Honeywell: My Interest Is Perking Up, The Value Is Tempting (NASDAQ:HON)

These are challenging times for multi-industrials, as the Street is starting to accept that short-cycle industrial end-markets may not see the hoped-for recovery in the second half and process end-markets are starting to slow as well. Meanwhile, themes like aerospace seem to be relegated to old news, even though the multiyear revenue and earnings growth potential here is still pretty strong.

In the 18 months or so since I last covered Honeywell International Inc. (NASDAQ:HON) shares of this leading multi-industrial have lagged the broader industrial space, with an 11% gain versus around 22% for the sector. Likewise, specific names like Eaton (ETN), Emerson (EMR), and Parker Hannifin (PH) have all outperformed. Granted, Honeywell’s valuation wasn’t exactly modest and some of this underperformance can be seen as re-rating away from that premium, but it’s underperformance all the same.

I’m a fair bit more interested in Honeywell today. I do still think expectations may be too high for short-cycle markets, but I like the longer-term leverage to aerospace, automation across buildings, factories, and process industries, and material sciences. If 5% long-term revenue growth, high-teens FCF margins, and EBITDA margins approaching 30% in 2028 are all valid assumptions, these shares have some appeal in a sector that doesn’t offer many apparent bargains.

Process Automation Is Holding Up, And Industrial Automation Will Recover

Weak capex across a range of short-cycle markets seems to have caught numerous companies and analysts off guard this year (it was one of my core theses for 2023…), and it has certainly had an impact on players in the market ranging from ABB Ltd. (OTCPK:ABBNY) to Eaton to Honeywell to Siemens (OTCPK:SIEGY) to Rockwell (ROK).

Honeywell isn’t generally thought of immediately as a factory/industrial automation company, and indeed the straight-up comparisons to players like ABB, Rockwell, or Siemens are fairly limited. Still, safety, sending, and workflow automation demand is sensitive to the same shorter-cycle trends, and it has had an adverse impact on the business.

More significant has been the sharp contraction in factory automation. I talked about this in relation to Cognex (CGNX), but after a surge in warehouse construction and automation to facilitate expanded e-commerce, major companies like Amazon (AMZN) have rapidly pulled back on spending. I don’t see much joy here for 2024, but Cognex has mentioned signs of stability and the pain should ease some in the coming quarters (the comps will start getting easier if nothing else).

Looking beyond 2024, automation penetration in warehouses and distribution centers is still relatively low, and I think there is a good runway for Honeywell over the long term. Not only should further re-shoring drive more warehouse/DC activity, I expect some of Intelligrated’s warehouse automation technologies to start making their way to factory floors (helping automate component and product inventory and movement).

I’m more bullish on the process side for the near term, though Honeywell doesn’t have the best mix exposure. Spending from the chemical sector has definitely slowed, and that’s one of Honeywell’s strongest areas, and likewise with pulp/paper. Pharma spending is significantly weaker this year, and Honeywell is a #2 player here behind Emerson. Meanwhile, oil/gas and refining spending seems to be getting pushed into 2025, and these are strong areas for Honeywell. I’d also note that metals/mining and utilities are two of the stronger segments, and Honeywell isn’t as competitive there.

Aerospace Is A Multiyear Driver

Investors have largely moved on from the aerospace theme, and that’s understandable, as I think everyone basically understands the drivers for accelerating narrowbody and widebody production from major OEMs like Airbus (OTCPK:EADSY) and Boeing (BA) over the coming five to 10 years.

That doesn’t mean that it’s not still a relevant driver for Honeywell, though. While Honeywell hasn’t shown quite the same leverage to stronger aftermarket demand as companies like Crane (CR) and Melrose (OTCPK:MLSPF), the company has been logging strong original equipment sales. Moreover, the defense business has really stepped up, and the company has been reinvesting here though M&A, including the recent acquisition of CAES Systems, a leader in high-reliability RF technologies.

Even if the commercial aerospace cycle is well-understood by the Street, I question whether it has been fully priced in, particularly given recent production challenges at Airbus and Boeing. As these production snafus untangle, I think Honeywell will see steady growth and positive incremental margins, and I think there’s underappreciated upside from defense and commercial space.

Active Again In M&A

Honeywell’s tone has shifted over the last year or two back towards a prioritization of growth, and management has gotten more active with M&A. In addition to the aforementioned CAES deal, the company spent $5B on Carrier Access Solutions and its portfolio of commercial access and electronic lock products, $700M on Compressor Controls (turbomachinery controls, with capabilities in areas like carbon capture), and an undisclosed amount on SCADAfence, a cybersecurity company for operational technology (or OT) and industrial control system (or ICS) security.

I like how all of these deals are clearly additive and complementary to Honeywell’s existing technologies and capabilities and fill in gaps. SCADAfence in particular could be an invaluable asset, as I believe industrial cybersecurity is still an area that needs more investment across a range of industries – look at the havoc caused by the recent cybersecurity breach at CDK Global and imagine the shenanigans a breach at a refinery or chemicals plant could cause.

I do expect Honeywell to continue to be active here. I would look for the company to add more sensing, scanning, mobility, and sustainable energy capabilities for Industrial Automation, more control and monitoring for Building Automation, and likely more tuck-ins for defense (particularly more on the electronics/RF side). I also wouldn’t be surprised by green tech/sustainable energy deals for Energy and Sustainability Solutions.

The Outlook

I do still see some downside risk to revenue estimates in 2024, as I don’t think a short-cycle recovery in the second half is as likely as the Street wants to believe. I’d note, too, that the Street has been consistently overestimating the Building and Industrial Automation segments, so there may be some downside risk here. On the flip side, there could be upside with Aviation on improving production schedules and a healthier-for-longer bizjet cycle.

I’m looking for around 5% to 6% revenue growth over the next five years and around 5% growth over the longer term, with all segments contributing meaningfully to that outlook. While Honeywell isn’t directly leveraged to building electrification, the control and automation products in Building Automation are tied into that trend. I’ve explained my feelings on Aviation, and I think Industrial Automation has a long runway of potential growth.

I’m expecting operating and EBITDA margin improvement across the next five years, with margin leverage driven by mix (more services and software), volume leverage in Aviation and once automation demand recovers, and operational improvements. Furthermore, I expect a few years of mid-teens free cash flow margins and gradual improvement toward 20% over time, driving double-digit long-term FCF growth.

Between discounted cash flow and margin/return-driven EV/EBITDA, I get a fair value range of about $220 to $240 for Honeywell. While my forward EBITDA multiple for Honeywell would be around 14.5x all things being equal, all things aren’t equal – Honeywell is in a relatively rare space with above-average operating margins, ROICs, and revenue growth, and companies that check all of those boxes typically get a premium of 100bp-300bp on their multiples (I’m using 100bp).

The Bottom Line

Honeywell isn’t necessarily a screaming bargain, as a fair value in the low $220’s (the low end of my range) is only about 5% above today’s price. Still, there isn’t an abundance of bargains in the quality industrial space today. I do have concerns that the market and the industrial sector may both be at risk of sharper pullbacks, but I do still think Honeywell stands out as a better than average option.

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