy.