Honeywell – I Will Bide My Time Before I Initiate a Position

(Last Updated On: January 5, 2018)

Summary

  • Honeywell is a high quality company worthy of holding as a long-term investment even though it does not have an impeccable dividend history.
  • Honeywell will be spinning off two segments of its business before the end of 2018. Studies suggest spin-offs perform well but that investors must stay the course over the long haul to reap the rewards.
  • When HON provided its 2017 outlook, its PE based on projected adjusted EPS was ~17. That ratio is now closer to ~21.75 and the ratio is ~20 based on FY2018 projections.
  • I fully intend to acquire HON shares but am being extremely cautious given current euphoric market conditions and will bide my time before initiating a position.

Introduction

Some investors restrict their search for investment opportunities to companies with:

  • attractive dividend yields;
  • a lengthy history of consecutive annual dividend increases.

When such search restrictions are set, it is possible to inadvertently overlook great companies worthy of further analysis.

Honeywell International Inc. (NYSE: HON) is one such company.

Company Overview

HON is a diversified technology and manufacturing company with global operations managed through four operating segments.

  • Aerospace;
  • Home and Building Technologies;
  • Performance Materials and Technologies;
  • Safety and Productivity Solutions.

HON’s history can be found here.

Aerospace

This operating segment is a leading global supplier of products, software and services for aircraft and vehicles sold to original equipment manufacturers (OEMs) and other customers in a variety of end markets: air transport, regional, business and general aviation aircraft, airlines, aircraft operators, defense and space contractors and automotive and truck manufacturers. It is also a leading provider of aircraft engines, integrated avionics, systems and service solutions, and related products and services for aircraft manufacturers, and turbochargers to improve the performance and efficiency of passenger cars and commercial vehicles.

In addition, it provides spare parts, repair, overhaul and maintenance services (principally to aircraft operators) for the aftermarket. Aerospace products and services include auxiliary power units, propulsion engines, environmental control systems, wireless connectivity services, electric power systems, engine controls, flight safety, communications, navigation hardware and software, radar and surveillance systems, aircraft lighting, management and technical services, advanced systems and instruments, satellite and space components, aircraft wheels and brakes, repair and overhaul services, turbochargers and thermal systems.

This is HON’s largest operating segment. In fiscal 2014 – 2016 , sales from this segment accounted for ~39% of total HON revenue and when Q3 2017 results were released in October 2017, HON projected this segment would generate roughly ~36.5% of total 2017 revenue.

Sales to commercial aerospace OEMs were ~7% in fiscal 2014 – 2016 and sales to commercial aftermarket customers of aerospace products and services were ~11.5% during the same period.

HON’s sales to the U.S. Government (principally by Aerospace), through various departments and agencies and through prime contractors, amounted to ~$3.5B/year in fiscal 2014 – 2016.

Home and Building Technologies (HBT)

This segments is a leading global provider of products, software, solutions and technologies that help owners of homes stay connected and in control of their comfort, security and energy use; enable commercial building owners and occupants to ensure their facilities are safe, energy efficient, sustainable and productive; and help electricity, gas and water providers supply customers and communities more efficiently.

The products and services include controls and displays for heating, cooling, indoor air quality, ventilation, humidification, combustion, lighting and home automation; advanced software applications for home/building control and optimization; sensors, switches, control systems and instruments for measuring pressure, air flow, temperature and electrical current; products, services and solutions for measurement, regulation, control and metering of gases and electricity; metering and communications systems for water utilities and industries; access control; video surveillance; fire products; remote patient monitoring systems; and installation, maintenance and upgrades of systems that keep buildings safe, comfortable and productive.

Performance Materials and Technologies (PMT)

PMT develops and manufactures advanced materials, process technologies and automation solutions.

The UOP division provides process technology, products, including catalysts and adsorbents, equipment and consulting services that enable customers to efficiently produce gasoline, diesel, jet fuel, petrochemicals and renewable fuels for the petroleum refining, gas processing, petrochemical, and other industries.

The Process Solutions division is a pioneer in automation control, instrumentation, advanced software and related services for the oil and gas, refining, pulp and paper, industrial power generation, chemicals and petrochemicals, biofuels, life sciences, and metals, minerals and mining industries.

The Advanced Materials division manufactures a wide variety of high-performance products, including fluorocarbons, hydrofluoroolefins *, specialty films, waxes, additives, advanced fibers, customized research chemicals and intermediates, and electronic materials and chemicals.

*Hydrofluoroolefins are unsaturated organic compounds composed of hydrogen, fluorine and carbon. These organofluorine compounds are of interest as refrigerants. Unlike traditional hydrofluorocarbons (HFCs) and chlorofluorocarbons (CFCs), which are saturated, HFOs are olefins, otherwise known as alkenes.

Safety and Productivity Solutions (SPS)

SPS provides products, software and connected solutions to customers around the globe that improve productivity, workplace safety and asset performance.

Safety products include personal protection equipment and footwear designed for work, play and outdoor activities.

Productivity Solutions products and services include gas detection technology; mobile devices and software for computing, data collection and thermal printing; supply chain and warehouse automation equipment, software and solutions; custom-engineered sensors, switches and controls for sensing and productivity solutions; and software-based data and asset management productivity solutions.

Competition

Some of HON’s major competitors by operating segment are:

  • Aerospace: Borg-Warner (automotive), Garmin, General Electric, Rockwell Collins, Thales and United Technologies
  • HBT: Emerson Electric, Itron, Johnson Controls, Schneider and Siemens
  • PMT: Albemarle, BASF, Dow, Dupont, Emerson and Sinopec
  • SPS: 3M, Mine Safety Appliances, Kion Group, TE Connectivity and Zebra Technologies

2017 Financial Guidance

On October 20, 2017, HON released its Q3 2017 results and provided full year guidance. The following is a snapshot of what was communicated by HON.

Source: HON October 20, 2017 Q3 2017 Earnings Release

An update was subsequently provided December 13, 2017.

Source: HON December 13, 2017 2018 Outlook presentation

2018 Spin-Offs

After a thorough review of HON’s multiple businesses, an announcement was made in October 2017 that the Transportation Systems and the Homes and Global Distribution businesses would be spun off no later than December 2018 into separate publicly traded entities.

The key assessment criteria used in the portfolio review process was:

  • Market attractiveness and growth potential;
  • Technology trends and prospects for disruption;
  • Competitive position and financial performance of each business;
  • Ability to realize synergies from Honeywell Operating System, Technology strengths and global scale;
  • Capital requirements and investment returns versus other portfolio options.

Source: HON October 10, 2017 Portfolio Update presentation

FY2018 Outlook

On December 13, 2017, HON provided its outlook for fiscal 2018.

Source: HON December 13, 2017 2018 Outlook presentation

Dividends, Dividend Yield, and Dividend Payout Ratio

HON’s dividend history dating back to 2002 can be found here.

Readers will note that HON held its 2003 and 2004 annual dividend at the same level as in 2002. In addition, HON held its 2010 annual dividend at the same level as in 2009. As a result of this spotty dividend history some investors may be reluctant to invest in HON.

Furthermore, HON’s current sub 2% dividend yield based on the current $154.50 stock price will likely dissuade many investors from investing in HON.

In my opinion, this would be a mistake. Even if we disregard the $0.6636 ‘special dividend’ paid in 2016, HON’s dividend compound annual growth rate amounts to ~9%.

Readers can also take comfort that HON’s dividend payout ratio is typically in the high 30% – low 40% of the Earnings per Share (EPS) range. This leaves management with ample flexibility to continue to increase the dividend.

Effects of Spin-Offs

In 1997, Joel Greenblatt published You Can Be a Stock Market Genius, in which he explained why spinoffs as a group trounce the broader market.

In November 2017, Monish Pabrai, a highly respected investor, revisited this study and analyzed the impact of spin-offs in 2000 – 2017 (‘The Spin-Off Portfolio’). The findings from this recent analysis indicated that investing in The Spinoff Portfolio during this timeframe required resilience and is not for the faint-hearted. In fact, the Spinoffs lost more than 25% of their value in 2007 versus a 5.5% gain by the S&P 500. While the Spinoffs ultimately triumphed, The Spinoff Portfolio underperformed the S&P 500 in 7 of these last 18 years thus reaffirming the importance of staying the course over the long haul to reap the rewards.

Interestingly, The Spin-Off Portfolio did not include the Broadridge Financial Solutions (NYSE: BR) and CDK Global (NASDAQ: CDK) spin-offs from Automatic Data Processing (NASDAQ: ADP). Both BR and CDK are companies in which I received shares as I owned shares in ADP when these entities were spun off in 2007 and 2014, respectively. I still own shares in all 3 entities and they have performed extremely well.

Naturally, not every spin-off will work out well as evidenced from the results of The Spinoff Portfolio study. You need to be patient. Having said this, I like spin-offs because:

  • Conglomerates have the complexity of owning and operating multiple different businesses units. Markets and investors generally favor pure play companies focused on one core business.
  • Many spinoffs are spun off to realize their full value since subsidiaries are usually undervalued when merged with the parent company.
  • Spinoffs have a smaller market capitalization compared to the parent. As a result, some fund managers must sell shares of spinoffs once received because their funds’ mandate is to invest in large-cap companies. This typically places downward pressure on the spun-off company’s share price shortly after the spin-off.
  • Generally, the new board of directors and the management team own a stake in the spinoff. Since they are largely compensated based on equity incentives tagged to the performance of the new spinoff, it is in their best interest to ensure the spinoff performs well.

Valuation

Management has forecast adjusted EPS of $7.10 for FY2017. Based on the $154.50 closing stock price on January 4, 2018, the current adjusted PE ratio is ~21.75.

When HON provided its 2017 outlook on December 16, 2016, its projected adjusted EPS range was $6.85 – $7.10. At the time, HON’s shares trading at ~$117. Using these figures, the adjusted PE ratio was in the 16.5 – 17 range.

Source: HON December 16, 2016 2017 Outlook presentation

Furthermore, the December 16, 2016 Outlook presentation called for $4.6 – $4.7B in Free Cash Flow. This is the same range HON communicated in its October 20, 2017 Q3 2017 Earnings release. No change but the adjusted PE ratio has risen!

In December 2017, HON has projected FY2018 adjusted EPS of $7.55 – $7.80. Using this range and the current $154.50 closing stock price, we arrive at a projected adjusted PE ratio range of 19.8 – 20.46 for FY2018. This is also higher than recent historical levels; I am excluding the period in which we experienced a Financial Crisis for purposes of this comparison.

Honeywell – Final Thoughts

I view HON as a very high quality company and I certainly do not discount the value of quality. Having said this, I sense a level of irrational exuberance amongst many in the investment community. At some stage of the game, I suspect there will be some event(s) which will trigger a stampeded to the exists and HON, like so many other companies, will get caught in the downdraft; I have no idea when there will be a pullback but I strongly suspect one will occur before HON spins off the Transportation Systems and the Homes and Global Distribution businesses.

As a result, I am in no hurry to initiate a position in HON.

In the immortal words of Warren Buffett:

“The trick in investing is just to sit there and watch pitch after pitch go by and wait for the one right in your sweet spot. And if people are yelling, ‘Swing, you bum!,’ ignore them.”

I wish you much success on your journey to financial freedom.

Thanks for reading!

Note: I sincerely appreciate the time you took to read this post. As always, please leave any feedback and questions you may have in the “Contact Me Here” section to the right.

Disclaimer: I have no knowledge of your individual circumstances and am not providing individualized advice or recommendations. I encourage you not to make any investment decision without conducting your own research and due diligence. You should also consult your financial advisor about your specific situation.

Disclosure: I do not currently own shares in HON and do not intend to initiate a position within the next 72 hours.

I wrote this article myself and it expresses my own opinions. I am not receiving compensation for it and have no business relationship with any company whose stock is mentioned in this article.